Good News For Mesa, TSA Is Potentially Bad News For ACA

A series of moves by United Airlines (UAL) [OTC BB: UALAQ.OB] to restructure its United Express business appear to exclude longtime code-share partner Atlantic Coast Airlines [Nasdaq: ACAI] from its future plans. UAL signed a memorandum of understanding (MOU) with Mesa Air Group [Nasdaq: MESA] July 1 to expand its service as a United Express carrier by 35 regional jets (RJs), with an option for 25 more.

Then on July 10, UAL signed an MOU with Trans States Airlines (TSA) to operate as a United Express carrier right in ACA's backyard. TSA is a privately-held regional carrier that operates in the Midwest as AmericanConnection and in the Northeast as US Airways Express. The 10-year deal calls for TSA to operate up to 25 50-seat regional jets for United Express out of Chicago (ORD) and Washington, D.C. (IAD), where ACA is based.

ACA is the only United Express carrier that has not signed an MOU for future United Express service. The news sent stock of ACA into a tailspin. Wall Street analysts downgraded from "buy" to "neutral" ACA's stock following Mesa's announcement, and the share price fell 19 percent to $11.16. The share price bottomed out at $8.72 on July 2, and rebounded to slightly more than $10 per share in the following days.

Meanwhile, Mesa on July 9 signed a letter of intent with US Airways [OTC BB: USALA.OB] for a minimum of 25 and a maximum of 55 70-seat RJs, which would be in addition to the 52 50-seat RJs Mesa now has under contract with US Airways.

Jamie Baker, an analyst with J.P. Morgan, characterized the Mesa-UAL deal - coupled with the new 11-year contract between UAL and SkyWest Airlines' [Nasdaq: SKYW] (C/R News, June 16) - as a "distinct negative" for ACA, and labeled ACA's stock "underweight." Together, SkyWest and Mesa have scheduled 83 RJ deliveries between them for United Express service.

"As such ... we are growing increasingly skeptical as to incremental growth opportunities for [ACA], above and beyond its handful of deliveries scheduled for this year and next," Baker said. Atlantic Coast has more than 80 jets in operation with United, with another seven planned for this year and six more planned for next year. It also plans to add 28 jets in 2005.

ACA entered the negotiations with United seeking a rate increase, which was "clearly inconsistent with the stated goals of United," Baker said. Baker and other analysts were confident, however, that ACA and UAL would reach an agreement on a new United Express contract this summer. But Baker said, "We believe it will be at terms far more favorable to United than to Atlantic Coast."

Tony Cristello, an analyst at BB&T Capital Markets in Richmond, Va., predicted it would be very difficult for United to walk away from ACA, due to the number of jets (87) that ACA flies for United Express, and the feed into Washington Dulles International Airport that ACA provides United. In addition, the bankruptcy court must approve all of United's MOUs, and it is not likely to allow United to walk away from ACA due to the large disruption in United's network it likely would cause, Cristello told C/R News.

One sticking point in the negotiations between ACA and United may be the opportunity for ACA to pursue other code-share partners, Cristello said. Currently, 85 percent of ACA's business comes from United, and United must give written permission to ACA to code-share with other airlines.

In a statement, ACA said it had been holding periodic negotiations with UAL over the terms of a new United Express contract. But during the most recent talks June 30, the two sides did not reached an agreement "on terms [ACA] believes acceptable." ACA would not say when negotiations with United might resume, ACA spokesman Rick DeLisi told C/R News. "I think at this point the uncertainty that we've been faced with since the time United declared bankruptcy [in December 2002] continues," DeLisi said.

In its statement, ACA claimed it is developing contingency plans to establish an alternative to the United business in the event no new United Express contract is signed. "[ACA] would pursue such an alternative if it is considered by management to offer more favorable prospects than offered by United," the statement said. ACA would not elaborate on what new business opportunities it is pursuing. Neither ACA nor UAL would predict the timing or outcome of a possible new code-share arrangement. ACA has been under pressure to reduce costs and recently announced a new pilots' contract (C/R News, June 30).

Jonathan Ornstein, Mesa's chairman and CEO, refused to characterize the Mesa-UAL deal as taking market share away from ACA or any other United Express carrier. In public, UAL officials have said United has been "constrained" in its regional jet growth, implying that it would need more carriers on more routes, Ornstein said in a conference call with market analysts.

"I think that fears or concerns that we would be taking business away from other carriers ... are over-exaggerated," Ornstein said. "Does this make things more competitive? For sure. Could United consolidate its United Express operations? Maybe. But I have to tell you that we have no indication from them that this business is necessarily being taken away from anybody."

ACA is one of four regional carriers that has a contract with United for short-haul flights. Planes operated by ACA, Mesa, SkyWest and Air Wisconsin all fly as United Express under these agreements. ACA is the only one of the four airlines without an MOU with UAL on a future United Express contract.

Mesa To Face Some Challenges

Under Mesa's expanded code-share agreement with UAL, Mesa will operate the 35 RJs in addition to the 10 Dash-8 aircraft already under contract. The announcement increases Mesa's overall fleet by 25 percent (it would grow by 36 percent if all the options are exercised) from its current fleet of 141 aircraft.

UAL has not told Mesa on what routes the new jets would fly, only that they would operate on "selected routes," Ornstein said. "I'm not sure at this point where these aircraft are going to go," he said. The distinction is important because it would indicate if UAL is aiming to replace certain code-share partners by the routes they fly. UAL has not released a post-bankruptcy emergence plan indicating how it intends to restructure its costs, what number of RJs it thinks it needs to operate, if it plans to expand its United Express service, etc. An Air Line Pilots Association official told C/R News that United is trying to shave 20 percent off all of its vendor costs, including its United Express carriers.

