Viable business models continue to evade US regional airlines

Once the darling of the US regional airline industry with margins major airlines salivated over, SkyWest has seen its operating margin plummet from 10.9% in 2006 to 1.1% in 2011 as it began work to integrate the operations of its subsidiaries Atlantic Southeast Airlines (ASA) and ExpressJet, which was acquired by ASA in 2010.

SkyWest yearly operating margin: 2006 to 2011

2006	2007	2008	2009	2010	2011
10.9%	10.2%	7.3%	8.1%	7.3%	1.1%

Source: Morningstar

SkyWest has admitted its expectations in executing a seamless merger between ASA and ExpressJet were too high, which resulted in missed financial targets for each quarter in 2012. SkyWest's USD27.3 million loss in 2011 was its first loss in 23 years, reflecting the pains of attempting to integrate two carriers while facing rate reductions in ASA's contracts with its legacy partner carriers. SkyWest was also hit with escalating maintenance costs on its ageing fleet of 50-seaters, which along with the integration challenges caused it operating expenses to jump from USD2.6 billion in 2010 to USD3.6 billion in 2011, which contributed to a 79.6% tumble in the company's operating profits to USD41 million.

SkyWest concludes it did not have the benefit of a thorough due diligence process prior to its 2010 purchase of ExpressJet, and in hindsight says it would have factored in the cost of risks associated with not having a comprehensive understanding of the entire ExpressJet operation in the price it offered for the carrier. Highlighting the competitive costs it agreed to under a 10-year deal with United Airlines when it purchased ExpressJet, SkyWest is hopeful some adjustments can be made in ExpressJet's operations as United Express to make the economics of the agreement more favourable.

SkyWest consolidated earnings: 2010 and 2011

Source: SkyWest

An element of the agreement reached between SkyWest and United in 2010 covering the ExpressJet operations stipulated no rate resets until at least five years into the contract term, so it is not clear if United would be willing to change the rates paid to SkyWest for the ExpressJet operations anytime in the near future. As SkyWest approaches United to discuss the ExpressJet contract, United is also facing pressure from partner Pinnacle Airlines to rework the economics of a contract covering the operation of 30 Bombardier Q400s for United. Pinnacle has warned it cannot justify continuing those operations for United if long term without contract improvements. United may have a weak appetite to change the dynamics of these contracts as it faces its own cost headwinds from the merger with Continental and rising expenses from investments in mainline product upgrades including reconfiguring the Continental fleet with a premium economy offering.

Divide over who should pay increasing maintenance costs

SkyWest attributed a portion of the increased maintenance expense recorded during the period to replacing a higher number of components during heavy C-Checks on its 50-seat regional jets. Carriers operating 50-seat jets will continue to face higher maintenance costs on those aircraft during the next few years as the fleet continues to age and more heavy checks are required.

SkyWest has indicated it is engaged in talks with its major partners to help them understand the maintenance cost pressures it faces on its fleet of 50-seat aircraft, which comprises 69% of its fleet operated by subsidiaries ExpressJet and SkyWest Airlines. Last year, ASA transitioned to the ExpressJet brand.

Recently, SkyWest chairman Jerry Atkin highlighted an industry-wide problem with the ageing 50-seat jet fleet, and the associated costs operators would incur. He indicated he is hopeful that SkyWest's partners - Alaska Airlines, Delta Air Lines, United and US Airways - will grant some level of reimbursement to SkyWest to help cover the uptick in those costs.

It could be an uphill battle for SkyWest in convincing its partners to cover the higher maintenance costs on its 50-seaters. As of 31-Dec-2011, SkyWest's subsidiaries operated 160 50-seat jets for Delta, which has repeatedly said it will continue to shrink the number of jets that size flown in its Delta Connection operations as the economics of operating those aircraft become increasingly unattractive.

American Airlines has flagged an up-gauging of its regional fleet, subject to scope clauses, will contribute to a USD1 billion revenue improvement.

