Delta Air Lines, Inc. Earnings: Holding Up Well Despite Hedging Losses

By Markets Fool.com

Delta Air Lines became the first airline to report Q1 earnings this morning. As expected, the company's profitability was dragged down by significant hedging losses, which totaled $1.1 billion in the quarter.

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However, the company still managed to post a profit in the seasonally weak winter quarter. That serves as a clear demonstration of the strength of the airline industry, and of Delta Air Lines specifically.

The hard numbers
Delta's reported adjusted Q1 EPS of $0.45, which was just $0.01 ahead of the average analyst estimate. However, this represented a considerable gain over Delta's Q1 2014 adjusted EPS of $0.33. Capacity rose 5% compared to Q1 2014, driving a 5% year-over-year increase in revenue to $9.39 billion -- slightly below the average analyst estimate of $9.41 billion.

Delta's revenue increased 5% last quarter on 5% capacity growth.

For the full quarter, Delta's passenger unit revenue declined 1.7% year over year. This was slightly worse than the 1.5% decline Delta had projected earlier this month.

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As expected, there was wide variation by region. Domestic mainline unit revenue actually rose by 2.1% even as Delta increased capacity there by 7%. Meanwhile, unit revenue in the Pacific region plummeted by 9.2%, affected by the strong dollar and falling fuel surcharges. The Atlantic and Latin America regions experienced smaller unit revenue declines.

Good cost performance -- except for the hedges
Delta's non-fuel unit costs (excluding profit sharing and one-time items) fell 1.4% year over year in Q1. Delta's 5% capacity growth during the quarter helped, as did the strong dollar, which reduced Delta's costs outside the U.S. in dollar terms.

Delta's fuel costs also fell because of the sharp drop in oil prices. Its average fuel price was $2.93/gallon, down from $3.03/gallon last year. But the savings would have been far greater but for Delta's hedging losses. At market rates, Delta would have paid just $1.87/gallon for fuel in Q1.

Strong profit growth ahead
Delta's management forecast that the decline in passenger unit revenue will accelerate to 2%-4% in Q2. However, the company expects non-fuel unit costs to remain contained (up just 0%-1% year over year).

Moreover, the impact of fuel hedging losses will be much smaller next quarter, allowing Delta's average fuel cost to decline to $2.35-$2.40/gallon. This will help Delta achieve a 16%-18% operating margin in Q2, up from 15.1% in Q2 2014.

Profit growth should continue to accelerate in the back half of 2015. Delta has significantly reduced its fuel hedging exposure for Q3 and Q4. As a result, it expects to report fuel hedging losses of only $200 million-$300 million in the second half of the year. If oil prices stay near recent levels, this would bring Delta's fuel cost down to around $2/gallon.

To put it a different way, Delta CEO Richard Anderson stated in the earnings release that Delta is on track to enjoy more than $2 billion of fuel cost savings this year. Only $100 million of that benefit came last quarter, so there's still about $2 billion in savings ahead for 2015.

Delta is also actively managing its capacity to maximize profitability. Rather than concluding that its overall margin performance is "good enough," Delta plans to cut capacity in regions experiencing the most unit revenue pressure.

By Q4, Delta will have implemented capacity reductions of 15% or more in Japan, Brazil, and the Africa/India/Middle East region. It's also suspending its flights to Moscow for the winter season. The net result will be a 3% reduction in international capacity.

These decisive actions will likely keep Delta's profitability surging in Q4 and during 2016. Not surprisingly, many investors appear to be relieved. Delta shares rose more than 2% in pre-market trading on Wednesday morning.

The article Delta Air Lines, Inc. Earnings: Holding Up Well Despite Hedging Losses originally appeared on Fool.com.

Adam Levine-Weinberg is long January 2017 $40 calls on Delta Air Lines, 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.