Delta Surpasses Synergy Goals with Merger, Focusing on Premium Traffic

"We raised our industry view on airlines this morning from in line to attractive," said Morgan Stanley at the opening of the conference. "We do think there is an improving risk reward on the airline cycle call. We updated our estimates and liquidity projections and we also shifted our outlook thinking we won't get a better price on the airlines. We shifted our valuation framework to year end 2010 from year end 2009. If you are a believer in a recovery, you can argue for a fair amount of upside from here.

Legacies still a "distress play", but heading higher: Morgan Stanley

"These expectations came in a little bit and that's one of the things we were waiting to see. It is not as much as we were hoping for but they did come in quite a bit. Also, the US Airways recapitalization last week was a major event in the market didn't react to. If you got a major airline struggling with a liquidity squeeze, as we look forward, since they have addressed that liquidity issue, we feel better about recommending the group. We are recommending legacies as a distress play but, if you look, we are basically saying airlines broadly are going to go higher."

Delta's major focus on increasing liquidity: USD5.8 billion in Sep-2009

Delta's Halter indicated that the airline's major focus this year has been increasing liquidity, retiring debt and enhancing premium traffic. To that end, the carrier has renegotiated over 600 corporate contracts and increased corporate passenger numbers to more than what the two carriers produced individually. He attributed the increase to network changes that made the merged entity more valuable to business travelers. He pointed to the company's recent deal to obtain LaGuardia slots as part if its efforts to grow its revenue premium.

Corporate sales account for 20% of Delta passenger revenues and are "sequentially improving on a year over year basis to down 6-7% compared to 30-35% in the April/May period," said Halter. "In terms of ticketed sales volume, revenue for corporate sales was down 50% in April and May and is now at 25% through October."

He continued, "We have a strong financial foundation with best-in-class cost structure," in turning to liquidity. "We have been able to maintain lower costs resulting from the restructuring we did a few years ago. Addressing liquidity is critical. We ended the September quarter with $5.8 billion in unrestricted capital. Preserving our free cash flow is very important. We've minimized cap ex and invested in operating cash flow to the balance sheet and to pay down debt. The merger is running about six months ahead of schedule and we are on track to realize a $2 billion annual run rate resulting from the synergies of the merger."

…..And paying down debt

Saying the airline would update all of its financial statistics and guidance during the Delta's investment day on December 15, Halter indicated the airline is focused on paying down debt. He pointed to several financial transactions accomplished this year to address the 2010 maturities and obligations. "We were looking at USD3.4 billion of them early in 2010 but in September, using Pacific routes, slots and authorities, we refinanced Northwest debt and we were able to collect USD2.1billion dollars, resulting in USD600 million in incremental liquidity over the obligation due to the demand and strength of the offering," he said. "Last week we completed a double ETC transaction which further enabled us to refinance 2010 obligations which are now down about 55% to USD1.5 billion in obligations. That is a much more manageable number for 2010."

New aircraft to be paid for without debt

He added that once recovery requires more aircraft, Delta would prefer to pay for them with cash rather than debt. "Going forward we plan to pay for debt with cash rather than continually refinancing debt as you see now in the airline industry," he added. "Looking at Delta's USD16-17 billion in net debt, we clearly want to bring that down because it is costly and you have to carry interest."

Aircraft deliveries on the company's order book stand at four which will all be delivered - with financing already in place - by Jun-2010. "That contributes to our ability to de-lever our balance sheet," he noted.

Delta's cost structure is only up 2% from last year, attributed to its pension obligations. "We are projecting USD5 billion in liquidity at the end of the year," said Halter, adding that the drop from September's USD5.8 billion was not because of some underlying industry problem but was driven by the seasonal change in advanced ticket sales. "Given Delta's size and range of advance ticket sales in terms of cash collected early on in the year, and as we burn through that air traffic liability as travel plans occur, that is almost a USD1 billion swing. That is what you are seeing in the December quarter.

Managing costs and capacity - likely to be "flat" in 2010

"We are managing our capacity," he continued. "We are very focused on getting the costs out relating to that capacity. The challenge for industry right now is maintaining capacity discipline to make sure we don't come back and flood the market with higher capacity, higher utilization, higher gauge when demand not there. It is the demand/supply balance we need to maintain. When demand starts coming back, Delta can increase capacity 1-2% by changing the mix but we don't want to do that, or see the industry do that, unless there is demand to support it.

