Large Regional Jets - The Next Battleground
Prior to the early 1990s regional aircraft were synonymous with turboprop and piston operators. In 1991, Bombardier sowed the seeds of the regional jet (“RJ”) revolution by introducing the CRJ-100. By the middle of the decade, the CRJ-200 and its contemporary, Embraer’s EMB-145, had begun to propel the regional airline industry into the jet age. Passenger preference for jet aircraft aided the cause of the RJ as regional airlines and their ‘surrogates’, faced with the choice of operating RJs or potentially losing market share, placed large orders for Bombardier and Embraer RJ aircraft, among others. Recently, however, the airline industry started to witness a paradigm shift. The ‘small RJ’ era, which saw the introduction into service of approximately 2,000 regional jet aircraft over a 10 year period, appears to have rapidly matured, paving the way for a new battleground – competition with Large RJs. (For purposes of this article, ‘Large RJs’ will be a term of convenience used to refer to in-production aircraft models with 51-110 seats; however, the authors believe that the lines begin to significantly ‘blur’ between RJ aircraft and narrowbody aircraft for a number of types falling into this category, particularly given mission capabilities and seating capacity).
Birth Of The Regional Jet
The introduction of the RJ (primarily 50-seat aircraft) in the early 1990s started a revolution that rapidly spread through North America and Europe. By the end of the decade, 50-seat jet aircraft (and similar variants) played a vital role in reinforcing the ‘fortress hubs’ of network carriers, and became the preferred platform to provide feeder traffic to these hubs. For this ascension to the top of the regional aircraft hierarchy, RJs (both Bombardier and Embraer aircraft) owe a large part of their success to two phenomena – labor arbitrage and pilot scope clause relief. On the one hand, since a vast majority of RJs were operated by regional carriers at significantly lower labor rates, RJs became a more cost effective tool in the hands of network carriers; on the other, continued expansion of scope clause relief enabled network carriers to increasingly outsource the operation of 50-seat aircraft. There was also a third catalyst for the wide scale adoption of regional jets – the availability of favorable direct and indirect financing support from the regional jet manufacturers and other ‘interested parties’.
Today, network carriers are continuing to adapt their business models to cope with record high fuel prices and increased competition from low-cost carriers. In particular, the high relative fuel consumption of ‘small RJ’ aircraft coupled with continued pressure on unit revenues from low-cost carriers is shifting network carrier preference for incremental capacity and a portion of previously deployed regional jet capacity to larger jet aircraft that offer lower unit operating costs. For similar reasons turboprop aircraft are also enjoying increased relative demand, particularly for use in shorter haul (typically sub-500 nm) segments.
Labor Cost and Scope Clause Restructurings
In the post 9-11 era of out-of-court restructurings and bankruptcies, cost containment is a pivotal issue on which network carriers have staked their future. From 2002 through 2005, the nine largest network airlines in the United States (excluding Southwest) posted combined operating losses in excess of US$ 20 billion. To help stem losses and increase competitive standing, U.S. network carriers have sought a combination of increased scope clause relief and more dynamic wage structures – the objective being to competitively operate new aircraft models in the 51-110 seat segment, which had turned into a relative ‘void’ as carriers pursued the wide-scale retirement of their older aircraft types. Northwest and Delta are the latest network carriers pursuing competitive crew cost structures with which to operate Large RJs.
We view the actions being undertaken by Northwest and Delta to restructure labor costs, as well as the establishment by US Airways of a 100-seat pilot scale closely approximating that of JetBlue’s, as having enormous strategic implications for the industry. An intense competitive environment coupled with attaining a certain threshold of deployment of a given aircraft type/category can lead a fleet planner into making a decision that arguably falls under the subject matter of game theory. Specifically, the risk of being left behind quickly becomes more untenable than following suit with others – even if it is probable that any competitive advantage will be short-lived since most or all competitors will make the same decision.
With 20/20 hindsight it would appear that the extent of the 50-seat regional jet phenomenon was driven in part by this type of dynamic. It is our belief that the large regional jet segment could experience a similar phenomenon within a 3-5 year period as competitors seek to maintain a level playing field. We hold this view most strongly for the 80-110 seat segment, since aircraft falling within the 51-79 seat segment are subject to some degree of competition from 50-seat RJs to the extent such aircraft are available at the current market lease rates estimated by most appraisal firms.
