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With the American regional aviation model broken, consolidation is the answer

The old regional airline, capacity-purchase model is well and truly broken and airlines must evolve to find a more profitable model, Dahlman Rose analyst Helane Becker said in her latest briefing in a harsh evaluation of the sector based on losses and current efforts to restructure.

Regionals have been evolving, expanding capacity purchase portfolios or acquiring branded operations such as Republic’s acquisition of Midwest and Frontier to form Frontier Airlines. Even so, that doesn’t seem enough simply because they are still so many aircraft in a vastly shrinking regional airline system.

In what has become increasingly clear from the earnings calls, the problem is regionals have no control of their own businesses and rely totally on the whims of their major partners, despite the fact they have organised themselves into large holding companies in an effort to gain leverage both in costs and with their major partners. In addition, as it was made clear by SkyWest calls, contracts are not detailed enough to avoid a mid-course re-interpretation that results in hammering the regional partners by their major counterparts.

Still, regionals may develop a hybrid business model that combines the steady revenue of capacity-purchase agreements with branded service. While that has not worked in the past, that is largely because they used 50-seat regional jets as fuel skyrocketed. One airline has already proven the concept and, with the right aircraft, it could work.

The problem for regionals really began in the post-9/11 period when major-carrier bankruptcies allowed the restructuring of that sector. Regionals took on an increasing capacity lift for their partners with 8-10% margin contracts.

Major carriers were still suffering a negative or just-barely positive margins and in 2007 began a watershed change in the industry. During that time, regionals pointed to their long-term contracts as security against any changes but the lack of specificity in contracts has since resulted in a rude awakening with business reduced to contract minimums and at times, even less.

Current consolidation not enough

During the 2005-2010 period – and only at the behest of actions taken by their major carrier partners – the regionals began consolidating, although not half as much as needed. For instance, Delta Air Lines wanted to rid itself of Atlantic Southeast Airlines and convinced partner SkyWest Airlines, Inc to buy it in 2005. SkyWest is still trying to restructure its operations there after nearly six years and has found it impossible given Delta’s rapidly changing schedules and policies that cancel and delay regional flights first.

Still, that did not keep SkyWest Airlines Inc from acquiring ExpressJet in 2010 since it was a good opportunity to grow in a non-growth industry. Its stated objective was to expand its CPA portfolio and economies of scale but it came after the merger of United and Continental, meaning the effort went for naught. Now, it is struggling with the restructure of its SkyWest Airlines subsidiary to accommodate the changes in CPAs at the same time as it is consolidating ExpressJet and ASA.

Perhaps Pinnacle, however, provides the greatest cautionary tale. Once again Delta wanted to rid itself of owned regionals and convinced partners Pinnacle Airlines Inc and Trans States to acquire Mesaba and Compass, respectively. While Trans States is privately held, meaning the results of its acquisition is largely unknown, the radical downsizing of Mesaba’s Delta Connection operation must at least have Pinnacle management wondering what happened to its sound Mesaba investment.

Regionals have little choice

The regional partners really had no choice in the acquisitions since they wanted to keep major partners happy. Indeed, despite its contracts, SkyWest always stated during calls that it wanted to be a “good partner”, helping Delta with what it needed. Other management conducted equally delicate and diplomatic dances with their major partners. Unfortunately, Delta doesn’t know what “good partner” means and has continually short-changed its regional partners.

“The regional airlines have little leverage with their major airline partners, and without leverage we believe it will be difficult for the industry to return to profitability,” said Ms Becker, describing the ultimate results of the less than symbiotic relationship between regionals and majors. “The regional airlines generally control a lot of aircraft, too many 50-seat aircraft, but there are still too many airlines competing for too few opportunities.”

Ms Becker suggests consolidation is the answer but, unlike their major-carrier counterparts, it has not resulted in a reduction of capacity, and won’t until carriers earn their Single Operating Certificates (SOC) now scheduled for the fourth quarter for both ExpressJet and ASA, and Mesaba and Colgan. Even so, the nuts and bolts of integration will occupy the whole of 2012. Both SkyWest and Pinnacle put recovery at 2013, but it remains to be seen since they rely so heavily on the vagaries of their major partners.

