filings.toolsItem 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
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Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Year in Review
Our pre-tax income for 2018 was $5.2 billion, representing a $349 million decrease compared to the prior year, primarily resulting from higher fuel expense and salaries and related costs, offset by increased operating revenue. Pre-tax income, adjusted (a non-GAAP financial measure) was $5.1 billion, a decrease of $137 million compared to the prior year. The adjustments to pre-tax income were primarily related to $53 million of fuel hedge mark-to-market ("MTM") adjustments and settlements in the current year compared to $259 million in the prior year.
Delta had a solid year in 2018 as the company maintained focus on its long-term strategy while also addressing the short-term challenges from higher fuel prices. Our culture and solid foundation enabled the company to successfully offset the majority of the $2.3 billion increase in fuel during 2018. Our strategic priorities for the year were (1) leveraging our strong brand to drive revenue growth, (2) improving our cost performance, (3) continuing to build our global franchise and (4) investing for the future.
Strong Brand Drives Revenue Growth
Compared to 2017, our operating revenue increased $3.3 billion, or 8.0%, with strong demand for our premium products and growth in revenues from non-ticket sources. Total revenue per available seat mile ("TRASM") and TRASM, adjusted (a non-GAAP financial measure) increased 4.3% compared to the prior year, led by (1) unit revenue growth in each of our four geographic regions, (2) broad-based strength in both leisure and corporate demand and (3) double-digit growth in premium products and non-ticket revenues.
Improving Our Cost Performance
Operating Expense. Operating expense increased $4.0 billion, or 11.4%, primarily due to $2.3 billion higher fuel expense and higher wages and profit sharing for employees. The increase in fuel expense primarily resulted from a 31% increase in the market price per gallon of fuel and our 3.6% capacity growth compared to 2017, which was partially offset by improved fuel efficiency driven by our investment in new aircraft. Salaries and profit sharing were higher due to pay rate increases for eligible employees implemented during 2017 and 2018, along with an adjustment to our profit sharing plan in 2018.
Our operating cost per available seat mile ("CASM") increased 7.5% to 14.87 cents compared to 2017, primarily due to higher fuel expense and salaries and related costs. Non-fuel unit costs ("CASM-Ex, a non-GAAP financial measure) increased 1.4% to 10.31 cents due to the pay rate increases discussed above.
Non-Operating Expense. Total non-operating expense was $113 million during 2018 compared to $466 million in 2017, primarily due to an increase in the pension benefit compared to the prior year, gains from investment-related transactions and lower interest expense.
Expanding Our Global Network
In 2018, international revenues grew 6.7% on a 0.9% increase in capacity. We made significant progress in expanding our global reach, implementing a transpacific joint venture with Korean Air Lines, entering into a joint venture agreement with WestJet with respect to trans-border routes between the U.S. and Canada and reaching an agreement with Air France-KLM and Virgin Atlantic to combine our separate transatlantic joint ventures into a single three-party transatlantic joint venture. The WestJet and three-party transatlantic joint venture agreements remain subject to receipt of required regulatory approvals.
Investing for the Future
Our $7.0 billion cash flows from operations funded $5.2 billion in capital expenditures for the business. As part of our multi-year refleeting initiative, we took delivery of 68 new aircraft, including A321-200s, B-737-900ERs, A350-900s, A220-100s and CRJ-900s. These deliveries allowed for the retirement of older, less efficient aircraft.
The non-GAAP financial measures pre-tax income, adjusted, TRASM, adjusted, and CASM-Ex, used above, are defined and reconciled in "Supplemental Information" below.
Results of Operations - 2018 Compared to 2017
Operating Revenue
| Year Ended December 31, | Increase | % Increase | |||||||||
| (in millions) | 2018 | 2017 | |||||||||
| Ticket - Main cabin | $ | 21,196 | $ | 20,380 | $ | 816 | 4.0 | % | |||
| Ticket - Business cabin and premium products | 13,754 | 12,087 | 1,667 | 13.8 | % | ||||||
| Loyalty travel awards | 2,651 | 2,403 | 248 | 10.3 | % | ||||||
| Travel-related services | 2,154 | 2,077 | 77 | 3.7 | % | ||||||
| Total passenger revenue | $ | 39,755 | $ | 36,947 | $ | 2,808 | 7.6 | % | |||
| Cargo | 865 | 744 | 121 | 16.3 | % | ||||||
| Other | 3,818 | 3,447 | 371 | 10.8 | % | ||||||
| Total operating revenue | $ | 44,438 | $ | 41,138 | $ | 3,300 | 8.0 | % | |||
| TRASM (cents) | 16.87 | ¢ | 16.18 | ¢ | 0.69 | ¢ | 4.3 | % | |||
| Third-party refinery sales(1) | (0.21 | ) | (0.20 | ) | (0.01 | ) | NM | ||||
| TRASM, adjusted (cents) | 16.66 | ¢ | 15.98 | ¢ | 0.68 | ¢ | 4.3 | % |
| (1) | For additional information on adjusting for third-party refinery sales, see "Supplemental Information" below. |
Passenger Revenue
Ticket and Loyalty Travel Awards Revenue
Ticket, including both main cabin and business cabin and premium products, and loyalty travel awards revenue increased $2.5 billion and $248 million, respectively, compared to the year ended December 31, 2017, consistent with the discussion of passenger revenue by geographic region, below. Business cabin and premium products ticket revenue includes revenues from fare products other than main cabin, including Delta One, Delta Premium Select, First Class and Comfort+. The growth in this ticket revenue primarily results from an increased number of premium seats driven by new aircraft deliveries, the continued expansion of our branded fare products and strength in business demand.
Passenger Revenue by Geographic Region
| Increase (Decrease) vs. Year Ended December 31, 2017 | ||||||||||||||||
| (in millions) | Year Ended December 31, 2018 | Passenger Revenue | RPMs (Traffic) | ASMs (Capacity) | Passenger Mile Yield | PRASM | Load Factor | |||||||||
| Domestic | $ | 28,159 | 8.0 | % | 4.9 | % | 5.2 | % | 2.9 | % | 2.6 | % | (0.2 | ) | pts | |
| Atlantic | 6,165 | 11.4 | % | 3.9 | % | 2.7 | % | 7.2 | % | 8.4 | % | 1.0 | pt | |||
| Latin America | 2,888 | 0.9 | % | (1.7 | )% | (0.5 | )% | 2.6 | % | 1.4 | % | (1.0 | ) | pt | ||
| Pacific | 2,543 | 3.0 | % | (1.8 | )% | (1.4 | )% | 4.9 | % | 4.5 | % | (0.3 | ) | pts | ||
| Total passenger revenue | $ | 39,755 | 7.6 | % | 3.5 | % | 3.6 | % | 4.0 | % | 3.9 | % | (0.1 | ) | pts |
Passenger revenue increased $2.8 billion, or 7.6%, compared to the prior year. PRASM increased 3.9% and passenger mile yield increased 4.0% on 3.6% higher capacity. Load factor was slightly lower than the prior year period at 85.5%.
Unit revenues of the domestic region increased 2.6%, resulting from our commercial initiatives, including branded fares, strong demand and fare increases implemented throughout 2018 in response to higher fuel prices. Our domestic operations have generated year-over-year unit revenue and business yield growth throughout 2018. During the September 2018 quarter, we signed a definitive agreement with WestJet that, after regulatory approval, will create a U.S.-Canada trans-border joint venture, providing enhanced offerings and more choice for customers.
Passenger revenue related to our international regions increased 6.7% year-over-year including growth in all three regions, despite reduced capacity in the Pacific and Latin America. During 2018, we continued to expand our branded fare products and leveraged the relationships with our alliance partners to generate unit revenue increases across all three international regions.
In the Atlantic, unit revenues increased due to year-over-year yield strength from business cabin traffic and the benefit provided by foreign currency fluctuations. Yield growth was particularly strong as we continued to leverage our alliance partners' hub positions in Europe's leading business markets of Amsterdam, London and Paris. During 2018, we initiated service on our flagship A350-900 with Delta One suites and the Delta Premium Select cabin from Detroit to Amsterdam. We also launched several new routes, including Los Angeles to Paris and Amsterdam, Indianapolis to Paris and Atlanta to Lisbon.
Unit revenues increased in Latin America principally as a result of yield growth, particularly in the Caribbean which has generated seven consecutive quarters of unit revenue growth. Key destinations impacted by the 2017 hurricane damage continue to recover. The increase was partially offset by the impact of political and economic uncertainty and foreign currency fluctuations in Mexico, Brazil and Central America. The negative impact of travel advisories and political uncertainty in Mexico has diminished toward the end of the year. We benefited from our joint cooperation agreement with Aeroméxico, which marked its first anniversary during 2018. Over that time, we have combined with Aeroméxico to launch nine new routes between the United States and Mexico, providing our customers with improved connectivity, more convenient schedules and seamless service between the two carriers.
Unit revenues increased in the Pacific region due to yield strength, particularly in Japan and Korea, and a benefit provided by foreign currency fluctuations. In May 2018, we launched a joint venture with Korean Air which provides more opportunities for our customers to reach destinations throughout Asia. During 2018, we also introduced our flagship A350-900 on routes from Los Angeles to Shanghai, Detroit to Beijing and Shanghai and Atlanta to Seoul-Incheon, which has improved the customer experience and added premium seats to the market, resulting in unit revenue increases.
