Contracts between regional carriers and US majors that ushered in the regional jet era late in the last decade are due to expire from next year, with the majority terminating in 2012-19. Attempting to predict the outcome of those negotiations, or if existing partnerships will survive, is akin to looking into a foggy crystal ball. But one thing is certain - the sometimes higher margins regional carriers enjoyed over their major partners in some of those contracts will fade into history as US network carriers demand financial returns of regional carriers that more closely match their own.
A quick snapshot of annual operating margins from Morningstar Research for the largest publicly traded US regionals early in the decade show Pinnacle Airlines, Republic Airways Holdings and SkyWest posting margins of 14%, 18.5% and 12.2% in 2003. That contrasts with annual operating margins at Delta, United and US Airways for the same year of negative 5.9%, negative 9.9% and negative 3.7%. Subsequent downcyles have caused regional operating margins to fall, but only two publicly traded regional carriers, Mesa and ExpressJet, have produced periodic negative annual operating margins since 2003.
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Other drastic changes are also in store as majors seek more equilibrium with their regional partners. "The days of 70% cost being passed through [to major carriers], I think they are gone," says Pinnacle Airlines chief executive Philip Trenary. Agreements built on pass-through costs allow regionals to earn a fixed fee for departure and incentives for operational performance while large ticket expenses such as fuel and maintenance are passed through to the major carrier.
Regional carriers are now attempting to determine the amount of risk majors will put to them during the next few years as contract negotiations start. "It is safe to say there is more pressure to accept more risk," says Trenary. But he believes majors will find it difficult to cede crucial business elements such as pricing and scheduling over to their regional partners. Major carriers are reluctant to do that after taking control of those functions once pro-rata deals of the late 1990s expired.
Under pro-rate agreements, the two partners negotiate a formula that entails the regional carrier receiving a portion of ticket revenues for both the trip leg they operate and a portion operated by the major. Under deals structured like this the regional usually bears all the costs for the leg it operates.
Trenary believes other pass-through cost such as maintenance will come under scrutiny during contract renewals, and are likely to be put back to regional carriers. Additionally, the new deals are going to be much shorter in duration, in the five- to six-year timeframe, says Austin of ExpressJet, versus the previous 10- to 20-yearagreements.
The white elephant lurking in the majority of these agreements is the 50-seat regional jet, whose fall from grace is well-documented. While US majors overall are seeking to cut the number of 50-seat jets in their fleets, the "tail risk" on those aircraft is likely to spur some desperate pricing in negotiations going forward. Tail risk occurs when the duration of a lease runs longer than a current contract between a major and US regional carrier, and can create challenges for lessees.
TAIL RISK
Almost all the major US regional carriers have some form of tail risk as some leases held by those operators run through 2023 and beyond. SkyWest Airlines president Chip Childs says Skywest management paysclose attention to tail riskat SkyWest and other airlines, but also believes "our risk" is "significantly less" than that of other carriers.
Phoenix-based Mesa has the most immediate risk in adding to the 39 aircraft it has already sitting idle. One element of its agreement with United allows for the major to terminate the operationof 26 Mesa Bombardier CRJ200s next year. United has certain five year renewal rights in the agreement, and has to give Mesa 180 days notice if it intends to extend the deal.In addition United has an early termination option that becomes effective next year on 10 Bombardier Dash 8 turboprops operated by Mesa. Together, the 36 aircraft represent roughly 18% of Mesa revenues, the company tells US regulators.
The company acknowledges failing to redeploy those aircraft or crafting subleasing deals at favourable rates puts the financial condition of Mesa at risk.But company chief executive Jonathan Ornstein believes that the desperate pricing US regionals could offer in contract renegotiations will be brief as "no-one will operate the aircraft long term at a loss". Ornstein says that at some point the market will correct itself by operators subleasing aircraft, returning them through a formal Chapter 11 restructuring or consensually restructuring terms of leases.
Although 50-seat jet costs appear widely unattractive in the current marketplace, Ornstein surmises that the aircraft is "not obsolete, just expensive". Clearly, early lease rates that fell between $110,000 and $135,000 a month are unviable, says Ornstein, but "there is a price point that works, the core issues are cost of equipment and price of fuel".
All 50-seat jet operator ExpressJet is clearly not as bearish as some industry pundits about the 50-seat jet, says its vice-president Austin. While he accepts the argument some saturation in the 50-set market exists, "at the same time there are very few in the desert". Austin reasons that a "rapid movement to the right" in the ownership of 50-seat jets, by cutting lease rates by one-third for example, "goes a long way to redefine competitiveness".
Highlighting the multitude of factors in the equation, such as who owns the lift, Austin adds that generally lessors are generally prepared for a steep adjustment as they renegotiate the second wave of agreements for the aircraft. Indeed, the downcycle that began late last year could be a boon for some 50-seat operations. Pinnacle chief executive Trenary highlights that demand is an important driver in aircraft selection and markets that merely a year ago looked unattractive for the small jets now are well-suited for the those aircraft.
TESTING THE THEORY
ExpressJet witnessed that phenomenon first hand with the onset of the H1N1 virus in Mexico in late April. Its largest partner, Continental Airlines, has the most extensive Mexican network of the US majors making it highly exposed to the plummeting demand after the outbreak of the virus.
The smaller jets allowed Continental to react quickly to H1N1 as it began temporarily cutting Mexican capacity by 50% from May, says the carrier. Yet at the same time the ExpressJet block hours for April-June were not materially different as Continental began using the smaller jets strategically to support the capacity reductions. Using the Acapulco and Los Cabos markets to illustrate thepoint, Continental says that narrowbodies were replaced by a single regional jet, and as it slowly started to rebuild the markets, a second regional jet was placed on the routes to better match capacity with demand.
