24-Dec-2016 8:15 PM

Delta Air Lines: cost pressure drives margin compression in 2017. Revenue generation is paramount

Analysis

Although Delta Air Lines expects to sustain strong pre-tax profits in 2017, cost inflation and continued unit revenue pressure are creating margin compression for the airline. Delta anticipates its operating margin for the year will fall below the 17% to 19% targets it has set for itself over the long term.

Delta acknowledges that in the past its ability to predict a return to positive unit revenue accurately has been dismal; but the company believes it will post a flat unit revenue performance in 1Q2017. The airline also concedes that when it set long-term margin targets earlier in 2016 it believed unit revenues would rebound faster than has ultimately materialised.

The company is characterising 2017 as a transition year in which it is crucial to restore unit revenues in line with cost escalation, concluding that it could be the first year in many that could test the durability of its business model. But Delta is encouraged by positive momentum in many of its markets, and the slowing of yield degradation in the key corporate sector.

Delta admits shortcomings in predicting a restoration of positive unit revenue

The majority of US airlines have been battling an overall negative passenger unit performance for two years, driven by lower fuel prices, increased supply and pricing degradation in the US market.

Delta has missed targeted periods for returning to positive unit revenue in both 2015 and 2016, and recently company CEO Ed Bastian admitted the airline has not been a good prognosticator of a restoration to positive unit revenue.

See related report: Delta Air Lines misses targets for a return to positive PRASM, caps 2016 capacity growth at 2%

The company's largest year-on-year decrease in unit revenue during 2016 occurred in 3Q2016, with a decline of 6.8%. For 4Q2016 Delta projects a 3% decrease, which is at the low end of previous guidance of a drop between 3% and 5%.

Delta's unit revenue performance by quarter in 2016

The airline believes that it will attain a flat unit revenue performance in 1Q2017; however, Delta has stated that its operating margins in 2017 will fall 100 to 200 basis points below a stated target of between 17% and 19% over the long term. Mr Bastian has remarked that Delta established those targets earlier in 2016 when the company believed unit revenues would rebound faster. However, he has stressed that Delta remains confident of achieving its margin goals over the long term.

Mr Bastian stated that the margin compression in 2017 is driven by Delta's cost growth escalating faster than unit revenue production. The company's projected cost increase excluding fuel for 2017 is 2% to 3%, the bulk of which is weighted toward 1H2017.

Some of the pressure is driven by a new collective bargaining agreement Delta reached with its pilots in 2016, which includes a 30% pay raise over a four-year period. The airline also plans to give 65,000 non-union employees a 6% pay raise in Apr-2017. Delta's CEO described 2016 as a year of labour reset, stressing that during the next number of years the company's labour rates will be normalised, and in line with inflationary pressure.

Delta's non-fuel unit cost performance: 2013 to 2017

The industry is bracing for cost pressure in 2017 from new collective bargaining agreements recently ratified by pilots and flight attendants. For 4Q2016 Southwest is projecting a rise of 4% to 5% in unit cost, excluding fuel, profit share and special items, of which 3.5ppt is driven by the new employee agreements. United anticipates a 3.5% to 4.5% increase in unit costs excluding fuel in 2017, of which 1.5% to 2% is driven by the effects of recent labour agreements.

Effects of a new pilot contract at the ultra-low cost airline Allegiant Air are driving a 5% to 9% rise in its unit cost excluding fuel for 2017. The company has said that an industry pilot pay reset should occur in Jan-2017, which should place Allegiant's pay rates within 15% of the average top three pay rates within the US industry.

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Delta sees encouraging trends in its various geographies heading into 2017

Delta also believes that capping its 2017 system capacity at 1% is driving some cost pressure; however, reining in capacity is necessary for the airline to bolster its unit revenues.

The airline is encouraged by a bump in domestic demand after the US presidential elections. Delta noted that business travel picked up considerably after the election of Donald Trump. That trend builds on the strengthening of close-in bookings that began in late 3Q2016.

Delta executives have noted that both leisure and business demand have been strong throughout 2016, although the missing piece throughout the year was traction in business yields. But trends are moving in the right direction. Post-election the business yields are down in the low single digits, versus declines of 7% to 8% earlier in 2016.

Offering some insight into specific geographical regions, Delta executives remarked after a challenging 2016 that the US domestic environment was turning quickly.

Delta has slightly more exposure to the US domestic market than its large global network airline peers American and United. For the week of 12-Dec-2016, 86% of Delta's seats are deployed into the US domestic market, compared with 83% for American and 78% for United.

Delta Air Lines international vs domestic capacity (% of seats): 12-Dec-2016 to 18-Dec-2016

The airline's unit revenues in Latin America turned positive in 3Q2016, which was driven by a turnaround in Brazil that is holding steady. Unit revenues on routes to Brazil are increasing in the double digits, which Delta executives have stated to be offsetting some weakness in Central America.

