Delta Air Lines, Inc. (NYSE:DAL)
2014 Raymond James Institutional Investor Conference Call
March 04, 2014 09:50 AM ET
Paul Jacobson - Chief Financial Officer
Savi Syth - Raymond James
Savi Syth - Raymond James
All right. Good morning everybody. Thanks for attending the Delta Air Lines presentation today. First quarter is the weakest, seasonally weakest quarter for Air Lines and not too long ago, not many airlines made a profit in the first quarter. Delta came close in 2012 and 2013 they had their first 1Q profit and what’s more impressive though is as a result of industry capacity discipline as well as strategic investments that Delta has made despite this unprecedented barrage and winter storm that we’re having this year we expect Delta not only to make a profit in the first quarter of ‘14 but also to expand the operating margin from last year. So we’re happy to have with us today Paul Jacobson, the CFO of Delta, as well as the Jill Greer, the Managing Director of Investor Relations and with that I am sure you’re waiting to hear from Paul and not me so I’ll turn it over.
Thank you Savi and good morning everybody and good morning to everyone listening on the webcast, sorry you’re not able to enjoy the beautiful weather here in Orlando I can see many smiling faces that are glad they’re not in the Northeast these days. Vacationing down here or getting all the work done to. Our presentation today will contain forward-looking statements, any differences or any disclosure you can check through our 10-K through our risk factor sections we have discussed.
2013 as Savi mentioned really started off with a tremendous accomplishment of having our first profitable March quarter in 13 years, the history of this industry is that we have typically made all of our profits in the summer and tried not to give them away in the winter and we set our sites in 2013 in getting off on the right foot and trying to buck that trend and through a tremendous effort by the Delta team we were able to turn that around and drive a slight profit in the first quarter of 2013 which ultimately launched the record year that we had for the full year for any airline in history at $2.7 billion, that launched us a propelled us into the S&P 500 earlier more recently last year and we became immediately the fourth best performing stock in the S&P 500 up over 130% last year.
But that year is now behind us and we have to look forward we want to spend some time talking about today as how we are charting our course for what we really want to become in the journey that we are on which is really to become different than just a very well or high performing airline but rather to really change the landscape and become viewed as a high quality industrial transport company through the stabilization of earnings growth, returning capital to shareholders and through a number of initiatives that we’ll talk about.
We recognize the history of this industry, the volatility that we faced we are recognize that many of investors have heard overtime, this time it is different. We truly believe that we are in a very different perspective right now and hopefully some of the points that we will be able to highlight today will help convince some of you as well.
It’s great to see so many new faces in the room. And ultimately all of that performance culminates with prudent capital deployment we have to get to a position where we are able to consistently return capital to our shareholders. It is a dimension that throughout the history of this business has really been missing on a consistent basis. It was generally viewed as, during the good times or during peak times, whatever was left over, we would allocate a little bit to shareholders. We want to change that contacts and make sure that when we see the type of strength that we have in cash performance in the discipline of capital investment leading to stable consistent free cash flow, that we are returning that to shareholders as a continued reward for the royalty and for the investment and recognition of the stewardship responsibilities that we have.
As I mentioned, 2013 was a phenomenal year for Delta, $2.7 billion of profit. We actually eclipsed to the record quarter with irrespective of year in Delta’s history, so if you take the record first quarter, second, third and fourth, no matter when it happened in history and added them together Delta eclipsed that in 2013 truly a wonderful free and a testament to the power and the effort and the culture that we have at Delta that we are able to rally behind that.
71% year-over-year increase in earnings and almost the full three points of free tax margin filled both by operational growth as well as the continued benefits of our delivering program, which we will touch on little bit later. All of that have to be coupled with CapEx disciplined and prudent capital management. If you look back again to the last time that the industry was generating this type of cash flow back in the late 90s; Delta’s combined CapEx during those times was close to $5 billion.
So despite the fact that we were generating $4 billion to $4.5 billion of operating cash flow, we are still increasing leverage on the balance sheet because of the CapEx profits that was lumpy that was relatively undisciplined. We believe we have solved that, we believe we have changed that by setting up the capital program that seeks to invest about 50% of our operating cash flows. And there are some unique characteristics about the way Delta is managing its capital portfolio that we’ll touch on a little bit later.
