Is a Crisis Coming in Regional Aviation? By Matthew Bennett

One of the most successful sectors of the aviation industry over the past decade has been services. In North America, regional airlines such as SkyWest and Mesa Air, which serve low-density markets, have been embraced by market analysts and shareholders for their high margins and stable earnings. Their market strength has been driven by the versatility of regional jets, cost discipline, and the advent of creative risk-sharing partnerships with major airlines. The economics of these businesses, however, are poised to shift dramatically with the introduction of larger regional jets. Major airlines and their regional affiliates who do not consider the implications now may later face the consequences of inaction.

A Great Takeoff

Regional jets have proven to be ideal for flying on routes that are too “thin” to support traditional narrowbody aircraft (e.g., B737) service and, as a result, regional aviation capacity has expanded rapidly. In 1997, there were fewer than 150 regional jets in North America. By 2002, the number of regional jets had grown to over 1,000, and more than 2,000 are expected to be in the air by 2006 (Exhibit 1).

Exhibit 1 US Regional Jet Population Growth (Number of planes)

2,500

2,000 19% CAGR 11%

16%

1,500 22%

28% 1,000 33% 48% CAGR 33% 500 43% 57% 79% 0 1997 1998 1999 2000 2001 2002 2003 2004 2005E 2006E

Source: BACK Aviation, UBS report August 2003.

What sets regional carriers apart, however, has been their consistent profitability. While the majors continue to flounder in a sea of red ink due to high operating and labor costs, regionals’ economics are fine-tuned for their market niche. Their costs are competitive, and their service is targeted at relatively price-insensitive business customers, producing a healthy profit. For example, on a typical 500-mile route on which a 50-seat regional jet replaces a 126-seat narrowbody aircraft (known as “downgauging"), the regional jet’s revenue per available seat mile (RASM) may be over 50 percent higher, while its cost per available seat mile (CASM) is only 9 percent higher. Additionally, load factors in many cases are higher on regional aircraft. These factors work

10 Mercer on Transport & Logistics together to raise operating margin significantly for the 50-seater, illustrating why regional jets are so prevalent today.

Regionals have also benefited from the recent industry downturn, which caused major airlines to outsource lower-density routes that they could not operate profitably. This has been done primarily through fixed-fee or cost-plus contracts, known as capacity purchase agreements (CPAs). CPAs have the attraction of mitigating earnings risk for the regionals through pre-determined target margins, while protecting the brand and ensuring the availability of capacity for the majors.

Under CPAs, network carriers are generally responsible for commercial planning, revenue management, sales and distribution, and branding and marketing. It is also customary to assume fuel and insurance risk. The contracted regional carrier handles labor, maintenance, and operation of the aircraft, as well as station and ground requirements. Target operating margins range between 10 and 15 percent under most CPAs, and are usually re-priced annually to ensure revenues and costs are in line with targets.

A Smooth Flight?

The result of the regional aviation boom is that the market value of such carriers has grown at a compound annual rate of 22 percent over the past eight years, comparable to the market performance of low-cost carriers such as Southwest and JetBlue (Exhibit 2). The superior growth and economics provided by CPAs have made many of these carriers the “darlings” of Wall Street. Given that the current business model appears to be working so well, analysts are continuing to predict high growth in this sector, particularly for those carriers who are beginning to abandon 50-seat planes in favor of more economical 70-seaters. Expectations of 20 to 35 percent earnings growth are commonplace for the leading regional airlines.

Exhibit 2 Share of Airline Industry Market Value by Segment (based on quarterly market value) Market Value CAGR 100% Regional +22% carriers

80%

60% Low-cost +24% airlines

40%

20% Mainline -15% carriers

0% Q1-96 Q1-97 Q1-98 Q1-99 Q1-00 Q1-01 Q1-02 Q1-03

Source: Compustat, Mercer analysis. Mainline = American, Delta, Continental, United, Air Canada, America West, Northwest, US Airways, Midwest Express, TWA, Midway. LCCs = Southwest, Vanguard, AirTran, Frontier, JetBlue, ATA. Regional = Mesa, SkyWest, Great Lakes, ACA, Mesaba, Big Sky, ExpressJet.