Delta is pushing forward with its investment in Aeromexico and the establishment of a joint venture with its SkyTeam partner. The two airline have agreed to abide by onerous conditions imposed by the US Dot in order to gain government approval of the tie-up, including the divestiture of 24 slot pairs at Mexico City Juarez International airport, and limiting the JV to five year term after which the airline they would need to reapply for antitrust immunity. Delta is upping its stake in Aeromexico from 4% to 49%.

See related report: Aeromexico and Delta JV: major uncertainty reigns after DoT hits hard with slot divestitures

Although the Pacific remains challenging, with an onslaught of competitive capacity, Delta believes its performance should turn positive by summer 2017.

The company is emphasising the benefits of Korean Air's hub in Seoul, hinting at potential deepening ties with its fellow SkyTeam partner. In the past Delta and Korean's relationship has been rocky, but Mr Bastian cited breakthroughs in the relationship in 2016 and believes relations should continue to improve in 2017. The airline has said that in the past both Delta and Korean had encountered challenges finding a balance where each company attained value, but now Delta believes it is close to unveiling plans for closer cooperation with Korean in the future. Delta remains the only US large global network airline without a joint venture partner in the strategic trans-Pacific market.

The trans-Atlantic has proved challenging for large global US network airlines in 2016 - as a result of the UK's Brexit vote, terrorist attacks and heightened competitive capacity. There has been a lot discussion about capacity additions from low cost airlines, including Norwegian and WOW Air, but Delta executives have said that growth of those airlines would have the least impact in the trans-Atlantic over the short term.

Currency pressure and other factors continue to create challenges in the region, but Delta is attempting to emphasise the flying of its SkyTeam partners and Virgin Atlantic at European hubs, and also focusing on North American point of sale to overcome challenges in European-originating sales created by devaluing currencies.

Delta's first-mover advantage in segmentation is reflected in USD2.7 billion by 2019

Delta was an early, subtle adopter of product segmentation in the US space, in 2013 rolling out a range of fares to match the ULCC Spirit in selected markets where the airlines overlapped. Even though Delta was a first-mover among its large US network airline peers in the basic economy fare space, the proliferation of that product at the airline has been slow. During 2016 Delta's bare-bones basic economy fare was only available in 38% of its domestic markets. But by YE2017 the fare will be an option for customers in all of the airline's domestic markets.

Both American and United are in various phases of development of segmented fares as an adaptation to pricing changes ushered in by ultra-low cost airlines.

American executives have previously stated that the company would be disappointed if its fare segmentation efforts did not produce over USD1 billion in revenue. United has also forecast USD1 billion in revenue benefits from its segmented fares by 2020. Delta's first-mover advantage is reflected in its revenue projection for branded fares - USD1.7 billion in 2017 and USD2.7 billion in 2019.

See related report: American Airlines pulls many levers to improve PRASM, but cautions there is no overnight solution

Delta also continues to reap benefits from a co-branded credit card agreement it has with American Express. It estimates USD300 million in incremental benefits year-on-year in 2016, for a total annual revenue contribution of USD3 billion. By 2021 Delta expects the credit card arrangement to contribute USD4 billion in annual revenue.

Delta joins other US airlines in working to improve revenue management techniques

US airlines have recently been vocal about challenges they are encountering in the complex issue of revenue management. Airlines ranging in size and business scope from Hawaiian to United have taken the view that current revenue management strategies are sub-optimal. Much of the frustration is driven by antiquated systems and United - which uses a 20 year old revenue management system - plans to improve its demand forecasting and adopt better practices for demand aggregation in the 2017 to 2018 period.

See related report: United Airlines Part 1: New management declares ambitions to usher in a new competitive era

Delta, too, believes it needs to evolve its revenue management skills. "We are great at playing the airline revenue game, but not great at playing the consumer revenue game", said company president Glen Hauenstein. As an example, Mr Hauenstein explained that Delta did not collect historical data until a couple of years ago. The airline could track inventory sold, but could not trace historical fare bands purchased. Now the airline plans to collect and use that data.

During the past year many of the large US airlines have discussed what appears to be the discontinuation of Saturday night stays or advance purchase requirements. Mr Hauenstein has stated that Delta had been disappointed over the past year in its ability to apply fare fences to business customers. But he believes those trends are "reversing out", and his position is that advanced purchase and stay requirements "will play as big a role as they ever have".

Delta understands the a RASM-CASM balance is crucial as it embarks on 2017

Delta is joining numerous airlines in declaring that a labour rate reset is driving cost pressure in 2017. Although the short-term pain from the new agreements is formidable, they are crucial to ensuring favourable labour relations and maintaining a competitive edge through content employees who feel appropriately compensated for the sacrifices they have made during much leaner times in the business.

For Delta and all US airlines the RASM-CASM equation is becoming more pronounced as 2016 closes and 2017 draws near. Against unit costs rising markedly, restoring unit revenues is now more important than ever. Delta and its counterparts seem to understand the significance of attaining positive unit revenue. Obviously the key for those airlines lies in effectively executing their strategies to shore up their revenue performance.