Delta: Building a
“durable” business model Jan/Feb 2017

In recent years, Delta has beaten its US legacy carrier peers handsomely on all financial fronts, be it profit margins, ROIC, debt reduction or returning capital to shareholders. Its financial metrics rank among the top 10% of S&P industrials and it now has investment grade credit ratings. Yet, Delta’s stock market valuation suggests that investors still view it as a relatively risky proposition.

At Delta’s mid-December investor day, its top executives argued that Delta’s share price should be 90-130% higher than the current level (around $50) if it was valued at multiples of what they called “high quality industrial transports” or HQITs (nine US companies, including FedEx and UPS).

The valuation gap exists because many investors still view airlines as highly cyclical and prone to damaging price wars. They remember the sector’s pre-2010 capacity expansion, market share battles and decade-long financial losses.

It does not help that Delta, like its peers, has seen unit revenues fall every month since November 2014. Delta is seeing steep labour cost escalation just as fuel prices are on the upturn, and its profits are expected to decline in 2017.

This is a theme that is playing out across the industry. Cost increases are outweighing improving unit revenue trends, resulting in margin deterioration. IATA predicted in December that North American carriers would see their aggregate net profit fall by 11% to $18.1bn in 2017.

Investor perception has improved, though, as US airline profits have surged in the past two years following sector consolidation and Chapter 11 restructurings. Evidence of that includes the gradual broadening of US airlines’ investor base and the return to the sector of high-profile firms such as Warren Buffett’s Berkshire Hathaway.

Delta’s key message at the investor day was that, despite the 2017 challenges, the past two years’ strong margins, returns and cash flows are sustainable in the long term.

The presentation focused on three themes: the importance of unit revenue growth, the sustainability of current performance thanks to various strategies, and Delta’s ability to achieve its long-term targets.

Importantly, Delta is on the verge of returning to PRASM growth — expected in the first quarter of 2017. To ensure the trend continues, Delta is capping this year’s system capacity growth at 1%. CEO Ed Bastian said that strict capacity discipline would continue “until we get our margins back to where they need to be”.

The management talked about building a “durable” business model with the help of more diversified revenue streams, greater productivity and a solid investment-grade balance sheet.

They stressed the importance of maintaining a strong brand, with “best-in-class customer satisfaction and highly engaged employees”.

And disciplined capital investment is also important, because it enables long-term earnings growth without burdening the business with high leverage.

Delta is portraying 2017 as a “transition year”, during which it will get its unit revenues “back in line” to offset the cost pressures. It remains committed to a long-term operating margin target of 17-19%.

However, to keep things in perspective, Delta is still projecting a healthy 15-16% operating margin for 2017 — only 1-2 points below the long-term target range.

The pertinent question is whether 15-16% margins become the new normal in a higher fuel cost environment or Delta will be able to tweak the margins back up with the help of new revenue initiatives.

Delta is a leader in segmentation and ancillary revenue strategies. What’s next for the branded fares? Could Delta soon be perceived as an Amazon-type, one-stop shop for every kind of travel need?

Another interesting question is where Delta will make its next foreign airline investments. Delta has big plans with Aeromexico in 2017 and something in the works with Korean Air. How will it develop those partnerships? And how exactly is Delta sharing best practices with its partners?

Returning to positive PRASM

US airline investors have been obsessed with the unit revenue metric since the spring of 2015. Although airline managements feel that it is more appropriate to focus on profit margins, the new labour and fuel cost pressures have meant that suddenly everybody is intensely focused on PRASM. CEO Ed Bastian calls it Delta’s “number one financial priority”.

Delta had expected its system PRASM trend to turn positive in mid-2016, but that did not happen because low fuel prices, a stronger dollar, geopolitical shocks and domestic competition exerted further pressure on yields. In particular, domestic business yields remained extremely soft.

But, strangely enough, immediately after the US presidential election air travel demand picked up and business travel yields improved dramatically. Delta reported flat system PRASM for December, which was better than expected.

