Delta Air Lines Inc (DAL) — Q1 2015 Earnings Call Transcript

Thanks, Sherlon. Good morning, everyone, and thanks for joining us. Here in Atlanta today, we have Richard Anderson, our CEO, Ed Bastian, our President, and Paul Jacobson, our CFO, and we have the remainder of the leadership team here in the room with us for Q&A. Richard will open the call, Ed will then address our financial and revenue performance, and Paul will conclude with a review of our cost performance and cash flows. To get in as many questions as possible during the Q&A, please limit yourself to one question and a brief follow up. Today’s discussion does contain forward-looking statements that represent our beliefs or expectations about future events. All forward-looking statements involve risks and uncertainties that could cause the actual results to differ materially from the forward-looking statements. Some of the factors that may cause such differences are described in Delta’s SEC filings. We’ll also discuss non-GAAP financial measures. All results exclude special items unless otherwise noted. And you can find the reconciliation of our non-GAAP measures on the Investor Relations page at ir.delta.com. And with that, I will turn the call over to Richard.

Thanks, Jill. This morning we reported the best first quarter in Delta’s history, producing solid top line growth, margin expansion, and substantial free cash flow. Our pre-tax earnings grew 34% from last year to $594 million despite $300 million from early hedge settlements in the quarter. We earned $0.45 per share versus a consensus of $0.44. We grew our top line revenues by 5%, increased our operating margin by 1.0% to 8.8%, and generated a return on invested capital of 22% for the last 12 months. Our strong cash generation continued with $1.1 billion of operating cash flow and north of $500 million of free cash flow in the first quarter. We contributed $900 million to our pension plans, maintained net debt levels of just over $7 billion, and returned $500 million to shareholders in dividends and buybacks. We continue to run by far the industry's best operation. In the March quarter, we delivered a 98.6 completion factor that included a lot of tough weather days. We had 25 days with zero mainline cancellations. Our mainline on-time rate improved 3.1 points to 83.4%. This operational performance is contributing to solid increases in customer satisfaction; we have achieved all-time highs in our Net Promoter scores, and our customer complaint rate has decreased by 23% so far this year. These outstanding results were made possible by the dedication of our employees who work hard every day to provide an industry-leading customer experience and outstanding returns to our shareholders. Looking forward, the business as a whole is performing quite well. While the strong dollar is creating a $600 million headwind for our international revenues, it is also a factor in keeping fuel prices down, which will contribute over $2 billion in gross savings year-on-year in 2015. We are looking at June quarter operating margins of 16% to 18%, up over 200 basis points year-over-year, with over $1.5 billion of free cash flow in the June quarter. These record results in cash flow show that the strong dollar is a net positive for Delta. We will use that cash flow to further reduce our debt levels and buy back our stock. These are permanent positive changes to our capital structure. But even with this record level of performance, we have a lot of work left to do to improve our business for our owners. The domestic business is performing very well and demand is solid. Our network and product investments combined with the world-class customer service of our employees have widened our domestic revenue premium to the industry, which currently stands at 115%. We will continue to be disciplined with our domestic capacity levels, with our domestic growth driven by higher gauge in fewer total airplanes, which will cause us to improve efficiency and drive higher operating margins. On the international side, like all U.S. global companies, we are working through volatile currencies around the world. We are taking action to address these issues by reducing our international capacity by 3% year-over-year this winter. This is a six-point reduction versus our planned capacity levels. Unlike other U.S. global companies, our margins and profitability will expand in 2015 in the face of currency volatility due to dramatic fuel cost reductions and top line growth. With flat system capacity for the fourth quarter, we should get our unit revenue growth back on the right trajectory. Cost productivity is a core part of Delta, and we've kept our non-fuel CASM growth below 2% for seven consecutive quarters. We have good control of our costs, and we continue to drive productivity through domestic upgauging, technology investments, and leveraging our scale. The biggest cost opportunity ahead of us is fuel. We restructured our hedge book this quarter, which will put the bulk of our hedge losses behind us after this quarter. So starting July 1, we will have a significant tailwind for fuel with prices being 25% lower than what we will pay in the first half of the year. Over the long term, our focus is on building a durable business model not just through our margin expansion efforts but also by taking risk out of our enterprise. We have the best labor relations in the industry with a strong paper performance culture and a history of working collaboratively with all of our employees. On business risk, we expect considerable time diversifying our revenue streams and building out a geographically balanced network. 