Time seems ripe for IPOs as regional values blossom

 - May 15, 2008, 8:57 AM

Airline executives whose predictions of regional divestitures raised eyebrows just two years ago watched their prophesies turn to hard reality in late February, as Northwest Airlines announced its intention to spin off its Memphis-based Express Airlines I subsidiary and Continental Airlines revisited its plans to divest itself from Continental Express. Two weeks later the IPO parade continued, as Republic Airways Holdings, the parent company of Indianapolis-based Chautauqua Airlines, filed for its own $85 million offering, continuing a trend that has investors eyeing new opportunities in the historically lucrative regional airline sector.

All three airlines will trade on the Nasdaq, joining the ranks of Atlantic Coast, SkyWest, Mesaba Airlines, Great Lakes Aviation and Mesa Air Group. Northwest plans to retain 13 percent of Pinnacle’s common stock, estimated to total some $400 million in market value. Republic, which recently learned that American Airlines will remove the AA* code from some of its flights to meet ASM restrictions in its mainline pilot contract, said it plans to use the proceeds to expand operations, buy more airplanes and pay off debt it owes to its only current stockholder, WexAir LLC. Its Securities and Exchange Commission (SEC) registration statement did not indicate how much of a stake, if any, WexAir plans to retain.

With its IPO, Northwest joined an apparent trend officially begun by Continental Airlines last year, when the Houston-based carrier announced it would spin off Continental Express. In the aftermath of September 11, however, Continental postponed its plans until late February, when it amended its SEC registration statement and resumed preparations for the sell-off.

More CRJs for Express I

The decision by Northwest became public at the same time the company awarded its Memphis-based subsidiary 41 forty-four-seat Bombardier CRJ440 regional jets out of an order for 75 placed last year. Now flying 42 fifty-seat CRJs, Express I still flies 23 Saab 340s from its other bases in Minneapolis and Detroit. Northwest still has not allocated 12 fifty-seat CRJs of an order for 54 placed in 1999, as well as 34 CRJ440s from its follow-up order with Bombardier. Placement of the final 12 fifty-seaters remains contingent on Northwest’s ability to negotiate an amendment to its pilot scope clause, which restricts its regional affiliates to 42 regional jets certified to carry 45 passengers or more.

Fellow Airlink affiliate Mesaba Airlines continues to lobby for the remainder of the unallocated jets, although that Minneapolis-based airline must reach an agreement on a new labor contract before Northwest considers awarding its independent partner more jet opportunities. Meanwhile, talk of a third, unidentified regional airline joining the Airlink family to provide another source of regional jet feed for Northwest continues to reverberate, adding further incentive for Mesaba to resolve its pilot issues soon after the contract’s June amendable date.

While Northwest intends to maintain a minority share in Pinnacle, Continental will initially own 68.8 percent of Continental Express during the first phase of its divestiture process. However, it intends to fully divest itself of the subsidiary in the long term, perhaps within six months, depending on market conditions. Continental plans to sell 20 million shares of the subsidiary for between $14 and $16 apiece, giving the company a market cap of as much as $1 billion. Originally, the company expected to sell 18.75 million shares at between $15 and $17, but post-September 11 devaluation prompted it to revise its plans to arrive at a comparable market cap.   
ConEx Worth $1 billion

Nevertheless, the historic ability of regional airlines to outperform their mainline counterparts both on the stock market and balance sheet has at least contributed to the recent push toward divestiture of wholly owned subsidiaries. For example, Continental Express’ estimated market value of $1 billion would account for roughly half of Continental’s entire market cap, even though its regional subsidiary drew roughly 11 percent of the company’s revenue last year. According to its prospectus, the regional subsidiary turned a profit of $48.1 million last year, while the mainline lost $95 million.

Of course, freeing wholly owned regional airlines from the costs associated with the administrative burdens inherent in their much larger parents presents another attractive aspect of such strategies. In 2000 Delta Air Lines bought the assets of Cincinnati-based Comair and Atlanta-based Atlantic Southeast Airlines to assert more operational control over those affiliates; it clearly would have preferred to save the $3 billion it spent to take control of those airlines. In fact, Delta’s purchase of Comair likely contributed to another, perhaps unforeseen aggravation–namely last year’s Comair pilot strike. Eyeing the deep pockets Delta 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 at least $200 million in revenue.

In the case of Continental, a spinoff of Continental Express would retire a pilot “flow-through” agreement, a consequence that last year drew harsh criticism from ALPA because of its potential to affect ConEx pilots’ rights to graduate to the mainline. Since September 11, however, the flow-through agreement resulted in 233 mainline pilots moving to Continental Express, resulting in the furlough of another 386 regional pilots and inordinately high training costs for the company. As a result, Continental canceled its plans to furlough another 100 pilots last month when it found that the cost of the transition training would negate any salary savings at the mainline.