Larger RJs Virtually Assured, Analyst Says

NEW YORK CITY - Regional carriers will continue to grow both in demand and capacity, eventually moving into the 90-seat regional jet market, according to James Parker, managing director of Raymond James & Associates. Speaking at the annual Raymond James' Growth Airline Conference held here last week, Parker said that the major airlines will continue to shrink and eventually be limited to widebody routes and high density, long-haul markets, while the regionals will provide feeder service to those markets using 50- to 90-seat aircraft. The low-cost carriers will also grow over the coming year to serve the medium to high-density routes, taking roughly 40 percent of the domestic traffic.

Airfares are expected to stay low during 2003, causing the major carriers to take their narrowbody aircraft out of the market, leaving those routes to their regional partners who control the supply of regional jets "and can afford to finance them," he said. While current scope clauses prevent the operation of 90-seat RJs for most regionals, "most airline pilots, we believe, will eventually agree to an easing of scope clause restrictions because RJs with 90 seats, and more with 70 seats, are necessary to feed traffic into hubs for the profitable operation of widebody aircraft, which entail the highest pilot pay rates."

Mesa Air Group CEO Jonathan Ornstein told conference attendees that Mesa now has the greatest RJ growth of any of the regional carriers and will take delivery of the first Bombardier CRJ900 this week for operation as an America West carrier. America West has no scope clause restrictions, so Mesa will be able to operate the CRJ900 on its routes. The larger RJs will be operated predominately in the California shuttle market, Ornstein said. He also noted that the Mesa pilots "understand the correlation between low cost and growth opportunities," which benefits them directly in helping increase the airline's market. America West presently has the lowest costs of any of the major carriers "and will be the first to get its head above water" when the economy begins to improve, he said.

Ornstein said that Mesa is one of the lowest cost providers among the airlines, with costs from 5 percent to 31 percent lower than the low-cost to high-cost carriers. This, in turn, has helped it to grow capacity at a two-year average annual growth rate of 39 percent, with a 48 percent average increase in contract capacity.

Mesa has alliances with America West, US Airways, Frontier and Midwest Express and currently has 71 RJs with firm orders for an additional 45 and options on 145.

Ornstein also said that Air Midwest should become profitable this year through "restructuring opportunities," although its fortunes depend on US Airways, which is scheduled to increase its RJ fleet from 70 to over 400. Air Midwest lost $3 million last year.

As for its partnership with Frontier, Mesa presently works on a pro-rated type arrangement with the airline and is presently in discussions to change that arrangement. There is a "huge demand" for regional jets and Mesa can't afford to lose money when the aircraft can be used in more profitable service, he said.

Mesa also has 54 turboprops, although it is reevaluating that fleet in terms of the market conditions, Ornstein said. Those aircraft can be profitable with Air Midwest this year, although he said he will not hesitate to park the turboprops "if it is necessary to ensure the profitability of the group."

A key element for the Mesa Group is that no matter what happens with the majors, there will always be a big demand for Mesa aircraft, he said. If any major carrier goes under, a large amount of capacity will go out of the industry, with the regionals called in to fill the gap "virtually overnight."

Two of the biggest issues facing the industry will be financing and delivery schedules, Ornstein said. He noted that Mesa has just signed a five-year lease on eight RJs from Australia, although there are virtually no used RJs on the market. There is also no real advantage of leasing used aircraft versus new aircraft, he said. The new aircraft have good warranties, but require long-term leases. The used aircraft that are available do not have the warranties of the new, but are available on shorter-term leases, so the lease rates work out about the same.

As for financing, "No one is getting out of their deliveries, with all RJs scheduled for delivery having financing in place," he said. Some regional carriers are using backstop financing to ensure they have financing in place. The price of RJs has also remained steady, he said. "Some people thought that as 737 prices have dropped, [the price of] RJs would come down. Not so. RJs are retaining their value."

ExpressJet President Jim Ream told the attendees that his airline expects to have its $325 million debt to Continental paid off by 2005, "or possibly during the first quarter 2006," and is looking for increased capital for expansion. Ream noted that ExpressJet increased its cash balance to $121 million and reduced its debt to Continental by $227 million, "including $80 million in prepayments."

For the future, ExpressJet is "in conversation" with other major airlines about diversifying beyond Continental. This "is possible, but not probable," he added. He said that he does not see the airline getting aircraft larger than the 50-seat ERJ-145 and ERJ-145XRs it currently flies, such as the Embraer 170 or 190. "We do not see enough markets for larger aircraft, [plus] the scope clause does not allow aircraft bigger than 59 seats." ExpressJet presently has 192 Embraer ERJs in operation with financing now in place for 82 firm orders plus 100 options on ERJ45s and ERJ45XR (extended range) aircraft.

The Continental Express carrier has just announced its 2002 operating results, reporting a $1,089.1 million operating revenue with $941 million total operating expenses, giving it an operating income of $147.8 million and a net income of $84.3 million. The $1.1 billion in revenue was an 11 percent growth over the $980.5 million in 2001, although that was skewed by the Sept. 11 impact on traffic, Ream said. Operating income was 46.3 percent improved over an operating income of $101 million in 2001 while net income was 75.3 percent better than the 43.1 million net income for 2001.

