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In this past decade we've seen airlines go through plastic surgery, receiving facelifts and liposuctions across the board. Since 9/11, we've seen tremendous changes surrounding the airline industry: security, regulations, and operational costs. Overall, these variables have had tremendous, and far-bearing, negative impacts on the industry and especially on Delta Airlines, who filed for chapter 11 bankruptcy on September 14, 2005. In the report, they cited high labor and jet-fuel costs as factors in their filing. It took until April 2008 for Delta (NYSE:DAL) and Northwest's merger to be announced, clearing through by October of that year (NY Times). Delta has gone through tremendous changes while trying to lead the airline industry; most notably of which was their SkyTeam Global Alliance, bankruptcy and merger with Northwest, and acquisition of an oil refinery from ConocoPhillips.

Strategic Alliance

In response to the Star Alliance's foundation in 1997, Delta came together with Aeromexico, Air France, and Korean Air to create the SkyTeam alliance in June 2000; growing its membership to 16 airlines as of now. The effects of strategic alliances, like Star Alliance and SkyTeam, have been the most effective attempt to reclaim pricing power since the deregulation of the airline industry in 1978. Not only does it consolidate the pricing power into the hands of a few large alliances, but it also helps minimize excess capacity on flights, increasing each flight's profitability. So far, the effects of Delta merging and codesharing have been staggering, attributing largely to passenger load factor increasing from 68.8% in 2001 to 82.1% in 2011 (10k Report). Since the entrance and success of Star Alliance, new airline alliances are taking place, replacing the traditional merger-and-acquisition model of growing. The effects of these alliances have also been counterintuitive and beneficial to both the consumers and airlines. Although we would have expected consolidated pricing power to translate to higher airfares, we've actually seen quite the opposite. Adjusting for inflation, domestic airfares have fallen by 16.4% from 2000-2011, but the increased capacity from codesharing and the merger with Northwest has helped uplift airline bottom-line profitability.

Bankruptcy and Merger

In September of 2005, Delta Airlines finally declared Chapter 11 bankruptcy. Although it put a concerted effort in avoiding bankruptcy, it decided to opt into this last-resort tool amid suffocating costs. In April 2008, after much swirling speculation, Delta finally acquired Northwest Airlines for $3.1 billion. Unfortunately though, with all proposed mergers comes the struggle of actually merging everything; from technologies that booked seats and reservations to training staff from two companies to act as one. Merging was not an easy feat, but it was well worthwhile to Delta's bottom-line profitability. Delta's CIO (Chief Information Officer) shed some light on the monstrous task associated with merging; including consolidating 1,199 computer systems down to 600, replacing more than 140,000 electronic devices, and transferring Northwest's bookings to Delta, requiring computer engineers to perform 8,856 separate steps in just a few days. Also, the merger expanded Delta's fleet of aircrafts from 359 in 2007 to 684 by 2008; also, expanding from 23 aircraft models to 25. With this immense merger, nearly doubling Delta's size, came the crucial necessity of managing the massive fleet profitably. So far, though, the Delta-Northwest merger has been relatively seamless and profitable on the bottom-line.

Oil Refinery

Historically, labor expense was consistently the airline's largest operational costs, with fuel expense situated as the second largest expense. This fixed hierarchy of expenses began changing over the last decade and fuel price volatility skyrocketed. Last year, for Delta Airlines, fuel expense composed 29.4% of total operating expenses, up from composing 25.7% of total operating expenses in 2011. Also, fuel costs, as a proportion of total revenues, increased from 23.9% in 2010 to 29.4% in 2011. The company did experience a 10.6% increase in revenues from increased passenger utilization of aircrafts, but also experienced a disproportionate 28.1% increase in fuel expenses, largely attributable to the rapidly increasing fuel prices over the year. The effects of volatile fuel prices are blatantly apparent in its ability to suck out nearly all profitability in aircraft carriers. We've seen jet fuel prices rise from just $0.74/gal in September 2001 to $2.79/gal this May, representing a 277% increase in an operational cost which used to be historically stable. Consequently, Airlines have traditionally aggressively hedged against increasing fuel prices to lock in profitability; however, recently Delta has taken it 10 steps further.

