Regionals special report: Sombre fiesta

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Regional airline executives gathering in Spain will be hard-pushed to get into the party mood after a year that has forced them to seek out new niches and innovative ways to make ends meet

This month around 500 regional airline executives will gather for the European Regions Airline Association general assembly in Barcelona, but the Spanish fiesta spirit is likely to be lacking. "Traffic figures were picking up," says long-standing ERA director general Mike Ambrose. "But the light at the end of the tunnel turned out to be the burning top of the Icelandic volcano."

Mount Eyjafjallajöekull struck a fiery blow to European regionals, crippling them with lost revenues and hefty payouts under European compensation rules. "It was enormously damaging for cashflow - the absurd regulation 261 just milked cash from our members," says Ambrose. "It wasn't that they had their business strategy wrong. Some airlines with a fleet of only 20 aircraft had half a million in cash taken out of their enterprise. Now, because of regulation 261, they have to build it up again." Ambrose estimates that a quarter of ERA's members were seriously affected.

(c)alex e proimos (flickr creative commons)

©Alex E Proimos
One very real casualty is Aer Arann, a 40-year-old Irish regional airline which - while still operating normally - has just entered the equivalent of US bankruptcy protection. Chief executive Paul Schütz has "no doubt" that, without the volcanic ash crisis, he could have avoided this fate. "We were ahead of budget and forecast until volcano day," he says.

After two loss-making years Aer Arann's cost cutting plan was beginning to kick-in and this April it began a new franchise operation for Aer Lingus. "If we hadn't had these extraordinary circumstances, we would have had a reasonably good year," says Schütz.

Instead, the airline's cashflow was crippled as uncertainty over airspace closures drastically shorted its passenger booking profile. Schütz says the volcano drove €4.5 million ($5.8 million) in direct and indirect costs, pushing Aer Arann to the brink. "If we didn't get examinership, it would have been time to turn off the lights. It was that close," he says.

Schütz insists Aer Arann's business plan is sound. It just lacked the financial rigidity to weather another crisis while still wounded by the downturn. The volcano was primarily a European issue, but in an industry susceptible to everything from plagues to meteorological abnormalities, smaller players can suddenly be brought to crisis point.

And it is not only European regionals that are suffering. "It's not the best time in the battle ground, when costs are up but the yields are slim," says Bangkok Airways president Puttipong Prasarttong-Osoth. But prospects for Asia remain good. "In two years from now, I see substantial growth for regional airlines, particularly in this part of the world where the biggest economic hubs are being shifted to China and India. For Bangkok Airways, we plan to tap new markets, launching new flights to key cities in India by next summer."

In the USA the picture is not as bright. Earlier this year Mesa Air Group, parent to Freedom Airlines and Mesa Airlines, entered Chapter 11. Others looking to avoid this fate have been locked in a consolidation frenzy, dramatically shifting the landscape as each player seeks to cut their costs and gain leverage for major feeder contract renewals.

Meanwhile, Delta's remaining wholly owned regional subsidiary Comair has just detailed a dramatic restructuring that will see it will downsize from 97 to 44 aircraft by the end of 2012. President John Bendoraitis says Comair's block hour costs are 20% higher than its rivals. "Our current cost structure does not enable us to be competitive. To secure our future, we need to demonstrate our ability to operate as a standalone entity. We must be able to earn a profit while reducing our operating costs to what the market is willing to pay for our services."

MARKET FORCES

"In a way, the market itself is destroying the [regional] segment," says Jürgen Hild, managing partner at consultancy firm Aviation Competence. "If the market is not willing to pay the revenue needed to provide a strong enough margin for the operator, routes will disappear." Hild believes we may see a cycle where unsustainable regional routes are dropped for two to three years until the market is willing to pay sustainable rates.

But at the same time opportunities are emerging. Lufthansa Regional, where Hild was formerly head of partner management, will exit 50-seat operations in February 2011 creating potential openings for other players. "When small animals walk behind a big elephant in the jungle, they are happy with the shit the elephant leaves behind. The elephant is content and so is the jungle," says Hild.

