U.S. Regional airline restructuring Part I: Is consolidation inevitable – or essential?


Despite the massive upheaval in the U.S. regional airline industry in the past seven years, the segment remains at risk owing to one simple fact - too many airlines are chasing too few contracts. There are, after all, still 16 feeder airlines for only four major carriers.

In 2011, CAPA examined the regional airline industry in the wake of the Financial Crisis, concluding the regional model was broken. Now, four years later, we have a clearer vision of how the industry has changed and what lies ahead for a smaller, stronger industry.

But the model remains broken and, sadly, little can be done about it. Indeed, the issue is so sensitive that few are even willing to discuss the issue.

  • The U.S. regional airline industry is at risk due to too many airlines competing for too few contracts.
  • The number of publicly held regional airlines has decreased from five to two since 2009.
  • Regional airline operating margins have declined, while mainline airlines report higher margins.
  • The shift from 50-seat jets to larger aircraft is reducing the number of 50-seat regional jets in the fleet.
  • Regional airlines face challenges such as pilot shortages, rising labor costs, and new regulations.
  • The regional airline industry needs to recapture control of revenues and consider restructuring to achieve stability.

Only two publicly held regional airlines remain in the US

In 2009, there were five publicly held regionals - SkyWest, Republic, Mesa, Pinnacle and ExpressJet. Today there are two - SkyWest and Republic, who have since returned to profitability but still struggle with headwinds. Mesa filed for bankruptcy, emerging later to join another big player, Trans States, as a privately held carrier. ExpressJet was acquired by SkyWest and merged with Atlantic Southeast Airlines. Pinnacle also filed for bankruptcy, was acquired by Delta, changing its name to Endeavor.

In the 1980s there were 300 regional airlines, the top 100 carrying 90% of the business. By 2012, this had reduced to 30 and only the top five carried 90% of the business. The subsequent restructuring is now achieving results.

Since 2008, the industry has tried diversifying beyond the capacity purchase model. Even so, every single strategy failed, making them more risk averse than ever. At the same time, mainline airlines shifted costs to their regional partners upending the regional business model. Contracts today are shorter and less lucrative. Regional airlines are in the position of making commitments for aircraft with a 20-year life on the strength of contract that could be as short as two to seven years.

Regional airline operating margins are lower and more fragile

Regional airline operating margins have declined from the mid teens before the recession to mid single-digits today as low-cost carriers and mainlines report double-digit margins with the singular exception of United. But that is not the whole story.

"That 6% margin is completely dependent on the regional meeting all operational and contractual goals, which is easier said than done when it is the mainlines who decide which flights to cancel," said InterVISTAS Executive Vice President Bill Swelbar. "Paying double-digit margins to regionals was an expensive arbitrage play by mainline carriers against their unions but, at the end of the day, it did buy them time until consolidation was complete."

In addition to taking on additional costs from the majors, regionals today are facing stiff headwinds including pilot shortages exacerbated by new regulations, rising labor costs and additional capital requirements as the fleet shifts from 50-seat jets to 70+ seats.

High cost 50-seat regional aircraft are on the way out

Fifty-seat jets still account for a little less than half the 2,353-aircraft (as of July 2014) regional fleet and are largely owned by regionals. Illustrating how little 50-seaters are valued, Delta CEO Richard Anderson noted that at USD110 per barrel, they required a 150% load factor to make money.

With 1,702 regional jets in the fleet, 950 have 50 seats or fewer. Half will be gone in the next few years. With maintenance costs for the first generation of regional jets unexpectedly high, new aircraft acquisitions, including more predictable maintenance planning, help on the cost side but that will be offset by two factors - higher labour rates and fewer flights.

Regionals are paid by the block hour. Larger aircraft mean fewer trips, fewer block hours and less revenue.

Republic CEO Bryan Bedford, however, put that into perspective when he told analysts the larger jets give the airline nearly a 50% revenue boost in higher utilisation alone.

The regional airline solution is simple, achieving it is not

The only way forward for the industry is to recapture control of revenues - and that will require a radical change to the mainline/regional partnership. But with so little leverage and majors playing one regional off against another for ever-declining capacity purchase rates that is unlikely unless the industry consolidates considerably.

"It is hard to imagine a regional restructuring like that the mainline carriers went through," said Mr Swelbar. "Wages are already low and it can be said that low wages are but one issue exacerbating the pilot supply problem. So the only thing they can do is to fly bigger aircraft. Trip costs are roughly the same as the 50-seat platform but the unit costs are much lower.

Those carriers that can rework their flying portfolios to include more 76-seat flying will certainly perform better in the short to medium term.

"So restructuring for the regionals is really about seat densification to bring down costs because a court-assisted restructuring would probably not yield a successful result", he believes. Bankruptcy certainly did little to change industry dynamics for Mesa or Pinnacle.