11 Mercer on Transport & Logistics Equally, major airlines are betting on the continued good performance of regionals to help them out of their doldrums, with many in the process of signing new contracts. Regional service has become the cornerstone of several recovery plans, with the majors transferring an increasing number of routes to regionals under CPAs.

On the surface, network carrier to regionals makes sense, given that majors remain uncompetitive in many markets despite restructuring efforts. Flexible work rules also enable regional pilots to fly more than their network counterparts, positioning regionals to “pick up the slack” on routes with poor operational characteristics for large planes.

The question is whether this gamble will pay off much longer. There are signs that the regional business model is already coming under pressure. In particular, the 50-seat regional jet is likely to provide diminishing returns, as there are few new markets left that can be served profitably. In fact, Bombardier and ––the two largest manufacturers of regional jets––face a dwindling backlog for 50-seaters.

This sector also is likely to see a major struggle between regional and network carriers over strategic control. Major airlines, particularly those in bankruptcy, are putting pressure on regional partners to accept reduced margins on new contracts, together with more expense and revenue risk. They are also attempting to exert control through allocation of 70-seat regional jet flying to captive regionals vs. wholly owned subsidiaries. Additionally, the majors would like to see operational costs reduced in the regional sector, and will continue to exert downward pressure on margins.

Turbulence Ahead

While all these issues may affect the regional business model to some degree, none will have the impact of what may be the industry’s next “category killer”: the introduction of larger, more cost-effective 100-plus seat regional jets (Exhibit 3). The superior economics of these new jets will enable carriers to enter traditional regional markets at lower fares, stimulating demand and supplanting the current fleet of 50-seat jets that require higher fares to operate profitably.

That this will happen––and soon––is evidenced by the interest of low-cost operators. JetBlue announced last summer that it was buying 100 Embraer ERJ- 190s (100 seats), and had identified nearly 1,000 cities where it could introduce service. JetBlue expects to start taking delivery of the jets in 2005. And Southwest has stated that it is evaluating the aircraft’s economics.

The ERJ-190 will offer a significantly better customer experience than the current fleet of 50-70 seaters (e.g., wider seats, more headroom/legroom, less noise), and will be able to fly longer routes. It even compares favorably with narrowbody aircraft such as the B737 in terms of comfort and performance. Add to this the leather seats and seatback video that JetBlue plans to install on their regional jets, and you have a radically improved customer experience compared with what most regional passengers are accustomed to today.

12 Mercer on Transport & Logistics Exhibit 3 New RJs: Filling the “Capacity Gap”

Turbo props 1st generation RJs CRJs Next generation RJs Narrowbodies FRJs

ERJs

ERJ-170

ERJ-190

MD-80

B -717

A318/319/320/321Family B -737 Family

B -757

30 50 70 90 110 130 150 170 190 Seating capacity Source: Mercer analysis.

Most importantly, the new mid-sized jets are likely to drastically alter the economics of the regional market. Regional carriers survive by taking only the highest-yield traffic in low-density markets. Although they have fewer seats and higher costs per available seat mile, they fly higher loads and charge significantly higher fares than network carriers. If low-cost carriers enter these markets with larger, more comfortable jets at stimulative fares, demand for lower fares will collapse current 50-seat regional jet economics. As a result, value will migrate to the operators of larger 100-seat regional jets.

To illustrate the impact, we can revisit our initial example of a B-737 route downgauged to 50-seat regional jet service (Exhibit 4). A carrier entering this market with a 100-seat regional jet would have 15 percent lower unit costs than the 50-seat jet. If a carrier such as JetBlue or Southwest were to start selling tickets at $87 on the 100 seater (a fare that would provide a healthy operating margin), the 50-seat operator would be forced to drop its average fares from $158 to $107. This would reduce the revenues on the smaller jet to below operating costs. Meanwhile, the lower fares in the market would stimulate demand and drive higher load factors. In the end, the 100-seat ERJ-190 could achieve a RASM on par with the 50-seat aircraft, with CASM 15 percent lower than the 50-seater and 8 percent lower than a B737.

Additionally, by filling a critical “capacity gap” between small regional planes and the large aircraft used predominantly on major routes, larger regional jets will be able to take advantage of new growth opportunities. Demand can be better matched with capacity, frequency of operations can be increased on many city pairs, and more distant markets can be flown, given the planes’ greater range. Ultimately, carriers that adopt 100-plus seat jets have an opportunity to shift the customer value proposition and market economics of regional jet service squarely in their favor.

