Fate Of Three Majors Cloud The Future

There continues to be a disconnect between the actual performance of the regional airlines and Wall Street's assessment of their stocks.

After a successful first half during which all six publicly traded, traditional regional carriers posted a profit, the outlook remains strong for a solid second half performance. Neither the network carriers nor the low-fare carriers can boast a clean-sweep in the profitability sweepstakes.

By another measure, the regional airline sector out scored the majors and low-fare carriers on two of the four operating indexes tracked by Blaylock & Partners. The regional sector has the highest average yield, 20.26 percent compared to 12.16 percent for the networks and 10.41 percent for the low-fare carriers. The regionals earned the most per mile as measured by revenue per available seat mile (RASM): 15.71 cents compared to 10.66 cents for the networks and 8.28 cents for the low-fare carriers. The low-fare carrier segments outperformed the others on average operating margins and cost per available seat mile (CASM).

The fate of the regionals is tied to the performance of the network carriers. Because of the long-term code-share contracts, the regionals continue to make money - even flourish as the legacy carriers switch more flights to regional jets (RJs).

"Unfortunately because of the general industry malice," said Ray Neidl, of Blaylock, "the regional partners of the legacy carriers are experiencing share reductions in stock prices and low price-earnings multiples. This is despite the fact that they are largely protected from higher fuel costs with their cost-plus or revenue-guarantee contracts, which enable them to obtain healthy double-digit margins."

With the amount of uncertainty facing the airline industry, the stocks of the regionals will perform on par with the group - poorly, said Tony Cristello, an analyst with BB&T. "The prospects for the industry's risks coupled with oil prices and the negatives of the major carriers are weighing down their regional partners. If we start to see oil prices come back down and the major partners come back, we will see the regionals as a group come back," he said.

Setting aside stock evaluations and focusing on operations, industry observer Doug Abbey, of the Velocity Group, doesn't expect to see any larger scale changes in the second half. "I think you will see some jockeying for the top rank as some carriers continue to grow and some fall." Abbey expects to see continued growth at Chautauqua Airlines, a unit of Republic Airways [RJET], and others with multiple code-share partnerships. On the decline will be FLYi [FLYI], the former Atlantic Coast Airlines and parent of budding Independence Air. FLYi is transitioning out of its code-share partnership with Delta Air Lines [DAL] and has already ended its relationship with United Airlines [UALAQ]. It is the only regional carrier to post a loss in the second quarter.

The fate of United, US Airways [UAIR] and now Delta clouds just about everything on the horizon for the regionals, both individually and collectively. In its second quarter filing, US Airways warns that unless it obtains concessions, it may default of its loans agreements by Sept. 30 and be forced to return to bankruptcy. Once stable Delta admitted that it burned through more than $700 million of its cash reserves to stay in the air during the first half. It wants $1 billion in wage concessions from its pilots to avoid Chapter 11. Already in bankruptcy, United is now openly talking of dumping its pension plans in order to exit bankruptcy - a move that would severely damaged employee morale. If United is successful in shedding its pension plan obligations, the five other legacy airlines may try a similar move. Without the pension burdens, analysts note that the network carriers could be cost-competitive with most of the low-fare carriers.

United, US Airways and Delta control 40 percent of the domestic capacity. If they reduce that capacity by 15 percent each to improve their yields and reduce their fuel expenses, then the regionals will be scrambling, Cristello said.

Many of the analysts are sitting on the fence as to whether a bankruptcy filing at Delta and US Airways would be good or bad for the regionals. A deep cut could simply be a loss for all - the mainline and its code-share partners. Depending upon how a network carrier cuts back its capacity and routes, there could be more flying for the regional carriers as smaller jets are substituted for the mainline aircraft. The infamous scope clauses could be reworked at some of these airlines, giving the regionals the rights to fly larger aircraft.

"There is no doubt that there should be a major restructuring of the industry over the next two to three years, whether the government changes its approach to airline mergers or not," said Neidl. "We basically have too many airlines with too many expensive hub operations and right now too much capacity. Capacity reduction should happen in one of three ways: bankruptcy and liquidation of one or more airlines; a change in government policy to allow mergers; or more anti-trust exemptions for domestic airlines to plan and work closer together."

Within the next year, Cristello predicted that SkyWest [SKYW] or ExpressJet [XJT] might break from the ranks of their peers and try their hand at independent flying. Neither, he said, would go the independent-only route of FLYi. Instead, he said, either carrier would try to strike an accord to fly their own livery in a way that doesn't anger their code-share partners.

