Editor's Choice

Delta Means Change

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When looking for potential investments, companies challenging the existing models of their industry deserve a look. Often times it is those who choose a new path that reap the greatest returns. But at the same time, these changes must be well researched by potential investors to determine if they truly benefit the bottom line. For today's investigation we will examine Delta Air Lines (NYSE: DAL) to see if its strategy regarding aircraft age and a refinery purchase will bear fruit for its investors.

Challenge #1: Airlines must fly the newest planes

Every time a new aircraft order is placed, it is greeted with much fanfare from both the seller and the buyer. The seller gets to display a big order number and demonstrate the airlines are in love with their latest technology. At the same time, the buyer gets to show off a new, modern fleet and showcase its investment in the future. We saw this at United Continental (NYSE: UAL) when the first Boeing 787 took flight. Customers were treated to a speech by the CEO and a full breakfast buffet at the airport. UAL, like many other 787 buyers, is looking to capitalize on fuel efficiency gains and reduced maintenance costs in addition to attracting "new plane fanfare." UAL also proudly announced future routes to be flown by its 787 fleet to gather increased press coverage and hopefully attract more customers. With more 787s on order, neither UAL nor its rivals plan on letting up on the purchase of new planes any time soon. Yet Delta Air Lines is trying something radically different: they are buying up old jets.

One may wonder why an airline would buck the trend of increasing fuel efficiency with new aircraft. New aircraft also require less maintenance and incorporate many of the feature passengers are most likely to want. However, Delta is trying to reduce costs and new aircraft orders are a major cost. From Delta's perspective, why would they purchase a brand new airplane when a fully operational 13 year old MD-90 can be had for only $5 to $6 million? But Delta is coming up with ways to capture some of the advantages of new aircraft while saving money by, well, not purchasing new aircraft.

A November Wall Street Journal article described much of Delta's plans for incorporating the airplanes they are acquiring at rock bottom prices into their existing fleet. The airline refurbishes the MD-90s before they go into service, giving them a fresh coat of paint, a new set of seats, and complete lavatory renovations. It's like Extreme Makeover: Airliner Edition. Clearly, Delta is making every effort so that when passengers fly on these planes they feel as new as they day they first took flight 13 years ago.

Of course maintenance is still an issue, as is the case with most older aircraft. Delta argues it is prepared for increased maintenance but does not expect it to become overly burdensome on the airline's bottom line. Then of course there's the issue of fuel efficiency. These older planes will consume more fuel than similar modern aircraft, but Delta still believes they are a good purchase. While Delta does maintain a fuel hedging position, a prolonged rise in jet fuel prices could harm Delta more than its competitors if it is still using these less efficient MD-90s. However, Delta has a (partial) answer to higher jet fuel costs, which brings us to the next challenge of the norm.

Challenge #2: Airlines should only fly planes

An oil refinery is back up and running after undergoing a $100 million renovation to optimize production. But this refinery is not owned by an oil company or even a refining company: it's owned by Delta Air Lines.

What would drive an airline to buy an oil refinery in the first place? In Delta's case it was to save on jet fuel by cutting the refining profit spread. The airline expects to save $300 million annually because of this acquisition. If they are right, it is one of they best decisions ever made by airline management since the entire initial investment could be recouped after only a year of savings. In addition, Delta hopes to supply its refinery with Bakken crude, which sells for a significant discount to crude from the Middle East and West Africa due to Bakken crude's landlocked position. The oil would be shipped by train to Delta's east coast refinery, where it can be turned into jet fuel, conveniently located near the airline's active New York operations.

Yet this is only a partial solution to the problem of volatile jet fuel prices. Delta is refining, not extracting oil, and thus will still be exposed to fluctuating oil prices. This puts Delta largely back in the same boat as other airlines, including US Airways (NYSE: LCC), which takes a hand off approach to managing oil prices. US Airways chooses to not hedge fuel costs as many other airlines do, allowing them to reap greater benefits if oil prices fall but be forced to take higher losses if oil prices rise. For investors looking for a falling oil price play, US Airways could be an interesting option as it would benefit more than its competitiors. But Delta's refinery buy was to reduce refining costs, and those savings should hold true even if oil prices rise. For this reason, many analysts are hailing this as a positive move by Delta, and some are even speculating that other airlines may purchase refineries as well.

Choosing a New Flight Path

When we think of airlines we tend to think of the massive risks and frequent bankruptcies associated with them, but we often don't notice legitimate change when it does happen. Make no mistake, Delta Air Lines is by no means a safe, blue chip investment, but recent efforts to cut costs by going against traditional industry rules could provide an interesting future. For this reason I am long Delta as I watch to see how their moves play out, for better or for worse.

TulipSpeculator1 owns shares of Delta Air Lines. The Motley Fool has no positions in the stocks mentioned above. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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