Big worries for tiny markets

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The regionals are the Goldilocks of the airline industry, trying to fit "just right" aircraft to "just right" routes while struggling with the same meteoric increases in fuel prices that are overwhelming air transportation as a whole.

The cutbacks that are prompting major carriers to park planes, downsize hubs and lay off employees are also affecting the regional operators of aircraft ranging from 19-seat Beech 1900s to 86-seat Embraers.

Operating contracts are being revised to shift risks and beef up performance expectations. Aircraft are being pulled out of service. Elsewhere, mergers and acquisitions are being contemplated. Some regionals are going out of business, leaving smaller markets with little or no scheduled airline service.

"Skyrocketing fuel prices pose a severe threat to the 70% of the nation's airports whose only scheduled service is from regional airlines," said Roger Cohen, president of the Regional Airline Association. Regional carriers BigSky, Skyways and Air Midwest, which served smaller communities under the federally subsidized Essential Air Service program, folded this year because they could not pass on fuel costs to the federal government.

Across the regional industry, the fuel and revenue risks are borne by the mainline carriers, while their smaller airline partners -- both independents and those owned by mainline operators -- usually bear the cost of acquiring the aircraft, operations, dispatching, maintenance and labor. But that arrangement could now be threatened. As the price of crude oil has risen above $130 a barrel, the "crack spread," the price difference between crude oil and jet fuel, has jumped from the historically typical $5 a barrel to between $30 and $40 a barrel. That, in turn, is pressuring the industry on all fronts.

Regional carrier executives warn that along with less frequent flights, their customers can expect to see sharply higher airfares as ultralow, discount fares are eliminated in the new airline environment.

"It'll be as expensive to go on a vacation as it is to go on a business trip," said Mesa Air Group Chairman and CEO Jonathan Ornstein. "That's really where the difference is right now. Those people [leisure travelers] are going to be cut off the plane, or it's going to become more expensive."

New operating agreements

ExpressJet, which was spun off in 2002 from Continental Airlines, this month began operating under a new, seven-year contract with its former parent. The previous, 10-year agreement was renegotiated two years ahead of schedule. The new agreement calls for the same size fleet for a year, with Continental having the right to withdraw 15 aircraft after one year.

Like most regional partners, ExpressJet operates on fixed hourly rates with expenses such as fuel passed through to the mainline carrier.

The new agreement is based on rates that are "considerably lower" than its previous contract, ExpressJet said. That's forcing the Houston-based carrier to do some aggressive cost-cutting to stay competitive with Continental's other regional partners.

Continental previously moved some of its Express service to other independent carriers because they had lower costs than its former wholly owned subsidiary. "It's all about who can provide the lowest-cost fee to the mainline carrier," said Tulinda Larsen, managing director at OAG Analytical Services in Washington. "If the independent can, they're going to get the job. If they don't, they lose it."

Contracts that five years ago gave the regional carrier a good bit of latitude about operational efficiencies are all under review.

Dion Flannery, president of US Airways Express, said: "We absolutely are looking at all aspects of the contracts we have today [and] our understanding of what newer contracts might mean, might entail and might include in terms of operating metrics, those criteria by which the regional partner is measured and incented and penalized in terms of payment. That's going to be a huge focus going forward."

Flannery oversees two in-house regionals, Piedmont and PSA, as well as contracts with independent partners SkyWest Airlines, Mesa Air Group and Republic Airlines.

The key, said Russell Childs, president and COO of Utah-based SkyWest, the largest of the regional carriers, "is to make sure we have an economic model that's going to work, make sure you've got the right people in place to provide the service. We've got to make sure we take care of our people in these tough times. We've got to make sure we have the right infrastructure and tools and equipment in place to keep our performance top in the industry."

The right airplane for the job

The domestic U.S. airline industry is looking for every way possible to remove capacity where it exceeds demand and thus keep fares low. For the regionals, the primary target is jets with 50 or fewer seats.

With the advent of smaller jets in the late 1990s, regional operators became enamored with the idea of all-jet fleets. Jets offered more comfortable accommodations and were quieter than turboprop aircraft, which had been the industry's workhorse.

But today the regionals are discovering that when jet fuel is selling for $175 a barrel and up, there are too many small jets, and it is impossible to operate them profitably.

"Traffic's actually pretty good, but with fuel prices just so much higher than anyone planned, it's hard to make ... the smallest of the aircraft work in most environments," said Mesa's Ornstein. His company is embroiled in a legal battle with Delta Air Lines, which wants out of its contract with Mesa's Freedom Airlines unit to operate 50-seat jets. Mesa has threatened bankruptcy if Delta is successful in abrogating the contract, which generates about $20 million in monthly revenue to Phoenix-based Mesa. SkyWest and Pinnacle are also fighting Delta in court over contract issues.

Ornstein argues that there's a place for the smaller jets, particularly as the industry contracts: "There's going to be a big capacity reduction, and fares will go up. As fares go up, the economics of the regional jet start to come back into play, because you're talking about fewer seats and higher fares."

If "small" is 50 seats or less, the 70-seat to 86-seat regional jet appears to be the sweet spot right now. However, only two regionals, SkyWest and Republic, have the available capital to acquire newer, more fuel-efficient aircraft.

