Pressure on regional airline fee-for-departure contracts has forced down guaranteed margins from roughly 13 percent to about 10 percent during the first quarter, according to a report issued last week by Calyon Securities' Ray Niedle. The trend follows a finding by the U.S. Department of Transportation Bureau of Transportation Statistics (BTS) report saying that regional carriers reported a 2.7 percent decline in profit margins during the fourth quarter 2005. The seven regional carriers reported a $50 million operating profit during the final quarter of 2005, said BTS.

The Calyon report, 1Q06 - Brighter Outlook on Price Increase Expectations, said that legacy carriers were exacting revenge on their low-cost counterparts which have forced a major restructuring of the industry. It noted that airlines have been able to increase yields and revenue per available seat mile (RASM) through price increases. The bulk of these improvements came through better yield and seat inventory management that has benefited the legacies far more than the LCCs, which have been "driven to the wall" by fuel costs. Despite this, the industry is expected to lose about $300 million in the full year, despite expected earnings of $800 million in the second quarter. "The once high- flying LCCs seem to be facing more of a challenge with fuel prices.", he said, citing Southwest's strong fuel-hedge positions as helping the airline significantly.

"The regional sector has generally remained profitable as a result of the fixed-costs contract..." said Niedl, adding that stock prices have come under pressure owing to the perception that those contracts are at increased risk as the result of the major-carrier bankruptcies. "The market fears more to come and possible outright contract cancellations in some cases. We believe diversified providers such as SkyWest, Republic and Mesa are in good positions to take advantage of the industry turbulence and grow with new or expanded contracts because of their strong balance sheets, good cash positions and aggressive management. Some of the other carriers, such as Pinnacle and ExpressJet, with only one customer, face more uncertain futures." Indeed, the greatest concern expressed by the investment community in a recent financial conference call with ExpressJet, was whether Continental would pull the rest of its contract in three year's time.

Listening to the regional conference calls with the investment community as they explained their quarterly results every carrier proclaimed it has the "best balance sheet in the industry" or the "lowest cost per ASM" (available seat mile -- CASM), all of which keeps them competitive as they vie for future fixed-cost contracts such as the Northwest contract that remains undecided.

However, examining Niedl's charts, the lowest CASM, at least for the first quarter, goes to Republic Holdings at 11.77 cents, displacing Mesa which, in first quarter 2005 had a CASM of 11.63 cents. Excluding fuel costs, which are passed back to the major partner, Republic, again takes the point with Mesa in close pursuit at 7.88 cents and 8.28 cents, respectively.

SkyWest has the highest revenue per ASM (RASM) in the first quarter at 15.80 cents compared to Republic which has the lowest at 13.10 cents. At 21.10 cents, Pinnacle has the highest yield in the five-airline group tracked by Calyon, while ExpressJet has the lowest at 17.44 cents. Mesa has the lowest operating margin at nine percent while Skywest has the highest at 11.2 percent.

Comparing fourth quarter 2005 industry-wide statistics, BTS reported that regionals, in the fourth quarter 2005 had the highest unit revenues at 15 cents per available seat mile.

The highest unit revenues in the 2005 fourth quarter were reported by American Eagle, according to BTS.Regionals also had the highest domestic passenger revenue yields at 20.4 cents per revenue passenger mile with American Eagle, Comair and Atlantic Southeast (now part of SkyWest) reporting the top revenue yields in the industry. American Eagle took the lead in that category, according to BTS.

Comair and American Eagle reported the highest unit costs amongst the regionals.

Futurecast

ExpressJet is expected to finish the year with the lowest CASM at 11.62 cents. Even so, Republic will take back the position with the lowest CASM in 2007 with 10.30, according to Calyon predictions. Excluding fuel costs, Republic will maintain its place this year and next dropping to as low as 6.80 cents. Pinnacle will finish both years with the highest CASM at 11.35 cents and 11.24, respectively, said Niedl.

Calyon is predicting that ASMs for four of the five carriers will increase this year, as well as for 2007, during which ExpressJet is expected to take a 20 percent hit as the result of the loss of 25 percent of its Continental Express business to Republic Holdings.Yield for Mesa this year and next is expected to grow only 1.5 percent and 0.1 percent, respectively, while yield for most of the field is predicted to drop. SkyWest, which is expected to lose yield by 0.5 percent this year, will match Mesa's 2007 yield growth of 0.1 percent.

RASMs will also experience erosion this year and next for ExpressJet. However, with the exception of Republic, RASMs for SkyWest, Mesa and Pinnacle are expected to grow this year. In 2007, however, all but Mesa are expected to take a decline in RASM.

In his report, Niedl cited positive moves by major airlines such as not ordering new aircraft until they return to profitability. "However, the negative is that we still hear from some industry managers that they will not give up market share through pricing," he said. "With industry capacity constraints for the next couple of years, due to a tight aircraft market, we question why the airlines would not just relinquish flying the lower-yielding passengers to other carriers."

Niedl said its top picks remain GOL in Latin America, Alaska Air Group and SkyWest, although he called Copa Airlines and USAirways interesting stories he is watching.

"The industry as a whole appears to be on the verge of returning to profitability but not all the airlines in our universe are about to cross the line to profitability," he said. "In our opinion, most of the legacy carriers will have good second and third quarters; it appears that continuing strong demand will enable them to stay ahead of the higher fuel prices with ticket price increases and better yield management during the high revenue-generating months. On the other hand, the....LCC sector may have to slow its rapid growth due to its profitability shrinking or even disappearing as the result of high fuel prices."

He pointed out the difficulty for LCCs to increase yields since they are more dependent on price increases rather than better yield managements, which draws more attention from the public. In addition, he said, they are faced with having to stimulate demand with rapid expansion programs. Even so, he sees Southwest as the only non-regional carrier in the position to step up growth even as it faces a lack of aircraft availability owing to full order books at Boeing and Airbus which stretch out into the next few years. Ray Niedl, Calyon Securities, 212-261-4057