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The second largest U.S. airline Delta Air Lines Inc. (DAL - Analyst Report) reported second quarter 2012 adjusted earnings of 69 cents per share. The quarter’s earnings were a penny ahead of the Zacks Consensus Estimate thanks to falling fuel prices, fare hikes and the ongoing cost-cutting measures.

Adjusted net income excludes $561 million of fuel hedging losses, $171 million of severance costs and $22 million of cost related to other streamlining actions. Including these charges, Delta reported a loss of 20 cents in contrast to earnings of 23 cents in the year-ago quarter.

Revenue

Revenue increased 6% year over year to $9.73 billion in the reported quarter and inched past the Zacks Consensus Estimate of $9.7 billion. On an annualized basis, Passenger, and Other revenues grew 7% and 2%, respectively, while Cargo revenue dipped 1%.

Airlines traffic, measured in billions of revenue passenger miles, inched up 0.3% year over year. Capacity or available seat miles fell 1.3% while load factor (percentage of seats filled with passengers) grew 140 basis points year over year to 85.1%. Passenger revenue per available seat mile (PRASM) or unit revenue rose 8% year over year, led by a 9% increase in PRASM in both Atlantic and Pacific.

Operating Expenses

Total operating expenses, including special items, rose 11% year over year, primarily due to restructuring expenses and higher wages and benefits.  

Consolidated unit cost or cost per available seat mile (CASM), excluding fuel and special items, crept up 3.6% and CASM, including fuel and special items, increased 12.1% year over year in the reported quarter.

Liquidity

Delta Air Lines’ balance sheet continues to be strong. At the end of June 2012, the company had $5.3 billion in unrestricted liquidity including $3.5 billion in cash and short-term investments, and $1.8 billion in undrawn revolving credit facilities.

The company reduced its adjusted net debt to $12.1 billion from $12.2 billion at the end of the prior quarter. Delta has attained approximately $5 billion of debt reduction over the past two years. Management is on track to minimize it to $10 billion by the next year.

The company generated operating cash flow of $683 million in the reported quarter while capital expenditures were $652 million.

Guidance

Despite the uncertain economic growth, the company continues to expect strong momentum in third quarter unit revenue through capacity reductions and pricing actions.

For the third quarter, Delta Air Lines expects operating margin in the range of 10–12% and consolidated unit cost, excluding fuel, to grow 5–6% year over year. Additionally, the company expects domestic flying to decrease 0–2% year over year and international flying to decrease 3–5% year over year.

The estimated fuel price, including taxes and hedges, is approximately $3.09 per gallon and total liquidity is projected at $5.1 billion with capital expenditures of $400–$450 million.

Going forward, Delta expects to remain profitable as it continues to reap benefits from the investments made to improve operating efficiencies and customer experience. Further, the company targets $1 billion in cost savings over the next two to three years largely driven by its domestic fleet revamp.

Our Take

We remain 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.

On the cost side, Delta is taking several steps such as cutting flights to less-profitable markets, retiring inefficient planes, consolidating facilities and acquiring oil refinery to reduce costs.

Despite these positive attributes, we remain on the sidelines due to new pricing rules, competitive threats from United Continental Holdings Inc. (UAL - Analyst Report), Southwest Airlines (LUV - Analyst Report) and JetBlue Airways Corp. (JBLU - Analyst Report), its unionized workforce and heavy investments, which might weigh on the bottom line.

We are maintaining our long-term Neutral recommendation on Delta Air Lines. For the short term (1–3 months), the stock retains a Zacks #2 (Buy) Rank.

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