Analysts Disagree On End Of RJ Revolution

In the view of industry analysts, the era of the regional jet has not run its course, despite the prognosis of a noted Wall Street analyst.

Jamie Baker, an analyst at JP Morgan, recently issued a report stating that the regional jet revolution is drawing to a close, in large part because mainline operators are likely to cut labor costs between 20 and 30 percent. He also said that regional carriers such as Atlantic Coast Airlines and SkyWest will probably experience a material reduction in profit margins as United Airlines and Delta Air Lines squeeze margin rates.

Baker said, "Whereas regional airlines entered the industry downturn trading as growth stocks, they stand to emerge as trading more like traditional airlines - thereby disappointing the typical growth investors they have attracted." Most views on the regional sector fail to incorporate declining mainline labor costs, he said.

He noted that with negotiated rate settlements between United and its two "fee for departure" partners, ACA and SkyWest, possibly several months away, he could find "no compelling reason" for aggressively buying shares in either regional carrier, despite a universally strong sentiment on Wall Street. Joe Burey, editor of Airline Financial News, a sister publication of C/R News, reported that while Baker believes regional aircraft will continue to play a significant network role, he also expects growth rates, margins and earnings multiples to further decline, possibly sharply.

The idea that regionals are immune to the cost reduction efforts of their major carrier partners has been exposed as a fallacy, Baker said. He cited United Airlines reportedly seeking as much as a $170 million annual reduction in the costs of its $1.5 billion regional program, while Delta is seeking to approximate whatever savings United ultimately achieves.

ACA and SkyWest derive 100 percent of their income from those two carriers, operating under "fee for departure" contracts. Baker said that while the carriers may be able to partially offset lower departure rates through aggressive cost cutting, operating margins are ultimately expected to compress by as much as 50 percent.

Raymond James & Assoc. has a different view of ACA and SkyWest. The company rates their stock as "outperform" and "strong buy," respectively. Both carriers are being negatively impacted by the uncertainty of United's fate; United is expected to address contracts with both regionals as early as this month. James Parker, managing director at Raymond James, said that he expects ACA's contract to be affirmed at a 10 percent profit margin, which would improve profitability from current levels but would be below historic margins of 12 to 13 percent. This would improve ACA's ability to purchase additional RJs. However, it would not resolve the question of whether those aircraft would be needed if United goes into liquidation. The chance of United going into Chapter 7 liquidation has now diminished, he said.

Rick Delisi, ACA director of public relations, told C/R News that despite the current bankruptcy of United, the regional carrier is continuing to operate under its current contract. It is presently in talks with United concerning its operations as a United Express carrier and any future equipment it might need.

Parker also expects SkyWest to finalize its agreement with Delta over the next few months, giving it an operating margin slightly under 10 percent, but that should rise closer to 10 percent in 2004-2005. He also expects United to increase the number of RJs in its United Express fleet, particularly with SkyWest.

Baker said that over the coming year or two, the forecasted reduction in mainline costs will reduce the labor cost advantages of regional carriers by as much as half, thereby diminishing the marginal appeal of regional jets currently being built.

"Since we do not believe that the smaller regional airlines are capable of maintaining the current labor arbitrage through a like reduction in their own pilots costs, lower mainline wages will likely manifest in a retardation of regional growth rates and a resurgence in the popularity of B737/A320-sized aircraft," Baker said.

However, Douglas Abbey, president of Washington, D.C.-based AvSTAT Associates, said that Baker's figures are "simply too high," a point validated by numerous sources throughout the industry. "I don't put a lot of credibility in his argument," Abbey said. "Just because the majors have potentially squeezed out 30 percent of labor [costs] does not mean they are now the favored means of operating RJs. By no means is the extension of that line of thinking plausible anytime soon, especially given the [major's] high indirect costs."

Baker noted that ACA and SkyWest do not appear to have alternative partners waiting in the wings should their contracts with United and/or Delta disappear. He pointed out that Continental and Northwest have contractual as well as practical incentives to maintain the value of their existing regional subsidiaries. American Airlines is in no shape to take on a new partner; US Airways is aggressively seeking RJs, but not at non-union airlines. SkyWest is non-union. Even if alternative partners are found, it is a buyer's market, and few, if any, are likely to match United's industry-leading departure rates that ACA and SkyWest have come to expect, he said.

With mainline labor expenses expected to fall by 20 to 30 percent over the next two years, and with regional pay levels unlikely to match that reduction in cost, the marginal appeal of continued regional growth is quickly diminishing. As such, Baker expects to see significant cancellation or deferrals of RJs on order, with an attendant pressure on regional capacity growth.

Questioning Baker's analysis, Regional Airline Association (RAA) President Debby McElroy said that there will always be a critical role for the RJ since "regional carriers still enjoy a significant cost advantage in operation of these aircraft in markets of 500 to 1,000 miles." She noted that "even with the reductions that the majors have been able to make," the regional airlines have cost structures "that are significantly lower than the majors."

George Hamlin, senior vice president for Washington, D.C.-based Global Aviation Associates, said that two of Baker's premises were wrong - that the regional jet revolution is drawing to a close and that lower mainline pilot costs threaten marginal RJ opportunities. However, Hamlin agreed with one issue raised by Baker - that 70- and 90- seat RJs hold significant appeal. He said that RJs "have been fruitful and multiplied" and that "RJs on steroids have begun to appear." The use of these larger RJs will require a new way of thinking in relation to how they are integrated into mainline flying and how pilots are promoted up the ladder from RJs to larger narrow body and ultimately wide body aircraft.