ExpressJet (XJT)

SkyWest Airlines:

The regional jet market is inextricably linked to the fortunes of the airline industry as a whole and, as such, regional jet manufacturers have also been subjected to economic uncertainties, and the adverse market conditions faced by the broader civil aviation market.

Traditionally, regional aircraft have been used on shorter, lower-density routes. These markets were historically well served by turboprop aircraft until regional jets first appeared in the late 1980s. As low-cost carriers have increased their market penetration and point-to-point flying, traditional hub-and-spoke carriers have made increased use of regional aircraft to maintain service to the spoke cities. Regional jets have lower pilot and operating costs than larger jets, and major carriers have responded to the downturn in the economy and the increase in low-cost carrier penetration with increased reliance on smaller aircraft. Because of their longer range, and because passengers view these aircraft as more akin to larger jets in terms of comfort and convenience, airlines have substituted regional jets for larger jets on lower-density routes, as well as on busier routes at lighter times of the day.

Regional jets and turboprop aircraft make up 14.9% and 10.9% of the total hours flown worldwide respectively, although the percentage remains smaller on a seat or distance basis. Regional jets are primarily concentrated in North America, which accounts for 75% of scheduled hours flown by regional jets worldwide. Regional jet operators are highly concentrated – the top seven carriers in terms of regional jet hours account for more than 50% of worldwide regional jet activity; this compares to 15 carriers for 50% of widebody aircraft hours and 19 carriers for 50% of narrowbody aircraft hours.

The regional jet manufacturing base is largely restricted to Empresa Brasileira de Aeronautica, S.A. (“Embraer”) and Bombardier, Inc. (“Bombardier”) which are jointly responsible for over 80% of the regional jets operating in the world today. Such companies as Fairchild Dornier and BAE Systems manufactured the remainder, but have largely exited the new regional jet market. Nevertheless, increasing competition in the future is likely from Sukhoi with its Superjet 100, the proposed Chinese AVIC I Commercial Aircraft Company ARJ21 Advanced Regional Jet, and potentially from Mitsubishi with its Mitsubishi Regional Jet (“MRJ”).

Almost all of the capacity growth in regional jets has come from carriers in North America and, in particular, the United States. From 2004 to 2006, regional jet capacity remained reasonably static in Europe, while regional jet capacity in Asia and the Pacific Rim decreased 40% over the same period, mainly due to the removal from service of older regional jets such as the BAe-146 series. However, it should be noted that capacity for Embraer and Bombardier regional jets is now growing in Asia and the Pacific Rim. Although the market still represents a comparatively small portion of the overall regional jet market, this growth does suggest significant potential for the future.

The ongoing threat of terrorism, competition from low-cost carriers, and persistently high fuel prices have forced the major U.S. carriers to cut costs and capacity simultaneously. With longer-range regional jets available, many major airlines have chosen to transfer capacity from narrowbody mainline aircraft to regional jets, enabling the reduction of trip related fuel costs, but at the same time increasing market penetration by increasing flight frequencies.

Despite the sharp growth of regional jet operations in the United States through 2007, the ability to make full use of regional aircraft has been limited by labor contracts

that include scope clauses. While scope clauses differ from airline to airline, they all affect the ability of the carriers to use regional aircraft by limiting the size and the number of the regional aircraft that can be flown. For example, US Airways had been limited to flying no more than 70 regional aircraft that could be no larger than 69-seat capacity. With the major restructuring of labor contracts that occurred in the recent downturn, there has been a relaxation of the scope clauses. The maximum number of regional jets that US Airways can fly has increased to 465, with the maximum number of seats increased to 90. Similarly the maximum aircraft size for United has been increased from 50 to 70 seats. The weakening of the scope clauses is expected to increase the use of regional aircraft by the major airlines, and the increase in allowed aircraft size will continue to move the average regional jet to the 70-seat and larger size. In the United States, it is likely that there will continue to be a market for the 50-seat aircraft as the small turboprop markets develop and the smaller regional jets replace those aircraft. It will, however, be a comparatively mature market and much-reduced demand is expected for new aircraft.

Outside of North America, growth of smaller regional jets is likely to remain more modest. Few routes in the developing world would benefit from migrating from narrowbody to regional jet usage because of the latter’s higher unit costs. The same could be said for Europe, where congestion and high landing fees at many airports result in pricing that favors larger jet aircraft. SH&E anticipates that the majority of growth in the global regional jet market will be for larger aircraft such as the 70 to 110-seat offerings from Embraer and Bombardier.

The structure of regional airline operation in the U.S. is also undergoing significant change as airlines face relentless cost pressures. Although a majority of the regional airlines that are used by the major carriers are wholly owned subsidiaries, a number of the regional affiliates are independent of the major carriers and fly under contract either on a pro-rate or a fee per departure basis. Under the fee-per-departure contract, the major carrier controls the marketing and scheduling, and pays a set fee to the regional carrier with the regional carrier relatively insulated from market risk. The converse is true of pro-rate contracts under which the regional carrier has freedom to set schedules and often to sell local tickets. The pro-rate agreements set the terms for splitting the ticket revenue received from passengers with segments on both the regional and the major carrier and the regional carrier assumes a greater proportion of the market risk.

Major carriers often have both kinds of contracts with different regional airlines. For example, Delta has fee-per-departure contracts with Chautauqua Airlines, ExpressJet, and SkyWest, and also pro-rate contracts with American Eagle Airlines and

ExpressJet. In a major recession, however, the major carriers cannot afford to continue paying the higher fees, and, as occurred in the recent downturn, many major carriers renegotiated the terms of the contracts, making them less advantageous to the regional carriers. For example, United announced in November 2004 that it would competitively re-bid routes that Air Wisconsin Airlines Co. (“Air Wisconsin”) was flying. Many of these routes were subsequently awarded to SkyWest, Go Jet Airlines, and Mesa. Meanwhile, Air Wisconsin now operates feeder services on behalf of US Airways.

The ownership status of many regional carriers has changed over time. For example, ASA and Comair became wholly owned subsidiaries of Delta Air Lines in 2000, and Air France acquired Brit Air in 2000. Conversely, ExpressJet Airlines, Inc. had been wholly owned by Continental Airlines, Inc. (“Continental”), but the regional airline became a public company with an initial public offering in 2002. In September 2005, Delta announced the sale of wholly-owned subsidiary Atlantic Southeast Airlines to Delta Connection carrier SkyWest. Meanwhile, ACE Aviation Holdings, Inc., the parent of Air Canada, completed the spin-off of its Jazz regional subsidiary in February 2006 and Pinnacle Airlines purchased Colgan Air in late 2006.

Despite these present structural uncertainties the growing importance of regional flying to both U.S. and European major carriers. As seen in the following figure, the percentage of the total domestic capacity flown by regional airlines has increased substantially at a large number of major airlines from 2006 to 2007: