With its decision to sever its code-share agreement with United Airlines [OTC BB: UALAQ.OB] and remake itself as a low-fare airline, Atlantic Coast Airlines [Nasdaq: ACAI] becomes the first regional carrier to attempt the risky maneuver. ACA's stock price plummeted on the news.

Regional airlines have lost code-share contracts in the past. But never has one tried to rework its core business plan in such a fundamental way as a result of that loss.

"I am aware of other carriers discussing this concept. I am not aware of any other regional that has put plans and programs into place to the extent that Atlantic Coast has to be ready to make this move," Deborah McElroy, president of the Regional Airline Association, told CRAN.

Kerry B. Skeen, ACA's chairman and chief executive, said the decision -- two years in the making -- to operate independently after a 14-year partnership with United was the more palatable of two risks - signing a restrictive new code-share with a bankrupt major carrier or venturing out on its own. ACA and United had failed to reach agreement on a new code-sharing agreement after months of negotiations (CRAN, July 21, p. 1).

When asked if the decision to go independent was a move by ACA to strengthen its negotiating position in its talks with United, Skeen said, "It is not our intention to have a deal with United ... This is not a negotiation ploy." Later, he added that if United wanted to work out a new code-share agreement with ACA, "Our door is always open."

While United said it was "surprised" by ACA's announcement, it also left open the possibility of signing a new code-share with ACA. If none is signed, United said it has a contingency plan, but did not elaborate on what it is.

In a not-so-subtle warning shot across ACA's bow, United in July signed new code-share partners Mesa Air Group [Nasdaq: MESA] and Trans States Airlines to operate as United Express carriers. The Trans States deal was especially provocative for ACA, because the deal calls for Trans States to operate out of Washington Dulles International Airport, where ACA is based and has provided exclusive United Express service for years.

ACA plans to continue to operate under the terms of its existing contract with United that runs through the end of this year. Its United Express business accounts for 85 percent of its contract flying revenue, while its service as a Delta Connection carrier accounts for the final 15 percent. ACA said the decision will not affect its code-share with Delta.

Flying as an independent carrier also has risks, but ACA is not a new start-up. It has been in business longer than most other low-fare carriers it hopes to one day compete with: AirTran [NYSE: AAI], JetBlue [Nasdaq: JBLU] and Frontier [Nasdaq: FRNT], Skeen said, though not as long as Southwest [NYSE: LUV].

Right out of the blocks, ACA believes it will become the dominant carrier in the Washington region with 275 departures per day with its 85 regional jets (RJs) now in service. ACA has firm orders for two more Bombardier CRJ-200s, scheduled for delivery by year's end. An option for 34 more CRJs likely will not be exercised, because of the company's plans to pursue larger narrowbody jets.

ACA also is unique among the regional carriers in that it controls 46 gates and aircraft slots at Dulles terminals A and T. The T terminal gates are able to handle some narrowbody aircraft.

ACA anticipates that its daily departures from Dulles will grow to more than 325 with the addition of 18-20 larger narrowbody aircraft. ACA has contracted with Skyworks Capital to help it acquire new aircraft from Airbus [Paris: EAD.PA] or Boeing [NYSE: BA] to service routes of 1,000 miles and more. The company's current fleet of RJs would continue to serve the sub-1,000-mile markets.

By comparison, United has 67 flights per day out of Dulles, while US Airways [OTC BB: USALA.OB] has 183 daily departures at Washington National Airport and Southwest has 156 daily departures at Baltimore/Washington International Airport (BWI).

One of the main challenges facing ACA will be creating a new brand. ACA has relied on United for its marketing, promotion, sales, planning and scheduling for years, and may be looking at a name change and other marketing moves to build the new brand.

In a July 28 conference call with financial analysts, Skeen said that ACA's advantage in the number of departures in the Washington region will help in that regard. "We think that will be a huge attraction to developing our brand in very rapid course," he said.

George Hamlin, senior vice president of Global Aviation Associates, a Washington, D.C.-based commercial aviation consulting firm, said Skeen found himself between a rock and a hard place. "His assessment that in a world where regional services are mostly, if not all, fee-for-departure, and the number of major carriers decreases, that it's in essence like musical chairs," he told CRAN.

"There are fewer and fewer spots and, in effect, the majors can whipsaw the regionals -- playing them one off against the other. I think what [Skeen's] saying is ... he doesn't want to be there, and so he's thinking about doing something different entirely. That's logically consistent, and that makes sense."

Skeen said ACA started closely studying its future business plan just after United filed for Chapter 11 bankruptcy in December 2002. For a long time, shareholders and observers thought that signing a new code-share agreement with United was the "holy grail," Skeen said. "At the end of the day we didn't feel that."