Other Revenue
| Year Ended December 31, | Increase (Decrease) | % Increase (Decrease) | |||||||||
| (in millions) | 2018 | 2017 | |||||||||
| Ancillary businesses and refinery | $ | 1,801 | $ | 1,591 | $ | 210 | 13.2 | % | |||
| Loyalty program | 1,459 | 1,269 | 190 | 15.0 | % | ||||||
| Miscellaneous | 558 | 587 | (29 | ) | (4.9 | )% | |||||
| Total other revenue | $ | 3,818 | $ | 3,447 | $ | 371 | 10.8 | % |
Ancillary Businesses and Refinery. Ancillary businesses and refinery includes aircraft maintenance and staffing services provided to third parties, our vacation wholesale operations, our private jet operations and refinery sales to third parties. The increase compared to 2017 primarily resulted from growth in our aircraft maintenance business of 19% on higher engine overhaul volume.
In December 2018, we sold DAL Global Services, LLC (“DGS”), which provides aviation-related, ground support equipment maintenance and professional security services, to a new subsidiary of Argenbright Holdings, LLC. We received a non-controlling 49% equity stake in the new company and $40 million cash. The new company will continue to service our customers and third parties, and is expected to continue operating at the same airport locations it currently serves. In 2019, DGS will no longer be reflected within ancillary businesses and refinery. DGS generated $244 million and $214 million in third-party revenues during 2018 and 2017, respectively.
Loyalty Program. Loyalty program revenues relate to brand usage by third parties and other performance obligations embedded in mileage credits sold, including redemption of mileage credits for non-travel awards. Loyalty program revenues increased compared to 2017 related to growth in our co-brand credit card relationship with American Express through both additional card acquisitions and increased spend.
Miscellaneous. Miscellaneous revenue is primarily composed of lounge access and codeshare revenues.
Operating Expense
| Year Ended December 31, | Increase (Decrease) | % Increase (Decrease) | |||||||||
| (in millions) | 2018 | 2017 | |||||||||
| Salaries and related costs | $ | 10,743 | $ | 10,058 | $ | 685 | 6.8 | % | |||
| Aircraft fuel and related taxes | 9,020 | 6,756 | 2,264 | 33.5 | % | ||||||
| Regional carriers expense, excluding fuel | 3,438 | 3,466 | (28 | ) | (0.8 | )% | |||||
| Depreciation and amortization | 2,329 | 2,222 | 107 | 4.8 | % | ||||||
| Contracted services | 2,175 | 2,108 | 67 | 3.2 | % | ||||||
| Passenger commissions and other selling expenses | 1,941 | 1,827 | 114 | 6.2 | % | ||||||
| Ancillary businesses and refinery | 1,695 | 1,495 | 200 | 13.4 | % | ||||||
| Landing fees and other rents | 1,662 | 1,501 | 161 | 10.7 | % | ||||||
| Aircraft maintenance materials and outside repairs | 1,575 | 1,591 | (16 | ) | (1.0 | )% | |||||
| Profit sharing | 1,301 | 1,065 | 236 | 22.2 | % | ||||||
| Passenger service | 1,178 | 1,123 | 55 | 4.9 | % | ||||||
| Aircraft rent | 394 | 351 | 43 | 12.3 | % | ||||||
| Other | 1,723 | 1,609 | 114 | 7.1 | % | ||||||
| Total operating expense | $ | 39,174 | $ | 35,172 | $ | 4,002 | 11.4 | % |
Salaries and Related Costs. The increase in salaries and related costs is primarily due to pay rate increases for eligible employees implemented during 2017 and 2018.
Aircraft Fuel and Related Taxes. Fuel expense increased $2.3 billion compared to the prior year due to a 31% increase in the market price per gallon of fuel and a 3.6% capacity growth, which was partially offset by improved fuel efficiency driven by our investment in new aircraft.
The table below shows the impact of hedging and the refinery on fuel expense and average price per gallon, adjusted (non-GAAP financial measures):
| Average Price Per Gallon | |||||||||||||||||||
| Year Ended December 31, | Increase (Decrease) | Year Ended December 31, | Increase (Decrease) | ||||||||||||||||
| (in millions, except per gallon data) | 2018 | 2017 | 2018 | 2017 | |||||||||||||||
| Fuel purchase cost(1) | $ | 9,131 | $ | 6,833 | $ | 2,298 | $ | 2.22 | $ | 1.70 | $ | 0.52 | |||||||
| Fuel hedge impact | (53 | ) | 33 | (86 | ) | (0.01 | ) | 0.01 | (0.02 | ) | |||||||||
| Refinery segment impact | (58 | ) | (110 | ) | 52 | (0.01 | ) | (0.03 | ) | 0.02 | |||||||||
| Total fuel expense | $ | 9,020 | $ | 6,756 | $ | 2,264 | $ | 2.20 | $ | 1.68 | $ | 0.52 | |||||||
| MTM adjustments and settlements(2) | 53 | 259 | (206 | ) | 0.01 | 0.06 | (0.05 | ) | |||||||||||
| Total fuel expense, adjusted | $ | 9,073 | $ | 7,015 | $ | 2,058 | $ | 2.21 | $ | 1.74 | $ | 0.47 |
| (1) | Market price for jet fuel at airport locations, including related taxes and transportation costs. |
| (2) | MTM adjustments and settlements include the effects of the derivative transactions disclosed in Note 5 of the Notes to the Condensed Consolidated Financial Statements. For additional information and the reason for adjusting fuel expense, see "Supplemental Information" below. |
Regional Carriers Expense, Excluding Fuel. The decrease in regional carriers expense compared to the prior year results from the $75 million reduction in rent expense following the impairment of the Endeavor CRJ-200 fleet effective January 1, 2018. For additional information on this impairment, see Note 8 of the Notes to the Consolidated Financial Statements.
Depreciation and Amortization. The increase in depreciation and amortization primarily results from our increased capital expenditures in recent years. These investments have allowed for additional new aircraft deliveries, including A321-200s, B-737-900ERs, A350-900s, A220-100s and CRJ-900s, fleet modifications and technology enhancements. As we take delivery of new aircraft, we continue to evaluate our current fleet compared to network requirements.
In addition to investing in our fleet, we have also increased our technology investments in an effort to enhance interactions with our customers and allow us to deliver more personalized service, further enhancing the customer experience and strengthening our brand and competitive position. During 2018, we delivered several capabilities that enable our front-line employees to personalize their interactions with our customers, added self-service features on both the mobile app and delta.com and launched the first facial recognition biometric terminal for international travelers at the Atlanta airport.
Ancillary Businesses and Refinery. Ancillary businesses and refinery includes expenses associated with aircraft maintenance and staffing services we provide to third parties, our vacation wholesale operations, our private jet operations and refinery sales to third parties. Expenses related to refinery sales to third parties, which are at or near cost, increased $46 million compared to the prior year, primarily resulting from higher sales volume. The remainder of the increase in ancillary businesses and refinery primarily resulted from growth in our aircraft maintenance business.
In December 2018, we sold our staffing services business, DGS, to a subsidiary of Argenbright Holdings, LLC. Therefore, in 2019, this business will no longer be reflected within ancillary businesses and refinery. During 2018 and 2017, DGS incurred expenses of approximately $200 million per year related to services performed for third parties.
In addition, during 2018 and 2017, DGS incurred expenses of approximately $350 million related to internal Delta services that were primarily recorded in salaries and related costs. After the sale of DGS to a third party, Delta will record these expenses and our portion of the new entity's financial results under the equity method of accounting, in contracted services.
Profit Sharing. Profit sharing expense increased $236 million to $1.3 billion, marking the fifth consecutive year that Delta employees will receive over $1 billion in recognition of their contributions to the company's performance. The increase in profit sharing is related to the alignment of our profit sharing programs under a single formula, which was implemented October 1, 2017. Under this formula, our profit sharing program pays 10% to all eligible employees for the first $2.5 billion of annual profit (as defined by the terms of the program) and 20% of annual profit above $2.5 billion. Prior to October 1, 2017, the profit sharing program for merit, ground and flight attendant employees paid 10% of annual profit and, if we exceeded our prior-year results, the program paid 20% of the year-over-year increase in profit to eligible employees.
Results of Operations - 2017 Compared to 2016
Operating Revenue
| Year Ended December 31, | Increase (Decrease) | % Increase (Decrease) | |||||||||
| (in millions) | 2017 | 2016 | |||||||||
| Ticket - Main cabin | $ | 20,380 | $ | 20,489 | $ | (109 | ) | (0.5 | )% | ||
| Ticket - Business cabin and premium products | 12,087 | 11,045 | 1,042 | 9.4 | % | ||||||
| Loyalty travel awards | 2,403 | 2,234 | 169 | 7.6 | % | ||||||
| Travel-related services | 2,077 | 2,046 | 31 | 1.5 | % | ||||||
| Total passenger revenue | $ | 36,947 | $ | 35,814 | $ | 1,133 | 3.2 | % | |||
| Cargo | 744 | 684 | 60 | 8.8 | % | ||||||
| Other | 3,447 | 2,952 | 495 | 16.8 | % | ||||||
| Total operating revenue | $ | 41,138 | $ | 39,450 | $ | 1,688 | 4.3 | % | |||
| TRASM (cents) | 16.18 | ¢ | 15.66 | ¢ | 0.52 | ¢ | 3.3 | % | |||
| Third-party refinery sales(1) | (0.20 | ) | (0.09 | ) | (0.11 | ) | NM | ||||
| TRASM, adjusted (cents) | 15.98 | ¢ | 15.57 | ¢ | 0.41 | ¢ | 2.6 | % |
| (1) | For additional information on adjusting for third-party refinery sales, see "Supplemental Information" below. |
Passenger Revenue
Ticket and Loyalty Travel Awards Revenue
Ticket, including both main cabin and business cabin and premium products, and loyalty travel awards revenue increased $933 million and $169 million, respectively, compared to the year ended December 31, 2016, consistent with the discussion of passenger revenue by geographic region, below. Business cabin and premium products ticket revenue includes revenues from fare products other than main cabin, including Delta One, Delta Premium Select, First Class and Comfort+. The growth in this ticket revenue primarily results from the continued expansion of our branded fare products and strength in business demand.
