Revenues up, profits down for SkyWest, new Delta rates begin to show

For the past few years, Delta has said it is seeking more competitive rates and more risk sharing from its regional partners. The new rates and increasing maintenance expenses dragged down the company's third quarter performance.

The new rates, now in the process of reaching a final agreement with Delta, kicked in during the third and fifth years of its current contract effective 8-Sept-2005. CFO Brad Rich said the actual rates - seeking a Delta Connection average in the third year and the second lowest in the fifth year which became effective on 8-Sept-2010 - was a complex undertaking which is only now reaching conclusion.

Rich described the new discussion as being about the mechanism for adjusting rates in which the original wording was unclear. They have also agreed on an escalation formula. Minimum utilisation remains unchanged. Even so, ASA has experienced a significant drop in utilisation which, he noted, of course makes unit costs hard to contain. He said the biggest challenge was determining what the average Delta Connection rate was, which required re-examining all contracts and putting them on as much of an apples-to-apples comparison as possible.

The companies have what Rich called a preliminary understanding and expect to conclude the transaction during the fourth quarter. Even so, it reduced SkyWest Inc's revenue by USD4.9 million pre tax between 8-Sept and the end of the quarter on 30-Sept.

"If you look at the run rates it will mean a further reduction of couple of million per quarter in addition to the USD5 million we reported in the third quarter," said Rich. "There will be very little impact on the SkyWest Airline rates. The primary impact will be on ASA rates."

While the new agreement did not extend the term of the Delta Connection contract for the flying, it did, said Rich, extend the rates to a longer term, providing more stability on revenues. The same is true of its United flying where fuel and maintenance created a volatility in the USD100 million range over the last few quarters, said Rich. However, in the third quarter that volatility was in the USD13 million range.

"The good news is our operating revenues showed a lot less volatility in the top-line created by pass-through fuel," he told analysts yesterday. "The year-over-year comparisons are more normal and stable. The primary driver for this is the fundamental change in the block-hour production which was up 4.5% in the quarter and accounted for USD36.6 million of the total USD49.1 million increase in revenues in the quarter. The remainder was pass-through expenses on fuel and maintenance. good news on op revs, seeing a lot less volatility in top line op revenues created by pass-through fuel."

Reimbursements for expenses under the contracts including fuel and maintenance are recorded as revenue, resulting in an operating revenue increase of USD10.3 million in the quarter compared with 3Q2009. The remaining increase in operating revenues was primarily due to an increase in ground handling and other revenue.

Maintenance costs a challenge

Rich also pointed to the imbalance between the United pass-through costs for maintenance and actual maintenance costs as impacting the third quarter results, adding that is something that will likely continue over the next year. Under the United Express agreement with SkyWest Airlines and Atlantic Southeast, SkyWest recognizes revenue at a fixed hourly rate for mature engine maintenance on regional jet engines and SkyWest recognizes engine maintenance expense on its CRJ200 regional jet engines on an as-incurred basis as maintenance expense. During the third quarter CRJ-200 engine expense rose USD2.1 million compared with 3Q2009 on the timing of scheduled engine maintenance events. Consequently, the expenses in excess of pass-through re-embursments totalled USD9 million, which Rich said would be about the same in each quarter over the next year.

Rich also reported that pro-rate flying for United and AirTran did very well in the quarter having increased its fleet from 38 aircraft in 3Q2009 to 61 aircraft. Pro-rate flying makes SkyWest Inc's revenues more seasonal. However, it experienced an USD8 million swing from the USD2 million net loss incurred in 3Q2009 to USD6 million pre-tax profit for the third quarter 2010. Pro-rate flying constitutes about 15% of revenues for the mix of Brasilias and CRJ-200s. The trick was to make pro-rate flying pay for the regional jets. Even so, Rich pointed to the increased flexibility the company has in being able to change the fleet rapidly. The RJs have gone into some unique markets where majors had heavier equipment, he said, adding, if they were not profitable they would be pulled down.

Turning to expenses, Rich reported total airline expenses (total operating and interest expense) increased USD54.6 million to USD628 million, or 9.2%, in the third quarter compared to 3Q-2009. Excluding fuel and engine overhaul costs directly reimbursed under SkyWest's flying contracts, total airline expenses increased USD44.3 million, or 8.7%, from 3Q3009.

Rich acknowledged the huge challenges for the company. He reported that non-fuel CASM dropped 1.1% to 8.9 cents but represented a 2.2% decline from the 2Q2010. Despite the help offered by eliminating the redundancies as ExpressJet is integrated into ASA, cost reductions will be critical to maintaining the company's competitiveness.

"It is going in the right direction," he said. "However, you have to remember that the whole purpose in the new rates is to keep our rates competitive. That means we have to work very aggressively to match our cost structure to the new rate structure. We will make some progress on costs with the integration of ExpressJet expected later in this quarter as we enhance our ability to gain better utilisation and reduce redundant functions. But the real benefits of the ExpressJet acquisition will not come until we have a single operating certificate which we expect in 12 to 14 months. In addition, as difficult as the maintenance mismatch is on the financials, when you adjust SkyWest Airlines performance on a steady state and eliminate the mismatch, SkyWest Airlines had one of the best quarterly performance it has ever produced so, fundamentally, things are going very well."

Rich said that ExpressJet scheduled its stockholders meeting, at which the acquisition is expected to be approved, for 10-Nov-2010. "We've had no real surprises," he said. "Once we close the deal there will be an immediate integration of administrative functions followed by an aggressive plan to accomplish a single operating certificate. Any negative issues that may come out of the transaction will be more than offset by new purchase-accounting rules."

In addition to eliminating redundant functions, the company will also eliminate the public company expenses and, from that, expects a relatively quick operational positive contributions to income.

The only guidance he would provide for the fourth quarter noted that ASMs for the quarter for SkyWest and ASA would be six billion but would rise to 7.5 billion with the addition of the ExpressJet flying. However, he indicated that further guidance would come when the deal closed later this quarter. With ExpressJet the fleet will jump from 460 to 700 aircraft.

ASMs were up 6.4% to 6.3 billion will RPMs rose 5.1% to 5.7 billion. Load factor was up .5% to 80% while break-even load factor is 76.5%. Yield rose 1.5% to 12.2 cents while RASM rose 1.9% to 10.9 cents. CASM was up 3% to 10.3 cents. Block hours rose 5.4% to 379,129 while average trip length shrank 2.4% to 498 miles.

Further foreign investment

He also reported the launch of the company's second foreign investment, in the Mekong Aviation Joint Stock Company. It earlier invested in Brazil's Trip Airlines, with a total of USD30 million invested in the Brazilian regional for a 20% share. It now owns 30% of Air Mekong through a USD7 million investment made during the third quarter. Mekong is the third private airline to be licensed in Vietnam.

The airline launched 9-Oct-2010 using four CRJ-900s. SkyWest and Atlantic Southeast have provided significant assistance in the development of the Air Mekong venture by acquiring aircraft for operations and assisting in other commercial and corporate matters. Additionally, some of Air Mekong's organizational leadership and pilots were previously employed by Atlantic Southeast.

The airline will grow to 28-30 flights daily next month when it adds two new routes to the four launched services which include Hanoi, Ho Chi Minh City, Da Nang, and Phu Quac.

Debt repayments from United Airlines and cash from operations spiked the amount of cash and marketable securities to USD883.2 million during the third quarter, up significantly from the USD732.4 million SkyWest had at the end of December. United paid back a USD74 million term note during the quarter. However, Rich said the original fiscal help to United was done in two tranches, an USD80 million term note which United just paid off, and the deferral of USD49 million in operating case which remains in place.