SkyWest: A Business Under Threat


It's no secret in the airline industry that 50-seat jets are on their way out. These little airplanes became very popular among U.S. carriers in the 1990s and early 2000s, as they are faster than turboprops and small enough to offer frequent service between hubs and small cities. However, they burn far more fuel per seat than larger regional jets and mainline aircraft, and also cost more per seat to maintain.

These were reasonable trade-offs in the 1990s, when jet fuel prices were well below $1 per gallon. In today's environment, when jet fuel routinely costs $3 per gallon, the additional fuel expense makes it uneconomic to fly these planes.

For that reason, Delta Air Lines announced a plan last year to reduce its 50-seat regional jet fleet to no more than 125 aircraft by the end of 2015, down from a high of 550 planes in 2008 and 2009. It is replacing that capacity with larger regional jets (mostly seating 76 passengers) and small mainline aircraft (110 seats). United Continental is also replacing many of its 50-seat jets with larger regional jets, although it remains well behind Delta in that process.

SkyWest: rolling with the punches
One of the big potential victims of this switch is regional carrier SkyWest . Regional carriers fly regional jets and turboprops for legacy carriers, and SkyWest is the biggest player in this market. In fact, it is the largest operator of 50-seat (and smaller) regional jets in the world, with more than 500 such aircraft in service. With so much of its business tied to a disappearing market segment, it's clear that SkyWest is in a delicate situation.

It's particularly critical for SkyWest to adapt because while it does some flying for all of the legacy carriers, 97% of its capacity was allocated to United and Delta in 2012. Since both of these carriers are looking to dramatically slash their 50-seat jet fleets, SkyWest needs to move quickly into more stable market segments.

Moving up
SkyWest hopes to make the best of a bad situation by growing its fleet of large regional jets. The legacy carriers like these aircraft a lot more, because they have lower unit costs than 50-seat jets but are more comfortable for passengers and can accommodate a first-class cabin, which attracts business travelers. Since large regional jets provide higher value to the major airlines, they are willing to pay a premium for them, allowing the regional airlines to improve their operating margins.

Indeed, in the past year SkyWest has signed contracts with its top two customers, Delta and United, to operate large regional jets for them. However, other regional airlines may be positioned to gain share from SkyWest during the transition to large regional jets. For example, top competitor Republic Airways operates a similar number of large regional jets and turboprops as SkyWest; SkyWest currently has 199, versus 183 for Republic.

By contrast, Republic operates just 70 small regional jets, compared to SkyWest's more than 500. As a result, SkyWest is not likely to replicate its dominance of the 50-seat-jet market in the 70- to 76-seat-jet market. Moreover, since large regional jets have significantly more seats than the 50-seat jets they are replacing, airlines do not need as many of them. This means that SkyWest's fleet size will shrink dramatically, as will its need for pilots.

The company may be able to manage this downsizing through attrition, as the major airlines (which offer higher pay than regional airlines) have begun hiring again. However, it remains a significant potential risk factor to be aware of.

Long period of transition
SkyWest's heavy reliance on 50-seat jets means that it is a business facing significant threats. While the company has long-term contracts to fly these small planes for major airlines (primarily United and Delta), in some cases the contracts end before the aircraft are scheduled to be retired or returned to the lessor. This creates a risk of future write-downs if SkyWest is unable to dispose of these unwanted assets. Moreover, while the company dominated the 50-seat regional airline business, it is unlikely to replicate that dominance in the large regional jet category.

Republic Airways, which has lower exposure to the 50-seat-jet market, therefore seems like a safer bet for investors. Although, SkyWest does have the ability to manage this transition to make the best of the situation. In a companion piece that I will publish later this week, I will assess some of SkyWest's opportunities to fly into a better future.

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Editor's note: A previous version of this article misstated the number of large regional jets and turboprops that SkyWest operates. The Motley Fool regrets the error.

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Adam Levine-Weinberg is short shares of United Continental Holdings and is long Sep 2013 $33 Puts on United Continental Holdings and long Aug 2013 $10 Calls on Republic Airways Holdings. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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