As the nation's network carriers look forward to another year of deep red ink, the profitable regional airlines are expected to begin to feel some of the pain.
In the third quarter, the seven largest regional carriers had the highest operating profit margin in the industry. The regionals' collective 10.8 percent profit margin far surpassed the 3.6 percent profit margin of the seven largest low-fare airlines and the 7.6 percent loss margin reported by the network carriers.
"I think they will have a marginally tougher time next year," said Mort Beyer, of Virginia-based Morten Beyer & Associates, an aviation consulting firm. "Whether they can increase [their profits] as much as they have in the recent past, is also dubious."
The regionals have managed to make money, while their big league partners are continuing to post mounting operating losses, because of their long-term code-share contracts. But the good times won't last forever.
"The more stress the majors are in, it will translate into more stress for the regionals," said Daryl Jenkins, a visiting professor at Embry-Riddle Aeronautical University. "Everybody's fortunes are interlinked. If the majors have a cold, so will the regionals. At a certain point, they will share in the misery with everyone else."
The network carriers - and even some low-fare operators - will be in a "more precarious financial position" in 2005 than at any time since the days immediately after the 2001 terrorist attacks, according to an analysis by Fitch Ratings. The collective loss for the industry last year will top $5 billion. Furthermore, cash flow has been so poor that few airlines were able to make a significant dent in their troublingly high debt load.
While 2004 was to be the year of the turnaround, the skyrocketing price of oil imperiled nearly every airline, except Southwest Airlines [LUV]. Fuel prices did decline in the closing weeks of 2004, but the prices remain far above all estimates in the carriers' business plans. "Fitch believes that another year of fuel price pressure similar to that seen in 2004 will expose all the solvent majors - American [AMR], Delta [DAL], Northwest [NWAC] and Continental [CAL] - to extreme liquidity pressures that could force more severe restructuring actions prior to the winter of 2005-06." Even the best positioned of these carriers may face bankruptcy pressures within the year.
Other analysts are not as cataclysmic in their predictions.
"The network carriers will reduce their losses. I can't say they will be back to profitability in 2005," David Swierenga, of AeroEcon, told Regional Aviation News. "They will significantly reduce their losses. The gap between costs and airline prices was enormous in 2004. Although the carriers are making progress on the cost side of the equation, I don't think it will be enough to close the gap. I don't think they will be able to raise prices a lot to close it even further."
While 2004 was cash flow "negative," Swierenga estimates that this year will be cash flow positive. "Even though it is not profitable, [the industry] is generating positive cash flow. As long as you are in that situation, bankruptcy is less of a threat."
Too many seats chasing too few passengers was a formula for disaster last year. Instead of working to improve their margin yields, the network carriers continued to battle each other and the increasingly aggressive low-fare carriers for market share. The low-fare carriers have gained strong footing on the most traveled routes and these carriers are setting the fares.
The public has returned to flying, surpassing the milestones set in 2000.
"The load factors are incredibly high. The public is using the capacity offered," said Ron Kulmann, an airline consultant with Unisys R2A. "The network carriers have not been able to get their costs down to make money on flying full planes."
Instead of cutting capacity to balance the market, Swierenga said the network carriers might need to add capacity to soak up the demand as more people fly. While the majors don't have new aircraft coming on line this year, Swierenga noted they continue to have the ability to add "low cost capacity" by shifting more traffic to the regionals.
Low-fare rivals Southwest, JetBlue [JBLU], AirTran [AAI] and ATA [ATAHQ], all are scheduled to take delivery of new aircraft this year, enabling each of them to expand.
Beyer notes that the costs of the regional carriers have been increasing. "Some of the regional carriers will face cost increases because seniority is increasing, the aircraft is aging and maintenance of some older RJs begins to be an issue as warranties lapse. The major carriers have to be thinking of squeezing them harder to get more money out of the transaction."
Jenkins added that the network carriers are "getting much more frugal as to how they are sharing their revenue."
