Mesa faces new realities of evolving regional biz

 - May 9, 2008, 5:03 AM

Jonathan Ornstein has learned something over the years about mending fences–and breaking down barriers. Although the outspoken and sometimes brash chairman and CEO of Phoenix-based Mesa Air Group has fought his share of battles during his 13 years in the airline business, Ornstein has found ways to overcome conflicts with those he needs to survive and prosper.

Now in his fourth year at the helm of the country’s third-largest independently owned regional airline group, Ornstein’s decision to make Mesa the launch customer for the new CRJ-900 regional jet marked a return to at least outwardly cordial terms with Canada’s Bombardier. Meanwhile, the company’s long legal battle with United Airlines came to an unceremonious end after Mesa’s board decided to settle its lawsuit against the world’s largest airline, a decision admittedly borne out of pragmatism if not a recognition of the suit’s futility.

While participating in a ceremony to mark Mesa’s firm order for 20 CRJ-700s and 20 CRJ-900s in late July, Ornstein publicly put to rest any lingering animosity toward Bombardier. The feud erupted when the Canadian manufacturer balked at accepting Mesa’s Brasilia turboprops during negotiations for 50-seat jets that eventually went to Embraer early last year. At the time, Ornstein pointed to the lack of favorable delivery positions for the CRJs as the reason for his decision to sign a firm order for 32 Embraer ERJ-145s. The real reason, of course, went far deeper than that.

“We had some very big disagreements,” said Ornstein during the Phoenix event. “[Bombardier] backed up some financing and there was a question at the time whether there had been a material adverse change, which would have allowed them out of the financing. And there was some question about us returning some Brasilias…I mean it was just a big mess. But Steve Ridolfi was clearly a marketing guy that had a different view than his predecessor. [Ridolfi replaced Robert Gillespie as president of Bombardier Regional Aircraft on Sept. 1, 1999–Ed.] And Ric [Allison, Bombardier sales manager] really maneuvered us through all the channels up there and got the relationship back on course.”

Of course, America West’s support for the CRJ-900s played no small part in Mesa’s decision to choose the Bombardier product over Embraer’s upcoming ERJ-190. “The biggest thing with the Canadair was our partner’s willingness to take them,” said Ornstein. “We could have the greatest airplane in the world that uses no fuel, if our partner wouldn’t allow us to operate them, it wouldn’t matter.”

Ornstein also stressed the importance of the larger CRJs’ commonality with Mesa’s 50-seat CRJ-200s, 32 of which fly mainly under its America West code share. The airline expects to take the first of its CRJ-700s on firm order next April. Both the CRJ-700s and CRJ-900s will include six first-class seats, reducing passenger capacity to 64 and 84, respectively.

Mending Fences
While the return of normalized relations with Bombardier likely helped Mesa secure a new long-term code-share contract with America West in March, Mesa’s reconciliation with United perhaps opens the more intriguing prospect of a reunion between the independent regional and the world’s largest airline. Embroiled in an extended dispute with United over its decision in 1998 to cancel Mesa’s West Coast and Denver code-share deals, Ornstein and company found themselves in an awkward position when Mesa’s largest code-share partner, US Airways, appeared likely to merge with the regional airline’s old nemesis. Rather than be caught with their “hat in their hand,” as Ornstein put it, Mesa agreed to forego its monetary claim in exchange for a two-year extension of its US Airways contract in the event the merger won Justice Department approval.

Even though the merger ultimately did not pass antitrust tests, Ornstein called the resolution with United “the best thing we ever did,” particularly given his desire to enter more code-share contracts with major airlines. “United had offered us a pretty big cash settlement, but my view was, $10 million isn’t worth spit compared to having a good relationship with the world’s largest airline, and it’s much better just to let the thing go,” said Ornstein. “I’m good friends with [United v-p of alliances] Montie Brewer; he and I can now talk freely on the telephone. I knew Rono [Dutta, United’s president] back in the old days, when I was with Continental; we can speak freely. And Chris Rado, who runs the commuter operation…I can tell you right now he’s become a good friend of ours. For example, he was negotiating with Air Wisconsin and called us up with some thoughts on how they should structure the lease cost deal. We’ve developed a relationship that’s 180 degrees different than it was.”

The ‘Comair Effect’

Of course, when Mesa filed the lawsuit in 1999, talks between United and US Airways had yet to reach a serious stage, and the tendency of major airlines to buy their regional affiliates appeared likely to limit opportunities for multiple code shares. Today, the superior stock valuations of regional airlines and lessons learned from the recent Comair strike appear likely to result in a reversal of that trend, said Ornstein, opening many more chances for independent entities such as Mesa to sell their services to a variety of potential mainline partners.

