US Airlines: Now solidly profitable across the cycles? October 2014

US airlines reported strong results for the third quarter and expect more of the same in Q4. How are Delta, American and United using the significant cash generated? And how are the airlines preparing for what could be a choppy 2015 in international markets?

The third-quarter results of the nine largest US carriers were uniformly excellent. Operating margins were all in the double-digits, ranging from JetBlue’s 10.7% to Alaska’s 21.6%. The three largest carriers also achieved double-digit pre-tax margins (excluding special items) and ROIC.

Delta — the margin leader in recent years because it was the first to complete a Chapter 11 restructuring and a merger in 2008 — earned an ex-item pretax profit of $1.6bn (14.3% of revenues) in the third quarter. ROIC for the last 12 months was 19.3%. The management noted that the results were consistent with those of high-quality S&P 500 industrials.

United has staged a spectacular financial recovery this year after the serious IT/technology integration issues it experienced in 2012 in the wake of the 2010 merger with Continental. In the third quarter, United’s ex-item pretax profit doubled to $1.1bn (10.4% of revenues). ROIC in the 12 months to September 30 was 12.3%.

American, which began earning healthy profits even before its late-2013 Chapter 11 exit and completion of the merger with US Airways, has seen progressively stronger results in the past three quarters. For the latest period, AAL posted an ex-item pretax profit of $1.2bn, accounting for 10.8% of revenues. AAL is expecting a similar 10-12% pretax margin in the current quarter, which is typically the seasonally weakest for the industry.

Net profits in some cases were diluted by huge extraordinary charges brought about by continued restructuring. Delta recorded $657m in special charges, mainly related to the accelerated retirement of its 747s. American had $281m in net special charges, including $168m of merger integration expenses.

The combination of strong earnings and relatively modest capex has meant significant free cash flow (FCF) for many US carriers. Delta generated $910m of FCF in the third quarter and is on track to produce nearly $3.5bn in 2014.

US airlines’ efforts to pay down debt are increasingly being recognised by the rating agencies. In early October S&P raised Delta’s corporate credit rating from ‘BB-minus’ to ‘BB’, which is just two notches below investment grade.

In June Alaska became the second airline in the US (after Southwest) to gain an investment-grade credit rating (from Fitch). Alaska has led the industry in terms of profit growth and deleveraging, achieving a 21.8% adjusted pretax margin in the third quarter and a 17.2% after-tax ROIC in the 12 months to September 30. The Seattle-based niche carrier has lowered its adjusted debt-to-capital ratio to 31%.

But Alaska’s extraordinary margins and financial ratios have not gone unnoticed by competitors. Delta has started to grow aggressively in Seattle — something that has kept the lid on Alaska’s share price.

Why the strong profits?

2014 will be the fifth consecutive year of healthy profitability for the US airline industry. The reasons for the legacy sector’s profit run are well documented: a decade of restructuring, many Chapter 11 visits, an intensive new consolidation phase, years of tight capacity discipline, repeated domestic fare increases, lucrative new ancillary revenue streams and smarter managements that are more profit and return oriented.

In this year’s third quarter, US carriers benefited from two additional factors: the decline in fuel prices and continued strong domestic air travel demand.

The spot price of WTI crude oil has fallen from the $100-per-barrel level in early August to the low-80s in late October. The decline has benefited especially American, which does not have any fuel hedges in place.

The combination of healthy air travel demand and tight capacity in the US has continued to facilitate fare increases and solid unit revenue growth. Most recently, in mid-October the industry successfully implemented a Delta-led modest system-wide fare increase.

A strong domestic environment benefits Delta, American and United enormously because they still earn half or more of their total revenues domestically. In the third quarter, domestic operations accounted for 63% of American’s, 56% of Delta’s and 48% of United’s mainline passenger revenues.

The domestic entities cushioned the carriers against the volatility now seen in international markets — something that was clearly evident in the regional breakdowns of passenger revenues, PRASM and yields released in the third-quarter reports.

At Delta, domestic passenger revenues surged by 11.6% and unit revenues by 7.2%. Internationally, transatlantic revenues and PRASM rose by 3.9% and 0.2%; Pacific revenues and PRASM fell by 2.8% and 2.2%; and Latin revenues rose by 10.3% but PRASM declined by 5.1%.

At United, domestic passenger revenues rose by 6.5%, PRASM by 7.9% and yield by 7.6%. Internationally, revenues rose by 4.7%, PRASM by 1.9% and yield by 2.8%.

At American, PRASM was up 5.7% domestically and down 6.1% internationally. The latter consisted of 5% growth on the Pacific, a 2.3% decline on the Atlantic and an 11.7% decline on Latin America routes (despite a mere 1% capacity increase).