Even with the market down on regional stocks, Cristello would not rule out a merger in SkyWest's future. The carrier ended the first half with $477 million in cash on hand. Given its union-free environment, SkyWest is looking for an acquisition without unions or with weak unions, he said. Any acquisition would need to fit within the parameters set by both SkyWest's code-share partners as well as the target carrier's partners.

At the same time, Cristello said that Mesa Air Group's [MESA] interest in new ventures has waned since its pilots rejected overtures to fly Boeing [BA] 737s. "Don't rule them out," he said, "but they are not at the front of the line."

Looking Down The Road

ExpressJet: The ongoing pilot negotiations continue to weigh down this stock, Cristello said. "There is a perception that they have higher labor costs," he added. Because Continental Airlines' [CAL] need for regional jets appears to have been met, Cristello said it is unlikely that ExpressJet will see "future growth."

Neidl noted that ExpressJet's contract with Continental is subject to modification at year's end, which adds to the uncertainty of the regional carrier's future. He predicts its earnings per share next year will be $1.81.

FLYi: The former Atlantic Coast Airlines is transitioning to a low-fare carrier flying both regional jets and Airbus 319s. Some estimate the carrier will burn nearly $290 million of its cash reserves by January, Neidl noted. Its second quarter losses "were roughly as expected," he added.

While the initial operation of Independence Air has "been better than expected," Cristello said, "they need to make money. How much cash are they willing to burn?"

Independence has triggered a fare war along the East Coast - the battle is not confined to direct competitors flying through Washington Dulles International Airport. "There is way too much capacity in the market. It has become a battle with everyone matching what Independence has been doing," Cristello said.

MAIR Holdings [MAIR]: While MAIR's principal unit, Mesaba Airlines, has not placed a new RJ into service for Northwest Airlines [NWAC] since 2000, analysts continue doubt if it will be used by Northwest to fly new RJs. Unlike Pinnacle Airlines [PNCL], MAIR does not have any long-term debt on its books and it has a healthy $154 million cash balance. Analyst James Parker, of Raymond James, notes that the cash stash amounts to $7.33 per share of its $8.95 per share book value.

Mesa: "The stock has been under the most pressure," Cristello said, especially with US Airways again teetering on bankruptcy. "The question is will this be just another Chapter 11 or does it go all the way to liquidation? If it were just a Chapter 11, I think it will relieve the pressure on Mesa and its stock price. US Airways doesn't want to disrupt the continuity of its network. I think [US Airways] will push to re-affirm their contracts with their regional partners."

Neidl believes Mesa is "somewhat insulated" as US Airways tries to renegotiate its partnership contract "because it already charges below-market rates." A new US Airways contract could drop Mesa's profit margin on the US Airways Express flights down to 8 percent from 10 percent.

Looking down the road, Cristello said that Mesa might use its growing cash balance to take the company private.

Pinnacle: The future of Pinnacle lies in the hands of the Northwest pilots (CRAN, Aug. 9), the analysts agree. If Northwest and its mainline pilots strike an accord to fly 70-seat regional jets, then growth is limited at Pinnacle. Cristello see some hope for additional 50-seat orders beyond next year when the 129th - and final - CRJ 200 is delivered since Northwest "is lagging behind the others in RJ utilization."

Looking at the same scenario is disconcerting for Parker since the regional industry as a whole will have an over-capacity of RJs by next year.

Republic: Whereas diversification was once a fine strategy to avoid risks, Cristello noted that Republic now faces greater risk because three of its four partners are ailing - US Airways, United and Delta.

"Primarily because of the low overhead and more productive work rules," Parker said, "Republic Airways is one of the lowest, if not the lowest, cost producers in the regional airline sector. This enables it to aggressively price its service to gain incremental businesses and at the same time realize profit margins that are among the highest in the sector."

SkyWest: "Delta is the big question," Cristello said. While the Atlanta carrier is the source of 50 percent of SkyWest's revenues, it still has not been able to put a new partnership contract on paper. The two sides reached a verbal accord early in the first quarter. Cristello said that without the signed contract there is "a fear" that should Delta go bankrupt, SkyWest's margins would be adjusted down from their current levels.

>>Contacts: Tony Cristello, BB&T, (804) 780-3269; Ray Neidl, Blaylock & Partners, (212) 715-6627; Doug Abbey, Velocity Group, (202) 338-1727; James Parker, Raymond James, (404) 442-5860.<<