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US Regional airline restructuring Part 2. Towards an independent regional force; & regulatory change

As a result of industry consolidation, restructuring and the loss of hundreds of markets, U.S. regional airlines are sitting on a potential goldmine, according to industry veterans. But, in order to cash in, they need regulatory relief - and for that they must make the case that it is not airlines who need the relief but business travellers and the small- to medium-sized communities.

Major airlines are no longer interested in subsidising small community air service, Delta CEO Richard Anderson is on the record as saying. So this points to new directions, challenges and opportunities. To understand the size of the opportunity two statistics tell the story. In the 1980s regional airlines served about 800 markets, most of which were off hub. As of Jun-2014, that number was down to 431 - a striking loss of over 200 markets since 2013.

This second part of our US regional airline report reviews the potential upside in what is presently a challenged market and why a resurgence would be good for consumers and regional economic development.

The ability to fly directly between US regional cities has declined dramatically

Communities and regional airlines are anxious to develop new services that would be more responsive to business travellers. Indeed, the industry really needs only two things to achieve this new status: the restoration of the 19-seat cap for Part 135 aircraft and new, small aircraft.

“Small regionals might have the biggest opportunity we’ve ever seen, growing right under our feet,” a regional veteran told CAPA. “I look at the way we feed hubs as a series of concentric circles. Small regionals operate in the inner circle. The next circle is the large regionals and then the majors. The bottom of the large regionals’ territory dictates the growth cap on the smaller carriers. Large regionals are all getting larger aircraft, driving shell-count down and frequency reduction which will likely result in the abandonment of a large number of markets. Thus, the innermost of those concentric circles is going to get bigger and the little guys will have lots more elbow room.”

With regulatory relief, the pilot shortage would be greatly eased and regionals could provide the structured training programme safety regulators want to see. Today, pilots must achieve 1,500 hours to be eligible to fly. However, when they graduate from a college training environment they lack more than 1,000 hours and they become personally responsible for the costly acquisition of those hours.

If the Part 135 rules were changed, regionals could follow the Cape Air, Part 135, single-pilot model in which new hires are provided a structured training environment while they earn the balance of the hours needed.

In this vacuum, opportunities for new airline growth abound

“Give me a brand new aircraft and a modest increase in the Part 135 cap and I could set the world on fire,” another veteran president told CAPA. “Our slice of the industry needs to go back to the basics connecting communities and giving the local business communities what they want. With that, I could afford to solve my own local pilot supply problem and prevent the loss of air service to many communities in my area.”

Under such a scenario, regionals could declare their independence from the sometimes-crushing capacity purchase agreements (CPAs) and re-invent the regional airline industry in a more self-standing form, mirroring the post-deregulation industry and reconnecting hundreds of communities to the air transport map.

The argument is so compelling one airline president went so far as to say he could do without CPAs and thumb his nose at the majors.

Although many airport passenger flows are up, they tend to be merely spokes

Airline veterans see the potential for three business models – point-to-point services; reorganising into independent airlines to compete with the car; and/or creating “scratch” airlines that would not have the legacy costs of current regional airlines and could capitalise on the efficiencies of next generation regional aircraft.

“We no longer serve the business community,” one president concluded. “The business traveller wants to get out at a reasonable time in the morning, get to their destination and get home to be with the family for dinner. You can’t do it. You’ve got to go through a hub.”

What is missing is intra-regional service. “Many airports look as if they have grown because enplanements are up,” said one veteran. “What the statistics don’t show is that all the new flights go to a major hub. Yes, they’ve sweetened the pie with the presence of low-cost carriers and the vacation traveller count is way up. But the number of opportunities to fly between other cities within the region has declined dramatically and that is a huge story no one is reporting.

“Below the surface there has been a dramatic loss in the number of cities served” he continued. “There are business-oriented city pairs in the Northeast, for instance, which used to have 20 flights daily and now there are none. To me, that means the overall quality of air service has declined. The guys I talk to who work at colleges and light industry ask why they can no longer get easily from Manchester, NH, to Rochester, NY. They all have to go to Philadelphia or New York hubs and wait for connecting flights before going back up north to their destination. The hubs are not set up for them. They are set up to get vacation travellers from Manchester, NH, to Miami and that leaves the local business communities in the dust.”

To illustrate the power of direct services, one company tested the theory, creating an intra-regional hub in the Northeast. The service, with a 30-minute connect time, saved five hours or more on a single trip.

Airline "capacity discipline" means reduced services, leaving city pair gaps

A former airline executive concurred. “Capacity discipline is great but it has introduced big service gaps,” he said. “The future is in addressing the gaps that have been created. Will it be new airlines with older aircraft or a new generation of airlines that are well financed and modern? I frankly bet on the latter but it will likely be a mix of the two. I think you will see back to the future with regionals but it will be good news, bad news. The good news is the barrier to entry is lower but the bad news is there are no new small aircraft. They will also have to overcome the power of frequent flyer programmes.”

