Delta Air Lines' CEO Discusses Q1 2014 Results - Earnings Call Transcript

Apr.23.14 | About: Delta Air (DAL)

Delta Air Lines (NYSE:DAL)

Q1 2014 Earnings Conference Call

April 23, 2014 10:00 AM ET

Executives

Jill Sullivan Greer – Managing Director-Investor Relations

Richard H. Anderson – Chief Executive Officer

Edward H. Bastian – President

Paul A. Jacobson – Senior Vice President and Chief Financial Officer

John E. Walker – Senior Vice President-Corporate Communications

Glen W. Hauenstein – Executive Vice President-Network Planning & Revenue Management

Analysts

Jamie N. Baker – JPMorgan Securities LLC

Michael J. Linenberg – Deutsche Bank Securities, Inc.

John D. Godyn – Morgan Stanley & Co. LLC

David E. Fintzen – Barclays Capital, Inc.

Savanthi Syth – Raymond James & Associates, Inc.

Glenn Engel – Bank of America Merrill Lynch

Helane R. Becker – Cowen and Company, LLC

Dan J. McKenzie – The Buckingham Research Group, Inc.

Duane Pfennigwerth – Evercore Partners, Inc.

Thomas Kim – Goldman Sachs & Co.

Joe W. DeNardi – Stifel, Nicolaus & Co., Inc.

Hunter K. Keay – Wolfe Research LLC

Jack Nicas – The Wall Street Journal

Mary Schlangenstein – Bloomberg News

Ted Reed – The Street

Operator

Good day ladies and gentlemen and welcome to the Delta Airlines March Quarter Financial Results Conference Call. My name is Sherlon and I will be your coordinator. At this time all participants are in a listen-only mode. Until we conduct a question-and-answer-session following the presentation. As a reminder, today’s call is being recorded.

I would like to now turn the conference over to Ms. Jill Sullivan Greer, Managing Director of Investor Relations.

Jill Sullivan Greer

Thanks Sherlon. Good morning everyone. Thanks for joining us on our March quarter call. Speaking on the call today will be Richard Anderson, Delta’s CEO, Ed Bastian, our President and Paul Jacobson our Chief Financial Officer. Richard will open the call, Ed will then address our financial and revenue performance, and Paul will conclude with a review of cost performance and cash flow. We have the entire leadership team here with us in the room for the Q&A session. 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 contains 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 discuss non-GAAP financial measures. All results exclude special items unless otherwise noted. And you can find the reconciliation of our non-GAAP measure on the Investor Relations page at ir.delta.com.

And with that, I will turn the call over to our CEO, Richard Anderson.

Richard H. Anderson

Good morning. I want to take a minute to introduce our new Chief Operating Officer, Gil West. Gil is a 28 year industry veteran including his most recent position as Delta’s Senior Vice President for Airport Customer Service and Technical Operations. He is a great leader and he’s led the tremendous performance at Delta in completion track the baggage, on time customer service and our non-fuel CASM performance. He is a good friend and we congratulate him on his promotion.

We also huge owe a huge thanks to a really dear old friend Steve Gorman for his outstanding carrier as the Chief Operating Officer at Delta. We missed his friendship, leadership and of course his always unique point of view. We wish him best in his well earned retirement.

This morning we reported a $444 million pre-tax profit for the March quarter, which is an increase of $363 million over last year. We earned $0.33 per share beating consensus by $0.04. We grew our top line 5%, grew unit revenues 3.2%, kept our non-fuel CASM at 0.3% and expanded our operating margin by 4.4 points to 7.9%. We generated $390 million of free cash flow, reduced our net debt to $9.1 billion and returned a $176 million to our owners through dividends and share repurchases.

Our March quarter performance is remarkable because the severe weather in January and February reduced our pre-tax by $55 million. But for the weather, we would have had $500 million pre-tax profit in the seasonally most difficult quarter of the year, and that says a lot about the franchise we have here at Delta.

I want to take a moment to recognize the extraordinary efforts of all the people at work at Delta. We canceled about 17,000 flights in the first two months of the year due to weather. Through it all, our people stayed focused on taking great care of our customers which helped produced the highest customer satisfaction scores of any network carrier and a record March quarter profit.

Our operating performance in customer service across the board is fully rebounded at the top of the industry. And as a result, we’ve accrued $99 million for our 2014 profit sharing program. I think these numbers reflect a resilient foundation that’s really based upon the creativity and execution of the people at Delta. Despite the weather in the quarter, we met or exceeded our guidance for mid January on margin, revenue and costs. That’s because we’re determined to be a consistently high performing S&P 500 company that deserves the trust of long-term investors.

We are focused on the significant opportunities ahead, as we continue to transform Delta. And let me reiterate on our long-term goals, 10% to 12% annual operating margin, 10% to 15% EPS growth, 15% ROIC, return on invested capital. $5 billion operating cash flow with 50% reinvested in Delta, and we’re going to operate company under investment-grade balance sheet metrics with a target of $7 billion in net debt.

In 2014, we’ll meet these goals again as we’re forecasting another year of significant earnings improvement, margin expansion and cash generation. The demand environment remained strong as we expect single-digit unit revenue increases in Q2 on 2% to 3% capacity increases.

Fuel prices are relatively stable and we have a significant positive fuel hedge book for the year. We are building additional momentum through our revenue fee ancillary businesses and aviation related businesses which all are performing quite well.

We are confident about our ability over the long-term to maintain a non-fuel cost structure with sub 2% y-o-y growth and significant non-op benefits from debt reduction. These strategies are expected to produce a June quarter operating margin of 14% to 16%.

This company is run through long-term shareholder value. We measure our return on invested capital with a goal of generating at least 15% return on invested capital, which is nearly double our weighted average cost of capital. This requires not only a focus on earnings, but also strict discipline around capital deployment. Our Board of Directors under our Chairman, Dan Carp, is exacting in requiring management to prove returns for every dollar we invest.

