We’ve partnered with Falko to bring you more free analysis and charts. Once a month, we’ll include a second analysis for the week on one of our favorite and least understood markets: regional aviation. Of course, our regularly scheduled programming will arrive on Thursday as usual.

The business of moving passengers around the world is often oversimplified. As originally broken down in our opening analysis, The hidden value of ‘regional’ aviation, airlines are not a monolith. In the same way, airline business models are not the same, even at the fundamental level.

In this most recent analysis published in cooperation with Falko, we focus on the specific airline business model of the capacity purchase agreement (CPA) airline. Rather than compare the regional airline model only to other airlines, we find a more similar comparison to models entirely outside that of aviation – utilities. 

It is in this unorthodox comparison that we find compelling reasons to look at the regional airline model from a renewed perspective, rather than simply as a smaller version of the larger airline model. A contrarian inspection of the fundamentals of regional capacity purchase agreements reveals key differences in how risk and reward are considered – key differences often overlooked.

What are Capacity Purchase Agreements?

The general business model of the airline industry is to move passengers and goods for money. The more passengers and goods that fly for higher prices the more revenue the airlines generate.

While this is generally true of airline business models, the CPA model differs in a structural way. Rather than receiving fares from traveling customers in exchange for a reserved seat, capacity purchase providers offer just that – capacity. 

The large airline partner assumes the risk of selling tickets to passengers while the CPA provider provides the seats. 

A Capacity Purchase Agreement is one between the regional airline and the major airline partner that defines how much capacity will be made available and at what rates and conditions. The CPA airline will provide X seats and block hours of flying across Y aircraft for a given rate. Put more succinctly, the CPA provider delivers fixed supply while the major airline partner manages the fluctuations in demand. 

If a downturn arrives and air travel declines, the CPA provider continues to deliver agreed supply at consistent rates, while the major airline shoulders the revenue risk of the downturn.

Conversely, the major airline will benefit from a stronger travel environment, while the CPA airline continues to earn consistent revenues for the supply offered. It is this consistency that separates the CPA business model from almost all other airline business models. As long as the CPA airline provides an agreed level of service, fluctuations in revenues are minimal, whether during downturns or exceptionally strong markets.

The comparison, then, of CPA airlines to typical airlines quickly falls apart. The typical airline business model is highly seasonal - not only from economic cycles but also in different travel levels throughout the seasons of the year. CPA airlines trade this higher risk and the potential for higher reward for consistency. 

Comparing CPA airlines to utilities

It is from this level of consistency that CPA airlines are better compared with utility companies than with other airlines. An odd notion to consider at surface level, CPA airlines and utility companies share a fundamental consistency: capacity.

The idea of CPA providers more closely related to utility companies than traditional airlines was originally put forward by Joe Allman of Republic Airways during Falko’s investor event in New York last year. It is an idea we find intriguing and with substantial merit.

Indeed, comparisons of profitability trends between CPA airlines and traditional airlines quickly expose a level of volatility in the traditional airline business not present with the CPA providers.

Focusing on the large public North American CPA providers of SkyWest Airlines and Jazz Aviation in comparison with other North American airlines, it becomes apparent how cyclical and volatile traditional airlines are. Traditional airlines are fully exposed to fluctuations in demand, as was seen through 2001 and the 2020 pandemic.

However, during the same periods, the CPA providers did not see the same fluctuations. In fact, through most of the unprofitable downturns of the traditional airlines, CPA providers were not only less affected by demand, but also remained consistently profitable.

Not without fluctuations of their own, CPA providers are unaffected by the general movements of the air travel market. The reason for this is fundamental to the consistent nature of the CPA agreements. Higher profit potential is traded for lower risk.

Comparing the same CPA airlines with the largest North American utilities emphasizes how different the sector is from the rest of the airlines. 

Utilities still see volatility in profitability, just at muted levels compared to those of the traditional airlines. Yet, utility companies are far less affected by market demand, and deliver value to shareholders by focusing on delivering consistent supply – similar to the CPA airlines.

Aligning consistent costs with consistent revenues

Beyond the management of risk through consistent revenues, both utilities and CPA airlines are able to manage risk through consistent costs.

While both utilities and CPA airlines achieve consistency and reduced levels of risk in their business models, they have not achieved a complete lack of risk. Indeed, this is present in both industries’ financial results. The fluctuations are reduced, however they still exist. 

This is key to understanding further similarities between the two sectors. While largely protected from swings in demand, the utility and CPA-focused airline is still subject to operational challenges and potential mergers and acquisitions – no different to traditional airlines.

For instance, SkyWest Airlines saw a large, negative EBIT margin in late 2017, primarily due to a write-down of recently acquired ExpressJet Airlines. Again in 2022-2023, the transition to unprofitability came as a direct result of the airline’s inability to hire sufficient pilots. Still protected from demand-level shocks, the airline proved incapable of providing the agreed lift to its major airline partners, resulting in multiple quarters of losses.

For utilities, risk is still inherent in the operation of the pipelines or electric powerlines that move energy from source to consumer. This risk is consequential, and as a result, the utility company has become an expert on managing those risks.

The same can be said of a CPA airline. While demand risk is absorbed by the major airline partner, the regional airline still retains operational risk, including finding labor and ensuring on-time operations. Similar to utilities, the CPA airlines are able to become operational experts, designing the airline for reliability and safety while not being subject to large demand fluctuations.