On April 30th, 2012, Delta announced a widely controversial acquisition, spurring the boots of analysts and investors across the board. To hedge against high jet-fuel costs, Delta said it would spend $150 million to acquire ConocoPhilip's (NYSE:COP) oil refinery and spend another $100 million to renovate the plant to produce more jet fuel. Apparently though, from the statements of Delta's CEO Richard Anderson, the investment will be a homerun. Projections estimate that the investment will save Delta $300 million annually on fuel expenses, which will practically pay for itself in just one year. According to a filing, achieving similar saving measures by purchasing more fuel efficient Boeing 737's would sum to upfront capital investments of $2.5 billion.

This sort of vertical integration, especially in the airline industry, has been titled as an innovative approach to reducing fuel costs; allowing Delta to transfer the profits, which would have been realized by the oil refinery, to its own bottom-line. Still though, Delta needs to complete making changes to the refinery before reaping its benefits, which should be ready by the end of the third quarter.

It's going to become very, very interesting how the oil refinery plays out for Delta. Currently, the refinery is positioned to supply jet fuel to its domestic locations; however, if successful, it may acquire additional refineries to supply jet fuel for both its domestic and international locations. Also, we may see a shift towards continued vertical integration amongst Delta's legacy peers like United Continental (NYSE:UAL) and US Airways (LCC). I believe, though, that the carriers to adopt this strategy most quickly will be low cost carriers, like Southwest (NYSE:LUV), whose core strategy lies in cost minimization.

Capacity Trend

In the past decade, the entire airline industry has faced tremendous difficulty derived from two recessions and the 9/11 terrorist attacks. Each of these three events has utterly devastated Delta's bottom-line profitability with very little opportunity to minimize the blunt of the expenses because of the traditional airline business model.

For almost every business, their largest operational costs come from their variable costs; construction companies need labor, soda companies need ingredients and aluminum cans, and pen manufacturers need ink and plastic. All these companies have fixed expenses, but the overwhelmingly biggest expenses come from variable inputs. For these companies, this sort of cost structure is beneficial during economic slowdowns because, just by cutting back on production, they can cut back on most of their expenses, allowing them to minimize their losses. Airlines are not like most businesses though. To their unfortunate dismay in the past decade, an overwhelmingly large proportion of their costs are fixed. Regardless of whether or not they fill an airplane with passengers, airlines will still pay for the aircraft leases, fuel expense, labor costs, and leasing space from airports. It can be argued that airlines don't have to fly unprofitable flights, but there are multiple dynamics which force them to eat the short-term costs to avoid long-lasting, permanent consequences of losing market share. These dynamics arise from the immense competition between airlines fighting for retaining market share, in an industry where customer loyalty is dismal, at best.

Consequently, Delta has had to mitigate losses by increasing their passenger load factors over the years to make the flights less unprofitable. Traditionally, aircrafts would fly at about 70% capacity, which maintained profitability, but barely. However, this practice quickly led to multi-billion dollar losses across the entire industry once jet fuel costs began sky rocketing. This was most apparent when in 2008, with jet fuel reaching $3.89/gal in June, amid a very weak domestic and global economy resulting from the economic recession, the airline industry experienced a net loss of 23.75 billion (Airlines for America). In a drastic attempt to mitigate the immense losses stemming from weak consumer demand in the past decade, Delta began increasing its passenger load factor from a low of 68.8% in 2001 to a peak of unheard of 83% in 2010 (See: Passenger Load Factor Chart). This large decrease in capacity is not isolated to just Delta Airlines, but has been an aggressively pursued plan across the entire airline industry. Essentially, it has become "do or die".

(click to enlarge)

Customer Experience

It's very difficult for customers to differentiate between one airline and another because most are pretty much the same. There are exceptions, like Southwest, who stem away from the traditional hub-and-spoke model to pass down the saved costs onto their customers, but, other than that, most legacy carriers have been plagued by how homogenous they really are. Consequently, customers have almost no loyalty and would jump to a competitor offering lower airfares. In attempts to solidify market share, in an undifferentiated market with very little customer loyalty, Delta Airlines created its SkyMiles program, rewarding customers for their loyalty, but also began focusing on the customer experience:

