21-Mar-2013 10:20 PM

Delta presses forward to build a competitive network in a consolidated and mature US market

Analysis

Delta Air Lines continues to leverage the competitive strength it holds over its US legacy peers to flesh out its network and build pockets of strength as United and Continental remain in the throes of their merger integration and American and US Airways lay the groundwork to begin the complex process of combining their respective organisations.

During the last couple of years Delta has used the nimbleness it enjoys versus its legacy domestic competitors to broker equity investments in foreign carriers to build a robust network ahead of the completion of US consolidation. Those investments have moved in tandem with Delta’s bolstering its presence in New York through its slot swap deal with US Airways and its investment in facilities at JFK and LaGuardia airports.

During 2013 Delta is attempting to strengthen its position in the fragmented but strategic Los Angeles market through a 12% boost in daily seats year-over-year from Jul-2012 to Jul-2013.

But, despite a solid strategy to fortify its network and out perform its peers in many financial metrics, Delta’s stock price continues to trade weaker than its competitors, despite recent declarations by management that the carrier would record its best first quarter performance during 1Q2013 in a decade.

It may be that Delta's increasing costs are cause for discomfort.

Recording a profit during 1Q2013 after 13 years of 1Q losses

Delta estimates it will turn a profit during 1Q2013, its first profitable first quarter in 13 years. Recently company President Ed Bastian remarked that when Delta recorded its last profitable first quarter in 2000, fuel prices per gallon were USD0.62 cents compared with current prices of roughly USD3.25 per gallon. He estimated that represents a USD2 billion increase in costs. Fuel costs during the last five years have consistently remained at levels of USD100 per barrel or higher, but Delta has recorded annual profits since 2010, and expects to remain profitable during 2013.

By its own estimates, Delta’s 2012 pre-tax income of nearly USD1.6 billion was more than double the USD679 million recorded by Southwest. Estimates from Morningstar show that Delta also in 2012 recorded the highest operating cash flow among its peers.

Delta pre-tax income versus its US airline peers: 2012

US legacy carrier (and Southwest) operating cash flow: 2012

Carrier	Operating cash flow
Delta	USD2.5 billion
Southwest	USD2.1 billion
United	USD935 million
US Airways	USD1 billion

Yet Delta’s closing share price on 20-Mar-2013 of USD17.07 was trading USD15.43 below United’s USD32.50 share price, and below US Airways’ shares priced at USD17.23. Southwest has a closing share price of USD12.79.

Mr Bastian says patience has been required of Delta’s shareholders as the carrier during the last few years has used its free cash flow to pay down more than USD5 billion in net debt, which will help the carrier reach its goal of USD10 billion in net debt during 2013. While the carrier plans to continue to pay down debt, Mr Bastian noted that Delta will now look at evaluating optimal uses of its free cash flow during the next three years. He did not get into specifics, but indicated that Delta is considering “some element of return to our shareholders”, and would reveal its plans ahead of its annual shareholder meeting in Jun-2013.

Using the cash flow to pay out dividends or a stock repurchase should help lift Delta’s stock price as it turns its focus to some return to investors after working to get its balance sheet in order.

Plans to use Virgin Atlantic to turn a corner in New York

Delta during the last few years has been working to improve its position in the large New York market, gaining 132 slot pairs at New York LaGuardia from US Airways and strengthening flights from JFK. Mr Bastian estimated Delta has gained seven points of corporate market share in New York during the last three years and believes that will continue to grow during 2013. Driving Delta’s efforts to capture market share in New York going forward is the carrier’s equity stake in Virgin Atlantic.

The two airlines are also forging a trans-Atlantic joint venture to leverage Virgin Atlantic’s position in the critical New York-London market, where Delta had admittedly had a weaker position against oneworld joint venture partners American and British Airways.

Delta's increase in New York corporate share: 2009 to 2012

Based on Delta’s estimates of seat share during 1Q2013 from JFK to London Heathrow, combined Virgin Atlantic and Delta would comprise a 36% share compared with AA-BA’s 62% share.

While the oneworld partners still hold an advantage, the combined share of Delta and Virgin Atlantic does help each carrier gain some leverage in the competition for corporate share in the largest trans-Atlantic market.

But Delta through its 49% stake in Virgin Atlantic is investing in the carrier during a time of transition as new CEO Craig Keeger takes the helm, and new domestic flights within the UK are debuting from London Heathrow. All of the change is underpinned by Virgin Atlantic’s weak financial performance. The carrier during FY2011-12 recorded a loss of GBP92 million, and it has been reported its losses for FY2012-13 will grow to GBP135 million.

