Delta Plunges on Guidance

Updated from 10:56 a.m. EST

Delta Air Lines ( DAL) shares plunged nearly 12%, after the carrier warned first-quarter losses will be deeper than expected partly because of the high price of oil, a troubling sign that the airline recovery may have stalled out during the seasonally slow winter months.

In a filing with the Securities and Exchange Commission, the nation's third-largest carrier said it expects a net loss of about $400 million, up from its previous forecast of $300 million to $350 million, implying a loss of around $3.25 a share. Analysts expect Delta to lose about $307.5 million, or $2.51 a share, in the first quarter, according to Thomson One Analytics.

Delta's Friday filing prompted a negative reaction from Wall Street, with a flurry of brokerages dropping their earnings estimates and investors dumping shares. By midday, Delta shares were off $1.05, or 11.9%, to $7.79, on 5.1 million shares traded, well above its average daily volume. The downdraft pressured other airlines as well, most of which are coming off solid but unspectacular results for January and February. The Amex Airline index was off 5.4%.

Delta, which is struggling to cut costs, including wage concessions from its pilot union, attributed the move to higher fuel prices and "continued pressure on passenger revenue," and said the situation further illustrates "Delta's critical need to reduce costs to a competitive level for the long term."

Indeed, Delta's comments highlight the pressing concerns the company needs to address in a restructuring plan it hopes to complete by July, which includes a 30% pay cut for unionized pilots. But because the pilots' contract does not expire until May 2005, unlike its rivals, Delta may have to wait a year to cut labor costs.

"Disappointment is nothing new for a carrier with labor concerns. All eyes are on the pilots at Delta and Friday's warning actually strengthens management's argument that Delta's current cost structure is unacceptable," said Jamie Baker, airline analyst at J.P. Morgan. "The situation will likely worsen before showing any signs of progress."

Oil and the Airlines
Fuel costs are the second-largest expense that airlines have, which creates tremendous volatility for airline earnings, especially at legacy carriers who have not hedged the price of oil.
Carrier Morgan Stanley EPS Estimate at Price of Oil Per Barrel
$28/bbl $30/bbl $32/bbl $34/bbl* $36/bbl $38/bbl
American $2.36 $1.34 $0.31 -$0.70 -$1.74 -$2.77
Continental 0.35 -0.41 -1.18 -1.94 -2.70 -3.46
Delta -4.71 -5.23 -5.74 -6.30 -6.77 -7.28
Northwest -0.86 -2.02 -3.17 -4.40 -5.49 -6.64
AirTran 0.67 0.62 0.57 0.52 0.46 0.41
Frontier 0.86 0.74 0.63 0.53 0.40 0.28
JetBlue 0.89 0.84 0.80 0.76 0.72 0.68
Southwest 0.51 0.50 0.49 0.48 0.47 0.46
* -- Current Morgan Stanley EPS estimates assume $34/bbl.Source: Morgan Stanley Research.

Fueling Deeper Losses

It may be darkest before the dawn, but the rising cost of fuel has blackened Delta's outlook. The carrier said that rising fuel costs accounted for $47 million in losses, about half the increased first quarter loss estimate. For much of the first quarter, crude oil has been near $36 a barrel, more than $6 above most Wall Street expectations.

Despite restructuring operations to fly more efficiently, Delta and others have been unable to offset stubbornly high oil prices. In 2003, Delta used 5.5% less fuel than in 2002, but fuel costs nonetheless rose 15.5%, which is why fuel accounted for 14% of Delta's total expenses in 2003, up from 12% in 2002.

Fuel may be a big factor in Delta's woes, but in a surprising move, the company said it has unwound its hedging positions. In its 10-K, the company revealed that it settled all of its fuel hedge contracts prior to their settlement dates in February, netting the company $83 million in cash.

"We estimate that effective gains of $34 million, net of tax, will be realized during 2004 as fuel hedge contracts settle and the related aircraft fuel purchases being hedged are consumed and recognized in expense," the company said in the SEC filing, noting that $17 million of the gain will be recognized in the upcoming quarter.

But while the move has helped Delta increase its cash position, Morgan Stanley analyst William Greene wondered if its balance sheet and deep losses would prevent it from hedging oil down the road. According to Morgan Stanley research, every $1 move in the price of a barrel of oil would move Delta's earnings per share by roughly 25 cents. (For more on how oil affects the airlines, please read " Airlines Poisoned By Oil.")

"Presumably liquidating fuel hedges raised some cash and locked in gains to be amortized over future periods," said Greene, in a note. "However, this leaves Delta unhedged at a time when its credit outlook is not improving, which may make it more difficult to establish future hedge positions."

A Laborious Situation

And Delta has more than the price of fuel to worry about; it's exposed to a potentially explosive set of negotiations with pilots over wages. According to Goldman Sachs, Delta's pilot contract is $800 million more expensive than rival network carriers and won't feel the kind of turnaround seen at AMR ( AMR), parent of American Airlines, until 2005 at the earliest.

"With a competitive pilot package, we believe Delta could return to profitability in 2005, but we doubt this can be achieved until after the contract becomes amendable in May 2005," said Glenn Engel, "Despite Delta's low stock price, we believe it's too early to purchase the shares."

Not everyone agrees that it's too early to cash in on a recovery at Delta -- J.P. Morgan and others say it's a compelling strategy for investors who like high risk. But Delta's warning means that fuel could have an impact on first-quarter earnings at other carriers, even those who have gained wage concessions, like American.

With low-cost carriers moving into new domestic markets, adding routes and cutting prices to entice consumers to buy fares, pricing power is tough to come by. Even with network carriers adding back flights they shelved a year ago in the run up to the war in Iraq, the revenue growth generated by capacity increases may not be able to offset the rising cost of fuel and failure to raise ticket prices.

While international traffic at network carriers will help offset the weakness in domestic travel, Delta's warning and the hot competitive environment have left Wall Street concerned that an oversupply of flights will hurt the airline recovery.

"Any large hub carriers' shortfalls will be smaller because of strong performance on international routes," said Engel. "On the other hand, Delta's loss creates a question about the sustainability of big airlines' capacity additions. If forced to back down, we would switch our preference from hub carriers to low-fare airlines."

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