Regional Airlines: Scrambling for New Strategies
A revolution is transforming the regional airline industry from one in which small planes smoothly funnel local traffic to hubs into something more like a hotbed of desperate innovation. The smaller carriers are being squeezed on all sides—by major airlines seeking cutthroat rates for contract flying, by low fares that have crimped traditionally fat margins on short routes, and by rising fuel costs. The business model that fueled rapid growth of regional airlines over the past decade—selling seats to hub-and-spoke legacy carriers—has been severely dented by the industry's downturn. "Regionals in the last year or so saw a 180-degree turn: They saw expenses spike with fuel and then within six months, they had a revenue problem because high-yield business travelers stayed home," says Doug Abbey, an independent airline consultant in Washington and a former researcher for the Regional Airline Assn. "They had a cost issue that almost immediately segued into a revenue problem. It was a double whammy." Those pressures have forced most regional carriers to scramble for new strategies. Perhaps the boldest course has been struck by Indianapolis-based Republic Airways (RJET), which went on a furious acquisition spree this summer. In rapid-fire deals consummated in July and August, Republic bought Midwest Airlines from private equity firm TPG and acquired Denver-based Frontier out of bankruptcy court for $108 million and the forgiveness of secured claims, trumping a rival bid from Southwest (LUV). Republic aims to diversify its revenue sources by, in essence, becoming a competitor to other carriers, including client airlines for which it flies short hauls under contract. "I don't view us entering the branded business as competing with them," Republic CEO Bryan Bedford says. Yet with the acquisitions, Republic now operates hubs in Denver and Milwaukee and is squarely in the sights of Southwest, which is making an expansion bid in both cities. AirTran Airways (AAI) is also working to make Milwaukee a strategic focus city, complementing its base in Atlanta. a decade-long boom crashed in 2008The entire industry is watching Republic's move closely. "Republic will certainly be an experiment," says Jonathan Ornstein, CEO of Mesa Air Group (MESA), parent of Mesa Airlines. "It entails risk, but I think they took a look at the future and decided it made sense." Fortunes have turned quickly for regional carriers. From 1999 to 2008, their traffic more than doubled, from 77.5 million passengers to 159 million, and revenue passenger miles more than tripled, to 73 billion, according to the RAA. Fliers got used to climbing aboard a plane that carried a major-airline name paired with that of a regional partner—say, SkyWest flying for Delta (DAL). Today, the smaller carriers account for a significant portion of legacy carriers' total flying, including 41% at US Airways (LCC), 40% at United (UAUA), 39% for the combined Delta-Northwest, and 38% at Continental (CAL), according to data compiled by Daniel McKenzie, an airline analyst with Next Generation Equity Research in Chicago. The future, however, could well bring a stagnant contract-flying business, barring an economic resurgence that boosts business travel and leads to higher fares. The big airlines are no longer willing to serve many smaller markets because those places produce less traffic and far fewer business travelers than metro areas. For example, by April, American (AMR) plans to end service between St. Louis and 20 destinations as it bolsters more lucrative flying at its bigger hubs. In a similar effort, US Airways plans to cut nearly half its daily flights from Las Vegas by February, and will pull out of Wichita and Colorado Springs entirely. arranging revenue splitsThe big airlines face further pressure from pilot unions. Bedford doubts they will offer airlines leeway on the "scope clauses" in their contracts that effectively limit how much flying airlines can outsource to the regionals. Such contract terms limit the size and number of aircraft an airline may deploy. The reality for carriers, Bedford says, is that "the best thing we can do in our core business is sort of hold the line" financially. Amid the turmoil, business relationships between regionals and others spring up and dissolve more quickly than ever. On Nov. 4, AirTran Airways and Utah-based SkyWest Airlines, the largest U.S. regional by passenger count, announced a partnership in which SkyWest offers daily flights on its own brand between Milwaukee and six mostly Midwestern cities that AirTran doesn't serve. Each carrier will collect the revenue from the portion of the route it flies. (For example, on