The performance of the international entities can be summarised as follows. The transatlantic was the best-performing international region for US carriers, even though there was excess capacity in the summer. Delta and United saw very difficult conditions on the Pacific, because industry capacity was up substantially. United has continued to see 20% capacity growth from foreign competitors especially on the China routes, while the weakening yen has put pressure on Narita flying. Latin America has been a tough market this year, with both supply and demand issues (the region’s economic slowdown, World Cup-related woes, Venezuela, etc).

New challenges

Except for the nice surprise with fuel, 2014 has been a challenging year in terms of negative external factors for global airlines: the disappearance of MH370, the shooting down of MH17, the Ukrainian conflict and the resulting US, EU and Russian economic sanctions, monies trapped in Venezuela, the rise of ISIS, Western military action in Syria and Iraq, and the Ebola crisis.

Other negatives affecting US airlines now also include currency headwinds (resulting from the dollar’s 5-10% appreciation in recent months), a modest slowing of domestic bookings this autumn, and tough fourth-quarter RASM comparisons at some carriers (especially United). American has trimmed its fourth-quarter PRASM growth estimate by as much as two points to 0-2% because of the Venezuelan situation.

Concerns about Ebola, the RASM outlook and the global economy have led to mighty stock market gyrations. Between September 2 and October 13, the NYSE Arca Airline Index (XAL) declined by 18%. However, by late October XAL had recovered much of the earlier fall as a result of the worst Ebola fears subsiding, stock upgrades from analysts, the excellent third-quarter results and reassuring commentary from airline managements.

Although travel demand to and from West Africa has declined and airlines have reduced capacity in those markets (including Delta pulling out of Liberia), US airlines claim not to have seen any measurable negative effects from Ebola so far. Bookings, unit revenue and profit outlooks for the current quarter remain strong.

Analysts theorise that, as long as Ebola is not an airborne disease and thus remains extremely difficult to catch, and given that US carriers’ exposure to Africa is low (only 1% of system capacity), the effects could never be as bad as with the 2003 SARS epidemic, which many US investors have been busy studying. The SARS impact was sharp but short, reducing US airlines’ transpacific revenues by 40% for a few months, but after that traffic quickly returned to normal.

A global economic downturn in 2015 is potentially more serious. Then again, as JP Morgan analysts have argued, the worst that could conceivably happen for US airlines would be something like a 5% RASM decline. Any recession scenario in 2015 would probably mean lower oil prices, and the net effect would be that “industry profits would barely budge from the 2014 levels”.

Near-term capacity discipline

US airlines’ continued domestic capacity discipline is virtually a given by now, but the good news is that, in light of the weakening global environment, the top three carriers are exercising much restraint also in international markets this winter.

American has trimmed its transatlantic capacity plan for the winter from 5% growth to a 2% decline. American is also cutting Latin America capacity this winter, contrasting with its earlier plan to grow by 4% in that market.

At this point American is looking to grow system capacity by 2-3% in 2015, but more than half of that would come through increased aircraft seat density — something that the airline hopes will be “highly earnings accretive”.

Delta is keeping system capacity growth at about the rate of GDP growth and currently envisages 2% ASM growth in 2015. The strategy is to grow modestly through seat density increases and up-gauging. Delta has become a master of the strategy of growing modestly with fewer aircraft; since 2009 it has reduced its fleet by 200 aircraft.

Delta plans to keep its international capacity flat in 2015. Together with its JV partners it has reduced transatlantic growth to 1-3% this winter, with a similar rate expected in 2015. The primary growth focus will be on London, where combined capacity with Virgin Atlantic will be up by 2.6% this winter. Delta calls Heathrow a “bright spot”, having seen the JV margins improve by 270 basis points this year. The rest of Europe will see just 1% ASM growth, while markets with high volatility (Moscow, Tel Aviv and West Africa) are seeing a 20% capacity reduction.

Delta is in the middle of an extensive Pacific restructuring, which involves reducing capacity, “getting the gauge right” and adding more non-stop services from the US. Delta is building Seattle into a new transpacific gateway. The transatlantic capacity cuts have freed up smaller widebody aircraft that Delta can now redeploy on the Pacific, allowing it to accelerate plans to retire its 16 remaining 747-400s (by 2017).

United expects its JV with Lufthansa and Air Canada to reduce transatlantic capacity by 0.5% this winter. United’s own ASMs to Europe will actually decline by 3%.

Having restructured extensively on the Pacific in recent years, and despite the China challenges, United says that its Pacific network is solidly profitable. It expects to grow seasonal capacity by a double-digit percentage in the Pacific beach markets. In addition to new routes linking Guam with Seoul and Shanghai, United is launching SFO-Tokyo Haneda and LAX-Melbourne routes (the latter with 787-9s).