Some suggest regionals are gaining leverage - but that is doubtful. "If you look at the size of the regional networks within each major carrier, they are needed and can't be replaced at the drop of a hat," said one industry ex-president. "But, as long as you have one carrier undercutting the others, then the madness will continue."

The dominance of mainline airlines limits the regional airlines' options

Having experienced wrenching bankruptcies, mergers and failed diversification, the regional industry has no new strategies to balance the control that the mainline airlines have over the business. Consequently it remains fragile, contending with contracts in which only 25% of costs are passed through to mainline partners.

Some 75% of costs, according to Cowen Analyst, Helane Becker, are reimbursable at pre-determined rates but if costs rise higher than those rates then the regional airline is forced to absorb the balance until it can negotiate a better deal with the next contract.

Regional/mainline contracts have their roots in a regulated era, Ms Becker explained. The Civil Aeronautics Board determined that a 12% operating margin was the standard for airlines. In turn, that is the target set by mainlines for regionals under cost-plus contracts that targeted a margin rate of 12-14%. When regionals and majors first started code sharing, regionals scratched out a living on the pro rate between their 200-mile legs and the 600-mile major carrier legs.

"At that time, the majors really needed the feed," according to a regional industry veteran. "But we had to have higher rates and that ushered in the non-standard pro rates. Comair, for instance, earned a 30% margin with that but that drove the major carriers nuts. That's when the capacity purchase agreement came in which guaranteed a profit of 16-18%."

Ironically, at a time when analysts were lauding regional fiscal performance just as mainlines were losing their collective shirts, they were pressuring mainline carriers to change the contracts. That launched the regional airlines' race to the bottom that continues today. The downward pressure on contracts and cost shifting became a recipe for disaster.

Pilot duty regulations add further problems for regionals

Compounding contract changes, new pilot duty regulations call for a hard stop at 16 hours, which means an increase in staffing requirements that cost the airline industry an estimated USD200 million. A new regulation was also introduced requiring 1,500 hours of flight time before a pilot can be hired for the right seat.

Between 2015 and 2022, according to industry estimates, more than 14,000 pilots will retire. That is great news for the major carriers, since they will be trading USD150,000 salaries for new-hire salaries that are a third of that. But it also means more regional pilots will be sucked into the majors' seniority ranks and low cost carriers will have to focus on crew retention.

But that is not the only problem with the pilot corps. That race to the bottom led regional pilots effectively to cross subsidise their major carrier counterparts.

"When it comes to winning contracts, the work goes to the lowest bidder," said Swelbar. "One result is regional pilots get whipsawed. ALPA talks about creating a level playing field without referencing the union's own role in determining pay and benefits at the regional level."

Union support for regional airline pilots is ambiguous at best

Remarkably, regional crews apparently don't realise this because ALPA denies any pilot shortage exists. Instead, it says there is a pay shortage - conveniently ignoring the fact that it was the unions' own collective bargaining that set those inadequate rates.

Case in point: American pilots recently signed a contract calling for an immediate 23% pay rise and a 3% annual increase for the length of the contract. This sounds attractive, but measured against 35% pay cut they took pre-bankruptcy it is not outrageous. However the Envoy/American Eagle pilot contract calls for freezing their pay at current levels for the next decade.

Regional pilots have voted down other tentative agreements, including the industry-leading agreement forged by Republic last year, which increased average pay between 30% and 50% and set new-hire pay at the top of the regional scale (about USD30,000 annually from USD22,000). SkyWest pilots also rejected a tentative agreement that analysts saw as pivotal to the airline's future competitiveness and profitability.

The pilot shortage remains a challenge for regional airlines

Republic is a good example of the hiring challenge. Its goal in 2012 was to hire 400 pilots and it managed with no problem. In 2013, its goal was 500 pilots but it fell short by 50 pilots and increased its goal in 2014 to 550 pilots, again falling short by 50 pilots. It is essentially keeping up with attrition of about 13-15% of its pilot corps but does not have enough pilots to grow, according to Ms Becker.

There are solutions, she argues, acknowledging they are both long-term and unlikely considering U.S. Congressional gridlock. Congress could follow Europe, increasing the retirement age to 67. Military pilots could be encouraged to retire now that military activity is winding down.

The military-to-airline path lost its lustre amidst the volatility of the industry since 2000 with bankruptcies, changing pilot contracts and lost pensions. That has now changed with the financial success of the mainline carriers. Finally, Ms Becker suggested airlines could also follow their airline counterparts around the world, creating ab initio flight academies.

Movement is afoot to lower the 1,500-hour requirement, with heavy lobbying from regionals, but that, too, is unlikely since families from the Colgan crash in 2009, which spawned the new regulations, remain very active. As it is, there is no scientific basis concluding 1,500 hours would make better pilots. Indeed, the Colgan captain had much more experience than that.

