Red-Faced Regionals Are Ready to Rebound

Wing Tips examines why these underperfomers for this year should bounce back soon. (They're cheap, for one.)
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No doubt about it.

Wing Tips has been sorely disappointed by the performance of most of the regional airlines this year. As longtime readers know, we had

picked a number of the regionals as some of our favorite stocks for 1999. The sector's dismal performance has done serious damage to our overall stock-picking record for the year.

In addition, three smaller regional airlines that had provided investors with some decent profits over the last few years --

Atlantic Southeast

,

CCAir

and

Reno Air

-- bit the dust as attractive investment choices when they were gobbled up by larger entities earlier this year.

The result has been a year in which the perennial hot-rocket performance of the regional airline sector has suffered. Miserably. Through this past Friday, the year-to-date performance tallies show the damage.

On Monday, Brian Harris, an analyst at

Salomon Smith Barney

, initiated coverage on the regionals, giving the sector an outperform ranking. After reading his research note, we have to agree with him. As frustrated as we are with the performance of the group so far this year, we still think the underlying fundamentals for earnings growth are here -- and more so than with many of the major airlines.

Let's look at some of the reasons Wing Tips thinks this sector should get back to its usually strong-performing ways before long.

  • The regionals are now trading at historically low levels. This sector usually trades well in excess of 20 times forward earnings. Now, many are trading in the 11 times price/earnings range for the year 2000.
  • The sector continues to grow at an average of 20% per year, and with more and more regional jets on the horizon, the growth levels should continue to be strong. The capacity issues plaguing many major airlines are not a factor here. In most cases, the only reason more capacity is not being added is the fact that Bombardier and Embraer simply cannot build the smaller jets any faster. As one representative of Bombardier told me recently, "We don't want to make the same mistake that Boeing (BA) - Get Report did." The result? Long waits, sometimes as long as two years, for airplanes. So forget all those overcapacity issues with the majors. The issue with the regionals is just the opposite.
  • As Harris points out, the sector also benefits from creative revenue arrangements with the major carriers. These arrangements, in most cases, reduce the downside potential for the regional in terms of unexpected dips in revenue. Of course, the deals also prevent large upswings. But if a regional's contract with a major carrier is a good one, that eliminates the angst. In effect, the regionals are "affiliates" of the major airlines -- somewhat protected from the normal ravages of the erratic and oftentimes fickle airline industry.
  • We have talked about this regarding Mesaba Airlines (MAIR) many times. Mesaba, the feeder airline to Northwest Airlines (NWAC) , has a so-called capacity-buy arrangement with Northwest. This is the best arrangement a regional airline can have because the major carrier pays the smaller airline a flat rate to fly each passenger, then antes up other incentive payments. The regional airline does no marketing, does not have to worry about whether passengers show up and is not affected by fuel price increases, because the major airline foots the fuel tab as part of the agreement. Northwest buys X number of seats at X price. Period.

Mesa Air

(MESA) - Get Report

has a similar arrangement with

America West

(AWA)

, and from what we can tell, that pact is the shining star of Mesa's new operation. By contrast, Mesa's arrangement with

US Airways

(U) - Get Report

involves a less-favorable combination of revenue split and capacity buy.

Readers will recall that we recently

tagged Mesa as our turnaround regional airline pick. Harris also sees Mesa as the turnaround choice.

In his report, Harris gave buy ratings to

Atlantic Coast

(ACAI)

, Mesa and Mesaba.

Atlantic Coast gets the buy on two points. First, the

United Airlines

integration at Dulles is complete. (United's a unit of

UAL

(UAL) - Get Report

.) We agree with Harris that the worst fallout from the overexpansion at Dulles is probably behind the airline. Second, Atlantic Coast still has the greatest potential growth in the pipeline.

Atlantic Coast was a pick of ours at the beginning of the year. We live by the pick. We die by the pick. We still like Atlantic Coast.

Harris tagged Mesaba a buy because of its very advantageous operational contract with Northwest and because the stock is dirt cheap -- trading at around 7.6 times the estimated 2000 P/E ratio.

Harris slapped a neutral ranking on shares of

Comair

(COMR)

and

SkyWest

(SKYW) - Get Report

. Comair faces external factors -- most of which we have mentioned

here before. The carrier's contract with

Delta Air Lines

(DAL) - Get Report

is up for renewal in October, and the stock -- in our and in Harris' opinion -- is pretty fairly priced right now as a result.

SkyWest gets put in the neutral box because of its stock price. Comparing the airline to its peers, the airline is not as good a buy at this time, as say Mesa, Mesaba or Atlantic Coast.

Our thoughts? Either something is terribly wrong, or we were affected by the recent eclipse. But this time, we agree 100% with an analyst.

I know. Scary.

Holly Hegeman, based in Dallas, pilots the Wing Tips column for TheStreet.com. At time of publication, Hegeman held no positions in any securities mentioned in this column, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. You can usually find Hegeman, publisher of PlaneBusiness Banter, buzzing around her airline industry Web site at

www.planebusiness.com. While she cannot provide investment advice or recommendations, she welcomes your feedback at

hhegeman@planebusiness.com.