Passenger Revenue by Geographic Region
| Increase (Decrease) vs. Year Ended December 31, 2016 | ||||||||||||||||
| (in millions) | Year Ended December 31, 2017 | Passenger Revenue | RPMs (Traffic) | ASMs (Capacity) | Passenger Mile Yield | PRASM | Load Factor | |||||||||
| Domestic | $ | 26,079 | 4.3 | % | 3.2 | % | 2.7 | % | 1.1 | % | 1.6 | % | 0.4 | pts | ||
| Atlantic | 5,537 | 2.2 | % | 4.8 | % | 0.3 | % | (2.5 | )% | 1.8 | % | 3.6 | pts | |||
| Latin America | 2,862 | 6.6 | % | 3.1 | % | 1.0 | % | 3.3 | % | 5.5 | % | 1.8 | pts | |||
| Pacific | 2,469 | (8.8 | )% | (9.0 | )% | (7.7 | )% | 0.2 | % | (1.2 | )% | (1.2 | ) | pts | ||
| Total passenger revenue | $ | 36,947 | 3.2 | % | 2.2 | % | 1.0 | % | 1.0 | % | 2.2 | % | 1.0 | pt |
Passenger revenue increased $1.1 billion over the prior year. PRASM increased 2.2% and passenger mile yield increased 1.0% on 1.0% higher capacity. Load factor was 1 point higher than the prior year at 85.6%.
Unit revenues of the domestic region increased 1.6%, resulting from our commercial initiatives, including branded fares, and an improving revenue environment. We continued to differentiate our product offerings and enable customer choice through segmentation, including offering Basic Economy throughout our domestic network. Our domestic operations closed 2017 with three consecutive quarters of year-over-year unit revenue growth, with robust demand for both business and leisure. We saw improvements in business markets with 81 of the top 100 business markets producing positive yields during the December 2017 quarter, up from 50% earlier in the year.
Passenger revenues related to our international regions increased 0.5% year-over-year primarily due to strength in the Atlantic and Latin America regions, partially offset by revenue declines in the Pacific. During 2017, we continued to expand our branded fare products offered throughout the international regions.
The Atlantic region closed 2017 with three consecutive quarters of year-over-year unit revenue growth on strong business class bookings. We continued to leverage our alliance partners' hub positions in Europe's leading business markets of Amsterdam, London and Paris to increase the volume of U.S. point-of-sale traffic. The U.K. was particularly robust, with unit revenue growth throughout 2017, including double-digit growth in the second half of 2017. During the year, we expanded our Basic Economy product to mitigate the impact of ultra-low cost carrier capacity increases.
Unit revenues increased in Latin America principally resulting from unit revenue improvement in Brazil, related to both improved traffic and higher fares. This improvement was driven by the strengthening of the Brazilian economy and additional connectivity for our customers provided by our relationship with GOL. Increased leisure traffic to Mexico and the Caribbean, and the incremental value provided by our alliance with Aeroméxico also contributed to the Latin America unit revenue improvement. Although unit revenue improved in the Caribbean, hurricane damage in several markets during 2017 resulted in temporary service adjustments. Finally, we continued to differentiate our product offerings, including expanding Basic Economy and selling Comfort+ as a separate fare product in Latin America.
Unit revenue declines in the Pacific primarily resulted from industry capacity growth in the region. We continued to optimize the Pacific region with a 7.7% reduction in capacity during 2017, focused on refining the network to generate incremental value from our Chinese and Korean alliances and differentiating our product offerings, including expanding Basic Economy and selling Comfort+ as a separate fare product. During 2017, we reached an agreement to create a transpacific joint venture with Korean Air, offering an enhanced and expanded network, industry-leading products and service, and a seamless customer experience between the U.S. and Asia. We also retired our last B-747-400 and introduced our new A350-900 with Delta One suites and the Delta Premium Select cabin on routes from Detroit to Tokyo-Narita and Seoul-Incheon, resulting in improvements in both profitability and customer feedback. These efforts began to show results as the Pacific returned to positive PRASM growth during the December 2017 quarter for the first time in more than four years.
Other Revenue
| Year Ended December 31, | Increase | % Increase | |||||||||
| (in millions) | 2017 | 2016 | |||||||||
| Ancillary businesses and refinery | $ | 1,591 | $ | 1,293 | $ | 298 | 23.0 | % | |||
| Loyalty program | 1,269 | 1,110 | 159 | 14.3 | % | ||||||
| Miscellaneous | 587 | 549 | 38 | 6.9 | % | ||||||
| Total other revenue | $ | 3,447 | $ | 2,952 | $ | 495 | 16.8 | % |
Ancillary Businesses and Refinery. Ancillary businesses and refinery includes aircraft maintenance and staffing services provided to third parties, our vacation wholesale operations, our private jet operations and refinery sales to third parties. The increase in ancillary businesses and refinery primarily resulted from $268 million of additional refinery sales to third parties.
Loyalty Program. Loyalty program revenues relate to brand usage by third parties and other performance obligations embedded in mileage credits sold, including redemption of mileage credits for non-travel awards. Loyalty program revenues increased compared to 2016 related to growth in our co-brand credit card relationship with American Express.
Miscellaneous. Miscellaneous revenue is primarily composed of lounge access and codeshare revenues.
Operating Expense
| Year Ended December 31, | Increase (Decrease) | % Increase (Decrease) | |||||||||
| (in millions) | 2017 | 2016 | |||||||||
| Salaries and related costs | $ | 10,058 | $ | 9,394 | $ | 664 | 7.1 | % | |||
| Aircraft fuel and related taxes | 6,756 | 5,985 | 771 | 12.9 | % | ||||||
| Regional carriers expense, excluding fuel | 3,466 | 3,447 | 19 | 0.6 | % | ||||||
| Depreciation and amortization | 2,222 | 1,886 | 336 | 17.8 | % | ||||||
| Contracted services | 2,108 | 1,918 | 190 | 9.9 | % | ||||||
| Passenger commissions and other selling expenses | 1,827 | 1,751 | 76 | 4.3 | % | ||||||
| Aircraft maintenance materials and outside repairs | 1,591 | 1,434 | 157 | 10.9 | % | ||||||
| Landing fees and other rents | 1,501 | 1,472 | 29 | 2.0 | % | ||||||
| Ancillary businesses and refinery | 1,495 | 1,182 | 313 | 26.5 | % | ||||||
| Passenger service | 1,123 | 964 | 159 | 16.5 | % | ||||||
| Profit sharing | 1,065 | 1,115 | (50 | ) | (4.5 | )% | |||||
| Aircraft rent | 351 | 285 | 66 | 23.2 | % | ||||||
| Other | 1,609 | 1,621 | (12 | ) | (0.7 | )% | |||||
| Total operating expense | $ | 35,172 | $ | 32,454 | $ | 2,718 | 8.4 | % |
Salaries and Related Costs. The increase in salaries and related costs is primarily due to pay rate increases for eligible employees.
Aircraft Fuel and Related Taxes. Fuel expense increased $771 million compared to the prior year due to a 22% increase in the market price per gallon of fuel, partially offset by reduced fuel hedge losses compared to the prior year and profits generated within our refinery segment.
The table below shows the impact of hedging and the refinery on fuel expense and average price per gallon, adjusted (non-GAAP financial measures):
| Average Price Per Gallon | |||||||||||||||||||
| Year Ended December 31, | Increase (Decrease) | Year Ended December 31, | Increase (Decrease) | ||||||||||||||||
| (in millions, except per gallon data) | 2017 | 2016 | 2017 | 2016 | |||||||||||||||
| Fuel purchase cost(1) | $ | 6,833 | $ | 5,579 | $ | 1,254 | $ | 1.70 | $ | 1.39 | $ | 0.31 | |||||||
| Fuel hedge impact(2) | 33 | 281 | (248 | ) | 0.01 | 0.07 | (0.06 | ) | |||||||||||
| Refinery segment impact(2) | (110 | ) | 125 | (235 | ) | (0.03 | ) | 0.03 | (0.06 | ) | |||||||||
| Total fuel expense | $ | 6,756 | $ | 5,985 | $ | 771 | $ | 1.68 | $ | 1.49 | $ | 0.19 | |||||||
| MTM adjustments and settlements(3) | 259 | 450 | (191 | ) | 0.06 | 0.11 | (0.05 | ) | |||||||||||
| Total fuel expense, adjusted | $ | 7,015 | $ | 6,435 | $ | 580 | $ | 1.74 | $ | 1.60 | $ | 0.14 |
| (1) | Market price for jet fuel at airport locations, including related taxes and transportation costs. |
| (2) | Includes the impact of pricing arrangements between the airline and refinery segments with respect to the refinery's inventory price risk. For additional information regarding the refinery segment, see "Refinery Segment" below. |
| (3) | MTM adjustments and settlements include the effects of the derivative transactions discussed in Note 5 of the Notes to the Consolidated Financial Statements. For additional information and the reason for adjusting fuel expense, see "Supplemental Information" below. |
Depreciation and Amortization. The increase in depreciation expense primarily results from new aircraft deliveries, including B-737-900ER, A321-200, A330-300 and A350-900 aircraft, fleet modifications and accelerated depreciation due to the planned retirement of our MD-88 fleet and two B-767-300ER aircraft.
