The potential value of the Euro-regionals June 2002

Regional jet airlines in the US are proving very valuable to their mainline owners, as the spin–offs and flotations of ExpressJet and Pinnacle have demonstrated (see Aviation Strategy, May 2002). Could the same process be duplicated in Europe? One of the first problems is that of scale. As the table opposite shows, there are about 680 regional jets in Europe as opposed to about 1,100 in the US. More importantly, the biggest and by far the most important European operator of regional jets is Lufthansa Cityline with 68 regional jets and a traffic base of 6m in 2001.This compares to 145 for Continental Express (ExpressJet), 122 for American Eagle, 104 for Comair, 93 for Atlantic Coast, 75 for Atlantic South East, 62 for Mesa, etc.

US regionals have managed to conclude generous agreements with their parents, the Majors, usually involving set payments per block hour designed to guarantee operating profit margins of 10%-plus. The parent normally provides handling and marketing services, access to cheaper financing or acts as lessor to the regional subsidiary.

This presents a unique proposition to investors. Operating profit margins are more or less guaranteed by the parent and traffic/ revenues growth will increase rapidly, partly as a result of the transfer of mainline services from the parent to the regional subsidiary.

Where US regionals have blundered has usually been in operating their own point–to point services. When they have come up against low–cost competition, dire consequences have followed. For example, Midway, which tried to compete with its relatively expensive RJ fleet against mainline services, ended up in bankruptcy.

The contrast between the regionals in Europe and in the US is marked. No European regional has been able to negotiate anywhere near as advantageous terms as its US counterpart. This is probably because, with the exception of KLM at Schiphol, no Euro–major is reliant for regional feed to make its hub work efficiently.

The logic of consolidating regionals

Indeed, the European trend in recent years has been to consolidate the regionals into the main airline group rather than spinning them off. Examples include: British Airways (BRAL and CityFlyer), Air France (Regional Airlines, Protéus and Flandre Air), SAS (Wideroe and Skyways) and Lufthansa (Eurowings).

This trend has largely been driven by concern over the loyalty of regionals and franchisees. BA’s purchase of CityFlyer was at least influenced by the prospect of Virgin Atlantic taking over the regional airline and building a feeder operation at London Gatwick. At the time Air France bought out its financially troubled regional affiliates, it seemed likely that the French domestic market was being widely infiltrated by other Euro–Majors — by BA through Air Liberté, by KLM through Regional and by Swissair through Air Littoral. Lufthansa may have been worried about KLM controlling Eurowings. In retrospect, these concerns do not seem to have had much basis, but they were important considerations at the time.

The danger of consolidating regional subsidiaries into the mainline group is that the costs advantages of the subsidiary are eroded. Unions will naturally seek harmonisation on wage levels and productivity agreements between different parts of the same group. There may also be a tendency for other operating costs to drift up because of the new financial security (or delusion of security) offered by the parent.

Euro–regionals are probably about five years behind their US counterparts in that the bulk of their operations are still point–to–point services on thin routes rather than feeder operation to the major airline hubs. However, the industry is changing rapidly: as the Euro–majors have cut back capacity and downsized, the aligned regionals have been encouraged to fill the resulting network gaps.

Other opportunities will arise as the European flag–carrier rationalisation continues.

For instance, SN Brussels Airlines appears to be attempting to build a Comairtype hub out the remnants of Sabena’s intra- European network, but this is a very low–profile and under–capitalised operation at present.

CityLine might seem to offer the best European prospect of a European regional sell–off, and such a move might fit in with Lufthansa’s strategy of maximising the values of the various segments of its total aviation company. CityLine is based at Cologne/Bonn and operates domestic and international service into the Lufthansa hubs at Frankfurt, Munich and Hamburg. Traffic grew by 5% last year as routes were transferred from Lufthansa.

However, the question is whether CityLine’s operations and markets are sufficiently differentiated from the low–cost carriers, which are now beginning to focus on the German market — Ryanair with its base at Frankfurt Hahn and easyJet through its potential take–over of Deutsche BA.

Regional/LCC economics

The economics of the Euro–regionals are interesting. Average flight times in Europe are 1.18 hours (about the same as the low cost carriers). Their average load factor was 57% in 2001 (compared to 80%-plus for the low–cost carriers). Evidently, the costs/ASK of operating a 50–seater regional jet are considerably higher than the low–cost carriers' 737NGs, which also have much higher utilisation rates.

This implies that regional airlines' costs/ASK are on average four times higher those of a low–cost carrier. So, whereas easyJet can make a healthy margin on average one–way fares of €60, Euro–regionals have to secure average fares (taking into account the lower load factor) of perhaps five times that level in order level to survive.