U.S. Regionals Seek Course Corrections

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This is a tough time for U.S. regional airlines.The major carriers, upon whom regionals rely for business, have slashed domestic capacity--first to cope with last year's skyrocketing fuel prices, and then with the long and deep recession.The legacy airlines they once thought of as partners also have become more like clients in a buyer-vendor relationship. Delta Air Lines in particular is looking for wiggle room in long-term contracts to let it cut regional services or payments to the carriers, two of which--Mesa Air Group and SkyWest--are in court with Delta over contract disputes. SkyWest is also wrangling with Delta out of court on contract-based calculations for resetting of rates.From August 2008 to February 2009, U.S. regional airlines reduced their workforce by more than 6%, about 4,000 employees. Shares in Mesa Air Group, one of the largest players, are trading for pennies--literally--on the stock market and the company is in danger of being delisted. Republic Airways Holdings has felt compelled to invest in carriers to keep them from going out of business or into bankruptcy, so it can maintain or add them as clients for its jets.
The demand for 50-seat aircraft has dropped precipitously, and the future of fuel costs makes it unlikely that it will recover significantly. The fall-off in business traffic has lowered, or even eliminated, the profitability of some regional jets. And the regionals are being pressured to cut costs at a time when shrinking fleets make unit-cost reductions especially challenging.
With the use of predominantly long-term, fixed-fee contracts, the business model adopted by the regional carriers proved itself very resilient in the past 10 years, even when major carriers ran into financial trouble, says Jonathan Ornstein, Mesa Air Group's chairman and CEO. But he concedes that "the Achilles' heel of the business model was that it relied upon contracts with major carriers for their financial health, and [those contracts] had a term associated with them."So where do U.S. regional airlines go from here? Do they revamp their business models, stay on the same course until the economy improves or pick a middle ground? For now, they seem to be opting for the middle ground: Maintaining a belief in the fundamentals of their model while recognizing their business will never be quite the same.Some changes are already taking place.
Regional carriers are moving away from jets with 50 or fewer seats. Republic Airways Holdings is leading the way--as of the end of March, aircraft of 70 seats or more accounted for 130 of its 221 aircraft. At the same time last year, Republic had 118 aircraft with 36-50 seats and 108 with 70 or more.And regionals are operating in some bigger markets now, not just small-city-to-big-hub feeder routes. The number of flights linking large hub airports has increased in total and as a percentage of all regional airline operations, according to the Jacobs Consultancy. Global airlines have shifted more of their own aircraft to international routes with no low-cost-carrier competition and "outsourced" more domestic flying to the regionals. Industry analyst Michael Boyd does not even like to call them "regionals" anymore--or even "airlines."They're not in the airline business; they're in the leasing business," Boyd says. "It's a leasing model. [And] the need of the major carriers to lease in certain types of airplanes will evolve." It is not likely that many, if any, regional carriers would go along with that terminology. But they do acknowledge that the business is changing.
This need to *****retool and rethink is a far cry from just a few years ago, when demand for regional services was booming. In the midst of a recession and in the aftermath of the Sept. 11 terrorist attacks and their added impact on traffic, the major carriers turned to regionals to fill their domestic flights, and they grew rapidly.In 2000-05, by the FAA's count, the U.S. regional airline fleet grew nearly 25%, to 2,830 from 2,274 aircraft."There was a time when the majors were fighting over regional jet capacity," Ornstein recalls.But 2005 was the peak, and the bottom dropped out last year. In April, according to the Regional Airline Assn. (RAA), the U.S. regional fleet stood at 2,324 aircraft--almost back to where it was at the beginning of the decade.Average aircraft size has increased, but after average annual growth in traffic topping 15% in 2000-07, traffic fell slightly in 2008, although that understates the drop. In the fourth quarter of last year, according to RAA numbers, traffic declined 8.2% year-over-year on a 9% cut in capacity.Nonetheless, regional airlines are still big service providers. Regional jets accounted for 15% of domestic capacity in 2008 and 36% of domestic flights, according to Jacobs Consultancy figures. The RAA says regional airlines serve 631 U.S. airports, and provide the only scheduled service at 486 of them.But the shrinking pie for regional services--and the drop in demand for 50-seat aircraft in particular--has sharpened competition and left regionals more vulnerable to major airline demands.Some of this will play out years from now, as existing long-term contracts between major and regional airlines expire. Still, regional carriers also have to make changes now.

