Things have to be really, really bad for SkyWest to post a loss, especially when it should have been benefitting from its acquisition of ExpressJet. In fact losses at the company are unheard of since the March 1988 quarter and, for that, the company has become the premier US airline for its unique winning streak. But, the first quarter of 2011 ended a 91-consecutive-quarter profit streak owing to, what the airline described as, a perfect storm, some of it related to trying to please one of its major partners.
Worse, CFO Brad Rich indicated that some of the factors contributing to the unusual results would carry through the rest of the year. While the increased maintenance costs cited as contributing to its performance will continue until mid-2011, it will then completely disappear. The company hopes to recover the costs associated with a last minute change in its United contract calling for CRJ 700 operations at Houston to replace XJT’s Embraer 145 operations there.
In the meantime, the action resulted in a loss of USD11.1 million, a USD26.1 million negative swing from the USD15 million profit in the first quarter of 2011. The company said the additional pre-tax crew costs of approximately USD10.6 million resulted from pre-delivery training costs required to operate future growth aircraft and costs associated with relocation of crews to accommodate United schedules.
“It was a perfect storm when a lot of things were out of adjustment,” Vice President Finance and Treasurer Micheal Kraupp explained to CAPA. “A lot of it was weather which included Houston shutting down. There are also cost issues that were creeping up on us including crew costs that were significantly higher than anticipated, especially in training. The severe winter weather storms, in January and February, resulted in 13,500 fewer block hours than expected that resulted in lost revenue of approximately USD9.7 million.” Atlanta was also significantly affected by weather.
First quarter ASMs dropped to 8.6 billion as a result of weather but will rise to 9.4 billion in the second quarter, 9.6 billion in the third and 9.2 in the fourth quarter for a full year total of 36.9 billion.
“We also had the opportunity to take aircraft operating for United and move 30 Embraer 145s from Houston to Chicago,” he continued. “The plan was also to take 17 CRJ 700s to Houston but they got static from the Continental pilot union because of scope. So they pulled back on that. Then they realised they could operate those flights under a codeshare as United flights so we had to scramble to move crews down there and ended up paying double time and premium pay just for crews. We intend to go after reimbursement because it was all done at the last minute and was not at all well thought out. We may get some recovery.”
Mr Rich reported that the fleet changes between Chicago and Houston had a disproportionate disruption impact on the ExpressJet rather than the SkyWest side.
Mr Kraupp also explained the last-minute aircraft and crew movement for United was exacerbated by increasing maintenance work at Atlantic Southeast Airlines owing to lack of cost oversight of the third-party, maintenance organization. “They were doing C checks,” he added, “and they did five more than planned and that was compounded by the fact that costs there were out of control. We have since changed procedures and now have greater oversight of the programme.” The company had planned for 28 C checks, not 33.
Fuel was also a driver, although only for its pro-rate operation. SkyWest Airlines' pro-rate revenue increased approximately USD10 million as a result of a 9.2% increase in the average passenger fare and a 6.9% increase in passengers enplaned compared to 1Q2010. Total revenues for the pro-rate business were USD75 million, but ultimately, the operation lost USD6.9 million in the quarter. Mr Rich reported that fuel, alone, increased just over USD6 million.
It has only been profitable in 3Q-2010. Expressing the impatience of analysts one asked point blank why SkyWest was even in the pro-rate business. Mr Rich reminded them there there is a lag between the ability to raise fares and rising fuel costs assuring them that the outlook looks better for improving pro-rate revenue. “It has really not shown up in the fares yet,” he said. “We also have a lot of flexibility with the fleet and unique markets where we are replacing, in many cases, flying done by much larger mainline aircraft so we have the flexibility and are planning some adjustments in the future.”
The CRJ 200s used in the operation are also on short-term leases running out over the next year with 60- to 90-day cancellation clauses.
SkyWest President Chip Childs added there is a “tremendous utilization uptick on the pro-rate flying which helps from the cost perspective on the contract flying.” He expressed cautious optimism that the operation will break even throughout the rest of the year. He also pointed to the proposed changes in the Essential Air Service programme, killed in the House version of the FAA reauthorization bill, indicating that should that happen some markets will have to be modified.