Contracted Services. The increase in contracted services expense predominantly relates to additional contract labor expenses associated with investments in our technology infrastructure and other activities to improve the customer experience.
Aircraft Maintenance Materials and Outside Repairs. Aircraft maintenance materials and outside repairs consist of costs associated with the maintenance of aircraft used in our operations. The increase in aircraft maintenance materials and outside repairs expense primarily relates to an increase in maintenance activity in order to enhance service reliability of certain aircraft.
Ancillary Businesses and Refinery. Ancillary businesses and refinery includes expenses associated with aircraft maintenance and staffing services we provide to third parties, our vacation wholesale operations, our private jet operations and refinery sales to third parties. Expenses related to refinery sales to third parties, which are at or near cost, increased $268 million compared to the prior year, primarily resulting from higher sales volume.
Passenger Service. Passenger service expense includes the costs of onboard food and beverage, cleaning and supplies. The increase in passenger service expense predominantly relates to costs associated with enhancements to our onboard product offering and higher traffic.
Aircraft Rent. The increase in aircraft rent primarily results from new leased aircraft deliveries since 2016, including B-737-900ER and A321-200 aircraft.
Non-Operating Results
| Year Ended December 31, | Favorable (Unfavorable) | |||||||||||||||
| (in millions) | 2018 | 2017 | 2016 | 2018 vs. 2017 | 2017 vs. 2016 | |||||||||||
| Interest expense, net | $ | (311 | ) | $ | (396 | ) | $ | (388 | ) | $ | 85 | $ | (8 | ) | ||
| Unrealized gain/(loss) on investments, net | 14 | — | — | 14 | — | |||||||||||
| Miscellaneous, net | 184 | (70 | ) | (255 | ) | 254 | 185 | |||||||||
| Total non-operating expense, net | $ | (113 | ) | $ | (466 | ) | $ | (643 | ) | $ | 353 | $ | 177 |
Interest Expense. At December 31, 2017, the principal amount of debt and finance leases was $8.9 billion. During 2018, we issued $1.6 billion of unsecured notes, $1.4 billion of NYTDC Special Facilities Revenue Bonds and $621 million of aircraft secured loans. As a result of the debt issuances, partially offset by principal payments, the amount of debt and finance leases was $9.7 billion at December 31, 2018. Despite the increase in debt during the current year, interest expense decreased $85 million compared to the prior year due to recent refinancing transactions at lower interest rates resulting from our improvement to an investment grade credit rating in recent years and the favorable interest rate environment.
Unrealized Gain/(Loss) on Investments. Unrealized gain/(loss) on investments reflects the unrealized gains and losses on our equity investments in GOL, China Eastern, Air France-KLM and Alclear Holdings LLC, the parent company of CLEAR. Before we adopted the new financial instruments accounting standard in 2018, we recorded unrealized gains and losses on available-for-sale investments in accumulated other comprehensive income/(loss) ("AOCI").
Miscellaneous. During 2018, miscellaneous non-operating income is composed of pension benefits and realized gains from the DGS transaction and CLEAR share sale. This income was partially offset by our proportionate share of losses from our equity investments in Virgin Atlantic and Grupo Aeroméxico, charitable contributions and foreign exchange losses. The favorable movement in 2018 compared to 2017 primarily results from:
| • | Pension Benefit. The pension benefit increased $243 million in the current year compared to the prior year as plan assets increased $4.4 billion from the prior year end. In recent years, we have contributed significantly more to the pension plans than the minimum funding requirements, including $500 million in 2018 and $3.5 billion in 2017. |
| • | DGS Transaction. In the sale of our DGS entity to a subsidiary of Argenbright Holdings, LLC, we received a non-controlling 49% equity stake in a new entity and $40 million cash, which resulted in a gain of $91 million. See Note 4 of the Notes to the Consolidated Financial Statements for more information. |
| • | CLEAR Share Sale. We sold a portion of our equity interest in Alclear Holdings LLC, and recognized a gain of $18 million. |
The favorable movement resulting from pension benefit in 2017 compared to net cost in 2016 primarily resulted from our $3.5 billion pension contribution during 2017.
Our equity investment earnings and foreign exchange gains/(losses) vary and impact the comparability of miscellaneous from period to period.
Income Taxes
Our effective tax rate for 2018 was 23.6%. We expect our annual effective tax rate to be between 23% and 24% for 2019. At December 31, 2018, we had approximately $2.2 billion of U.S. federal pre-tax net operating loss carryforwards, which do not begin to expire until 2027. We believe we will utilize the majority of our remaining federal net operating losses and tax credits during 2019.
For more information about our income taxes, see Note 12 of the Notes to the Consolidated Financial Statements.
Refinery Segment
The refinery primarily produces gasoline, diesel and jet fuel. Monroe exchanges the non-jet fuel products the refinery produces with third parties for jet fuel consumed in our airline operations. The jet fuel produced and procured through exchanging gasoline and diesel fuel produced by the refinery provides approximately 200,000 barrels per day for use in our airline operations. We believe that the jet fuel supply resulting from the refinery's operation has contributed to reduced market price of jet fuel, and thus lowered our cost of jet fuel compared to what it otherwise would have been.
During the December 2018 quarter, the refinery completed a planned maintenance event ("turnaround") and did not produce any refined products for approximately 60 days. The turnaround was in accordance with the long-term maintenance plan for the facility to allow for the safe completion of major repairs and upgrades.
The refinery recorded operating revenues of $5.5 billion in 2018, compared to $5.0 billion in 2017. Operating revenues in 2018 were primarily composed of $3.6 billion of non-jet fuel products exchanged with third parties to procure jet fuel, $962 million of sales of jet fuel to the airline segment and $900 million of non-jet fuel product sales. Refinery revenues increased compared to the prior year due to higher costs of crude oil leading to higher pricing for associated refined products and higher margins on distillate product.
The refinery recorded income of $58 million and $110 million in 2018 and 2017, respectively. The refinery's income in 2018 was lower primarily due to the turnaround in the December 2018 quarter and lower gasoline margins nationwide.
A refinery is subject to annual EPA requirements to blend renewable fuels into the gasoline and on-road diesel fuel it produces. Alternatively, a refinery may purchase renewable energy credits, called RINs, from third parties in the secondary market. The refinery, operated by Monroe, purchases the majority of its RINs requirement in the secondary market. During 2018 observable RINs prices declined approximately 60%, which minimized our compliance costs during the current year.
For more information regarding the refinery's results, see Note 15 of the Notes to the Consolidated Financial Statements.
Financial Condition and Liquidity
We expect to meet our cash needs for the next 12 months from cash flows from operations, cash and cash equivalents, restricted cash equivalents, short-term investments and financing arrangements. As of December 31, 2018, we had $4.8 billion in unrestricted liquidity, consisting of $1.8 billion in cash and cash equivalents and short-term investments and $3.0 billion in undrawn revolving credit facilities. During 2018, we used existing cash and cash generated from operations to fund capital expenditures of $5.2 billion, and return $2.5 billion to shareholders.
Sources of Liquidity
Operating Activities
Cash flows from operating activities continue to provide our primary source of liquidity. We generated positive cash flows from operations of $7.0 billion in 2018, $5.0 billion in 2017 and $7.2 billion in 2016. We had lower operating cash flows during 2017 primarily due to incremental pension plan contributions, as discussed below. We also expect to generate positive cash flows from operations in 2019.
Our operating cash flows are impacted by the following factors:
Seasonality of Advance Ticket Sales. We sell tickets for air travel in advance of the customer's travel date. When we receive a cash payment at the time of sale, we record the cash received on advance sales as deferred revenue in air traffic liability. The air traffic liability increases during the winter and spring as advanced ticket sales grow prior to the summer peak travel season and decreases during the summer and fall months.
Fuel. Fuel expense represented approximately 23% of our total operating expenses for 2018. The market price for jet fuel is volatile, which can impact the comparability of our periodic cash flows from operations.
Pension Contributions. We sponsor defined benefit pension plans for eligible employees and retirees. These plans are closed to new entrants and are frozen for future benefit accruals. Our funding obligations for these plans are governed by the Employee Retirement Income Security Act, as modified by the Pension Protection Act of 2006. We had no minimum funding requirements in 2018. However, during the first three months of 2018, we voluntarily contributed approximately $500 million to these plans. In the first half of 2017, we contributed $3.5 billion to our qualified defined benefit pension plans using net proceeds from a $2.0 billion debt issuance, shares of our common stock from treasury with a value of $350 million and existing cash. We contributed $1.3 billion in 2016. We have no minimum funding requirements in 2019, but we plan to voluntarily contribute approximately $500 million to these plans.
