The Worst Has Yet to Come for Regional Airlines

You may not be familiar with  SkyWest (SKYW) or  ExpressJet , but there's a good chance you've traveled with one of these airlines. Operating small jets and turboprops from low-density markets, regional carriers paint their aircraft with the colors and logos of their code-share partners, while providing connecting traffic to major hubs. SkyWest, for example, flies out of Chicago as United Express and from Salt Lake City as The Delta Connection, while ExpressJet operates as Continental Express.

For the safe and efficient transfer of passengers, regional airlines receive a guaranteed revenue stream with a contractual profit margin and are reimbursed for many flying costs such as fuel, landing fees, and insurance. Regional carriers are only indirectly exposed to the variations in ticket prices, passenger loads and fuel prices that trouble legacy carriers. With deals like this, it's not surprising that regional airlines have been consistently profitable through the course of the commercial airline cycle. But should investors be taking notice?

Most Morningstar followers know that we think a firm's intrinsic value is best determined by projecting and discounting its free cash flows. When looking at the regional airline group, we focus on the sustainability of a carrier's free cash flow over the long haul. To begin this approach, let's first take a look at the reasons behind the proliferation of regional flying in the United States.

Why So Many Regional Airlines?
The slowdown in air travel demand after 9/11 forced legacy carriers (like  United Airlines , for example) to downsize their fleets to match the reduced demand on many routes. Often, this required the replacement of larger mainline aircraft with smaller regional jets. This was a simple solution for slackening demand, except that mainline pilots at legacy carriers refused to fly these smaller planes in an attempt to protect their salaries. Pilots of smaller aircraft generally earn less than those who operate larger mainline planes. Legacy airlines, therefore, opted to outsource these short-haul flights to regional carriers.

But to protect their mainline jobs, pilots' unions negotiated scope clauses, or stipulations in union contracts that restrict the size and number of smaller jets that can be outsourced to regional carriers. As long as legacy carriers abided by these rules, they were allowed to allocate short-haul capacity to regional carriers, thereby matching capacity with demand and increasing route flexibility. As more and more routes were downsized, the market for regional flying took off, with regional passengers surging to more than 151 million in 2005 from just more than 80 million in 2001. Regional carrier growth has been impressive, and regional carrier profitability has been even more so, despite the massive losses by their network partners in recent years.

Operating Margins for U.S.Carriers
	Regional Carriers	Legacy Carriers
1998	17.0%	8.5%
1999	17.0%	7.1%
2000	16.0%	5.0%
2001	4.0%	-12.6%
2002	7.0%	-13.4%
2003	11.6%	-4.1%
2004	10.6%	-6.7%
2005	9.2%	-4.4%
Source: Regional Airline Association, Morningstar data

In our view, this imbalance is unsustainable over the long haul: Either legacy carriers will return to enduring profitability, or regional carriers will share more in legacy carriers' pain. The recent upswing in air travel demand has legacy carriers now turning profits alongside their regional brethren, but the next economic downturn, the timing of which is uncertain, will likely push mainline carriers back into the red, much like it has done in previous cycles. Also, legacy carriers, by necessity, must strive for leaner operations, as unit costs remain significantly greater than those of their low-cost rivals (like  Southwest (LUV), for example).

With these factors in mind, we recognize that the recent profitability of legacy carriers is largely a function of the current upswing in air travel demand and not that legacy carriers have transformed into sustainable profit-making entities (check out this article, "Why We're So Bearish On Legacy Airlines"). Global shocks and the general economic cycle coupled with legacy carriers' high financial and operating leverage make enduring profitability nearly impossible to achieve. As a result, we think that to resolve this profit imbalance, margins will continue to shrink for regional carriers.

Weakening Economics, Fierce Competition, and Limited Supplier Power
To no surprise, pressure on contractual operating margins for regional flying has already taken hold, both in and out of the bankruptcy courts.  Northwest  and  Delta  are currently using Chapter 11 protection to extract cost savings from their regional affiliates. These exploits have followed United Airlines' successful bout during its restructuring process to force its code-share partners to accept less-lucrative terms. Furthermore,  Continental  recently achieved more than $100 million in annual cost savings by choosing Chautauqua to replace capacity previously operated by ExpressJet.

