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Monday, February 16, 2004

New Embraer 190 May Blur The Regional-Mainline Divide

As Largest Regional Jet Is Rolled Out, Embraer 170 Nears Certification

With much fanfare, Brazil's Embraer [NYSE: ERJ] last week rolled out its largest regional jet, the Embraer 190.

As the Embraer 190 begins flight certification, the plane has the potential to erase the already gray line separating regional airlines from mainline carriers. "It could change the world," said Jim Craun, a senior vice president at Eclat Consulting. "It has the potential to do that."

The Embraer 190 is the third element in the Embraer 170 family. However, it is the second to be built. Embraer anticipates that the Embraer 170 will be certified for commercial operation on Feb. 20. And it anticipates delivering the first of the 170 class to US Airways [Nasdaq: UAIR] shortly after certification.

The aerospace firm has spent $850 million since 1999 developing the new 170/190 class of larger regional jets. The new family has 245 firm orders and 305 options.

Embraer had firm orders for 110 Embraer 190s even before base model Embraer 170 had been certified. The launch customer of the Embraer 190 will be JetBlue Airways [Nasdaq: JBLU]. It has firm orders to buy 100 planes and options to buy 100 more. It expects to get its first plane in the third quarter of 2005.

"One of the big questions in aerospace: Does technology drive strategy or does strategy drive technology? Right now this is still speculative," said Richard Aboulafi, an aviation analyst with the Teal Group. "The no-mans land between regionals and majors has never disappeared, but with the industry under such transformation pressures, this product is likely to find a receptive market, especially in the long run. Upfront there is still a line between regionals and majors. What you have now is an aggressive low-cost carrier that is trying to prove a new concept with this plane."

When JetBlue placed its order last summer it rewrote the rules of commercial aviation. Instead of hiring a regional airline to use smaller jets to provide feeder service to the JetBlue focus cities of New York, Long Beach, Calif., Oakland, Calif., and Boston, the low-fare carrier has decided to use the Embraer 190 as a point-to-point vehicle to service markets too small for its Airbus 320s. The carrier has projected that there are 1,700 city pair combinations that the new plane could serve.

"The JetBlue experience will show if someone other than a regional can operate a plane that size profitably," said Alan Sbarra, a vice president with Unisys R2A Transportation, a consulting firm. "What JetBlue is planning on doing with it is still a little bit unknown. In a plane that small it is hard to get your seat costs down to a competitive level, especially in markets that you want to stimulate traffic. What JetBlue is trying to do with a plane of smaller size is to go into markets with leisure travelers and more price-sensitive business travelers.

"The economics of this plane is that it is smaller and lighter than a plane from Boeing [NYSE: BA] and Airbus, with a similar number of seats, so operating costs should be a little less. It is still a question mark if the economics will work," Sbarra said. "It will blur the line between major and regional [operations] as it is getting close to the size of the Boeing 717 and the Airbus 318."

To date as the largest regional jet, the Embraer 190 approaches the seating capacity of the B717 and the A318. The Embraer 190 will seat from 98 to 106 in a single-class cabin. Its slightly larger sibling, the Embraer 195, will seat 108 to 118 in a one-class cabin. The B717 typically carries 117 passengers in a one-class cabin with seating configured in a three abreast-two abreast pattern. The A318 also carries 117 passengers in a one-class cabin with all seating three-abreast. The Embraers are designed with two-abreast seating.

The Regionals

The major network carriers will deploy the Embraer 190s with their regional partners to improve the yields on routes feeding into network hubs. "I think it will be used by the traditional regionals feeding into the hubs. The mainlines will farm out the flying to the regionals who have more competitive labor costs," Sbarra said.

However, the acceptance of the Embraer 190 will be tied to the labor contracts at the network carriers. The "scope" clauses in the mainline carriers' pilot contracts restrict the type of aircraft that a regional partner can fly under a code-share arrangement. In anticipation of deploying the Embraer 170, Sbarra said that US Airways is negotiating an agreement to allow regional partners to fly a 70-seater. "No one is talking about a 100-seater."

The scope clause restrictions are contained in the contracts with the legacy carriers. "The low-cost carriers don't have [scope clauses] because they have a better relationship with their pilots," Craun said.

