How Delta Air Lines, Inc. Will Keep Producing Record Earnings

By Markets Fool.com

Nearly a year ago, Delta Air Lines reported that it had earned a record profit in 2013. Adjusted net income soared from $1.6 billion to $2.7 billion as Delta expanded its pre-tax margin by about 3 percentage points compared to 2012.

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Delta is on pace to produce even better earnings in 2014. Some investors have worried that this performance may be unsustainable. However, at Delta's annual Investor Day last week, the company's management team explained how Delta can keep earnings soaring to new heights in the future.

Maintenance expertise: The key to Delta's success
If Delta's competitive advantage over its airline peers had to be boiled down to one key strength, it would be its maintenance expertise. Delta has historically had a very good maintenance operation, but in the past few years, Delta's "TechOps" team has taken its game to the next level.

Delta Chief Operating Officer Gil West pointed out in his presentation that Delta has reduced its number of maintenance-related cancellations by more than 90% since 2010. This has led to a sharp increase in the number of days in which Delta has completed every scheduled mainline flight.

Source: Delta Air Lines Investor Day presentation.

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As a result of this performance, Delta is now the most reliable carrier among the major U.S. airlines across numerous metrics. Through the first three quarters of 2014, Delta had the best completion rate, the best on-time performance, and the lowest mishandled-bag rate of the top four U.S. airlines. This should keep Delta in the top tier of the annual Airline Quality Rating survey.

Delta benefits from its superior maintenance team in two ways. First, it helps Delta earn a revenue premium. High-yielding business travelers in particular are willing to pay extra to have confidence that they will get to their destination on time.

Second, Delta's maintenance expertise allows it to reliably operate older aircraft. Delta has saved billions of dollars in aircraft acquisition costs in the past few years compared to United Continental and American Airlines. Yet despite operating an older fleet, Delta's maintenance costs are 10% below the industry average.

Fleet flexibility
Let's take a closer look at Delta's fleet strategy. In recent years, Delta has laid out a very clear value-driven fleet strategy with four key components.

First, Delta looks to own aircraft rather than leasing them. Second, Delta tries to keep its planes flying as long as possible -- beyond 30 years, in some cases -- while retaining the flexibility to retire them earlier. Third, Delta buys new aircraft only when it can get a great deal, and focuses on "proven technology" rather than cutting-edge models. Fourth, Delta sources many of its narrow-bodies for domestic operations from the used-aircraft market.

Delta frequently buys out-of-favor used aircraft for its domestic network.

This strategy has several advantages. To start with, it helps Delta keep capital expenditures down. This leads to strong free cash flow, including record free cash flow of more than $3 billion in 2014. Delta is using this cash to bolster its balance sheet while also growing its dividend and opportunistically repurchasing stock.

Furthermore, this strategy keeps fixed costs low. With less money invested in aircraft, Delta can vary utilization seasonally or year to year based on demand in order to maximize profitability. Additionally, with most of its fleet owned free and clear, Delta can easily retire planes that have become uneconomic to fly. Management pointed to the recent decision to retire the 747 fleet by 2017 as an example of this.

Delivering fuel savings to the bottom line
U.S. airlines have a huge profit growth opportunity in 2015, as oil prices have plummeted by nearly 50% since late June. As of last week, market fuel prices were down about $0.70 from the average for 2014. If oil prices stay near today's level, Delta, United, and American will each save $3 billion or more annually before the impact of hedges.

Delta hedges fairly aggressively. Thus, it expects to realize a smaller fuel savings of about $1.7 billion in 2015 before getting the full benefit of lower oil prices in 2016. Management's goal is to turn as much of this fuel-cost savings into incremental profit in 2015 and 2016 as it can.

This means Delta isn't changing its capacity or pricing plans based on the drop in fuel prices. Delta executives stated that they have pretty good knowledge of competitors' costs. This allows Delta to avoid destructive price wars by recognizing when competitors' fares are unsustainably low.

Delta is replacing its 747s with smaller aircraft like the Airbus A330.

Also, Delta is reducing capacity in markets with weaker demand. Delta will cut capacity in Japan by 10%-15% next year as the devaluation of the yen has hurt unit revenue. Additionally, by 2017, it will replace the 747s that serve many Asian routes with smaller aircraft that are much cheaper to operate.

Moreover, Delta has numerous ongoing initiatives to maximize revenue. This includes adding more premium seats and doing a better job of selling them; negotiating a new, more lucrative co-branded credit card agreement; retooling its frequent-flier program to reward the most profitable customers; and changing its customer-facing fare categories.

Last, Delta needs to keep its non-fuel costs in line. Its most important weapon on this front has been steady "upgauging" of the fleet. This involves replacing old planes with larger ones and adding seats to many of Delta's existing planes. Larger planes are typically cheaper to operate on a per-seat basis, while the marginal cost of adding seats to a plane is very low.

A solid plan for 2015 and beyond
Delta Air Lines thus has a strong plan to drive earnings growth in 2015 and beyond. Delta's reliability is helping it boost its revenue premium. Its ability to keep older planes running reliably will also allow it to keep capex at moderate levels, driving strong free cash flow. (This in turn can benefit EPS through debt reduction, accelerated pension funding, and share buybacks.)

Furthermore, the drop in fuel prices will benefit Delta more than some of its competitors, as Delta has not invested as much money in buying the newest, most fuel-efficient planes. If jet fuel prices remain closer to $2 per gallon than $3, Delta's maintenance expertise will become an even bigger competitive advantage.

Delta has projected that its pre-tax income will rise from about $4.5 billion in 2014 to at least $5 billion in 2015. In light of the potential $1.7 billion fuel-cost savings and Delta's detailed plans to offset any fuel-related pressure on revenue, this guidance seems conservative. It's basically a foregone conclusion that Delta will earn another record profit in 2015 -- the only question is by how much.

The article How Delta Air Lines, Inc. Will Keep Producing Record Earnings originally appeared on Fool.com.

Adam Levine-Weinberg has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.