Profit Sharing. Our broad-based employee profit sharing program provides that, for each year in which we have an annual pre-tax profit, as defined by the terms of the program, we will pay a specified portion of that profit to employees. In determining the amount of profit sharing, the program defines profit as pre-tax profit adjusted for profit sharing and certain other items.
We pay profit sharing annually in February. We paid $1.1 billion in 2018, $1.1 billion in 2017 and $1.5 billion in 2016, to our employees in recognition of their contributions toward meeting our financial goals. During the year ended December 31, 2018, we recorded $1.3 billion in profit sharing expense based on 2018 pre-tax profit, which we paid to employees in February 2019.
Effective October 1, 2017, we aligned our profit sharing plans under a single formula. Under this formula, our profit sharing program pays 10% to all eligible employees for the first $2.5 billion of annual profit and 20% of annual profit above $2.5 billion. Prior to that time, the profit sharing program for pilots used this formula but for 2016 and the first nine months of 2017, the profit sharing program for merit, ground and flight attendant employees paid 10% of annual profit and, if we exceeded our prior-year results, the program paid 20% of the year-over-year increase in profit to eligible employees.
Investing Activities
Capital Expenditures. Our capital expenditures were $5.2 billion in 2018, $3.9 billion in 2017 and $3.4 billion in 2016. Our capital expenditures during 2018 were primarily related to the purchase of aircraft, (including A321-200, B-737-900ER, A350-900, A220-100 and CRJ-900 aircraft), advanced deposit payments on future aircraft order commitments and modifications to our domestic fleet. Our capital expenditures during 2017 and 2016 were primarily for the purchase of aircraft and modifications to upgrade aircraft interiors that enhance our product offering.
As part of a multi-year initiative, we are investing in aircraft intended to provide more premium products, improved customer experience and better operating economics. We have committed to future aircraft purchases that will require significant capital investment and have obtained, but are under no obligation to use, long-term financing commitments for a substantial portion of the purchase price of a significant number of these aircraft. We expect that we will invest approximately $4.7 billion in 2019 primarily for (1) aircraft, including deliveries of A321-200s, B-737-900ERs, A220-100s, A330-900neos, A350-900s and CRJ-900s, along with advance deposit payments for these and our new A321-200neos and A220-300s as well as (2) aircraft modifications, primarily related to cabin enhancements to improve the customer experience. We expect that the 2019 investments will be funded primarily through cash flows from operations.
Equity Investments. During 2017, we completed a $622 million tender offer and settled derivative contracts for $173 million to obtain additional capital stock of Grupo Aeroméxico. During 2017, we also acquired shares of Air France-KLM for $450 million. See Note 4 of the Notes to the Consolidated Financial Statements for more information on our equity investments.
Los Angeles International Airport ("LAX") Construction. During 2016, we executed a modified lease agreement with Los Angeles World Airports ("LAWA"), which owns and operates LAX, and announced plans to modernize, upgrade and connect Terminals 2 and 3 at LAX by 2023. Based on the lease agreement, we are designing and managing the construction of the initial investment of $350 million to renovate gate areas, support space and other amenities for passengers, to upgrade the baggage handling systems in the terminals and to facilitate the relocation of those airlines located in Terminals 2 and 3 to Terminals 5 and 6 and Tom Bradley International Terminal ("TBIT"). The relocation was completed during 2017. We are also designing and managing the construction of an expansion of the project, which is expected to cost an additional $1.5 billion, of which $1.3 billion has been approved by LAWA. The expanded project will include (1) redevelopment of Terminal 3 and enhancement of Terminal 2, (2) rebuilding the ticketing and arrival halls and security checkpoint, (3) construction of infrastructure for the planned airport people mover, (4) ramp improvements and (5) construction of a secure connector to the north side of TBIT.
A substantial majority of the project costs will be funded through the Regional Airports Improvement Corporation ("RAIC"), a California public benefit corporation, using an $800 million revolving credit facility provided by a group of lenders. The credit facility was executed during 2017 and we have guaranteed the obligations of the RAIC under the credit facility. Loans made under the credit facility will be repaid with the proceeds from LAWA’s purchase of completed project assets. Using funding provided by cash flows from operations and/or the credit facility, we spent approximately $208 million on this project during 2018 and expect to spend approximately $240 million during 2019.
New York-LaGuardia Redevelopment. As part of the terminal redevelopment project at LaGuardia Airport, we are partnering with the Port Authority of New York and New Jersey ("Port Authority") to replace Terminals C and D with a new state-of-the-art terminal facility consisting of 37 gates across 4 concourses connected to a central headhouse. The terminal will feature a new, larger Delta Sky Club, wider concourses, more gate seating and 30 percent more concessions space than the existing terminals. The facility will also offer direct access between the parking garage and terminal and improved roadways and drop-off/pick-up areas. The design of the new terminal will integrate sustainable technologies and improvements in energy efficiency. Construction will be phased to limit passenger inconvenience and is expected to be completed by 2026.
In connection with the redevelopment, during 2017, we entered into an amended and restated terminal lease with the Port Authority with a term through 2050. Pursuant to the lease agreement we will (1) fund (through debt issuance and existing cash) and undertake the design, management and construction of the terminal and certain off-premises supporting facilities, (2) receive a Port Authority contribution of $600 million to facilitate construction of the terminal and other supporting infrastructure, (3) be responsible for all operations and maintenance during the term of the lease and (4) have preferential rights to all gates in the terminal subject to Port Authority requirements with respect to accommodation of designated carriers. We currently expect our net project cost to be approximately $3.3 billion with Delta bearing the risks of project construction, including any potential cost over-runs. Using funding provided by cash flows from operations and/or financing arrangements, we spent approximately $304 million on this project during 2018 and expect to spend approximately $530 million during 2019.
Financing Activities
Debt and Finance Leases. During 2018, we issued $1.6 billion in aggregate principal amount of unsecured notes, consisting of $600 million of 3.4% Notes due 2021, $500 million of 3.8% Notes due 2023 and $500 million of 4.375% Notes due 2028 (collectively, the "Notes"). We used the net proceeds from the offering of the Notes to repay borrowings outstanding under our secured Pacific term loan B-1 facility and 2015 term loan facility and for general corporate purposes.
Concurrent with the unsecured debt offering, we entered into a $2.65 billion unsecured revolving credit facility, up to $500 million of which may be used for the issuance of letters of credit (the “Revolving Credit Facility”). The Revolving Credit Facility was undrawn at the time we entered into it and as of December 31, 2018. The Revolving Credit Facility replaced the undrawn secured Pacific revolving credit facility and the 2015 revolving credit facility, both of which were terminated in conjunction with the repayment of the term loans described above.
The Revolving Credit Facility is split evenly into a $1.325 billion three-year facility and a $1.325 billion five-year facility. Borrowings on both facilities bear interest at a variable rate equal to LIBOR, or another index rate, in each case plus a specified margin.
Also during 2018, the New York Transportation Development Corporation ("NYTDC") issued Special Facilities Revenue Bonds, Series 2018 (the "2018 Bonds") in the aggregate principal amount of $1.4 billion. We entered into loan agreements with the NYTDC to use the proceeds from the 2018 Bonds to finance a portion of the construction costs for the new terminal facilities at the LaGuardia Airport. The proceeds from the 2018 Bonds are recorded in cash restricted for airport construction on the Consolidated Balance Sheet ("balance sheet").
During the December 2018 quarter, we obtained $621 million in aggregate principal amount of loans secured by 10 aircraft. These loans bear interest at a variable rate equal to London interbank offered rates ("LIBOR") plus a specified margin and are due in installments from 2019 to 2023.
Despite the recent debt issuances, since December 31, 2009, we have reduced our principal amount of debt and finance leases by $8.3 billion. This level of debt reduction, combined with more favorable interest rates on our remaining debt, reduced our 2018 net interest expense by more than $500 million compared to 2009. The principal amount of debt and finance leases was $9.7 billion at December 31, 2018.
During 2018, the three major credit rating agencies reaffirmed our investment-grade ratings:
| Rating Agency | Current Rating | Outlook |
| Fitch | BBB- | Stable |
| Moody's | Baa3 | Stable |
| Standard & Poor's | BBB- | Stable |
Capital Returns to Shareholders. Since first implementing our quarterly dividend in 2013, we have annually increased the dividend per share and paid $2.9 billion in total dividends, including $909 million in 2018. Through dividends and share repurchases, we have returned $12.3 billion to shareholders since 2013, while reducing outstanding shares by approximately 21% compared to the beginning of 2013. During 2018 alone, we repurchased and retired 29 million shares at a cost of $1.6 billion.
On February 7, 2019, the Board of Directors approved and we will pay a quarterly dividend of $0.35 per share to shareholders of record as of March 1, 2019.
Fuel Hedge Restructuring. During 2016, we entered into transactions to defer settlement of a portion of our hedge portfolio until 2017. These deferral transactions, excluding market movements from the date of inception, provided approximately $300 million in cash receipts during the second half of 2016 and required approximately $300 million in cash payments in 2017.