Bankrupt Partners
While Unisys, among others, does not see any other legacy carrier filing for bankruptcy this year, the verdict is mixed on United Airlines [UALAQ], now entering its third year in Chapter 11 protection, and US Airways [UAIRQ], now in its second bankruptcy proceeding.
Most people are ready to write off US Airways, Beyer said. "I don't. I think they will have a real tough time. They have not changed the spots on that airline. They still have big hubs in Philadelphia and Charlotte. They are still not getting enough hours out of their pilots. They are paying them less money, but they are also flying them less."
If US Airways manages to survive, Beyer predicts that the carrier will "squeeze" its regional partners to cut costs. "United has been squeezing regional partners pretty hard and I think US Airways will do the same."
There are indications that US Air-ways continues to have irreconcilable problems, Kulmann said. "The omens are not good at this point."
Since Kulmann's observation, more than 10,000 pieces of luggage at US Airways were misdirected over Christmas weekend. A large number of flight attendants and ramp workers in Philadelphia called in sick, and coupled with the Dec. 22 snowstorm, caused "an operational meltdown," in the words of CEO Bruce Lakefield.
Wall Street analyst Robert Ashcroft, of UBS Securities, believes that US Airways will come close to the brink of liquidation by mid-January. However, he believes in the end it will avoid going out of business.
In addition to its in-house regionals - PSA, Piedmont and Midatlantic - US Airways has code-share partnerships with Mesa Air Group [MESA], Republic Airways [RJET], Trans States and Colgan Airways.
"If anything happens to US Airways, there will be regionals out there feeling the hurt," Jenkins noted.
Mesa would have the largest exposure. It has 59 50-seat RJs among the 140 RJs in the US Airways Express fleet.
If US Airways liquidates, Fitch estimates that 6 percent of the domestic capacity, primarily on the East Coast - would be up for grabs. If survivors did not flood the market with new capacity to capture US Airways' passengers, Fitch said it would be a chance for the carriers - both network and low-fare - to raise fares in an effort to close the earnings gap.
JetBlue will be the wild card in a US Airways liquidation scenario that could limit the growth opportunities for the regional carriers and the other legacy airlines, Kulmann said. By the third quarter, JetBlue will begin flying the new 90-seat Embraer [ERJ] 190. A number communities, exclusively served by US Airways Express partners, will be "magnets for somebody like JetBlue to start cherry picking" the most lucrative markets, he said. The US Airways code-share partners are hampered by the higher operating costs of the 50-seat RJ - lower trip costs but higher operating costs per available seat mile (CASM).
In addition, Kulmann said the regionals are no longer small nibble operators, but are now large operators with the same "institutional mindset and cost structure" as their network partners.
"The reality is that demand is constrained by fare levels. Time and time again we have seen the expansion of traffic with much lower fares. If you are looking at a regional point that barely fills a 50-seat aircraft, it may be because of the $500 ticket to the nearest major gateway. There may be a lot of opportunity at $100 a seat," he said.
Even after more than two years in bankruptcy, United does not seem to be as close to death's door as US Airways. United's executives have been bravely predicting they will successfully exit bankruptcy this year - these are the same people who thought they would be out of Chapter 11 by July 2004.
"I think they have a lot of hurdles to overcome," Kulmann said. "They have made some headway, but they are not sliding down an easy slope."
In an effort to trim another $1.4 billion in annual labor costs, United told the court last month that it would lose $745 million in 2005 if it does not get relief from its employees and the court. The carrier estimates that its loss in 2004 will be $800 million.
While the United pilots recently agreed to an additional 15 percent pay cut as well as endorsing the termination of its pension plan, Kulmann said other unions and the U.S. Pension Benefit Guaranty Corp. (PBGC) object to the termination. The admittedly creative solution of permitting pilots to sell $550 million in notes to be shared by the 6,600 active pilots as a way to cover the difference between the generous United pension plan payments and the much-lower PBGC payments, does not benefit the 6,000 retired pilots. "The other unions think this is unfair," Kulmann added.
Jenkins interprets United's recent moves as good signs. "This is the first time in many years that they are taking restructuring seriously. They are reducing capacity and finding routes that make sense."
