For decades, the following question has amused commercial aviation enthusiasts and airline analysts alike: What is a regional airline? In general, a regional airline provides air transport services between a base of operations and airports located in less populous areas. A regional airline’s fleet consists mainly of 9- to 78-seat turboprop aircraft and/or 30- to 108-seat jet aircraft. A regional airline uses said aircraft to operate short-haul (less than 3 hours) and/or medium-haul (3 to 6 hours) flights. More than half of U.S. scheduled passengers flights are operated by regional airlines.
From 1999 to 2008, the regional airline industry experienced a considerable amount of growth. Available seat miles increase by approximately 168%, while revenue passenger miles rose by around 246%. Furthermore, regional airlines are providing an ever increasing proportion of domestic available seat miles. The regional airline business model is interesting as it permits relatively certain profit in an industry characterized by regular (and sharp) fluctuations in aircraft fuel and airline ticket prices, as well as passenger loads. The major regional airlines, or regional airline holding companies, are SkyWest (NASDAQ:SKYW), ExpressJet (XJT), Pinnacle Airlines (PNCL), and Republic Airways (NASDAQ:RJET).
How Do Regional Airlines Make Money?
The regional airline business model is one of the more profitable airline business models. Regional airlines generally enter into code-share agreements with major airlines, and are permitted to leverage the major airline’s brand recognition. The regional airline is authorized to use the major airline’s two-letter flight designator codes to identify the regional airline’s flights and fares in the central reservation systems, as well as operate under the major airline’s regional operations banner. The two types of code-share arrangements are pro-rate agreements and capacity purchase agreements (CPA).
Under a pro-rate agreement, or revenue-sharing arrangement, ticket revenues are distributed according to a pre-negotiated proration formula. Suppose a passenger were to fly from A to B on a regional airline, and from B to C on a major airline partner. The revenue generated by the complete trip, A to C, would be divided amongst the regional airline and the major airline. Note that if the passenger were to simply travel from B to C, the regional airline would not be entitled to a share of the ticket revenue. Under a pro-rate agreement, a regional airline incurs all costs related to the flights it operates, and is responsible for pricing, scheduling, ticketing, and seat inventory variables. The regional airline assumes a great degree of risk, but stands to profit from falls in aircraft fuel prices, as well as rises in passenger loads and airline ticket prices. As a result, profit margins associated with pro-rate agreements tend to be greater than those possible under a capacity purchase agreement.
Capacity Purchase Agreements
Under a CPA, or fixed-fee arrangement, part, or all, of a regional airline’s seat capacity is purchased by a major airline partner. The regional airline operates flights on behalf of the major airline, and is generally paid a fixed-fee for each block hour completed. In addition to providing services such as ground support and gate access to the regional airline, the major airline incurs pass-through costs, or operating expenses related to aircraft fuel, navigation, airport use, and terminal handling. Moreover, the major airline determines pricing, scheduling, ticketing, and seat inventory variables. The regional airline is responsible for labor expenses, aircraft maintenance, and aircraft rent (referred to as controllable cost items). A CPA protects a regional airline from variations in passenger loads, as well as fluctuations in aircraft fuel and airline ticket prices.
A regional airline may operate exclusively under the regional operations banner of one major airline, or may operate on behalf of several major airlines. By operating under more than one banner, the regional airline reduces the riskiness of its flying portfolio. When negotiating code-share agreements, major airlines seek to obtain a low-cost agreement by playing off regional airlines against each others. Moreover, major airlines must take into account mainline pilot scope clauses when entering into code-share agreements.
The Effect of Mainline Scope Clauses on the Regional Airline Industry
Mainline pilot scope clauses are contractual clauses negotiated between mainline pilots and the major airline by which they are employed. The scope clauses greatly influence the regional airline industry as they govern such factors as the types of aircraft used for regional airline operations, the number of regional airline aircraft in operation, the routes on which regional airline aircraft operate, and the number of block hours operated by regional airline aircraft. In general, regional airlines benefit from any relaxation of scope clauses.
From 2010 to 2016, major airlines will have to negotiate with regional airlines for the use of a considerable number of 50-seat aircraft. If mainline scope conditions are relaxed, 50-seat aircraft operations would be replaced (to a certain extent) with 70-seat aircraft operations, and would represent a boon for the regional airline industry.
Given the growth of the regional airline industry and the profitably of the regional airline business model, regional airlines are challenging investor perceptions toward airlines. The regional airline business model takes advantage of the major airline’s brand recognition, and minimizes risk in a volatile industry. Mainline scope clauses greatly influence the regional airline industry, and relaxation of scope conditions is key for growth in the next decade.
Disclosure: The author has no positions with respect to the stocks mentioned in this article.