I think probably the biggest accolades for 2013 really go to the front lines and the Delta people. We achieved a number one ranking in all of DOT’s key metrics baggage on time performance completion factor among our network carriers. And this has not always been the case. If you look at Delta’s operating performance as recently as 2010 after we put the two companies together, we really lagged in those things that are important making sure that we get passengers from point A to point B, making sure that we are delivering an on time operation to streamline and smooth out connections.
And this has been a focal point. In fact if you look at some of the unit cost growth that we've had since 2010 that was largely attributed to investments that it took in order to improve the operation. So in 2013 it was a record year by all accounts and it was a good weather year. We will acknowledge that and 2014 is not emerging as a good weather year. Already in January and February, in each month we've cancelled more flights than we cancelled all of last year due to weather. So approximately 8,000 cancellations for each month.
But I think there is room for a little bit optimism. As Savi mentioned in her opening remarks we are still expecting to expand our operating margins this quarter proving that maybe we can sustain some of these storms or rainy days so to speak and still deliver the type of performance on a consistent basis that is worthy of a much different perspective around valuation of [bunking] history.
We also achieved a number of milestones including achieving Fortune’s most admired airline, we also cracked the world’s most admired companies for Fortune Magazine recently and just a few weeks ago became Air Transport World’s Airline of the Year, which is the first time in 13 years that U.S. carrier has been given that nod which is a true comprehensive view of product, service, customer satisfaction, and financial performance as well.
So, 2013 by all accounts a fantastic year but the story doesn’t really end there. We have to figure out how do we take that and leverage it for the future and improve on that performance. So at our Investor Day in December of last year, we outlined a set of key goals that we’re focusing on for the long-term that we are committed to achieving in order to change the view of the history of this business and really, really look to earn our way into being recognized as a high value industrial transport company. This includes operating margin performance of 10% to 12%, annual EPS growth of 10% to 15% on a continuous basis, ROIC of at least 15%, return on invested capital, $5 billion of operating cash flow with the commitment to reinvest about 50% back into the business in order to drive free cash flow performance, and continuing to improve our balance sheet. And looking at our metrics over time, we’ve seen considerable improvement. We’re not quite where we need to be, but we do want to get our balance sheet to an investment grade looking balance sheet. Whether or not we achieve those actual ratings from the agencies, we do have our sights set on that.
And when you look at how that compares particularly on a financial performance around EPS growth and return on invested capital, it’s in line or exceeds the subset of companies that we’ve dubbed high quality industrial transport. This includes companies like CSX, Ryder Systems, FedEx, UPS, other high quality names that you are used to seeing. And this type of performance we believe, if it’s sustainable which we are committed to making, we can be talked about among those companies.
How do we get there? Well, we get there by adhering to really our guiding principles and what really we are trying to do at the core here which is to continue to use our scale, our productivity to drive for continued efficiency gains. We announced last year, in December of 2012, our billion dollar structural cost initiative which was to tamp down the rate of growth in our unit cost performance. And that was a great exercise. That was to really re-snap the bar. Going forward, we are committed to keeping our unit cost growth below 2% on a quarterly basis. And in order to do that, we have to have a constant drive for efficiency and productivity throughout the organization.
There are lots of tools that we have at our disposal, the biggest of which is our domestic refleeting that’s ongoing right now. We’ll spend some time talking about that but upgauging the airline by getting rid of our significant portion of our 50 seat regional jets which at these fuel prices are relatively inefficient, upgauging them with 717s with two class regional jets as well as some of the new deliveries that we have coming up.
Continuing to expand our network reach through the growth and the establishment of a hub at an international gateway in Seattle, this is a way for us to help to reoptimize through some of investments that we have made, particularly with Virgin Atlantic gives us access to London Heathrow in the most lucrative market, most heavily traveled market JFK to London Heathrow [bus] gives us that foothold in corporate traffic where we really need to be participating that historically we haven’t. So the games that we have seen in our corporate travel base is particularly in the New York area have been somewhat today with one hand type behind our back. Through the new joint venture and antitrust immunity that we have with Virgin Atlantic, that opportunity is plentiful for us going forward because now we have a schedule that allow us to complete with the AA, BA alliance in that New York to London travel market, just an example of how we are expanding our reach.