During 2016, we early terminated certain of our outstanding deferral transactions and made cash payments of $170 million, including normal settlements. As a result, during the year ended December 31, 2017, we reported $20 million in cash receipts and $244 million in cash payments associated with these transactions. During the year ended December 31, 2018 we reported $19 million in cash payments associated with these transactions.
Undrawn Lines of Credit
We have $3.0 billion available in revolving lines of credit. During February 2019, we drew $750 million from our unsecured Revolving Credit Facility for general corporate purposes.
These credit facilities include covenants customary for financing of this type. If we are not in compliance with these covenants, we may be required to repay amounts borrowed under the credit facilities or we may not be able to draw on them.
Covenants
We were in compliance with the covenants in our financing agreements at December 31, 2018.
Contractual Obligations
The following table summarizes our contractual obligations at December 31, 2018 that we expect will be paid in cash. The table does not include amounts that are contingent on events or other factors that are uncertain or unknown at this time, including legal contingencies, uncertain tax positions and amounts payable under collective bargaining arrangements, among others. In addition, the table does not include expected significant cash payments representing obligations that arise in the ordinary course of business that do not include contractual commitments.
The amounts presented are based on various estimates, including estimates regarding the timing of payments, prevailing interest rates, volumes purchased, the occurrence of certain events and other factors. Accordingly, the actual results may vary materially from the amounts presented in the table.
| Contractual Obligations by Year**(1)** | |||||||||||||||||||||
| (in millions) | 2019 | 2020 | 2021 | 2022 | 2023 | Thereafter | Total | ||||||||||||||
| Long-term debt (see Note 7) | |||||||||||||||||||||
| Principal amount | $ | 1,441 | $ | 2,048 | $ | 1,019 | $ | 1,676 | $ | 929 | $ | 2,195 | $ | 9,308 | |||||||
| Interest payments | 387 | 300 | 248 | 195 | 128 | 643 | 1,901 | ||||||||||||||
| Finance lease obligations (see Note 8) | |||||||||||||||||||||
| Principal amount | 109 | 77 | 68 | 28 | 23 | 98 | 403 | ||||||||||||||
| Interest payments | 17 | 12 | 8 | 5 | 4 | 13 | 59 | ||||||||||||||
| Operating lease obligations (see Note 8) | 1,185 | 1,022 | 845 | 712 | 673 | 4,289 | 8,726 | ||||||||||||||
| Aircraft purchase commitments (see Note 11) | 3,290 | 3,130 | 3,190 | 2,760 | 1,850 | 1,940 | 16,160 | ||||||||||||||
| Contract carrier obligations (see Note 11) | 1,505 | 1,344 | 951 | 872 | 769 | 2,862 | 8,303 | ||||||||||||||
| Employee benefit obligations (see Note 10) | 146 | 144 | 125 | 119 | 111 | 6,027 | 6,672 | ||||||||||||||
| Other obligations | 874 | 709 | 470 | 732 | 566 | 765 | 4,116 | ||||||||||||||
| Total | $ | 8,954 | $ | 8,786 | $ | 6,924 | $ | 7,099 | $ | 5,053 | $ | 18,832 | $ | 55,648 |
| (1) | For additional information, see the Notes to the Consolidated Financial Statements referenced in the table above. |
Long-Term Debt, Principal Amount. Represents scheduled principal payments on long-term debt.
Long-Term Debt, Interest Payments. Represents estimated interest payments under our long-term debt based on the interest rates specified in the applicable debt agreements. Interest payments on variable interest rate debt were calculated using LIBOR at December 31, 2018.
Finance and Operating Lease Obligations. Refer to Note 8 of the Notes to the Consolidated Financial Statements for additional information regarding finance and operating leases.
Aircraft Purchase Commitments. Refer to the aircraft purchase commitments table in Item 2 for additional information about our future aircraft purchases.
Contract Carrier Obligations. Represents our estimated minimum fixed obligations under capacity purchase agreements with third-party regional carriers. The reported amounts are based on (1) the required minimum levels of flying by our contract carriers under the applicable agreements and (2) assumptions regarding the costs associated with such minimum levels of flying.
Employee Benefit Obligations. Represents primarily (1) our estimated minimum required funding for our qualified defined benefit pension plans based on actuarially determined estimates and (2) projected future benefit payments from our unfunded postretirement and postemployment plans. For additional information about our defined benefit pension plan obligations, see "Critical Accounting Policies and Estimates."
Other Obligations. Represents estimated purchase obligations under which we are required to make minimum payments for goods and services, including, but not limited to, aviation-related, maintenance, professional security, insurance, marketing, technology, sponsorships and other third-party services and products.
Critical Accounting Policies and Estimates
Our critical accounting policies and estimates are those that require significant judgments and estimates. Accordingly, the actual results may differ materially from these estimates. For a discussion of these and other accounting policies, see Note 1 of the Notes to the Consolidated Financial Statements.
Loyalty Program
Our SkyMiles loyalty program generates customer loyalty by rewarding customers with incentives to travel on Delta. This program allows customers to earn mileage credits by flying on Delta, Delta Connection and other airlines that participate in the loyalty program. When traveling, customers earn redeemable mileage credits based on the passenger's loyalty program status and travel fare paid. Customers can also earn mileage credits through participating companies such as credit card companies, hotels and car rental agencies. To facilitate transactions with participating companies, we sell mileage credits to non-airline businesses, customers and other airlines. Mileage credits are redeemable by customers in future periods for air travel on Delta and other participating airlines, membership in our Sky Club and other program awards.
To reflect the mileage credits earned, the loyalty program includes two types of transactions that are considered revenue arrangements with multiple performance obligations: (1) mileage credit earned with travel and (2) mileage credit sold to participating companies.
Passenger Ticket Sales Earning Mileage Credits. Passenger ticket sales earning mileage credits under our loyalty program provide customers with (1) mileage credits earned and (2) air transportation. We value each performance obligation on a standalone basis. To value the mileage credits earned, we consider the quantitative value a passenger receives by redeeming miles for a ticket rather than paying cash, which is referred to as equivalent ticket value ("ETV"). Our estimate of ETV is adjusted for mileage credits that are not likely to be redeemed ("breakage"). Management uses statistical models to estimate breakage based on historical redemption patterns. A change in assumptions as to the actual redemption activity for mileage credits or the estimated fair value of mileage credits expected to be redeemed could have a material impact on our revenue in the year in which the change occurs and in future years. We recognize breakage proportionally during the period in which the remaining mileage credits are actually redeemed.
At December 31, 2018, the aggregate deferred revenue balance associated with the SkyMiles program was $6.6 billion. A hypothetical 10% change in the number of outstanding miles estimated to be redeemed would result in an approximately $200 million impact on annual revenue recognized.
We defer revenue for the mileage credits when earned and recognize loyalty travel awards in passenger revenue as the miles are redeemed and services are provided. We record the air transportation portion of the passenger ticket sales in air traffic liability and recognize passenger revenue when we provide transportation or if the ticket goes unused. A hypothetical 10% increase in our estimate of the ETV of a mileage credit would decrease annual passenger revenue by approximately $100 million, as a result of an increase in the amount of revenue deferred from the mileage component of passenger ticket sales.
Sale of Mileage Credits. Customers may earn mileage credits based on their spending with participating companies such as credit card companies, hotels and car rental agencies with which we have marketing agreements to sell mileage credits. Our contracts to sell mileage credits under these marketing agreements have multiple performance obligations. Payments are typically due monthly based on the volume of miles sold during the period, and the terms of our marketing contracts are generally from one to eight years. During the years ended December 31, 2018 and 2017, total cash sales from marketing agreements were $3.5 billion and $3.2 billion, respectively, which are allocated to travel and other performance obligations, as discussed below.
Our most significant contract to sell mileage credits relates to our co-brand credit card relationship with American Express. Our agreements with American Express provide for joint marketing, grant certain benefits to Delta-American Express co-branded credit card holders ("cardholders") and American Express Membership Rewards program participants, and allow American Express to market using our customer database. Cardholders earn mileage credits for making purchases using co-branded cards, may check their first bag for free, are granted discounted access to Delta Sky Club lounges and receive other benefits while traveling on Delta. Additionally, participants in the American Express Membership Rewards program may exchange their points for mileage credits under the loyalty program. We sell mileage credits at agreed-upon rates to American Express which are then provided to their customers under the co-brand credit card program and the Membership Rewards program.
We account for marketing agreements, including American Express, consistent with the accounting method that allocates the consideration received to the individual products and services delivered. We allocate the value based on the relative selling prices of those products and services, which generally consist of award travel, baggage fee waivers, lounge access and the use of our brand. We determined our best estimate of the selling prices by considering discounted cash flow analyses using multiple inputs and assumptions, including: (1) the expected number of miles awarded and number of miles redeemed, (2) ETV for the award travel obligation, (3) published rates on our website for baggage fees, discounted access to Delta Sky Club lounges and other benefits while traveling on Delta and (4) brand value.
We defer the amount for award travel obligation as part of loyalty program deferred revenue and recognize loyalty travel awards in passenger revenue as the mileage credits are used for travel. Revenue allocated to services performed in conjunction with a passenger’s flight, such as baggage fee waivers, is recognized as travel-related services in passenger revenue when the related service is performed. Revenue allocated to access Delta Sky Club lounges is recognized as miscellaneous in other revenue as access is provided. Revenue allocated to the remaining performance obligations, primarily brand value, is recorded as loyalty program in other revenue over time as miles are delivered.
