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US regional airlines: restructuring ahead for the sector? July 2004 Download PDF

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After a decade of extremely rapid RJ growth and continued healthy profits in the post–September 11 environment, the US regional airline sector has encountered turbulence.

Profit margins are declining and there is uncertainty about growth prospects.

One key player (Atlantic Coast) has already defected to the low–cost carrier (LCC) camp.

Because of the major airlines' continued cost cutting and impending hub retrenchment, as well as likely industry consolidation, the regional sector may see its own significant restructuring over the next few years. What options do the regionals have? Which airlines will remain tied to the major carriers and which will take the LCC route? It was not supposed to be like this.

Regional airlines were supposed to be significant beneficiaries of their partners' restructuring. Demand for RJs accelerated in the aftermath of September 11, as United and other large network carriers scrambled to deploy more 50–seat RJs to replace mainline jets in markets were traffic had declined.

The RJ was set to play a key role in aiding legacy carriers' financial recovery, whether in or out of bankruptcy.

Regional airlines were poised to continue to thrive also because of the protections afforded by their "fixed–fee" or "fee–per departure" contracts with the major carriers.

Previously regarded as the industry’s safest and most predictable business model, the fixed–fee agreement eliminates risk associated with fuel prices, load factors and fares, and guarantees profit margins.

The long–term agreements were designed to give regional airlines — particularly the largest ones like Mesa and SkyWest (and formerly ACA) — the earnings stability they needed to finance significant RJ expansion.

All in all, those airlines looked like they had got it made, thanks to their ability to finance aircraft and provide low–cost, rightsized lift.

As many as three US regional airlines have gone public since September 11 (though some raised less than expected and their post–offering stock performance was poor). As part of their long–term plans, Continental and Northwest spun off regional subsidiaries ExpressJet (April 2002) and Pinnacle (November 2003). Earlier this summer, Wexford Capital, owner or manager of funds that control Chautauqua and Shuttle America, completed an IPO for Republic Airways Holdings. That is a new holding company for Chautauqua (which operates 50–seat RJs for AMR, US Airways, Delta and United) and Republic Airline, a new carrier scheduled to begin 70–seat RJ operations for United in October.

Even though many regional airlines continue to post healthy profits and grow rapidly, the outlook for the sector has worsened considerably in the past 18 months or so.

Much has happened that points to structural change, but there would appear to be two key catalysts: UAL’s Chapter 11 strategy regarding regional partners (from spring 2003) and a new round of cost cutting and hub retrenchment by the legacy carriers (from autumn 2004, following this year’s fuel price hike).

UAL’s actions were significant in that they showed that the fixed–fee model does not work so well when a major carrier is in financial trouble. UAL had been expected to leave alone the United Express contracts, but it chose not to as it was under significant pressure to cut costs. Its Chapter 11 status enabled it to reject the long–term agreements and demand new ones that incorporated rate reductions.

The new contracts meant reduced profit margins for the regional carriers. Some of the airlines also complained that the economic terms would deteriorate over time or that they were offered shorter contracts than they were comfortable with.

In addition to imposing tougher contract terms, the major carriers now also increasingly encourage competition — or "play one regional against another", as ACA noted when it walked away from United Express. Last year both Delta and Northwest invited bids from a large number of operators for new RJ flying, after previously allocating growth to old–established partners.

Such policies have made life harder and created additional uncertainty for the old–established regionals, but they have meant growth opportunities for new or smaller airlines. Over the past year, Trans States, Chautauqua, Republic and Shuttle America have been signed up as new United Express partners, Mesa has been brought back and Air Wisconsin has had its RJ agreement expanded (all of that mostly to replace ACA, which reinvented itself as Independence Air in June). The Republic IPO, which had been on hold for more than two years, may have been possible only because of the new United Express EMB–170 contract secured in March.