The Mesa-UAL deal does not require Mesa to operate any particular fleet type, but does call for 20 70-seat and 15 50-seat aircraft. Mesa anticipates that about 30 of the 35 total RJs will be in service for United Express by mid-2004 and the remaining five should be in service by mid-2005.

Mesa is facing difficulties in expanding its fleet to fulfill its end of the bargain, from obtaining financing for more airplanes to convincing the RJ manufacturers to build more aircraft more quickly, Ornstein said. Mesa has finalized leases on three used Bombardier CRJs and is in the process of finalizing four more. Mesa has agreed to move forward on the delivery of four Embraer ERJs that were under an earlier agreement with Embraer for 36 aircraft, but on which Mesa had taken delivery of only 32. Mesa also will shift some of its delivery positions with its other code-sharing partners to place the aircraft with United, he said.

Mesa also has delivery positions available on CRJ700s and CRJ900s, which are slated for code-share partner America West [NYSE:AWA]. "There will no doubt be movement among all of the partners in terms of [transferring] aircraft around to try to maximize the fleets of each," Ornstein said. Mesa also has received verbal assurances from RJ manufacturers Bombardier and Embraer that they will be able to boost production to help meet Mesa's anticipated operational schedule, he added.

Mesa recently raised $100 million in cash via a convertible deal, which could ultimately fund the equity portion for about 20 to 25 jets, Ornstein said. The debt portion remains the last hurdle, although Bombardier has indicated it would provide a portion of backstop debt financing. Additionally, Mesa has obtained about $45 million in cash from the sale of its spare-parts inventory business.

Mesa must meet a tight timetable to train crews to operate the new aircraft. Mesa has done a lot of work to increase efficiencies and reduce costs in crew training. In its most recent pilots' contract, Mesa introduced provisions to prevent pilots from moving back and forth between training on different aircraft types. No longer can a first officer or captain bounce between training on a Dash 8 to a jet to a Beech 1900. If he is hired to fly a Dash 8, for example, he can only receive training to become a captain of a Dash 8.

The change has eliminated roughly 60 percent of Mesa's training events, Ornstein said. This has allowed Mesa to be "much more aggressive" in its ability to take on more aircraft per month. Where the airline used to be able to add just one aircraft per month, it now has the capacity to add three or four per month, he said. Mesa also is receiving the highest number of applicants for crew positions in its history. And with exclusive use of ERJ and CRJ simulators at its home base of Phoenix, the airline thinks it will be able to train new crews quickly.

The 35 additional RJs will add about 2.3 billion available seat miles (ASMs) to Mesa's total, Ornstein said, boosting Mesa's anticipated total ASMs to about 6.8 billion this year and about 7.8 billion in 2004, depending on how fast it can get the new aircraft in operation. The company estimates more than $250 million in additional revenue from the contract, which is a revenue-guarantee contract, Ornstein said, adding that the company is expecting to return margins in the range of 6 percent to 10 percent. The agreement is expected to be effective in August 2003 and, unless extended, has a final expiration of December 2013.

The agreement is Mesa's third memorandum of understanding in the past 10 months. The carrier signed two deals with US Airways [OTC BB: USALA.OB] for 20 and 50 RJs in late 2002. Mesa currently has in service about 17 aircraft of the 20 MOU and none of the 50 RJ pact.

Mesa operates 141 aircraft with 1,042 daily system departures to 162 cities, 43 states, Canada and Mexico and the Bahamas. It operates in the West and Midwest as America West Express; the Midwest and East as US Airways Express; in Denver as Frontier JetExpress and, as of July 6, United Express; in Kansas City with Midwest Express and in New Mexico and Texas as Mesa Airlines. The company, founded in New Mexico in 1982, has about 3,300 employees.

ACA operates as United Express and Delta Connection in the Eastern and Midwestern United States and Canada. It has a fleet of 148 aircraft, including 118 regional jets, and offers more than 840 daily departures, serving 84 destinations. ACA employs more than 4,800 employees.

>>Contact: Rick DeLisi, ACA, 703-650-6550, rick_delisi@acaicorp.com, Web: http://www.atlanticcoast.com; or Jonathan Ornstein, Mesa, 602-685-4001; Web: http://www.mesa-air.com/<<

United Express, At A Glance

United Airlines has reached new agreements with three of its four United Express code-share partners. Atlantic Coast Airlines is now the only one without a new deal. Negotiations are ongoing. Last week, Mesa Air Group became a full-fledged partner via a 10-year deal to provide expanded feeder service, and Air Wisconsin came to terms on a new 11-year deal. In June, SkyWest inked an expanded 11-year deal (C/R News, June 16). The Air Wisconsin agreement calls for the airline to expand its existing fleet of 20 regional jets by another 20, which will operate in the United Express program out of Washington, D.C., Chicago and Denver. All of the agreements between United and its United Express carriers are conditional on approval of the U.S. Bankruptcy Court in Chicago that is reviewing United's operations. Air Wisconsin also must finalize agreements on labor cost savings with its flight attendants, mechanics and customer-service employees. Analysts had predicted that ACA's contract was going to be more problematic than the other partners given its willingness to challenge United in bankruptcy court. It had accused its partner of defaulting on the contract by refusing to negotiate new rates. It also sought, unsuccessfully, to vacate contractual requirements to buy new planes.