15% of our passenger revenues are part of immunized joint ventures, and 20% of total revenues from non-ticket sources. Finally, we are reducing our financial risk; we have lowered our fixed cost structure uniquely with our aircraft purchase strategy, which gives us the flexibility to quickly make capacity adjustments. We have also substantially strengthened our balance sheet with nearly $10 billion in debt reduction in less than five years. We are only two notches away from investment grade, and with another strong year in 2015, we expect to operate Delta with investment grade credit metrics by year-end. With a clear path to long-term margin expansion and reduced risk, we get improved earnings predictability and better visibility to the long-term cash generation of this business. We are investing in our future at a healthy pace of $2 billion to $3 billion annually, which is more than sufficient to support our strategies, and this year we expect to generate $4 billion to $5 billion in free cash flow after those investments. Less than 10% of the S&P 500 generate free cash flow at this level. In 2015, Delta will once again comfortably exceed our long-term commitments to our owners, and despite being one of the top performers in the S&P 500 over the last several years, we believe there is considerable upside in Delta stock. Our free cash flow yield is roughly 12% to 13% compared to the S&P Industrials average of 5% to 6%, and our PE multiple is at roughly half the level of this peer group. We are working through our updated long-term plan now. We'll take the plan to our Board at the end of this month. Part of that work includes developing the next set of metrics that will guide the business, including the optimal long-term debt target and level of shareholder returns for the company. We believe this plan will give long-term equity holders very clear guidance on our future and what they can expect from our cash flows, and it will show that Delta has earned a place among the top tier S&P 100 companies. We look forward to sharing those plans with you in mid-May. With that, I'll turn the call over to Mr. Bastian and Mr. Jacobson.

Thank you, Mr. Anderson, and good morning, everyone. We delivered a record March quarter with pretax income increasing over 30% to $594 million, despite a $300 million early hedge settlement. Our net income was $372 million or $0.45 per share versus a consensus of $0.44. We expanded our operating margin by a point to 8.8%, which includes the impact of the early out-of-quarter hedge settlements that cost us roughly three points of margin. These results are in line with the initial margin guide we gave in January. The quarter was obviously impacted by our $1.1 billion in hedge losses, thus to give you a better sense of the core performance of the business, end market fuel prices, our margin for the quarter is 17.8%, among the best in the industry and provides a good go-forward perspective on our margin expectations given our hedge losses will be largely behind us as of July 1. I want to thank the great Delta people for their dedication and determination that made these record results possible. We continue to grow the top line, which will be up 5% to $9.4 billion against a backdrop of roughly 45% lower market fuel prices and $105 million in currency headwinds. Corporate revenues increased 3% despite pressure from currencies, with strength in the Trans-Atlantic driven by our joint venture with Virgin Atlantic and from the financial services industry, both up double digits in the March quarter. Our recent survey shows corporate travel managers continue to be optimistic about the remainder of the year with roughly 85% of respondents anticipating they will maintain or increase spending over the balance of this year. We also saw good traction with our ancillary revenues. Merchandising revenues including branded fares, first-class upsell, and preferred seating grew by 27% and contributed an incremental $50 million to our top line this quarter. However, the strong dollar and lower international surcharges are causing our revenue performance to fall short of expectations. As Richard mentioned, we are taking action with our winter capacity plans to address these issues which I'll give details on in just a few minutes. First, on the March quarter. Passenger unit revenues declined 1.7% driven by 1.5 points of currency effect. However, the underlying demand environment is stronger than the RASM optics would suggest. In fact, on a currency-neutral basis, unit revenues were essentially flat with last year's levels. Our domestic performance remains solid with RASM flat on 5% higher capacity. And as a reminder, two of those capacity points were caused by the first quarter 14 winter storm cancellations, which created one point of RASM benefit that we had to overcome this year. Our Seattle expansion is performing