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Best of Airways — Delta Prepares Its Wide-Body Future

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Best of Airways — Delta Prepares Its Wide-Body Future

Delta Air Lines

Best of Airways — Delta Prepares Its Wide-Body Future
October 04
14:02 2017

Analyzed by Vinay Bhaskara • Airways Magazine, August 2014


Earlier this year, Delta Air Lines (DL/DAL) released a request for proposal (RFP) for the replacement of fifty wide-body aircraft from its fleet. The second largest carrier in the globe is looking ahead to replace a significant number of its Boeing 767-300ER and 747-400 aircraft with newer and more efficient options.

According to an email sent to Delta’s management employees, the airline will consider the Boeing 787 and 777-300ER (77W), the Airbus A350 (-900 and -1000 only) and A330 family, as well as the yet-to-be-launched A330 NEO (New Engine Option). Delta’s CEO, Richard Anderson, ruled out an order for the recently launched Boeing 777-X, calling it “an experimental airplane.” On the flip side, he was complimentary of the Airbus A330 NEO, stating, “I hope they [Airbus] do offer an A330 NEO. There is a huge need for a small wide-body aircraft. We really need Airbus to step up and re-engine.”

Delta currently has a solid wide-body order of 28 airframes, including 10 Airbus A330-300 (placed in mid-2013), and 18 Boeing 787-8 aircraft. The Dreamliner order was inherited from its 2008 merger with Northwest Airlines (NW) and was initially scheduled for delivery between 2010 and 2012, although it’s been deferred to occur between 2020 and 2022. In addition, the airline holds purchase options for six Boeing 777-200LR aircraft, which could, in theory, be converted to firm orders for the larger 77W.

The Boeing 787-8 has been used by several airlines around the world as a Boeing 767-300ER replacement, usually in seating configurations of between 200 and 250 passengers. Delta currently operates 58 Boeing 767-300ER aircraft with seating configurations between 208 and 226 passengers, and 16 Boeing 747-400 configured to seat 376 passengers. However, given the age of these aircraft, an expensive D-Check (the required Heavy Maintenance Visit) will be necessary by the end of this decade, forcing the airline to look for replacements well before then.

All Boeing 747-451 aircraft were inherited from the Delta-Northwest merger. PHOTO: CARLOS LUGO.

A complex fleet strategy

Before analyzing the replacement options for Delta, it’s instructive to understand what is behind Delta’s overarching fleet strategy after its merger with NW. Historically, Delta tends to buy used or older generation aircraft. Take, for example, the recent inclusion of Air Tran’s (Southwest) Boeing 717 fleet. The reason was rather simple: they were relatively inexpensive.

There’s a certain element of risk mitigation with this decision in that new aircraft programs like the Boeing 787 and Airbus A350 have been overrun with delays, cost increases, and, in the former case, severe reliability issues. But the rationale is overwhelmingly tied to reducing capital expenditures by purchasing less expensive aircraft.

The reduction of capital costs has two effects: direct operating costs through depreciation, and an increase in free cash flow. These are tied together in the following manner: on a long haul route of the type operated by a typical Delta Boeing 767 or 747, capital costs represent on average about 15-25% of the overall operating costs for an aircraft (the lower the purchase price, the lower this portion of the operating cost). Fuel represents upwards of 60% of operating costs at present prices, though that figure fluctuates based on the price of jet fuel.

In short, Delta has placed a massive bet since 2008 that the price of fuel will remain low enough so that the much lower capital costs (purchase prices) on its fleet will offset their fuel burn disadvantage from less-efficient engines with the older models, against the higher fuel efficiency of newer aircraft.

Delta is betting that the combination of conventional hedging, lower-cost jet fuel from its Trainer Refinery (purchased from Philips 66 in 2012), and the rapid growth of shale oil production in the US will stabilize or even depress jet fuel prices, which will allow them to apply the same principles that led to the purchase of the MD-90 aircraft, the inclusion of Air Tran’s Boeing 717 fleet, or the potential Airbus A321/A330-300 order to this RFP.

If Delta bets right (and the combination of its present track record of superb margins and macroeconomic factors imply that it is betting right), then it’s the perfect scenario for boosting its free cash flow— one of the most important metrics used by investors to evaluate stocks.

Delta’s major ambition currently is to be treated as a high-quality industrial stock with investment grade credit ratings. Cutting back on aircraft capital expenditures while sustaining savings through lower fuel costs allow Delta to continue its push for that status.

What’s the best choice for Delta?