See related article: American Airlines defends USD1 billion revenue growth plan

SkyWest Inc fleet breakdown as of 13-Mar-2012

Source: CAPA - Centre for Aviation

Pinnacle has had its own struggles in convincing its major partners to raise contract rates to cover increased maintenance costs as evidenced by a dispute with partner Delta over reimbursement of heavy maintenance costs on some 50-seat CRJ200s. A tentative settlement reached between the two carriers resulted in Pinnacle indicating a USD6 million reduction in reimbursable costs in 2012.

Republic Airways Holdings is striking a different tone as it works to restructure its 50-seat Embraer ERJ145 operations. Company CEO Bryan Bedford recently declared the company does not expect its network partners to fix its problems, which include maintenance costs escalating on the 50-seat jets at what he describes as at an alarming rate. Republic's strategy is to achieve viable long-term operating costs on its ERJs by engaging suppliers and other stakeholders to create operating economics to sustain demand for the jets from its network partners.

Republic Airways Holdings feet breakdown by customer and aircraft: 2011

Source: Republic Airways Holdings

Small jet exposure at Republic is less pronounced than SkyWest. Republic estimates its 44 to 50-seat small jet operations accounted for roughly 24% of its 2011 revenue while its operations of 70 to 86-seat jets accounted for the remaining 76%. Republic also believes the higher percentage of larger regional jets in its fleet gives it an advantage over SkyWest and Pinnacle as those newer aircraft types help to drive down the average age of its aircraft fleet.

Republic Airways Holdings vs competitors average age of fleet and seats per aircraft: 31-Dec-2010

Source: Republic Airways Holdings

Abandoning branded flying

Republic purchased Frontier and Midwest Airlines in 2009 with the hopes of diversifying its business as the regional sector in the US matured and opportunities for growth were shrinking.

But almost from the day it purchased both carriers and later folded Midwest into the Frontier brand, Republic faced competitive challenges in Frontier's two main hubs of Denver and Milwaukee. It also incurred losses through its attempts to feed those hubs with smaller aircraft. Last year, Republic set out on a plan to restructure Frontier through a USD120 million cost savings scheme ultimately designed to transition the carrier to an ultra low-cost carrier to make it attractive as Republic sought a sale or spinoff of the carrier.

Republic moved quickly to recoup its nearly USD109 million investment in acquiring Frontier once it realised running a separate branded airline would not give the holding company financial stability over the long term. The cost improvements were reflected in Frontier's 4Q2011 and full-year results as revenues increased 8.9% year-over-year in 4Q2011 to USD422 million and 10% for the full year for total revenue of USD1.7 billion. Frontier also managed to eek out a USD7.8 million pre-tax profit for the fourth quarter, reversing a USD11 million loss recorded the year before.

Previously, Republic CEO Bedford remarked that prior to Frontier's restructuring there was little to talk about it in terms of monetising the carrier and he was not certain if Frontier was "saleable".

Yet even if Republic gains a favourable financial result in selling or spinning off Frontier, its core business remains steeped in a stagnant industry, with regional airlines fighting for a shrinking share of business from US major carriers. With some contract renewals coming into full swing during the next few years, regionals face increasing pressure to offer their partners optimal costs while major airlines look for their regional partners to assume more risk than they have historically under previous capacity purchase agreements.

See related article: Frontier drags on Republic as it prepared to reveal restructuring plan for the entire company

During 2011, 30% of SkyWest's costs for operations with its major airline partners were passed through to the major carriers while 70% were reimbursable at pre-determined rates. Pass-through costs include items such as fuel expense. Keeping costs in check during the next few years will be challenging for all regional airlines to ensure their expenses are not greater than the set reimbursable rates.