She noted consolidation among legacies resulted in a 3% decline in capacity from the 2007 peak but, more importantly, an 8% decline in domestic capacity as international remained relatively flat from 2008 levels. This leaves regionals with too many aircraft and taking losses as they ground unnecessary lift resulting from capacity purchase agreement (CPA) changes.

List of regional providers

The future looks bleak given the fact there are still too many companies chasing a diminishing number of CPAs. In addition to consolidation, the wholesale retirement of older aircraft, which are driving up maintenance expenses, will also help the industry. However, that could be stalled by scope clauses.

“We recognize there is the issue of scope with respect to some of the majors,” she said. “Continental Airlines codeshare partners cannot fly aircraft larger than 50-seats, so it is possible the 50-seaters will stay in service even though they are not economically viable. That said, does SkyWest really need 732 aircraft? Probably not, but until United and Continental finish their own restructuring, we doubt they'll focus on the regional aircraft. We believe it will take several years for the industry to sort itself out; indeed, both SkyWest and Pinnacle managements indicated 2012 is a transition year. Given that outlook, investors are probably better off investing in some of our top picks if they want exposure to the airline industry.”

Self determination may be better

SkyWest has long viewed its operation as a factory with its production being capacity, but that still has not sheltered it from production declines. While regionals once benefited from the CPA model growing to become huge operations, they were probably better off when they controlled everything given the problems they face today.

“The result is the evolution of the model into what it is now: managements beholden to their major-carrier partners for revenues while trying to manage the cost structure in an environment of rising fuel prices and major airline industry consolidation,” said Ms Becker. “We recognize the major airlines need the traffic the regional airlines provide, but it seems as though the major carriers treat their partners somewhat cavalierly, in the sense they ask the regional to adjust schedules without a lot warning.”

And that is unlikely to change: Mesa Airlines provides the key to the fate of regionals who do not cooperate. SkyWest is still fighting the same battle over Delta’s actions in court. The same analysts who laud the majors for their improving results are the very same ones who express frustration with what they are doing to their regionals. It seems clear they are as powerless as the regionals to effect any change in major-carrier practices.

Being treated cavalierly was clearly a factor at both Pinnacle and SkyWest, which drove up crew and training costs as they absorbed millions in additional costs that, to date, seem to be un-reimbursable. While managements say they will be or are talking to their major counterparts about their problems, it is entirely unclear that it will make a difference.

In fact, it is highly unlikely, as evidenced by Republic Airways Holdings CEO Bryan Bedford who this monthdid not even suggest renegotiating with major carriers but, instead, is relying on restructuring aircraft lease agreements to cut costs. Clearly he has seen the writing on the wall and is is attempting to repeat his success lowering Frontier costs by renegotiating leases with his CPA aircraft. In addition, Republic is slowly getting out of the 50-seat business.

Ms Becker also pointed to irregular operations as a major factor in regional airline problems and she is right, as often noted by CAPA, the regional flight is the first to be cancelled or delayed. Here again, Pinnacle and SkyWest are illustrative of the problem, especially when close-in schedule changes force rising costs in crew positioning and training.

“It is difficult to perform to the standards set in the contractual agreements when the major partner is adjusting schedules forcing the regional partner to scramble to accommodate the new schedule,” wrote Ms Becker. And both airlines cited either penalties or lost bonuses as the consequence for failing to meet performance targets.

In the beginning, the idea, said Ms Becker, was to replace cost volatility by pushing that on to the major partner but even before the meltdown in 2008, Delta announced it would be pushing back as the result of watching regionals post 10% margins compared to low-single digit, if any, major-carrier margins.

Still that did not relieve regionals of the duty to control costs. Despite their efforts, the mismatch between costs and reimbursements is now the core of the problem since schedule volatility returned regionals’ cost volatility. In their defence, regionals have been cutting costs but rising maintenance expenses on ageing aircraft, along with the volatility of major-carrier assignments for their regional partners have overwhelmed those efforts.

Ms Becker points to contractual mismatches with capacity-purchase contracts extending 10 years to labour deals that are half that, which is behind Pinnacle’s results. The problem, she noted, was the lack of escalation clauses to provide for labour and other increases. Mr Bedford said that pegging the rate increases to the Consumer Price Index, where rising costs ultimately overwhelm the much punier compensation rate increases.