The first tangible sign of that reversal appeared in July, when Continental Airlines announced its intention to sell 20 percent of its now wholly owned Continental Express subsidiary, laying the foundation for an eventual full spinoff of the Houston-based regional airline. While the potential for lowering costs by freeing ConEx from the inherent administrative burdens of the larger company certainly played a role in Continental’s decision, Ornstein suspects the airline’s approaching contract talks with its pilots as perhaps the largest issue the airline hoped to mitigate.

“The Comair situation is going to have a big ripple effect throughout the industry,” said Ornstein. “Believe me, I don’t think it did not play a small part in Continental’s decision to spin off Express, which has been percolating since I was there. But I think [the Comair strike] may have been the final straw. What’s happening is that the largest [regional] carriers’ majors are realizing they can get a fair amount of value. If Continental’s able to pull this off it’s a billion dollar market cap. I would be surprised if US Airways doesn’t come up with something of its own.”

Eyeing the deep pockets Delta Air Lines brought to the negotiating table, the Air Line Pilots Association sought to raise the salary scale of Comair’s pilots to that of Delta’s, leading to a three-month walkout that cost the parent company some $200 million in revenue and nearly spelled the end of the Cincinnati-based regional. As contract negotiations for Continental Express approach this fall, Continental will have already taken the first step toward ridding itself of similar concerns.

Ornstein said he also thinks the industry trend away from traditional pro-rate agreements and toward fee-per-departure, or “cost-plus contracts,” will help encourage further divestiture, steering major airlines toward cheaper feed alternatives. While under pro-rate agreements major carriers traditionally showed little interest in the spending habits of their regional partners, contract-style agreements create an environment where regional airlines must compete with each other on cost, or lose code-share opportunities to lower bidders. Those realities have Ornstein preaching the virtues of austerity to all his employees, particularly his pilots, whose contract becomes amendable in five months.

Nevertheless, the Mesa chairman and CEO recognizes the potential affect of the Comair settlement on the negotiations with his own pilots. Now that the Comair pilots have set a new “high-water mark” regarding compensation, Ornstein faces the challenge of convincing the rank-and-file of the long-term benefits of accepting less.

“We want to do everything we can to make our pilots well-paid and all of our people well-paid, but we also want to know that we can compete for business,” said Ornstein. “That’s really how we advance people in their careers, whether they be pilots or mechanics or station people–it just opens that many more opportunities.”

Ornstein points to the experience of Southwest Airlines as an example of how he hopes to achieve that balance. Even though Southwest’s pilots remain the second-lowest paid flight crews in the major airline industry next to America West, CEO Herb Kelleher has managed to create a model for growth Mesa can only hope to emulate by offering incentives his employees “can assign value to,” said Ornstein.

“You see these Southwest pilots retiring with $4 million in stock; that’s not a bad deal,” said Ornstein. “Herb has just been terrific at giving his pilots what they need to feel good about what they’re doing. The toughest part of my job is that you’ve got to balance the future with current requirements. I don’t think any of us want to end up like TWA. There’s a lot of questions about whether some of the majors have put themselves on that slippery slope. Can United in the long term afford what they’re doing now? I don’t know. I know they’re pulling down a lot of flying.

“That’s what we don’t want to happen. If I can’t explain that means not paying people $3 an hour more, that’s my problem. I’ve got to be able to explain that and get everybody to buy in on that. Believe me I know I’m not Herb Kelleher. But what he does through power of personality I try to do through persistence. Because I believe if people know their fortune is tied to the company, people start turning off the lights when they leave.”

In the Catbird Seat?

Despite the challenges it will inevitably bring, the Comair settlement may eventually help Mesa, reasoned Ornstein, because Mesa will compare favorably to airlines that cannot control labor costs as a result of the new precedent, he reasoned. Nevertheless, Mesa’s first attempt to land a Delta Connection contract with a new base in Cincinnati failed when Comair finally settled the strike. Unable to convince Delta to sign a deal and recognizing the futility of an independent operation in an established fortress hub, Mesa canceled its plans.

Undeterred, Ornstein has not given up on Delta, however. “I still think there are opportunities even though it didn’t happen right there,” he said. “It’s nothing they’re going to move to immediately, but if it wasn’t for the Comair situation, I think the chances were less likely.”