Delta’s planned 1% system ASM growth this year will be made up of 2% growth domestically and a 1.5% decline internationally.

Latin America was Delta’s first region to see PRASM growth in Q3 2016. The turnaround was led by Brazil, which continues to see high-double digit unit revenue increases. This year’s planned 1% Latin ASM growth targets the relatively healthy Mexican and Caribbean markets while returning capacity to Brazil.

The Pacific entity remains a challenge because of excess industry capacity, though Delta believes that PRASM there will turn positive by the summer. The plan is to reduce Pacific capacity by 6% in 2017 and to rely more on airline partners in China and Korea.

Delta’s Tokyo operations continue to see structural change. Less than 50% of the carrier’s Asian services are now via Tokyo, compared to 100% 7-8 years ago; and the operation is split between the two Tokyo airports. Delta hopes eventually to focus all of those operations on Haneda, which may be possible with further Haneda liberalisation in the run-up to the 2020 Tokyo Olympics.

The transatlantic revenue environment also is difficult because of continued currency headwinds, demand issues and industry capacity growth by LCCs and the super-connectors. It is a tough winter in a highly seasonal market.

Delta was earlier believed to be considering specific moves to counter the growing LCC threat on US-Europe routes, but at the investor day the executives merely made the point that the LCC effects were “probably the least impactful to the Atlantic in the short run”, with currency movements and demand being more relevant issues. However, Delta subsequently disclosed in early January that it would introduce its Basic Economy (a domestic fare type targeting LCCs) to all international markets, including the transatlantic, during the second half of 2017.

Delta is expecting robust US-originating summer demand to Europe due to exchange rate developments. It is keeping its transatlantic capacity roughly flat in 2017, relying more on its European hub partners and hoping to capitalise on a strong summer.

The transatlantic remains Delta’s most profitable international region. It has been able to sustain a “15% all-in margin” on US-Europe routes even in the current environment, in large part thanks to strong airline partnerships that have given it hubs in London, Paris, Amsterdam and Rome.

Delta believes that the Pacific, its least profitable region, will also achieve a modest profit in 2017. The Latin region is in the middle, performing quite well with low-double digit profit margins.

Customer experience matters

Delta achieves a revenue premium to the industry. By its estimate, its PRASM was 109% of the industry average in 2016, up from 97% in 2005.

Delta attributes the revenue premium to being “more and more appreciated” by its customers. One way to measure that is the Net Promoter Score (NPS), a simple metric that asks passengers: “Do you prefer us or not?” Delta’s domestic NPS surged to an industry-leading 40.2% in 2016. “Higher NPSs are highly correlated to higher revenue production and higher profits”, Delta executives noted.

Operational integrity and friendly/engaged employees are among the top criteria influencing customer perception of an airline. At Delta, both operational performance and employee satisfaction are at all-time highs. The latter reflects an industry-leading profit-sharing programme (which paid out $1bn for 2016) and a policy to maintain industry-leading or top-tier pay rates.

Product improvements are important. Delta strives to offer products and services that customers value and want to purchase. IdeaWorks recently named it one of the world’s top five airline revenue innovators for 2016.

The IdeaWorks report noted that Delta had broken ranks with its peers by “investing a healthy $50m of the revenue windfall from bag fees to actually improve service for the customer”. Delta now attaches RFID tags to all checked bags so that passengers can track the whereabouts of their bags via a mobile app.

Delta says that it has initiatives in place for 2017 and beyond to sustain and improve the domestic revenue premium. On the product front, it has introduced Branded Snacks and is experimenting bringing food back to the main cabin in some transcontinental markets.

This year’s highlight will be the introduction of the A350-900 and a new all-suite international business class product on the Pacific, where Delta currently has a relatively low NPS score.

Other customer-friendly fleet moves include replacing MD-88s with new A321s and 737-900ERs, reducing reliance on 50-seat regional jets and ordering the CSeries (from 2018).

