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Remarks of Charles L. Pieper
Chairman, Fairchild Dornier
July 30, 2001, Washington, DC

Good afternoon, ladies and gentlemen. It is certainly a pleasure to be here with you today. 

Before getting into our perspective on the regional jet business, I'd like to set the stage and give you some insight into Fairchild Dornier from an investment perspective. 

Along with being Chairman of Fairchild Dornier, I am an operating partner at CD&R, a private equity firm with offices in New York City and London. We've been in business some 25 years, realizing an average annual 40 percent return on investment. We currently finalize about one or two deals a year worth a billion dollars or more, and we’ve just completed our sixth fund, worth $3.5 billion. Our total funds under management is $5 billion representing 13 companies and more than 30,000 people. Our operations are characterized by generating returns from operational improvements, creating both a better company and a better product, not just through financial leverage. In our organization structure we currently have 14 partners with CD&R -- seven financial and seven operational. In looking for companies in which to invest, our target investments are stand-alone companies or corporate orphans in need of transformation. They have nothing fundamentally wrong with them, but are lacking the financial and human capital to take them to the next level.

We considered Fairchild Dornier right in our strike zone for three reasons: great product, great people, great market.

We, along with our German partner, Allianz Capital Partners, bought the business just a year ago last April. We fully funded it through its product development with $400 million in equity and $800 million debt. We are very excited about it.

Although Fairchild Dornier in its present form is just over a year old, it is made up of two highly respected companies whose ancestry goes back virtually to the dawn of aviation -- one European, one American. 

Now we are a single entity with our corporate headquarters and primary manufacturing facilities in Germany, a second manufacturing and support organization in San Antonio and our marketing headquarters just a few miles down the Dulles Toll Road in Herndon. We currently employee some 4,100 people worldwide, including about 900 in the U.S.

Our transatlantic character gives us a unique perspective of both the European and U.S. regional airline scene, the two largest and fastest growing areas of the regional airline industry. So I thought I would take this opportunity to give you our view of what is going on in those two arenas, but in the context of explaining the regional jet evolution – or better characterized – revolution. 

There are notable differences between the U.S. and Europe in their initial growth stages. For example, the 50-seat regional jet market is bigger in the U.S. while the 70-seat regional jet market is bigger in Europe. But more important are the enormous similarities in passenger response and in the challenges the industry faces. First, some stage-setting facts: 

• The regional jet market has been the fastest growing segment over the last five years, growing at 15 percent per year compared to the majors growing at 5 percent
• It is expected to continue to outpace the majors for the next 20 years, growing at an average annual rate of 8 to 9 percent, compared to only 4 percent for the majors.
• The market is large! Regional jets with less than 100 seats are a $200 billion/ 9000 aircraft market over the next 20 years. Compare this size to the Airbus A380 market of $280 billion which is almost the same value, but the RJ market has seven times the number of planes. That will bring the total RJ share from 8 percent to 15 percent of the total industry. Roughly 80 percent of the regional market is split evenly between North American and Western Europe.
• It is also the most profitable segment for the carriers. 
• The three major manufacturers, Fairchild Dornier, Embraer and Bombardier, are now reporting sales of more than $6 billion, with firm backlogs in excess of $33 billion
• What is fueling all this at its core is the demand of the travelling public. Travelers worldwide prefer jets to turboprops and they prefer point-to-point over hubs.

Although the revolution has clearly started, it is still in its development stages --with much more to come. 

We see it occurring in four phases:

Phase 1 was the development of the 50-seat jet aircraft. The 50-seater invented and proved the concept of regional jets, first in the U.S., then in Europe. This phase actually started in 1993 when Bombardier introduced the CRJ to the market. After a hesitant acceptance, the 50-seat regional jet has swept the board in the last 4-5 years, led by such pioneers as Lufthansa CityLine and Comair.

In the U.S. regional fleet today, more than 80 percent of the 50-seat aircraft are now jets, with a current backlog of over 600 aircraft. These figures illustrate what a stunning transformation has been made in a few short years; it has been, indeed, the beginning of the Regional Jet Revolution.

Interestingly enough, these jet aircraft have generally not replaced turboprops. In the U.S., the jets have been used almost entirely by the major carriers to increase feed to their major hub airports such as Chicago, Atlanta, Houston, and Dallas to take advantage of the lower costs of operation of the regional carriers. 

Direct “origin and destination,” or "O and D," nonstop flights between non-hub cities are still relatively rare in the U.S. However, in Europe the 50-seat regional jet is starting to take root, being used with increasing frequency to provide secondary-city O and D service, although the total 50-seat market is still a few years behind North America. In Europe, 75 percent of 50-seat aircraft are still turboprops, although 82 percent of the 50-seaters on order are for jets.

