After years of unabated growth in size and earnings, the regional sector is coming under increasing pressure and new strategies will be needed as the market changes
One of the most successful sectors of North America's aviation industry over the past decade has been regional jet services. Regional airlines such as SkyWest Airlines and Mesa Air, which serve low-density markets, have been embraced by market analysts and shareholders for their high margins and stable earnings. Their market strength has been driven by the versatility of regional jets, cost discipline and the advent of creative risk-sharing partnerships with major airlines.
The economics of these businesses, however, are poised to shift dramatically with the introduction of larger regional jets. Major airlines and their regional affiliates that do not consider the implications now may later face the consequences of inaction.Regional jets have proven to be ideal for flying on routes that are too "thin" to support narrowbody service and, as a result, regional aviation capacity has expanded rapidly. In 1997, there were fewer than 150 regional jets in North America. By 2002, the number of regional jets had grown to over 1,000, and more than 2,000 are expected to be in the air by 2006.
What sets regional carriers apart, however, has been their consistent profitably. While the majors continue to flounder in a sea of red ink due to high operating and labour costs, regionals' economics are fine-tuned for their market niche. Their costs are competitive, and their service is targeted at relatively price-insensitive business customers, producing a healthy profit.
Take as an example a typical 500m (800km) route on which a regional jet replaced a narrowbody. The 50-seat regional jet's yield (revenue per seat mile) is over 50% higher than the 126-seat narrowbody, while unit seat costs are only 9% higher. Additionally, load factors in many cases are higher on regional aircraft - in this case 69% for the 50-seater versus 57% for the narrowbody. These factors work together to raise the operating margin by 26 points for the 50-seater, illustrating why regional jets are so prevalent today.
Regionals have also benefited from the recent industry downturn, which has caused major airlines to outsource lower-density routes that they cannot operate profitably. This has been done primarily through fixed-fee or cost-plus contracts, known as capacity purchase agreements (CPAs). CPAs have the attraction of mitigating earnings risk for the regionals through pre-determined target margins, while protecting the brand and ensuring the availability of capacity for the majors.
Under CPAs, network carriers are generally responsible for commercial planning, revenue management, sales and distribution and branding and marketing. It is also customary to assume fuel and insurance risk. The contracted regional carrier handles labour, maintenance and operation of the aircraft, as well as station and ground requirements. Target operating margins range between 10% and 15% under most CPAs, and are usually repriced annually to ensure revenues and costs are in line with targets.
Strong market performance
The result of the regional aviation boom is that the market value of such carriers has grown at a compound annual rate of 22% over the past eight years, comparable to the market performance of low-cost carriers such as Southwest Airlines and JetBlue Airways. The superior growth and economics provided by CPAs have made many of these carriers the "darlings" of financial markets. Given that the current business model appears to be working so well, analysts are continuing to predict high growth in this sector, particularly for carriers that are beginning to abandon 50-seat aircraft in favour of more economical 70-seaters. Expectations of 20% to 35% earnings growth are commonplace for the leading regional airlines.
Equally, major airlines are betting on the continued good performance of regionals to help them out of their doldrums, with many in the process of signing new contracts. Regional service has become the cornerstone of several recovery plans, with the majors transferring an increasing number of routes to regionals under CPAs. On the surface, network carrier outsourcing to regionals makes sense, given that they remain uncompetitive in many markets despite restructuring efforts. Flexible work rules also enable regional pilots to fly more than their network counterparts, positioning regionals to "pick up the slack" on routes with poor operational characteristics for large aircraft.
The question is whether this gamble will pay off much longer. There are signs that the regional business model is already coming under pressure. In particular, the 50-seat regional jet is likely to provide diminishing returns, as there are few new markets left that can be served profitably. In fact, Bombardier and Embraer - the two largest manufacturers of regional jets - face a dwindling backlog for 50-seaters.
This sector also is likely to see a major struggle between regional and network carriers over strategic control. Major airlines, particularly those in bankruptcy, are putting pressure on regional partners to accept reduced margins on new contracts, together with more expense and revenue risk. They are also attempting to exert control through the allocation of 70-seat regional jet flying to captive regionals versus their wholly owned subsidiaries. Additionally, the majors would like to see operational costs reduced in the regional sector, and will continue to exert downward pressure on margins.
While all these issues may affect the regional business model to some degree, none will have the impact of what may be the industry's next "category killer" - the introduction of larger, more cost-effective 100-plus seat regional jets. The superior economics of these new jets will enable carriers to enter traditional regional markets at lower fares, stimulating demand and supplanting many of the current fleet of 50-seat jets that require higher fares to operate profitably.
That this will happen - and soon - is evidenced by the interest of low-cost operators. JetBlue announced last summer that it was buying 100 Embraer 190s (100-seaters), and has identified nearly 1,000 cities where it could introduce service. JetBlue expects to start taking delivery of the jets in 2005. Additionally, Southwest has stated that it is evaluating the aircraft's economics.