In a similar fashion, the CPA airline is not subject to other market forces that may drive volatile costs. Fuel represents one of the highest costs for any airline; however, a typical CPA airline does not pay for its own fuel. That risk, too, is born by the major airline partner in that the fuel cost is considered “pass-through”. In short, the major airline partner pays for the fuel that is used in its regional CPA aircraft. This further decreases risk for the CPA airline; however, it also reduces the already-thin profit margin.

This thin profit margin can be viewed by investors as risk in it’s own right, however the trade of margins for risk must be considered. Particularly for debt providers or aircraft lessors, a narrow profit margin for an airline would typically signal risk, however in the case of the CPA airline, it was specifically traded for a near-elimination of market risk.

The most volatile nature of revenues and costs to an airline is effectively neutralized through the capacity purchase agreement. For example, fuel costs, representing as much as 40% of an airline’s operating costs, could fluctuate as much as 300% in a season. Adjusting for inflation, the past two decades have witnessed fuel prices ranging from $0.50 to $6.50 per gallon. CPA airlines are protected from this volatility and risk.

Another method by which CPA airlines are distinctly able to manage risk is through the long-term nature of the agreement. CPA agreements are traditionally signed between five and eight years, sometimes extending beyond a decade. This allows the regional airline to align aircraft financing terms with a committed stream of revenue. In a similar fashion, utilities are building capital-intensive infrastructure projects as growth, aligned with a long-term need by the customer to utilize the investment. 

CPAs reduce risk but are not risk-free

Even though a capacity purchase agreement is designed to trade reduced risk and consistent revenues and costs for reduced profit margins, they are not free of risk.

Case in point are two regional airlines, Mesa Airlines and Republic Airways which have both navigated the Chapter 11 bankruptcy protection process in the past 10 years.

For Mesa Airlines, despite having consistent revenues and a protection from market cost fluctuations, the airline still required bankruptcy protection.

Largely as a result of the airline’s inability to manage costs and operational reliability to a level aligned with the negotiated CPA agreement, Mesa filed for bankruptcy protection in 2010.

The airline has since emerged, having provided capacity purchase agreement flying for both American Airlines and United Airlines. Today, the airline continues to operate as a CPA provider for United.

Another example of a CPA failure was Republic Airways, which filed for Chapter 11 bankruptcy protection in 2016. What makes the Republic bankruptcy unique is that the airline was profitable at the time of its filing. An unexpected extension of 50-seat aircraft flying by a major airline partner suddenly gave Republic Airways flying commitments for which it no longer had the pilots to meet. The unorthodox bankruptcy filing was the result.

Finally, the way a CPA airline can fail is simply with expiration of the CPA. If no extension or another partner is not found, the airline would be unable to pay its staff or continue operating. 

Yet, even as dire as the situation may be for a CPA airline, it still does not necessarily materialize as risk for debt holders or lessors. The example of Compass Airlines can be used to show how aircraft leases and financings were aligned with CPA agreements. Even though CPA agreements were not extended with Compass Airlines, the aircraft were redeployed into other CPA airlines operating for the same major airline partner. 

In this instance of an orderly wind-down, the risk on the aircraft was either transferred to the new airline or resolved entirely. While this type of “failure” is not advantageous for the airline, it is not a culmination of risk for the lessor. The end of a CPA is long expected and planned for by the creditors and the airline.

Capacity Purchase Agreements from the lessor perspective

Much of the value of the capacity purchase agreement to the airline is in managing volatility and risk. This benefit is essentially passed through to an aircraft lessor considering placing an aircraft at such an airline. For those lessors and investors able to understand the fundamental differences in traditional airlines versus CPA providers, this exchange of risk for reduced profit margins can provide a significant advantage. 

While lease rates are largely market-based, the risk of default is greatly reduced with a CPA. Further, the ability to align leases or other financings with the term of the CPA provides an additional level of certainty that an investment will either be returned in a profitable state, or extended to further improve an already profitable deal.

The flip side of this advantage, however, is that the market for CPA-aligned aircraft leases is finite, often subject to the pilot union scope clauses addressed in the first analysis. While this limits the opportunity for low-risk asset growth, it also places greater advantage to those organizations able to best work with the distinct needs of a CPA airline.

Yet, there remains no reason why an aircraft operating within a CPA agreement cannot be placed anywhere else. Upon completion of the CPA, if the aircraft is returned to the lessor, it can be placed in any other operation, including other CPA airlines or traditional airlines worldwide.

It is in this way that aircraft placed with a CPA airline under a well-written lease agreement can provide both the benefits of an airline and a utility. From the utility perspective, the aircraft becomes a piece of infrastructure which has been committed to by the parent airline through its duration – a pipeline of capacity.

Yet, from the airline perspective, the aircraft remains a highly liquid asset, capable of being placed anywhere in the world with little more than a ferry flight to reposition the aircraft at the next operator.

If you are interested in learning more about investing in small commercial aircraft, please contact Falko’s Investor Relations team at [email protected]. For further information about Falko, visit their website or follow them on LinkedIn.

For a PDF download of this analysis, you can find it here: https://visualapproach.io/mp-files/re-examining-the-regional-airline-cpa-business-model.pdf/

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