Delta Air Lines' Virgin Atlantic Investment Is Being Vindicated

By Markets Fool.com

In late 2012, Delta Air Lines made a bold move to acquire a 49% stake in trendy U.K. airline Virgin Atlantic for about $360 million. This investment was far from a sure thing, as Virgin Atlantic was mired in persistent losses at the time.

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Delta Air Lines invested $360 million in Virgin Atlantic a few years ago. Photo: The Motley Fool

Virgin Atlantic returned to profitability in 2014 and posted further earnings growth in 2015 despite incurring big fuel hedging losses. As those hedging costs fade and as Virgin Atlantic upgrades much of its fleet to the highly efficient Boeing (NYSE: BA) 787-9, profits should rise even further, leading to a big payoff for Delta. Here are the details.

Virgin Atlantic releases 2015 earnings results
This week, Virgin Atlantic announced that its full-year adjusted pre-tax profit rose more than 80% in 2015, reaching 22.5 million. That's still not a very impressive result, though, as it represents a pre-tax margin of less than 1%.

However, Virgin Atlantic's profit would have been 10 times higher had it not incurred 198 million in fuel hedging losses last year. The company expects its fuel hedging losses to be much smaller in 2016, allowing it to capture more of the benefit of low fuel prices.

Virgin Atlantic's transatlantic joint venture with Delta has also bolstered its finances. By operating as a single airline on routes from the U.S. to the U.K., the two carriers have been able to offer more schedule choices for customers, driving market share gains. Virgin Atlantic is also benefiting from connecting traffic that Delta provides in the U.S.

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In 2015, Virgin Atlantic's unit revenue declined 2.9% in constant currency. Early in the year, Virgin Atlantic dropped its flights to Tokyo, Mumbai, and Cape Town. All of this capacity was redeployed to the U.S. This led to high capacity growth in the U.S.-U.K. market, which may have hurt Virgin Atlantic's unit revenue. However, as this new capacity matures in 2016 and beyond, unit revenue should bounce back.

Fleet changes will also drive profit growth
Fleet modernization will be another key driver of profit growth for Virgin Atlantic. In late 2014, the company received its first 787-9 Dreamliner from Boeing. It began 2015 with two Dreamliners and added another seven during the year.

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So far, the 787-9s have mainly replaced Virgin Atlantic's A340-300s and A340-600s. The A340 has very high fuel consumption due to its four-engine configuration. Virgin Atlantic has estimated that the 787-9 burns 27% less fuel than the A340-300.

Virgin Atlantic is retiring its fuel-guzzling A340s. Photo: Wikimedia Commons user Peter Bakema

Virgin Atlantic has also started to retire its older Boeing 747 jumbo jets, and some of these may be replaced by Dreamliners. The carrier has eight more 787-9s scheduled to arrive from Boeing in the next couple of years, and it has also expressed interest in exercising options to buy another four.

The cost savings from moving to more fuel-efficient planes is obviously lower today than it was a few years ago when oil prices were much higher. However, fuel is still a significant input cost for Virgin Atlantic. Replacing fuel-guzzling four-engine planes with the highly efficient Boeing 787-9 will help reduce its unit costs.

The new Dreamliner fleet could also help on the unit revenue front. The 787-9 is somewhat smaller than most of the planes it is replacing at Virgin Atlantic. By offering fewer seats in certain markets, Virgin Atlantic may be able to increase its average fare.

Looking for a steep profit growth trajectory
Delta Air Lines is already benefiting from its Virgin Atlantic investment, as the joint venture has significantly improved Delta's position in the key London business market. Soon, it should also start recording a meaningful amount of equity income from its Virgin Atlantic stake.

Virgin Atlantic CEO Craig Kreeger has set a goal of surpassing the company's record profit of 99 million by 2018. Assuming fuel prices stay low, this target seems extremely conservative. Depending on how much money Virgin Atlantic loses on its fuel hedges in 2016, its earnings could reach a new record as soon as this year.

Furthermore, Virgin Atlantic will continue to phase out its four-engine planes in favor of more fuel-efficient models from Boeing (and possibly Airbus) in the coming years. That should drive further profit growth. As a result, Delta could soon be earning very high annual returns on its modest $360 million Virgin Atlantic investment.

The article Delta Air Lines' Virgin Atlantic Investment Is Being Vindicated originally appeared on Fool.com.

Adam Levine-Weinberg owns shares of The Boeing Company and 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.