Changes to those programmes – basing rewards on money spent not miles travelled – have thrown their value into question, however, especially for small-business travellers. It then becomes a matter of passengers deciding whether or not frequent flyer rewards are worth spending two-to-three times longer travelling through a hub to get to their destination. Or, will they change their habits and just get to where they want to go where a direct service is offered? If the fares are competitive with a hub, then such services could make a big difference as the commercial aviation hassle factor rises.

De-hubbing creates just such an opportunity. According to OAG, the number of destinations at Cincinnati dropped from 123 in 2007 to 55 in 2014. Similarly, Memphis destinations dropped from 87 to 34 while Cleveland declined from 82 destinations to 47.

Cincinnati Connectivity Aug-2007

By 2014 this network had drastically declined.

Cincinnati Connectivity Aug-2014

In Cleveland, a similar impact has been felt.

Cleveland Connectivity Aug-2007

Cleveland Connectivity Aug-2014

Right-sizing aircraft to fit regional routes can profit from higher yielding business travellers

“Everyone may be happy to have Southwest come in to a downsized hub but economic development and airport officials will tell you they’d rather have 93 nonstop destinations and let people grouse about fares,” said a former regional president. “These new carriers could be the fly in the ointment because they solve the problem of having the right size aircraft for each market. That is a recipe for success because you are carrying high-yield business travellers and getting them to where they actually want to go.”

He also pointed to the efficiency of next generation regional aircraft. “They will have the same aircraft seat costs as a narrow body if manufacturers of the MRJ and the E-Jet achieve what the marketing materials promise,” he said.

“There will be an opportunity for smaller carriers flying aircraft with seat mile costs in line with the narrowbody jet. What would be interesting is the development of a clean-sheet carrier with no legacy costs for labour or aging fleets. You could build a new carrier for much less than contracting with an existing carrier. They could order 50 aircraft and pay crews better than scale.”

That is virtually what Air Canada did in placing its Q400s and 15 E-175s with newcomer Sky Regional in response to the 12.5% mark up Jazz Airlines charged for controllable costs under its CPA with Air Canada.

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Silver Airways has created a hybrid model

Silver Airways has already created a model that combines point-to-point service with connections to eight domestic and international carriers using the non-standard pro-rate that was so successful before CPAs became the norm. Half of its traffic is local and half connects.

“Being independent is critical because we say where and when we fly but we also have tight relationships that can provide us feed from out of state and for those who need to go longer distances,” CEO Sami Teittinen explained.

“It is more important to have a strong presence in markets you serve and having enough schedule flexibility for business travellers to go from point A to point B. We are heavily focused on Florida and the Bahamas and point-to-point service. We have grown more than 70% in our Florida services from this time last year and today we contribute more than 50% of all intra-Florida flights, so the market is definitely responding. There are no easy connections within the state of Florida and that means passengers have to go to mainline hubs out of the state and change planes. We don’t charge a premium for point to point. We want to be competitive and price head-to-head with the mainline service over a hub.”

Silver Airways network, Apr-2015

“Mainlines are always going to need feed but, for us, it became a question of how long they would be willing to foot the bill for every regional airline to supply that feed,” explained Teittinen. “That is a question that faces every regional airline.”

Meanwhile the majors are cutting back on routes – and on partners

Further mainline cutbacks also worry InterVISTAS Executive Vice President Consultant Bill Swelbar. “The question is how much redundant flying will there be once consolidation is complete,” he told CAPA. “Then the question becomes how much small-market flying mainlines will want in the future. The pilot supply issue compounds these questions. Not only will network appetites for small market flying play into the ultimate size and shape of the regional industry, pilot shortages may make the decisions for them on how much small-market flying is feasible.

“If the majors do not want to deploy their regionals to do it, small airframes can certainly be found at very low capital costs. Pro rate and at-risk flying opportunities will certainly present themselves and communities will be more willing to open their checkbooks to help mitigate the risk. Nature abhors a vacuum so there will be an answer to some vacated markets but probably not for all,” he concludes.

Mainline carriers are cutting back on the number of their regional partners. The answer, said Mr Teittinen, is for an airline to declare independence by building commercial capabilities including reservations, revenue and network management, contracting its own airport facilities and having its own handlers, while developing strong partnerships with mainline airlines.

That is fine for smaller, nimble carriers, but larger regionals are so focused on restructuring to cope with new CPA agreements it is unlikely they have the bandwidth to reorganise as an independent carrier at the same time. Indeed, one airline CEO, when asked about the prospects for a new point-to-point carrier, said flatly he had no idea since he was so focused on feeding his partners.

