ANALYSIS: Air Canada regional strategy heightens competition

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As Air Canada's strategy to diversify its regional lift starts to take shape, its airline partners are under increased pressure to find cost savings and they vie to supply flights in an increasingly competitive environment--especially as WestJet's new regional carrier Encore enters the country's regional market next year.

Jazz is by far Air Canada's largest regional partner, operating a fleet of 125 aircraft under the Air Canada Express brand.

In anticipation of the diversification strategy, the regional airline has been set on finding cost savings and competitive edge. Although the carrier has a stable agreement in place with Air Canada for several more years, the real question will be the types of growth opportunities Jazz will identify as the mainline carrier further assesses its fleet structure and potentially augments partnerships with other regional feeders. But immediate growth is not something the carrier is expecting to see under its capacity purchase agreement (CPA) between the two carriers.

"We've heard from Air Canada that we should not anticipate growth for Jazz as Air Canada looks to lower regional costs and diversify the sources of regional lift," Chorus chief executive Joseph Randell told investors on a 14 November conference call. Air Canada is trying to enact cost savings measures of its own, and shifting the sources of its regional lift is one part of achieving that.

Jazz's current capacity purchase agreement with Air Canada represents the vast majority of the carrier's regional flying and lasts until 2020, so it still has visibility of these fixed costs and guaranteed minimum block hours for several years to come regardless of any plans the mainline carrier has for changing up its regional feeders. However, the long-term effects of Air Canada's new strategy remain to be seen.

Jazz has been anticipating cost saving measures at Air Canada for years, but the shift to more regional players was solidified only recently after a five-year collective agreement between Air Canada and its pilots, achieved through arbitration in July after a contentious 19-month period of negotiations with the Air Canada Pilots Association.

Air Canada is expecting to be more competitive under this new labour pact by allowing adjustments with regional feeder airlines. Under the new pilot agreement, Air Canada can now operate up to 60 76-seat regional jets for its regional operations, said Air Canada chief executive Calin Rovinescu during the carrier's 8 November investor call.

"As a result, we can now do business with several regional partners in Canada, whereas in the past, we were limited in this regard, and that competition should be healthy," he said.

Air Canada's diversification strategy in the regional arena started taking shape this October, when it announced it would transfer its fleet of 15 Embraer 175 aircraft to Montreal-based Sky Regional airlines. That airline will fly them on short haul routes from Montreal and Toronto to the northeast U.S. after the transfer, which is set to happen between Februrary and June 2013.

Sky Regional began operating as Air Canada Express in 2011 with flights between Toronto and Montreal. While this did not directly affect the CPA between Air Canada and Jazz, it set the stage for the other regional players to build up flying for the airline. On a much smaller scale, carriers Air Georgian and EVAS Air Charters operate some regional flying for Air Canada with Beechcraft 1900D aircraft.

Jazz has taken action to diversify its customer base and investment opportunities, but market conditions have caused challenges on this front. For example, in 2010 it signed up for a five-year flight agreement with Thomas Cook for Boeing 757-200 flying to holiday destinations. Despite this, Thomas Cook announced in April that it would be ceasing to operate its dedicated 757 fleet, therefore terminating the agreement three years earlier than expected. The carrier did not comment on potential future diversification projects in the works during its investor call.

Randell says that Chorus will work with Air Canada to find "win-win" flying agreements for both airlines and assist where it can with respect to cost cuts, but notes that the company is insistent on protecting its own shareholders. Jazz is set on improving its own costs and has identified opportunities to find savings in its own operation. Some areas include efforts to reduce in overhead expenses and finding efficiencies in from maintenance and in the IT systems.

"We do have a relentless focus on costs here at Jazz, and that certainly has to continue," said Randell.

Air Canada reported last week on its investor call that its capacity purchase cost with Jazz increased by Canadian dollars (C$) C$18 million ($17.9 million) or 7% on higher CPA rates with the regional carrier, affected by unfavuorable exchange rates and increased flying hours.

The carrier saw operating expenses increase year-over-year by 4.8% in the third quarter, including higher costs for salaries, fuel, maintenance and other areas. Depreciation and amortization expenses also increased by $4.4 million, largely related to purchasing its Q400s. At the same time, it saw a significant 167% boost in net income in the third quarter at $37.2 million.

Nevertheless, Jazz believes it will continue to be a significant provider to Air Canada going forward. The regional said that it received a $1.1 million increase in incentives through the CPA year-over-year in the third quarter due to several factors, including on-time performance, maintenance and dispatch reliability.

Planning for cost cuts at Air Canada is not a new task for Jazz. In anticipation of economic uncertainty, the two airlines amended their capacity purchase agreement in 2009 to run until 2020 instead of 2015. The change provided Chorus with more certainty with regard to the block hours it would be flying for the airline, but at the same time it lowered the rate of Chorus' mark-up from 16.72% to 12.50% on its controllable costs.

To accommodate its renewed fleet, Jazz further amended its CPA with Air Canada to reflect the six Bombardier Q400 options that it converted into orders at the Farnborough Air Show in July. These aircraft are added to the 15 Q400s it already integrated into the fleet. The number of covered aircraft under that agreement will decrease from 125 to 122 as the new 74-seat aircraft replace 50-seat CRJ100s.

Chorus plans to receive the new Q400s throughout the course at a rate of two aircraft per month in February, March and April 2013. Starting in December 2012, the airline will remove all of its nine CRJ100 aircraft to be replaced with the new models, which average 17 years. Chorus will own the aircraft through its leasing arm separate from Jazz, which could open up possibilities for new partnerships in the future at a later date.