Last week, Delta Air Lines (NYSE: DAL) reported a sharp decline in unit revenue for the third quarter. Falling fuel prices weren't enough to prevent Delta's profit from sinking on a year-over-year basis. However, Delta did forecast that its unit revenue trajectory will start to improve in Q4.
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Following the earnings release, Delta's management spent about an hour discussing the company's results and outlook with analysts and members of the media. The earnings call focused heavily on Delta's plans for returning to unit revenue growth. Here are five key points that Delta Air Lines executives emphasized.
Domestic unit revenue declines flattening out
The improvement was most evident in September when domestic unit revenue declines moderated to 2.5% for the month, driven primarily by improving business revenues. It is these trends that give us cautious optimism that we will have a path to positive RASM [revenue per available seat mile] in the domestic entity in the December/January timeframe; if not, shortly thereafter.
-- Delta President Glen Hauenstein
For a while, Delta executives have been projecting that unit revenue would soon stabilize. Fares for advanced bookings started moving in the right direction earlier this year. However, Delta's revenue growth efforts were undermined by persistent weakness in close-in yields: fares for the last-minute tickets that are frequently sold to business travelers.
Delta has been hurt in 2016 by falling fares for last-minute business travel. Image source: The Motley Fool.
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That harmful trend is finally petering out. Close-in yields for domestic travel have improved significantly since mid-August and are now roughly flat year over year. Barring another downturn in demand, domestic revenue per available seat mile should return to growth by early 2017 at the latest.
Capacity discipline and rising fuel prices will bolster unit revenue
I think the other thing to note is that capacity levels are lower than they've been all year long and will stay there until we get to the unit revenues we need. And fuel prices have also firmed up, which is providing a pricing floor.
-- Delta CEO Ed Bastian
Slower capacity growth will be one of Delta's key tools for returning to sustainable unit revenue growth. Through the first seven months of 2016, Delta increased its domestic capacity by about 5% year over year. During Q4, it plans to grow at half that rate in the U.S. Looking ahead to 2017, Delta plans to grow global capacity by just 1% relative to 2016.
Additionally, based on the discussion during the earnings call, Delta's management appears to expect rising fuel prices to quickly change the competitive environment. According to this line of reasoning, as higher costs crimp airlines' profit margins, they will all stop trying to undercut one another's fares.
At some point, this is bound to occur. It's much more profitable to cut some capacity if demand misses forecasts than to drive fares ever lower. However, it's not clear yet whether rising fuel prices will translate to higher fares as quickly as Delta expects.
Latin America becomes a bright spot
I am pleased to say [Latin America] is the first region to have turned the corner with a unit revenue improvement of 1.5% this quarter ...
-- Glen Hauenstein
The one geographic region that has turned the corner is Latin America. Delta reported 1.5% unit revenue growth there, driven by an astonishing turnaround in Brazil. Unit revenue had declined on Delta's routes to Brazil for four years running, including particularly steep declines last year. However, a rebound in the Brazilian real led to a 30% surge in unit revenue on routes to Brazil during Q3.
Mexico was the other main point of strength in Latin America. Indeed, solid demand in Mexican business markets has driven steady unit revenue growth there throughout 2016.
On the other hand, Delta faces more intractable problems in many of its other international markets. Overcapacity and fare wars are having a particularly severe impact on unit revenue for routes to Europe and China.
Costs are starting to rise again
We expect our non-fuel unit costs to increase 1% to 2% in the December quarter, which doesn't include any impact for a potential pilot agreement.
-- Delta CFO Paul Jacobson
Delta Air Lines' revenue recovery efforts are becoming particularly vital because unit costs are starting to creep higher again. After non-fuel unit costs increased just 0.1% in Q3, Delta is projecting a 1%-2% rise in Q4. Fuel prices are also starting to move higher, although for now Delta is still benefiting on a year-over-year basis from lower hedging losses.
The big whammy is Delta's new tentative pilot contract. If it is ratified, it will add hundreds of millions of dollars in labor costs. That could drive non-fuel unit cost growth above 3%.
New aircraft configurations coming?
I think we have to look at our entire service offering and ensure that we are supplying what the market wants to buy. ... You don't need to create an airline within an airline, you just need to adjust to what people want to buy in the marketplace.
-- Glen Hauenstein
The combination of cost creep and fare pressure in international markets may drive Delta to make bigger changes to its product offerings to remain competitive. Those could include creating new aircraft configurations.
Delta President Glen Hauenstein remained vague about what Delta may change. However, he hinted that Delta could squeeze more seats onto airplanes flying some transatlantic routes. By spreading its costs over more seats, Delta would be better able to match fares from no-frills airlines like Norwegian Air without undermining its margins.
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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.