Severe threat to RJ50 sector from US legacy crisis Aug/Sep 2004
As the post–September 11 airline industry restructuring shifts to a higher gear in the US this autumn, with US Airways filing for Chapter 11 and facing possible liquidation, there could be one unexpected casualty: the 50–seat regional jet ("RJ50").
In his latest report on regional airlines, UBS analyst Robert Ashcroft argues that developments at the most financially troubled legacy carriers could lead to a "glut in RJ50s".
And should the 50–seat RJ market somehow survive the next year or two, the 100–seat Embraer E190 in the hands of JetBlue and possibly other LCCs is "highly likely to be an RJ50–killer".
Such developments could have dire consequences especially for the independent regional airlines that have financed RJ50s themselves with long–term leases or loans — top–notch companies such as Mesa, Republic and SkyWest.
The 50–seat RJ is obviously not going to disappear entirely, even under the most pessimistic of scenarios. It overwhelmingly dominates the US regional airline RJ fleets, accounting for 1,322 of the 1,534 RJs operated as of August 27 (UBS figures).
As Bombardier likes to point out, 66% of the US domestic markets have less than 100 daily passengers.
However, the UBS report draws attention to the fact that just about every trend points to the RJ50 greatly diminishing in importance. First, demand for 50–seat RJs has been weak in the post–September 11 period — only 81 new commitments. The continued high number of deliveries mostly reflects pre–September 11 commitments; for example, AMR Eagle is still taking delivery of a massive RJ50 order placed many years ago.
Ashcroft suggests that RJ50 fleets in the US have been overbuilt as a result of pre–September 11 conditions that no longer exist (high fare environment, absence of larger RJs) or are in the process of changing (scope clauses in pilot contracts).
Many of the legacy carriers have indicated their preference for larger RJs by swapping RJ50 orders for RJ70s as soon as permitted by their scope clauses. US Airways recently switched its 23 remaining RJ50 orders to RJ70s. United has reduced its pre–September 11 RJ50 commitments by 59 while taking on 70 RJ70 commitments — and United has not replaced all of the 87 RJ50s that Atlantic Coast took away for the Independence Air operation.
Most significantly, low–cost carrier (LCC) actions have indicated that the 50–seat RJ is not compatible with the LCC business model.
The UBS report notes that America West, Frontier and AirTran have all reduced or eliminated RJ50 operations, while Independence Air has said that it would have opted for 70–seaters in a clean–slate design.
JetBlue’s planned 100–seat E190 service will reduce RJ50 viability, because it will bring low fares to the types of smaller–city high–fare markets that currently in large part support the high per–seat cost RJ50s.
The impact will not be felt for two years or more but that, on the negative side, JetBlue is unlikely to be the only E190 operator.
LCCs prefer larger aircraft simply because of their need to keep unit costs low. The same applies to the legacy carriers now that they are moving towards the LCC model as a survival tactic.
Chapter 11 has proved a very effective tool for reducing large aircraft ownership costs, particularly in a deep industry slump when aircraft values and lease rates have plummeted. Chapter 11 is also handy for shedding aircraft that one no longer wants.
UBS suggests that the likely upcoming Chapter 11 visits will see legacy carriers tackle RJ50 obligations and that the process could "strand significant RJ50s without major airline employment".
For those unfamiliar with the legacy–regional relationships in the US, there are basically two types regarding aircraft ownership.
In one, the RJs are owned or leased by the legacy and subleased by the regional (often a partly or wholly owned subsidiary or division). In the other model, the RJs are owned or leased by the regional.
When the RJs are owned or leased by the legacy, reducing aircraft ownership costs in Chapter 11 means the usual process of renegotiating leases and financings and/or returning aircraft to lessors or financiers. The regional loses the business but will not be stuck with the aircraft.
When the regional owns or leases the RJs, the legacy in Chapter 11 can reduce costs by rejecting the feeder agreement.
That could mean renegotiating the terms of the deal and/or rejecting RJs. If the contract is renegotiated, the regional’s profit margins are typically squeezed (unless it can cut costs). If the RJs are rejected, the regional not only loses the business but also is stuck with the aircraft.