  1. In 2002, technological advances bring convenience to customers by providing easy-to-use kiosks, expediting the check-in process.
  2. In attempts to decrease flight increase on-time departures, reduce airport congestion, and free up Delta aircraft, Delta initiated "Operation Clockwork" in 2005; becoming the biggest single-day schedule design in aviation history. Overall, more than 51% of Delta's entire routes were restructured to provide better, quicker service.
  3. In 2006, Delta expands its global routes, providing 141 new nonstop routes and also 41 new destinations. J.D. power ranked Delta Air Lines 2nd in overall customer experience. Business Traveler awarded them as having the best frequent flyer program, airline website, and airport lounges.
  4. In 2008, Delta became the first U.S. airline to provide onboard Wi-Fi for domestic mainline fleets.
  5. In 2010, Delta launched a $2 billion effort directly solely in improving the customer experience by providing: new full-flat beds, individual in-seat video on all wide-body aircraft, and increased First Class cabins to regional jets.

Delta Airlines realized something much more quickly than its competitors had: customer experience is always key. It's true that customers are extremely price sensitive to airfares, but it's also true that they love on-flight entertainment, especially for frequent flyers who practically live in planes. I fly roughly 10-12 times per year to, and from, California-New York. I've always booked with Continental airlines, while they were in the midst of their mergers. On about half my flights, I had a personal screen to watch movies and T.V. shows from without charge, but in the other half, I either had to pay for watching movies, or didn't even have the option at all. Of course I didn't pay the ridiculous rate they wanted, but I did develop very mixed feelings about Continental as a result. On one hand, some of my flights had fantastic "free" entertainment the whole way, while on the other hand, I either had to pay, or didn't have the option. This experienced facilitated a distaste towards Continental because, on some level, I expected some level of positive customer service, but my expectations were often unmet, leaving me wondering if there are other airlines who could provide me a better experience for roughly the same cost.

Just the fact that I even contemplated a competitor airline means Continental is doing something terribly wrong. Even though I have a frequent flyer account, I still have almost no loyalty to the company. Instead, all I want is good on-board entertainment and service in exchange for my loyalty, not some points that are relatively worthless. I'm living in the now, in the present, and in the present I want to forget about my 6 hour flight and breeze through it with movies, shows, and music, rather than staring out the window dwelling over the flight. Delta has taken note of this and, in a noble effort to differentiate their service, they've gone down the right path. Instead of differentiating through a façade of marketing and campaigning their airplane as "superior", they're actually spending billions focused on bettering the customer's experience. I like companies who put their money where their mouth is, and Delta is one of them.

Consensus

Delta Airlines has transgressed far and wide in the past decade; becoming a company on the radar of many analysts and consumers. It has adapted to the volatile jet fuel prices by taking aggressive actions to decrease excess capacity, and even buying its own oil refinery. Also, and probably most note worthy, it has begun focusing extensively on the customer experience; differentiating itself away from just price, and to better, much needed, customer service. Overall, in a very homogenous industry, Delta Airlines is making great progress in trying to differentiate itself from its competition.

Delta is currently priced at $10.39, with a $16.36 price target, giving it a 57.5% "premium"; however, I would take the attractive looking premium with a grain of salt. Airline stocks strongly correlate with the perception of the global economy, which we all know is still extremely fragile. Personally, I have a strong risk aversion when it comes to airline stocks because of their history throughout tough economic patches. That's not to say, though, that airlines cannot remain profitable during recessions; case in point: Southwest's 39 consecutive years of profitability. I like Delta's approach towards minimizing its operational costs, which will reduce its break even load factor. I'm going to wait to see two things happen before considering investing in Delta:

1) To see how effective Delta will be in managing its oil refinery and if it's truly as cost-effective as they claim.

2) To see how consumers react to Delta's push towards increasing customer experience. Primarily, I'm looking to see whether or not Delta can command higher airfares, while generating increased demand, for its entertainment-equipped flights.

Because of an airline's high fixed cost structure, they perform terribly in weak economies, but can perform exceptionally well during stronger economies. With capacity at above 80%, reduced cost structure, and stronger pricing power through consolidation, airlines can, and will be, extremely profitable with an economic rebound.

I advise you to read my articles analyzing the entire airline industry to get a better understanding before investing:

In-Depth Drilldown of the Airline Industry- Part 1

In-Depth Drilldown of the Airline Industry- Part 2

Disclaimer

Please read my standard disclaimer for my articles here

Source: Airline Industry: Focus On Delta