Though majors use regionals, in some cases, as a finance arm to expand their fleet, we contend that the primary value of regional services to the legacy carrier depends on regional carriers' labor cost advantage. Most regional carriers are younger than their network partners and often are not unionized, which translates into lower salaries and benefits for their workers. We believe that, as length-of-haul-adjusted labor costs for legacy carriers converge with those of regional airlines, the value of outsourcing regional flying deteriorates.

Labor Cost Per Available Seat Mile, in Cents*
	Regional Carriers	Legacy Carriers	Difference
2001	2.46	4.60	2.14
2002	2.70	4.89	2.19
2003	2.54	4.60	2.06
2004	2.38	4.23	1.85
2005	2.21	3.73	1.52
First half of 2006	2.10	3.30	1.20
*Length of haul adjusted, 1,000-mile trip Source: SEC filings, Morningstar data

Though the difference between legacy and regional labor costs is still sizable, the gap has closed substantially. We expect this labor disparity to shrink even further as a result of recent structural changes in the airline industry. For starters, the growing overlap in aircraft sizes operated by mainline and regional pilots suggests that pay scales could potentially converge, especially if scope clauses continue to be relaxed. One example is  US Airways , which, after emerging from bankruptcy, chose its own mainline pilots to fly its regional Embraer 190 jets, rather than hiring  Republic  to provide the service. In addition, with fewer spots available for mainline pilots as domestic flying continues to be outsourced to feeder airlines, regional pilots are gaining tenure, putting upward pressure on wage rates within the regional ranks. We expect these conditions to lessen the attraction of regional flying services over time.

What's more, over 80 regional carriers in the United States will ensure that market rates will match the value of regional flying, as there are only a handful of large domestic network operators from which to seek business. To make matters worse, most requests for proposals for regional flying are based on number of aircraft, not on the amount of capacity to be flown or passengers to be carried. Therefore, the trend toward larger regional aircraft (70 to 90 seats), which can provide incremental capacity with fewer planes, will likely slow the growth of domestic regional jets in service, despite continued outsourcing by the majors. We expect this deceleration to heighten competition as regional carriers become increasingly aggressive in their attempts to secure new business or retain existing capacity.

But perhaps most ominous is that network carriers possess substantial bargaining power during contract negotiations. Most feeders are ill-equipped to break ties with their larger affiliates due to the higher unit costs associated with flying smaller jets on shorter routes. One has to look no further than the Independence Air liquidation to ascertain the possible fate of regional carriers that attempt to go at it alone. Also, flying rates on most contracts are reset annually, providing legacy carriers with frequent opportunities to adjust terms to match the market or demand further concessions. In the worst cases, network airlines can cancel agreements with one year's notice to replace existing capacity with a lower-cost provider.

Declining Profitability Is Inevitable
So, what does all this mean? For one thing, we expect operating margins to continue to fall for the regional group. For example, our long-term operating margin assumptions for  Mesa Air  and ExpressJet are significantly lower than their 2005 levels. Additionally, we think SkyWest and Republic will experience reduced profitability in coming years, as legacy carriers continue to seek out the lowest-cost regional service provider. Our long-term margin forecasts would be even lower for these regional carriers if we excluded the positive impact from declining fuel costs, which are direct pass-through expenses.

Regional Carrier Operating Margins
	2005	2006*	Long Term*
Republic	17.5%	18.5%	16%
SkyWest (SKYW)	11.2%	11.3%	10%
Mesa Air	11.4%	7.8%	7%
ExpressJet	10.0%	8.9%	7%
Source: SEC filings * Morningstar estimates

What's more, due to the fragility of regional carrier contracts and the "musical chairs" the industry has experienced in recent years, we have little confidence in the sustainability of a regional carrier's future free cash-flow streams. Though we expect the number of code-share feeders to decline as carriers with bloated cost structures fail or team up with better operators, we do not think this change will be enough to stifle cutthroat competition among the regional clique. As investors may have gathered by now, we think regional airlines represent poor long-term investment opportunities.