ACA's research focused on all the unknowns over the life of the proposed 11-year code-sharing agreement with United.

Skeen pointed to United's history of friction with various labor groups, which could challenge the long-term viability of the agreement. Many airlines that exit Chapter 11 bankruptcy proceedings eventually go bankrupt again, he added.

Finally, the proposed agreement would make it very easy for United to unilaterally consolidate its operations over the life of the agreement.

"We don't see consolidation as a good thing in terms of Express carriers," Skeen said.

Why ACA Thinks It Will Succeed

One of the main reasons ACA believes its transition to a low fare-carrier will succeed is that it controls 46 gates and aircraft parking positions at Dulles. ACA dominates the airport's A terminal, which was built for the carrier in 1999, and some of the gates it controls at Terminal T are able to handle larger narrowbody aircraft. ACA also has an established infrastructure at Dulles, where most of its 4,800 employees are based, including the maintenance division.

Following are other reasons ACA is confident it will succeed as a low-fare carrier:

Highest Frequency of the Competition -- ACA would have the most frequent flights of any of the area's low-fare carriers. With its 87 RJs (two are scheduled for delivery later this year), ACA will start its new venture with 275 departures per day, far above the other low-fare carriers operating out of Dulles -- AirTran and JetBlue, each of which have a fraction of the flights out of Dulles. Skeen predicted that Dulles will not attract another low-fare carrier, due to ACA's formidable advantage in numbers.

Low-Fare Strategy -- ACA hopes to exploit its fleet of RJs by flying to smaller markets such as Rochester, N.Y., Charleston, S.C., and Savannah, Ga., where Southwest, JetBlue and AirTran, which operate larger planes, do not. ACA hopes to fill a niche and make money in markets where other airlines cannot compete because of their larger jets, Skeen said.

United probably would bring onboard another United Express carrier to replace ACA, but fares likely would not be competitive with ACA's low-fare initiative. United's operations at Dulles are either from major U.S. markets feeding into Dulles or are transatlantic European flights. United does not target local, non-connecting traffic.

ACA hopes to offer fares that are 30 percent to 40 percent below the current advance purchase fares in similar markets, and about 60 percent to 70 percent below walk-up fares. For example, United's one-way fare from Dulles to Charleston, S.C., is about $483 whereas ACA would charge less than $150.

"These markets will not be attractive to carriers with larger jets because of the differences in cost," Skeen said in a conference call with investors.

In general, ACA's fares would be $15-$20 higher than those of Southwest, Skeen predicted. But for that difference, travelers from Northern Virginia would prefer to depart from Dulles rather than make the hour to three-hour drive -- depending on traffic -- to Baltimore, he said. Furthermore, ACA would offer higher frequency with seven to eight departures per day in each market, Skeen said.

Dulles is the 25^th largest air travel market in the country with about 13 million local (non-connecting) passengers per year. If all three of the Washington, D.C.- area airports - Dulles, National and BWI -- are factored into the equation, the area becomes the third largest air travel market in the nation, with 42 million passengers per year, Skeen said.

Moreover, Dulles does not have any significant low-fare service. JetBlue and AirTran serve a few larger markets out of Dulles, but about half of the markets flying into Dulles have no low-fare service to Dulles or anywhere else, Skeen said. Also, about three-quarters of ACA's connecting markets into Dulles do not have low-fare service. Recent surveys indicate that about one-quarter of the traffic at BWI -- where Southwest is the leading carrier -- originates from Northern Virginia, home of Dulles and ACA.

Cost Control -- One of the biggest advantages ACA sees is that it will be controlling all its own costs. Already ACA predicts daily aircraft utilization rates to rise by two hours, from about nine hours per day to about 11 hours per day, which would reduce unit costs, Skeen said.

ACA's cost per available seat mile (ASM) in its RJ operation is anticipated to be around 15 to 16 cents, whereas United's unit costs with its United Express operation are estimated to be about 20 cents. ACA's unit costs are considerably higher than that of other low-fare airlines, but ACA's operations are expected to have much shorter stage lengths and the airline will be operating mostly RJs where seat costs are higher due to the smaller size of the aircraft.

ACA plans to use its RJ fleet in low-density markets where traditional low-fare airlines operating narrowbody aircraft generally cannot compete.

Most of ACA's bookings would be performed by customers through the Internet, which would save the company from having to hire and train an extensive reservations department. ACA plans to have a small direct reservation system, but it will largely outsource the business to the Open Skiesreservation system, also used by JetBlue, AirTran and Ryanair [Nasdaq: RYAAY].