Projects in the works to improve the airport experience include a $10bn redevelopment project at LaGuardia (mostly funded by local authorities), consolidating two terminals at LAX (for easy international-domestic transfers) and new flagship Sky Clubs in Seattle and Atlanta.

Maintaining lead in segmentation

Delta pioneered Basic Economy in 2014 — a domestic no-frills fare type that American and United, too, are introducing this year (see the November 2016 and December 2016 issues of Aviation Strategy).

But Delta is determined to maintain its lead in segmentation. First, it plans to complete the domestic rollout of its Basic Economy by mid-2017 (currently only available in 40% of US markets). Delta expects to have a competitive advantage at least over United’s Basic Economy, which is somewhat more restrictive.

Second, Delta is introducing a new fare type: Premium Select. As a result, it now offers five products in the domestic market: First Class, Premium Select, Comfort+, Main Cabin and Basic Economy.

Third, there is scope to improve distribution; the different classes of service are not yet available in all distribution networks. Fourth, there is scope to improve revenue management.

Delta’s so-called branded fare revenues have increased from $900m in 2014 to $1.4bn in 2016 and are projected to grow to $2.7bn in 2019. There are many new initiatives in the pipeline as Delta believes that it is “in the early innings of this kind of customer segmentation and that this will deliver significant shareholder value over the next 3-5 years”.

Airline JVs and investments

Delta is unique in the US for its post-2010 strategy of acquiring minority equity stakes in airlines around the world as part of long-term commercial alliances or immunised joint ventures. In addition to the continued development of the transatlantic JV with Air France-KLM and Alitalia, Delta has acquired equity stakes in Aeromexico (August 2011), GOL (December 2011), Virgin Atlantic (June 2013) and China Eastern (July 2015).

The strategy, which was discussed in depth in the Jan/Feb 2016 issue of Aviation Strategy, fits in with Delta’s goal of achieving cost effective and capital-efficient growth. Alliances help it gain access to major markets, build a geographically balanced network and diversify revenues — strategies that reduce business risk. And, as the transatlantic JVs have demonstrated, there can be healthy profit contributions. But getting the deals in place can be a slow and frustrating process.

In December Delta received the US DOT’s final approvals for its planned investment and immunised JV with Aeromexico. It was a long and contentious process, in large part because of Aeromexico’s dominant position in slot-constrained Mexico City. In the end Delta agreed to conditions that it had initially labelled as “unprecedented” and “unwarranted”.

Delta and Aeromexico are required to divest 24 daily slots at Mexico City and four at JFK (the latter was originally six, a minor concession on the DOT’s part), which will be allocated to LCCs. The grant of ATI is limited to five years.

Delta launched its planned cash tender offer for an additional 32% of Aeromexico’s capital stock on 13 February. If fully taken up, the deal will increase Delta’s ownership stake to 49% (it currently owns 17%, which includes a 4.1% stake, options and Delta pension trust holdings). As an interesting twist, Delta increased the offer price from 43.59 to 53.00 Mexican pesos, to share the benefit of the peso’s sharp decline against the dollar since Donald Trump was elected president. At the 13 February exchange rate, the deal represented a $590m investment for Delta, down from $700m originally.

Delta and Aeromexico expect to implement their planned immunised $1.5bn JV in the second quarter. A more liberalised US-Mexico ASA became effective in August 2016, and the two countries are believed to be working to achieve a full open skies regime.

The slot divestitures seem well worth it because of the potential long-term benefits of the JV, which include becoming the number one airline system on US-Mexico routes and gaining access to a large, relatively underdeveloped domestic marketplace (125m population).

Delta views Aeromexico as a potentially highly lucrative investment. There is scope for joint purchasing and procurement and an opportunity to “bring some of the Delta technology and best practices to Mexico”.

Then again, there is robust and growing competition from LCCs, both domestically in Mexico (where LCCs have 60%-plus of the market) and on the US-Mexico routes. The competitive scene is one reason why Aeromexico’s operating margins remain in single digits.