Rate changes affecting ASA
There has been an impact from changes to contract rates pushed by mainline carriers moving to have regionals take on more of the risk. Major carriers, seeing the robust margins brought in by regionals even in a down economy, decided a few years ago to have regionals take on more risks and have been working to do that at each contract renewal. The move began at Delta and the lower contract rates at SkyWest Inc subsidiary Atlantic Southeast Airlines, resulted in a USD7.2 million loss in revenues, according to the company. Even so, when asked if the unprecedented first quarter results were a reflection of the changing contracts between regionals and their mainline counterparts, Mr Kraupp said no, pointing to a number of high-cost factors.
One of the priorities for ASA President Brad Holt is to trim costs in line with the new rates. However, much of the problem stems from reduce stage lengths and block hours.
“The cost issues were materially exacerbated by the lower production in stage length and utilization. The average stage length dropped from 450 to 300,” said Mr Rich, who was careful not to criticize 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 that 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.”
Mr Rich also acknowledged that the impact of ASA and XJT will have a compressive effect on margins for the rest of the year. “In looking at future potential, you have to break expectations down into near term and longer term, that is, the next year and then beyond the next year,” he said. “With the exception of expenses incurred preparing for growth aircraft, if you take out pro-rate fuel and the maintenance timing mismatch, overall SkyWest airlines is pretty much intact as you move through the next year. Once the maintenance mismatch flips in 2012, the margin potential is very strong and similar to what we have seen for many years.
“The ASA performance should expect lower margins than previously generated and it is going to take time to adjust the cost structure to second lowest rate in the Delta contract,” he continued. “There are two components. We are confident the cost reduction initiatives will have a meaningful impact separate from the impact of the integration benefit from ExpressJet. With ASA cost reduction, we’ll get back to a a positive margin on that alone. Then, when you put integration into mix, the cost reduction at ASA, the maintenance mismatch, together with the fleet replenishment and replacement within our contracts, we see a meaningful upside as we get a year out, there is even more meaningful upside margin potential after that.”
Loss highly unusual
“This loss is the first in 23 years,” Mr Rich told analysts, adding he signaled coming problems during the 4Q-2010 earnings call. “This is not reflective of our future potential. We are getting our hands around it and making sure we clearly understand the drivers and which ones are one-time, non-recurring events and which ones warrant corrective action that are appropriate for those we have in our control.”
He attributed part of the problem not only to the massive weather events last winter but to an increasing seasonality of service, something the company had not experienced before to this extent owing to the volatility of its major partners’ schedules.
“We didn’t know the magnitude the impact of some of these issues,” he explained. “When it became clear we issued a release on 1-April estimating a net loss in the range of USD13-15 million. It was less than that.”
ExpressJet bump overwhelmed by costs
While the expected bump in revenues from ExpressJet did occur, it was accompanied by a greater bump in expenses. The USD211 increase in revenues from XJT which was quickly overwhelmed by the USD226.2 million in XJT expenses for the quarter. The subsidiary incurred a USD15.1 million operating loss in the quarter.
CFO Brad Rich indicated that the integration is moving ahead on target with the single operating certificate on schedule for the end of the year. Integrating the administration functions and IT is substantially complete while the labor component continues to be the issue with the most work remaining. Half of the USD15 million pre-tax loss for XJT related to weather with the other half split evenly between crew-related and integration issues.
“The first quarter loss is not what we expected but it was not due to inability to make integration progress,” he said. “The weather impact hit ExpressJet significantly more than SkyWest or ASA because of the closure of Houston and its concentration of flying there. We also didn’t expect some of the schedule requirements from our partners that also had a material impact. We’re not complaining because it is our mission to meet the needs of our partners but there were things asked of us that had a fairly definitive financial impact such as re-allocating crews and the disruption from the re-allocation of flying. The weather we hope was a one-time, non-recurring event and we think the schedule re-allocation is not a long-term recurring issue.”
Mr Rich pegged the training and other reallocation costs associated with the United change between Chicago and Houston at USD10 million. It has also baked the additional costs for the transition of Horizon’s eight aircraft and the subsequent rollout of its five-aircraft, Alaska CPA agreement, into its Alaska contract. Mr Childs reported there have so far been no changes to its AirTran operation at Milwaukee and the company was awaiting a conversation with Southwest on the matter.
In addition, the first quarter consolidated results include a USD2 million loss for SkyWest’s share of the Air Mekong start up operation in which it has a 30% ownership stake. However, that was planned for and budgeted.
