CHRIS KJELGAARD / NEW YORK
Facing a bleak future of losses and crises, the North American airline industry is finding the regional sector has a big part to play in making capacity fit demand
North America's air transport industry remains mired in its worst ever economic crisis and analysts say the major airlines could take seven years to recover. Insiders say the only good news is the strong performance of the regional operators, and believe it must continue for the industry to survive - but the majors must change fundamentally so the regionals can evolve to help them weather the crisis.
At last month's Airfinance conference in New York, the news was not good. Analysts Richard Bittenbender of Moody's Investors Service and Ray Neidl of Blaylock & Partners painted a stark picture of losses and crises continuing beyond the end of 2004 at the major North American carriers. The analysts could foresee no recovery in earnings or cash flow before 2005 and said the US majors would remain unable to rebuild their capital structures to 2000 levels until at least 2008 and possibly 2010.
"It's a lost decade for the US airline industry unless something happens to change it," said Bittenbender, pointing out that the US majors' combined book equity - a theoretical number much higher than their actual equity position - stood at just $7 billion by the end of 2002. What was worse, Southwest Airlines alone accounted for $4.7 billion of the total. Neidl agreed, adding: "I've never seen a cycle like we have now. You might say it's the perfect storm."
But these analysts, along with almost everyone else monitoring North America's airline industry, see regionals playing a fundamental part in solving the industry's financial and structural problems. Neidl says the best thing for the industry would be the liquidation of a major airline and he believes it likely that "a couple of big carriers will disappear over the next couple of years", but he also sees the majors relying more on their regional partners as they try to fight their way back to profitability.
Once the poor relations of the industry, the regionals now have a crucial role. Ever since 11 September 2001, North America's major carriers have increasingly relied on the regionals and their small jets to provide optimal amounts of capacity in shrinking markets. "I think the regional jet outlook is very positive these days," says Mesa Air Group's senior vice-president and treasurer, Rob Stone. "The US Airways restructuring has validated the value of regional jets to the major airlines."
Many industry insiders believe the rise of the regional carriers in North America still has a long way to run. "The research we've done shows they were the only component of the US aviation system that expanded after 9/11." says consultant George Hamlin, a senior vice-president with Global Aviation Associates.
Barry MacKinnon, vice-president of marketing and airline analysis for Bombardier's regional aircraft division, agrees. "In the restructuring of the [North American] industry, regional jet flying has continued to grow," he says. "The regionals are a key element of the majors' strategy to get out of financial trouble and ensure their future." He says the regionals are vital to the majors' efforts to maintain market presence where they can profitably do so, and critical to their attempts to survive as a hub-and-spoke network rather than point-to-point carriers.
Regional Airline Association (RAA) president Deborah McElroy says several majors have handed over huge portions of their domestic networks to their lower-cost regional affiliates for them to fly using their smaller jets. For instance, subsidiary Atlantic Southeast Airlines took over most of Delta Air Lines' flying at Delta's secondary hub at Dallas/Fort Worth.
But some, notably JP Morgan analyst Jamie Baker in a recent paper, believe that although North America's regional carriers have been the industry's darlings until now, their spectacular rise is slowing. He believes the regionals' rapid growth will tail off as US and Canadian majors re-evaluate their networks and services in the light of newly reduced pilot and staff labour costs, which had swollen to more than 40% of the majors' total expenses.
End of the revolution
"We believe the regional jet revolution is drawing to a close," writes Baker, who believes lower mainline pilot salaries "threaten" the creation of new opportunities for regional jet flying. Baker points to ExpressJet's decision to defer ERJ-145 deliveries because affiliate Continental felt its own narrowbodies could now do the job more cheaply on some routes. He believes the threat to the expansion of regional jet flying will continue because the economics of mainline narrowbody aircraft - cheaper on a per-seat unit cost basis than any regional jet, but much more expensive on a trip-cost basis - are now much closer to those of regional jets than before, as pilot salaries have fallen.
But most observers disagree. They see the majors continuing to right-size capacity to fit demand on domestic routes by asking their regional affiliates to add many more small regional jets of 50 seats or fewer. After all, says Hamlin, why schedule a 185-seat Boeing 757 to carry 30 people who will pay a 50¢ yield per seat/mile and then fill up the aircraft with backpackers paying a 5¢ yield, when for a much lower trip cost you can schedule a 50-seat regional jet and - assuming a 60% load factor - still obtain an average yield of 18¢ from each of 30 people paying a 30¢ yield? Even though the regional jet has unit costs of, say, 15¢ per available seat compared with 10-12¢ for the mainline 757, at an 18¢ average yield, the operating margin on the regional jet flight will be about 15%. You can then forget about carrying the backpackers and still make more money overall.
