The Big Time Beckons The Small Birds

New routes could mean quick growth--and major airline-style risk

With annual losses that measure in the billions and woes that seem only to multiply, the airline industry is hardly a haven for investors. Yet when a carrier called Comair Inc. had a secondary offering on Feb. 19, to raise money for new jets, investors rushed aboard. The stock, introduced at 231 4, rose to 261 4 on the first day. The issue was oversubscribed, selling 2 million shares instead of the planned 1.7 million. "There was a lot of demand from some very good institutions," says John R. Barber, a managing director at Kidder, Peabody & Co., which co-sponsored the offering. Comair's stock recently traded around 30.

Welcome to the high-flying world of commuter airlines. While the major carriers continue to suffer, once lowly commuters, which operate as partners to the big airlines, are flourishing. And for the half-dozen commuter lines, or regional airlines, that trade publicly, the jump in market values has been astonishing (chart). In the past 18 months, the stock price of Mesa Airlines Inc., the nation's largest commuter carrier, has more than quintupled, to $36.

NEW FRILLS. The changing shape of the airline industry is propelling the commuters to new heights. In the past, commuters mostly served routes of less than 400 miles, deemed too short and too lightly traveled for the majors. But now, the ailing big carriers have begun abandoning unprofitable service on short jet routes under 1,000 miles. That lets the regionals move in with their fleets of 19-to-72-passenger propeller planes.

Events are moving rapidly: In February, four-year-old Atlantic Coast Airlines tripled its service on six routes from United's Dulles Airport hub, outside Washington. Delta has announced it will move regional partner Atlantic Southeast Airlines Inc. (ASA) into eight routes it now flies out of Dallas. American Airlines, which owns its four American Eagle commuter lines, and USAir, which doesn't, have made similar shifts.

But the growth isn't coming without risks. Some commuters, such as Comair, are buying small jets, which are more expensive to operate. Labor costs may rise. And regionals still are held hostage by the majors, who can horn in on more lucrative routes or leave their smaller partners stranded if they pull out of a major hub. StatesWest Airlines went bankrupt last year after USAir retreated from the California market. The big airlines can also hurt regionals' margins by renegotiating the rates they pay for flight segments. They say they have no such plans, but "all it takes is a push of the pencil," says airline analyst Cameron Burr of First Equity Development, a Stamford (Conn.) investment banking firm that specializes in airlines. "Regionals live and die by the majors."

Regional carriers are tiny compared with the majors. As a group, the country's 150 commuters carried 10% of all passengers last year and accounted for only 2% of traffic. But small as they are, these carriers have prospered by feeding a steady flow of passengers from second-tier cities into such hubs as Atlanta, Chicago, and Salt Lake City. Profitable partnerships with dominant airlines often mean virtual monopolies at some hubs. A preponderance of business travelers allows the commuters to charge relatively steep fares. And that, combined with low wages and lower fuel costs, gives them higher margins than major airlines could ever dream of: Many commuters enjoyed double-digit margins last year while their larger counterparts haven't seen profits in three years. "It's an entirely different market" from the majors, says Richard Milling, a vice-president at Boullioun Aviation Services, an airline-financing concern in Bellevue, Wash.

For travelers, this will mean many more trips on commuter lines than before. On some routes, such as Dallas to Oklahoma City, for example, passengers may find the majors offering jet service only at peak periods, with commuters flying the routes at other times. Some markets have lost jet service completely and others will follow. So the commuters are scrambling to make that prospect palatable to flyers. To rid the industry of its puddle-jumper image, ASA, Mesa, and others are ordering up dozens of new planes with larger cabins, overhead baggage compartments, quieter engines, and more sophisticated navigational electronics to aid flying in bad weather.

Those rising ambitions could drive commuters into rough territory if they're not careful. Increasing labor costs loom, as low-paid younger pilots stay at their jobs longer instead of moving on to major carriers. The highest pilot wage at Comair is $50,000 now; at Delta, it's four times that. Comair's plan to fly jets holds risks that have pushed other regionals near the brink. WestAir nearly fell into bankruptcy after it began flying jets into the San Francisco market. Even Delta--which holds a 20% stake in Comair, as it does in three of its four commuters--concedes the Comair move could backfire. "The risk is higher costs," says Delta marketing executive Richard Lowry.

There's also the dicey possibility that a commuter will develop a good market only to have its major-airline partner take it back. That happened to Air Wisconsin Inc. five years ago, when United pushed into the Chicago-Madison and Chicago-Milwaukee routes, crowding Air Wisconsin out.

GROWING PAINS. Mesa faces problems of another kind. The airline, which has used rapid acquisitions to build traffic, may experience growing pains. Although the purchase of West Air, Air Midwest, and Aspen Airways has helped it multiply revenues eighteenfold over five years, to $316 million last fiscal year, observers say the carrier may run into trouble as it seeks to integrate the operations. "Our plate is full," concedes Mesa CEO Larry L. Risley, who figures that cost-cutting and trimming of capacity will keep the carrier out of trouble.

For now, investors clearly find the upside tantalizing enough to put aside worries. Mesa, Comair, SkyWest Airlines, and ASA shares all trade near their 52-week highs. Atlantic Coast Airlines is readying plans to go public soon.

No one feels headier about the carriers' good fortune than David R. Mueller, the 40-year-old founder and CEO of Comair. "If you're crazy enough to want to invest in an airline," he says, "you ought to invest in one like this." The question is: How much bigger can the regionals get before they get too big for their own good?

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