United this month has reduced its domestic mainline flying by 12 percent and increased its United Express flying by 23 percent.
United is reviewing proposals from a number of regional carriers to fly the 500-some daily routes now flown by Air Wisconsin. The bids to provide up to 70 RJs for the service were opened last month and are now under review. Air Wisconsin is the only regional code-share partner not flying under a post-bankruptcy contract. United sought bids for the Air Wisconsin routes to prove to its employees and the court that it is serious about further cost cutting, Ashcroft said.
While United would not say who submitted bids (RAN, Dec. 20), both the carrier and Independence Air [FLYI] has since acknowledge that Flyi did submit a bid. Flyi, which until last July operated as Atlantic Coast Airlines, had been a United Express partner for 14 years before scrapping the relationship over new contract terms.
Independence Air
Flyi is the one regional carrier that is teetering on the brink of bankruptcy because its new carrier, Independence Air, has not performed as well as had been predicted in its start-up business plan.
The Virginia-based carrier con- tinues to fly its 83 Bombardier [BBD] CRJ 200s with a 52 percent load factor. Ashcroft estimates that the airline that made $83 million in 2003 will post an operating loss of $194 million when it closes the books on 2004. He estimates it will lose another $136 million this year.
"Independence Air is definitely proving that regionals can't stand on their own," Beyer told Regional Aviation News. "The operating costs per seat mile for the regional jets are just too high. Unless the big guy absorbs part of it, you can't operate an RJ in a competitive market against a bigger jet."
Kulmann is not so quick as to dismiss the Independence Air business plan. "I don't know if it is a good or bad model. One is hard-pressed to know if the model is inherently flawed or if the circumstances under which it is operating are working against it right now. [Independence is] up against people who are on death row [US Airways and United], who are flying regardless of the price. If US Airways were not there, they will stand a much better chance. The demand is there."
Independence can save itself, Beyer said, by restructuring its RJ routes. "They need to reduce their flight frequencies and go to line-haul flying."
Ashcroft said that Independence's "one realistic chance of success as a low-cost carrier is if US Airways collapses - or its collapse is seen as imminent." Until the fate of US Airways becomes clear by mid-month, Ashcroft said Independence will remain committed to its current business plan and it will continue to have problems wringing concessions from its lessors.
Should US Airways stay a float, Ashcroft said Independence will need to seek alternatives: its own Chapter 11 filing, selling the company or quickly shifting back to its former role as a traditional regional. If the Flyi board fails to act by May, Ashcroft predicts a shareholder revolt with the election of a new board. Since October, Par Investment Partners, of Boston, has purchased 8.5 percent of the Flyi stock.
Ashcroft does not rule out Mesa coming in after a Chapter 11 filing and buying its assets. However, a number of contingencies must be worked out, including the termination of the Airbus 319 obligations and other contractual legacies of Independence Air, a contract to fly its RJs for a major carrier and the willingness of the Flyi pilots to scrap the existing contract.
"If US Airways collapses, we think Mesa would lose more than what it would gain from adding Flyi to its empire," Ashcroft said.
Mesa in late 2003 staged an unsuccessful hostile takeover of what was then Atlantic Coast Airlines. Mesa, at the time, was seeking the 83 RJs to increase its flying with United.
The fate of two other regional carriers - Comair and Atlantic Southeast Airlines (ASA) - is dependent upon the financial health of its parent, Delta Air Lines. The carrier narrowly avoided its own bankruptcy filing last fall when it struck a deal with the pilots that cut nearly $1 billion in annual operating costs. Delta also refinanced some of its debt while obtaining new equity. It still faces about $20 billion in debt obligations.
Delta's Regionals
"The company will have about 12 months to address its long-term needs, particularly its cost structure and over-leveraged balance sheet," said Ray Neidl, of Calyon Securities. "The company also has indicated that despite the strategic value of its regional airline units, it will not overlook a possible sale of those assets if necessary.