With positions on Virgin Atlantic’s board, Delta will exert some influence over Virgin Atlantic’s future, but given the mounting losses and overall uncertain economic state in Europe, it could take a fair amount of time for Delta to recoup its USD360 million investment in Virgin Atlantic. Obviously Delta believes that is a small price to pay to secure an improved position between London and New York, which is “a must-have market”, said Mr Bastian. But Delta CEO Richard Anderson has previously laid out a time frame for Virgin Atlantic to improve its fortunes, noting that Delta expects its new partner to be profitable within the next three years.

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Delta’s moves during the last few years to strengthen its position in New York have resulted in the carrier capturing 33% of the one-way seats on offer (18-Mar-2013 to 24-Mar-2013) from LaGuardia and a 22% share at JFK. The new partnership with Virgin Atlantic provides the missing piece Delta needs to have an effectively stocked war chest in the New York market.

New York LaGuardia Airport capacity by carrier (% of seats): 18-Mar-2013 to 24-Mar-2013

New York John F Kennedy International Airport capacity by carrier (% of seats): 18-Mar-2013 to 24-Mar-2013

Working to even the playing field in Los Angeles

During 2013 Delta is moving to fortify another large corporate market as it adds new service from Los Angeles and expands frequencies in other markets. The expansion should help lift Delta’s seat share in Los Angeles, which presently stands at 13%. Los Angeles is highly fragmented, with no one carrier claiming a significant share of the seats on offer.

But it remains a strategic US west coast gateway, and all the major network airlines need to ensure they maintain equal footing with one another in the market.

Los Angeles International Airport capacity by carrier (% of seats): 18-Mar-2013 to 24-Mar-2013

Between Apr-2013 and Jul-2013 Delta is introducing new year-round flights to Seattle and Spokane, Washington; Nashville, Tennessee; and San Jose, Costa Rica. The carrier’s flights to Costa Rica mark the first from the US west coast to the country’s capital city by a US carrier. Schedules in Innovata show that Avianca-TACA subsidiary LACSA operates service from Los Angeles to San Jose.

Delta joins Southwest and American in operating service from Los Angeles to Nashville, and enters the crowded Los Angeles-Seattle market presently served by its partner Alaska Airlines, Virgin America and United.

Schedules in Innovata show that when Delta launches flights between Seattle and Los Angeles it will account for roughly 8% of the seats on offer. Alaska will hold a commanding 68% share followed by Virgin America’s 19% share and nearly 5% held by United.

Los Angeles International to Seattle/Tacoma International (seats per week, one-way): 19-Sep-2011 to 08-Sep-2013

The reasons behind Delta’s decision to enter the amply served Los Angeles-Seattle market are not clear, given its partner Alaska is the largest carrier on the pairing. Asked about Delta’s launch of service Alaska CEO Brad Tilden recently stressed the strong relationship Alaska has with Delta, noting Alaska provides significant feed to Delta’s widebody operation from Seattle.

Delta has been expanding long-haul flights from Seattle to Asia, reflected in its planned service to Shanghai and Tokyo Haneda in Jun-2013 joining existing service to Tokyo Narita, Beijing, Osaka, Amsterdam and Paris.

Mr Tilden did not address Delta’s flights from Los Angeles and Seattle specifically, but it is obviously not part of a joint strategy. He observed only that there are “little things that happen along the edges”.... “I don’t think we should let them [those little things] distract us from what is overall an exceptionally good relationship.”

Delta faces no competition on its service from Los Angeles to Spokane. Alaska is the largest carrier operating from Spokane, holding a nearly 41% seat share. The carrier operates numerous flights from Spokane to its Portland and Seattle hubs. Delta also serves Spokane from its Minneapolis and Salt Lake City hubs, but also flies direct from those markets to Los Angeles. Spokane might be a test case for some uncompetitive point-to-point flying from Los Angeles.

The passengers on the pairing could drive some very slight incremental traffic on long-haul service operated by Delta partners in Los Angeles – SkyTeam members Aeromexico, Air France-KLM, China Airlines, China Eastern, China Southern and Korean and non-alliance carrier Virgin Australia and WestJet. Presumably all of the capacity Delta is adding in Los Angeles will benefit its partnerships by driving more passengers onto long-haul flights from the airport, which serves a US gateway to Asia. Delta and Virgin Atlantic also plan to begin codesharing during 2013 on Virgin’s flights from Los Angeles to Heathrow.