Management micro manager’s capital expenditures as we required internal rate of return well above our return on invested capital with rapid paybacks. Long-term executive compensation and management compensation throughout the Company is tied to achieving the 15% return on invested capital. Our owners have entrusted us with their money and we promise to be good stewards.

Our fleet strategy is a good example of prudent capital deployment. In addition to 19 new 737-900s this year, which were cash flow positive day one, we’ll take delivery of 42 717s this year. These aircraft have at least 12 to 20 years of useful life and a cost substantially less than $10 million a copy without a dollar of upfront investments by Delta to bring them into the fleet. This approach to refleeting will drive margin expansion at a lower capital cost. This strategy has produced a 16.4% return on invested capital for Delta over the last 12 months.

We will consistently improve our free cash flow. The cash generation of this business is in the top tier of the S&P 500. We expect to produce more than $5 billion of operating cash flow in 2014 with more than $3 billion of free cash flow. This puts our free cash flow yield north of 10%.

Our cash generation over the last year has allowed us to accelerate all aspects for our capital deployment plan. Our adjusted net debt is $9.1 billion and we are on track to reach $7 billion in net debt next year two years ahead of schedule. We made $500 million of incremental contributions to our pension and have reduced the unfunded liability by nearly 25% to just over $10 billion. And we have returned $525 million in cash to our owners through dividends in buybacks in the last nine months. And expect to complete our $500 million repurchase authorization two years ahead of schedule. A year-ago in April 2013, our Board adopted a five year plan, which included our shareholder return strategy.

We expect by the end of 2014 to have achieved the goals in that plan three years early. Our board and management are in the process of determining the next phase of our shareholder returns and we look forward to publicly announcing that strategy and discussing our new five year plan in early May, just as we did last year.

So across the board our performance is the Delta standard for the industry, while rivaling that of other high-quality industrial transports. We run our business on the same metrics as high-quality S&P 500 industrial transports with the same kind of discipline, determined decision-making you see from fine well-run companies. We have a lot of work ahead of us, but also significant opportunity.

I want to just take one minute because we haven’t done this before, and I want to thank Jill Greer and Bonita Reynolds-Bailey for putting up with us in the process every quarter of producing our press release and our earnings material, and I want to thank them. I think we have the best IR team in the industry.

With that, I’m going to turn it over to Ed.

Edward H. Bastian

Well, thanks, Richard. Good morning, everyone. Appreciate you joining us today. This morning, as Richard said, we reported a pre-tax profit for the quarter of $444 million, which was $363 million higher than last year’s March quarter.

Our op margin expanded by 440 basis points to 7.9%, and given the introduction this quarter of non-cash book tax expense, we believe pre-tax results provide the best year-over-year comparison of our performance. Our net profits of $281 million or $0.33 per share beat consensus by $0.04.

We achieved these results despite the impact of the severe storms in January and February, including two storms that shut down our major hub in Atlanta for several days, costing us $90 million in revenue and $55 million in pre-tax profits.

I’ll join Richard in also thanking the Delta team for their dedication and determination in producing great operational performance, customer satisfaction and financial results during a very tough quarter. The Delta people continue to prove they are the very best in the business.

On the revenue front, we are seeing a solid demand environment, which produced revenue growth of 5% or $416 million despite the $90 million revenue loss due to weather. Our passenger revenues grew 5% on a 1.7% increase in capacity. We’re seeing solid gains in the corporate space with corporate contract revenues up 6% for the quarter. We did see some weather impact on corporates in January and February, but demand rebounded in March and our corporate revenues were up in the 8% range for the last four weeks led by double-digit gains in the financial services, automotive and media sectors.

Passenger unit revenues increased 3.2%, driven by both higher loads and yields. There was about 0.5 point RASM benefit in the quarter from the storm cancellations. We saw our best unit revenue performance in the domestic system, which increased 6%. We saw particular strength in hub-to-hub flying, continued strong results in Atlanta and importantly, both Los Angeles and Seattle delivered high-single digit unit revenue improvement on double-digit capacity growth. In fact, Seattle had the highest domestic unit revenue gain of any of our hubs for the quarter.

Internationally, trans-Atlantic was our best performing entity despite the impact of the shift of Easter into April. Unit revenues increased to 0.5 point was about up 2 points of RASM pressure from the Easter shift. The revenue improvement was driven by a combination of yield improvement and higher loads on 1.5% lower capacity.

Latin unit revenues were flat as we absorbed an 18% increase in capacity primarily to Mexico and Brazil to improve connectivity with our partners Aeromexico and GOL. In the Pacific, our unit revenues were down 5% on flat capacity. The yen weakened 11% year-over-year, moving from 92 in the first quarter of 2013 to its current level of around 102. This weakness drove a $54 million decrease in revenues, but the bulk of that was offset by our hedges as well as savings and expense. You should note our yen hedge book at the end of March had a value of $118 million. One bright area in the Pacific portfolio has been China, with all of our China market showing year-over-year unit revenue gains despite a 15% capacity increase.

Looking forward to the June quarter, we expect to continue the trend of top line growth and margin expansion. We are expecting a solid increase in unit revenues on 2% to 3% higher capacity. The late calendar replacement of these through this year has shifted that holiday’s traditional travel from March to April, and we are seeing currently April unit revenues up in the 6% range.

Our forward expectations for May and June are strong, with both months showing unit revenues up in the 5% to 7% range. This solid demand environment coupled with the success we’ve had with our cost initiatives and the declining fuel price point to an operating margin of 14% to 16% throughout the midpoint is 400 basis points of expansion over last year’s 11% margin.

Looking beyond the June quarter, we see a number of sources of profitable revenue growth, which we’ve been aggressively investing in over the last six years. First, our investments in the network, product and operations are producing solid, sustainable revenue gains, but there is more room for growth.