But Delta also sees an opportunity to learn from Aeromexico, especially about best practices in social media and how to cater for a young demographic. Apparently Aeromexico is “well ahead” of Delta in the use of technology, innovation and digital enhancement in providing for the millennial generation.

One of Delta’s big focuses for 2017 is building its longstanding but hitherto slow-to-develop relationship with Korean Air (see Aviation Strategy Dec 2016). At the investor day, Delta executives talked about building Seoul Incheon into a great Northeast Asian hub. Korean Air’s new facilities there will allow the two airlines to have “world-class connectivity”. The executives hinted that there would soon be announcements about “Korean and Delta becoming much closer in the future”.

Delta says that while it still has an “evolving landscape of relationships” in Asia, the partnerships already cover the top five cities in the region that account for 70% of US-Asia traffic. Delta has a 3.2% equity stake in China Eastern and a commercial alliance also with China Southern. A new immunised JV with Virgin Australia has given Delta a strong position in the US-Australia market.

Delta has a strong relationship with GOL that has helped the Brazilian LCC complete a successful restructuring during Brazil’s turbulence. In July 2015 Delta participated in GOL’s rights offering to the tune of $56m, which increased its ownership stake to 9%. Delta also guaranteed $300m in GOL loans secured by GOL’s shares in its publicly listed SMILES loyalty programme. In early February Delta agreed to provide a new $50m, four-year loan to GOL to help strengthen its partner’s cash position in Brazil’s upcoming low season in Q2.

Disappointingly, Delta and GOL have not been able to file for ATI for their codeshare relationship because Brazil has not yet ratified the US-Brazil open skies regime that was supposed to take effect in October 2015.

But Delta has always viewed the GOL investment as being for the longer term. It has worked closely with GOL and believes that its partner is now in a good position, as Brazil’s economy turns around and starts growing again.

At some point Delta is likely to increase its ownership stake in GOL. In the short term it will be limited to a 20% stake. However, in mid-February there were reports that political consensus on eliminating the limit on foreign ownership in Brazilian airlines had finally been reached and that the federal government was close to issuing a provisional measure to start the process.

Delta believes that the Latin America region represents the greatest growth opportunity over the next five years. Late last year it was reported that Delta was one of three airlines to have submitted a bid for an equity stake in Avianca, which put out a call for a strategic partner in June 2016. However, in recent weeks Avianca has disclosed that it intends to pursue a “long-term, strategic commercial alliance” with its Star partner United, though the terms are yet to be negotiated.

In addition to making more opportunistic strategic investments in airlines, Delta is investing to manage the relationships better. Last year it set up an international group, with its own president and CFO, for that purpose. The key aim is to facilitate the sharing of best practices.

In November Delta implemented AIR4, an innovative technology platform that enabled Virgin Atlantic to be embedded into the Delta passenger service systems. It means that Delta now operates Virgin’s reservations system. In addition to cost and scale benefits to Virgin, it results in a seamless customer experience. Delta says that the biggest challenge it faces with partnerships generally is that everyone is on a different “technology pace”.

Delta has benefited enormously from the Virgin Atlantic relationship. The investment, which involved Delta buying SIA’s 49% stake for $385m in 2013, was expected to achieve full cash payback by the end of 2016. The JV has fixed Delta’s Heathrow access problem and made it a credible player in the important New York-London business travel market.

Interestingly, Delta has also learned a few things from Virgin Atlantic, including how to design airport lounges. President Glen Hauenstein explained: “Virgin has a club that is a reason to fly Virgin” and Delta wanted the same — a club that is a reason to fly Delta.

Labour cost pressures

At the beginning of December Delta’s pilots ratified a new four-year contract, effective to the end of 2019, that provides for a cumulative 30% pay increase (18% retroactive increases for 2016 and annual increases thereafter) and retains profit-sharing. The deal ensures that Delta’s pilots remain the best paid in the industry and has serious labour cost ramifications.

Delta took a $475m cost hit from the pilot deal in the fourth quarter, which included the full-year impact for 2016 and meant the carrier reporting an operating margin of 10.8% for Q4.

