Can US regionals withstand pressure from their major airline partners to cut margins and still continue to outperform their big brothers?
Regionals remain the bright spot in a US airline industry still feeling the pain of multi-billion dollar losses and sluggish growth. While the majors have taken steps towards recovery over the past year, shrinking their collective loss from $11 billion in 2002 to an estimated $7 billion in 2003, regionals are posting profit margins hovering around 10%.
But even as they continued to outshine the majors in terms of financial performance, regionals lost some of their lustre in the eyes of their industry partners this past year. Tensions centreing on costs, equipment upgrades and an increasingly unforgiving operating environment were brought to a head. "Last year was a year of transition for the regionals," says long-time industry observer James Parker of Raymond James. "Margins are still quite substantial, but they did come down."
After gladly handing over capacity to their lower-cost feeders following the events of 11 September 2001 and the subsequent drop in US air travel, majors began to take some of it back over the course of the last year, says Parker. Not only that, the majors increasingly began to disregard factors like historical relationships and ownership status when the time came to renew codeshare contracts. Instead, the focus was overwhelmingly on cost.
Margin cuts
"There has been increased pressure by majors on regionals to cut margins," says airline analyst Douglas Abbey of the Velocity Group in Washington DC. "Some have done so willingly," he says, naming Air Wisconsin, Mesa and SkyWest. Others were not so willing: "Atlantic Coast said we're going to go on our own, in the form of Independence Air."
At the same time, the looming threat from the low-fare sector grew larger over the last year, putting downward pressure on air fares and forcing major carriers to go after costs like never before. In turn, the majors pressured their regionals into concessions, such as lower margins for more regional jet flying in some cases, which in the long term stand to benefit regionals enormously, says Parker. "Regional airline growth is only enhanced by the rapid growth of low-cost airlines, which forces high-cost legacy carriers to shrink and outsource more of their flights to regional carriers which operate regional jets," he says.
According to many insiders, the most significant development in the regional sector over the past year has been the easing of scope clauses, especially as it pertains to the restructuring of major airlines US Airways and United Airlines. "These two carriers, which had both filed for bankruptcy and had substantial ATSB [Air Transportation Stabilization Board] loans, got significant relief in the 70-seat class," says Abbey. Analysts say their ability to operate larger regional jets will challenge other major carriers that do not have that flexibility.
US Airways, once saddled with one of the most restrictive scope clauses in the industry, emerged from Chapter 11 bankruptcy protection last year with one of the most generous. As a result, the Virginia-based airline placed a record-setting $4.3 billion order last May for 170 regional jets, covering 50- and 70-seaters and divided between Bombardier and Embraer, to be operated by its US Airways Express feeders. Under the jets-for-jobs programme to give work, albeit at substantially lower pay, to 1,900 furloughed mainline pilots, US Airways' agreement allows it to operate up to 465 regional jets (the carrier has options for another 380). Of the firm orders, 85 were for the 70-seat Embraer 170, making US Airways the North American launch customer, and 25 were for the seat Bombardier CRJ700 Series 705.
But the jets-for jobs settlement did not calm the labour waters for long. Just two months after placing the record regional-jet order, US Airways dropped plans to fly the CRJ705 in favour of the 70-seat CRJ700 under pressure from the Air Line Pilots Association (ALPA), which objected to the proposed flying terms for the larger CRJ variant. Protests centred on the higher take-off weight of the CRJ705, based on Bombardier's 86-seat CRJ900, which ALPA said was out of compliance with the newly agreed scope clause.
Despite the setback, US Airways remained steadfast in its belief that regional flying was its best hope for recovery in the light of increasing competition from the low-cost sector. Much of this anticipated regional jet flying would come from MidAtlantic, US Airways' planned Pittsburgh-based regional arm set up to operate the Embraer 170 under the more liberal scope clause. Hailed as critical to ailing US Airways' future by chief executive David Siegel, MidAtlantic's path to operational status was lined with difficulties.
Finally Flying
Certification setbacks with the Embraer 170 postponed the original November launch, only to be followed by labour conflicts between US Airways and MidAtlantic over pilots' pay. MidAtlantic finally launched earlier this month, operating three Embraer 170s on eight routes.
