Regional airlines try new routes; Some pursue own brand as fee-based contracts change

Regional airlines are undergoing a transformation that could provide investors with new opportunities down the road.

Following several years of strong growth, the U.S. airlines that fly regional jets, seating between 35 and 100 passengers, last year experienced a slowdown. So these airlines, which account for half of all commercial flying in the U.S., are taking different routes to find new sources of income.

More than 40 airlines belong to the Regional Airline Association, the industry's trade group. They range from seat-of-the-pants operations to publicly traded names such as ExpressJet Holdings Inc., Mesa Air Group Inc., Pinnacle Airlines Corp., Republic Airways Holdings and Skywest Inc.

Traditionally, small regional airlines have had predictable streams of revenue through fee-based contracts with major carriers. The regionals offer connecting flights to smaller airports where big airlines don't fly. Those contracts, with locked-in fees, put regional carriers in the driver's seat when the airline industry downturn hit in 2001.

But in the past couple of years, the big airlines signed new contracts with the regionals, cutting the fees they paid. That pinched profits, causing regional carriers to seek new sources of revenue.

Some regional carriers now have begun expanding by flying under their own names. In the past, even the larger regionals kept a low profile, flying mainly under the flags of other airlines. Passengers might not know, for example, that a plane sporting Continental Express livery in fact is part of ExpressJet's fleet.

ExpressJet now has an ambitious plan to take its own brand to 24 cities while it continues to fly for other airlines.

"What ExpressJet is doing is a bellwether for the industry," said Roger Cohen, head of the Regional Airline Association.

Phoenix-based Mesa also has expanded its geographic reach. Last year, the airline introduced interisland service in Hawaii. The carrier also has entered a joint venture with China's Shenzhen Airlines, that country's biggest private airline, to form a new regional airline based in Beijing.

Analysts have mixed views about the changing regional airline industry. Ray Neidl at Calyon Securities has an "add" rating on two airlines, Republic and SkyWest, based on their relative financial strength and growth potential.

JPMorgan analyst Jamie Baker is more cautious, with an "underweight" rating on Mesa, Pinnacle, ExpressJet and SkyWest. He believes the airlines remain at risk to downturns or consolidation at major airlines, even as they make a financial stretch to start new ventures.

American Airlines, a unit of AMR Corp., and Delta Air Lines Inc., own the regional airline subsidiaries American Eagle and Comair, respectively. Delta has considered divesting Comair, but American has said it remains committed to owning American Eagle. Earlier this year, Northwest Airlines Corp. acquired Mesaba Airlines, its regional partner of 22 years.

But the "scope clause" remains a longtime headache for regional carriers. It's a provision in pilots' contracts that limits the number of planes or seating capacity of regional jets that can be operated by a major airline. It's designed to protect the higher-paying jobs of mainline pilots from being outsourced to regional carriers. Scope clauses are easing as new contracts get signed, Neidl said, but it's a "long and slow process."