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Delta aggression toward US regionals revealed in latest earnings calls

10-May-2011

An interesting discussion as to how Delta is trying to change the financial dynamics of the US regional airline industry occurred during the Pinnacle Airlines conference call, as Dahlman Rose analyst Helane Becker frankly stated that Delta is not a good partner for any of its regional partners.

The response from Pinnacle CFO Peter Hunt was perhaps the largest crack yet in the wall of silence held up by regionals who have been dancing around the subject for years. Even so, even he played a diplomat’s hand with his response.

“You’re right,” he told Ms Becker during the earnings call. “Delta is aggressive with its regionals but I view that as both a positive and negative. It does make them a more demanding partner to work with but it also means they are very action oriented and they respond when they see a crisis and that’s what we are looking for in a partner. We want one that, in the long run, is going to do well and is action oriented to make certain they perform well. That is not necessarily all negative.”

Delta squeezing regionals

SkyWest usually emphasises it is its job to ensure its partners have what they need but it was the first to hint at what Mr Hunt called Delta’s “aggressive” posture with regionals when it sued Delta over the major carrier withholding payments owed related to irregular operations that are reimbursable to SkyWest Airlines and Atlantic Southeast airlines. The suit remains pending in a Georgia court. To date, the cumulative total the regional airline has recognised is USD31.7 million of revenue withheld by Delta. Another hint came in Delta’s treatment of Mesa when it spun its Freedom Airlines subsidiary out of the Delta Connection programme which ultimately contributed to Mesa’s bankruptcy.

Delta has continually squeezed the St George, Utah-based carrier. The latest rate changes at its Atlantic Southeast subsidiary resulted in a USD7.2 million loss in revenues, according to the company. Because of that ASA has to find a way to cut at least that much in costs at a time when the biggest problem stems from reduced stage lengths and block hours.

“The cost issues were materially exacerbated by the lower production in stage length and utilisation. The average stage length dropped from 450 to 300,” said Mr Rich, who was careful not to criticise his Delta Connection partner. “These are only the facts and it is something we have to deal with. When you reduce production that drives up costs. We are working better and more cooperatively and more openly with Delta and we are seeing improvement. But to get this back to a meaningful sold margin we have to get production and cost closer together and it will be a smaller margin than the first four years we had ASA but it will be a solid, positive margin. But we have to make progress with some of the fundamental production issues that have negatively impacted us. We have already seen a meaningful improvement in March and April and you will see that going forward in the upcoming quarters.”

Pinnacle owed

Judging from what it has experienced over the past decade with Northwest and with changes in the Delta programme, few could argue that Pinnacle is owed, big time. Pinnacle had a dispute with Delta on similar grounds as SkyWest which was later resolved out of court. It also experienced Northwest’s bankruptcy which forestalled any rate increases thus, Pinnacle has not seen a rate increase in that programme – now part of the Delta Connection – in 10 years.

The new rates will be effective Jan-2013. The original contract called for an adjustment every five years but Northwest was in bankruptcy when the first five years came due, putting off any rate increases until 2013. However, during the past decade, said Mr Hunt, cost increases have far outpaced inflation owing to its ageing CRJ200 fleet. Consequently, the company is in for a sizeable increase beginning 2013.

But, in hindsight, Delta went after SkyWest, Pinnacle and Mesa around the same time which was shortly after then-Delta Connection head Don Bornhorst warned carriers the days of 10% margins when majors were experiencing a sea of red ink were over. He bluntly told them he wanted them to assume more risk and it was widely suspected that Delta’s actions were designed to squeeze concessions out of its regional partners.

Since then, except for the law suits, regionals have played their cards very close to their vest when discussing the carrier but Delta’s regional capacity moves over the past few years have told the tale.

Concern over Delta tactics

Ms Becker expressed concern that in the upcoming negotiations for new rates with Delta resulting from the Mesaba acquisition, that Pinnacle would not fare very well.

Similar to ASA’s production problems, Mr Hunt said the company is in negotiations with the Atlanta-based carrier to also adjust rates owing to the reduction in Saab flying which has resulted in higher costs and lower productivity for crews. The adjustment will be retroactive to 1-Jan and is expected to be USD500,000 in the first quarter with a similar amount in the second quarter. He expected the deal to be completed in the next two months.

But it was clear from Mr Hunt’s response that, at least in its negotiations to buy Mesaba, Pinnacle had anticipated some of Delta’s usual tactics.

