Delta Airlines (DAL) was the first major airline to report Q2 results. Expectations for the group are high as stories of skyrocketing ticket prices suggested a windfall quarter. Inflationary pressures from higher fuel costs and wages were expected to take their toll but, surely the group would ride out that turbulence on the wings of pricing power?

So how did Delta perform in the second quarter?

The airline giant reported earnings of $1.44 per share which fell short of the $1.72 street expectations. This raised a red flag for investors. Where was the shortfall?

Revenues were not the culprit as Delta’s top line jumped 94% from the prior year to $13.82 billion, slightly better than analyst projections of $13.4 billion. This was the highest sales number since the pandemic and runs at 99% pre-pandemic levels. 

Domestic revenue was up 3% compared to 2019. Domestic corporate sales were roughly 80% recovered compared to 2Q19. International travel skyrocketed, rising 84% compared to the June 2019 quarter. International travel booked for September is at a record level. 

A deeper dive into the numbers uncover the headwinds facing earnings. Operating Income of $1.4 billion was lower than expected but operating margins of 11.7% marked the company’s first double-digit figure since 2019.

The June quarter non-fuel cost performance increased 22%, well above the 8% target for 2022. Lower capacity, higher-related expenses and investments in operational reliability led to the pressure. Maintenance costs increased 20% from the prior year as higher costs for parts and labor took their toll. Wages were also on the rise as the company gave employees, excluding pilots, a 4% raise on May 1.

Adjusted fuel prices of $3.82 per gallon were up 37% sequentially and 94% from 2019. 

Free Cash Flow was $1.6 billion after the company paid down $1 billion in debt and reinvested $864 million into the business to improve capacity issues. 

The poor cocktail of lower capacity and higher expenses caused DAL to miss bottom-line projections. Will these issues persist?

Delta provided an outlook for its third quarter and updated its longer-term forecasts.

DAL expects Q3 revenues to increase 1-5% sequentially, in line with estimates. The company expects to maintain operating margins in the range of 11-13%. It reiterated that it would achieve a “meaningful” full year of profitability. 

It does not provide EPS guidance but comments around capacity and expenses suggest the metric will remain under pressure. 

Capacity issues will persist as Delta expects it to be down 15-17% in the third quarter. 

Fuel prices are projected to run in the range of $3.45-3.60. The mid-point represents an 8% decline sequentially but is still up 80% from 2019. 

Gross capital expenditures will be approximately $1.8 billion. DAL expects to see its debt levels increase slightly to $20 billion from the current $19.6 billion.

Delta remains confident that its actions to improve efficiencies will eventually lower its unit cost basis. Still, it admitted that it was unlikely to hit its 8% non-fuel expense target for 2022. Capacity is expected to decline 5% for the year.

The airline remains on track to achieve its 2024 targets of over $7 adjusted earnings per share and $4 billion in free cash flow. It expects 60% of its revenues to come from premium products and non-ticket revenue sources. Management believes a structural shift to premium products will be key to managing inflation and economic cycles. 

Bookings remain a key tailwind. CEO Ed Bastion said that booking trends remained strong into Labor Day and early Fall. He does expect to see normal seasonality in late Fall which suggests a decline in demand trends is on the horizon. 

The capacity and expense issues will continue to linger. Strong bookings and pricing power should help offset some of those pressures, but one must wonder if consumer spending will keep up with high ticket prices. It was interesting to see airfare as one of the few categories that declined in the June CPI report.

Business travel was also a key driver, but we have seen companies announce a slowdown in hirings. Will we see similar cost cutting on travel expenses? Then there is the recent uptick in COVID cases. How will passengers respond to these headlines?

The stock does have one thing going for it as it is dirt cheap trading at 5.1x forward earnings. Of course, those earnings estimates are likely to get cut by analysts. 

Shares of DAL are fighting to hold the $28-29 level for support. It would be impressive to see it continue to hold these levels in a tough macro tape. Upside would likely be limited to the $32 area. Long story short, we would expect to see DAL in a holding pattern in this $28-32 area until we get some further clarification on travel spending trends.