If the United Express changes caused much hassle and turmoil, a new round of cost cutting and retrenchment by the majors could have serious repercussions for RJ growth opportunities over the next few years. This will especially be the case if the legacy carriers end up closing many smaller hubs, where they currently rely extensively on RJs. A liquidation of a major carrier, such as US Airways, would of course have dramatic impact in terms of creating overcapacity in the regional sector.

Profit outlook

The industry–wide shift from revenue sharing to fixed–fee contracts in the late 1990s meant a reduction in regional airline operating margins from typically 16–20% (or over 20% in some cases) to 10–14%.

The regionals were happy to obtain a lower but stable and predictable earnings stream, but they had been under pressure to do so because the majors wanted control of their partners' capacity and fares.

Since September 11, operating margins have typically declined by another 4–5 percentage points (mainly due to contract revisions), with 10% being currently the typical target in fixed–fee contracts.

There is variation in trends, depending on individual airlines' circumstances. While SkyWest and ExpressJet are in the process of moving down from 14–15% margins to the 10% level, Mesa is actually moving up from 5–7% margins in 2002 and 2003 to 8–9% this year (it has traditionally accepted lower margins, in addition to being one of the lowest cost producers).

If profitability is the criteria, the regional sector is still a very good place to be in. The first–quarter 2004 operating margins of SkyWest (13.7%), ExpressJet (13.4%) and Mesa (8.6%) compare very favourably even with the margins of the most profitable LCCs — JetBlue (11.3%), AirTran (4.3%) and Southwest (4.1%). And of course, ACA, which achieved 11–12% margins in 2002 and 2003 as a regional airline, is now going to plunge into losses for at least two years as an LCC.

The problem is that the regional airline margins may come under renewed scrutiny when the legacy carriers return to serious cost cutting, which is expected this autumn. It will be tough for the majors to find additional savings, so regional airlines (along with lessors, lenders and other partners) may again have to contribute.

In a recent research note, JP Morgan analyst Jamie Baker mentioned the possible scenario of US Airways disappearing and, as a result, Mesa and Chautauqua having significant excess RJ capacity. As those two are currently the lowest–cost producers, they could "siphon opportunities tentatively held by ExpressJet, Pinnacle and SkyWest, or at a minimum cause those operators to reexamine their departure rates (yet again)".

Baker suggested that this could mean another 5–percentage point reduction in operating margins.

It would still be a profit, but it might be unacceptable from the aircraft financing perspective. Even at the current 10% margins — albeit also with much uncertainty associated with major carrier bankruptcies — regional airlines have found it tough–going to secure permanent financing for all of their RJ deliveries.

Growth prospects

Like LCCs, US regional airlines have significantly increased their market share since the early 1990s (the start of the regional jet revolution) and particularly since September 11. According to Bombardier, the sector’s domestic passenger share surged from 9% in 1990 to 13% in 2000 and by another three points to 16% in 2002. (In terms of domestic ASMs, the regionals' share is less than 10%.) Between April 2000 and April 2003, RJ seat capacity doubled, while major carriers' domestic narrowbody seat capacity fell by 23% and LCCs' seat capacity rose by 31%. RJs now account for about one quarter of the US domestic fleet.

The widely held view is that demand for 50–70 seat RJs will continue to grow strongly in the short term (for a few more years) but that after that the RJ market will saturate.

But there is considerable disagreement as to when that point might be reached.

The still–significant RJ firm order backlog certainly indicates continuation of strong growth for the sector for a couple of years.

In a mid–June research note, Merrill Lynch analyst Mike Linenberg predicted capacity growth of 22.3% in 2004 and 20.1% in 2005 for the regional sector (including the majors' fully owned subsidiaries).

However, what will happen beyond the two–year time horizon is anyone’s guess. A major carrier liquidation or hub eliminations by several carriers could bring the RJ saturation point much closer than previously envisaged. Smaller networks need less feed.