100-seat advantages
The Embraer 190 will offer a significantly better customer experience than the current fleet of 50-70 seaters (such as wider seats, more headroom/legroom and less noise), and will be able to fly longer routes. It even compares favourably with narrowbody aircraft in terms of comfort and performance. Add to this the leather seats and seatback video that JetBlue plans to install on its regional jets, and you have a radically improved customer experience to that which most regional passengers receive today.
Most importantly, the new mid-sized jets are likely to drastically alter the economics of the market. Regional carriers survive by taking only the highest-yield traffic in low-density markets. Although they have fewer seats and higher seat costs, they fly higher loads and charge significantly higher fares than network carriers. If low-cost carriers enter these markets with larger, more comfortable jets, at stimulative fares, demand for lower fares will collapse current 50-seat regional jet economics in many markets. This will cause value to migrate from operators of smaller 50-seat aircraft to operators of larger 100-seat regional jets.
To illustrate the impact, we look at our example where a Boeing 737 route was downgauged to 50-seat regional jet service. A carrier entering this market with a 100-seat regional jet would have 15% lower unit costs than the 50-seat jet. If a carrier such as JetBlue or Southwest were to start selling tickets at $87 on the 100-seater (providing a healthy operating margin), the 50-seat operator would be forced to drop its average fares from $158 to $107. This would reduce the revenues on the smaller jet to below operating costs. Meanwhile, the lower fares in the market would stimulate demand and drive higher load factors. In the end, the 100-seat Embraer 190 could achieve a seat mile yield on par with the 50-seat aircraft, with unit costs 15% lower than the 50-seater and 8% lower than a 737.
Additionally, by filling a critical "capacity gap" between small regional aircraft and the large aircraft used predominantly on major routes, larger regional jets will be able to take advantage of new growth opportunities. Demand can be better matched with capacity, frequency of operations can be increased on many city pairs, and more distant markets can be flown, given the aircraft's greater range. Ultimately, carriers that adopt 100-plus seat jets have an opportunity to shift the customer value proposition and market economics of regional jet service squarely in their favour.
Unfortunately, the very CPA agreements that proved so valuable in early regional airline relationships may hamper the ability to respond to this threat. While CPAs protect a regional airline from revenue risk, they also place them under the strategic control of the major airline with their pilot scope clauses. Major airline scope clauses typically restrict the size and number of jets that their regional partners may fly, and even restrict routes. Regional affiliates that are restricted from entering particular markets or operating particular aircraft, and major airlines that cannot economically operate in those markets or with those aircraft, may further bolster the potential for new entrant 100-seat operators.
To win in the evolving regional sector, all players will be called upon to re-examine their markets. It will also be critical to consider historical economic-shifting competition when looking at strategic response options.
Common themes
A number of responses are available to incumbent regionals and major airlines. A "one size fits all" approach will not work - each carrier will have to assess which strategies offer the best fit with its business model and resources - but there are some common themes:
Fly different aircraft - In the near term, replacing 50-seaters with 70-seaters provides an opportunity to spread costs and lower fares. Network carriers could attempt to operate 100-seat jets as part of their own major fleets, but their economics are unlikely to match those of regionals or low-cost carriers. Airlines could also fly other narrowbody aircraft (such as Boeing 717s or Airbus A318s) on routes where adequate demand stimulation might exist. AirTran Airways, for example, is using 717s to enter moderate-density regional routes. Fly aircraft differently - Carriers could evaluate the potential to operate 100-seat jets more economically through higher utilisation and a more dense seating configuration. This could potentially be achieved by allowing current lower-cost subsidiaries (for instance United's Ted or Delta's Song) to manage these operations. Engage pilots - Network carriers could engage pilots in scope clause renegotiations, with a goal of enabling regional affiliates to acquire and operate the 100-seat aircraft, or obtaining lower wage rates for these aircraft. Pilots may not be willing to make more concessions, however, as the economy rebounds. Develop the next-generation CPA - Majors could develop a new CPA which would allow them to outsource 100-seat jets to regionals, but with network pilots flying some or all of the aircraft. The impact on costs for regionals (due to increased pilot pay) would have to be assessed, as well as the impact on the regionals' relationships with their own pilots' union. Initial analysis suggests that the economics of such a CPA could work under the right agreement.It is likely to take at least two years for the full effects of the new 100-seat jets to be felt in the regional aviation market. Network and regional carriers have a valuable window of opportunity to get ahead of this issue before it begins to have an adverse effect. As a first step, carriers need to assess their current contracts to ensure the moves they make today will not hamper them in future when competing in regional markets.
Network and regional carriers together can test and segment markets to identify which are most vulnerable to encroachment, and begin working to minimise their exposure to 50-seat aircraft values. Finally, potential competitive responses need to be evaluated to determine which are most feasible for a particular carrier, and likely to provide lasting value once the regional market shakeup begins in earnest.
REPORT BY MATTHEW BENNETT AT MERCER MANAGEMENT CONSULTING IN BOSTON
| About the author Matthew Bennett is a principal in the Aviation Practice at Mercer Management Consulting, based in Boston. Michael Zea and Andrew Watterson, directors in Mercer's Aviation Practice based in New York and Dallas, also contributed to this report, as did Scott Kend, an analyst in the New York office of Mercer. |
Source: Airline Business