a trip from St. Louis to Los Angeles via Milwaukee, SkyWest retains the St. Louis-Milwaukee revenue.) Unlike its traditional contract flying, SkyWest bears the risk for sales and fuel costs on the "prorated" flights feeding Milwaukee. AirTran will handle such ground services as baggage and check-in at each city. "Growth in the regional business is clearly going to come [from working with] the low-cost carriers" such as AirTran and JetBlue (JBLU), consultant Abbey says. He and others are deeply skeptical that SkyWest will make money on the flights, but note that the airline needs to deploy its jets somewhere for the hope of any return, regardless of the economic climate. The AirTran deal represents "a strategic positioning that will stimulate growth and drive long-term value for all of our stakeholders," SkyWest spokeswoman Marissa Snow said on Dec. 2. regionals' operating margins: betterHere's one example of the industry's revenue problem—and the type of fare competition the SkyWest-AirTran partnership will confront: A one-way flight early on Dec. 15 from Indianapolis to San Francisco, connecting at Chicago O'Hare, could be purchased on Dec. 3 for $78.20, including all taxes and fees. A fare that low, which includes a regional flight and is likely to attract primarily business travelers, decimates the network airline's yield for the route and is a major reason the large airlines press their regional partners so severely for cheaper flying rates. Even as they squeeze the smaller carriers for better rates, the majors still rely on them to maintain a presence in cities where mainline jets don't make economic sense. And despite all the economic turmoil, routes flown with regional jets typically make money—their operating margins are still generally better than those on many of the mainline routes the network airlines service with their own flights. The small-airline boom—and some of the bust—wouldn't have happened without the advent of modest, 50-seat regional jets. An industry darling for the 1990s, those planes were churned out by the hundreds at Bombardier and Embraer, the primary suppliers, as big airlines raced to add service to smaller cities. As of July 2009, more than 1,200 such jets were in service in U.S. regional fleets. But those planes were suited to a different era, when crude oil was $30 to $40 per barrel and its price was relatively stable. Today, oil trades at $76 per barrel and is subject to wild swings. It's much harder to operate regional jets economically because they have only 50 seats to spread those costs among, compared with larger models with 76, 84, and even 100 seats. Mesa: plagued by surplus 50-seat jetsThe problem, according to many experts, is that the industry bought far too many 50-seat jets, partly because of the union scope rules that limit how large a craft nonunion pilots can fly. Given the jump in fuel costs, airlines are now striving to cull several hundred of them from the U.S. regional fleet in favor of larger, more productive models. Mesa has been particularly hard-hit by the math. The Phoenix-based carrier has about half of its 136-plane fleet in 50-seat models. Mesa, whose long-struggling share price has fallen to 12¢, continues to work with creditors on what to do with those planes. To find more profitable uses for them, Mesa has deployed them far and wide: Some serve Hawaiian inter-island service—a joint venture with yet another Republic unit—while five others just returned to the U.S. following a joint venture in China that Mesa left this summer. "Our issue is getting jammed with all these aircraft," says Ornstein, the CEO. Separately, Mesa and Delta are locked in litigation over Delta's attempt to terminate a contract covering 22 50-seat jets that Mesa flies for Delta. Big carriers are also more likely to play regionals off against each other, a process enabled by a dramatic shrinkage in contracts from once-common 7-, 10-, and 15-year terms. Today contracts may cover two or three years, or even less. On Nov. 6, Mesa said United had declined to continue a deal covering 26 planes Mesa flew for it. Most of that flying is being transferred to Houston-based ExpressJet Holdings (XJT), which receives a discount on 30 50-seat jets it subleases from Continental, allowing it to bid for contracts at rates other airlines can't or won't match. ExpressJet also flies 214 jets strictly for Continental Express and operates a charter service. The new United-ExpressJet contract covers 22 jets, with a two-year term for half the planes and three years for the other half. "What we're seeing is the end of a life cycle," says Abbey, the consultant. "Granted, it was very brief and spectacular, but it has run its course."