Rounding out new year-round service is Delta’s planned operation from Los Angeles to San Jose, California, another crowded market served by American, Alaska, Southwest, Virgin America and United.

Delta is also competing with Alaska on its seasonal flights to Anchorage from Los Angeles. Anchorage during the last few years has gained some increases in seasonal traffic from US carriers. JetBlue during May-2013 is introducing seasonal service from Seattle to Anchorage, joining seasonal Long Beach-Anchorage service the carrier has been operating since 2011. United plans to begin seasonal service from its Newark hub to Anchorage in Jul-2013, offering one weekly flight on Saturdays.

On its planned seasonal service to Bozeman Delta is competing with United. Delta already serves Bozeman primarily from its Salt Lake City and Minneapolis hubs, but also offers less frequent service from its Atlanta hub.

Boston is another crowded market Delta is entering from Los Angeles. Once the carrier begins seasonal service in Jul-2013 it will become the fifth carrier serving the market. Aside from stamp-collector syndrome as Delta flexes its muscles, it is hard to find the logic in the decision to operate service to Boston since it does not hold a leading position in either market.

In Boston, Delta has a 12% seat share, compared with 15% for US Airways and about 30% for market leader JetBlue.

Boston Logan International Airport capacity by carrier (% of seats): 18-Mar-2013 to 24-Mar-2013

Using foreign equity investments to fill international network gaps

Delta is also building out its network in other strategic geographical regions through equity stakes in its SkyTeam partner Aeromexico and Brazil’s second largest carrier Gol, which has been struggling financially during the last year as demand in the Brazilian domestic market place cooled.

Since Delta and Gol announced Delta’s USD100 million investment in the Brazilian carrier in late 2011 along with the US carrier assuming a seat on Gol’s board, speculation has been growing that Gol would eventually join the Delta-anchored SkyTeam alliance.

But since that time Gol has repeatedly stated its intent to remain independent even as the alliance winds shift in Latin America with LATAM’s joining of oneworld, leaving Star without a strong partner in Brazil. After LATAM announced its alliance decision, Gol CEO Paulo Kakinoff remarked in local press reports the carrier’s intent to remain independent, which would leave it able to service both Star and SkyTeam connections.

Even if Gol does remain on its own, Delta’s partnership with the carrier gives it some traction in Latin America’s largest market. Delta’s position in Latin America is weak compared to its legacy counterparts United and American and during the last year American in particular has been building up service in Brazil, leveraging its stature as the largest airline between the US and Latin America.

Easing concerns about costs and its performance of its new oil refinery, hit by Sandy

Delta during the last year has been recording unit cost creep as it invested in certain product improvements including fleet-wide Wi-Fi, lie-flat business class seats and a significant terminal upgrade at JFK set for debut in May-2013. Those projects and wage increases from a pilot contract negotiated during 2012 have pressured the carrier’s unit costs, but Mr Bastian assured that the bulk of the 3% to 5% rise in unit costs during 2013 would occur during the first half of the year.

The carrier has undertaken a USD1 billion cost improvement programme that entails a fleet restructuring, maintenance costs improvements, lowering distribution expense and increasing staffing efficiency. After the scheme is completed, Delta believes that it can drive unit costs expansion of flat to 2% growth in the long term.

Delta’s highly watched execution of the resumption of production at an oil refinery it purchased during 2012 outside of Philadelphia, Pennsylvania hit a snag when superstorm Sandy struck the US west coast in Oct-2012. The storm disrupted production at the refinery and resulted in Delta recording a USD63 million loss from Trainer’s operations during 4Q2012.

Mr Bastian admitted Delta has experienced some teething pains with the restart of operations at the refinery.

He stated that operational delays resulted in the refinery operating at about 75% capacity in Jan-2013 and Feb-2013, but assured the facility would breakeven for 1Q2013. As production reaches full scale, Delta expects the refinery to produce a USD75 million to USD100 million profit in 2Q2013.

Delta continues its attempts to widen competitive advantages it holds over network peers

Delta handily recognises the advantage it holds over its large US network legacy peers in completing its merger with Northwest roughly two years ago.

With the integration complete it can quickly make the necessary moves to strengthen its network and drive down its most volatile expense – fuel. Only time will tell if its foreign investments and the acquisition of an oil refinery will preserve the carrier’s edge, but Delta seems ready and willing to adapt to both competitive pressure and cost constraints by taking its future into its own hands. Meanwhile, the market appears to be cautious about the carrier's ability to keep a lid on costs as it moves along.