Goodwill and Indefinite-Lived Intangible Assets
We apply a fair value-based impairment test to the carrying value of goodwill and indefinite-lived intangible assets on an annual basis (as of October 1) and, if certain events or circumstances indicate that an impairment loss may have been incurred, on an interim basis. We assess the value of our goodwill and indefinite-lived assets under either a qualitative or quantitative approach. Under a qualitative approach, we consider various market factors, including the key assumptions listed below. We analyze these factors to determine if events and circumstances have affected the fair value of goodwill and indefinite-lived intangible assets. If we determine that it is more likely than not that the asset may be impaired, we use the quantitative approach to assess the asset's fair value and the amount of the impairment. Under a quantitative approach, we calculate the fair value of the asset using the key assumptions listed below.
When we evaluate goodwill for impairment using a quantitative approach, we estimate the fair value of the reporting unit by considering both market capitalization and projected discounted future cash flows (an income approach). When we perform a quantitative impairment assessment of our indefinite-lived intangible assets, fair value is estimated based on (1) recent market transactions, where available, (2) the royalty method for the Delta tradename (which assumes hypothetical royalties generated from using our tradename) or (3) projected discounted future cash flows (an income approach).
Key Assumptions. The key assumptions in our impairment tests include: (1) forecasted revenues, expenses and cash flows, (2) terminal period revenue growth and cash flows, (3) an estimated weighted average cost of capital, (4) assumed discount rates depending on the asset and (5) a tax rate. These assumptions are consistent with those that hypothetical market participants would use. Because we are required to make estimates and assumptions when evaluating goodwill and indefinite-lived intangible assets for impairment, actual transaction amounts may differ materially from these estimates. In addition, we consider the amount by which the intangible assets' fair values exceeded their respective carrying values in the most recent fair value measurements calculated using a quantitative approach.
Changes in certain events and circumstances could result in impairment or a change from indefinite-lived to definite-lived. Factors which could cause impairment include, but are not limited to, (1) negative trends in our market capitalization, (2) reduced profitability resulting from lower passenger mile yields or higher input costs (primarily related to fuel and employees), (3) lower passenger demand as a result of weakened U.S. and global economies, (4) interruption to our operations due to a prolonged employee strike, terrorist attack or other reasons, (5) changes to the regulatory environment (e.g., diminished slot access or additional Open Skies agreements), (6) competitive changes by other airlines and (7) strategic changes to our operations leading to diminished utilization of the intangible assets.
We assessed each of the above assumptions in our most recent impairment analyses. The combination of our most recently completed annual results and our projected revenues, expenses and cash flows more than offset any negative events and circumstances. The stabilized operating environment for U.S. airlines has also contributed to improved financial results.
Goodwill. Our goodwill balance, which is related to the airline segment, was $9.8 billion at December 31, 2018. Based upon our qualitative assessment of all relevant factors, including applicable factors noted in "Key Assumptions" above, we determined that there was no indication that goodwill was impaired.
Identifiable Intangible Assets. Our identifiable intangible assets, which are related to the airline segment, had a net carrying amount of $4.8 billion at December 31, 2018, of which $4.7 billion related to indefinite-lived intangible assets. Indefinite-lived assets are not amortized and consist primarily of routes, slots, the Delta tradename and assets related to SkyTeam and collaborative arrangements. Definite-lived assets consist primarily of marketing and maintenance service agreements.
We performed qualitative assessments of our indefinite-lived intangible assets, including applicable factors noted in "Key Assumptions" above, and determined that there was no indication that the assets were impaired. Our qualitative assessments include analyses and weighting of all relevant factors, which impact the fair value of our indefinite-lived intangible assets.
Long-Lived Assets
Our flight equipment and other long-lived assets have a recorded value of $28.3 billion at December 31, 2018. This value is based on various factors, including the assets' estimated useful lives and salvage values. We review flight equipment and other long-lived assets used in operations for impairment losses when events and circumstances indicate the assets may be impaired. Factors which could be indicators of impairment include, but are not limited to, (1) a decision to permanently remove flight equipment or other long-lived assets from operations, (2) significant changes in the estimated useful life, (3) significant changes in projected cash flows, (4) permanent and significant declines in fleet fair values and (5) changes to the regulatory environment. For long-lived assets held for sale, we discontinue depreciation and record impairment losses when the carrying amount of these assets is greater than the fair value less the cost to sell.
To determine whether impairments exist for aircraft used in operations, we group assets at the fleet-type level or at the contract level for aircraft operated by regional carriers (i.e., the lowest level for which there are identifiable cash flows) and then estimate future cash flows based on projections of capacity, passenger mile yield, fuel costs, labor costs and other relevant factors. If an asset group is impaired, the impairment loss recognized is the amount by which the asset group's carrying amount exceeds its estimated fair value. We estimate aircraft fair values using published sources, appraisals and bids received from third parties, as available.
See Note 8 of the Notes to the Consolidated Financial Statements for information related to our impairment of the Endeavor CRJ-200 fleet.
Defined Benefit Pension Plans
We sponsor defined benefit pension plans for eligible employees and retirees. These plans are closed to new entrants and frozen for future benefit accruals. As of December 31, 2018, the unfunded benefit obligation for these plans recorded on our balance sheet was $6.4 billion. We had no minimum funding requirements in 2018. However, during the first three months of 2018, we voluntarily contributed approximately $500 million to these plans. We have no minimum funding requirements in 2019, but we plan to voluntarily contribute approximately $500 million to these plans. The most critical assumptions impacting our defined benefit pension plan obligations and expenses are the discount rate, the expected long-term rate of return on plan assets and life expectancy.
Weighted Average Discount Rate. We determine our weighted average discount rate on our measurement date primarily by reference to annualized rates earned on high-quality fixed income investments and yield-to-maturity analysis specific to our estimated future benefit payments. We used a weighted average discount rate to value the obligations of 4.33% and 3.69% at December 31, 2018 and 2017, respectively. Our weighted average discount rate for net periodic pension benefit cost in each of the past three years has varied from the rate selected on our measurement date, ranging from 4.57% to 3.69% between 2016 and 2018.
Expected Long-Term Rate of Return. Our expected long-term rate of return on plan assets is based primarily on plan-specific investment studies using historical market return and volatility data. Modest excess return expectations versus some public market indices are incorporated into the return projections based on the actively managed structure of the investment programs and their records of achieving such returns historically. We also expect to receive a premium for investing in less liquid private markets. We review our rate of return on plan assets assumptions annually. Our annual investment performance for one particular year does not, by itself, significantly influence our evaluation. The investment strategy for our defined benefit pension plan assets is to earn a long-term return that meets or exceeds our annualized return target while taking an acceptable level of risk and maintaining sufficient liquidity to pay current benefits and other cash obligations of the plan. This is achieved by investing in a globally diversified mix of public and private equity, fixed income, real assets, hedge funds and other assets and instruments. Our expected long-term rate of return on assets for net periodic pension benefit cost for the year ended December 31, 2018 was 8.97%.
The impact of a 0.50% change in these assumptions is shown in the table below:
| Change in Assumption | Effect on 2019 Pension Expense | Effect on Accrued Pension Liability at December 31, 2018 | ||||||
| 0.50% decrease in weighted average discount rate | $ | (5 | ) million | $ | 1.2 | billion | ||
| 0.50% increase in weighted average discount rate | $ | 3 | million | $ | (1.1 | ) billion | ||
| 0.50% decrease in expected long-term rate of return on assets | $ | 65 | million | $ | — | |||
| 0.50% increase in expected long-term rate of return on assets | $ | (65 | ) million | $ | — |
Life Expectancy. Changes in life expectancy may significantly change our benefit obligations and future expense. We use the Society of Actuaries ("SOA") published mortality data, other publicly available information and our own perspective of future longevity to develop our best estimate of life expectancy. The SOA publishes updated mortality tables for U.S. plans and updated improvement scales. Each year we consider updates by the SOA in setting our mortality assumptions for purposes of measuring pension and other postretirement and postemployment benefit obligations.
Funding. Our funding obligations for qualified defined benefit plans are governed by the Employee Retirement Income Security Act. The Pension Protection Act of 2006 allows commercial airlines to elect alternative funding rules ("Alternative Funding Rules") for defined benefit plans that are frozen. We elected the Alternative Funding Rules under which the unfunded liability for a frozen defined benefit plan may be amortized over a fixed 17-year period and is calculated using an 8.85% discount rate.
While the Pension Protection Act makes our funding obligations for these plans more predictable, factors outside our control continue to have an impact on the funding requirements. Estimates of future funding requirements are based on various assumptions and can vary materially from actual funding requirements. Assumptions include, among other things, the actual and projected market performance of assets, statutory requirements and demographic data for participants. For additional information, see Note 10 of the Notes to the Consolidated Financial Statements.
Investments Valued at Net Asset Value ("NAV") Per Share. On an annual basis we assess the potential for adjustments to the fair value of all investments. Certain of our investments valued using NAV as a practical expedient have a lag in the availability of data. This primarily applies to private equity, private equity-related strategies and real assets. We solicit valuation updates from the investment fund managers and use their information and corroborating data from public markets to determine any needed fair value adjustments.
