Delta Delivers Premium Revenue Yields, but There Is No Free In-Flight Lunch

Equity Analyst

Nicolas Owens

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Delta Air Lines positions itself as a premium airline, with the highest costs and revenue per seat mile in the North American market. Even in the relatively harmonious 2015-19 period after the airline industry consolidated and fuel costs fell, Delta's industry-leading operating margins declined due to increased fuel, labor, and depreciation expense on almost flat capacity. While we believe Delta will continue to garner premium revenue yields, we see the spread between those yields and its overall costs more closely resembling the industry's in the long term, especially as the levers of segmentation and the definition of a business traveler evolve.

A pillar of full-service airlines' strategy before the pandemic was price discrimination between so-called business and leisure travelers. More-frequent and shorter-stay travelers who booked through their employers' corporate travel agency got bulk discounts for last-minute bookings and premium seats. The pandemic scrambled this formula as travel habits rapidly evolved, and the reality is that business and leisure travelers can be the same person. Airlines must find new ways to attract and reward brand-loyal frequent travelers willing to pay up for a more comfortable travel experience.

Our outlook for U.S. airlines is quite rosy in the near term, but these companies are acutely governed by the laws of gravity and economics. As travel restrictions lifted in 2022, demand rebounded more quickly than airlines' capacity to meet it, constrained by shortages of planes, pilots, and other crew. As a result, airlines have recorded record revenue and profits. These conditions function as a boon to the whole industry, and we believe they will take until at least 2024 to even out. When they do, we forecast a return to more normalized operating conditions, which will erode airline profitability. When airplanes and personnel are no longer a constraint, we expect the incremental incentives that airlines constantly operate under to return to the fore, leading to competition over prices and market share anywhere their route maps overlap, which is almost everywhere.

Business Strategy & Outlook

Airlines rent out seats by the hour on aircraft designed to fly for decades, and their operations and financial results are subject to fluctuations beyond their control, including ticket prices, fuel costs, labor costs, weather, and seasonal variation in people's travel plans. The airline business is highly price-competitive, capital-intensive, and labor-intensive, all of which makes it difficult for an airline to generate any profit beyond its cost of capital. IATA, an industry group, estimated in 2018 that return on invested capital had only approached the industry's cost of capital once in the preceding two decades, never exceeding it. Our own modeling reflects the same reality. We conclude that Delta Air Lines does not have an economic moat.

What's more, the industry has been pummeled by three of the most severe global macroeconomic events of the last two decades: the terrorist attacks on Sept. 11, 2001, two global pandemics (SARS and SARS-Cov-2), and the great recession of 2007-08. In each case air carriers experienced drastic and systemic disruptions to their operations, staffing, and financial viability, including bankruptcies and increased leverage. Similar macroeconomic events are likely to recur in the foreseeable future, and investors in airlines would risk permanent capital loss in such a situation.

Airlines hire and train thousands of people with specialized skills, including ground crews, technicians, and air crews. They tend to plan their routes from a few months to a year in advance, and we observe that their costs for salaries, wages, and benefits usually total between one fourth and one third of revenue and tend to grow in tandem with their overall route capacity (measured as available seat miles, or ASMs). In the short term, these costs are fixed, even though they flex with capacity in the medium and longer term. Embedded in the cost of doing business as an airline, and exacerbating the challenge of staffing, is the strong seasonality of travel—over the last 20 years, U.S. carriers have collectively faced a 30% January-to-June spike in monthly demand (or you could see that as a 23% June-to-January slump), measured as aggregate monthly revenue passenger miles. International demand is more volatile and brings extra competition from non-U.S. carriers.

The most volatile expense an airline experiences is for fuel. Although the amount of fuel required to power a given aircraft on its daily routes is known to the gallon (or by weight at takeoff), the price the airline will have to pay for a gallon can vary widely over a year, seasonally, and even regionally. Airlines were paying more than $3 per gallon of jet fuel (kerosene) in 2011, and fuel prices spiked in the 2022 aftermath of postpandemic supply shortages as well as macroeconomic stress on the energy market caused by Russia's invasion of Ukraine. From 2011 to 2015, jet fuel prices stayed over $2 per gallon, and airline industry ticket prices (termed yield and measured as cents per passenger mile) approached 25 cents in the period. When jet fuel prices fell in 2016, airline yields did, too. The most important point about fuel prices is that each airline experiences them more or less the same way—they are a commodity. And airlines have shown they can pass this element of their costs on to customers by charging more per mile when fuel prices are high. Over the long term, airline CPI, a measure of inflation, has been remarkably stable, notwithstanding a bit of a bump in 2022-23, which reflects the spike in fuel prices and which we do not believe will persist as competition heats up again.

The most costly competition airlines engage in is for aircraft. Every handful of years, Boeing and Airbus offer new models of aircraft that can fly a bit farther or carry a few more passengers on almost the same amount of fuel. We observe a steady increase in the available seat miles per gallon consumed across all airlines, as they consistently upgrade their fleets. The major U.S. carriers—Delta, United, and American—were able to fly an average airplane seat about 60 miles on a gallon of fuel in 2012 and are approaching 70 ASMs per gallon in 2023; Southwest, which flies only variants of the narrowbody 737, went from 70 ASMs per gallon a decade ago to approaching 80 in 2023. While this trend reflects ongoing improvements in engine efficiency, wing, and fuselage design, it also represents a competitive ratchet that no airline can afford to ignore—multiplied over many hundreds of millions of seat miles per year, even a small difference in fleet efficiency would represent a structural disadvantage for an airline competing on the same routes. Thus, airlines constantly refresh their fleets to stay competitive. (New seats, bigger luggage trays, and the like are a side benefit of new planes that also may augment an airline's brand perception for a short time.) 

Major U.S. carriers have partnered with a credit card-issuing bank to promote loyalty programs that feature their frequent-flyer miles. For some, these programs, in which the bank pays the airline more for the miles up front than they are technically worth to redeem, represent the lion's share of ongoing operating profit. We do not see these programs as changing the competitive dynamic or structural profitability of the airline. The airlines have just time-shifted when they experience the profit of serving one of their most loyal customer segments, in many cases redeeming miles for services such as baggage allowance, priority boarding, and lounge access, that cost incrementally very little to provide over and above the actual cost of the flight.

Airlines provide invaluable service to their customers and communities, often stimulating the economies of those destinations they connect into the global travel network. However, investors in airlines are flying on a wing and a prayer, as we see no prospect for durable economic profit in this industry. Instead, Airbus and Boeing, the duopoly of airframe suppliers, reap the economic reward from providing successively more efficient, powerful aircraft, which airlines line up to buy or rent so their service and cost profile can keep up with competing carriers.

None

Economic Moat

Delta Air Lines

Delta Air Lines, Inc. engages in the provision of scheduled air transportation for passengers and cargo. It operates through the Airline and Refinery segments. The Airline segment provides scheduled air transportation for passengers and cargo. The Refinery segment consists of jet fuel and non-jet fuel products. The company was founded by Collett Everman Woolman in 1928 and is headquartered in Atlanta, GA.

Earnings data Q4 2023

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Delta Air Lines, Inc. engages in the provision of scheduled air transportation for passengers and cargo. It operates through the Airline and Refinery segments. The Airline segment provides scheduled air transportation for passengers and cargo. The Refinery segment provides jet fuel to the airline segment. The company was founded by Collett Everman Woolman in 1928 and is headquartered in Atlanta, GA.

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