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Fasten Your Seatbelts

Hawaii interisland traffic has shrunk, but interest in starting more local airlines is not waning. Fierce competition and lower fares are ahead

During some of Aloha Airlines' darkest days in bankruptcy last fall, the news releases began. Phoenix-based regional carrier Mesa Air Group announced in September it intended to start flying interisland routes in the first quarter of 2006. Mesa, the low-cost carrier that was thriving on the Mainland while most airlines foundered, wanted a piece of Hawaii.

illustration: Michael Austin

Industry insiders in Hawaii couldn't help but speculate that Mesa's main aim was to shake up Aloha and scare away any prospective investors. More releases followed on Mesa picking its management team and deciding on scheduling and fares Ð all while Aloha met with distraught creditors and lessors and wary investors.

Mesa and its feisty chief executive officer, Jonathan Ornstein, had for years eyed the Hawaii market as a key strategic move for the publicly traded company (NASDAQ:MESA). Hawaii allows Mesa to make a big splash in a small pond. Ornstein says he had kicked the tires when Hawaiian Airlines was in bankruptcy. When Aloha was deep in its Chapter 11 reorganization, he signed a letter of nondisclosure and took a look at the books.

Ornstein says he is not surprised that Mesa's announcement rattled some people at Aloha. But he adds that his intent was not to debilitate Aloha's restructuring. In an ultra-competitive business, Ornstein says the reality was that Aloha's bankruptcy was a sign of weakness and a window of opportunity. "We are always looking for opportunities to grow and we did view this as an opportunity," Ornstein says.

The Hawaii Cycle

Ornstein says that, even with Aloha Ð at press time Ð poised to emerge from bankruptcy, Mesa is determined to enter the Hawaii market. Ornstein maintains Mesa is the best low-cost carrier around and is better structured to offer low-fare Island service than Hawaiian and Aloha, both of which mix interisland trips with longer transpacific routes.

Plus, he adds, riding a good year on the Mainland, Mesa has $300 million in capital socked away to back its venture. "We have the ability to put a lot of firepower into it and we have the right cost structure to fly short flights," Ornstein says.

Aloha and Hawaiian executives say they are more than ready to take on any newcomer. Industry experts are split on whether Mesa will in fact arrive if Aloha successfully reorganizes.

But industry consultant Bob Mann, of New York-based R.W. Mann, says it is nearly inevitable someone else will step up if Mesa backs down. Mann says the entrance of a third carrier in Hawaii has been cyclical. Whenever the fares hit highs that the public has a hard time swallowing, as they have today, someone emerges.

Take FlyHawaii, the startup interisland airline backed by Lion Coffee founder James Delano. It was slated to open this year, but interest cooled after Mesa talks heated up.

"There is always somebody who thinks 'I could be the third guy. I could clean up,'" says Mann. "But even if they do, it is a tough market and [Aloha and Hawaiian] are not going to be willing to give up market share."

MARKET SHARE:
INTERISLAND TRAFFIC BY AIRLINES '03
source: Department of Transportation Airports Division, compiled by Airline Consultant Rodrick Aoki of Avairpros

Shrinking Market

When asked about the potential entrance of a third carrier into the Hawaii market, Mark Dunkerley, president and CEO of Hawaiian, quipped, "This is a movie that has been seen many times before and it always has the same ending. I don't see any reason to suppose we will get a different ending to the same movie."

Dunkerley is using the history of airlines in Hawaii as his guidepost for the potential outcome of the appearance of a third carrier today. Hawaii has seen Mid Pacific Air, Discovery Airways and Mahalo Air in the past 25 years, and all three failed to knock off either Aloha or Hawaiian or to coexist. As far as major interisland carriers go, Hawaii is a two-carrier town.

But Dunkerley says Hawaiian, a subsidiary of Hawaiian Holdings Inc. (AMEX:HA), is not focused on any individual potential competitor, but rather on the unique challenges of the Hawaii market and how his airline can best respond. "We need to focus on our customers and providing a service that is second to none," he says.

Unlike other airlines based in cities such as Chicago, Hawaiian and Aloha are based in a market with just 1.2 million people, he says. "That puts a limit on the core business for which we have a natural advantage versus our [Mainland] competitors." The Island airlines, he says, are also at a disadvantage when it comes to lower costs: the Mainland big hitters can reduce costs by scale.

Last, he says, the interisland market has shrunk in recent years, as more carriers fly directly to Neighbor Islands and Neighbor Islands develop infrastructure, from medical care to shopping outlets, so people have less need to travel to Oahu.

State Department of Transportation Airports Division statistics on air travel show that the total number of enplaned and deplaned passengers in interisland traffic dropped in 2001 by 11.6 percent, then slipped 6.4 percent and 8.9 percent in 2002 and 2003, the most recent years available. In raw numbers, that's falling from 20.8 million in 2000 to 15.6 million in 2003.

"That makes our market very different from any other market in the world," Dunkerley says. "The demand for air transportation is growing globally and I can think of no other market in the world that is shrinking as it is in Hawaii."