Recent Accounting Standards
Standards Effective in Future Years
Comprehensive Income. In February 2018, the Financial Accounting Standards Board ("FASB") issued Accounting Standards Update ("ASU") No. 2018-02, "Income Statement—Reporting Comprehensive Income (Topic 220)." This standard provides an option to reclassify stranded tax effects within accumulated other comprehensive income/(loss) ("AOCI") to retained earnings due to the U.S. federal corporate income tax rate change in the Tax Cuts and Jobs Act of 2017. The adoption of the standard may impact tax amounts stranded in AOCI related to our pension plans. This standard is effective for interim and annual reporting periods beginning after December 15, 2018.
Recently Adopted Standards
Leases. In 2016, the FASB issued ASU No. 2016-02, "Leases (Topic 842)." This ASU and subsequently issued amendments require leases with durations greater than 12 months to be recognized on the balance sheet. The standard is effective for interim and annual reporting periods beginning after December 15, 2018, and early adoption is permitted.
In July 2018, the FASB issued ASU No. 2018-11, "Targeted Improvements - Leases (Topic 842)." This update provides an optional transition method that allows entities to elect to apply the standard using the modified retrospective approach at its effective date, versus recasting the prior years presented. If elected, an entity would recognize a cumulative-effect adjustment to the opening balance of retained earnings in the year of adoption. We adopted the new standard as of January 1, 2018 during the December quarter using the transition method that provides for a cumulative-effect adjustment to retained earnings upon adoption and have recast our 2018 quarterly results. The Consolidated Financial Statements for the fiscal year ended December 31, 2018 are presented under the new standard, while comparative years presented are not adjusted and continue to be reported in accordance with our historical accounting policy.
Statement of Cash Flows. In 2016, the FASB issued ASU Nos. 2016-15 and 2016-18 related to the classification of certain cash receipts and cash payments, and the presentation of restricted cash within an entity's cash flows statement, respectively. We adopted these standards effective January 1, 2018.
Financial Instruments. In 2016, the FASB issued ASU No. 2016-01, "Financial Instruments—Overall (Subtopic 825-10)." This standard makes several changes, including the elimination of the available-for-sale classification of equity investments, and requires equity investments with readily determinable fair values to be measured at fair value with changes in fair value recognized in net income. In February 2018, the FASB issued ASU No. 2018-03, "Technical Corrections and Improvements to Financial Instruments—Overall (Subtopic 825-10)" to clarify certain aspects of ASU No. 2016-01. We adopted these standards effective January 1, 2018.
Prior to the adoption of this standard, our investments in GOL Linhas Aéreas Inteligentes, the parent company of VRG Linhas Aéreas (operating as GOL), and China Eastern were accounted for as available-for-sale with changes in fair value recognized in other comprehensive income. At the time of adoption, we reclassified an unrealized gain of $162 million related to these investments from AOCI to retained earnings.
Our investment in Air France-KLM was accounted for at cost during 2017 as our investment agreement restricts the sale or transfer of these shares for five years. Upon adopting ASU Nos. 2016-01 and 2018-03, we recognized a $148 million gain in unrealized gain/(loss) on investments in our income statement related to the value of Air France-KLM's stock compared to our investment basis at December 31, 2017. Consistent with our investments in GOL and China Eastern, this investment is now accounted for at fair value with changes in fair value recognized in net income.
Retirement Benefits. In 2017, the FASB issued ASU No. 2017-07, "Compensation—Retirement Benefits (Topic 715)." This standard requires an entity to report the service cost component in the same line item as other compensation costs. The other components of net (benefit) cost are required to be presented in the income statement separately from the service cost component and outside a subtotal of income from operations. We adopted this standard effective January 1, 2018. The components of the net (benefit) cost are shown in Note 10 of the Notes to the Consolidated Financial Statements.
Supplemental Information
We sometimes use information ("non-GAAP financial measures") that is derived from the Consolidated Financial Statements, but that is not presented in accordance with GAAP. Under the U.S. Securities and Exchange Commission rules, non-GAAP financial measures may be considered in addition to results prepared in accordance with GAAP, but should not be considered a substitute for or superior to GAAP results. Reconciliations below may not calculate exactly due to rounding.
The following table shows a reconciliation of pre-tax income (a GAAP measure) to pre-tax income, adjusted (a non-GAAP financial measure). We adjust pre-tax income for mark-to-market ("MTM") adjustments and settlements on fuel hedge contracts, the MTM adjustments recorded by our equity method investees, Virgin Atlantic and Aeroméxico, and unrealized gains/losses on our equity investments accounted for at fair value, to determine pre-tax income, adjusted.
MTM Adjustments and Settlements. MTM adjustments are defined as fair value changes recorded in periods other than the settlement period. Such fair value changes are not necessarily indicative of the actual settlement value of the underlying hedge in the contract settlement period. Settlements represent cash received or paid on hedge contracts settled during the period.
Equity Investment MTM Adjustments. We record our proportionate share of earnings/loss from our equity investments in Virgin Atlantic and Aeroméxico in non-operating expense. We adjust for our equity method investees' hedge portfolio MTM adjustments to allow investors to better understand and analyze our core operational performance in the periods shown.
Unrealized Gain/Loss on Investments. We record the unrealized gains/losses on our equity investments accounted for at fair value in non-operating expense. Adjusting for these gains/losses allows investors to better understand and analyze our core operational performance in the periods shown.
| Year Ended December 31, | ||||||
| (in millions) | 2018 | 2017 | ||||
| Pre-tax income | $ | 5,151 | $ | 5,500 | ||
| Adjusted for: | ||||||
| MTM adjustments and settlements | (53 | ) | (259 | ) | ||
| Equity investment MTM adjustments | 29 | 8 | ||||
| Unrealized gain/loss on investments | (14 | ) | — | |||
| Pre-tax income, adjusted | $ | 5,113 | $ | 5,250 |
The following table shows a reconciliation of TRASM (a GAAP measure) to TRASM, adjusted (a non-GAAP financial measure).
| • | Third-party Refinery Sales. We adjust TRASM for refinery sales to third parties to determine TRASM, adjusted because these revenues are not related to our airline segment. TRASM, adjusted therefore provides a more meaningful comparison of revenue from our airline operations to the rest of the airline industry. |
| Year Ended December 31, | ||||||
| 2018 | 2017 | |||||
| TRASM | 16.87 | ¢ | 16.18 | ¢ | ||
| Adjusted for: | ||||||
| Third-party refinery sales | (0.21 | ) | (0.20 | ) | ||
| TRASM, adjusted | 16.66 | ¢ | 15.98 | ¢ |
The following table shows a reconciliation of CASM (a GAAP measure) to CASM-Ex (a non-GAAP financial measure). We adjust CASM for the following items to determine CASM-Ex for the reasons described below:
| • | Aircraft Fuel and Related Taxes. The volatility in fuel prices impacts the comparability of year-over-year financial performance. The adjustment for aircraft fuel and related taxes allows investors to better understand and analyze our non-fuel costs and year-over-year financial performance. |
| • | Ancillary Businesses and Refinery. These expenses include aircraft maintenance we provide to third parties, our vacation wholesale operations and refinery cost of sales to third parties. Results also include staffing services performed by DGS. Because these businesses are not related to the generation of a seat mile, we adjust for the costs related to these areas to provide a more meaningful comparison of the costs of our airline operations to the rest of the airline industry. |
| • | Profit Sharing. We adjust for profit sharing because this adjustment allows investors to better understand and analyze our recurring cost performance and provides a more meaningful comparison of our core operating costs to the airline industry. |
| Year Ended December 31, | ||||||
| 2018 | 2017 | |||||
| CASM (cents) | 14.87 | ¢ | 13.83 | ¢ | ||
| Adjusted for: | ||||||
| Aircraft fuel and related taxes | (3.43 | ) | (2.66 | ) | ||
| Ancillary businesses and refinery | (0.64 | ) | (0.58 | ) | ||
| Profit sharing | (0.49 | ) | (0.42 | ) | ||
| CASM-Ex | 10.31 | ¢ | 10.17 | ¢ |
Glossary of Defined Terms
ASM - Available Seat Mile. A measure of capacity. ASMs equal the total number of seats available for transporting passengers during a reporting period multiplied by the total number of miles flown during that period.
CASM - (Operating) Cost per Available Seat Mile. The amount of operating cost incurred per ASM during a reporting period. CASM is also referred to as "unit cost."
CASM-Ex - The amount of operating cost incurred per ASM during a reporting period, adjusted for aircraft fuel and related taxes, ancillary businesses and refinery and profit sharing expenses.
Passenger Load Factor - A measure of utilized available seating capacity calculated by dividing RPMs by ASMs for a reporting period.
Passenger Mile Yield or Yield - The amount of passenger revenue earned per RPM during a reporting period.
PRASM - Passenger Revenue per ASM. The amount of passenger revenue earned per ASM during a reporting period. PRASM is also referred to as "unit revenue."
RPM - Revenue Passenger Mile. One revenue-paying passenger transported one mile. RPMs equal the number of revenue passengers during a reporting period multiplied by the number of miles flown by those passengers during that period. RPMs are also referred to as "traffic."
TRASM - Total Revenue per ASM. The amount of total revenue earned per ASM during a reporting period.
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