Pessimism at the Mighty Delta

Madhu Unnikrishnan

April 26th, 2020

  • Pessimism, but not despair. That describes the short- to medium-term sentiment at Delta, arguably the strongest airline in the world before entering what’s become the industry’s greatest crisis ever. As with all passenger airlines during the current Covid-19 pandemic, its entire revenue base has all but vanished in a matter of weeks, with traffic volumes at a mere 5% of normal levels. As things stand today, more than 400 of Delta’s airplanes are idled (soon to be 650), 37,000 of its workers are on voluntary leave without pay, and every single day, the airline is burning through something like $100m of cash.

    That said, Delta’s pre-crisis virtues — its investment grade balance sheet, for example — were hardly for naught. It began the year with nearly $3b in cash, an armada of valuable planes, a rather variable cost base, pre-arranged credit lines, and ample credibility with lenders. And so, it was able to raise more than $5b in additional cash during the first quarter of 2020, thus ending the period with nearly $6b in cash, despite the $2.1b it spent buying stakes in Latam and Korean Air, and despite distributing $1.6b worth of profit-sharing checks in February (based on the nearly $5b net profit it earned in 2019).

    How did it raise so much new money? Mostly by borrowing and by selling aircraft (in sale-leaseback arrangements with lessors). It separately borrowed $3b from existing lines of bank credit. Just last week, it borrowed yet another $3b, secured by a pool of assets including New York, Washington, and London airport slots. Not stopping there in its dash for cash, Delta secured $5.4b in federal aid ($1.6b of that repayable) designated to pay workers. It can also apply for another $4.6b in federal loans (it has several months to decide).

    No less important to Delta’s cash management are its efforts to slash costs. Already entering the crisis, a sizeable chunk of its labor costs was variable, including the profit share payments it certainly won’t be issuing this year. The large number of workers taking voluntary leave (varying from one to 12 months) will help preserve cash. So will moves like cutting executive pay, closing airport lounges, deferring aircraft deliveries, and suspending dividends, stock buybacks, and airport projects. Delta was in fact able to variableize 60% of its cost base. As a result, management thinks it can slice its $100m rate of daily cash burn in half, to $50b a day by the end of June, even assuming revenues remain close to zero. It also expects to have roughly $10b in cash by the end of Q2, $4b more than it had at the end of Q1. And yes, it could still raise more cash if necessary, through advance sales of SkyMiles to its partner American Express, for example.

    Looking back at Q1, Delta recorded its first operating loss for the period since 2011. Back then, it paid $2.89 per gallon for fuel. Last quarter, it paid just $1.82 per gallon, and that was before the oil market started utterly collapsing this month. Versus the same quarter last year, Delta’s fuel bill dropped 18%, which was one reason it managed to escape the period with just a modestly bad negative 5% operating margin. January and even February were in fact still strong, notwithstanding some early signs of distress in Asia, and later Europe. It wasn’t until the second week of March that the Covid pandemic froze the domestic U.S. economy. The empty planes through most of March, however, were enough to sink revenues by 17% y/y. There wasn’t much difference between premium and non-premium — both saw roughly similar declines. Cargo was just as bad. Geographically, Latin America, which started feeling the pandemic later, was least bad. Asia, where the pandemic started, was worst.

    As for operating costs, they fell just 5%, with the cheaper fuel offset by a 5% increase in labor costs. In Q1 of 2019, Delta’s operating margin was positive 10%. Will things be better this quarter? No, they’ll be a lot worse, with net sales expected to be negative as customers demand refunds for tickets they bought on flights no longer scheduled. Customers who opted for future travel credits, meanwhile, represent future obligations well into 2021. Relaxed ticketing rules and courtesy extensions of SkyMiles benefits will further weigh on future revenues. Cash flows from operations will likely be negative for the remainder of 2020.

    When will salvation come? It could be three years before a sustainable recovery, said Delta’s CEO Ed Bastian. Which means the industry, including Delta, will almost surely need to shrink. Downsizing won’t be the only unpleasant aspects of the next few months and perhaps quarters. Delta, remember, owns large ownership stakes in not just Latam and Korean Air but also Air France/KLM, Aeromexico (see below) and Virgin Atlantic, all bloodied by the crisis. Bastian in fact, speaking on CNBC, suggested Virgin might require a bankruptcy-like restructuring. Also in question are joint ventures with the now-bankrupt Virgin Australia (see feature story), and a prospective joint venture with Canada’s WestJet. Thank goodness it didn’t buy a stake in Alitalia. Delta’s oil refinery is expected to lose money next quarter. New airport and aircraft cleaning procedures will add operating costs, never mind the massive opportunity costs associated with the idea of permanently blocking middle seats to promote social distancing.

