Delta's jet fuel gamble is starting to pay off
Sky-high fuel costs have made cost-cutting, not growing market share, the mantra for many airlines. One of Delta's riskier cost-cutting moves, buying an oil refinery, looks like it's starting to pay off.
Delta bought the refinery, which is in Trainer, Pa., just outside of Philadelphia, in 2012 for $150 million as a way to hedge against its biggest expense, jet fuel costs.
The idea was to become a "price influencer," Delta CEO Richard Anderson said.
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"It's given us the ability to participate in the pricing of jet fuel in the United States," Anderson said. "When you give up 35 to 40 percent of your business, you're not going to be successful. We're of the view at Delta that we control 100 percent of our business and it's our responsibility to navigate high fuel prices."
The bet wasn't a sure thing: Phillips 66, which sold the Trainer facility to Delta, reportedly wanted to sell the shuttered Pennsylvania facility because of its low profit margins.
But after losing a combined $136 million in the previous nine months, the Trainer refinery turned a profit for the first time in the third quarter, bringing in $3 million.
As a result, the price Delta paid for a gallon of jet fuel dropped 5.4 percent to $2.97 during the quarter. Though its overall fuel costs increased 3 percent, which Delta attributed to an increase in flying capacity.
Delta has said the oil refinery purchase could save the airline as much as $300 million a year in fuel costs, which accounted for 32 percent of operating expenses in the third quarter.
"They didn't make this purchase to make profits, but it could drive earnings through savings," said Savanthi Syth, an analyst at Raymond James. "They still have to prove that what looked good on paper will look good in practice."
Along with the benefits come quite a few risks: Owning the facility leaves Delta vulnerable to volatile markets for gasoline and fuel oil, which have lower margins than jet fuel. Refineries also require extensive maintenance and are heavily regulated.
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"It adds some risk to the story," said Andrew Davis, an investment analyst at T. Rowe Price, which holds more than 13 million shares of Delta. "Historically, refining margins don't stay big for long. That's something investors have to watch."
Anderson took over as Delta's CEO just four months after the company emerged from bankruptcy in 2007 and has navigated the post-recession turbulence in the airline industry. Delta now holds the biggest market share among major domestic carriers at 16.5 percent and its market capitalization, at more than $24 billion, is nearly twice of that of chief rival United.
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Investors are taking notice: Delta's stock price, which plummeted to $4 when the economy cratered in early 2009, has more than doubled in 2013, making it one of the best performers in the S&P 500. Among 12 analysts surveyed by CNBC, seven rank Delta as a "buy" and another four have it as a "strong buy." One analyst has it at "hold."
"The airline industry continues to evolve into a much more investable space," said Davis, the T. Rowe Price analyst. "Delta is the leader right now and everyone else is following them."
Delta had a stronger-than-expected third quarter but ended it with nearly $12 billion in debt on its balance sheet. Anderson said he wants Delta to get its debt under $10 billion by the end of the year, with a $7 billion target by 2018 as he pushes for an investment grade credit rating. Delta has shrunk its debt by 24 percent since 2008 and was upgraded by Moody's in June, but has far to go leave its "junk" status behind.
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Getting fuel costs under control, and boosting profits at the refinery, could help Delta stay ahead of its competitors, analysts said.
"They're laser-focused on anywhere they can cut costs," Syth said. "It's not a slam dunk but if it helps them control fuel costs, they'll get an advantage."
—By Craig Giammona, Special to CNBC.com