We’ve got to continue to improve the product and continue to improve the operation. One thing that we are focused on in a consolidating industry is in order to gain continued advantage, we’ve got to have a differentiated product. And we believe the way that Delta can differentiate itself is through the power of the Delta people, who no matter what nature throws at them, particularly this first quarter, they have done a phenomenal job of keeping the airline functioning during very, very challenging times, despite all the cancelations we have had. It takes a lot of work to get that back on schedule. And they’ve done a tremendous job. But by differentiating ourselves operationally, we are effectively putting a better more consistent product out there for the market to utilize. And we have seen that tangible benefit in terms of our revenue performance on a relative basis has helped to distance ourselves from our competitors as well.
Restoring balance to the supply chain and leveraging our scale benefits, this one is relatively new for Delta and I think relatively new for the industry. But if you study this industry in any depth, you’ll know that the history is that a lot of suppliers and vendors and companies and industries that are tangential to the industry have actually enjoyed pretty consistent sizable returns over time, largely as a result of the fraction industry that we’ve had. There wasn’t anybody that could really establish a presence with the suppliers. We’ve done certain investments, we’ve made certain process changes to try to leverage that and capitalize on that size. The biggest example of this is probably one of the most visible is the Trainer refinery. This was an opportunity for us to get seat at the table in the supply chain as it relates to jet fuel, no longer dismissing fuel prices, something that was out of our control but getting into a position where not only can we help to influence the supply by keeping a refinery open and therefore helping to tamp down product crack spreads but also have a sizable production position that allows us to shift our production around and help to lower our jet fuel cost throughout Delta, this all regardless of how the refinery performance itself. Although we have some tools that we believe we can get the refinery profitable to generate specific benefits for Delta in 2014.
And lastly, building a powerful balance sheet, this is a way to differentiate ourselves further. While the industry continues to invest heavily in new equipment, our fleet strategy gives us the benefit of lowering our overall capital investment while we’re going through the refleeting exercise by taking advantage of previously owned aircraft.
This is a contrarian investment philosophy that leads to some pretty good value capture for us when you look at the long term views of capital management. Not saying that that’s the right strategy or wrong strategy, there are many different ways to manage a fleet, but we think for Delta based on our unique position, we’re able to take advantage of this. And the way we can monetize our operational performance as well as our maintenance productivity is by lowering the overall capital base that we need to invest in the airline on a consistent basis to achieve the same size and scale.
This slide shows our non-fuel unit cost growth. As I touched on the history here was that going back to 2010, we were heavily investing in the operation. And we came under some criticism, some right, some wrong I think for the relative cost growth. The rest of the industry was growing at a rate about half their size during that time period. And while we committed to turn it around which I believe we have, we weren’t apologizing for the investments that we were making because if you go back and look at the operational performance of Delta in 2012, it was nothing to be particularly proud of. In fact inconvenience millions of passengers more than what we’re doing on a regular basis today.
So that investment was needed, but we also recognized that that cost performance was not sustainable. So as I mentioned embarked upon the $1 billion structural cost improvement initiative to [temp] down that rate of growth and reset the bar at a much lower level, but now we’re relying on different initiatives that we have both tactical and strategic that will allow us to keep that cost growth below 2% annually going forward.
Those include the refleeting initiatives, the maintenance; we get a lot of productivity advantages through maintenance. One of the opportunities for us is as we’ve disclosed on prior earnings calls, we’ve actually purchased old airplanes that are retired and we purchased those for parts. So getting a cheap access to spare parts helps us to manage the fleet that we have going forward and given the complexity of our fleet and the fact that we’re willing to fly airplanes, the rest of the industry is foregoing in favor of better fuel efficiency or maintenance honeymoon, we’re able to get those airplanes and those pools and parts at very, very attractive prices helping to keep down the rate of maintenance inflation and otherwise giving us a little bit of an advantage that we can then use to deploy less cash to fly airplanes that other airlines might consider challenge.