We have recently completed our full flat-bed installation and business elite across our entire international widebody fleet, becoming the only U.S. carrier to offer this service with direct-aisle access. And we are also now the only U.S. carrier to offer personal on-demand entertainment at every seat in all long-haul international flights.

Our product and service investments are especially important to our corporate customers and a large driver of our 107% revenue premium to the industry. And not only are we continuing to see gains in corporate share, overall corporate travel spend is expected to increase. Our most recent corporate travel survey show that nearly 85% of corporate travel managers expect their spend will increase on Delta in 2014.

Our initiatives in New York are also delivering results and we’re on track to bring our entire New York franchise to profitability this year. New York unit revenues increased 5% on 2.6% higher capacity in the March quarter. This was a significant achievement as the region was particularly impacted by the Easter shift. We are seeing RASM improvements in the double digits for April in New York.

All of our New York to L.A. flights will feature our premium flat-bed products starting July 1. We’re also gaining good traction with New York corporates with the expansion of our Heathrow service through our joint venture with Virgin Atlantic. We officially launched our immunized JV with Virgin on January 1. We’re now coordinating on pricing, scheduling and capacity with the introduction of the first combined schedule on March 30.

We’ve also co-located our departures to New York, Boston and Seattle at Terminal 3 at Heathrow, offering Delta customers access to more amenities including the Virgin Clubhouse. Customer response has been overwhelmingly positive.

Our non-operating expense this quarter includes a $31 million charge for our share of Virgin Atlantic’s March quarter loss. This is the seasonally weakest quarter of the year for Virgin and we expect they will deliver standalone profitability in 2014 providing non-operating benefit to us for the full year.

Our Seattle expansion is a key part of our Pacific network restructuring. We’re pleased with our performance so far in Seattle with unit revenues improving in the quarter despite a 17% increase in capacity, which helped drive several points of margin expansion. Connecting traffic now accounts for 65% of our current Seattle flows, a trend we see increasing as we mature our service to Hong Kong, Seoul and London.

And finally, another important area of revenue opportunity is our merchandising efforts. These are products and services that allow customers to tailor their travel experience and approve their overall satisfaction while also increasing our revenue.

Products like Economy Comfort, First Class Upsell and Priority Boarding grew 20% year-over-year to a $165 million in the March quarter. Our First Class Upsell product helped increase our paid first class load factor by 5 points to 45%. We think we can grow this high margin revenue stream by $500 million annually over the next three years.

I’ll wrap up here by simply stating that while we are pleased with the type of results we’re producing, we’re even more excited about the opportunities that lay in front of us.

With that, I’ll hand the call over to Paul.

Paul A. Jacobson

Thank you, Ed and good morning everybody. Our cost performance this quarter truly reflects the great work by the entire Delta team. Our total operating expenses increased $13 million driven by the impact of employee investments including $99 million of profit sharing expense during the quarter. These cost increases were almost fully offset by lower fuel expense savings from our productivity initiatives and receipt of a $25 million insurance claim related to Superstorm Sandy.

On the unit cost basis, our non-fuel unit cost increased only 0.3% despite one point of cost pressure from storm cancellations. When we affirmed our cost guidance in March, we said we expected unit cost to increase more than 1%. The drivers of our out performance versus that is to estimate with the finalization of the Sandy insurance claim during the quarter, and higher than expected completion factor in the month of March, which drove slightly more capacity for the quarter.

This is now the third consecutive quarter that we have kept our non-fuel unit cost growth below 2% in line with our longer term cost commitment. With good momentum behind us, we have a number of initiatives in place that should continue to allow us to sustain this rate of growth. We’re also making prudent investments in our employees products and operations.

The biggest initiative under way is our domestic refleeting. We took delivery of 24 aircraft this quarter and retired 15 mainline planes in 16 50-seat regional jets. We are on track to retire more than 70 50-seaters this year, which would put that fleet below 200 aircraft at the end of the year. The refleeting gives us a strong tailwind on unit cost as we leverage our scale to produce capacity much more efficiently.

For the March quarter, we generated 0.4 higher domestic capacity and 5.2% fewer departures. In addition to the maintenance savings from retiring the 50-seaters. This trend will continue for the next few years as we move through the refleeting project.

On the fuel side, our fuel cost of $3.03 per gallon this quarter included $107 million in hedge gains, which help to offset direct losses at the refinery.

For the March quarter operations at the refinery produced a $41 million loss. Production was reduced during the quarter as we shut down one of our crude units for scheduled modifications. These modifications to the crude unit are part of our initiative to increase the production of higher value distillates intellect jet and diesel, which we expect to account for roughly 50% of the production slate at Trainer going forward.

Our other major initiative at Trainer is domestic crude sourcing which accounted for 50,000 barrels per day of Trainer’s needs during the quarter. We expect this to continue ramp up to a full year average of 70,000 barrels per day for 2014.

Though the first quarter tends to be weak for the refining space, rising RINs expense contributed to the refinery’s loss. We’re continuing our efforts to work with the EPA to address this issue. And we expect both the refinery and our hedge book to reduce our fuel cost for the upcoming quarter. We’re projecting a fuel price for the June quarter of $2.97 to $3.02 per gallon including refinery benefits and $100 million of hedge gains.

Our non-operating expense for the quarter included a $23 million charge associated with the devaluation of the Venezuelan bolivar for transactions related to 2014. When the reversal of our tax valuation allowance at the end of last year, our net profit was reduced to reflect a 36% tax rate for the quarter. However, we have minimal cash tax obligations due to our $15 billion NOL balance.

As Richard mentioned earlier, we are transforming Delta into a high quality industrial company. And two of the important ways we’ll do that are through our balance sheet and our cash flows. On the cash flow side, we have strong cash generation from the business as Richard mentioned. We generated more than $950 million of operating cash flow during the quarter. A solid result, but even more so given that it is net of more than $600 million in pension funding and $500 million in profit sharing payouts during the quarter.