For the past year, with the increasing availability of the smaller 30- to 40-seat jetliner, we have been seeing the move to Phase 2 of the Regional Jet Revolution. These aircraft, represented by the 328JET and the EMB135, are beginning to take over from the 30-seat propeller aircraft. This market is primarily in North America where regional airlines fly aircraft approximately half the size of the regional airplanes in Europe. So the 30- to 40-seat jet is ideally sized, but the question has always been -- can a jet operate as economically as a turboprop at the smaller seat size? Developing technology, particularly in small jet engines, has now made this possible. So we are just beginning to see Phase 2 of the Regional Jet Revolution as these smaller jets begin to take over from 30-seat turboprop aircraft.

We see the turboprop market diminishing in number, but probably more slowly than forecasted five years ago. Clearly, the least efficient are being retired but the most efficient are being used for routes where volume growth does not justify jets; and when they do, the jets move in and efficient turboprop planes are moved to develop new city pairs to start the process all over again.

Phase 3 of the Regional Jet Revolution is just starting to unfold. It will see the introduction of the new technology 70-seat jets, initially in Europe. The regional carriers in Europe already fly aircraft significantly larger than those in North America, including a number of jet aircraft such as the Fokker 70 and Fokker 100 and the British Aerospace 146 RJ. But the new technology aircraft, such as the Embraer ERJ170 airplanes and the Fairchild Dornier 728JET family, will introduce significantly lower operating costs, with much improved cabin comfort, to the regional business. 

The initial orders for each of the competing new 70-seat jets were, in fact, placed by European carriers. Brit Air ordered the Bombardier CRJ 700, Cross Air ordered the ERJ170 and Lufthansa Cityline ordered the 728JET. Clearly the lead into Phase 3 of the Jet Revolution is coming from Europe, primarily because there are no scope clause constraints on operating these 70-seat jets, but also this size of aircraft is well suited for the increasing point-to-point, O and D market; for example, Birmingham to Munich, or Hamburg to London Stanstead. It is clear that when these aircraft enter service in 2003, they will bring a whole new standard of passenger comfort to the regional marketplace while offering improved operating costs over the older generation jets and increased efficiency over the larger props.

Today, U.S. regional carriers are limited in their use of the 70-seat category by the so-called “scope clause” issue. This is where the major airline pilot unions negotiate with the major airline management and generally seek to limit the amount of jet flying that can be done by the regional carriers. As an example, the recent agreement between American and its pilot union states that any 70-seat jet flying must be done by the major carrier. 

Although not all airlines have this restriction, as a general rule the limit comes in at about 70 seats. This makes it more difficult to economically justify operating a 70-seat jet if the pilots’ salaries are based on the pay scales of the major carrier. This has continued to limit the speed of development of the 70-seat jet business in the U.S.

Phase 4, the final stage in the Regional Jet Revolution, will see 70- to 110-seat jet aircraft moving into the U.S. domestic market and the European major carriers serving intra-Europe. 

The new 70-110-seat families of regional jets offered by Fairchild Dornier and Embraer will begin to look very attractive to the major carriers as replacements for aircraft such as the DC9-30 and 737-500. Thus we are already beginning to see interest in the new 100-seat aircraft offered by regional aircraft manufacturers, but as aircraft to be bought and operated by the major carriers. This phase will see the development of true "seamless service" in the U.S., bringing major carrier service and passenger comfort standards to the regional marketplace.

Furthermore, we foresee that the new 70- and 100-seat aircraft will open up a whole new structure of point-to-point service within North America, similar to that which has already been developing in Europe. We can identify more than 50 North American cities that have a population of between half a million and two million people that provide huge point-to-point potential for 70-seat size aircraft. The range, capacity and the economics of our new 70- to 100-seat aircraft are well suited to develop this new system of point-to-point operation within both Europe and North America, therefore bypassing the congested hubs --something that, as passengers, we will all applaud. 

This all sounds like a very rosy picture, but there are some clouds on the horizon.

First, we need to consider the effects of the current economic cycle.

Let me quote you some recent, somewhat intoxicating, growth figures from a number of regional carriers versus the way it was a year ago, all in the face of traffic declines by at least five major U.S. carriers.

These are their May traffic figures –

RPMs  Load Factor

One truth we have all relearned from the recent tech bubble is that all industries are cyclical.

• So clearly, this can’t continue forever, but we do think there is still a lot of runway ahead, for several reasons: Demand is a long way from being saturated. Point-to-point, the most powerful demand element, is just developing. And in this cycle, load factors are 700-900 points higher than 10 years ago. People are still flying.
• When faced with a slowdown, bigger aircraft are parked, not smaller ones.
• The “Nirvana” for the carriers is high load factors and high yields.
• These parameters are best met with purpose-built planes, not big heavy ones shrunk to size. We have seen a lot of interest from the major carriers for exactly this reason.

Overall, at least for this cycle, we can see growth slowing from the mid-to-high teens to around 10 percent -- a decline, but certainly not negative.

Economic cycles will clearly have an effect, but we think it is significantly dampened by being so close to the beginning of our growth curve and with so much unmet demand still there.

The second cloud has to do with issues brought about by unions, namely, the effect of pilot scope clauses and increased wage settlements.