Although Ornstein concedes that major airlines will pay “a small premium” for superior on-time performance and service, exploiting opportunities that arise by what he views as a more competitive code-sharing environment will depend largely on controlling costs, and not only those related to labor. Ever since he took control of Mesa in May 1998, after a two-and-a-half-year stint at Brussels-based Virgin Express, Ornstein has complained about the cost of flying the airline’s Beech 1900D fleet.

Although he conceded that Mesa contributed to its own financial problems with poor management decisions, he blames the FAA’s requirement that all scheduled operators flying airplanes carrying more than nine seats meet Part 121 rules as the primary reason for the airline’s decline during the late 1990s. Ornstein’s remedy–to shed many of his Beech 1900s in favor of more jets flown under fee-per-departure contracts–has worked to a degree. Mesa has since registered dramatic financial improvements since it lost $48.6 million during the 1997 fiscal year.

Now carrying a market cap of $400 million and holding $100 million in cash, Mesa has turned a profit every year since Ornstein began his second tenure with the airline in 1998. Despite rising expenses, adjusted earnings per share rose 28 percent during the quarter ending June 30, while total operating revenue rose 16 percent over the same period, to $140.42 million. Now flying a total of 32 Bombardier CRJ-200s and 18 Embraer ERJ-145s, the airline’s contract flying now accounts for 65 percent of its passenger revenues.

Playing Hardball with Raytheon
Mesa plans to return another 15 Beech 1900Ds to Raytheon Aircraft over the next 18 months, leaving 44 of the 19-seat turboprops with its Kansas City-based Air Midwest subsidiary. Although it has already shed nearly half of its peak complement of the costly turboprops, Air Midwest still negatively affects the company’s balance sheets, as does Mesa’s Charlotte, N.C.-based CCAir subsidiary. Mesa, which owns 51 of its remaining 59 1900s, has purposely defaulted on its debt payments to Raytheon in a maneuver to renegotiate the terms of the loans.

“We’ve got to get Raytheon to come to grips with the fact that the airplanes are no longer $35,000 a month airplanes given the fact that BAE is happy to lease Jetstreams for $10,000 a month,” said Ornstein. “We clearly have seen the 1900 become economically obsolete.” Nevertheless, Mesa finds itself left with little choice but to continue operating the airplanes because, according to Ornstein, it would lose $1 million for every copy it sheds.

Other factors have contributed to the airplanes’ obsolescence as well, he added, including rising parts and maintenance costs and tougher training requirements. An engine overhaul that once cost $125,000 now costs $325,000, according to Ornstein. Meanwhile, a pilot upgrade in the type previously required four hours of simulator training. The Part 121 transition has driven that requirement to 24 hr, resulting in a $10,000 to $15,000 hike in training costs per pilot, in Mesa’s estimation.

Meanwhile, Mesa’s East Coast 19-seat operation–CCAir–has turned from a money maker when Mesa bought the Charlotte-based airline in 1999 to a big drain on the company’s profits, prompting management to shed five Jetstream 32s and three de Havilland Dash 8-100s from the fleet within nine months. Ornstein and company CFO Rob Stone place the blame mainly on high labor costs. However, Mesa inherited those costs when it bought the airline; perhaps more significantly, yields have declined with increased competition from regional jets in the area, primarily from Atlantic Coast Airlines. “We’re not going to pump more money into CCAir,” said Ornstein. “People are going to have recognize the reality of the situation there.”

Referring to the upcoming Mesa Airlines pilot negotiations, Ornstein points to CCAir as an example of how a high-cost environment results in organizational stagnation. “CCAir’s pilots have the best contract in the regional industry, and they’ve got five-year FOs,” said Ornstein. “I just have to convince my pilots to give a little bit, and instead of waiting around to get upgraded after seven or eight years like at American Eagle, they can upgrade in 18 months here. The question they need to answer is, ‘Would I rather be a mid-range-paid ERJ captain or the best-paid Jetstream FO in America?’”