    Even if domestic demand does start to creep back later this year, Delta’s international network, and especially its longhaul international network, could take much longer to recover. As the time horizon lengthens, however, Delta’s outlook becomes more optimistic. For all the current gloom, certain aspects of the crisis present new opportunities to build an even stronger airline. Delta can implement new productivity measures, find new areas of costs to remove, and accelerate its fleet transition, for example. MD-88s, scheduled to leave by December, will now leave by July. A decision on MD-90s will come soon. B767s, B757s, and smaller regional jets could be headed for the exits as well. With Airbus no less distressed than its customers, Delta doesn’t plan to spend any money on new planes this year and might defer additional orders. Planes in general will almost surely be cheaper as it emerges from the crisis. So will aircraft parts, not to mention labor, software, and especially fuel.

    Some of its rivals — abroad if not at home — are already downsizing and collapsing. Travelers, it says, will value quality, reliability, and safety more than ever, and Delta has sterling reputations for all three. Sure, Delta acknowledges, businesses will do a little more videoconferencing post-crisis. But it’s hardly a substitute for meeting face to face. Perhaps Delta’s private jet business, recently upsized with an investment in the firm Wheels Up, will win some new business as corporations avoid cramped commercial flying for health considerations. On a more mundane level, cash outflows from refunds are starting to stabilize. Cargo sales, meanwhile, are generating some revenue.

    If there’s any airline that’s going to survive the monstrous 2020 pancession, it’s Delta. It has the most important quality any airline can have right now: Staying power. Losses, for sure, will be ugly in Q2. They might be ugly in subsequent quarters as well. But with mountains of cash, bankruptcy is a distant prospect. Delta is now busy postulating various scenarios on future supply and demand conditions, and what new health procedures and practices might transpire in the post-coronavirus era. Whatever form the recovery takes, Delta wants to be ready when you are.

A Darker Picture at Aeromexico

  • Aeromexico, half-owned by Delta, also reported its Q1 financial results. They were much uglier than Delta’s, headlined by a $126m net loss and a negative 13% operating margin. Aeromexico is no stranger to losses in the offpeak first quarter — its Q1 operating margin last year was negative 2%. But it showed progress in the latter half of 2019, ending the year with a double-digit 10% margin in Q4. Among the favorable developments late last year: cheaper fuel and a stronger peso. Fuel, of course, remained cheap in the opening quarter of 2020. But the peso weakened, violently so in March as the Covid pandemic threw financial markets into disarray.

    A closer look at Aeromexico’s world on the eve of the crisis paints a darker picture than the sunny U.S. landscape to the north. Overcapacity was deflating shorthaul yields as three low-cost carriers grew and upsized their Airbus narrowbody fleets. Mexico’s economy was largely stagnant. Aeromexico felt compelled to withdraw from multiple U.S. routes because the six B737 MAXs it had were grounded (it was supposed to have received 14 by now). A new world-class airport for Mexico City, promising to relieve frustrating congestion, was abandoned mid-construction. With just a 51% stake in its loyalty plan, potential to fully benefit was limited.

    Now, it’s downright Armageddon as the virus pandemic and oil crash obliterate the most important drivers of Mexico’s economy, most notably inbound tourism, oil exports, remittances from Mexicans working in the U.S., and contributions to the supply chains of U.S. manufacturers. The impact of the Covid crisis on demand wasn’t fully felt until the final two weeks of the quarter. But still, Aeromexico’s load factor for the period dropped six full points. Revenues dropped 14% y/y, but operating costs declined only 5% (driven by a 20% fall in fuel costs). Capacity measured by ASKs shrank 9%. The declines were everywhere: domestic revenue fell 15%, international revenue fell 14%, ancillary revenue fell 21%, cargo revenue fell 7%, and so on.

    So what now? Aeromexico reacted to the crisis by quickly securing concessions from labor unions, aircraft lessors, lenders, and other stakeholders. Fixed labor costs, in fact, were halved, aided by a voluntary unpaid leave program lasting up to three months. Total fixed cash costs, which ran to about $110m per month pre-crisis, are now down to roughly $50m per month. To further relieve cash outflows, the carrier secured the right to delay payments for jet fuel and airport services. It’s working with Mexico’s government to get further liquidity assistance, while emphasizing that it’s not asking for a bailout or any subsidies. Though it does have wrong-way fuel hedges, they won’t cause any cash outflows. Unlike its LCC rivals, which lease a large portion of their fleets, Aeromexico owns many of its planes, meaning sale-leaseback deals are an option to raise cash. It would hate to sell its loyalty plan stake, but it theoretically could if necessary. It’s still talking to Boeing about additional MAX-related compensation.