But there is more to the story. Aware that there are not only routes that will continue to require mainline narrowbody capacity but also many others for which 50-seat regional jets will be inadequate, yet for which mainline aircraft will remain too large in the depressed North American economy, the majors are looking to the regionals to fill this gap. By pressuring their mainline pilots to approve concessions and allowing the regionals to increase the size of the regional jets they fly and to relax restrictions on where these aircraft can be flown, the majors are trying to help themselves - and are writing a new chapter in the history of the regional carriers at the same time.
Frederico Curado, executive vice-president of civil aircraft for Embraer, says the North American majors' restructuring is continuing apace. He feels the majors are unlikely to be happy if they continue to lose huge sums of money, but also see their regional affiliates boosting their profits by being allowed to use larger aircraft. Nevertheless, he believes the current fee-per-departure model governing most relationships between the majors and regionals will prevail as the North American airline market proceeds with a massive restructuring. Curado says a major part of that restructuring will be the advent of 70-seat, and perhaps 90-seat, regional jets to fill the gap between the 50-seaters and the 130-plus-seat jets to which the majors have retrenched.
To a limited extent, the 70-seat regional jet (effectively to date just the Bombardier CRJ700) is becoming an established part of the North American airline scene. ASA, American Eagle, Comair, Horizon Air and Mesa's Freedom Airlines have a few CRJ700s in service and deliveries continue to the extent that scope clauses in the major carriers' mainline pilot contracts allow. But most industry insiders see the numerical limits on 70-seaters as nowhere near high enough to help the North American industry survive. Radical changes are needed to demolish those limits, they say.
"The RAA has absolutely raged against scope constraints," says McElroy. "They're not good for anybody. I would argue that the pilots who see this only as a job issue are missing the point." The point, she says, is that while mainline pilots fear increased regional jet operations because they are worried about losing their jobs, they forget regional jets bring large amounts of incremental traffic into the majors' hubs to provide the flow of connecting feed traffic that the majors need.
Artificial constraint
Curado agrees, labelling scope clauses as the only artificial constraint the North American market faces. Hamlin adds: "The problem is that a scope clause is an attempt to work on the supply side but it doesn't reflect the demand side, which ultimately means revenue. If you're not generating sufficient revenue, unit cost is meaningless."
Industry observers see good news, however. As a result of US Airways' immersion in Chapter 11 bankruptcy protection, the Virginia-based carrier has led the way in achieving scope clause reform, transforming what was the most regional jet-restrictive scope clause in the US industry to the least restrictive. United has had a much less restrictive scope clause than US Airways in terms of total regional jet allowance, but has no permission to operate new-build 70-seat regional jets on its network. Now it appears poised, under its own Chapter 11 proceeding, to achieve a breakthrough with its own mainline pilots. Movement on regional jet scope relaxation is apparent, too, at troubled American Airlines, but for now any relaxation looks likely to involve nothing larger than 50-seaters.
America West's scope clause (liberal to date but possibly facing constraints on regional jet numbers after renegotiation of the pilot labour contract, now under way) has even allowed it to contract Mesa to operate 80-seat jets for the America West Express regional network. Mesa will operate 25 Bombardier CRJ900s, each configured to seat 80 people in two classes, for America West. Although Hamlin believes the CRJ900's 80-seat capacity might fit rather better alongside mid-sized America West's mainline operations than those of a much larger major, he reckons "regional jets on steroids" will become a feature of the North American industry in due course.
Much could hinge on the huge regional jet order placed by US Airways. Certain to feature a large number of 70/75-seat aircraft, the order will position US Airways as potentially the biggest mainline operator of mid- to large-sized regional jets. If its competitors begin to find themselves disadvantaged - particularly if US Airways becomes the North American launch customer for the new wide-cabin Embraer 170 and 175 - Curado and others believe big orders could follow from other US majors forcing through scope-clause revisions.
But while the North American regionals and the manufacturers that will provide them with 70-seaters and 90-seaters have considerable room for optimism, Bombardier's MacKinnon says the near-term skies for the regionals are not without dark clouds. A difficult and continuing problem in the current environment is the availability of financing for aircraft. Lease equity has become difficult to find in the US capital markets, and even though the regionals continue to outperform the majors financially, investors are not differentiating in their investment analyses between the two kinds of carriers and the aircraft they operate.