Meanwhile, bankruptcy proceedings for United Airlines parent UAL, not due to be settled until the second half of this year, gave scope relief to its regional affiliates as well. The result was a spate of new aircraft orders in the 70-seat class, including those for two new United Express regional feeders. Mesa Airlines, renewing its relationship with United six years after an acrimonious split, ordered 20 CRJ700s, along with 15 CRJ200s and 10 Bombardier Dash 8-200s. Another new United Express partner, Republic Airlines, also placed orders and options for 50 Embraer 170s to be operated from Washington Dulles and Chicago O'Hare. Long-time feeder SkyWest Airlines, the first to solidify ties with United post-bankruptcy filing, committed to 30 CRJ700s along with 26 additional CRJ200s in September.
United's and US Airways' use of the 70-seat regional jet, although a mainstay already for carriers like American Eagle, Atlantic Southeast Airlines and Comair, will help level the competitive playing field in the US industry, says Deborah McElroy, president of the Regional Airline Association (RAA). "The continued integration of 70-seat aircraft into US operation will put pressure on airlines that are not able to operate them because they lack that tool in their competitive arsenal," she says.
But it is the even larger 90- to 100-seat regional jet that is set to more drastically change the regional sector, says Parker at Raymond James. As much as the industry applauded the more liberal use of 70-seaters, most say it is the advent of 90-seat regional jet flying that will provide the next phase of growth for the industry. So far, the Bombardier CRJ900 and Embraer 190 are mostly forbidden by the scope clauses at the majors - but this is set change once JetBlue begins operating the Embraer 190 next year.
JetBlue will "force the majors to get the same aircraft" for their regional partners, says Parker. Ideal for medium- to lower-density markets, the aircraft's trip costs will be well below those of the major carriers' narrowbodies, particularly when operated by regionals or low-cost carriers like JetBlue. But there is a question about the impact of the larger regional jet on labour relations and on costs. "Who's going to operate it? My guess is the regional pilots will do it. The majors will have to negotiate something," Parker says. But Abbey at Velocity Group had a different take: "As they approach the sweet spot of the majors at 100 seats, regionals will come up against a brick wall. The larger the regional jet, the more major pilots will operate them."
Rising influence
Low-cost airlines are driving the shape of the airline industry's future, influencing both the majors and regionals over the past year, analysts say. One of the most visible effects this fast-growing sector has had is in forcing the majors to downsize their narrowbody fleets in favour of the regional jet, a trend helped by their own exorbitant cost structure and a poor economic climate.
Raymond James estimates that low-cost carriers' share of the domestic passenger market has increased from 18.5% in 2000 to 23% in 2003. This growth appears set to continue unabated with relatively large new aircraft orders being placed in the past 12 months by low-cost carriers AirTran, Frontier and JetBlue. With these growth plans came new aspirations from the low-cost sector within the regional market.
Of the three low-costers in the market for aircraft, only AirTran backed away from its regional operation in the past 12 months, ending a partnership with Air Wisconsin and opting to give more flying back to its own Boeing 717 fleet. Denver-based Frontier, however, delved into the regional sector last year, launching Frontier Jet Express, a regional arm set to fly up to nine CRJ700s. Frontier Jet Express as of February had five 70-seaters, operated by Horizon Air, flying to Boise, Idaho; Oklahoma City; Ontario, California; and Tucson, Arizona. Frontier Jet Express is also supplementing the carrier's mainline services from Albuquerque, New Mexico; Minneapolis/St. Paul, Minnesota; San Jose, California; and Austin and El Paso in Texas after Frontier ended its codeshare relationship with Mesa in December.
JetBlue's ground-breaking order for the Embraer 190 last July made waves in the regional sector, but the carrier does not plan to use the 100-seater in the traditional regional sense. Instead, JetBlue is expected to establish a substantial hub-and-spoke operation at New York Kennedy with the regional jet, bringing low fares to medium- and lower-density markets. Then there is low-cost pioneer Southwest Airlines, a steadfast all-Boeing 737 operator, which has publicly acknowledged it is considering an operation using larger regional jets. "This is an endorsement that the aircraft is credible and can do things that smaller regional jets and narrowbodies cannot," says Abbey.
