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 regional jet 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 US Regional Jet Population Growth
(Number of planes)
2,000 19% CAGR 11%
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
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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
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)
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.
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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 outsourcing 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
Embraer––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.
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.
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Exhibit 3 New RJs: Filling the “Capacity Gap”
props 1 st generation RJs
CRJs Next generation RJs
B -737 Family
30 50 70 90 110 130 150 170 190
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 regional
airline 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
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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
Exhibit 4 Illustrative Economics for Entry of Low-Cost Airlines into
(stage length of 500 miles)
CRJ-200 CRJ-700 ERJ-190 B737-3
(50 seats) (70 seats) (100 seats) (126 seats)
Expenses $8,529 RASM 0.147 0.147 0.143 0.129
CASM 0.147 0.138 0.124 0.135
Yield 0.214 0.214 0.174 0.179
$4,000 $3,682 $3,671
Load 69% 69% 82% 72%
$932 Passengers 34 48 82 91
$0 Average $107 $107 $87 $89
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
! 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
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! 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
! 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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