“The second quarter for Air Mekong will be similar to the first quarter,” said Mr Rich. “Then, as load factor continues to improve and we get some relief from regulations on fares, that is expected to improve. We have also been able to carry more freight and mail and we are seeing ways to improve yield. If you combine the improving yield and the load factor we expect losses to come down in the third and fourth quarters to about USD1 million.”
The loss was recognized in the first quarter consolidated results but occurred in 4Q-2010. Its investment in Trip yielded a USD1.5 million gain for the first quarter even though the actual gain occurred in 4Q-2010. Mr Rich acknowledged the diluting impact of TAM’s investment in the Brazilian regional which will yield a 10% stake. Currently, SkyWest’s ownership is more than 20% which would decline to a little under 20%. Mr Rich said the TAM investment and partnership with Trip is expected to have a meaningful positive impact on implied valuation on SkyWest’s investment since it is a premium on book value.
The block hours for both SkyWest and Atlantic Southeast airlines jumped 4.1% during the quarter resulting in USD8.6 million in additional revenue although consolidated block hours jumped 56.9% to 539,910 for the quarter on XJT. The company did not report results for individual subsidiaries in its release.
Rising revenues and expenses
SkyWest also experienced a USD4.1 million increase in ground handling and other revenues for the quarter on the ExpressJet acquisition. As with its major carrier counterparts, its loss came on rising revenue which came in at USD866 million for the first quarter, up 37% from the prior-year quarter.
Total airline operating expenses including interest expense, jumped 44.9% to USD274.5 million, in the quarter attributable primarily to the acquisition of ExpressJet. After excluding expenses for fuel and engine overhaul costs directly reimbursed under SkyWest's flying contracts, total airline expenses increased USD14.1 million, or 2.8%, for the quarter.
The USD14.1 million in airline expenses was primarily the result of SkyWest incurring pre-tax expenses of approximately USD8.9 million related to both the number of airframe heavy inspections and higher than anticipated costs for each inspection. The company has been discussing its rising maintenance costs for many quarters and the mismatch between SkyWest Airlines production and the timing of heavy inspections. Mr Rich said it would continue through the year.
“We had a material price variance as well as the five unscheduled C checks,” he said. “The positive thing is we are now identifying some significant actions we can do to manage the cost of these events and I think we’ll see a quick improvement and meaningful reductions in expenses going forward. The majority of this issue has occurred and been recognized in the first quarter so there won’t be nearly this order of magnitude in the rest of the year.”
In addition, as a result of recent increases in jet fuel pricing, for which SkyWest Airlines has exposure on its pro-rate flying, SkyWest Airlines incurred additional pre-tax fuel costs for its pro-rate flying of approximately $6.1 million for the quarter for the 61 aircraft in the pro-rate operation which generated an additional USD10 million in operating revenue over the year-ago period.
During the quarter ended March 31, 2011, SkyWest repurchased 1,226,392 shares of its common stock at a total cost of USD19.6 million and has remaining authorisation to repurchase up to an additional 4.5 million shares of its common stock. Since 2007, SkyWest has repurchased 15.5 million shares of its common stock at a total cost of USD296.7 million.
The company reported that four of the eight sub-leased CRJ 700s acquired from Horizon were already at work in its Delta Connection program. The remaining four will be delivered by June. It is to operate five CRJ 700s for Alaska under a standard CPA agreement set to begin in May through which it will sublease five CRJ 700s.
It also contracted to acquire four new CRJ 700 Next Gen aircraft set for delivery in the third and fourth quarters to replace aircraft for CRJ 200s now in the Delta Connection programme. Delta is spinning out most of its smaller regional aircraft.
At March 31, 2011, SkyWest had approximately USD706.9 million in cash and marketable securities, compared with approximately USD804.9 million at the end of 2010.
“The 98 million decline in cash is concerning but explainable,” said Mr Rich. “There are three items that drove it - pre-paid rents of USD53 million which happens every first quarter, the USD19.6 million to repurchase common shares and the USD13.2 million in aircraft deposits to Bombardier for the four aircraft we are acquiring.”
SkyWest's long-term debt was USD1.71 billion at the end of the quarter compared with USD1.74 billion at the end of the prior-year’s quarter resulting from payment of normal recurring debt obligations. SkyWest has significant long-term lease obligations that are recorded as operating leases and are not reflected as liabilities on SkyWest's consolidated balance sheets. At a 6.2% discount rate, the present value of these lease obligations was approximately $1.98 billion in 31-Mar.