well with domestic unit revenues up 2% on 55% higher capacity. We also saw strength in our JFK long-haul markets, especially the Transcons as we continue to make corporate gains in New York and Los Angeles. Our hub-to-hub markets also performed well with 4% RASM gains. In the Trans-Atlantic, unit revenues declined 3% driven entirely by a three-point currency headwind on four points of higher capacity. Strength in core Europe and London offset headwinds in Africa, the Middle East, and Russia, which pressured entity unit revenues by more than two points. To give perspective, these markets collectively saw unit revenue declines up 15% despite 10% capacity reductions. We're pleased with the performance of our two Trans-Atlantic joint ventures. This quarter, as these relationships with Air France, KLM, and Virgin Atlantic allowed us to expand margins despite significant currency pressure on the euro and pound. In Latin America, unit revenues declined 4% on 13% higher capacity. The entirety of the decline was driven by currency and pressure from last year's Venezuela in capacity reductions. Our partners GOL and AeroMexico contributed $33 million in incremental revenues this quarter and we have more opportunity to expand these relationships. Along with AeroMexico, we’ve filed an application for anti-trust immunity for a new $1.5 billion joint venture between the U.S. and Mexico. This is a significant opportunity that expands options for customers to the largest market in Latin America. We face our toughest revenue environment in the Pacific where unit revenues declined 9% with roughly seven points of the decline driven by foreign exchange. Specifically, the Yen revenue headwind in the quarter was $40 million net of hedges. For the remainder of 2015, our Yen hedges are valued at about $110 million. Now looking forward to the June quarter, we are forecasting total revenues to increase about 2% with RASM down 2% to 4% on 3% higher capacity. About three points of that RASM decline is attributable to currency and international surcharge declines. It is also important to note that we are lapping a very strong Q2 2014 performance in which we grew system RASM at 6%, which is the toughest comp we'll face this year. Our summer revenue performance combined with significantly lower fuel prices and continued strong cost controls should result in another record profit with second quarter operating margin of 16% to 18%, up two points year-on-year. Excluding hedges, our second quarter margins are expected to be north of 20%. Domestically, the demand environment remains stable, and we expect unit revenues to be roughly flat this quarter on 3% to 4% more capacity. This is consistent with the performance we saw in March of what we're already seeing in April. We expect international RASM to be down in the high single digits in Q2, with five points of impact from currency. In addition to currency, we're also continuing to experience softer demand trades in certain markets including Brazil, Russia, the Middle East, and Africa. However, revenue headwinds from currency will be more than offset by cost reductions and fuel price declines. Cash flow and margin performance in the international entities will be at record levels this summer. Post Labor Day, we will reduce our planned international capacity by six points, resulting in a 3% year-on-year reduction to get our RASM performance back to better levels for the winter. This reduction will be a key component to achieve the pricing improvements necessary to drive longer-term sustainable margin expansion. In the Trans-Atlantic, we will reduce our planned capacity levels by five points resulting in a 0% to 2% capacity decline for the fourth quarter. The biggest adjustments will be in Africa, India, and the Middle East, which will see a reduction of 15% to 20%. In addition, we will suspend service to Moscow for the winter season. In Latin America, our network investment tails off later this year with capacity growth less than 2% by the fourth quarter. To address the RASM pressure we've seen from the devaluation of the Real, we'll reduce capacity to Brazil by about 15%. We'll also make adjustments to longer-haul ethnic markets that are highly reliant on foreign point of sale traffic. These capacity adjustments, along with lapping the impact of last year's capacity reductions in Venezuela, should drive a better unit revenue result. The Pacific will take longer to show improvement as we take the next steps in our network restructuring there. Through gauge reductions, we'll take another 15% to 20% of capacity out of Japan, including a 25% reduction in our intra-Asia and beach lines since those markets have been significantly impacted by the devaluation of the Yen. These capacity reductions will be achieved through down-gauging, which will allow us to retire six more 747s by the end of the year. In total, our Pacific capacity will decline 10% in the fourth quarter. We should have good margin and cash flow performance through the seasonally strong second and third quarters. Once the peak summer season ends, we are moving quickly on our capacity actions that will continue to drive momentum in the business. Now, I'll turn the call over to Paul to go through the details on cost and cash flow.