Pinnacle is negotiating over new rates covering Mesaba integration costs and the integration of the seniority lists. Mr Hunt reported the increase will come in the form of a one-time, USD18 million-20 million payment in mid-2012 tied to pilot labour and training costs during the integration process.  The prospective rate increase to be paid post-integration is expected to be as much as USD14 million-17 million annually.

The new pilot rates kicked in during February and cost the airline USD2.1 million in additional expenses during the quarter. It also paid the pilots their USD11 million signing bonus in April which, coupled with the new pay scale, will continue to affect the rest of the year. It incurred USD800 million in integration costs in the first quarter and expects those costs to reach USD12 million throughout this year and into the next when the integration is scheduled to be complete mid-year.

“With respect to us and the rate adjustments we’ve be negotiating,” he explained, “we sat down with Delta in June when we negotiated to buy Mesaba and did try to make the language as clear as possible so it is not open to interpretation or vague. I think the road we have to go down to determine the rate is one that is a little more clear than in past negotiations with Delta. Having said that, we wouldn’t be putting out some of the numbers we gave you today if we didn’t have a degree of confidence that they will be in those ranges.

“The costs associated with the pilot contract and the cost structure we have, which is competitive, is what it is and I don’t think there is a lot of room for debate,” he continued. “These pieces are fairly straightforward. There may be some pieces of the adjustment that relates to allocating costs between the operations but I do feel comfortable that we’ll end up with the ranges I indicated.”

Ms Becker asked, given the changes Delta has made in its relationship with Pinnacle since its acquisition of Mesaba, if there were any chance to renegotiate the purchase price. Mr Hunt indicated that the purchase price has been paid and the company will continue paying on the note Delta gave it to acquire Mesaba.

“What we tried to do is put in these inflection points where we have these rate adjustments so we are always driving back to the expected profitability we and Delta agreed to in the contract,” he explained, adding the largest changes were coming on the Pinnacle, not Mesaba, side. “While Mesaba operating income was down in the quarter, we expect that to change to the kind of levels we expected from the contracts we negotiated with Delta. The rate adjustment should take care of the cost pressure we had both this year and the last several years on the Pinnacle side. We’ve just been waiting to get to the point in time where we have the rate adjustment that focuses on making sure we get the profitability out of the contracts we should be having.”

Mesaba’s operating income was down from the USD2 million expected under the Delta contract on the weather which cost it USD300,000 in lost revenues in addition to the penalties imposed by Delta. Performance penalties from Delta resulting from the disastrous weather in January and February rose USD1 million to USD2.1 million in the 2011 first quarter, said Mr Hunt.

Pinnacle was also asked about how it would fare in the recently announced cutbacks Delta is making at Memphis. The cost of moving assets and crews around increase costs pressure as was seen with SkyWest when it had to do the same with United when it replaced ExpressJet’s Embraer 145s with CJR 700s at Houston which cost the airline USD10.6 million in crew training and other reallocation costs which it will try to retrieve from United.

Mr Hunt acknowledged there have been a lot of changes in the past year with Delta including changes in the network, shifting between hubs, growth in the New York area with CRJ fly, something it did not have in the past.

“The information we are getting from Delta on additional shifting of capacity to other places does cause cost pressure when pilot productivity goes down,” he said. “Pilot costs are actually up about USD3 million but only two thirds of that is associated with the contract. The rest is productivity. As we get more spread out around the Delta network and its less focused on Memphis, Minneapolis and Detroit, costs are driven up. We still have to have line maintenance and an overnight facility. The more spread out you are the higher the costs. The good news is we continue to make adjustments so it will all be captured in the rate adjustment and should return us to our normalized margins.”

While Delta’s moves on its regionals are only the most visible to date, it is likely that the merger of United and Continental will have a larger impact on regionals than was thought. Indeed, regionals have been able to provide little visibility to the affect of the merger on the express operations. What we have seen is the merged company trying to get around Continental’s scope clause as it attempted to put 70-seat regional jets in Newark. While it received push back from pilots there, the company clearly made an end run around scope by using codeshare to put SkyWest’s CRJ 700s in Houston.

What is also clear is that regionals are the ones caught between the warring factions whether it be pilot scope or major carriers playing their regional partners off against each other. This makes for very uncertain times for the sector as they try to navigate their way to a profitable future. They are quickly becoming a flash point in the jockeying between majors as well as their pilots.


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