With that framework in mind, we can now turn to analyze Delta’s two replacement tracks. Our analysis found that the 787-8 has a double-digit operating cost advantage over the 767-300ER (including capital costs) but a slightly smaller advantage over the A330-200 for a typical 4,000 nautical mile route. However, were Airbus to launch an A330-200 NEO, the gap would shrink greatly due to savings from higher fuel efficiency so that any cost differential between the NEO and the 787-8 might be easily offset by Airbus offering more aggressive pricing discounts.

Another key element in the calculus for Delta is availability. The Boeing 787 is largely sold-out until at least 2020 and continues to sell at rapid rates each year. While the Dreamliner offers excellent operating economics, Delta can likely match these with the A330 NEO, as mentioned before, through discounting, which means that —all else being equal— the more available aircraft will win the contest. Technically speaking, the A330 NEO is not yet on offer, but we project that it will be soon with an entry into service date (EIS) in 2018, as Airbus looks to fill its A330 production gap. Pressure is already mounting from airlines around the world for Airbus to launch the new engine option A330, making it likely that it will be a major player in Delta’s replacement RFP.

Ten Boeing 777-232(LR) and eight 777-200(ER) are currently the long-haul workhorses in Delta’s fleet. PHOTO: DELTA.

Looking at the flight profile of the 767-300ER in Delta’s fleet, it is mostly used on trans-Atlantic flights to Europe/Africa, South America, and (on a much smaller scale) routes from the West Coast to East Asia. The only place where the 787-8 would be relatively more useful, from a network construction perspective, would be in its superior ability to open long and thin routes.

Up-gauging from the 767-300ER to hold down its direct operating cost per available seat mile (CASM), is also a potential option which would appear to favor a potential Airbus A330-300-sized NEO over the A350-900 for many of the same reasons (availability and lower purchase price). This option would make sense, especially to replace flights to Latin America and Asia, which are seeing growing traffic demand, and could thus handle the larger aircraft.

Indeed, a mix of A330-200 and A330-300 NEO aircraft (the former for trans-Atlantic and long/thin flights) would be our best bet, always with the assumption that Airbus will launch such planes. Alternately, the much less likely option of ordering the current generation A330-200 and/or A330-300 would also fit into the RFP. However, we do not see a further 787 order as likely at this time, though it remains a small possibility.

Turning to the larger aircraft, we see a competition between the Airbus A350-1000 and the Boeing 777-300ER (77W) for replacing the existing 747-400 fleet. Contrary to popular belief, Delta can, in fact, operate the 77W competitively against the A350-1000 and/or 777X of United Airlines and foreign carriers on a CASM basis. Annually, assuming that the 77W operates 12 hours per day, it will save Delta around USD 4.5 million in operating costs against the Boeing 747-400’s current figures. Multiplied across a fleet of 16 airframes, that figure rises to savings of up to $72 million, to say nothing of the 77W’s superior cargo revenue potential.

Delta has a varied mix of 74 Boeing 767-300 aircraft, ranging from the Extended Range (ER) version with winglets, to the non-ER, mostly used on transcon flights. PHOTO: CARLOS LUGO.

In conclusion, a 77W order would fit with Delta’s general fleet strategy, and we see this as the most likely outcome with the odds 70/30 in favor versus the Airbus A350-1000. Overall, Delta’s fleet strategy occupies an increasingly rare space in the US industry, and this RFP is only likely to reinforce that trend.

For both Airbus and Boeing, this RFP is more important than one would think, given that the order is likely to be for current generation aircraft. While conventional wisdom would dictate that Boeing and Airbus would prefer orders for their new generation A350, 787, and 777X programs, in fact, both Airbus and Boeing need orders for current generation (or NEO) A330 and 77W respectively. The reason is that both manufacturers face production gaps for these aircraft.

Airbus wants to extend its current A330 production until 2022, while Boeing needs to keep the 777 production line in Everett occupied until the 777X enters into service in 2020. However, both aircraft currently have backlogs that take the aircraft only through 2016, and especially for the 777, failing to fill that production gap would necessitate a costly downgrade in production rates.

While a Delta order for 35 A330 and 15 77W aircraft wouldn’t eliminate the production gap by itself, it would certainly help make a dent. Those factors combine to make this RFP a critical one for both Boeing and Airbus.

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About Author

Vinay Bhaskara

Vinay Bhaskara

Senior Business Analyst, Big Airline Enthusiast, Avid Airport Connoisseur, Frequent Flyer, Globetrotter. I Miss Northwest Airlines Every Day. vinay@airwaysmag.com @TheABVinay

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