In early April, we contributed another $300 million to the pension completing both our $655 million of prior funding, plus $250 million of additional funding. These payments will complete all of our funding for 2014. Our CapEx for the quarter was $570 million, which include a $275 million in aircraft purchases and $165 million in aircraft modifications. This resulted in $390 million of free cash flow for the quarter.

Turning to the balance sheet, we ended the quarter with $9.1 billion of adjusted net debt and a debt to total capital ratio of 44%. The debt reduction is moving our balance sheet closer to investment-grade metrics. And it’s also driving P&L benefit through lower interest expense. Our interest expense declined by $34 million in the March quarter and we expect to save more than $100 million for 2014.

We are on track to reach our $7 billion debt target next year, which will put us on a run rate of $500 million in annual interest expense, down from $750 million in 2014. During the quarter, we continued with the accelerated pace of capital returns, sending back $176 million to our owners through dividends and buybacks. We repurchased 4 million shares during the quarter at an average price of $30.94 per total of $125 million. We’ve now completed $375 million of our $500 million authorization and expect to complete that authorization during the June quarter.

Let me close by saying thank you to the entire Delta team for their contributions this quarter. It is their dedication and determination that really drives our results and makes Delta the airline of choice for customers and our investors.

With that I’ll turn it back to Jill.

Jill Sullivan Greer

Thanks Richard, Ed and Paul. Sherlon, we are now already to go to the Q&A session, if you could give everybody their instructions.

Question-and-Answer Session

Operator

(Operator Instructions) We’ll have our first question from Jamie Baker, JPMorgan.

Jamie N. Baker – JPMorgan Securities LLC

Hey, good morning everybody. First question relates to the pilots, and I realize it’s a little bit early to be asking given the contract runs through next year. But, when you achieved the current contract you had pretty clear asks, you needed improved access to large RJs. You needed better mechanism to facilitate a 50-seat retirements and of course, the 717 was a component of the current contracts.

So, as we look forward and ponder what the pilot ask might be for 2016 and beyond. It isn't clear to me that you're in a stronger position to negotiate it, it isn't clear what the management incrementally needs. Is there something we need to be concerned about?

Edward H. Bastian

Well. No, you shouldn’t be concerned about it, simply because of our track record. I think if you look back over the past eight years, we've always been able to partner with our pilots and figure out what we need to do to keep Delta at the top of the industry. And while we don't talk specifically about how or when we engage and what we talk about, our track record is the best in the industry in that regard.

Jamie N. Baker – JPMorgan Securities LLC

Okay. I'd agree with that. Richard, while I have you, on the 10% to 12% annual operating margin target through the business cycle, or the 15% ROIC, whatever metric you choose? The question I still get from investors is whether Delta is simply going to start growing again, once you achieve these targets? And as you know, the Seattle expansion has made some of your owners a bit nervous as it relates to capacity discipline, it's not my view, but I know you've had to confront it. Should we view the achievement of your financial target as an implicit license to start growing again? Or is there a different more shareholder friendly outcome?

Richard H. Anderson

Well, if you listen to my initial remarks closely, they were all geared toward making the shareholder the priority in our decision-making queue. And if you look at our capacity management over the past decade, it's been the most disciplined and will continue to be the most disciplined. And as we said at our annual Investor Day last December the growth that we are putting in the marketplace today is below GDP estimated growth.

And second, we're actually doing what we're doing with fewer shells. This quarter, we operated with seven fewer total airplanes in the fleet. So that will continue to be the kind of discipline that we have at Delta because we are focused on return – not just return, but for the whole airline, we like to look at returns by fleet and by sub-fleet.

Jamie N. Baker – JPMorgan Securities LLC

Excellent, always helpful to hear. Thank you, gentlemen.

Operator

We’ll go next to Michael Linenberg, Deutsche Bank.

Michael J. Linenberg – Deutsche Bank Securities, Inc.

Yes, hey. Good morning, everyone. Just two questions here. I just I want to go back to the miscellaneous expense, the $81 million. I guess $23 million of that is I guess the impact from the Venezuelan bolivar and then there's the $31 million from Virgin. What's the other piece? Then what was the Virgin, that $31 million, how did that compared to the March quarter of 2013?

Paul A. Jacobson

Mike, it’s Paul. There is other FX-related pressure in that miscellaneous income number that we see, but we called out the largest pieces of that.

Michael J. Linenberg – Deutsche Bank Securities, Inc.

Okay. Good. And then just on the Virgin year-over-year improvement or I should say whatever was versus a year ago, do you have that number?

Paul A. Jacobson

Well, we didn’t close, Mike is that. We didn’t close to – I think it was end of June last year. So we didn’t have the first quarter contribution, but as I said in my remarks, we expect they are going to be profitable to standalone for the full year. So it's going to be an uplift in our reduction actually in our non-op expense.

Michael Linenberg – Deutsche Bank Securities, Inc.

Okay, great. And then just a second question here. As one who follows GOL and Aeromexico, one of the things that we've seen at both those companies is that they've seen a significant improvement in how they really produce revenue. And when you talk to those management teams, they talk about the help that they've received from Delta. You know the fact that, you know they have the opportunity to learn the best practices from one of the best carriers out there and my question is, when we saw those investments, they seem sort of more as one-off type deals, but as you sort of look around the globe, are there other opportunities where strategically, it would make sense to replicate what you’re doing with Aeromexico and GOL and I realize I don’t want to sort of exclude Virgin Atlantic from that? Of course you’re doing that at Virgin Atlantic. But are there other opportunities like that?

Richard H. Anderson

Mike, this is Richard. As to your second question, we wouldn’t answer it on the call anyway, because that’s kind of like doing the Virgin transaction or the Aeromexico transaction or the GOL transaction. We’re not going to discuss that publicly. But I think the reason, I mean candidly, one of the reason why those firms are doing well is heads on both their boards.

