Delta blew the rest of its peers out of the water by producing nearly USD1 billion profit in the third quarter, illustrating just how big the airline is now that its merger with Northwest is well underway.
It must be pointed out, however, that its GAAP profit was USD363 million, according to President Ed Bastion, who added that the company incurred USD566 million in special items for non-cash expenses including USD360 million for debt extinguishment, USD153 million for Comair’s restructuring and USD53 million on merger-related expenses.
Chair and CEO Richard Anderson reported the company not only achieved a 13.5% operating margin in the quarter but beat the first call estimate on EPS by USD 16 cents.
“The results were driven by revenue performance, cost discipline and harvesting synergies from the merger,” he told analysts. “Passenger unit revenues were up 16% year over year and top line revenues grew 18% while consolidated ex fuel unit costs were flat on a 2% capacity growth in the quarter. We are guiding to a profitable December quarter. All this really illustrates the benefits of the merger.”
Despite the good results, Anderson said more work needs to be done to achieve consistent profitability and generate the 10-12% operating margins on an annual basis targeted by the company.
“We are focusing on building a sustainable industry model,” he added. “To that end, we will continue debt reduction, keep capacity deployment as low as possible, maintain discipline on costs and keep capacity in line with demand. All that will lower costs.”
Continued debt reduction
The company continued its debt reduction in the quarter with USD750 million debt repayments bringing its net debt down USD2 billion from the USD17 billion earlier in the year.
“That’s the most accretive thing we can do for our shareholders,” said Anderson. “You know we trade at a discount to the S&P 500 and in order to achieve parity we need to de-risk the business. Debt pay down reduces non-operating expense and that goes straight to earnings per share. Most importantly it builds in the flexibility to navigate the changes in the environment so our investors have confidence we we can deliver a sustainable business model.”
JP Morgan analyst Jamie Baker polled industry leaders on their definition of "discipline" and produced an interesting discussion on the subject, concluding it was an over-used term in the airline industry.
When Baker asked the same question of US Airways Chairman and CEO Doug Parker he received much the same answer as Anderson. Parker, who is deeply convinced that management philosophy in the US airline industry is truly different, said: “Discipline is a focus on what you’re supposed to do and not succumbing to temptation.
“Sometimes the temptation is, as opposed to creating value, it’s wanting to be the biggest or caring more about market share than you do about profitability,” he continued. “We’ve certainly seen that happen in the past in our business. We’re competitive people and you don’t like to see someone else getting more share than you do sometimes – that’s temptation.”
He then went on to chastise the analysts for bowing to temptation and funding start-ups during the top of the business cycle, without the least understanding of airline economics. Funding these start-ups is “based simply on cost structures or on some sort of consumer model that doesn’t have any basis on the real fundamental economics of airline profitability,” he said. “And then we’ve got to spend a lot of time fighting those guys off and we do.”
Anderson opts for more technical definition
“I think it means whatever growth you have in the business has to be below GDP and can’t be at expense of yield and RASM improvement,” said Anderson. “You have to keep up with demand but you can’t worry about chasing share. But you have to focus on what is going to drive the operating margin higher. It is a way for us to de-lever the business to avoid big capacity outlays if at all possible in the modification of or buying new equipment. So you have to take into account how your capital deployment is working.”
Baker agreed adding that the flexibility Anderson had referenced earlier was a key factor. “With the fuel and GDP forecasts, it is not clear your competitors are making any changes to their business plans and it is often a matter of how quickly you can adapt and the levers you have at your disposal to pull.”
Anderson pointed to Delta’s fleet plan as a perfect example. “It’s not having a big stream of airplanes that require a lot of cash deposits,” he said. “That is important. We like having a big chunk of fleet paid for and depreciated which makes it easy to park capacity with no monthly payment.”
Indeed, Delta’s fleet plan drew a question as the analyst wondered how the company could ground 180 aircraft and still increase capacity. Anderson explained the vast majority, 128, came out with the sale of Compass to Trans-States Holdings and Mesaba to Pinnacle.
“That’s how we develop operating margin,” he explained. “If you think about how we stack up against the low-cost carriers, one of the benefits of the merger is to have enough schedule permutations to get as good utilisation out of asset as possible. We have created several USD100 million by more tightly scheduling the aircraft. We fly the airline with a smaller fleet and that creates operating margin and we are going to do it again next year.”
Anderson reported that December capacity will be down 5% vs 2007 and 1% from 2008. Delta will further streamline its fleet next year and increase utilisation further “because capital intensive growth is not in our plan if we are going to get the 8-10% return on invested capital”.
He added that the capacity guidance for 2011 remains unchanged at between 1-3% over 2010 as the company reduces its fleet again by 20 to 30 aircraft.
“We still have work to do and we owe it to our stakeholders to get to that return-on-capital goal,” he concluded. “We can’t slow down. We are building a solid financial foundation by focusing on debt reduction, shrewd deployment of capital and pretty strict cost discipline.”
Bastion reported that the company generated USD3.7 billion in EBITDAR for the first nine months and expects to finish the year with EBITDAR at USD4.7 billion. He also said that free cash flow generated through the third quarter was USD1.5 billion, USD1.4 billion of which was on the merger synergies. He added the company will finish the year with USD1.5 billion in synergies.