THE DOGFIGHTERS
ALOHA AIRLINES
CEO David Banmiller

Employees: 3,700
Fleet: Nine Boeing 737-200 Passenger Advanced planes, three Boeing 737-200Cs, one Boeing 737-200QCs and eight Boeing 737-700s
HAWAIIAN AIRLINES
CEO Mark Dunkerley

Employees: 3,300
Fleet: 11 Boeing 717-200s, 14 Boeing 767-300ERs
MESA AIR GROUP
CEO Jonathan Ornstein

Hawaii Employees: Up to 800 projected
Hawaii Fleet: Tentative plan calls for eight Bombardier CJR 200s
source: Airline companies

Three Is a Crowd

Aloha CEO David Banmiller doesn't mince words about it: "The history of a third carrier in Hawaii has been awful."

A third carrier has historically come in and lowered prices, then the other airlines have followed, he says. However, because the market does not provide enough passengers to support three airlines, it becomes a game of attrition. The initial price drop is followed by instability in the market and eventual closure of an airline, which in the past has always been the upstart. Those kinds of dynamics have hurt both Hawaiian (two bankruptcies) and Aloha (one bankruptcy) in the past, not to mention the customers left with vouchers for defunct airlines, he says.

The belief that more competition means lower fares has not been borne out in Hawaii over time, Banmiller maintains. "It never works out. It's a pipe dream." Banmiller adds that neither Hawaii carrier is making "indecent profits." The fares today are largely a reflection of the increases in fuel prices, he says. The industry is struggling globally with fuel prices.

Banmiller also defends the airlines' transpacific routes, which some have criticized as a money siphon. Banmiller says those routes, through reorganization, have been made profitable and help the airline attract investors and expand.

Banmiller adds that Aloha is not the airline it was 12 months ago, and would prove formidable to any new challenger. In addition to its 60-year history in Hawaii, through reorganization, Aloha has trimmed $75 million from its expenses and its new investors, the Yucaipa Companies, led by billionaire supermarket magnate Ronald Burkle, are ready to infuse $50 million in cash and $50 million in debt financing to help the airline succeed.

"Both companies [Hawaiian and Aloha], through the bankruptcy process, have reenergized themselves, Banmiller says. "It is going to be harder than ever for somebody to come in."

Payoff Worth the Risk

Ornstein says he is well aware that an entrance into the Hawaii market is "not a slam dunk. I would never say this is a no-risk deal."

But the payoff appears worth the risk.

The majority of Mesa Air Group's business on the Mainland is running regional airlines as an extension for larger partners such as United, American West and Delta. As an independent airline in Hawaii, Mesa would be able to establish its name separately from those partners in a market where it will not fade into the background among scores of carriers.

"In Hawaii, with only eight aircraft, people will know about Mesa in two weeks," Ornstein says. "This would be a small part of our operations, but we can project a lot of force."

The plan is to start with eight 50-seat jets and, as Mesa builds its foothold here, in a year more than double the number of planes, including adding 90-seaters. The prices would range from $86 to $171 for roundtrip tickets and Mesa would fly to all major airports.

Ornstein says the company is now working on finding the appropriate planes for interisland service. He says Mesa is awaiting the best deal on twin-engine Bombardier CJR 200s, which could shortly become available through struggling Mainland airlines selling off their assets. He expects to enter the Hawaii market in the first half of 2006.

"We are just waiting for the right price for the right plane," he says.

GETTING GROUNDED:
STATEWIDE INTERISLAND AIR TRAFFIC
source: Department of Transportation Airports Division

A few observers are eagerly waiting for that day.

University of Hawaii economics professor Jim Mak believes that Mesa just might have the right formula to make it in Hawaii, and unlike earlier newcomers it has the capital to compete. "I think Mesa is going to come in with lower fares and the planes will be a little slower, but I think a lot of local people in Hawaii will be willing to fly the airline for a lower price."

Mak scoffs at the notion that Mesa would introduce instability into the market. Mak agrees that the Hawaii market will not support three airlines; he places the market at closer to 2.5 airlines. But competition breeds better airlines with better service and lower fares, he says. Mak maintains only the stockholders of the company that loses market share suffer.

"Consumers are the ones who will benefit and I think the state should do everything it can to help Mesa succeed," Mak says. "Ever since deregulation of the airline industry, we have seen airlines come and go. The efficient airlines stay and the inefficient go."

This time around, though, it might not be the challenger that disappears in interisland service, Mak says, and quickly adds that, even if Mesa doesn't come, someone else will see the potential payoff, perceive the vulnerability in the volatile Hawaii market, and make the plunge, he says.

Even Island Air, the small turboprop carrier that recently became independent of Aloha (See Story here), is nibbling at market share by increasing its flights in the Islands. And now small-time carrier Pacific Wings, with its band of four- and eight-seater, low-flying Cessnas, is running a television ad campaign.

"The handwriting is on the wall," Mak says.

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