"If you listen to what carriers are saying about capacity next year, capacity will be flat on average if there is a modest recovery," he continued. "The industry is very skittish about giving 2010 guidance but, even with a modest recovery, we would hope the industry maintains flat capacity. If you look at the aircraft on order and the limited number of aircraft deliveries next year, that will contribute to flat capacity and if demands comes back quicker we all have an opportunity to pick up that demand with increased utilization."

Plenty of parked capacity though

Delta has about 75 aircraft parked in the desert, but the lead time needed to bring them into service could be at least six months to a year, according to Halter, who noted maintenance capacity with current fleets and scheduled checks will create a bottleneck if combined with parked aircraft. Just increasing capacity one to two percent would take a couple of months, he said, adding it could be done at current staffing levels.

Demand and unit revenue returning, but premium still down

"The big question is the revenue environment," he continued. "We saw the industry go negative in November '08 and we hit the low point in the May/June period when revenues were down 25% for the industry. We have seen sequential improvements since then. It is not a hockey stick improvement. For Delta we were looking at unit revenue down in June about 23% and by October it was in the 11-12% range. If you carry that forward, we expect to see unit revenue down only 8% in Q4. Premium demand remains down but demand is there. Revenue is coming back on sequential basis but it is taking time."

Delta, he said, was different in that it receives about USD4 billion in revenue from non-passenger service, including USD500 million from its MRO business as well as SkyMiles and ground handling. He noted that while premium passenger numbers were down, the front of the aircraft is full with frequent flier upgrades. "They are buying fares that are above the lowest levels so we are seeing a gradual improvement in that," he said. "Traffic will probably be down in the beginning of the year but could be in growth mode year over year certainly before July. If we have a modest recovery on a year over year basis, it will probably be mid year before we see unit revenue growth."

The four tenets

Halter explained the four tenets of Delta's strategies:

1. Delta/Northwest synergies. While it has achieved most milestones including the October merging of Worldperks and SkyMiles, remaining action includes the single operating certificate expected by the end of 2009 and the technology cutover in the first quarter of 2010. The first quarter will also see the balance of the Northwest fleet completed in new livery. The only remaining sticking point will then be the merging of employee representation and seniority lists.
2. Squeezing costs out of the system, including reducing overheads by USD200 million, as well as realigning capacity to get fixed and variable costs out commensurate with capacity changes. The airline is focusing on its network, realigning hubs and traffic flows so that the Northwest and Delta hubs do not compete with one another. Delta has seven hubs including Tokyo Narita and, has completely changed the traffic flows, so hubs complement each other, reallocating equipment and reducing capacity to ensure a given point can connect cross the system without going to two different hubs. It is also exiting the freight business by the end of the year, which lost it USD150 last year.
3. Refocusing revenue efforts to drive a revenue premium by capturing a great share of the market including the lucrative New York market. "Combine [the US Airways slot deal] with the transcontinental and international flows over JFK, travelers have more opportunities to fly Delta than any other New York carrier.
4. Joint ventures such as the Air France/KLM partnership, as well as growing domestic partnerships are delivering benefits. "That JV amounts to a USD12 billion revenue opportunity across the Atlantic. One in four flights is part of the JV." Halter noted the airline recently cut a deal with Alaska Airlines to form an alliance that not only feeds passengers to its domestic network but to its four international gateways on the West Coast to Asia.

In conclusion…looking good

"So we are well positioned for long term success," he concluded.

"We are the leading global network, capitalizing on the benefits of former Delta/Northwest franchises to become Number 1 or 2 position in all of our markets.

"We are in a strong financial position which is focused on unit cost leadership, preserving free cash flow and de-levering the balance sheet.

"The merger is going well and we are accelerating the benefits to capture USD2 billion in synergies - or perhaps more than USD2 billion in benefits.

"We remain focused on managing capacity, watching the market. The changing demands require Delta to move quickly and with our fleet we have the opportunity to react quickly."