Similarly, UK regional carrier Flybe has reacted swiftly to Ryanair's decision to pull out of Belfast City, seizing the chance to base two more aircraft there and open three routes. Ryanair is closing its base because of delays to the airport's runway extension project.

Today's regionals have to be nimble, jumping in and seizing opportunities as they arise. "You can have no preconceived ideas, saying we are a schedule airline and we will only do this because that won't work," explains bmi Regional managing director Stewart Adams. "We've been referred to as the guys who live in a caravan. As soon as things get hard and things change, we'll hook on the caravan and we'll move somewhere else. That has worked very successfully for us for 23 years."

Aberdeen-based bmi Regional operates a fleet of 37-seat Embraer ERJ-135 and 49-seat ERJ-145s on full-service scheduled routes, oil and gas links, corporate charters and wet-lease contracts. Alongside its scheduled flying, which supports parent company bmi, it flies football teams to matches, wet-leases aircraft to Brussels Airlines and operates a shuttle service for Airbus.

"We're very much a niche carrier. We make no apologies for that at all," says Adams. "We've always had to be fast on our feet and look for the odd corner where we can go and hide. We don't tend to compete with A320s or 737s because we probably have to accept that they have won the battle long-term."

Over in Switzerland, Embraer E-Jet operator Baboo is facing a similar challenge. Chief executive Mark Darby says the battle is finding small niche or hub-bypass routes that fall below the radar of larger carriers. "If routes have the mileage and potential to grow, they attract low-cost players which can operate the route more effectively than a small regional. The standalone business is challenging."

Darby believes the answer to this regional quandary is consolidation. "This is how regionals get closer to the unit costs of low-cost carriers. You can't do it with five or 10 aircraft. You need to find ways of growing quickly. Organic growth is slow and quite high risk. Bringing airlines together into one lump, providing that the integration is done well, is probably way to go." Baboo itself is exploring a range of consolidation opportunities in the short term. "There is pressure to find a better way of doing things than we do now," says Darby.

CONSOLIDATION FRENZY

This is the US solution, with SkyWest, Republic and Pinnacle emerging as the front runners in the consolidation game. "The [US regional] industry has been shrinking, with fewer and fewer players which are becoming larger," says Michael Derchin of CRT Capital Group.

SkyWest, a sizeable operation in its own right, is acquiring ExpressJet, which it will merge into its Atlantic Southeast Airlines subsidiary. "We will continue to evolve; those with the best quality and most efficient operations will remain," says SkyWest Airlines president Chip Childs.

Pinnacle Airlines, which is parent to Colgan Air, acquired former Delta regional Mesaba Airlines earlier this year, while sister Delta regional Compass was sold off to Trans States. Meanwhile, Republic has added Frontier and Midwest to its growing stable of airlines: Chautauqua Airlines, Republic Airlines and Shuttle America.

"We've seen quite a bit of consolidation in the regional sector here in the USA, which is not dissimilar from the consolidation of the legacy carriers, and it's certainly possible we'll see more of it," says Republic chief executive Bryan Bedford. Derchin agrees: "A lot of transactions have taken place, but there are still some sizeable regionals which have not been sold off, so I still see quite a lot of activity in front of us. Delta has been in the process of selling off its regionals, but it hasn't sold Comair yet and I wouldn't be surprised if they did at some point. American Airlines also has a fairly large regional, American Eagle. It has said it's looking for ways of amortising subsidiaries to end up outside the AMR system."

Pilot scope negotiations will also continue to shape the US regional landscape, particularly as majors with differing policies come together. Derchin says Delta and Northwest took a while to sort out their regional operations and now all eyes are on Continental and United. "That's a very large airline with a lot of regional partners. It will be a big catalyst, shaking things up. They use different regionals and the scope of United is more liberal than Continental."

He explains that under bankruptcy protection United lifted its scope restrictions to 70 seats, while Continental is more restricted around 50-seat mark. "The pilots hated it and they might see this merger as an opportunity to rein in the new United."