Furthermore, Republic's Mr Bedford insists increasing flight hours does just the opposite. Newly minted pilots, he says, exit the highly disciplined, college-driven training programmes only to be forced to "drill holes in the sky" for another 1,000 or so hours. During this time, their flying skills deteriorate as they lose all the discipline they acquired in school.

A compromise with the FAA may help

The industry has cobbled together a compromise with the Federal Aviation Administration giving four-year-college-trained pilots credit for 500 hours. Regionals are also moving to create career paths for would-be pilots prompted by a landmark programme established many years ago by Cape Air.

The airline first partnered with the University of North Dakota and Embry Riddle Aeronautical University and JetBlue to create the JetBlue University Gateway Program, which has since been judged the "gold standard" in pathway programs. Cape Air's program now includes seven universities.

After graduation, students are guaranteed an interview with Cape Air for the right hand seat and, if hired, the opportunity to gain experience while being paid as a first officer. New hires at Cape Air fly its Cessna 402s, building time and training in a position that is not required in its Part 135 operation. They gain real-time experience and are on the seniority list. After 3,000 hours or about eight years they are guaranteed an interview with JetBlue. To date 20 pilots have traversed the program to the right seat at JetBlue and Cape Air now has 200 pilots in waiting.

Programmes such as this constitute an advantage for regionals because it means the pilots are not aimlessly flying as their skills deteriorate. But most regionals are Part 121 operators requiring two pilots. Even so, the programmes are also an advantage for would-be pilots who face major issues in their quest to become airline pilots:

The cost of their four-year education plus flight training can be more than USD125,000. Few could rationalise the expenditure for a USD20,000-a-year starting salary, forcing many to drop out.

But Ms Becker puts these issues in perspective. "People often educate themselves by going to college. The cost at a major private university in the U.S. can average more than USD50,000 annually for other professions. It is really no different for pilots." She expects that now that the industry has stabilised and hiring, pilots will see the value in making the investment for the salaries that can be expected for a seasoned pilot.

Regional airlines are also addressing the revenue side

"Regionals have done everything they can to restructure and twisted every dollar they can on the cost side," said a former regional president. "It is the revenue side that needs to be addressed."

Clearly, one goal should be changes to capacity purchase agreements. There is a place for CPAs, says Ms Becker, but regionals should have a mix of pro-rate and CPA flying. She suggests regionals insist on longer contracts with realistic price escalations.

"Take control of the inventory and pricing again," she told regionals gathered at the Regional Airline Association in 2013. "No other industry gives up revenue production to a third party. Don't sell 100% of your inventory to your major partner. It's a heck of a lot easier to make a decision on capital outlay for a 20-year asset when you know you will have the ability to raise prices if your costs increase.

"Let the travelling public put together their connecting schedule. You can still codeshare with the major airlines, but you will have more control over your future. Regionals have to be allowed to make money and that is not what happens today. You need to have competitive rates but you also need to protect your own interests, your employee interests and that of your stakeholders."

But the ex airline president suggested that returning to the pro rate would be very difficult. "The majors don't want unhealthy regionals but they want them to be dirt cheap."

But it is cost reduction where the emphasis lies - productivity improvements are possible

Any changes benefitting regionals on the revenue side of the ledger are highly unlikely given the failures experienced in the industry since 2008. Regionals are now completely risk averse and relying on cost cutting and streamlining fleets for their latest metamorphosis. Both Republic and SkyWest have announced that their cost-reduction strategies centre on reductions in fleet type.

Cost improvements for SkyWest will also come from better labour productivity, pressuring vendors for better deals and improving operational reliability by deploying spare aircraft throughout the system. With the industry's largest order book, SkyWest is in a position to win contracts if it can improve its reliability. It has taken positions on 400 aircraft from Embraer and newcomer Mitsubishi although it is not expected to firm up orders until the aircraft are under CPA contracts. Republic is in a similar position.

But, what of the rest? Mainline airlines should arguably be eyeing wholly owned regionals, such as PSA, Envoy and Piedmont, for improved efficiency through single operating certificates. After all, cost efficiency was the reason Republic cited for merging Chautauqua into Shuttle America. At the very least, it would surprise no one if Envoy (American Eagle's new name coined to differentiate it from the other regionals flying under the American Eagle banner) were shut down, just as Delta closed Comair and American closed Executive. American is already parting out lift requirements to other regionals.

The US regional airline outlook: more turmoil

So far there are no plans to do this but once the merger is complete it is likely regional efficiencies will rise to the top of the pile towards the end of this decade. The reasons for holding separate operating certificates are long gone with mainline consolidation and if United is consolidating partners it is likely American will cull its nine partners as well.

That means more turmoil for the industry since any move to consolidate wholly owned regionals will likely affect non-owned partners, including, in the case of American, Air Wisconsin, Mesa, Republic, Trans States and SkyWest.

But once that turmoil subsides, a much smaller, more stable regional airline industry may emerge - with the potential to grow.

Part 2 of this report will address opportunities for entrepreneurial operators in the regional airline industry

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