Michael Linenberg – Deutsche Bank Securities, Inc.

Very good. All right, well thank you.

Richard H. Anderson

By the way Steve Gorman is on the Aeromexico board.

Operator

We’ll go next to John Godyn, Morgan Stanley.

John D. Godyn – Morgan Stanley & Co. LLC

Hey. Thank you for taking my question. I think the team has done a great job of reframing the focus toward operating margin. So just building on that, I think when we look at the normal seasonality of the business over the last few years even regardless of the Easter shift, the third quarter has tended to have even better margins than the second quarter in a fuel cooperative environment. Is that the right framework?

Richard H. Anderson

John, we’re not giving third quarter guidance on this call. Obviously, the momentum is strong in the business and there will be a time to talk about that, but it’s not now.

John D. Godyn – Morgan Stanley & Co. LLC

Okay. Fair enough. I was hoping the team could also elaborate a bit on the aircraft RFP. There were some comments, I think, in the press about a hopeful outlook on the A330 NEO. On the other hand of course the team is very ROIC focused, and I guess there is a third component to that how it relates to the long-term CapEx guidance that you’ve all spoken to.

Richard H. Anderson

Well, we are just testing the market and it will be a pretty long process to see whether there is anything that makes sense from an ROIC standpoint, and the number could be, it could be a lot less than the number that we’ve talked about there. It just depends on what happens when we get the RFP responses back. And what we’ve said in our long-term guidance, it remains unchanged. We’re finished with all the flat-bed mods and you saw this year we’re down at – we’re at a number of about $2.3 billion in CapEx. So, we’re going to continue to make certain that whatever investments we do make are consistent with what you’ve seen us do in terms of return on invested capital and returning capital to shareholders.

John D. Godyn – Morgan Stanley & Co. LLC

Great. Thanks a lot.

Operator

We’ll go next to David Fintzen, Barclays.

David E. Fintzen – Barclays Capital, Inc.

Hey, good morning everyone. Just a question, kind of I guess on the wide RFP, but more conceptual. You’ve obviously gotten a lot of CASM benefit with the regional up-gauging and the domestic up-gauging. Are there similar long-term opportunities in international to move towards bigger airplanes or is that a market that’s more fragmented and you actually end up moving down in aircraft size? Just kind of curious how that plays through CASM over the next many years?

Edward H. Bastian

Talking about the causes – this is Ed, David; I don’t know that there’s a huge up-gauge strategy on the international. Certainly there’s a big CASM benefit as we look at the fuel efficiency of the new aircraft. We do operate a large fleet of 747s. So we would expect those would be candidates for replacement in this next cycle. If anything, we’d be down-gauging a bit there, but certainly picking up a very nice CASM return, probably thinking somewhere in the orders of 20% to 25% more fuel efficiency on the new aircraft.

David E. Fintzen – Barclays Capital, Inc.

Okay. That’s helpful. Thanks. And then just, as we’re looking at particularly Seattle and the development of the international there, I mean how should we think about kind of the spool up curve for new international flying? I mean historically it’s been two to three years to kind of get that flying up to system average. Is that the kind of the right way to think about Seattle or is that something you think can develop much quicker?

Glen W. Hauenstein

This is Glen. How are you doing?

David E. Fintzen – Barclays Capital, Inc.

Good. Good, Glen. Thanks.

Glen W. Hauenstein

Well, we’ve been very excited about the spool in Seattle so far. As a matter of fact in the month of March, all of our new domestic markets were segment profitable and Seattle’s margin improved by 8 margin points year-over-year despite a 22% increase in revenue. So we’re off to a great start, and we have a lot more to go in Seattle. So we’re looking forward to those all coming online over the next few months. And we do expect to become Seattle’s largest carrier in terms of revenues in the third quarter of this year. So we’re well ahead of our own internal forecast on Seattle and we’re pretty excited about the early returns.

David E. Fintzen – Barclays Capital, Inc.

Okay, great. That sounds very helpful. Thanks. Appreciate it.

Operator

Our next question comes from Savi Syth, Raymond James

Savanthi Syth – Raymond James & Associates, Inc.

Hey, good morning. Just wondering, how much of a benefit in this hub-to-hub flying and just domestic unit revenue are you seeing from the Virgin partnership right now? And is that some of the $120 million that you had projected in synergies or is that $120 million yet to come?

Edward H. Bastian

Savi, this is Edward. We’re certainly starting to see some benefits. I think it’s very early. I’d say it’s very early obviously since we just launched the JV as of the first of the year and we had ATI granted not until late last year. So the $120 million of synergies is the combination of the JV and the revenue benefits that the partnership will bring us as well as our share of the earnings of Virgin Atlantic going forward. It’s certainly benefiting our New York Heathrow P&L considerably and we expect over the next two years you’re going to see a pretty quick ramp up of those benefits.

Savanthi Syth – Raymond James & Associates, Inc.

Okay, understood. And I apologize for the overhead noise. I’m in an airport right now. But just a follow-up question on the refinery, has the upgrade work been completed, and is expectation still that it will be somewhat profitable in the second quarter and maybe profitable in the year?

Paul A. Jacobson

Good morning, Savi. This is Paul. The upgraded work has been completed. We have been producing approximately 50% distillate products throughout the month of March. We do expect that we will be profitable in the June quarter.

Savanthi Syth – Raymond James & Associates, Inc.

Got it. All right, thanks so much.

Operator

Our next question comes from Glenn Engel, Bank of America.

Glenn Engel – Bank of America Merrill Lynch

Good morning. Couple of question, please. One, the revenue was up 8% in the first quarter, you said mainly SkyMiles. Is that type of strength likely to continue?

Richard H. Anderson

Yes, we do expect to see some continuing improvements in our SkyMiles program, not just the benefits of the relationship with Amex, but in the future the changes that we’re going to be making back to our frequent flyer activities. We also got some benefits in the quarter from our JV relationships, particularly in Europe.