Key to the confidence which was shown by Continental in strategically using the 50-seat jets to ease the sudden drop in demand caused by the virus was the economics prominent in a new deal it negotiated with ExpressJet in June 2008."Continental looks at that aircraft like any other aircraft in its network," explainsthe carrier. "There is no discrimination against a large margin."
That contract supplies the first glimpse of future contracts between US regionals and their network partners. The fixed block rate hours, a major driver of regional revenues, are lower than those in the previous ExpressJet agreement with Continental, and subject to an annual adjustment tied to a consumer price index. Under the previous deal ExpressJetwas reimbursed for fuel, rent and other expenses that it recorded as revenue plus a 10% margin. Now those expenses are directly incurred by Continental.
At the time ExpressJet reached the new agreement with Continental, the US major estimated the new pact would result in annual savings of $50 million. ExpressJet recognised it needed to take steps to adjust to terms of the new agreement after estimating it required a $100 million reduction in annual operating costs to achieve profitability under the new arrangement, which included garnering $35 million in savings from its labour groups.But ExpressJet chief executive Jim Ream also recognised it made little sense for Continental to lose hundreds of millions, "and then for us to make tens of millions with an airplane that is supporting that network".
Austin from ExpressJet admits that with record fuel prices and the demand outlook present once the deal was finalised, the timing could not have been worse. But with each airline recognising fast-changing dynamics, he says the two partners struck a deal that reflects the current environment.
"It is good to be on the back side of that," he says. "The question now is what everybody else will do." Austin predicts other majors will hold the agreement Continental has with ExpressJet as a benchmark in forthcoming negotiations, and that should "put a lot of pain on other contracts out there".
Members of various regional airline executive management teams are not blind to the significant cost pressures they face in the next decade, and are scrutinising their operations to determine how to mitigate that pressure.
In June SkyWest chairman Jerry Atkin declared that the company has developed a cost reduction scheme to strengthen the competitive advantage it can offer major carriers in an effort to capture business from its rivals. "We are talking to every major carrier in the industry on additional codeshare opportunities," he says. "We are looking at contract renewals they have with our competitors."
At the same time SkyWest is looking to diversify its business through measured opportunities such as its investment in Brazilian regional carrier Trip. The carrier recently upped its investment in Trip to 16%. SkyWest Airlines president Childs says that, overall, the company prefers to grow organically, but believes it "would not be doing its job" if it did not examine opportunities both overseas and domestically. He cites the opportunity Trip provided for SkyWest to invest capital and achieve a solid return. "Latin America is not a bad place to do that," he says.
But not all overseas ventures for US regional operators have proven as fruitful. Mesa was the first regional operator to establish a foreign endeavour to use excess aircraft through its Kunpeng Airlines joint venture with Shenzhen Airlines. But roughly a year after its launch Mesa opted to sell its 49% stake in Kunpeng for less than its initial $5.8 million investment. Five CRJ200s that Mesa leased to Kunpeng were also returned.
Ornstein acknowledges the lessons Mesa learned through the Kunpeng endeavour, including obtaining a better understanding of the market and the business plan instead of relying on a partner. As the aircraft began returning to Mesa he also explained to employees the load factors on the CRJ200s were never above the mid-50s, which made it difficult for the aircraft to operate profitably.
Hawaiian inter-island carrier go!, which is a division of Mesa, recently marked its third anniversary. Ornstein believes go! is holding its own in the market, and says the smaller, five 50-seat CRJ200s that go! operates are "helpful right now in that environment". But he cautions: "That is not to intimate we are making money. As I have personally witnessed things can turn quickly."
He is referring to the $80 million Mesa was ordered to pay in damages to inter-island rival Hawaiian Airlines after a court determined that Mesa used confidential information it obtained from the Hawaiian 2005 Chapter 11 reorganisation to launch go!. Mesa was considering becoming an investor in Hawaiian. Ornstein admits the lawsuit took a "big whack" at the credibility of go!. He adds that while the product does well, "we made ourselves vulnerable with what happened".
DEFLECTING RISK
US regionals are adopting a myriad of remedies to deflect the inherent financial risk they face as majors increasingly seek to squeeze costs from all their suppliers.
Republic is making the boldest move through its purchase of Midwest Airlines and its acquisition of Frontier Airlines when it emerges from Chapter 11 restructuring in the fourth quarter. It remains to be seen if Republic can straddle meeting the needs of its network partners while managing two well-established independent brands.
Raymond James analysts forecast operating losses at Midwest for the second half of 2009 and 2010 as AirTran Airways and Southwest Airlines step up competitive capacity in Midwest markets from its Milwaukee base. But they also predict $20 million pre-tax profit from Frontier next year, which should "help offset dilution from Midwest in 2010".
All this dizzying posturing makes it difficult to predict who will survive and what role regionals will play within the next five years. Childs of SkyWest jokes that the carrier is having a hard enough time working with its partners to determine November schedules.
However, the overwhelming feeling is fewer regional names will be featured on the roster, with most executives agreeing that will occur through asset sales and carriers going out of business rather than through traditional merger and acquisition activity.
Despite the uncertain dynamics of the landscape, the shape regionals take still relies largely on how network carriers evolve over time. If major carriers truly morph into global carriers Trenary of Pinnacle could foresee regionals operating more as mainline carriers do today. But he emphasises: "That is not around the corner."
Source: Airline Business