Republic got a painful lesson in economic codependency in April when one of its mainline partners, Frontier Airlines, filed for bankruptcy and canceled an 11-year contract under which Republic operated 12 small jets. Republic is now the largest Frontier creditor, saying the move cost it $260 million.

Republic, which still partners with United, Continental, American, US Airways and Delta, is resizing its 230-plane fleet by eliminating 41 37-seat and 50-seat jets over the next two years. It's offsetting that with the purchase of 16 larger Embraer jets this year.

"We're matching the right machine to the mission in markets where a 146-seat A320 doesn't make sense, but the 86-passenger or 76-passenger Embraer 170 or 175 does," said Warren Wilkinson, vice president for governmental relations and corporate communications at Indianapolis-based Republic. "The trip costs on a large regional jet compared to a larger narrow-body jet are significantly lower. You deliver the same quality product at a much lower cost."

There is also a movement back to turboprops such as Bombardier's new Q-400 and the ATR 172, which are larger, much quieter and more comfortable than their predecessors.

Alaska Airlines, for example, filed with the Department of Transportation recently to turn over to Horizon Air, its wholly owned regional, some of its Los Angeles-to-Mexico routes, now flown with Boeing 737s. Horizon is in the process of getting rid of its 70-seat CRJ-700 jets in favor of the 74-seat Q-400.

The Q-400 is ideal for routes up to 450 miles, which make up most of Horizon's network, said industry consultant Robert Mann. During a recent Horizon analyst presentation, it was suggested the Q-400 "is somewhere in the region of 10% to 15% more efficient than the CRJ-700. That's the [efficiency] number you need to bring on new aircraft."

In-house or outside partners?

Along with contracts, business models involving the in-house regional versus the independent partner are also under review. US Airways' Flannery said the wholly owned carriers were integrated into the overall mainline management structure, which can offer advantages over independent partners.

 "Historically, there's been better communication and participation in terms of corporate objectives," Flannery said. "So, their response time and manageability is more apparent and transparent. You lose some of that as you deal with your regional partners who have interests that aren't perfectly aligned with yours, no matter how well-intended."

Delta, Northwest, American and US Airways still have major regional operations within their mainline structure.

But because the independent regionals are able to diversify by serving more than one mainline carrier, OAG analyst Larsen observed that "from the regional perspective, it's better to be outside the corporate structure of the mainline."

ExpressJet's new contract helps further separate it from Continental to pursue its other businesses, flying as Delta Connection under its own brand and on contract.

Another advantage to having an in-house regional is that a strapped mainline carrier can book one-time income from selling it off, as Continental did with Continental Express, Larsen said. But, she added, in today's environment, "who would buy them? That's the question."

With more performance requirements in contracts, the regionals are no longer the rock-solid investment they once were. The 20% annual rates of return that regional stocks used to generate are "things of the past," said Virginia-based independent industry analyst Darrell Jenkins.

Just as the consolidation talks are flying among the largest airlines, acquisition talks also are under way on the regional side of the business. ExpressJet rejected an all-cash offer from SkyWest on April 25. A month later, ExpressJet said it was "continuing to explore a full range of strategies and operational alternatives in response to the unsolicited merger proposal from SkyWest."

The changes ExpressJet agreed to in its new Continental contract made it no longer the attractive acquisition target it had been previously, said SkyWest's Childs.

"With oil approaching $140 a barrel, going up $11 in one day, I think the consolidation and acquisition situation within the regional airline industry ... is going to be pretty slim from here on out," Childs said.

Scant federal protection for small markets

The communities at greatest risk of losing air service altogether are the smaller U.S. cities served under the government-subsidized Essential Air Service program, as well as cities within 90 minutes' drive time of larger airports that offer more carriers and more destinations. But it's unclear what the ultimate ramifications of lost service would be.

The short-haul hops might have been profitable for the airlines once, but no more. And according to at least one analyst, some services might not be of much benefit to these communities in the first place.

"While the loss of it seems like a blow to the local economy," said Robert Mann, "in fact they were making terrific compromises to use the service that was already there, which was infrequent, was high-cost and may not have really met their needs."

The EAS subsidy program currently is tied up in the FAA's reauthorization legislation in Congress. The Bush administration wants to limit funding to a total of $50 million for the most isolated communities. At that funding level, more than half of the 145 EAS cities would lose service, which often sees carriers paid for flying empty or near-empty aircraft. DOT said 2008 funding was set at $125 million. There is no provision to pass through rising fuel costs on existing contracts.

To be sure, interest in participating in the EAS program isn't dead. When Mesa's Air Midwest surrendered its operating certificate to get out of the program, it left uncovered Athens, Ga., home of the University of Georgia and about 80 miles from Atlanta Hartsfield-Jackson Airport. Athens also lost service to US Airways' hub at Charlotte.

Within weeks, three entities had filed proposals with the DOT to pick up the contract but based on current fuel prices. Local airport officials in Athens backed the proposal from Pacific Wings, a Hawaii-based regional that has demonstrated it can wean itself from the EAS subsidy by using nine-seat Cessna 208 Caravans. The EAS program requires at least 15-seat aircraft unless there is local support for another solution.

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