Glenn Engel – Bank of America Merrill Lynch

That shows up in the other revenue line?

Richard H. Anderson

Yes.

Glenn Engel – Bank of America Merrill Lynch

Okay. And when I looked on the expense side, on the contract, the regional jet capacity cost, it was down 4%. That was in line with capacity, down 4%. I guess it surprises me. With all the cancellations I would expect to see cost pressures on a unit basis on the regional side. Why didn’t that occur?

Paul A. Jacobson

Glenn, this is Paul. That’s going to be offset by maintenance savings as a result of the retirement of the 50-seaters, will offset some of that pressure.

Glenn Engel – Bank of America Merrill Lynch

Is maintenance cost likely to be more level this year than it has been in the past where it’s been much more frontend loaded?

Paul A. Jacobson

Yes. I think as we talked about at Investor Day, we expected maintenance CASM to be flat for the year. I think due to timing there is a little bit of extra business in the first quarter, but generally around flat for the year.

Glenn Engel – Bank of America Merrill Lynch

And finally, where did the $25 million Sandy or credit show up?

Paul A. Jacobson

In other expense.

Glenn Engel – Bank of America Merrill Lynch

Okay. Thank you very much.

Operator

Our next question comes from Helane Becker with Cowen.

Helane R. Becker – Cowen and Company, LLC

Thanks very much operator. Hi, everybody. Thank you for the time. I just have a couple of questions and one point of clarification. When you talk about RASM, are you talking about total RASM or just passenger RASM?

Richard H. Anderson

Generally passenger RASM.

Helane R. Becker – Cowen and Company, LLC

Okay. Thank you. And then just on the new pilot rules that went into effect in early January. Can you just talk about where the cost associated from that would be and whether or not – and how you’re able to handle that successfully?

Richard H. Anderson

We’ve been able to handle it from an operating perspective incredibly successfully, and Jill how many perfect completion factor days do we have?

Paul A. Jacobson

We’ve got 24 year-to-date.

Richard H. Anderson

We have 24 perfect completion factor days year-to-date. And we’ve been able to manage through that actually quite effectively because the way our pilot agreement was already set up, we had a fair amount of flexibility in terms of being able to manage to the new rules and we put a lot of work into our systems and our planning in advance of 117. In fact, we asked the FAA to let us start a little bit early so that we could have it for the full month of January for the purposes of planning. So you see it or not, we don’t break out separately that kind of detail in our non-fuel CASM, but you can see overall our non-fuel CASM in the quarter was excellent.

Glen W. Hauenstein

I would just also add that practically our operational control center manages that on a daily basis to mitigate the impact.

Helane R. Becker – Cowen and Company, LLC

Okay, great. Thank you. And then can I just ask one other question? I saw yesterday a letter that the airport at Atlanta sent to, I guess, a bunch of the international airlines kind of looking around to expand their international service, to ask other airlines to expand internationally into Atlanta. And I’m just wondering if they do this incentive program that they are talking about, can you actually participate in that as one of the larger international airlines there?

Richard H. Anderson

Yes, we will participate and we’re eligible to participate in the program and plan on being able to qualify for much of the $2 million in grants.

Helane R. Becker – Cowen and Company, LLC

Great. Okay and that would show up I guess in what passenger revenue or that would just…

Richard H. Anderson

No, it's rents and landing fees. It's a reduction. The way it's properly accounted for is – it will just be a straight reduction in rents and landing fees, but we don't call that out by airport. So you are not going to be able to see it in the P&L.

Helane R. Becker – Cowen and Company, LLC

And it’s a small number but still I mean you might as well take advantage of that if you can get it.

Richard H. Anderson

Although Atlanta is by far the most efficient airport to land an airplane in the United States, I think our landing fee to give you an idea, our landing fee cost in Atlanta are half of what Miami is.

Helane R. Becker – Cowen and Company, LLC

Awesome that’s really great. Thank you so much for your help.

Operator

Our next question comes from Dan McKenzie, Buckingham Research.

Dan J. McKenzie – The Buckingham Research Group, Inc.

Hey, good morning everybody. Thanks for the time. I guess first congrats to Ben and team on winning a legal case in Italy, I think investors are breathing a huge sigh of relief. But a couple of questions here; one, what’s driving the strength to China. Is the strength coming primarily from new accounts, or call it corporate share gains. Or is it more that your existing accounts are just simply investing more heavily in the country. Any additional color here would be greatly appreciated?

Edward H. Bastian

We see very strong demand for corporates to China through the first quarter and we also were able to achieve a re-time of one of our Beijing slots from an un-preferred time to repeat time channel, which had a very positive impact on the Beijing operations. So a combination that's continuing to work with our Chinese partners on improving our connectivity and our schedules to interior China, as well as a good strong core demand from the U.S.

Dan J. McKenzie – The Buckingham Research Group, Inc.

Okay, very good. Thank you. Second question here is, I'm wondering if you can help us peel back the onion on the fleet reguaging initiatives. I believe when you introduced the initiative originally, Delta was targeting $1 billion of structural cost savings. Wondering if you can help us or just share what that cost savings contribution was in the first quarter? Where are we, with respect to that $1 billion goal? And do the cost savings a straight line from there?

Paul A. Jacobson

Hi, Dan this is Paul. Yes, when we outlined that $1 billion structural cost savings, there were a number of the buckets in there. Gauge was just one of them, which we had highlighted about $350 million a year of run rate benefits out of that program. We're probably still in the sort of early to middle stages of that process as we've just begun receiving and getting in a steady flow of 717s and some of the 7060 regional jet deliveries, so we still have more to come.

Dan J. McKenzie – The Buckingham Research Group, Inc.

Okay. Thanks everybody.

Operator

Our next question comes from Duane Pfennigwerth, Evercore.