Revenue for the September quarter was USD9 billion, said Bastion, up USD1.4 billion or 18% from the year-ago period on a 2% increase in capacity. Consolidated passenger unit revenue was up over 16% year on year, driven by higher corporate revenue and higher international mix, he said. Corporate revenue was up 35% year on year driven largely by a 27% increase in corporate volume.
Domestic unit revenue was up 10% year on year on a two point increase in capacity while domestic yields were up 12%.
Bastion also reported the continuing strength in the international arena with unit revenues up 29% with both yield and load factors showing significant improvement. Trans-Atlantic, he reported, was at 2007 run rates with unit revenues up 25% on a one point increase in capacity.
Pacific unit revenues jumped much higher, though at 45% year on year on a six-point growth in capacity. And, in Latin America, unit revenues were up 16% on an 8% increase in capacity. Bastion noted that revenue will strengthen further in the Latin American market as it moves into a seasonally stronger period.
“Our unit revenue production is noteworthy,” he told analysts pointing to the fact that the company was retiring its smallest, most expensive equipment. “However, that produces a downward pressure on unit revenues. We’ve had a large reduction in costs and that has resulted in stronger margin improvements. Despite the pressure of retiring aircraft, our third quarter RASM improved 200 basis points relative to the industry in the latest ATA data and we’ve outperformed the overall industry in both August and September.”
Other revenue u USD75m on higher bag fees
“The revenue outlook is good with demand staying strong,” said Bastion. “October unit revenues are up 11-12%, higher than in prior years. The strength shows we are managing advanced bookings with a keen focus on yields, leaving additional inventory available for late, high-yield traffic.”
Bastion noted that its December quarterly capacity projections have drawn concern at 5% to 7% with domestic up 3-5% and international up 10-12%.
“We are firmly committed to capacity discipline,” he said. “The schedule is actually down 5% from 2007 and in line with overall trends. Domestic, with its greater sensitivity, will be down 10% from 2007, greater than overall industry domestic reduction of 6.7%. Our international capacity in the fourth quarter will be up 4% versus 2007 consistent with the strong demand in Asia and Latin America. In total, 2010 will be up only one point from 2009 and in 2011, we are forecasting full-year capacity 1-3% above 2010. Still, that is 3-4% below 2008.”
CFO Hank Halter reviewed the expense picture, saying that ex profit sharing operating expense rose USD315 million or 4% on a 2% increase in capacity, higher fuel, volume-related and maintenance expenses. That latter was offset by merger synergies, however.
“Ex-fuel and profit sharing, our consolidated unit cost operating expense was flat,” he told analysts. “Our non-operating expense was down USD23 million to USD277 million. The December quarter cost performance ex fuel and profit sharing will be down 3-5% with mainline down 1-3%."
Halter said the December quarter will be solidly profitable with operating margins of 6-8%, the third quarterly profit in a row and the first December-quarter profit since 2000.
The company closed the third quarter with USD5.5 billion in unrestricted liquidity, USD3.9 billion of which was in cash. It posted operating cash flow of USD515 million in the quarter.
“The general rule rule is when you replace a low-cost provider with a high-cost provider, it improves the economic environment,” he said. “If you look at our performance in Salt Lake City in the past 12 months, Southwest has shrunk 10-11% and we’ve stayed flat to growing slightly. If you look at the AirTran system, we think there are some dis-synergies in the merger and when you do the math on revenue, cost and load factor operated on the AirTran system the only way to make that merger have the synergies promised, is by increasing fares and revenue. When we look at our competitive position, we probably have more competition than almost anyone else and we’ve shown our ability to compete effectively.”
Bastion jumped in to note that Southwest will be discontinuing AirTran’s business product, making it easier for Delta to compete.
During his analyst call, Southwest CEO Gary Kelly took exception at being called a high-cost carrier.
“Obviously, we're not a high-cost airline and I don't think there is any use in wasting anybody's time trying to prove what is obvious to everyone,” he told analysts. “We are leading the industry in virtually every economic category with our low-fare approach. We're the only one who doesn't charge all the ridiculous fees. So, of course, that's not what our strategy is. Our strategy is to keep our fare as low, continue to be the low-fare leader in the United States, not nickel-and-dime our customers. We already see a host of opportunities, particularly in Atlanta to go in and reduce the fares by half, to what Southwest Airlines' levels are, and enjoy the famous Southwest effect of stimulating traffic. It is not our plan to convert ourselves from a low-fare carrier to a high-fare carrier. You won't see that happen.”
When asked if the mergers have created enough concentration in the industry, Anderson only pointed to the progress made around the world, but indicated he thought the consolidation process was only three-fourths complete.
“With tighter credit and a lot less speculative capacity, the industry is required to develop a return on invested capacity,” he said. “That force is more powerful than anything else in the marketplace. You’ve had LAN and TAM and British Airways and Iberia and you will continue to see that elsewhere in the world. I think we’ve made substantial progress but we still have to build confidence in the investor base that forward earnings we talk about are actually there and won’t be taken away by things beyond our control or because we are not focussing on return on invested capital. That is the way be de-risk the balance sheet and build flexibility.”