Communities need connections – and some are prepared to pay

Mr Swelbar agrees. “I need more than fingers and toes to count the number of smaller airports that are deeply concerned about their future as a dot on the airline network grid,” he told CAPA. “Many of these communities have strong underlying economics that suggest they are safe. But as the industry evolves, that is not necessarily the case. The real question is whether the network carriers will actually need all of the feed from their regional partners to fill those mainline tubes as they serve only bigger and bigger markets.”

Communities are receptive to a regeneration of the commuter industry because they are anxious to maintain or regain their place on the aviation map or counter the fact their higher fares are driving passengers to hubs. Tucson, for instance, offered Alaska Airlines marketing dollars and waived airport fees in order to gain non-stop service to Portland, OR.

Even hubs are developing programmes to increase their connections to smaller communities. The Port of Seattle recently enhanced its seven-year-old Small Community Air Service Incentive Program encouraging new commercial air service to small communities in Washington, Oregon and Idaho after it failed to attract a single carrier.

Service from smaller Washington airports dropped from 42,000 annual scheduled departures to 11 airports in 2000 to less than 15,000 scheduled departures to seven airports in 2015. Other airports have had similar losses.

“Smaller airports nationwide have faced challenges attracting air service due to fundamental shifts in airline economics over the past two decades,” said the Port in its announcement. “We recognize the difficulties faced by small Pacific Northwest communities in attracting viable air service. This incentive could bring this closer to reality for these communities.”

The programme now provides full waivers of landing, gate/lobby and ticket counter fees as well as joint promotional support designed to assist the establishment of new services in the first two years. The port estimates the annual benefits to airlines could reach hundreds of thousands of dollars, depending on the level of service - although regional operators wonder what the costs will be after incentives expire.

SeaPort Airlines Executive Vice President Tim Sieber said airport costs remain a huge barrier for small regionals. “At the end of the day our biggest challenge is the cost of putting a nine-seat aircraft into an airport terminal,” he told CAPA. “Regionals have not had a seat at the airport table to discuss our needs for decades. We really struggle with airport costs and give credit to those airports like San Diego, Portland (OR) and Memphis that have responded to our concerns. When you look at USD250 a square foot and USD30,000 a month for a gate, it is a non starter. We need to come up with an economic model on a per-seat basis for a common-use gate, which considers short versus long-haul markets. The percentage of the fare that is consumed by airport costs is significantly higher for a nine-seat aircraft than it is for a larger jet. Airports should consider the needs of small airplane operators and the cost of operating small aircraft at these airports.”

Mr Sieber mentioned one further challenge. TSA will not deploy inspectors at airports with less than 30 seat aircraft. That challenges full interline connectivity if passengers can’t connect into sterile concourses. “For this new regional model to prosper,” he says, “TSA has got to be part of the equation. Right now the current policy puts them in a position of deciding economic winners and losers.”

Mr Swelbar sees public-private partnerships as the answer. “Communities could mitigate risks,” he explained. “This is a stark departure of where we were 10 years ago, but today community subsidies and revenue guarantees are much more a part of the air service vernacular. That reverses the roles of the regional operator from being solely a contract carrier to one that finds the most lucrative routes that the large carriers and communities see value in maintaining. I believe a relationship with one or more network carriers will be critical to the success of any widespread acceptance of this model by potential operators – at least with aircraft that have 37 seats or more.”

Regulatory burdens are stifling innovation in aircraft and new business models

“Right now we have a model based on the rates of profit allowed by mainline carriers that are completely inadequate for growth,” said an airline veteran. “But we don’t need to have that. Could small regionals still make it without CPAs? I think we could if we had a new, modern Part 121 aircraft with ease of maintenance and reasonable financing or we had a regulatory easement on the present nine-seat Part 135 cap I’d go independent tomorrow.

“When we could do what we wanted to do,” he recalled, “there was a lot of competition and most of us made money despite the fact, in the northeast alone, there were at least seven carriers. Connect rates were very low because most of our service was off hub. We could make money with a 40-45% load factor. If we went back into some of these markets today, the load factor would probably be 60%. Our expenses would be higher but the competition is gone and the traveller who wants to go from White Plains to Rochester is still out there.”

But sourcing new small aircraft is not easy

Inexpensive, old-generation turboprops can be had to develop new services but that is not what the industry wants. There are no new aircraft on the horizon and no one is interested in creating any. Cape Air launched a strategic initiative five years ago to find a replacement for its Cessna 402s and Senior Vice President Fleet Planning and Technical Operations Jim Goddard spent nearly two years on the road talking to manufacturers.

Italian-based Tecnam is developing a new aircraft – the twin P2012 Traveler – according to its website and Cape Air is closely monitoring its progress. Mr Goddard also referred to last year’s acquisition of the Reims Cessna F406 Caravan II by AVIC subsidiary Continental Motors, which partnered with ASI Innovation to purchase rights to the Reims aircraft after Reims Aviation went out of business.