Unfortunately, the very CPA agreements that proved so valuable in early relationships may hamper the ability to respond to this threat. While CPAs protect regional airlines from revenue risk, they also place them under the strategic control of the major airline due to pilot contract “scope clauses.” Major airline scope clauses typically restrict the size and number of jets that their

13 Mercer on Transport & Logistics regional partners may fly, and even restrict routes. Such restrictions on regional affiliates and the inability of major airlines to economically operate in certain markets or with certain aircraft would likely bolster the case for new entrant 100-seat operators.

Exhibit 4 Illustrative Economics for Entry of Low-Cost Airlines into Regional Markets (stage length of 500 miles)

CRJ-200 CRJ-700 ERJ-190 B737-3 (50 seats) (70 seats) (100 seats) (126 seats) $10,000 Revenue

Expenses $8,529 RASM 0.147 0.147 0.143 0.129 (US$) Profit $8,105 $8,000 $7,147 CASM 0.147 0.138 0.124 0.135 $6,215 (US$) $6,000 $5,155 $4,833 Yield 0.214 0.214 0.174 0.179 (US$) $4,000 $3,682 $3,671

Load 69% 69% 82% 72% $2,000

$932 Passengers 34 48 82 91 $322 $11 $0 Average $107 $107 $87 $89 ($424) Fare

($2,000) Margin 0% 6% 13% 5%- CRJ-200 CRJ-700 ERJ-190 737-300

Source: 2003Q3 data from DOT databases T100 and DB1B; Mercer analysis. Assumptions: Stage lengths from 400-600 miles. ERJ-190 average ticket price reflects cost + 15% premium; 737 average fare reflects 2.5% fare premium over ERJ-190

Holding on to Small Skies

Mercer believes that to win in the evolving regional sector, all players will be called upon to re-examine their markets. It will also be critical to consider historical reactions to competition when developing strategic response options.

A number of competitive responses are available to incumbent regionals and major airlines. A “one size fits all” approach will not work: Each carrier will have to assess which strategies offer the best fit with their business model and resources:

! Fly different planes: In the near-term, replacing 50-seaters with 70-seaters would provide an opportunity to spread out costs and lower fares. Network carriers could attempt to operate 100-seat jets as part of their own major fleets, but their economics are unlikely to match those of regionals or low cost carriers. Carriers could also fly other narrowbody aircraft (e.g., B717s or A318s) on routes where adequate demand stimulation might exist. AirTran, for example, is using B717s to enter moderate-density regional routes.

! Fly planes differently: Carriers could evaluate the potential to operate 100-seat jets more economically through higher utilization and a denser seating configuration. This could potentially be achieved by allowing current lower-cost subsidiaries (e.g., United’s Ted or Delta’s Song) to manage these operations.

14 Mercer on Transport & Logistics ! Engage pilots: Network carriers could engage pilots in scope clause renegotiations, with a goal of enabling regional affiliates to acquire and operate 100-seat aircraft, or obtaining lower wage rates for these aircraft. Pilots may not be willing to make more concessions, however, as the economy rebounds.

! Develop the next-generation CPA: Majors could develop a new CPA which would allow them to outsource 100-seat jets to regionals, but with network pilots flying some or all of the planes. The impact on costs for regionals (due to increased pilot pay) would have to be assessed, as well as the impact on regionals’ relationships with their own pilots’ union. Initial analysis suggests that the economics of such a CPA could work with the right structure.

It will likely take at least two years for the full effects of the new 100-seat jets to be felt in the regional aviation market, giving network and regional carriers a valuable window of opportunity to get ahead of this issue before it begins to have an adverse effect.

As a first step, carriers need to assess their current contracts to ensure the moves they make today will not hamper them down the road for competing successfully in regional markets. Network and regional carriers together can test and segment markets to identify which are most vulnerable to encroachment, and begin working to minimize their exposure to 50-seat aircraft values. Finally, potential competitive responses need to be evaluated to determine which are most feasible for a particular carrier and likely to provide lasting value once the regional market shakeup begins in earnest.

Andrew Watterson and Michael Zea, Directors in Mercer’s Aviation Practice, and Scott Kend from Mercer’s New York office, also contributed to this article.

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