    As Deutsche Bank analyst Michael Linenberg aptly put it during the carrier’s earnings call: “In the environment that we’re in, everything is open to renegotiation.” Aeromexico closed Q1 with $563m in cash, giving it confidence to state: “We are in a good position to withstand this contingency period.” Next month, it plans to operate at least 16 weekly widebody charters to China, mostly to transport medical equipment. That should be modestly cash positive. It’s operating about 20% of its normal schedule this month, mostly flying key domestic routes. It’s still filling about half of its domestic flights. And it’s trying to fly only routes where cash generation at least exceeds cash costs.

    Management thinks the recovery will be gradual, with traffic not returning to pre-crisis levels until well into 2021. But it does see things improving at least some this quarter. Most hopefully, Aeromexico thinks consolidation is inevitable. Interjet specifically, ailing badly even before the crisis, doesn’t seem long for this world. “So I think,” said CEO Andres Labastida, “the composition of the Mexican industry will be completely different once this crisis is over.”

Grounds for Optimism at Volaris

  • Aeromexico’s low-cost rival Volaris managed to make money in the first quarter of 2020. With only domestic and shorthaul international routes, it started seeing the full effect of the pancession only in the final two weeks of March, following two-and-a-half months of generally favorable conditions. The steep drop in demand first appeared on international routes, which for Volaris mostly means the U.S. and Central America. Only after that did a dramatic demand decline hit Mexico’s domestic markets. As executives noted, Mexico is about five to six weeks behind the U.S. and Europe in terms of Covid-19’s arrival. In addition, it was only in the final few weeks of the quarter that Mexico’s currency began its vertiginous depreciation.

    And so, planes were full most of the quarter—  85% full, in fact, which was almost two points higher than its load factor in last year’s first quarter. More importantly, Volaris earned a positive 4% Q1 operating margin, up from close to break even in the same quarter a year earlier. Its official net result was negative, but only due to one-off accounting items. Back at the operating level, revenues increased 9% y/y (on 7% more ASM capacity) while operating costs increased only 5% (helped by a 6% drop in fuel outlays). Volaris, remember, went from losses in 2018 to extraordinarily high profits by the end of 2019. Its Q4, 2019 operating margin, in fact, was 20%, fueled by a stable peso, strong ancillary performance, good demand conditions in its core family-visit market, success luring long-distance bus travelers, a new codeshare pact with Frontier, new NEO jets, and the deep distress of its rival Interjet. Perhaps most importantly, Mexico’s shorthaul overcapacity problem was tempered by Aeromexico’s missing MAXs.

    The point is, Volaris entered the crisis on a high note — if it hit a year earlier, the airline’s fate would be in far greater doubt. As it happens, Volaris today has a “robust liquidity position,” with about $450m in cash as of March 31. More than two-thirds of its balance sheet liabilities are to aircraft lessors, which have mostly agreed to defer payments so that Volaris can preserve cash while much of its fleet is grounded. It’s also deferring some new aircraft deliveries. Just as importantly, Volaris has flexible labor contracts in which a big portion of crew pay is tied to the number of hours people fly — with more than 60 planes grounded, labor costs thus automatically drop. Many workers are on partial-pay leave for up to three months. And the company lowered pay for most employees, ranging from 80% cuts for top executives to 20% cuts for lower-level workers.

    Volaris is optimistic for reasons beyond its abilities to manage cash flow. Management sees family-visit travelers, which typically account for half of its customer base, as the most resilient type of travelers. It’s a key reason, executives explain, why it reduced operations at a later stage than Aeromexico and other rivals. In fact, it expects load factors to decline only 10 to 15 points in Q3, when it hopes to be flying 40% to 50% of its normal capacity (it’s flying just 20% of the norm this month and 10% next month). Volaris carries almost no corporate or government traffic. Ancillaries represented nearly 40% of its Q1 revenues, having increased 9% on a per passenger basis during the period. Even during the crisis, it’s accelerating digital initiatives, including an upgrade to the latest edition of the Amadeus New Skies reservation system. It might get some government credit support to help with payroll.

    But as CEO Enrique Beltranena stressed: “I’m not expecting the state to rescue this company.” He’s hopeful that some demand will recover by the start of the peak summer season in June, noting again that family-visit traffic should be first to return. He thinks ultra-LCCs will recover a lot faster than higher-cost carriers. Demand growth, he adds, could return by the second half of 2021. Already for this year’s Q4, net bookings are positive. To be clear though, the next few months will be dark and dangerous. It’s currently burning $35m to $40m in cash per month. More than a quarter of the limited passengers currently booking tickets aren’t showing up for their flights (which means they’re not buying onboard ancillaries). Net bookings will be negative at least through May. Customer service channels are “overwhelmed” as customers ask for refunds, rebookings, or future flight credits. Mexico’s economy, though buttressed by existing IMF support and ample central bank dollar reserves, could shrink by a tenth this year. As Beltranena put it: “There should be no doubt, just like for every other passenger air carrier in the world, the future environment for the industry and for Volaris is very uncertain.”