Headcount, we’ve got to be disciplined particularly as it relates to merit headcount. We’re going to make sure that we staff the operation as it’s needed as we grow taking advantage of productivity where we can, but on the merit headcount and the administrative headcount we’ve got to keep that flat. And we’ve done a good job of maintaining discipline through that as we’ve emerged from the cost cutting and as we continue a pattern of modest growth going forward making sure that we are able to leverage the existing headcount that we have within the administrative and merit pools. That’s going to help us to drive productivity throughout the business.
On the fleet side, I touched on it several times in this presentation. This chart shows probably the most visual representation of the benefits of what we have been able to do with upguaging. The three bars on this slide, the dark blue bar is the profit margin attributable to the fleet on an index basis going back to the time of a merger. The bottom-line which is the light blue bar shows our average aircraft count down about 14 percentage points since that time while maintaining approximately a flat on the fleet, down about 5%, but by flying fewer aircraft and by upguaging the airline we are actually able to drive significantly improved profit margins through the fleet by using the fleets more efficiently and at a lower cost.
We are able to do this through a combination of new and previously owned airplanes, as I have mentioned it helps to keep the capital down. And in addition to this, not only our profit margin is expanding, but return on invested capital is expanding over the same time period because we are simply not replacing every airplane with a brand new airplane.
Case employing, the 717 that we are taking from Southwest we are acquiring 88 of their airplanes all approximately 10 to 12 years old and Southwest is actually putting all the money into reconfigure those, put them in through a maintenance check and deliver them to Delta in a Delta product spec. And when they do that we step into the lease on a subsidized basis going forward, lowering the overall capital cost to acquire those aircrafts.
Another great example of this has been the MD-90 project by going out and purchasing a 10 to 12 year old MD-90, we get about 20 years of life left in that airplane for a fraction of the capital cost of a new air plane. So we may spend $10 million to $12 million on an MD-90 to put it into a Delta configuration and fly as opposed to about a $40 million price tag for a brand new 737. So it’s got a little bit of extra life, it’s got a maintenance honeymoon, it’s got a little bit more fuel efficiency, but when you combine all of that and you strip out the ownership cost advantage that these airplanes have, we are able to boost our return on invested capital that way.
And again we are able to leverage the maintenance efficiency and productivity that we have because despite the fact that we’re flying an older fleet than the rest of the industry typically in the U.S., we do have a maintenance unit cost advantage over the rest of the industry. So prove positive that our productivity is actually generating benefits for us on a cost of capital basis.
Another unique way that Delta is managing its exposures is through fuel. We touched on Trainer and Trainer has been a great success story when you look at what the alternative was going to be. If you look at when we acquired that asset, there was probably well over a million barrels of capacity on the East Coast that were expected to be shuttered as a result of declining margins in the refining space. But as we know capacity particularly in refining capacity rationalization leads to higher margins for the refiners and that ultimately cost -- comes in the cost of the most inelastic part of the barrel which is jet fuel.
We have to take jet fuel to fly first and foremost; we can’t refuse to fill up the airplane because we don’t like the price that we’re paying. So as refining capacity started to come offline what we saw is a rapidly expanding jet fuel crack margin. In fact from the period 2009 through 2012, the crack spread was the fastest growing cost that we had at Delta. It wasn’t the cost of a barrel of crude oil; it was the difference between crude oil and jet prices. And we saw that sustaining, since we open this plant and brought it back online, we now produce approximately 40% of all the jet fuel in PADD I at the Trainer refinery and we’re looking at expand that.
In the first quarter we are undertaking a modification to the second crude unit. We did that with the first crude unit when we opened the plant. But by doing this same modification to the second crude tower, we expect our jet production to increase up to 40,000 barrels per day. This is up from the previous owner ConocoPhillips was running about 10,000 barrels a day of jet fuel prior to their announcement of closing that facility.
That put a lot of pressure on the jet crack. In fact if you look at jet prices prior to opening this refinery, they typically traded at about $0.04 per gallon premium to diesel. They’ve now traded over the last year and a half at about $0.02 to $0.04 discount to diesel fuel. Each penny a gallon for Delta is about $40 million a year.
So when you look at that we've actually seen what we believe is a pretty sizable benefit to Delta in terms of its lower jet fuel prices than what the status quo would have been, while the refinery has generated modest losses about $116 million in 2013 against the total fuel bill of over $11 billion.
