Led by industry trendsetter Delta Air Lines (NYSE:DAL), legacy carriers have recently moved to reduce their reliance on 50-seat jets. Of the regional airlines that still fly these smaller planes, Republic Airways (NASDAQ:RJET) has been especially assertive in shifting operations toward larger regional jets turboprops, which are more profitable to fly.
At its first annual investor meeting this week, Republic Airways revealed that it plans to exit the 50-seat-jet market within two years. By the middle of 2016, Republic will have completed its transition to larger aircraft, leaving other regional airlines to operate their few hundred remaining 50-set jets for the foreseeable future.
The decline of the 50-seat jet
It's been clear to most airline industry experts for the past few years that 50-seat jets are on their way out. They are less comfortable for passengers, they cannot accommodate first-class seats for business travelers, they guzzle fuel, and they are becoming expensive to maintain as they age.
Delta Air Lines has been the most aggressive in getting out of 50-seat jets. Just five years ago, Delta had nearly 500 small jets in its regional fleet; by the end of next year, that number will drop to no more than 125.
When it comes to regional carriers, Republic Airways has been the leader in moving away from 50-seat jets. In early 2009, Republic operated more than 90 jets of between 44 and 50 seats. By the end of 2013, it was down to just 68 of these smaller planes in active service, along with five available as spares or for charter service.
The end is near
A few months ago, Republic announced that it planned further reductions in its fleet of small regional jets as a result of the pilot shortage affecting the regional airline industry. By the end of August, Republic will permanently ground another 27 of its 44- to 50-seat regional jets. This is freeing up pilots to operate new 76-seat-jet flights through its partnership with American Airlines (NASDAQ: AAL).
Following this round of reductions, Republic Airways will only have 41 remaining 50-seat jets, all of which operate for Delta. As noted, Delta is quickly moving to ground its 50-seat jets. Furthermore, the capacity purchase contracts for all of these jets expire by May 2016.
Even if Delta were not interested in renewing its capacity purchase agreements, Republic could have attempted to transfer these last 41 50-seat jets to another legacy carrier. However, Republic's management concluded that 50-seat jets have been "commoditized," making it impossible to earn a decent profit flying them. As a result, they will be grounded when the Delta contract ends.
The financial implications
Republic's early exit from the 50-seat-jet business may have some short-term costs, but it should lead to higher long-term earnings power.
Republic will still incur the ownership costs for some of the 50-seat jets for a few years after they are removed from service. However, these expenses are very manageable: less than $100 million spread out over a few years in a worst-case scenario. Moreover, the worst-case scenario isn't very likely. Republic has had pretty good success recently in selling or subleasing its excess 50-seat jets. As a result, the company believes it can maintain an average pretax margin of at least 7.5% for the next five years.
Republic's ability to mitigate the headwinds from retiring 50-seat jets can be seen in its 2014 earnings forecast. The airline projected earnings per share of $1.20-$1.40 this year. That's up significantly from its original forecast of $0.90-$1.20, and also above its adjusted EPS from 2013.
Longer term, simplifying the fleet will improve Republic's efficiency. Today, a typical pilot career path might involve starting as a 50-seat jet first officer, moving up to a 76-seat jet as first officer, then returning to a 50-seat jet as captain and eventually moving to a large turboprop or 76-seat jet as captain. Each move requires new training.
About half of Republic's pilots go through a two-month training process each year. This leads to a lot of unproductive costs. By reducing its fleet to two aircraft types -- the Q400 large turboprop and the E170/175 large regional jet -- Republic can reduce the frequency of training events. This would allow it to operate more flights with the same number of pilots.
Recently, the success of regional airlines has been inversely proportional to their reliance on 50-seat jets. Regional airlines that fly lots of 50-seat jets are barely scraping by, and their problems will only become worse as the U.S. pilot labor pool shrinks in the coming years.
On the other hand, regional airlines that fly regional planes the Q400 large turboprop and the E170/175 large regional jets of between 66 and 76 seats, with first-class cabins, premium economy seats, and more overall space are in better shape. They are paid more by the legacy carriers, giving them more flexibility to raise pilot pay over time. Republic Airways is decisively moving into this category.
For investors, the end of the 50-seat jet era at Republic Airways can't come soon enough. The cost of grounding the 50-seat jets will be relatively small, and doing so will free up more pilots for large regional jet operations. As Republic grows the most profitable part of its business and downsizes its least-profitable flights, its earnings power should continue to grow.
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Adam Levine-Weinberg owns shares of Republic Airways Holdings and is long November 2014 $7.5 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.