United, Lufthansa Preview Losses

  • Back in the U.S., United gave a preview of its Q1 results, disclosing a $2.1b pretax loss for the period. Excluding special items, the loss will be closer to $1b. Delta’s Q1 pretax loss excluding special items, by comparison, was just $422m. United, like all airlines, is scrambling to stack as high a cash pile as it can, mostly by borrowing. But last week, it turned to the equity markets, announcing a new stock offer. Painful as it is to sell stock right now, with prices so depressed, it sure beats running out of cash and having to file for bankruptcy again, as it did after 9/11.

    Back on the debt side, United will apply for $4.5b in federal loan guarantees, on top of the $5b in payroll assistance it received; about 30% of that $5b must be repaid with below-market interest. It’s conducting sale-leaseback deals as well, in another example of burning the furniture to keep from freezing. A unique problem for United is its financial interest in Avianca and Azul, two South American airlines now in deep distress. Avianca, for its part, warns of its very survival. Already for Q1, United will incur a one-off charge of nearly $700m linked to loans it guaranteed to Avianca-related entities that probably won’t ever be repaid given the carrier’s state of distress.

    On a different note, United outlined some of the temporary steps it’s taking to promote traveler health and well-being. It’s spacing out customers while boarding, preventing customers from assigning seats next to another person, adding plexiglass dividers at customer service counters, disabling self-service touch-screen kiosks, streamlining onboard meal service, and removing seat-back magazines. United, furthermore, claims to be the first major U.S. airline to require its flight attendants to wear a face mask while on duty. It’s encouraging passengers to do the same. At some airports, it’s testing the idea of temperature checks for airport employees and flight attendants.
  • United’s close partner Lufthansa also gave a preview of its Q1 results, revealing a gruesome negative 19% operating margin, excluding special items. It lost money in last year’s Q1 too, but not nearly as much. In March alone, the German giant saw revenues plummet 47% y/y, leading to an 18% decline for the quarter as a whole. It also holds toxic fuel hedges. In addition, it faces multi-billion euros worth of liabilities related to money it owes suppliers, refunds it owes customers, and debt payments it owes lenders. As of last week, it held close to $5b in liquidity. But it spoke of significant cash declines expected in the coming weeks. Lufthansa, alas, “does not expect to be able to cover the resulting capital requirements with further borrowings on the market.” And so it’s desperately urging the governments of Germany, Switzerland, Austria, and Belgium to help.

    Austrian Airlines itself, a wholly-owned subsidiary, announced some business restructuring steps, in anticipation of demand falling 25% to 50% this year  — and not recovering more than 75% of pre-crisis demand before the end of 2021. Demand, it thinks, won’t fully recover until 2023 at the earliest. Austrian’s “plan for a new start” involves exiting all turboprops, all A319s, and three of its six B767s, the latter by 2022. By that time, it expects to have around 60 planes in total, down from 80 today. Nine of the 60 will be longhaul aircraft.

    The Lufthansa Group, remember, is heavily dependent on premium intercontinental flying, a segment that might take longest to recover. Its large maintenance and cargo units face tough times ahead as well, amid trade wars and fleet downsizing. When will Lufthansa officially report Q1 results? It was scheduled to go this week but postponed the release until the second half of May.

Hope From Holidaymakers

  • There’s more encouraging news to report from Jet2, a shorthaul LCC whose main business is selling holiday flights and tour packages to U.K. residents visiting places like Spain and Greece. In an earnings preview, its parent company Dart Group told investors to expect a tidy profit when it reports results for its fiscal year that ended last month. But much more importantly, it injected some hope for the industry by disclosing that customers are still making bookings for late summer (Jet2 plans to start flying again on June 17). The same is true for the upcoming winter. An “encouraging” number of passengers are electing to rebook flights rather than ask for refunds. Even better, summer 2021 bookings look “very promising.” Finally, a bit of good news from the airline sector.
  • Japan’s two largest airlines are scheduled to report this week. They’ll be publishing figures for their full fiscal years which ended in March, and thus included the just-completed January-to-March quarter. Both carriers, unsurprisingly, said revenues and operating profits came in well under earlier forecasts. In ANA’s case, fiscal year revenues were 6% below plan, while operating margin came in at 3%, not 7%. That implies a big calendar Q1 loss. For Japan Airlines, fiscal year operating margin was 7%, not the 9% it was expecting.   

Madhu Unnikrishnan

April 26th, 2020