Low cost & regionals: Branch lines

Source:
This story is sourced from Airline Business
Subscribe today »

US regionals may have taken a body blow when the troubled majors renegotiated their flying contracts, but they have gained the ability to branch out in new directions

Against the backdrop of the restructuring and reorganisation of the US major network airlines, through three bankruptcy reorganisations and major downsizings, the US regional sector has seen a profound change of its own. It has in effect traded guaranteed comfortable levels of return and profitability for greater freedom to seek profit.

As Phil Trenary, chief executive of Pinnacle Airlines, puts it: "We have been squeezed but we have won the right to seek more opportunities, to diversify, and so have that much more control over our fortune and future."

Time to experiment

Diversification by regional carriers into flying for multiple partners was until recently relatively uncommon. Horizon Air chief executive Jeff Pinneo has quipped that the Alaska Airlines unit was jokingly called "promiscuous" because it flew for carriers other than its parent.

The need to find new places and ways to fly has led some regionals to try corporate flying as charter operators and toward the risky path of flying on their own in so-called branded flying.

Continental Express affiliate ExpressJet, for instance, after losing some of the flying it did under contract for Continental, is now experimenting with branded or independent flying in its own colours on point-to-point routes. Few regional executives are optimistic about this experiment, with SkyWest's Jerry Atkin calling it "risky at best" and Pinnacle's Phil Trenary saying "that's probably not something that we would look at".

Pinnacle has tried diversification in a more manageable size with its purchase of Colgan, a step that represents another trend within the regionals: the resurgence of the modern, fuel-efficient turboprop.

It is Mesa Air Group that has been the most daring diversifier. Not only will it fly for as many majors as it can, Mesa also flies for itself on small community services and has embarked on two innovative offshore adventures: a Hawaiian stand-alone low fares operation dubbed go! and a planned regional jet venture in mainland China. This airline should begin flights later this year, starting with three Bombardier CRJ-200s from a base in Xi'an. Mesa will own 49% of the new Kunpeng Airlines.

Mesa chairman Jonathan Ornstein (pictured above) scoffs at sceptics who dismiss his new ventures. "We are desperately serious about Hawaii and we are making a go of go! We can make money there. And we see enormous potential in China, with perhaps 20 aircraft a year coming into the operation. We're big enough that we can try very different strategies". 

Chief executives of the largest regional groups point toward a new consensus: profitability going forward will not be determined by the arbitrary or even negotiated decisions of their major partners on how much those larger airlines will pay for flying. Instead, profitability will be determined by the ability and agility of regional executives to manage growth and diversification. Through the latest crisis, these regional carriers have gained the power to escape from their dependence on a single major partner and to operate on behalf of multiple partners, with contracts that provide reliable streams of income and balance out geographic or seasonal cycles. Bryan Bedford who, as chief executive of Republic Airways Holdings, runs one of the largest regional groups says: "The conventional wisdom and market criticism has been that, in good times, legacy carriers grow at the expense of regional. I contend that the rising tide lifts all carriers, and even though new contracts may be squeezing our margins, we are at our capacity. We are fully booked. In each of our competitions we are very satisfied with our returns. If we are not satisfied with the terms of a possible deal, we just don't bid on it." Republic, for instance, did not bid on new flying for Midwest or Northwest.

Superior yields

The regional sector has long enjoyed higher yields than others, with fares for the relatively shorter flights set by the majors and kept relatively high on a per-mile basis. The US Department of Transportation's Bureau of Transportation Statistics has consistently reported that the regional sector enjoys the highest yields, with third-quarter unit revenues averaging 15¢ a seat mile, compared to 14.1¢ for network carriers. The BTS also says the regional group's profit margin of almost 9% easily surpassed margins at network carriers of 5.4% and of low-cost carriers at 3.3% in the third quarter of last year.

So the key to profitability is cost control and, even with less generous contracts from the majors, the ingrained way of life of the regionals remains one of cost control and cost cutting, says Jerry Atkin, chairman of SkyWest.

He explains that this comes both through the tradition of regionals to retain their "mom-and-pop" culture of frugality, and the newer dynamic of rapid growth and diversification.

Atkin, one of the longest serving regional airline executives and a member of SkyWest's founding family, says: "We have plenty of experience in controlling costs. That is the key discipline in regional airlines, and once you can control costs, you can generate profits."

The majors, says Trenary, got what they wanted in the major reshuffling and re-bidding of flying contracts that dominated the last part of 2006 and the first part of this year: lower costs. Through their powers in bankruptcy, both Delta and Northwest put almost all of their regional flying out for competitive re-bidding, and that downward pressure on the flying they buy from regionals spread through the industry.

Trenary says that for many regionals, target margins set in the contract have dropped from about 10% to 8%, or less. At Pinnacle, the new contract, like other new regional flying pacts, removes some of the guarantees and built-in margins that were standard. For instance, Northwest will no longer give Pinnacle a margin on fuel, while margins on aircraft rents will fall as Northwest cuts the rates it charges Pinnacle to sub-lease jets.

Trenary believes regional managers have the skills to overcome these changes, and notes that after this year Pinnacle would have to share with Northwest any benefits it enjoys from exceeding the target margins.