United is also committed to keeping system capacity growth below GDP growth; the current ASM growth projection for 2015 is 1.5-2.5%. About half of it will come through additional seats and upgauging; the rest will come from increased aircraft utilisation. Like its peers, United believes that this strategy provides the “best opportunity for margin expansion”.

While Delta is clearly the most conservative of the three about growth in the near-term, it has indicated that its focus could soon shift to growing the global network. The management stated: “Looking further ahead, our international network provides the largest opportunity for additional margin improvement, as we accelerate our Pacific network restructuring, recalibrate our transatlantic capacity levels, and reap the benefits of our investment in our Latin network.” (The latter refers to Delta’s equity stakes in Gol and Aeromexico.)

All of the US carriers have indicated that they will increasingly be relying on their JV and other airline partners in the global arena.

Rewarding shareholders

Delta’s initial $350m shareholder reward programme, launched in May 2013, marked the start of a new era for capital deployment at US airlines. Delta has far exceeded the original target, returning more than $1bn to shareholders this year through dividends and share repurchases. In May 2014 the carrier increased its dividend by 50% and authorised another $2bn of share repurchases by the end of 2016.

Shareholder rewards were the obvious next step for Delta after three years of solid profits, significant FCF generation and reaching its debt reduction goal. Delta’s net debt has fallen by almost $10bn since 2009 (to $7.4bn), saving the carrier $500m in annual interest expenses.

Delta has also continued to pay down debt, address pension obligations and buy aircraft. It hopes to reduce net debt to $5bn by 2016. The plan is to invest roughly 50% of operating cash flow back into the business, keeping annual capex in the $2-3bn range.

Delta buys both new and used aircraft. It is currently evaluating proposals from Airbus and Boeing for a new widebody order, but the management has also noted a “huge glut of airplanes in the global market”, indicating good opportunities for used aircraft purchases. The carrier says that the current lower fuel prices are not influencing those decisions, because aircraft are long-term investments.

But Delta’s shareholder rewards put pressure on United and American to jump on the bandwagon — probably a little sooner than they would have liked, given their lower cash generation, higher aircraft capital spending and other priorities.

United has returned $220m to shareholders as part of a $1bn share buyback programme introduced last year. It has also modestly reduced debt. United’s priorities are to execute a $2bn cost-cutting plan, improve its balance sheet and continue to make “return-driven investments” in its product. Its long-term goals include reducing non-aircraft debt and bringing lease-adjusted gross debt down to $15bn.

United also has higher aircraft capex than Delta. It is taking 787-8s, 787-9s, 737-900ERs and E175s. But United is trying to rein in the spending. For example, it is retaining 11 767-300ERs that had been slated for retirement; the aircraft will get new interiors, winglets and reliability modifications to extend their useful life into the next decade. United also continues to explore the used aircraft market.

American announced a capital deployment programme in July, just seven months after exiting Chapter 11. The programme includes $2.8bn of debt and lease prepayments, $1bn share repurchases by year-end 2015, quarterly cash dividends (for the first time since 1980) and $600m of additional pension contributions. The amount returned to shareholders in the third quarter was $185m, made up of $72m of dividends and $113m in stock repurchases.

It is amazing that American is doing all that while still funding a major fleet renewal programme, significant product improvements and integration costs. As a glimpse into the fleet renewal, in the third quarter American received 22 new mainline aircraft and retired 28 older aircraft. Capex is about $3bn this year. In recent months the company has taken on $3.3bn of additional debt or credit facilities.

American: the rising star

While Delta has been the profit margin leader among the US “Big Three”, American is the rising star. Analysts are already getting excited about the prospect of AAL overtaking Delta in the margin league, possibly by the end of 2015.

But there is a need for caution here, because American is still far from completing the merger integration. Some of the toughest hurdles lie ahead in 2015, including a move to single IT/technology platform. Also, the incremental costs from labour integration are not yet known, because flights attendants have not yet ratified their joint contract, and talks with the pilots have not yet even begun.

American is already seeing greater cost inflation than its peers. Its ex-fuel CASM is projected to increase by 2-4% in 2014. BofA Merrill Lynch analysts estimate new labour contracts could add two percentage points to the CASM hike in 2015 and 2016.

On the positive side, AAL has had much success in attracting corporate contracts, especially in key markets such as New York. The management predicts that the original $1bn-plus merger synergy estimate will be met or exceeded. But analysts note that the synergies will not be meaningful until 2016.

United has also been narrowing the margin gap with Delta. United does not have potential tailwinds as powerful as American’s, but its substantial and promising “Project Quality” revenue initiative is still in the early stages. It is only a matter of time before American and United catch up with Delta.

By Heini Nuutinen

hmnuutinen@gmail.com