The additional pilot expense in 2017 will be around $490m, including a 3% annual increase at the beginning of January. Delta has also unilaterally decided to lift non-pilot employee pay by 6% in April 2017, which will add to the labour cost pressures this year.

The deal set a new higher bar for pilot pay in the US airline industry. It triggered an automatic pay increase for United’s pilots. In November Southwest’s pilots ratified a four-year contract that lifts pay by 29%.

The generous pay awards obviously reflect the industry’s record-level earnings. But Delta has also long had a goal of maintaining industry-leading pay.

The good news is that Delta has now gone through its “labour reset”, which means that labour cost increases in the next few years will be modest and predictable.

Also, Delta has identified productivity measures to mitigate some of this year’s cost pressures, which also come from higher fuel prices, lower capacity growth and product/service investments. It expects to achieve $1.5bn of productivity savings in 2017, which will help limit the non-fuel CASM increase to 2-3%.

Over the longer term, Delta is committed to keeping annual non-fuel CASM growth at 2% or less. That may be a little on the ambitious side, especially if capacity growth remains at the 1% level.

Aircraft upgauging plays a key part in the productivity boosting efforts. Average seats per departure on the narrowbody fleet are projected to increase by 5% between 2016 and 2018 because of continuing 50-seat retirements and replacement of MD-88s with 180-190 seat A321s and 737-900s. On the widebody side, Delta says that replacing 747s with A350-900s and A330neos will bring it from the highest to lowest-cost producer on the Pacific.

Notably, in late December Delta reached agreement with Boeing to cancel an order for 18 787s, which it had assumed in 2008 as part of its merger with Northwest.

Durable business model

Delta had a multi-year head-start over United and American on the merger front, so it was able to reap the benefits of its 2008 merger with Northwest quickly and achieve strong profitability. In the past seven years, it has earned $17.4bn in aggregate net profits before special items, including a $4bn profit in 2016.

Last year’s operating margin was 16.5%, up from 16.1% in 2015. Delta may have been the only US major carrier to achieve an increase in margins in 2016. Delta also believes that its margin contraction in 2017 will be less than that of competitors.

The other top US carriers, especially United, are striving to catch up with Delta’s margins and other financial metrics. But Delta is obviously not going to stand still. It will be discussing its long-term plans and financial targets at its spring analyst meeting in May 2017.

The targets outlined by Delta in May 2016 for the 2016-2018 period are to achieve a 17-19% annual operating margin, deliver annual EPS growth of at least 15%, achieve a ROIC of at least 25% and generate annual operating cash flow of $8-9bn, of which $4.5-5.5bn would be free cash flow.

Delta’s “balanced capital deployment” strategy means, first of all, reinvesting about 50% of operating cash flow in the business. It allows Delta to replace 30% of its mainline fleet in 2016-2020, fund strategic investments and continue to invest in technology.

Second, Delta continues to strengthen its balance sheet. Having reduced its adjusted net debt by almost $11bn since 2009, from $17bn to around $6bn, Delta has slowed the pace down as it nears the target and because interest rates have declined. The target is still $4bn, but the aim is to reach it in 2020, 2-3 years later than previously.

Delta’s balance sheet progress has been recognised by the rating agencies. Moody’s and Fitch upgraded it to investment grade in 2016 and S&P may well follow this year.

Third, Delta plans to return at least 70% of FCF to shareholders. It has now returned more than $7bn since 2013. In the future, the focus will shift more in favour of the dividend, which represents a long-term commitment to return cash to owners on a consistent basis. Delta’s dividends have grown steadily since 2013 and now total $615m annually.

Delta plans to continue contributing $1.2bn a year to its pension plan up to 2020, which is expected to result in it being 80% funded. Conveniently, the debt reduction target and pension funding goals will be reached around the time when the airline becomes a full taxpayer in 2019, after using up its NOLs. The management noted that Delta should therefore be able to absorb cash taxes without adverse impact on shareholder returns.