Bankruptcy Can Be Good For Regional/Low Fare Carriers

While the bankruptcy of US Airways and United, and the potential for bankruptcy among the remaining major U.S. airlines is "extremely frightening for investors" in those airlines, it is beneficial for regional and low-cost carriers, according to James Parker, managing director of Raymond James & Associates.

The fact that the majors are increasingly going to have to turn routes over to their regional partners is a generally accepted fact. However, at the annual Raymond James Growth Airline Conference held in New York City late last month, Parker outlined precisely how, and to what extent, the air transport industry is going to change in favor of the smaller carriers.

A key element, Parker said, was the leverage regionals will gain from the restructuring plans of major carriers going into Chapter 11 bankruptcy. This leverage comes from the fact that "the majors [will] need RJs [regional jets] even more and the regionals essentially control the supply of these aircraft. This is because the regionals have much lower operating costs and the ability to finance RJs, which bankrupt majors generally cannot do." (continued next page.)

Parker addressed the concern among investors that the majors will use Chapter 11 restructuring to become low cost carriers, able to compete against the regionals and low cost airlines such as Southwest, JetBlue and AirTran by retaining capacity while reducing costs. He said that, in his opinion, this fear is "not justified" because even if the majors are able to reduce their costs by 30 percent through reduction in labor costs, this would still only reduce their unit costs by 11 percent, which would still leave unit costs some 39 percent higher than the low cost carriers. Also, introduction of the regional jet into the fleet, begun in 1993, "enabled major airlines to improve profitability by shrinking because RJs are lower cost, embraced by the traveling public and appropriately sized to serve the majors' diminished premium priced air travel market."

US Airways' bankruptcy has already presented greater growth opportunities for the low cost and regional carriers and it is believed United will also substantially shrink its mainline fleet and rely more heavily on RJs, "which should convince investors that low fare and regional airlines actually benefit from major airline bankruptcies."

The fact that the regional carriers will eventually be able to move up into 70- and 90-seat RJs means they should be able to operate very profitably along side the low cost carriers in high density markets. However, low fare carriers will not be able to operate RJs profitably in low fare networks "because RJs generally require higher fares," Parker said. He pointed out that the fact that Southwest does not have RJs in its system "would suggest that low fares and RJs are difficult proposition." It also presents a challenge for the RJ manufacturers and regional airline management to get seat mile costs down to a level where the small jetliners are substantially profitable at fares commensurate with those of low fare airlines.

To what extent the increasing need for more RJs will lead to increased production by the world's two RJ manufacturers is, at this point, unknown. Neither Bombardier nor Embraer have announced any plans at this point for increased production rates for the coming year.

For investors, Parker cited four regionals that will likely be affected by the current economic conditions and are rated as good investment targets, although the impact of current conditions are both favorable and adverse. Both SkyWest and Atlantic Coast Airlines (ACA) are rated high for stock acquisition despite their association with United, with SkyWest rated as "outperform," and ACA rated as "strong buy." While United has not yet affirmed its current contracts with those two carriers, Parker believes that it will affirm the contracts as part of its restructuring and this "will be the catalyst ... for regional airline stocks to begin a recovery. This is because SkyWest and ACA are perceived by investors to be the leaders for this group of airlines."

There is the possibility that both of those carriers will provide concessions to United and, in turn, to Delta. These concessions could produce lower profit margins, with an estimated drop in earnings per share (EPS) of 10 percent. However, this drop in EPS will be more than offset by an increase in valuations of the carriers due to a more certain earnings path and the incremental increase in current small, 45- to 50-seat RJs as well as orders for larger, 70-seat aircraft. Parker said that in his opinion, the strong balance sheet and greater ability to finance RJs makes them the best airlines in the regional airline group to take advantage of the increased demand for RJs brought about by the current restructuring of the industry.

ExpressJet is also highly rated, with a "strong buy" rating, Parker said. This airline has "far exceeded Street expectations" since its IPO last April. Its management has run "an almost perfect airline" and its EPS are currently the most predictable among the regional airline group. The risk, however, is that 53 percent of its shares, some 34 million, are held by Continental. If that airline is confronted with a severe cash squeeze, it could be forced to sell a substantial portion of those shares, placing considerable short-term downward pressure on the share price.

Mesa Air Group is also rated as "strong buy" because it has the largest potential RJ growth, expanding some 156 percent from 68 aircraft at the end of fiscal year 2002 to 174 by the end of fiscal year 2005. Parker noted that one of the dangers was that an additional 70 RJs are to be used for Mesa's US Airways' operations based on the "Jets-for- Jobs" program, and that an agreement between the pilots and management has not yet been approved. However, Mesa Air Group chairman and CEO said that the issue has now been resolved by an agreement with the Air Lines Pilots Association (ALPA)and that it is just a matter of getting the smaller details worked out. The agreement was expected to be signed as of late last week.

The problem now, Ornstein said, is getting financing for the new aircraft. Half of the CRJs already have financing in place, and the airline is working at finding financing for the remaining half. Orders for even more RJs could be placed as required, although, again, it depends on finding financing, "which is not an easy thing," Ornstein said.

Parker said that based on the firm orders for RJs, along with the elimination of losses from the now defunct CCAir operations, Mesa's EPS should advance 96 percent to 80 cents per share this fiscal year.