Many of the RJ50s have been financed by regional airlines with loans and leases that have something like 16–year terms. If a glut develops, RJ50 values and lease rates would fall and the airlines could be stuck with (pre–September 11) high–ownership–cost aircraft that they can’t place. "These fleets then represent a long–tail liability — it is a brave investor who counts on a regional airline’s major partners to remain distress–free for such a term."
If a glut in RJ50s develops, the majors have even more leverage over RJ50 contractors than previously and are likely to "significantly reduce or delay" payments to their partners while in Chapter 11. This, of course, would make it even harder than at present to raise permanent financing for RJs.
In the RJ50 glut/Chapter 11 scenario, the regionals that would fare the best are the "asset–light" airlines that operate RJs on subleases. UBS notes that the market has traditionally disliked those airlines for that very characteristic — not having control over assets.
Ashcroft did not say this but it would be logical to conclude that, in an extreme (and probably very unlikely) case of a regional getting stuck with a large RJ50 fleet without employment, the regional might have to file for its own Chapter 11 to get rid of the aircraft.
It would be totally ironic if the independent regionals were punished in this way, because they are the ones that have helped the legacy carriers the most in the post–September 11 environment, thanks to their ability to finance aircraft.
The worst positioned are the "asset–heavy" regionals linked to US Airways (Mesa and Republic), and to a lesser extent those linked to Delta (SkyWest and Republic).
Mesa and Republic, which both generate 40–45% of their revenues from US Airways Express, have seen their share prices fall and analyst ratings further reduced in recent weeks, as US Airways' prospects have worsened.
In addition to reducing his Mesa and Republic ratings from "buy" to "neutral", UBS' Ashcroft has reduced his "baseline" valuation forward earnings multiple for regionals with RJ50 exposure from 12x to 9x. That is still higher than the major airlines' traditional 7–8x multiple because of the better growth prospects of regional airlines.
S&P noted on September 8, when again lowering US Airways' credit ratings, that time was running out to get cost cuts. One crucial date is September 15, when a $110m pension payment is due — the agency suggested that US Airways may opt not to make it and file for Chapter 11 instead.
September 30 will see the expiration of covenant–waiver agreements with GE, Embraer and Bombardier. This could mean loss of access to RJ financing commitments, which would jeopardise US Airways' new business strategy.
At stake are orders for 110 70–seaters scheduled to go to wholly owned units MidAtlantic and PSA.
UBS' Ashcroft believes that US Airways' liquidation would ground many RJ50s for some time — an unprecedented situation — and significantly hurt its regional partners. Other regionals might benefit in the short term (as their legacy partners would gain), but the net effect on the regional sector would be negative.
Ashcroft makes the point that Delta controls many RJ50s through its own subsidiaries, giving it an opportunity to seek ownership cost reductions. Also, it could get 70–seat RJ scope clause relief in a new mainline pilot contract (either before or in Chapter 11), as a result of which it might shed RJ50s (in Chapter 11) and order more RJ70s.
Delta said practically nothing about its future RJ strategy when it unveiled its new strategic plan on September 8.
The plan will eliminate hub operations at Dallas/Fort Worth in favour of growing the three other hubs and offering more point–to point services.
There would appear to be an overall reduction in RJ deployment between now and February — Merrill Lynch analyst Mike Linenberg calculated the reduction in daily regional flights at5%, observing that this could be "indicative of Delta’s appetite for additional regional jets for its network, particularly for the smaller shells". JP Morgan analyst Jamie Baker suggested that the wholly owned regionals — Atlantic Southeast and Comair — might be intended to form the collateral behind a Delta DIP financing, which would explain "management’s reluctance to agree with virtually every other network operator that 50–seaters are incompatible with the current revenue environment".
New regional model Ashcroft remains bullish on 70–seat RJs — the report indicated that the view would change only if both US Airways and United liquidated and the other four legacies did not get any further RJ70 scope clause relief.
The perfect regional model for the new environment? Ashcroft: "We see the key to future regional airline success as managing RJ50 exposure, grabbing as much RJ70 growth as possible, and probably opportunities beyond traditional regional airline roles — such as E190s."