MIAMI — Delta Air Lines reported a fourth quarter net loss of $712 million January 20, driven primarily by mark-to-market losses on its portfolio of fuel hedges. For full year 2014, Delta recorded a net profit of $659 million or $1.07 billion before taxes, down sharply from $2.52 billion a year prior. The primary driver of Delta’s net loss for both periods was a special charge of $1.28 billion in mark-to-market adjustments to Delta’s hedging portfolio.
Despite the headline numbers, at its core, Delta’s finances are just fine. Net pre-tax profits excluding special charges (overwhelmingly related to hedges) were $1 billion and $4.5 billion (up 70 percent year-over-year [YOY]) for the fourth quarter and full year respectively, while operating margins were 12.6 percent and 13.1 percent. Return on invested capital (ROIC) was 20.1 percent, and free cash flow was $3.7 billion (a better metric that offsets the front-loading of mark-to-market’s effect on accounting profit figures). Even the oft-maligned Trainer refinery generated a $105 million net profit for the quarter, driven by increased crack spreads and improved margins on refinery products.
At the same time, Delta’s fuel hedging strategy has (rightfully) come under scrutiny for the massive losses it has driven during the recent pullback in oil. The hedges it placed over the last couple of years were a strategic mistake, misreading the tea leaves of increased shale production (with producers moving down the cost curve) and that of other unconventional sources of oil.
But, and this may be little consolation to Delta’s shareholders, it was a reasonably easy mistake to make. Most airlines around the world that can afford it have hedges of one form or the other similar to those at Delta, and due credit to Doug Parker and the pre-merger US Airways team aside, it would have been equally easy to take a long run view of oil prices since 2000 (cresting to $140/barrel in 2008, crashing during the late 2000s recession, and quickly returning to $110/barrel by 2014), and assume that hedging was the right thing to do. Only one of the past 15 years had driven significant hedging losses for US airlines, while the broad consensus was that oil prices were heading up.
And it would be a mistake to assume that avoiding hedges all together is an ideal strategy. For the moment, Delta is unhedged in 2016 (reacting to the pressure), but if anything, now is the time for Delta to hedge. Or more precisely if and when prices decline into the $28-35 per barrel price range (West Texas Intermediate). Based on marginal costs, those prices are the lowest that the oil market can sustain in the long run, so Delta would be buying in near the bottom of the market. The worst case scenario is that prices vacillate between $35 and $50 for a couple of years, in which case Delta buys stability, or oil prices recover, in which case Delta makes back all of the money it lost in this past quarter’s mark-to-market adjustments. Hedging is ultimately an options investment, and like all options investments, it has the potential to fall apart. But precisely that moment when it falls apart is the best time to reinvest, because that can get you a much larger return. If oil hits the price points I outlined, Delta should absolutely continue to hedge.
Beyond fuel, it was yet another humdrum quarter for Delta, by which I mean another quarter where things mostly go right. By the historical standards of this industry, that is an incredible feat. When I started covering this industry in 2008, I never thought we’d see this day. That being said, there were still plenty of notable items that came out of Delta’s earnings call, and without diving too deeply into the details, here are a few that I found notable.
- Q4 corporate sales were up 7 percent YOY, with the strongest growth recorded from customers in Financial Services, Media, and Auto, and the New York City hubs at La Guardia and JFK are profitable, largely due to these corporate passengers;
- Domestic paid First Class load factor rose 6 percentage points to 49 percent;
- Revenues for the Economy Comfort product rose 18 percent YOY;
- Unit revenues in the Seattle market rose 6 percent on 33 percent increase in capacity as measured by available seat miles (ASMs);
- Amsterdam and Paris Charles de Gaulle were the most profitable parts of the trans-Atlantic business, though the Virgin Atlantic joint venture added $200 million to the bottom line;
- Amongst international destinations, Delta sees continued pressure in Russia and the Middle East due to geopolitics, as well as in Africa due to Ebola; and
- Profitability at the Tokyo Narita operation improved by $25 million due to the removal of the soon-to-be-retired Boeing 747-400s.
One key theme lurking under the radar is the latent, if sometimes overblown concern that Delta might be too aggressive as it pursues incremental growth opportunities in New York and Los Angeles, particularly when it enters highly competitive markets. I’ve already written at length as to why I don’t think that the US airlines are going to devolve into a capacity and fare war. And I’ll just add to that team by pointing out that the US economy is in good shape heading into 2015, with GDP growth of more than 3.5 percent projected. Given those growth levels and low fuel prices, capacity growth of 2-3 percent might not be such a bad thing. In fact, it is probably the best way for Delta to expand earnings per share (EPS) in the current environment.
An actual headwind to watch out for as we move into 2015 is a recent push by the International Association of Machinists (IAM) to unionize Delta’s flight attendants. While similar unionization pushes have failed at Delta in the past (most notably right after the Northwest merger), there does seem to be some substantial support for the IAM on property, support that extends beyond pre-merger Northwest militants. Delta’s profitability over the past couple of years has absolutely benefited employees, but certain groups, pilots in particular, have done better than the rest. Delta will be in for a fight, and if the IAM wins, expect higher costs, lower productivity, and lower profits.
Despite this specter, by and large the first few months of 2015 look promising for Delta. Unit revenues and capacity look to be flat YOY, though margins will improve due to lower fuel prices. I think oil has some room to run, so further mark-to-market hedging losses are probably forthcoming. In sum however, the benefits of lower fuel prices will far exceed the costs of hedging losses, and I project Delta will report a record net profit in Q1.
Delta’s unique mix of operational excellence and superb finances remain unmatched. At least for the first part of 2015, it remains the standard-bearer for the US airline industry.