The current RJ growth spurt was made possible by the relaxation of scope clauses as part of renegotiated pilot deals, particularly at United and US Airways. However, near term prospects for additional loosening of scope are not encouraging.

Baker made the point that while bankruptcy could pry open scope, a near–bankruptcy situation — such as that faced by Northwest and Delta — may do the opposite. This is because the airlines will need to maximise wage savings, and reigning in RJ flying could help.

The future will see more competition for RJ flying and no guarantee of growth opportunities. The best–positioned regional airlines are the lowest–cost producers and those linked to solvent partners (no airline currently meets both those criteria), as well as those able to finance RJs.

Mesa is expected to see the sector’s fastest growth rates over the next few years (ASM growth could be 68% this year), largely thanks to expanded service with US Airways. However, there is now significant risk of US Airways having to return to Chapter 11 and not making it through this time. The other key partners — United and Delta — are in or near bankruptcy, respectively.

But Mesa is still considered well positioned for growth thanks to its low cost structure and apparent ability to finance aircraft. While SkyWest should achieve 25–30% annual ASM growth in 2004 and 2005, beyond that it has not got significant RJ growth lined up. Its main partners, United and Delta, are struggling and it is very keen to secure new partners. Its main strength is ability to finance aircraft (based on an extremely strong balance sheet), but it may have to work on its cost structure.

ExpressJet has 15–20% annual ASM growth lined up in 2004 and 2005 with its sole partner Continental, but beyond that it has only eight RJs on firm order. It has come a long way — the world’s largest operator of RJs, with 229 in the fleet at the end of March. The problem is that Continental is not considering additional RJ growth — in early 2003 it actually deferred RJ deliveries, rather than parking mainline aircraft. With a not too exciting cost structure, ExpressJet faces a challenging future. It is believed to be trying to come up with a new business plan this summer.

Pinnacle is poised for extremely strong growth in the next two years (possibly 54% this year), having been Northwest’s favoured partner in terms of RJ allocation in the long lead–up period to the IPO. However, there are no firm deliveries scheduled beyond 2005. When initiating coverage of Pinnacle in March, UBS analyst Robert Ashcroft suggested that once some Northwest cost allocation problems are solved, Pinnacle will have a low–enough underlying cost structure to attract non–Northwest business.

Mesaba’s future looks uncertain because it has not placed any RJs in service for four years. One reason may have been earlier labour problems. The airline continues to operate Avro RJ85s for Northwest.

Republic Airways will grow extremely rapidly this year and in 2005, as Chautauqua expands its 50–seat RJ fleet (it had 83 RJs at the end of March) and Republic Airline launches EMB–170 operations. However, like most other US regionals, the company has no commitments beyond 2005. That said, Chautauqua/Republic is believed to have the regional sector’s lowest cost structure. It is therefore well positioned to capture new business.

Move to larger RJs?

While the 50–seat RJ will continue to play a major role (after all, 66% of the US domestic markets have less than 100 daily passengers), cost pressures have meant that regional airline growth will increasingly focus on larger RJs. In the first place, it will mean 70–seaters. But the best–positioned carriers will be those that also get the opportunity to operate 90–seat or larger RJs.

Mesa leads the pack also in that respect. Although Baker noted in an earlier report that it has not yet ordered "the ultimate killer app — the Embraer 190", 70–seat and 90–seat CRJs constitute two–thirds of its order backlog.

Baker estimated that Mesa’s 90–seat CASM (adjusted for all–coach configuration) is within 0.3 cents of the slightly larger EMB- 190 and a full 3 cents superior to the 50–seat RJ.

The 90–seat RJs will be important not just to reduce costs–per–ASM but because they will open up a new world of opportunities for regional airlines, including independent LCC–type operations. As is well known, JetBlue identified 900 potential low–fare markets suitable for the 100–seat EMB–190 (markets with daily volumes of 200–500 one–way passengers).