Simpler strategy
Undoubtedly, the low-cost influence has the majors emulating the way they do business. US Airways' Siegel regularly speaks of the airline's strategy to adopt lower fares and a more simplified fare structure as part of its reorganisation. But the regionals are also taking note. Last year saw one regional carrier, ACA, change course dramatically by opting to transform itself into Independence Air, a low-cost airline operating from its Washington Dulles hub. The announcement followed months of court battles with United and the inability of the two partners to arrive at a satisfactory codeshare agreement.
As part of its move to an independent low-fares operator, ACA will withdraw 86 of its CRJ200s from the United Express network to operate as Independence Air and retire another 22 BAE Systems Jetstream 41s. Independence will also take delivery of 25 leased Airbus A320 family aircraft beginning in September, to operate longer routes to Florida and the US West Coast. Left without its Dulles feeder, United is filling the gap there with increased contractual flying from new partners Chautauqua Airlines, Republic and Shuttle America and existing partners Air Wisconsin, Mesa and Trans States. Delta Connection, for which ACA operated 30 Dornier 328Jet regional jets from Boston and Cincinnati, has also severed ties with the airline effective this October.
Industry observers have mixed views on the fate of Independence Air, which is set to begin operations under its own name in June. Most are taking a wait-and-see approach. "The concept is very intriguing and not something that could be replicated on a larger scale," says Abbey. "Most regionals fly for majors. But people are watching."
"Healthy but challenged" is how the RAA's McElroy describes the state of the regional industry. She says carriers that are operating regional jets are growing, "because of the utility of these aircraft and their ability to assist the majors in achieving their recovery strategy".
Costs, however, remain a key concern and attempts to rein them in over the past year put a strain on regionals and their major airline partners, many of which are still losing money. Most notably it led to the demise of the year-long partnership between ACA and United after it became apparent that ACA was not going to give in to its partner's demand of more favourable terms on a new multi-year flying contract. It was also behind the US Airways decision to merge its Piedmont Airlines and Allegheny Airlines subsidiaries. By doing so, it hopes to save as much as $300 million a year in operating costs.
"Regional carriers are partners with majors just as their aircraft suppliers are. The majors are looking for all of their partners to reduce the cost of operations. Just as equipment manufacturers were asked to reduce lease rates and employees were asked to reduce wages, we were asked to take reduced compensation," says McElroy.
Regional carriers should remember that there are choices now for the major carriers when it comes to choosing regional partners, she adds. "We saw that with the recent United flying awarded to Republic for 70-seaters. They weren't an existing partner. We also saw it with Delta awarding 70-seater flying to ASA, an owned carrier, and to Chautauqua, a non-owned carrier. Delta specifically said they looked at the cost of providing service," says McElroy.
Fuel is another growing concern on the cost side, despite the fact that regionals operating regional jets under fee-for-departure conditions are fully hedged against fuel spikes. "Our fortunes are intricately tied to the majors," says McElroy. "The huge increase in fuel prices has the potential to eliminate all the cost reductions the industry collectively has made."
Cost issues aside, the outlook for the sector remains largely positive. Regionals' share of domestic passenger volume rose by 3.5 percentage points in 2003, according to Raymond James. Regional-jet flight growth ranged between 34% and 42%, while flights by all other aircraft types have been generally down.
Market shifts
The RAA expects the sector to add 160-180 new aircraft this year. Regional jets will be pushed into longer stage lengths on flights of more than 1,100km (600nm). The low-cost segment will continue to exert its influence this year as the market shifts from the majors to low-cost carriers and regionals. "Operation of regional jets is a key factor to the industry's recovery strategy and for competing effectively with low-fare carriers," says McElroy.
Some analysts, like Parker, predict that the low-cost carriers will soon dominate the US domestic market, growing to above 45% in the next five years. As such, the role of the regionals will expand considerably as they essentially become the domestic feeder network for the majors' hub-and-spoke systems. "The regionals will primarily operate 50- to 90-seat regional jets in all density markets carrying connecting, brand-loyal and convenience-oriented premium-priced traffic," he says. "This should enable regionals to operate very profitably even alongside low-fare airlines in high-density markets."
REBECCA RAYKO / MIAMI
Source: Flight International