"Until the issue is solved, it will limit the size of plane that the regional can operate. It was never an issue when it was turboprop vs. jet but when its jet vs. jet, it has become a problem. At 100, seats you are at the capacity of a full-size jet. It will be harder to sell to the pilots."

Mainline Carriers

While JetBlue is committed to use the Embraer 190 to develop new point-to-point service, two other low-fare carriers have acknowledged that they are exploring similar concepts. Canada's WestJet [Toronto: WJA] is exploring adding the Embraer to service smaller markets. And the low-fare king, Southwest Airlines [NYSE: LUV] has told analysts that it has explored diversifying its fleet to include a plane like the Embraer. However, Southwest, which wrote the book on flying only one fleet type, has been quick to dampen any speculation it is giving more than a cursory look at Embraer.

Should JetBlue be successful - an imitated - then the network major will have to respond, Craun said. "They will have to do something on their own. There is so much in play it is hard to predict who will be the winners and what they will win."

Aboulafi said the network unions would be forced to adapt to the rise of the Embraer. "There has to be a change in attitude by the unions. There will need to be a few 'Come to Jesus' meetings [between the unions and management]."

Air Canada [OTC: ACNAQ] has signed a memorandum of understanding to purchase 45 Embraer 190s and it has an option to purchase an additional 45. However, the unions representing the pilots of the Air Canada mainline and its Jazz subsidiary are fighting over which group gets to fly both the new Embraers and the smaller Bombardier [Toronto: BBDb] CRJ-200s and CRJ-700s. An arbitrator is expected to issue a ruling next month.

If US Airways "can reform itself," Aboulafi said the carrier's structure and plans to use regional jets can be the model for others to follow. "If United [OTC: UALAQ] survives, I can see them following the US Airways example."

He noted that Embraer is not the first to market a 100-seat plane that peaked the interest of the mainline carriers. "The Fokker 100 was not a disaster. It was just that American [NYSE: AMR] was forced to operate it with a mainline cost structure. If you cut costs across the board, you will have a lot more success in operating a 100-seater."

Sales Elsewhere

When Embraer began designing the new family, the target market was Europe, not the United States. "At first, Europe was to lead the way," said Aboulafi. "But the low-cost carriers started to hammer the regionals in Europe. They are taking the demand away from the city lines, like Lufthansa [OTC: DLAKY]."

Embraer was anticipating selling the plane to the regionals in Europe. "Europe is not looking good. Things are changing in Europe even faster than in the U.S."

A bright market, Aboulafi said, may be in Asia. New low-cost carriers are forming to provide both service between nations and less expensive intra-country service within the vast island nations of Indochina. The Embraer could play a role there, he said, but "the meat and potatoes will be the United States."

Embraer's Future

The Embraer 170/190 family is both a source of national pride for Brazil and a potential blockbuster for the company.

Embraer is currently ranked as the world's fourth-largest aerospace manufacturer and Brazil's President Luiz Inacio Lula de Silva said the rollout of the Embraer 190 shows Brazil "is not just an exporter of agricultural commodities and raw materials, but also manufactured products of high aggregate value. We believe we can manufacture airplanes as well as anyone in the world." Silva attended the rollout and doused the plane in champagne.

Embraer has an international workforce of 12,941 and a total back order of both commercial and military planes valued at $10.6 billion.

"If the center of gravity moves to the 100-seat range," Aboulafi said, "Bombardier is in serious trouble and Embraer is in a class by itself. If production ramps up to four per month, then Embraer will be in 'Fat City.' It will be a long time before Bombardier can get a larger regional jet to market. For Embraer to win a strategic victory, the 190 has to play out. Otherwise, it will just have parity with Bombardier."

Bombardier's largest regional jet is the CRJ-900, which seats 86 passengers.

If the majors enter into the segment, Craun said Bombardier would be forced to build a competing entry. "If the Embraer is super successful, Bombardier will have to find a way to counter it."

The success of the Embraer 170 and 190 can also spur sales of the smaller Embraer jets, said Aboulafi. Carriers wanting to maintain commonality will stay with the same manufacturer from the smallest to the largest jet.

>>Contact: Doug Oliver, Embraer, (954) 359-3414; Jim Craun, Eclat, (703) 294-5880; Richard Aboulafi, Teal Group, (703) 385-1992; Alan Sbarra, Unisys R2A Transportation, (919) 468-2844.<<


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