Financing Capability -- ACA appears to have a strong financial position. It has the infrastructure in place to support revenue of more than $757 million and has cash of more than $200 million, according to financial analysis firm of Raymond James Associates. Moreover, its cash position is likely to build in the near term because United -- for now -- is fully honoring ACA's contract and will continue to do so until the contract ends, at which time ACA plans to start its low-fare operation.

"Consequently, we do not think ACA will have any problem financing the 18-20 narrowbody aircraft," Raymond James said in an analysis of the events. "Also, it is obviously a buyer's market with regard to narrowbody aircraft type given the large number of these aircraft currently in the desert."

A spokeswoman for Bombardier Aerospace, Gail Carle, said her company expects ACA to exercise its option to purchase 34 more CRJ-200s, but she cautioned that the two companies have not spoken since ACA made its announcement.

"We have not had conversations on how they will take delivery," Carle told CRAN. "We have to talk to them if they're putting things on hold."

ACA's current contract with United goes through 2010. But ACA can fly narrowbody aircraft and do anything on its own under its own code. ACA will get a fixed date on narrowbody deliveries, and start up its low-fare operation with these aircraft no matter what United does with the current contract, the analysis said. "Since United must pay ACA under its current contract until it rejects the contract, ACA will be doing a lot of start-up activities with United's money," the analysis said. "ACA already had this option in mind, which may be one of the reasons it took a hard line with United."

ACA's new business strategy will need the cooperation of its employees, especially its three unionized groups, the flight attendants, pilots and mechanics, Skeen said.

ACA does not plan any layoffs, or employee pay cuts, to reduce costs. Instead, Skeen said, the airline plans to operate more flights, which would make better use of its aircraft and reduce costs, he said. Southwest follows a similar strategy.

Why ACA Decided To Split With United

Contrary to widely published reports, the contract dispute between United Airlinesand ACA was more about the long-term implications of specific provisions of the contract than it was about short-term financial questions, said Skeen. ACA felt the contract proposal unfairly favored United, and exposed ACA to too much future risk.

Following are the reasons ACA gave for severing its relationship with United:

• Under the proposed 11-year contract, United would have had the option in 2012 to begin phasing out a certain percentage of ACA's aircraft. This would have been a risky proposition because ACA and other United Express carriers likely will face higher costs in 11 years, and United would be able to replace them with lower-cost airlines, Skeen said. Moreover, ACA could be locked into a long-term lease, then learn that United was phasing out the fleet, he said.
• The proposed contract contained minimum to no-growth in the RJ fleet -- not enough to replace the turboprops ACA is currently in the process of retiring, Skeen said.
• The contract did not contain an annual review mechanism to give ACA the ability to reset its rates to reflect possible cost increases. Rate increases would have been based on the Consumer Price Index, which is not steady. Company managers forecast that this provision alone would likely have lowered the company's profit margin year-to-year. With the likelihood that the airline will face unanticipated costs in future years, "that was a huge risk to take on," Skeen said. Language in the contract says United would consider covering additional costs but would not be required to do so.
• The contract proposal also included a "force majeure" clause, which would enable United to take actions that would effectively reduce ACA's profit margin in emergency situations, such as a labor strike, said Richard Surratt, ACA's executive vice president and chief financial officer.
• United would be able to change incentive targets and performance standards at will, which it could use to cut ACA's profit margin. "United, in the new contract, has rights at their discretion to raise the bar and unilaterally change your margins by changing the performance standards," Skeen said.
• The contract would allow United to "force us to fire over 20 percent of our workforce," which translates into roughly 1,500 employees, Surratt said. United then could replace them with lower-cost alternatives brought in by United. This would reduce ACA's cost base and, in turn, cut its earnings because ACA's United Express revenue is derived from fixed-fee flights for United based on costs plus a specified margin of profit. ACA got the feeling that this was "another leverage point [United officials] intended to use later on" to shave costs, Surratt said.
• ACA would have received a 10 percent profit margin initially as United paid mature maintenance costs over the 11 years of the contract. But because maintenance costs rise as aircraft age, the profit margin would have declined some 3 percentage points by the 11^th year, Skeen said. "You start out with economics that are substantially lower than today, and there's a high probability that economics would erode over the length of the agreement," he said.

In the end, the risks in starting up a new low-fare carrier were more favorable than the risks of being bound to a long-term agreement with a company in bankruptcy, he said.

>>Contact: Rick DeLisi, ACA, 703-650-6550; Web: http://www.atlanticcoast.com; Deborah McElroy, RAA, 202-367-1170; George Hamlin, Global Aviation Assoc., 202-457-0212<<