Delta would get a higher price - either in a sale or spin-off - if it channeled new growth opportunities to its regional units, Ashcroft said. Recent deals with Republic Airways [RJET] and SkyWest [SKYW] run counter to that theory, he noted.
"If we have to pick the most likely Delta subsidiary to be spun out it would be ASA," Ashcroft said, "but only after it obtains a new pilot pay agreement. We also expect Delta to deal with Comair soon. Comair's pilot contract is one of the richest in the industry -unsustainable since the basic rationale of regionals is provision of lower labor costs. Comair pilots have declined to consider concessions."
Ashcroft noted that a Chapter 11 filing would give Delta a great deal of freedom to reshape Comair.
Shifting Aircraft Demands
The 50-seat RJ has been a key element in the Comair and ASA fleets as well as with most of the other regional carriers. It is now questionable if these 50-seat RJs are still that attractive.
"The passion for the 50-seater has suddenly turned cool," said Jack Feir, a Philadelphia-based airline consultant. "I wonder if the world has as many 50-seaters as it will ever need."
"The 50-seat market is beginning to dry up," said Bill Dane, an aircraft analyst for Forecast International. "The new planes will be competing with the same models made four or five years ago. We expect to see a fair number dumped on the used market which will dampen demand."
The pair agreed the growth in 2005 would be in the 70-seat and 90-seat models.
American Airlines last year backed out of its remaining ERJ 145s it had on order. More airlines, Feir said, will be attempting to convert their 50-seat RJ orders into larger planes. These conversions are highly dependent upon how tight the original purchase contracts were drafted.
In late December, Delta expanded its code-share contract with Chautauqua Airlines, a unit of Republic Airways. Chautauqua will begin flying 70-seat Embraer 170s for Delta in addition to its 50-seat ERJ 145s. Republic is canceling its order for eight ERJ 145s and substituting an order for 16 Embraer 170s (see Briefs). As the airlines consider upgrading to larger aircraft, the scope clauses in the pilot union contracts need to be amended. "The scope clauses will go away or become much less of a factor," Dane told Regional Aviation News. "It is a hindrance to the operator. We think common sense survival instincts will take over. Both sides are going to have to give."
The selection of a larger plane will be determined by the current aircraft, with some exceptions, Feir said. Those carriers flying CRJ 200s will purchase CRJ 700s, but not the 86-seat CRJ 900 models. "I think the CRJ 900 is a stretch too far. The Embraer 190 is the way to go," he said.
JetBlue's Looming Shadow
JetBlue, as the first operator of the Embraer 190, has the potential to upset the apple cart for both the regionals and the network carriers.
"I think JetBlue is perfectly capable of inflicting pain on everybody," Jenkins said.
JetBlue is flying the new Embraer with the lowest pilot contract rate in the industry (CRAN, July 19). "We are going to be back in the same situation of apples-to-apples comparison for airplanes, but an apples-to-oranges comparison for costs," Kulmann said. "It becomes a question whether all those RJs that had been deployed to take up the slack for the majors are going to be competitive with what JetBlue has. The regionals are back in the same soup as the legacy carriers."
The networks, he said, would begin to question the size of the RJs they have the regionals flying. The 50-seat RJ may be flying too long of routes, he suggested. "The long, thin routes are not long and thin because of demand, but because of the fare levels are too high. The majors have substituted smaller aircraft to reduce their overall cost of operation even if their seat costs go up. With reasonably competitive fares, there may be a need to fly larger planes - 70 seats or even 100 seats."
>>Contacts: David Swierenga, AeroEcon, (703) 255-3315; Daryl Jenkins, Embry-Riddle, (540) 364-6913; Ron Kulmann, Unisys R2A, (510) 729-6806; Mort Beyer, Morten Beyer & Assoc., (703) 276-3200; Robert Ashcroft, UBS, (203) 719-6064; Ray Neidl, Calyon, (212) 261-4057; Bill Dane, Forecast International, (203) 426-0800; Jack Feir, Jack Feir & Assoc., (215) 345-9009; Fitch, (312) 368-3141.<<
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