Investment risk
MacKinnon believes this is a natural problem driven by market forces, but feels investors are not differentiating as much as they should between the troubled majors and the still-profitable regionals. "Regional jets are in demand and [their numbers are] growing and a number of regionals have multiple codeshares, so their investment risk is not necessarily tied to one major carrier. They have a number of options open to them and theirs is a good-news story."
But insiders agree the liquidation of a major carrier would be bad news for its regional affiliates, at least in the short term. If a carrier such as United or American failed, the short-term impact on its associates' abilities to generate traffic, finance aircraft and market their services would be severe, given most North American regionals' status as mere providers of jet and turboprop lift capacity and lack of most airline-related marketing and sales functions.
Mesa's Stone believes a major's regional affiliates would be able to survive its demise. He concedes that initially they would suffer disruptions but says the major's markets would still need to be served. Other majors rushing in would realise the feed traffic network previously provided by the regional affiliates could be invaluable in helping the successor major rebuild the failed airline's operations at a hub. The biggest problem for any newly unaffiliated regional would be its weak negotiating position with a new major after its main revenue source had dried up.
Even if a regional is entirely dependent on one major carrier - as is the case with American Eagle, Continental Express and, to a large degree, Atlantic Coast Airlines (ACA) - Stone believes the regional could still survive its affiliate major's demise. "If there is value in that particular hub, those airplanes are going to get put to work," he says. It is even possible that if a major fails and no other major wants to move into any of its hubs, the former regional affiliate at that hub could survive alone if its own origin-and-destination network based on the hub were strong enough. Thus an ACA or a Comair, based at Washington Dulles or Cincinnati hub, that no other major might deem strong enough, might be able to survive, as an independent, the failure of a United or a Delta.
But despite the strength of its own network at Washington Dulles, ACA demonstrates the difficulties of being tightly allied with one particular major. Even though ACA has a Delta Connection operation, its reliance on the United Express network for most of its revenues has seen ACA furlough staff and pilots, reduce flying and defer deliveries of new CRJs. In the immediate aftermath of 9/11, ACA grew rapidly as United transferred poorly performing domestic routes to let ACA operate them using CRJs, but it appears that, for now, the carrier has stopped growing. In the worst crisis the North American airline industry has ever faced, no carrier is invulnerable.
| US Major & National Airline Pilot Scope Clause Rules on Regional Jets | ||||
| US mainline carrier | Seat size/ weight size cap | RJ fleet cap | 70-seaters or larger allowed | Comments |
| AirTran | No | No | Yes | No restrictions. Air Wisconsin operates CRJs for AirTran |
| Alaska Air Group | No | No | Yes | No restrictions. Aircraft operated by Horizon Air classified as "regional aircraft" |
| Aloha | No | No | Yes | No restrictions. Aloha has no supporting RJ operations at present |
| American | 70 seats | Yes | Yes | No limit on numbers for RJs of 44 seats or less. Cap of 67 aircraft of 45 to 70- seat size. Relaxation to allow more 50-seaters believed likely |
| American Trans Air | 70-75 seats/85,000lb | Yes | Yes | RJ fleet cap 120 aircraft |
| America West | No | No | Yes | No restrictions, but new pilot contract could cap RJ fleet at existing level with additional aircraft only allowed under formula tied to mainline growth |
| Continental | 59-seat RJ/79-seat turboprop | No | No | No limit on number of RJs operated |
| Delta | 70 seats/70,000lb | Yes | Yes | No limit on fleet of RJs under 70 seats, but cap of 75 aircraft on 70-seat RJs. Growth of 70-seat fleet tied to mainline block hour growth |
| Frontier | No | No | Yes | No restrictions. Only aircraft operated at present are 5 CRJ200s, by Mesa Airlines |
| Midwest | No | No | Yes | No restrictions |
| Northwest | 60 seats/70,000lb | Yes | No | No limit on RJs of 44 seats or less, but cap formula for 45 to 55-seat RJs. Mesaba has 36 69-seat Avro RJ85s grandfathered |
| United | 50-seat RJ/78-seat turboprop | Yes | No | Old scope limit was 384 RJs. Working scope limit is 236 RJs (existing plus affiliates' deliveries through early 2004). Another 150 possible. New scope clause allowing 70-seat RJs believed likely. Air Wisconsin BAE Systems 146s (70-plus seats) grandfathered |
| US Airways | 76 seats/82,700lb | Yes | Yes | Limit of 70 RJs (none over 50 seats) before new scope clause allowing 150 more RJs of 44 seats/46,600lb plus 245 RJs of 51-76 seats/82,700lb |
Source: Bombardier, Regional Airline Association, other
Source: Flight International