Importance of RJs
Ornstein’s challenge reflects the value he places on his company’s regional jets. While turboprop operations continue to shrink, the RJs–flying for US Airways from Charlotte, Washington National and Philadelphia, and for America West from Phoenix and Columbus, Ohio–will account for some 85 percent of the airline’s total revenue by 2004, according to Stone. Still awaiting delivery of another 18 ERJ-145s out of a total order for 36, Mesa plans to move all the CRJs now flying for US Airways to Phoenix and Columbus, fully segregating the Canadian-built RJs from its Embraer jets by the end of the year. As plans stand today, all 40 of the CRJ-700s and

CRJ-900s on order will fly for America West, although Ornstein admits to knowing nothing about his major partner’s deployment plans for the stretched Canadair jets.
“I have no idea what America West intends to do with the CRJ-900s,” he said. “The fact of the matter is [majors] don’t lose money with their big airplanes, they lose money at the bottom of the spectrum. What’s happening is that all these carriers look at those bottom airplanes such as 737s and realize they don’t work anymore.” Still, Ornstein remains wary of the risks associated with committing to the bigger RJs, particularly as America West remains one of the few airlines whose scope clauses allow regional affiliates to operate them.

“Under any circumstance there’s a financial reason to operate those aircraft, and that’s what ultimately will protect us–that they work from an economic standpoint,” he said. “But clearly one of the biggest issues from our perspective is to make sure America West is able to stay financially healthy.”

Meanwhile, the uncertain status of US Airways after its failure to merge with United poses still more questions for Mesa. Nevertheless, Ornstein said he believes US Airways’ financial woes will work to Mesa’s advantage because of the regional airline’s ability to lower costs. In fact, US Airways has asked ALPA for permission to fly more regional jets than allowed under its current scope clause. Last year an interim agreement reached between US Airways and its 6,000 pilots raised the number of jets the airline’s regional affiliates may fly to 70 from 35. Mesa, Chautauqua Airlines and Trans States Airlines fly a total of some 60 Embraer ERJ-145s under the US Airways Express livery. Under present conditions, Mesa could not fly as US Airways Express at least eight of the remaining 18 ERJs scheduled for delivery into next year.

Aside from the growth opportunities it would undoubtedly offer Mesa, a break in the scope clause at US Airways might motivate Ornstein and Rolls-Royce–maker of the AE3007 turbofans that power the ERJ-145s and equity provider for the leveraged leases on the airplanes–to speed a resolution to a dispute involving the financing of the Brazilian jets. Although Ornstein declined to publicize the deta0ils of the row, he clearly conveyed his distaste for the British company’s business practices and his preference for General Electric, which backs the leases on the CRJs.

“Rolls-Royce is very difficult to do business with,” said Ornstein. “Beyond the operational difficulties [with the engines], they’ve had problems living up to their contractual obligations. So the idea of doing business with the people at GE, who have been sweethearts to deal with, was obviously very attractive to us. I think we’re going to get 20 of these [CRJs] pre-financed by GE.”

Operational Difficulties
One of the most serious “operational difficulties” to which Ornstein referred includes premature fan-blade burn-through in the low-pressure compressor turbine in 21 Rolls engines, according to Mesa v-p of technical operations Don Harrison. The GE engines in the CRJs, meanwhile, have experienced some leaking in the number-four bearing, but generally have performed well, said the former Air Canada overhaul supervisor.

Conversely, the CRJ airframes experienced more than their share of problems involving the flap systems, landing gear, hydraulics, pneumatics and avionics. The most critical issues centered on faulty brake pressure signal units, seizing and leaking landing gear steering control valves and breaking hydraulic lines. Other irritations included nuisance messages in the avionics system and shattered windshield laminates. “Some time after we took the first airplanes two-and-a-half-years ago, we held several meetings and honed in on the top-ten problems,” said Harrison. “Since then, the airplane has gone from deplorable to satisfactory.”

Meanwhile, Ornstein echoed Harrison’s sentiments regarding the Embraer airplanes, praising the airframes while expressing less satisfaction with their engines’ service record. “Fortunately, [Mesa v-p of planning] Bill Kostel was well aware of some of the issues surrounding that engine,” said Ornstein. “So we were able to isolate the problems and protect ourselves reasonably well.” Despite his differences with Rolls-Royce, Ornstein seemed satisfied with the company’s maintenance support. “On the operational side, I think they’ve been reasonably good in fixing things when they break and staying after them.”

A few years back, such an acknowledgment about any adversary might have sounded somewhat out of character for Ornstein. Today, the notoriously combative airline veteran seems to choose his words–and his battles–a bit more carefully. But as scars cover old wounds, Ornstein hasn’t mellowed; his skin has just grown tougher. “You know, when Mesa was having its difficulties and I needed some of my big-shot friends to help out, most of them didn’t want to know me,” recalled Ornstein. “Now that things are turning around, suddenly things have changed. But I don’t hold any grudges. Life is too short.”