However, the introduction of regional jets has had enormous customer acceptance over the past five years. For that reason we believe that market forces may be starting to erode those artificial constraints.

Delta has become a leader in negotiating contracts with its pilots that still give the pilots the protection they want while allowing the airline to take advantage of the unique capabilities of the regional jet. Other carriers will have to follow suit or they will find Delta taking an ever-increasing share of the market. A case in point was the recent United contract with its pilots. Under its previous contract, United Express carriers could only operate 65 regional jets. The new contract allows up to 454 jets of 50-seats or less by the end of 2004.

A recent analysis by Merrill Lynch indicated that a similar scenario could be expected in the 70-seat category of regional jets as they come on line. So, it appears that market forces may prevail.

However, the Merrill Lynch study also noted that reductions of the scope clauses may not be all that great for the carriers. In order to get the necessary concessions from the pilots to allow the airlines to optimize aircraft size to market demand, the airlines are having to increase pilots salaries.

As was recently seen with the Comair pilots contract, the gap between regional and major pilot wages is narrowing. This could lead to less favorable, or even unfavorable, economics for regional jet operations, leading in turn to reduced demand for regional jets. 

We see two offsets to this cost pressure:

First, even at the salary levels of pilots who fly for the majors, RJs are profitable because the 5 percent added cost is not a knockout blow and the RJs themselves, at lighter weights than cut-down 717s and 318s, offer better economics. In addition, point-to-point RJ service allows for higher ticket prices and yields. So even with the higher pilot costs, carriers can earn attractive margins.

Second, the tide of ownership structure of the regional carriers has already changed dramatically following the Delta/Comair dispute. Majority ownership is giving way to minority status, and franchise agreements and code sharing are growing. Both Don Carty at American and Jim Goodwin at United have already said as much.

Carriers do not need to own the regionals to have excellent relationships. For evidence, look at ACA’s growth and United/Delta performance from operating their franchise services.

In both the U.S. and Europe, alternative competitive structures are emerging for the majors to avoid the union constraints and diversify their supplier risks.

I believe the marketplace will handle both of these first two clouds -- the economic cycles and the unions. They will cause bumps, but with relatively short-lived constraints, since carriers will find ways to meet huge passenger demands.

The third cloud is the most troublesome, and one for which everyone must be a part of the solution. It is the constraints imposed by out-of-date ATC environments, both in the U.S. and in Europe. Economics and image are at stake. When you see the topic on the cover of Newsweek and Time -- both offered reasonable solutions -- it makes one wonder why these same solutions do not have the requisite follow-up plans on either continent.

And make no mistake, it is a constraint to growth -- not just a travelers irritant.

Leo Mullen of Delta recently gave some startling figures for the U.S. on the runway issue alone.

• Delays are up 47 percent in the last two years, with 75 percent due to ATC/runway issues.
• It takes 10-plus years to complete a runway.
• Only three were completed in the 1995-1999 timeframe -- a capacity increase of 3 percent -- and only five more are in the pipeline to handle a 40 percent growth in traffic to 2010!

We believe that small airliners can be part of the solution by servicing small markets and bypassing the big hubs. Unfortunately, the major carriers still see the regional jet as a hub feeder rather than a mechanism to create a totally new market. 

We need to ask ourselves whether the hub and spoke concept is so ingrained in the U.S. airline psyche that point-to-point service will be artificially constrained regardless of ATC and airport congestion; or if one major carrier starts using its regional partners to bypass hubs, will this open the floodgates to point-to-point service by the other majors. 

We all know the problem is complex and that many people are working on solutions. We believe we have the technical capability, both in the air traffic industry and in the airplanes themselves, to solve the problem, but it would appear that the issue is perhaps as much political as it is technical. 

So we suggest that our aviation community -- made up of large and small airlines, the manufacturers, the airports, the systems integrators, the industry associations and the passengers -- should all come together as a single voice to seek and to provide solutions to the ATC issue. We are certainly ready to play our part.

At Fairchild Dornier, we are in the process of building a company as well as building aircraft. Since investing $1.2 billion over a year ago, we are currently hiring people at the rate of more than two a day while simultaneously building new production facilities for our 728JET and 928JET programs.

This has allowed us to incorporate the latest technology both in aircraft design and aircraft production. 

This advanced technology has enabled us to build aircraft that airlines can purchase and operate at the lowest possible price. This, in turn, will allow the regional carriers to maximize the capabilities of the regional jet and build a strong regional industry, not only in Europe and the U.S., but also in the rest of the world.

As an industry sector, we’ve gone from the days of swashbuckling owner-operators running their businesses on a shoestring with questionable service and reliability, and buying airplanes in ones and twos, to a point where regional carrier and passenger expectations are as high as those of the majors and aircraft purchases involve dozens of airplanes in multi-billion dollar deals with sophisticated financing provisions.

We know we can deliver the product and services required…but we think an accelerated and coordinated effort is needed to break through the ATC constraint. If the regional airline industry is to reach its full potential in serving large and small communities, we must take this last step together.