Delta Air Lines Inc. ( DAL - Analyst Report ) , the second largest U.S. airline, is slated to release its second quarter 2012 earnings on July 26. The current Zacks Consensus Estimate is pegged at 67 cents for the second quarter, representing a substantial 56.35% increase from the year-ago quarter.

Looking at surprises, Delta had average positive surprise of 9.68% in the trailing four quarters. In the year-earlier quarter, the company had surprised us by reporting 2.27% downside from our expectation.

Over the past two months, fuel price, the major threat to the company’s profitability, has dropped to a certain extent, making airline operations less expensive.

First Quarter Flashback

Though Delta’s adjusted earnings per share were at par with the Zacks Consensus Estimate, earnings on a GAAP basis climbed year over year on the back of fare hike actions, cost-cutting measures and fuel hedging gains that offset surging fuel prices.

Revenue improved on the back of strong unit revenue, particular in Atlantic and Pacific. Airlines traffic grew slightly from the year-ago quarter with decline in capacity (or, available seat miles) and increase in load factor (percentage of seats filled with passengers).

Operating expense rose mainly due to higher fuel expense and ancillary business expenses.

On the liquidity front, the company has attained approximately $5 billion of debt reduction over the past two years to $12.2 billion at the end of first quarter. Management is on track to minimize debt to $10 billion by 2013.

(Read our full coverage on this earnings report: Delta Meets, Guidance Firm)

Second Quarter Outlook

Last month, Delta Air Lines announced that it foresees $155 million in losses from fuel hedging strategies in the second quarter. The company now estimates fuel price to rise to $3.37 per gallon from the previous forecast of $3.28 per gallon due to hedge losses that were settled in May and June.

Delta Air Lines was 70% hedged for the second quarter at a jet fuel price of $3.05–$3.40 per gallon using collars and call spreads. As a result, the company expects to record operating losses in the quarter with negative 1% margin after accounting for the hedges and other special charges.

However, on a non-GAAP basis, Delta still expects operating margin in the range of 8–10% and consolidated unit cost, excluding fuel, to grow 3–4% year over year. Additionally, the company expects both domestic and international flying to decline 1–2% year over year.

Further, second quarter unit revenue is expected to grow 8% year over year thanks to growing business travel demand and flight expansion in the New York market. The addition of novel features to its services as well as introduction of new products will also contribute to revenue increase.

Agreement of Analysts

Estimates for the second quarter have been trending downward over the last 30 days with 10 out of 13 analysts making downward revisions. None of them moved in the opposite direction.

The analysts turned negative as Delta expects to record operating loss due to fuel hedging losses. Though the drop in fuel prices of late has helped the carrier to a certain extent, it indicates a slowing economy and consequent fall in global air travel demand. The falling fuel cost also increases the hedge losses.

For fiscal 2012, estimates reflect a positive bias over the last 30 days, as 8 out of 13 covering analysts have revised their estimates upward while 3 made downward revisions.

The analysts remained impressed with Delta’s initiatives to improve revenue while lowering overall cost. The company is progressing well on improving ancillary revenues by adding new features to its services as well as expanding new products, which are enhancing its value and profitability.

Moreover, Delta Air Lines believes 2012 will remain profitable with substantial improvements from last year on the back of growing revenues, capacity cuts, higher ticket prices and better customer satisfaction.

Magnitude — Consensus Estimate Trend

The magnitude of revisions for the second quarter remained stable over the last 7 days at 67 cents but went down by 13 cents over the last 30 days.

The Zacks Consensus Estimate for fiscal 2012 is $2.36, down 3 cents over the last 7 days but was up by a nickel over the last 30 days.

Neutral Recommendation

Despite the uncertain economic conditions, we expect Delta to exhibit strong revenue and earnings on the back of improving services, new product launches and reduced operating expenses — fuel and non-fuel costs. Additionally, the company is expanding networks in both domestic and international markets as well as de-leveraging its balance sheet in order to brighten long-term prospects.

Nevertheless, we remain on the sidelines due to fuel price volatility, competitive threats from major rivals like United Continental Holdings Inc. ( UAL - Analyst Report ) and Southwest Airlines Co. ( LUV - Analyst Report ) , as well as unionized workforce and heavy investments, which might weigh on the bottom line.

We are currently maintaining our long-term Neutral recommendation on the stock. For the short term, the stock retains a Zacks #2 (Buy) Rank.