"We had an operating margin of 13.6 percent, with a target margin of 10 percent," he said. The airline has a 10 percent margin base, although incentives could raise that, he added. For 2002, the 10 percent base margin plus margin band performance of 1.5 percent gave a prevailing margin of 11.5 percent. That was added to an improved labor cost of 0.7 percent plus incentives of 1.4 percent to achieve the 13.6 percent. Improved costs per block hour "yielded an upside for our shareholders and a rebate to Continental," he said.

Atlantic Coast Airlines (ACA) Chairman and CEO Kerry Skeen presented an optimistic picture to the attendees regarding the airline's relationship with United Airlines, saying that indications are that United will continue its operating agreements with its United Express carriers. This will result in ACA continuing to expand its RJs fleet. There is also the possibility that if United continues its contract with ACA, the regional will expand its CRJ order even beyond the currently agreed numbers. United currently accounts for 84 percent of ACA's operations, of which 36 percent of its available seat miles (ASMs) are flown out of its Washington Dulles hub and 64 percent are out of the Chicago O'Hare hub.

Skeen said that this year's route structure that ACA will fly for United has been slowed by the mainline carrier's preoccupation with its bankruptcy, and ACA is waiting for an official response from United regarding payment rates, so it can make future decisions on CRJ deliveries from Bombardier. That decision could come as early as this month, he said. ACA currently has 35 CRJs scheduled for delivery this year and 12 in 2004.

Skeen said that ACA is still flying for United Express at 2002 rates, while it "should be operating on 2003 rates." He noted that block hours have gone down, which means a higher cost per hour. This should provide for a rate adjustment based on the current contract, but "we have not been able to recoup any of those costs," he said. However, utilization could come back up, "depending on how United wants to use its express carriers," he said. The general belief is that United will be greatly expanding its United Express operations as it slims down to come out of Chapter 11. This, in turn, will increase the block hours for all the United Express carriers. He said that ACA has been contacted by other carriers that are interested in having it partner with them should United be forced to declare Chapter 7 insolvency. He is optimistic that United will successfully come out of Chapter 11 bankruptcy, "but we still have to have a plan for United going under." The airline is looking at all the options, he said.

The remaining 19 percent of ACA's operations are as a Delta Connection carrier, and it has now finalized its rate structure with Delta Connection for 2003. Skeen said that ACA has now acquired the ACJet operating certificate from Delta for $1 million. That $1 million will show up as an operating expense on the 2003 balance sheet, he said.

In response to a question on ACA's operations for Delta out of Cincinnati, the primary hub for Delta Connection carrier Comair, Skeen said that ACA's smaller 32-seat Fairchild Dornier 328JETs have better economics for the ultra-short haul routes to Cincinnati, which releases Comair's 50-seat RJs for the longer routes, thereby complementing rather than competing with that carrier.

SkyWest President Jerry Atkins said his airline is both the financially strongest regional in the industry with $500 million in cash, as well as the largest independent regional with 76 Brasilia turboprops and 79 CRJs. By the end of 2003, it will have reduced its Brasilia fleet to 69 while increasing its CRJs to 109. It will continue to divest itself of Brasilias in 2004, going to 63 turboprops while increasing its CRJ fleet to 140.

Atkins said that SkyWest's cash reserve plus its large fleet means that it can afford to go into an agreement with another code share partner, and that it is looking for an additional alliance, "hopefully before the end of the year." Like ACA, SkyWest presently flies as a Delta Connection and United Express carrier.

He said that SkyWest is expecting lower and less predictable earnings from both Delta and United this year, although it presently has enough capital beyond its needs for its existing business condition and it is continuing to grow capital. It also has reaffirmed that it is the lowest cost service provider to those two carriers and is planning to continue being the lowest cost provider, he said.

Regarding United's bankruptcy, SkyWest is assuming that United will survive and will need additional regional airline services. As a means of reconfirming that it is the lowest cost regional, SkyWest has offered a rate reduction based on the belief that United will confirm its contract commitment in February. However, as a backup plan, it is also looking at being able to shift to another carrier or combination of carriers for its Los Angeles, San Francisco and Denver hubs. The West Coast has some room for expansion while Denver would be "very good" for expansion, he said. Dallas/Fort Worth International Airport could produce half again as much growth. If United does not confirm its contract with SkyWest by March, "we will have to reconsider whether or not to keep taking RJs" for United Express. Atkins said that SkyWest is considering 70-seat RJs, and even looking for opportunities for aircraft up to 130 seats, although it's too late to plan anything for 2003 that would increase the size of aircraft within the fleet.

Bankruptcy and the Regionals

"If any major carrier goes under, a large amount of capacity will go out of the industry, with the regionals called in to fill the gap virtually overnight."

--Jonathan Ornstein, Chairman and CEO Mesa Group

ACA is optimistic that United will successfully come out of Chapter 11 bankruptcy, "but we still have to have a plan for United going under" and are looking at all the options.

--Kerry Skeen, Chairman, CEO Atlantic Coast Airlines

SkyWest is looking for another alliance and is also looking at being able to shift to another carrier or combination of carriers should United go under.

--Jerry Atkin, President, CEO SkyWest Express