Republic has sought to future-proof itself against scope uncertainty and a lack of market growth via its acquisition of Frontier Airlines and Midwest Airlines. "Maintaining a diversified and growing revenue stream has been a core attribute of Republic's success over the past decade and we think it will continue to be so in the coming decade," says Bedford.

Over in Europe, Danish regional Cimber Air attempted a similar diversification by acquiring failed budget carrier Sterling and re-inventing itself as Cimber Sterling. But this "David acquires Goliath" strategy is yet to be proven and few regionals have the financial muscle to go on a spending spree. Besides, it is tough even finding a low-cost niche.

Instead, like US regionals, European players are increasingly looking to team up with network carriers, offering feeder services or wet-leased capacity. "There's a fundamental question of whether regionals can exist as their own airline, or only as the appendage to a larger network," says Vik Bhatia, managing director of Boston Consulting Group's Dallas office. Schütz from Aer Arann agrees: "Purely independent regionals, unless they have a very particular niche, will struggle." Aer Arann sees its new Aer Lingus Regional franchise deal and other partnerships as core to its future strategy. Even Flybe, which swelled to be one of Europe's largest regional carriers when it acquired British Airways' regional business, has formed a new codeshare partnership with Air France and is in talks with Finnair about providing feeder services. It has also boosted its revenues by providing Olympic Air with capacity.

Partnerships and consolidation are popular because many regionals have cut their costs as far as they are able. Their priority now is on finding new dimensions to the business to generate revenues, and profits. "Regionals don't have much more fat to cut in to, so innovation and reactivity have to be their strength," says Ambrose from ERA.

But Lim Kim Hai, executive chairman at Australian regional Rex, disagrees. Eight years ago he introduced a productivity committee to look for potential savings. "Every year we find around A$2-3 million [$2-3 million] in new cost savings. You'd have thought we'd come to the end of our ability to squeeze out additional productivity gains, but we are still finding surprises for the time being," says Lim. But he is very specific about the kinds of gains he is seeking: "If I cut my meal cost from A$5 to A$4, but only get A$4 worth, I see that as zero gain. I pay less, but I get less."

Most airline chiefs would be delighted to hit a 10% profit margin, but Lim is far from satisfied. "Rex has one of the highest airline returns in the world - 10% is exceptional - but it is still not good enough to compensate for the risk and effort of this business."

Lim says Rex has done well by keeping below the radar of larger operators while optimising its network. "Over the last eight years our network hasn't changed much, but our profits have more than tripled, despite adding only one or two new routes," he says.

PUSH HARDER

Rex has a string of non-scheduled flying activities, both active and in the pipeline. When added together, Lim says these could contribute another 50% in revenues. "All our activities have a common thread, they are related to regional aviation," says Lim. "We are not just chasing down every business opportunity available." This additional work also helps to spread Rex's organisational overheads. "If I extrapolate our human factors group - which oversees safety, security, compliance and quality - to the size of Qantas, it would probably be a group of 300. That's unthinkable. A company like Qantas couldn't afford it and this is a real burden we have to face."

In a further defensive move, Rex has invested A$20 million in a new pilot training academy. "It's important to future-proof the pilot stream because we're bottom of the airline pecking order. One year we lost 50% of our pilots. We realised we could go out of business even if we were profitable because we just couldn't replace pilots quickly enough." The school has capacity to train 200 ab initio pilots every year, delivering around A$25 million in annual revenues.

The airline has also taken on a 10-year air ambulance contract and performs contract flying for the mining sector. But one of Rex's stranger revenue streams comes from providing target practice for the military. "We take a jet, tow a target and a ship fires at the target," says Lim. "We use a squadron of ex-fighter pilots and they simulate missile and aircraft attacks. We are aiming to supply the complete target needs of the air force and army. We will know the results by the end of the year."

Darby from Baboo chuckles at this suggestion: "I think when you get to that stage, [using your aircraft for target practice], maybe you should give up!"