Owning aircraft increases risk

The other problem with the model, she said, is the balance sheet risk since regionals own their own aircraft. Today, they own too many of the wrong aircraft, most notably the 50-seat regionals jets. While SkyWest consistently pointed to its lack of tail risk, meaning capacity purchase contracts synced with the lease contracts, it has not helped.

This is expected to worsen since regionals are facing re-fleeting and, as Ms Becker noted, they are deciding on a 20-year asset with a 10-year, capacity-purchase contract. To date, regionals have managed to cover this risk with short-term contracts, she noted.

The result of the current restructuring will likely be a better mix between giving over the entire operation to major-airline partners and self determination. Just how this will transpire remains to be seen. The question remains whether regionals will be able to wrest some control from their major partners and whether that will even help.

What will be interesting to watch is whether these transforming regionals will return to many of the bread-and-butter markets that built the industry or even to the more recently abandoned markets. ExpressJet proved one could develop a successful point-to-point model, albeit with the right aircraft. While its use of the 50-seat jet failed in a high fuel environment, returning to more efficient turboprops could increase regional airline flexibility.

Smaller airlines are already filling some of these voids but, here, too, they are hampered by the lack of aircraft even as they rely on hardy nine to 30-seaters to rejuvenate these markets. They are looking for a new, modern small transport and one airline even has a prototype about a year out.

Next few years will be transition period

A new Forecast International study pointed to the regional consolidation trend which has resulted in large holding companies controlling several companies. In addition to Republic Airways Holdings, SkyWest and Pinnacle, the model also includes Trans States Airlines.

"The size of the large regional powerhouses affords better economies of scale, more diverse teaming arrangements (and increased negotiating leverage) with the major airlines, and, potentially, greater revenue streams," said senior aerospace analyst Raymond Jaworowski.

But this comes at a time when demand for regional growth is severely limited, which compromises that power, especially in the mature, US and European markets, leaving another mismatch between the over supply of regional aircraft and lowering demand.

Regionals are already acquiring larger aircraft but scope is a limiting factor although, here again, Pinnacle sees the Q400 as a safety valve to that limitation. More seats at lower costs is its strategy. Mr Jaworowski predicted that despite such limitations, regional, low-cost and even legacy carriers are expected to acquire 90-125 seat regional aircraft in quantity.

Forecast International agrees with regionals they are in transition. In a new study, 'The Market for Regional Transport Aircraft', it concluded that the industry will see the production of 4198 aircraft between 2011 and 2020; a USD130 billion value in 2011 US dollars.

Jets will account for over 60% of the fleet but it is interesting to note that two major regionals have not gone with turboprops in their re-fleeting programs. Both Jazz and Pinnacle have opted for the Bombardier Q400 to replace their 50-seat jets, a clear indication that fuel will remain highly problematic for regional jets. The question then becomes whether US majors will opt for the more efficient, larger aircraft as part of their efforts to lower costs or continue to insist on the jet solution.

The only reason Continental opted for the Q400 is its scope limitation. Here again, is an opportunity for regionals to assert some control as the re-fleet. If majors are putting downward pressure on their costs, turboprops seem a natural solution to helping regionals achieve lower costs, even with the better economics of larger jets.

The Forecast International study indicates that Bombardier, Embraer and ATR will be the leaders among regional aircraft manufacturers during the 2011-2020 period, which is unsurprising given the nascent programmes developing elsewhere. 

Bombardier, with a product line that includes jets and turboprops, is expected to build 1278 regional aircraft during the timeframe, representing a 30.4% share of the market.

Embraer specialises in jets, and the study predicts that the Brazilian company will produce 992 regional jets for a 23.6% market share. Turboprop manufacturer ATR is expected to build 668 aircraft, representing a 15.9% share.

As regionals change their models, they may well become something very different, a combination of branded and capacity-purchase operations. That has not worked well in the past, given the experience at ExpressJet and Horizon not to mention Independence Air. They were using regionals jets, however, a new look at the old model, using more efficient aircraft, might be just the thing.

We know good markets exist because they built the regional industry in the post-deregulation period. We also know they are not good enough for CPA operations as regulatory and fuel costs escalated to force them off the legacy networks. We also know that business aviation has grown during the same time but that has left millions of cost-sensitive travellers out in the cold.

The capacity-purchase era may be waning with legacy consolidation but this may force regionals to go back to basics in developing their new model.

As they struggle to find a new model, they will certainly be interesting to watch.