At Mesa, a renewed contract to fly up to 50 regional jets for Delta, which Mesa chairman Jonathan Ornstein calls "a major strategic achievement", pays no mark-up or incentive compensation on fuel costs above a certain level, or on fuel that Delta provides.

At the same time that contracts revised by the majors loosen the restrictions on where and with whom they can do business, limitations of pilot-union scope clauses on aircraft size have been dramatically lifted and cash-rich investors have renewed their interest in regional airlines. As Bedford puts it: "We've seen a lot of relaxation of scope and though it isn't gone, we will see the lines of demarcation gradually moving in our favour. That frees us to operate and acquire the larger aircraft, the Embraer E-jets, and the capital markets have enough faith in us and in the regional sector that we can acquire them on favourable terms."

With growth comes diversification, and diversifying is the key strategy in keeping profits to a maximum and ensuring that profitability is achievable. Trenary says the first thing investors ask for when he meets them is diversification steps to take Pinnacle away from its dependence on a single contract with a single major. At Mesa, the strategy has taken the carrier overseas to China and to a new and highly contested market, the Hawaiian islands. Neither will Ornstein rule out further very different and innovative moves. The Hawaiian operation met considerable hostility from the two major intra-island carriers when it started in June, but Ornstein believes the market "needed shaking up".

At SkyWest, diversification has been achieved through the purchase of former Delta subsidiary Atlantic Southeast Airlines (ASA), for $425 million in 2005. Republic's holding company structure has allowed its carriers (Republic, Chautauqua and Shuttle America) to become regional flying providers to six major airlines.

Republic's diversification path

By the end of 2007, Republic will earn about 24% of its revenue from US Airways, 30% from Delta, 20% from United, 14% from Continental, 9% from American and 4% from Frontier. At Mesa, the split is 41% from US Airways, 36% from United, 17% from Delta and the rest from other contract flying as well at its independent Hawaiian unit go!

After Northwest re-negotiated its air services agreement with Pinnacle, Trenary went out and bought Colgan Air, a small Manassas, Virginia-based regional. At Pinnacle, the new revenue streams will reduce its dependency on Northwest to 70% next year, with Colgan's 30% contribution coming from three partners: Continental and US Airways at about 12% each and United the remainder. SkyWest's new Midwest contract, though small at 15 aircraft initially, will grow and help to diversify it away from its reliance on two majors, Delta at about 65% and United at about 43% (by capacity).

Regional executives agree that the need to add pilots and cabin crew is the single greatest management challenge they face going forward and, as training, recruitment and attrition costs increase, the single greatest threat to consistent profitability. For instance, SkyWest hired over 600 pilots last year. This year, when it adds 27 new regional jets, it expects to add 700 more new pilots. At Republic, human relations manager Jackie Thompson says of the group's aggressive recruiting: "Where aren't we hiring? We're going every place we can think of." Bedford adds that the airline is advertising "for the first time".

Atkin says that while the FAA's move to lift the mandatory pilot retirement age from 60 to 65 will help, SkyWest's attrition costs have doubled in the last year to about $6 million a year.

With pilot hiring comes another issue: labour costs. At SkyWest for instance, the two major units, SkyWest and ASA, are in very different situations, with SkyWest having no pilot union and ASA having a relatively militant chapter of the Air Line Pilots Association. The ASA pilots had been higher paid than the SkyWest pilots. ALPA's national leader, John Prater, has recently announced a concerted organising drive to enlist SkyWest pilots to the union.

Mesa's Ornstein believes that growth and promotion possibilities will help retain pilot group loyalty. He says: "If a pilot starts complaining about pay rates for a fifth-year first officer, I respond that fifth-year first officers are mythical creatures like unicorns. After five years they have been promoted to captain or have been hired away by a major and are making much better money." But Mesa is offering bonuses for new hires and has increased its co-operation with a New Mexico pilot-training academy.

If pilot hiring presents a real challenge, at least the other looming challenge - consolidation of the majors - is off the radar screen. The possibility of a US Airways takeover of Delta and a resulting merger mania worried these executives. But now, SkyWest's Atkin says: "Consolidation in the regional space is, I think, a tough thing to do and I'm not sure it makes a lot of sense. I think there will be consolidation of those who are doing a better job. They will increase their market share so it will happen more naturally than by mergers. It will in our space, in regionals, get down to a few large groups - us, Mesa, Republic, Pinnacle - and then the much smaller mom-and-pops."

Atkin says that with the return of some semblance of stability to the majors, growth may moderate. Analysts agree, with Jim Parker, the Raymond James and Associates analyst who specialises in the regional sector, predicting that the extraordinary rates of 2003-2005 - which reached between 16% and 30% annual capacity growth - will moderate this year into a rate of just over 2.6%.

For Atkin, this is welcome news: "In a lot of ways we see a need for a breather, a need for a little time to sit back and assess where we are and to concentrate on things like improving service where it needs improving, like planning for leadership succession, planning for longer-term issues and getting ready for the next step."

Republic has grown from a tiny, troubled turboprop-operator to a regional powerhouse in just five years. For more, see our blogs