Duane Pfennigwerth – Evercore Partners, Inc.

Hi, good morning, thanks. Just wanted to come back to this seasonality of earnings question, as you build out Seattle to Asia, restructure Japan, grow to Latin America. Is there any reason to expect at this point that the seasonality of your earnings has changed?

Richard H. Anderson

No, there is no reason to expect that to change. The changes within the network are not that material.

Edward H. Bastian

But I do think what, you've seen us be able to do last year and this year is to be able to run a profitable cash flow positive business quarter-in and quarter-out, and that's very important for our investors. It's very important for being a member of the S&P 500.

Duane Pfennigwerth – Evercore Partners, Inc.

Thanks for that. And then on the non-op line as we think about seasonality, can you give us any sense for the swing that you expect from Virgin as we approach their seasonally stronger quarters?

Paul A. Jacobson

Well, their strength will fairly be in Q2 and Q3. I mentioned then we're expecting them to be profitable for the year, but we haven't given the guidance as to what that number is. So you can expect to see positive contributions in both Q2 and Q3, and hopefully Q4 as well.

Duane Pfennigwerth – Evercore Partners, Inc.

Thanks. And then, just lastly, on your 10% to 12% EBIT margin target, what happens if you exceed that in a given year? Does the target change? And thanks for taking the questions.

Paul A. Jacobson

That expectation, Duane, is over the cycle. So we would expect certain years that we would be on the upper end of that range.

Duane Pfennigwerth – Evercore Partners, Inc.

Thanks.

Operator

Our next question comes from Thomas Kim, Goldman Sachs.

Thomas Kim – Goldman Sachs & Co.

I wanted to ask about the competitive environment on the Pacific and also with regards to the Pacific, can you help us break down the TransPac PRASM ex-Japan, what that would have looked like in Q1?

Richard H. Anderson

Tom, we don't give that level of detail. We did say that China was positive and obviously our Japanese flying was the main source of the negative unit revenue driven by the yen devaluation.

Thomas Kim – Goldman Sachs & Co.

Okay. And then just with regards to cargo, this has been an area where we've seen, I guess now a couple of years of weakness. Obviously not a huge part of the revenue, but it is one that's still a slight drag. And I was just wondering, if you can elaborate on what percentage of this is coming from domestic versus international, and are you seeing any signs that the cargo should recover? Thanks.

Richard H. Anderson

We are not seeing much signs of recovery. It continues to be a very difficult. Most of our the cargo weaknesses coming on the international front versus the domestic front and there is a lot of yield and as well as tonnage pressure that it's not unique to Delta, as you are seeing it across not just the U.S. industry, you are seeing on a global scale. There is too much capacity, cargo capacity out there in a lot of these international markets.

Thomas Kim – Goldman Sachs & Co.

All right, okay. Thanks a lot.

Operator

Our next question comes from Joe DeNardi, Stifel.

Joe W. DeNardi – Stifel, Nicolaus & Co., Inc.

Hi, thanks good morning. A question for you Richard on the international margins, just curious to get your perspective on how you view that competitive dynamics there in general relative to domestic? Obviously, domestic is benefiting from all the consolidation capacity discipline. So, is all of the soft consolidation that's happened internationally in terms of JVs and alliances? Has that effectively changed the competitive landscape, so that it looks a little bit more like what you are seeing domestically or does international look a little bit more like what you saw at domestic maybe five or 10 years ago?

Richard H. Anderson

International has gone through a pretty significant amount of consolidation, and if you just go by a region, when we look at our business down in Latin America, you had significant consolidation in Mexico. There is one single flag carrier in Mexico now and they are exclusive partners with Delta.

You've had consolidation in South America with LAN-TAM merger, the Avianca-TACA merger, so the world is really evolving there very quickly in much the same way as the U.S. If you look in the trans-Atlantic, as Ed pointed out, that's been consistently our very best performer, and our immunized joint venture and the immunized joint ventures essentially have three global alliances now in that marketplace.

And in Asia, when you look at the TransPac market, it's really clustered around the three alliances. So we’ve seen a good market dynamics in the regions that we operate around the world and we continue to expect that worldwide consolidation will continue.

Joe W. DeNardi – Stifel, Nicolaus & Co., Inc.

Okay and then for Paul. At the Analyst Day, the CapEx outlook was more like $2 million to $2.5 million, now it's 50% of cash flow. Can you help me understand why that's the right way to frame it longer-term, rather than saying, this is what we need to invest and 75% or whatever the number is goes back to shareholders, I feel like that's more along the lines of what an industrials company would do, so interested to hear your thoughts on that.

Paul A. Jacobson

Sure, Joe good morning. What we've outlined is 50% of CapEx as part of a broader, more balanced capital allocation strategy for all the cash that's generated inside the Company. I think that's been in line with that sort of $2 million to $2.5 million level, against the cash flow that we have been generating over time. So as we continue to evolve down that space, I think that's subject to continue modification for the size and the cash generation of the Company.

Richard H. Anderson

I would add one other thing; the great piece of discipline in our business is driving to a return on invested capital metric. Delta has shown a strong capability of hitting very high internal rate of return targets for a very measured investments internally. And I would focus on the return on invested capital number and making certain that we hold to that number and produce those kinds of returns on a consistent basis.

Joe W. DeNardi – Stifel, Nicolaus & Co., Inc.

Okay, thanks guys.

Jill Sullivan Greer

And Sherlon, we are going to have time for one more question.

Operator

That will come from Hunter Keay, Wolfe Research.

Hunter K. Keay – Wolfe Research LLC

Hi, thanks again. Hey, Glen, how come you eliminated some of your checked bag fees on routes a couple of weeks ago?

Glen W. Hauenstein

Hunter we’re not going to answer that.

Hunter K. Keay – Wolfe Research LLC

Okay. How come Seattle was only 10% to 20% of connecting traffic three months ago, but now it's up to 65% of connecting traffic? How did that happen so fast?