 

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At the moment, analysts see Republic and SkyWest as the strongest regional carriers. This is partly due to their profitability and strong cash positions, but also because Republic has increased the size of aircraft in its fleet and diversified its airline customer base, while SkyWest is operationally efficient and has many years to go on long-term contracts--its Delta deal goes to 2020. These qualities, analysts believe, are important in a market where smaller aircraft are losing their viability and regional airline clients are at risk of bankruptcy, or dissolution, or seem inclined to renegotiate or cancel contracts.Republic, perhaps as a stopgap measure, has invested in airlines to keep them viable. For example, it provided Midwest $25 million in loans last fall in exchange for a 10-year commitment that Midwest will fly 12 Republic 76-seat Embraer 170 aircraft. Last fall and early this year it also lent US Airways $35 million, which it described as money well spent on an important client to help keep it out of bankruptcy. Large creditors contributed even greater amounts to help out the airline.Last year Republic provided $30 million in debtor-in-possession (DIP) financing to help Frontier Airlines restructure in bankruptcy protection, as well. In March, it reached a new deal with Frontier for $40 million in DIP financing to effectively replace and expand the earlier agreement. Republic has even acquired a 50% stake in and taken control of Hawaiian carrier Mokulele, investing $11 million to rescue the airline that contracted for four of its 170s for inter-island service."One thing that remains constant is the need for regional airlines to remain vital to their network partners by offering creative solutions to complex challenges," a Republic official says. "The loans we have extended provide us with market rates appropriate to our partners' individual risk levels while improving their financial positions, which of course is supportive of our own interests as well."Republic and other regionals have become very focused on cutting costs. But unit costs especially are tough to control in a shrinking market. As Raymond James analyst Jim Parker points out, airlines that are not growing cannot spread their fixed costs out over a larger base. They are not hiring new employees, who would get compensated at the lower end of the pay scale, and the workers being furloughed are at the lower end as well. Typically, neither are shrinking carriers acquiring new, more fuel efficient, low-maintenance aircraft.That leaves regionals to find ways to "work better" and "be more productive," Parker says. And regionals insist they are doing just that and finding cuts elsewhere. Greater stability from the major carriers would help them right-size their workforces, they add.
Some attempts at changing the business model have failed, or remain works in progress. Mesa Air Group tried to expand overseas and make use of some of its 50-seat CRJ200s by getting involved in a regional startup in China in late 2006. It seemed like a good idea at the time, but the new carrier, Kunpeng Airlines, has not been profitable. Earlier this year Mesa agreed to sell its stake for a net of $3.6 million, taking a loss on its original $5.8-million investment.Moreover, Atlantic Coast's ill-fated conversion to Independence Air and ExpressJet's launch of a self-branded service, both of which no longer exist, probably have soured any regional airline on the notion of going that route--unless it gets desperate.Mesa is still making a go of it with Go, its Hawaiian inter-island operation, although maintaining profitability has been a struggle. And Republic Airways did receive U.S. Transportation Dept. approval in 2007 to operate as an independent carrier if it wants to, as did Republic Airways Holdings subsidiary Shuttle America this year, after telling the Transportation Dept. it wanted "the flexibility to react to new business opportunities that may arise in the future."
But those seem to be fallback positions, because Republic and Shuttle America are not indicating they plan to use that authority anytime soon. Parker, the Raymond James analyst, describes it as a fool's errand in any case, given regional jets' relatively high unit costs."Low fares and regional jets do not work," he says.That might leave regional carriers, well, pretty much where they are."I think the business model will stay effectively the same, the difference being you're going to have to have low costs and operate to [the client's] desired level of service, and it's going to be very competitive when those contracts come up," says Richard Leach, chairman of the Regional Airline Assn. and president and COO of St. Louis-based Trans States Airlines.At Raymond James, which has been closely tracking the U.S. regional airline industry since the 1990s, Parker also offers hope for a regional rebound.Parker predicts that if, or when, the big legacy airlines become profitable again, their labor groups will ask for more money. That means costs will rise, and the legacy airlines will want to outsource more flying. The majors are inclined to do that anyway, because they want to increase their international operations, for which they need a domestic feeder network."That may produce a resumption of growth in regional airlines in the future," Parker says.

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