Mesa is lucky in being able to introduce the 90–seat RJs at America West, where there are no scope clause restrictions. Otherwise, scope clause trends in respect of larger RJs are not encouraging. American’s revised pilot contract placed 70–seaters at the mainline. While United’s early 2003 contract allowed 70–seaters for the first time, it requires regional partners to offer some of the jobs to furloughed mainline pilots. US Airways has a similar "jets–for–jobs" programme. The potential problem at Northwest and Continental is that, with their large DC9–30 and 737–500 fleets respectively, they may certainly want to operate the largest RJs themselves.

Future structural changes

US regional airlines have basically four potential strategic options: remaining in fixed–fee feeder operations for the majors, merging with other regional airlines, linking up with LCCs or becoming LCCs themselves.

Of course, those basic strategies could be combined in a number of ways — the most obvious one would be a hybrid regional/ LCC.The companies most likely to stay in the fixed–fee feeder business are the lowest cost producers (in a sector full of low–cost producers), as well as those that do not harbour ambitions about operating 90–seat aircraft.

Republic may be the first of a new breed of regional airlines that are super–efficient, with 70–seat RJ fleets right from the outset and the lowest labour costs, and well–diversified in terms of partners.

Mesa’s unsuccessful hostile bid for Atlantic Coast late last year highlighted some potential benefits from regional airline mergers — better earnings, access to new partners and improved ability to finance aircraft.

However, the majors are not keen to see their regional partners grow too large.

The downside was illustrated by the difficult UAL/ACA breakup — the two were just too dependent on one another, with ACA providing 40% of United’s regional lift and United Express accounting for 85% of ACA’s revenues. Extensive regional consolidation is unlikely because sector dynamics favour diversification and multiple partners on both sides. In any case, it would have to be on the majors' terms because feeder contracts essentially give them veto powers over partners' mergers. That said, regional airlines are expected to pursue aviation–related acquisitions on an opportunistic basis, because many of them hold significant cash reserves.

Links between regional carriers and LCCs would seem logical but are not likely on a major scale in the foreseeable future. This is because most LCCs do not like the economics of 50–70 seat RJs and, like JetBlue, would probably prefer to operate 90–100 seaters themselves (rather than pay a profit margin to a regional).

However, there are likely to be small–scale opportunities, as illustrated by the Frontier–Horizon CRJ–700 code–shares.

Independent operation as an LCC is a potentially attractive option for many regional airlines, which already have the key LCC attributes (low–cost, efficient, lean and nimble). They also have the balance sheets and resources to fund the transition. As LCCs, they could operate the largest RJs and be in full control of their capacity, fares and schedules. There are significant growth opportunities in the LCC sector.

However, there are contractual impediments to either shedding feeder commitments or continuing as a feeder while introducing some large jet service. For example, Northwest’s and Delta’s mainline pilot contracts prohibit the use of regionals that also operate large jets. That is a pity because a gradual, multi–year transition from regional to LCC might appeal to the airlines more than an ACA–style abrupt switch.

While most of the airlines now include the LCC option in their contingency planning, Mesa is by far the most likely candidate. Its provisional plan calls for 737 operations out of Pittsburgh in the event that its largest partner US Airways disappears. While SkyWest has continued to insist that it will stick with feeder operations, analysts point out that both of its partners (United and Delta) will shrink and that it may not find new partners.

Jamie Baker suggested that it should exit the Delta programme and go independent with EMB–190 operations on the West Coast, where the competitive environment is less harsh than in the East.

All of this means that the US regional sector is likely to become more diverse, with feeder service being provided under different business models. This is in refreshing contrast with the previous trend — the late 1990s switch to fixed–fee contracts — which made the sector homogenous and rather boring.

Model Current Order Backlog
145LR 36  
1900D 41  
CRJ-200ER 16  
CRJ-200LR 34  
CRJ-701ER 15  
CRJ-900 21 24
DHC8 14  
Total 177 24

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