That's not good enough, we need to make sure that not only are we benefiting the industry as a whole, but Delta is also getting some specific benefits out of this acquisition since we’re taking all the risk. And we expect that we’re going to be in a position to be able to do that in 2014. And the primary difference is a substantial increase in the amount of domestic crude oil that we’re able to process in the refinery.
Last year we averaged about 17,000 barrels a day which was primarily backloaded in the second half of 2013. By the middle of this year we expect to process about 70,000 barrels a day of domestic crude or about 30% to 40% of the total crude guide. We are not stopping there, we expect to continue to try to find opportunities to deliver domestic crude to the region. Each barrel of domestic crude lowers our crude costs by about $4 to $5 a barrel against the alternative of West African and by putting 70,000 barrels a day, we can generate about $100 million of savings on $2 a barrel of overall savings in our crude costs going forward.
Now that is an opportunity that Delta uniquely alone faces with the advent and the increased production in the Bakken region and through the domestic shale plays that’s one that no other airline is positioned to be able to take advantage of. And we think that unique position is going to get us to a point where we can be profitable at the refinery in addition to driving the jet fuel benefits that we’ve seen today.
We’re also an active fuel hedger. In 2014 we’re very well positioned with our hedged portfolio. We’re committed to continuing to run a hedged portfolio. While the correlation between revenue and fuel price has certainly gained traction over the last several years through consolidation. There is still what we recognized is a lag effect. It’s not always quick to respond with the volatility of the oil markets. So we’re committed to the investments that we’ve made in our hedging program and we expect to continue that going forward. In fact in 2013 using recent market curves, we expect our fuel hedge portfolio to generate over $250 million of savings and the reduction to our fuel price throughout all of 2014. And we’re committed to participating in increases going forward. We are roughly 20% hedged for the first half of the year although that changes from time to time.
All of that leads to, we are generating significant amount of cash flow, how are we going to prudently deploy that. You see the evolution in our cash flow deployment has been from a pure focus of paying down debt exclusively leading up to the achievement of our $10 billion net adjusted debt goal in 2013 to more a balanced view around returning cash to shareholder as well as proactively putting some additional contributions into our pension plan in order to help smooth out the ultimate conclusion of the pension plan as we go through airlines relief through 2024.
The balance sheet has been a great play for us. As we have seen that evolution overtime we’ve paid down over $7 billion of adjusted net debt which has had the P&L benefit of approximately $500 million of interest savings helping to drive that pre-tax margin expansion. Last year we set our sites last May on achieving a new target of $7 billion. We expect to be able to complete that sometime during 2015. And that’s going to continue to have benefits. Ultimately we think the run rate interest expenses we get down to $7 billion can be down in to $500 million range. So over $1 billion of annual expense improvement from the time of the -- from the merger, this has been a great, great play for us going forward.
We are also committed to returning more cash to shareholders overtime, when we announced in May the initiation or depending on your perspective reestablishment of a dividend that hadn’t been paid in over a decade. We were committed to an annual return of cash with a $500 million buyback program spread over three years of about $350 million to $375 million a year. We have actually kind of doubled that pace.
So through the first six months of that program, we returned $350 million of cash to shareholders. And we announced at our Investor Day that we expect to complete that $500 million buyback program by our shareholders meeting this year, putting us on a trajectory of actually returning about $700 million of cash on a run rate basis to shareholders.
We do expect to announce our next repurchase authorization and an update to our dividend policy by the time of our annual meeting in June and we are actively having conversations with the board between now and then to determine what the right course of action to take, but stay tuned there is more on that to come.
So in conclusion, we believe we have got the right recipe for not only taking the performance that we saw in 2013, but continuing to differentiate ourselves through consistency and sustainability, both margin enhancement, return on invested capital and ultimately returning cash to shareholders. So thank you for your time and attention, especially those for you standing in the back. It’s a great crowd and so great to see so many new faces. Please to hope you enjoy the conference.
Savi Syth - Raymond James
We probably have time for one question. Then we will have a breakout afterwards. So is there a question. [Call ends abruptly]
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