Between the United/Continental merger, the Delta/Northwest merger, and a possible American Airlines/US Airways merger, there has been a flurry of activity among major U.S. carriers in the last few years. However, behind the scenes there has been even more activity among U.S. regional carriers, many of which you may have never heard of. Much of the activity has included consolidation, but there has also been a fundamental shift in the type of relationship between regional carriers and their major counterparts, which has already had broad implications for regional carriers and will certainly have an impact in the future.
First, let’s briefly review how regional airlines work. Typically, a small carrier with a niche in a certain region of the U.S. will contract their services to a larger carrier in order to feed traffic from small cities to the larger hubs. These small carriers operate their own aircraft typically with a capacity between 50 and 100 seats, utilizing small turboprop and regional jet fleets. They also have their own flight crews, maintenance operations, and more. Furthermore, the major airline that contracts the regional carrier will normally brand the services as “Express” or similar name (i.e. United Express, Delta Connection, US Airways Express), but one “Express” brand may consist of multiple contracts with different regional carriers. For example, United Express has 12 different contracts for regional service with CommutAir, SkyWest Airlines, ExpressJet, Trans States Airlines, Cape Air, Chautauqua Airlines, Colgan Air, Mesa Airlines, GoJet Airlines, Republic Airlines, Shuttle America, and Silver Airways. I bet you have not heard of three of those companies.
Like I previously mentioned, the regional airline industry has seen a lot of activity in the last few years, especially regarding consolidation. Here’s the timeline for the last eight years:

Figure 1: Regional airlines have heavily consolidated since 2006, and some major carriers have recently started divesting their regional subsidiaries
Why the heavy activity? Well, since the regional carriers operate on a contract basis with the major carriers, there is always constant pressure to lower their operating costs in order to provide a more efficient and competitive service. In order to accomplish lower costs and to survive, the regionals followed the method of the major carriers and decided to grow inorganically.

Figure 2: Revenues have grown overall at regional carriers, but the most growth has occurred among the independent carriers
They achieved the goal of lowering costs. Since 2006, the Cost Per Available Seat-Mile (CASM) has fallen at the three largest independent regional carriers (SkyWest, Pinnacle, and Republic) by 29%, 15%, and 1%, respectively, according to an analysis of their annual reports. Revenues have also soared since 2006 (see Figure 2). This seems to paint a pretty picture for the regional airlines, but do not be deceived. Figure 3 tells quite a different story, with quickly-rising costs since the mergers have occurred. The low operating margins and low CASM seems to indicate conflicting information, but there is an answer.

Figure 3: Operating margins at regional carriers have steeply declined in recent years
Since CASM is calculated by dividing the operating costs by the available seat-miles (ASM) that an airline offers each year, it will vary with capacity. A quick check of the ASMs from each company verifies that overall regional airline capacity has increased since 2006, which explains the declining CASM. Meanwhile, operating expenses have risen sharply since 2009. Next, we need to identify the source of the rapidly rising costs.
Initially, it’s easy to correlate the rising operating expenses to the mergers and acquisitions that have taken place. However, a carrier will typically begin to be profitable a few years after a merger is complete, due to realized synergies from the integrated and more efficient operations. So why is everyone suffering?
Maintenance is certainly a growing issue since the average fleet age of the regional carriers is rather high. In addition, according to a report by Aviation Week, “Three of every four of the General Electric CF34-3 engines that power 50-seat regional jets will need to be overhauled within the next three years at a total expected cost of more than $1 billion.”
When I looked further into their operational models, however, I don’t believe that it was any one expense, or group of expenses, that has led to this money losing situation. One of the key reasons to pursue a merger, like I mentioned, is to realize operational synergies by integrating the best of both companies in order to make as efficient of an operation as possible. That includes merging overlapping routes, integrating the fleets, obtaining a common seniority list and pay agreement for unionized workers, obtaining one common operating certificate, and much more. Due to the highly contractual nature of regional airline business, however, most of that integration did not happen. For example, SkyWest Inc. owns and operates two airlines: SkyWest Airlines and ExpressJet Airlines. Both have their own crews, aircraft, operating certificate, lease agreements, and more. In other words, they’re still more or less two separate companies and the operation is referred to as a “fenced operation.”
There are many reasons for a fenced operation. It could be a clause in the contracts with the major carrier or the flight crews want to protect their seniority/pay and maintain separate crew groups. The bottom line is that the fenced operations are causing some of the largest regional carriers to fail to realize valuable synergies and are not operating the most efficiently.

Figure 4: Many regional airlines operate the majority of their fleet with 50-seat jets (highlighted in red), leaving them exposed to additional pressure from the major carriers
There are still more reasons these companies are struggling lately, and I mentioned in my introduction that there has been a fundamental change in the relationship between regional and major carriers. Not too long ago, major carriers like Delta and American owned their own regional subsidiary. American owned American Eagle and Delta owned Comair. These subsidiaries, however, have not been competing well with the independent regional carriers by just about any measure. Just before American entered bankruptcy protection, however, they announced that they would be divesting American Eagle through a sale or spin-off. Delta also recently announced that it is shutting down Comair, effective September 29 this year. The primary reason behind these moves is due to the realization that the 50-seat regional jets are no longer as fuel efficient as the larger 60-80 seat regional jets (see my previous post on turboprops gaining market share over regional jets). The majority of Comair and American Eagle’s fleets consist of these aircraft, making quickly replacing them a formidable challenge.
This situation represents an opportunity for leverage for the major carriers. By getting rid of their regional subsidiaries, the major carriers can now demand the best and most competitive contract from a large pool of independent regional airlines. Delta has already utilized this leverage by renegotiating with SkyWest to acquire 36 76-seat aircraft and also get rid of 66 50-seat CRJ jets through 2015. If you know how WalMart exerts significant pressure on its suppliers to provide the lowest price and best quality, this situation is essentially the same.
In summary, regional airlines are going through tough times right now due to three main factors: failure to realize adequate synergies from consolidation, extra pressure from major carriers to keep their costs low, and the difficulty in maintaining a fleet of larger aircraft. It will be interesting to see how many contract revisions take place in the next few years between the major and regional carriers.