The twin-turboprop has a 14-passenger capacity and future customers could choose between the PT-6 and the Continental Motors’ line up of reciprocating diesel engine technology. Cape Air is not interested in a turbine aircraft, he said, but it is interested in something that could take the next generation fuels when lead is finally eliminated. It is also interested in an aircraft that would have a choice of engine types, which would broaden the market because it would be flexible enough for more small-aircraft markets.

General aviation manufacturers have looked at the sector and rejected it. One has considered a seven-seat, single-engine aircraft as well as a twin, 9 to 11-seat aircraft. Mr Goddard was told total development/certification costs are estimated at $100 million to $325 million, too costly to recoup research and development costs.

Of the 651 propeller-driven aircraft in the U.S. airline fleet, 508 are below 50 seats. In order to achieve the reliability required of Cape Air – 150,000 flights annually with a 99%+ reliability – airlines have created costly manufacturing facilities to rebuild their aircraft to ensure their integrity and safety.

Embraer, Bombardier and engine manufacturers GE and Pratt & Whitney are not interested. Understandably, they prefer to remain with larger jets, turboprops and power plants because that’s where the money is. Only 16 of the top 50 regionals carry 97.2% of passengers. That still leaves smaller regionals without a new aircraft and the inability to tap a growing opportunity.

The crisis in regional connectivity is likely to prompt Congressional action

“Only when vacated markets reach a critical mass will legislators and regulators take note that the nation’s route map architecture is forever altered,” Mr Swelbar predicted. “At risk are millions, if not billions, of dollars in economic impact on those communities that rely on regionals to support their economies.”

Mr Goddard agrees: “If communities want this type of service, they need to work with politicians. Yes, it is challenging but we think it is doable.”

Many in the regional industry call regulatory initiatives since the 1990s ill advised including the single level of safety, to which can be attributed the first wholesale loss of air service.

“You can’t fight these new regulations because of the emotion surrounding them,” said one regional president. “The Colgan crash prompted the requirement for a pilot to have 1,500 hours, even though the experience level in that aircraft wasn’t the issue in the crash. The resulting rule was overkill. The fact is, I could hire a guy tomorrow with 1,501 hours but he might not be the best candidate because he’d built that time towing banners over Miami Beach and has no experience flying in the north. At the same time, I can’t hire an F-18 pilot with 700 hours. The result is that we are short of pilots and there is a bunch of qualified people out there who became suddenly unemployable because of this rule.”

The industry is seeking relief in the form of more training credit for highly structured college training programmes. “We also need government help in the form of student pilot loan guarantees or grants in addition to relief from the nine-seat cap on Part 135,” he added. “Politicians have been told that communities are losing service but they don’t seem to appreciate the real crisis will come when the present pilot shortage skyrockets from the wave of mandatory age-65 retirements in the next few years. When that rolls across the country lights will go out at airports across the country. Congress will take notice and perhaps accept the solutions the industry has in mind that would retain the safety objectives but offer the prospect of restoring small community air service.

“We are now a quarter of the way into that age-65 retirement wave and we are already seeing a massive flow of pilots going from regional airlines to the majors,” he continued. “There simply aren’t enough pilots in the regionals to satisfy the expected demand. With the regional sector supplying exclusive service to two-thirds of the nation’s airports, that will be a crisis of major proportions. It’s been said, mostly by the unions, that the majors can’t afford to vacuum all the pilots out regionals because they’ll lose feed, so they will have to throw money at the problem. I’m not sure that’s true. The majors could simply focus on their long-haul flying until the shortage resolves itself, in which case the problem will fall on the regional carriers. The government will react but not right away and in the meantime there will be a huge loss of air service.”

A deep hole, but it's time to stop digging and think the way out

In aggregate the problems facing regional airline services are near-insurmountable. Or, more to the point, finding solutions with so many varied factors to address, is such a massive challenge that only a substantial redirection from the top down will effect the necessary change.

Meanwhile, regional economies and business travellers are the worse for the mess. There will be a tipping point at some time, but unless there is a wide recognition of the problems, that time could be a long way off.

The answer, it seems, is to chip away from the bottom up: finding a new way of thinking for regional air service. Regional executives see what can be done - given regulatory space - and airports know there is a problem. There is significant mutual upside if they can synchronise. But one essential ingredient is intelligent regulatory intervention.

That the upside is there seems obvious. But there is also strong potential for things to get worse as the pilot situation matures. It is important not to delay till the situation deteriorates beyond redemption.

Part 3 of this Report will address innovative new business models from the business aviation community - and their potential roles as the regional airlines of tomorrow.

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