Pinnacle's plight continues

Memphis-based Pinnacle Airlines is currently battling a gap between the costs it is incurring in some of its operations for major carriers and the reimbursements it receives. It has repeatedly warned that losses incurred from its operation of the Bombardier Q400 turboprops for United is unsustainable. It has received some temporary relief from United in the form of increased rate payments and the major assuming some ownership costs on the aircraft operated by Pinnacle subsidiary Colgan, but the interim deal expires on 01-Apr-2012. Pinnacle has also warned a contract covering 16 Bombardier CRJ900s operating as Delta Connection is also producing marginal economics, even after a rate adjustment for pilot costs starts this year.

Wringing any additional relief from Delta is a formidable challenge for Pinnacle. Delta during the last few years has taken a hard line with its regional partners, and in 2008 threatened to pull the contract now producing unfavourable economics for Pinnacle after claiming the regional failed to meet minimum on-time arrival targets stipulated under the deal.

Late in 2011, Pinnacle embarked on a cost restructuring and has repeatedly said filing for Chapter 11 bankruptcy protection could be an option if it cannot reach agreements with its major airline partners and suppliers to lower its expenses and reach concessionary agreements with its unions.

A integrated seniority agreement for the company' three subsidiaries - Colgan, Mesaba and Pinnacle - has proven to be more difficult and expensive due to training events created by the integration. Pinnacle management is seeking certain relief in the handling of vacancy bids under the seniority agreement.

Similar to SkyWest, part of Pinnacle's financial weakness was triggered by integration costs after its acquisition of Mesaba last year. Pinnacle has been working to transfer Mesaba's jet operations to the Pinnacle operating certificate and unifying the turboprop operations under the Mesaba brand.

Prior to issuing its warnings of a possible Chapter 11 filing, Pinnacle referred to 2012 as a transition year as new CEO Sean Menke worked with his team to analyse potential cost savings for the carrier.

Evidence of Pinnacle's cost challenges was highlighted in its third quarter financial results, as its expenses for the first nine months of 2011 jumped 36% from USD671 million to USD914 million and its losses for the time period totalled USD8.8 million. It had USD82 million of cash and current maturities on its long-term debt of USD64 million. In the comparable period for 2010, Pinnacle recorded a USD17 million profit and had USD100 million in cash on its balance sheet.

Even as both Pinnacle and SkyWest in 2011 endured pain with their respective merger integrations, they remain optimistic of a possible reversal of fortunes this year.

SkyWest expects a loss in the first quarter of 2012 but then believes it will post earnings for the full year after projecting a USD100 million pre-tax swing in its fortunes driven by a leveling off in engine maintenance, cost synergies between ASA and ExpressJet and better management of pilot assignments for the combined ExpressJet and ASA operations now unified under the ExpressJet brand.

Part of the agreement Pinnacle brokered with Delta to purchase Mesaba included rate adjustment increases covering operations for Delta performed by both Pinnacle and Mesaba to cover increased pilot costs. A one-time retroactive payment due from Delta this year could range between USD18-20 million and the annual amount of the rate increases scheduled to start this month is estimated by Pinnacle at USD14-17 million.

SkyWest's sheer size with its fleet of more than 700 aircraft guarantees the carrier a level of staying power that is not currently evident at Pinnacle. SkyWest chairman Jerry Atkin recently alluded to SkyWest's scope giving it the ability to acquire and finance aircraft at lower rates. It definitely gives the company an advantage, but it remains unclear how major partners intend to manage their regional feed during the next five years as the domestic marketplace in the US continues to mature. The days of regional carriers placing massive orders in the 100 aircraft range are long gone.

Pinnacle has no illusions that there is any short-term remedy for its cost problems despite the anticipated benefits from the rate increases in a portion of its Delta Connection operations.

During a recent communication with employees, Mr Menke reiterated unless the carrier achieves long-term cost reduction agreements with its constituents, the best way to improve its financial performance may still be through Chapter 11. "The regional airline industry overall is facing tremendous pressure as the factors shaping our business continue to change," he warned.

Others suggest the US regional industry will have to undergo consolidation.

See related article: With the American regional aviation model broken, consolidation is the answer