Delta Air Lines (NYSE:DAL) recently reported its July results, sparking a selloff across the sector. The company showed a 7% decline in PRASM (a measure of unit revenue) for July, which was in line with DAL's expectations but weaker than many analysts were expecting. Management expects unit revenue for the third quarter to fall within the midpoint of its initial guidance range of a 4-6% decline, which means DAL has some catching up to do over the next two months if it hopes to meet its target.
Despite improvements in profitability over recent quarters, analysts and investors continue to emphasize PRASM. Fellow contributor Stone Fox Capital makes the case that investors should focus on DAL's margin improvements rather than unit revenues, as it is profitability that ultimately determines cash flows, but we feel that the concern over DAL's deteriorating PRASM numbers is warranted.
PRASM, Passenger Revenue Per Available Seat Mile, is an important metric because it takes into account pricing. It measures how much an airline can extract from each passenger per mile flown. After several strong years of growth, we believe the airline cycle is reaching a peak, and the data seems to support this notion. Passenger traffic is decelerating or declining across the globe, and we expect this trend to persist. In order to generate top-line growth, carriers will need to rely more on pricing.
DAL's 7% PRASM decline reflected weak pricing. Slowing demand from higher margin business travelers and ongoing overcapacity in the trans-Atlantic region were largely responsible for the drop-off. Delta is not the only company to report poor unit revenue figures. Year over year, PRASM has declined across the sector. Carriers can improve PRASM in a few ways: by cutting capacity for a given level of demand, raising fairs, or by charging customers for other services (higher baggage fees is a common example). But as demand slows and competition increases, it becomes more difficult to raise prices or charge extra fees. The best solution, in our view, is to reduce capacity, but carriers have been reluctant to do this and sacrifice market share. Overcapacity will continue to be a problem for carriers over the next few quarters, and while DAL thinks it can return to positive unit growth by the end of the year, we are skeptical.
I understand the argument that revenue doesn't matter as much when costs are decreasing and profit margins are expanding. Despite the forecasted 5.2% unit volume decline in Q3, DAL expects to grow operating margin to the 19-21% range. The issue is that the improved profitability in recent quarters has been a result of lower oil prices more than anything DAL has done to boost productivity long term. We expect oil prices to remain weak for a while, but don't think they can fall much further. As a result, it will be difficult for DAL to generate higher margins in future quarters through reduced fuel expenses. This will leave DAL more reliant on pricing to boost margins.
DAL's 7% PRASM decline in July is worrying because it reflects slowing demand and increasing competitive pressures that have compromised the airline's pricing power. DAL has managed to offset these pressures and increase margins thanks to low fuel prices, but we don't think they can fall much further. Going forward, DAL will have to find other ways to expand margins, and it likely won't be able to through pricing.
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