Edward H. Bastian

I don’t think 10% to 15% was an accurate depiction I think it might have been a misunderstanding of what we were talking about last call, Hunter, that's got to be anything else, the full depth of our connecting close.

Hunter K. Keay – Wolfe Research LLC

Okay thank you, Ed. And the question is, is there any revenues from the Virgin JV hitting the revenue line or is it all showing up in the non-op line and if there are revenues, are there also ASMs associated with it coming through?

Richard H. Anderson

The revenues from the Virgin JV do show on the revenue line to the extent they are coming on Delta metal Virgin passengers, but most of the benefits at this point in time will show on the non-op line.

Hunter K. Keay – Wolfe Research LLC

And are there ASMs associated with that Ed, and thanks a lot.

Edward H. Bastian

No, we don’t have any Virgin ASMs in our numbers.

Hunter K. Keay – Wolfe Research LLC

Okay, thank you.

Jill Sullivan Greer

That is going to conclude the analyst portion of the phone call. I'm going to turn the call over to Ned Walker for the media.

John E. Walker

Hey, thanks very much Jill. Sherlon, if you could review the steps for the media to ask a question. Also we would like to ask the media if it could limit it to one question and a quick follow-up, we should be able to accommodate most everyone. With that, we will turn it back to you, Sherlon.

Operator

(Operator Instructions) We’ll have our first question from Jack Nicas, The Wall Street Journal.

Jack Nicas – The Wall Street Journal

Good morning, everyone thank you for the time. Richard, I was hoping you can speak to this. Can you discuss a bit about the accounting court ruling against Emirates, ruling that they could not fly from Milan to New York and how important that is for you guys and if Emirates tries that sort of flying with history of Emirates from other foreign countries to the U.S., is that something you guys are going to pursue legally and try to block that as well?

Richard H. Anderson

Well, Fifth Freedoms under the Chicago Convention way back in the 1940s were never intended to be used the way that they were used in those circumstances. And so, we’re optimistic that the decision of the Italian court will be a precedent that will be followed in other venues, because it was never the intention. The Fifth Freedoms were originally intended to take into account the range of airplanes to be able to fly nonstop, and it wasn’t intended to in essence set up operations between two countries neither of which you are citizen of, so – as standalone operations. So we’re pleased with the result and we will be very vigilant as an industry and being certain that these kinds of unbalanced trade activities from state-owned subsidized enterprises don’t create an unfair trade environment.

Jack Nicas – The Wall Street Journal

Thank you very much.

Operator

Our next question comes from Mary Schlangenstein, Bloomberg News.

Mary Schlangenstein – Bloomberg News

Hi. I wanted to see if you could possible give us an update on your activity regarding the Ex-Im Bank and its reauthorization? And I also wanted to ask the supporters of the reauthorization of Ex-Im Bank. You said they’re going to launch an all hands on deck effort to win the reauthorization, and I’m just wondering how bigger role you see for Delta in opposing that?

Richard H. Anderson

Well, we have played a significant role opposing it, and it’s not so much the reauthorization. It’s the bank needs to be reformed. There is no transparency around what it does with tax payers’ money in the United States and it creates a huge subsidy for state-owned carriers in the United States.

So in essence while we don’t have any aviation Airline policy, co-gen airline policy in the United States, our treasury goes and we get a very good view of this, because the companies that we own interests in, down in Brazil and Aeromexico, we get a pretty good glimpse of the kinds of financings that the Ex-Im Bank provides and they’re well below market. And they’re competing against private marketplace, alternatives to capital and we believe there needs to be reform.

And there is a place for the Bank in the marketplace when the bank was originally setup, back 60 or 70 years ago. It was to provide seed financing in developing nations. And now we’re providing, at a time when we run huge deficits in the United States, we’re taking the United States Treasury, the United States balance sheet and we’re financing investment grade state-owned airlines at borrowing costs that are probably around 300 basis points less than what Delta would pay, and that’s just not right for our government to do that. So there’s a place for the bank, but the bank needs to be reformed and it needs to be transparent and it shouldn’t be providing financing in any instance where there’s a private market alternative. And our concerns are only limited to widebody airplanes. Not narrowbody airplanes or industrial equipment or the like.

I will point out that both Valero Energy and Cleveland-Cliffs Steel have both also filed objections in their industries in instances where the Bank has financed their foreign competitors to compete against U.S. interests. In the end, it's about jobs, and I can tell you that when the Ex-Im does this, as in the case of Air India, it takes jobs away from the United States.

Mary Schlangenstein – Bloomberg News

Do you feel like you're gaining any traction on your efforts to get the reforms that put into place?

Richard H. Anderson

Yes, we are gaining traction. At the last ASU negotiation, we significantly increased the financing costs by a couple of hundred basis points. Second, in the last round of reauthorization, there were transparency requirements, which have been largely ignored, and there was a requirement that the United States, State Department and Treasury engage with EU authorities to negotiate an end to – both the EU and the U.S. run these huge, huge deficits. And the last thing they need to be doing is further funding those deficits by financing airplanes.

Okay, Sherlon with that we have time for one more quick question.

Operator

That comes from Ted Reed, The Street.

Ted Reed – The Street

Thank you. My questions were largely asked, so I'd just like to ask, is it now fair to call Delta in terms of revenues the world's second largest airline due to revenue trends?

Richard H. Anderson

We would rather tell operating margins.

Ted Reed – The Street

Are you second largest there?

Richard H. Anderson

I think we are top of the game there.

Ted Reed – The Street

All right, thank you.

John E. Walker

Okay, hey great. Thanks, Jill, Richard, Ed, Paul and Glen, thanks very much for your time. That concludes our March quarter financial results. We'll be back here in three months with our June quarter financial results. Thanks very much. Bye-bye.

Operator

That concludes today’s conference. Thank you for your participation.

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