Thank you, Ed. Strong cost control is a highlight again this quarter and was a key driver of our strong margin expansion we realized before early hedge settlements. Total operating expenses increased by $356 million, driven largely by higher volumes and investments in our product and people, as well as by higher profit-sharing expenses, which were up 40% versus last year. Non-fuel CASM declined 1.4% on a 5% capacity increase driven by up-gauging initiatives, lower maintenance expenses due to the 50-seat retirements, and other productivity improvement efforts. FX also benefited non-fuel CASM by about a point. Moving on to fuel. Our total fuel expense increased slightly as lower market prices were offset by higher consumption and our hedge losses. Our all-in fuel price was $2.93 per gallon, down from $3.03 in the same period last year. The early settlements added about $0.33 per gallon for the quarter. The refinery made an $86 million profit this quarter versus a $41 million loss in the same period last year. The improvement was driven by lower group costs driven by an increase in North American consumption, a continued favorable crack spread environment, and increased throughput. Over the last four quarters, the refinery has produced a cumulative profit of over $220 million. We expect that to continue to build in Q2 with a projected profit of approximately $80 million. As Richard mentioned and as we disclosed previously, we took steps in the first quarter to restructure our second half 2015 hedge book in order to balance our exposure while still retaining some level of longer-term upside protection. In February, we took advantage of the 20% spike in forward curves to settle about a third of our second half 2015 hedges for approximately $300 million. We also extended a similar portion of our exposure out of the back half of 2015 and into 2016. While the second quarter will have approximately $650 million in hedge losses, the average price per gallon will be significantly lower than what we realized in Q1. Specifically, we are projecting an all-in fuel price of $2.35 to $2.40 per gallon for the June quarter. For the June quarter, we are approximately 40% hedged against an increase in prices but have nearly full downside participation of about 90% all the way down to Brent prices of $40 a barrel. For the second half of the year, given the hedge book restructuring, we expect our fuel price per gallon to be consistent with the industry average. We have a total of about $300 million in hedge losses for the second half and 90% to 95% downside participation to a Brent price of approximately $40 a barrel. This will equate to roughly 25% lower price per gallon for Delta in the second half relative to the first. For the second half of the year, we expect our all-in fuel price to be in the range of $2 and $2.05 per gallon, which is approximately $0.70 to $0.75 lower than 2014. Overall, we continue to expect fuel costs to be an enormous tailwind and provide a net benefit of $2.2 billion for Delta for the year. We are also well positioned to benefit if fuel remains at these levels in 2016. As a result, our already strong cash flow will continue to grow, which will allow us to further strengthen the balance sheet by paying down debt, funding our pension plans, and returning cash to shareholders in 2015 and beyond. For the March quarter, we generated more than $1 billion of operating cash flow, net of $900 million in pension contributions. This compares to $605 million of pension contributions in last year's March quarter. We subsequently made substantially all of the remaining 2015 contributions for a total of $1.2 billion for the year. We also reinvested roughly $600 million back into the business, primarily related to aircraft modifications and the purchases required for our domestic re-fleeting. For the June quarter, we are projecting $1 billion in capital expenditures, primarily related to 737-900 and A330 deliveries, as we continue to reinvest in the business for the long term. With more than $500 million of free cash flow we generated during the March quarter, we continued our path of increasing shareholder capital returns with $75 million of dividends and $425 million of share repurchases. To date, we have completed $1.3 billion of our existing $2 billion authorization. Adjusted net debt at the end of the quarter was $7.4 billion, and our debt reduction lowered interest expense by $55 million for the quarter. We continue to expect strong free cash flow generation going forward and remain committed to a capital allocation strategy that drives value for our shareholders. We look forward to updating you on our longer-term capital deployment plan in May. In closing, I'd like to once again thank the entire Delta team for another record-breaking quarter. We have the best employees in the industry, and our performance is driven by their contributions. Thanks. And with that, I'll turn it back to Jill.

Thanks, Paul. Sherlon, we're now ready for the Q&A portion of the call with the analysts, so if you could give instructions on how to get into the queue.

Okay. With that, we will conclude our call today. Thanks everyone for joining and listening.