Introduction of Large RJs
Labor cost restructurings and the easing of pilot scope clause restrictions in themselves are significant developments, but for the industry to undergo a discernible change that could be classified as a paradigm shift, another key ingredient is required – the aircraft! The actual success of a particular aircraft – as well as of a type-category more generally – hinges on how competitive the operating economics are on both an absolute and relative basis. Our analysis indicates that certain large regional jet aircraft types currently offered by Bombardier and Embraer – coupled with competitive wage scales that did not exist just several years ago – provide operating seat-cost economics that are within a few percentage points (under certain assumption sets that we view as reasonable) of certain popular narrowbody aircraft models currently in production.
A look at the U.S. domestic airline market indicates that a substantial percentage of markets are relatively smaller sized (particularly if competition is assumed in a reasonable number of the markets). Additionally, the majority of U.S. markets are within the range capability of the Bombardier and Embraer large regional jet products (roughly 2,000 nm, give or take). Based on our analysis, we believe that the market opportunity for Large RJs is up to 80-85% of passenger demand in the top U.S. domestic markets (see figure 1).
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Figure 1: U.S. Domestic Daily Passenger Travel |
The actual penetration is likely to be much lower than this range and will depend upon multiple factors. Nonetheless, the ability to deploy Large RJ aircraft at relatively competitive unit costs and low break-even passenger levels should prove to be an attractive value proposition for many carriers. Longer-term, the U.S. as well as Europe should continue to experience the shifting of capacity from hub & spoke to point-to-point service as part of the long-unfolding deregulation of the industry. We believe that this continued shift drives growth in the number of carriers serving particular markets and growth in the connecting of new city pairs – factors that we believe will also lead to long-term carrier preference for smaller shell sizes for some material level of markets served.
In assessing the probable supply/demand characteristics for Large RJs it is also interesting to note that only about 10% of the worldwide operating fleet of Western-built regional jet and narrowbody aircraft fall into the 61-100 seat segment, and that approximately three-quarters of these aircraft are out-of-production models (such as Fokker 100s, DC-9-30s, etc). We believe that the relatively few number of ‘modern’ aircraft falling into this seat category combined with the positive economic fundamentals previously discussed indicate favorable long-term positive demand for aircraft falling into the 61-100 seat segment.
Large Regional Jets - The Next Battleground
As previously discussed, the industry’s evolution towards Large RJs is well grounded in terms of operating economics. Historical patterns indicate that labor agreements at the network carriers will continue to restructure in a manner which ensures that most carriers will not enjoy too great of a competitive advantage over their peers. If this pattern holds, the potential operator base that can ‘competitively’ operate Large RJs (i.e., through outsourcing or by operation with mainline crew at reduced pay scales) should substantially widen. These changing industry dynamics pave the way for the wide-scale penetration of Large RJs over the long-run.
Based on the foregoing views presented in this article, we expect the following three trends to emerge in the airline industry:
- Network carriers increasingly deploy Large RJs (predominantly with 80-110 seats) to enhance competitiveness in certain markets;
- Regional carriers concentrate their growth on Large RJs (predominantly with up to 79 seats) on behalf of network carriers and potentially some LCCs; and
- Additional LCCs operate Large RJs (predominantly with 80-110 seats) to tap thinner markets or to compete more effectively in highly contested markets.
First Wide-Scale Deployment of the Large RJ by a Low Cost Carrier
If ever the Large RJ needed a high profile ‘flag bearer’ to trumpet its capabilities, it found one in JetBlue, which deployed the first of its EMB-190s in October 2005. The growth of this fleet type by JetBlue might just be the catalyst the Large RJ (in particular, models in the 80-110 seat category) needed to tip it from a viable idea to an industry phenomenon. Although JetBlue has experienced some ‘hiccups’, these appear to be normal ‘teething’ issues similar to those experienced on certain of the most popular narrowbody aircraft types in worldwide service today. Some industry analysts believe that JetBlue will suffer a competitive disadvantage from introducing a second aircraft type into its operations. It is our view that David Neeleman’s ‘crystal ball’ – which has had an outstanding overall track record throughout his career – should not be discounted too quickly this time around!
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