| EXPRESSJET HOLDINGS INC Item 1A Risk Factors Factors that May Affect our Future Operating Results and Financial Condition Our actual results of operations and financial condition may vary materially from those anticipated, estimated or projected by us |
| Among the key factors that could have an adverse effect on our future operating results and financial condition are those set forth below |
| We may not be able to design and execute satisfactory, income-generating arrangements for the 69 aircraft that Continental intends to withdraw from the capacity purchase agreement We received notice on December 28, 2005 from Continental of its intention to reduce by 69 the number of aircraft that we operate under the capacity purchase agreement (a 25prca reduction of capacity) beginning in December 2006 |
| We have nine months from the date of notice to respond to Continental and exercise our option to either retain or return the aircraft |
| We are currently evaluating whether to retain the aircraft or return them to Continental |
| If we retain the aircraft, we cannot guarantee that we will be able to identify or profitably execute any income-generating arrangements such as flying these aircraft under our own designator code or for other parties or by subleasing them to third parties |
| Additionally, so long as Continental is our largest customer, if we enter into a capacity purchase or similar arrangement with another carrier, that has annual revenues greater than dlra500 million (prior to adjustment for inflation since 2000), for more than 10 aircraft at a less favorable net benefit to us than our capacity purchase agreement with Continental, then the capacity purchase agreement has a provision that may allow Continental to amend its agreement with us to be equally favorable |
| This most-favored-nations clause, as well as scope clauses in the collective bargaining agreements of other major carriers, additional costs to put in place an infrastructure to support these aircraft independent of Continental and other external factors (eg, the US economy, regulatory requirements, etc) may limit our ability to economically secure other arrangements for these aircraft |
| ______________________________________________________________________ [67]Table of Contents We depend on the financial and operational stability of Continental We are directly affected by the financial and operation stability of Continental |
| Continental provides substantially all of our revenue through our capacity purchase and other agreements |
| Despite improvements during the past year, the US domestic airline environment continues to be extremely challenging |
| Since September 11, 2001, Continental has reported significant losses, excluding special items |
| For the year ended December 31, 2005, Continental reported a net loss of dlra68 million and has indicated that its business and financial results are affected by and are subject to a number of factors, many of which are uncontrollable, such as low-cost competitors, the low-fare environment, higher fuel prices, pension liability, terrorist attacks and adverse regulatory rulings |
| We cannot predict the future impact of these factors on Continental |
| Furthermore, high fuel prices, the long-term impact of the changes in fare structures (most importantly in relation to business fares), booking patterns, low-cost competitor growth, customers’ direct booking on the internet, competitor bankruptcies, and other changes in industry structure and conduct cannot be predicted at this time, but could have a material adverse effect on both Continental’s and our financial condition, liquidity and results of operations |
| Our annual rate resetting process under the capacity purchase agreement with Continental may result in arbitration Under the capacity purchase agreement, we receive payment for each scheduled block hour in accordance with a formula designed to provide us with a target operating margin of 10dtta0prca |
| Since we have not agreed with Continental on rates for 2006, Continental has agreed to continue paying Airlines at the December 2005 rates until an agreement is reached |
| Any agreement to revise the current rate structure will be retroactive to January 1, 2006 |
| We may not be successful in negotiating the rates for 2006 or may not be able to retain our current target operating margin of 10dtta0prca, considering the current challenges facing regional carriers, as described in Item 1 |
| “Industry” section above, and, ultimately, may have to submit our disagreement to arbitration |
| Our capacity purchase agreement with Continental can still be terminated, even after the recent fleet reduction notice Beyond the 25prca reduction notice, Continental can terminate our capacity purchase agreement at any time with 12 months’ notice |
| If the agreement were terminated, our revenue would be substantially eliminated after the pertinent wind-down period, as we receive substantially all of our current revenues from our agreement with Continental and we would incur significant losses unless we were able to make other arrangements |
| We cannot be certain that we would be able to enter into substitute arrangements, or if we could, that they would be as favorable to us as our capacity purchase agreement with Continental |
| Our capacity purchase agreement is scheduled to terminate on December 31, 2010, subject to renewal by Continental through December 31, 2030 |
| However, Continental can terminate the agreement: • at any time for any reason with a minimum 12 months’ notice; • for cause, as described in “—Capacity Purchase and Other Agreements with Continental,” at any time without giving us notice or an opportunity to cure; • at any time upon our material breach that does not constitute cause, including our failure to complete a specified percentage of our scheduled flights, if the breach continues for 90 days after we receive notice of the breach; and • at any time, without giving us notice or an opportunity to cure, if Continental reasonably and in good faith determines, using recognized standards of safety, that there is a material safety concern with our operation of any flight under the capacity purchase agreement |
| As of the date of this report, we have not received any notice from Continental other than the aircraft withdrawal notice described above |
| ______________________________________________________________________ [68]Table of Contents We may lose access to our aircraft, facilities and regulatory authorizations, as well as any airport related services that Continental currently provides to us We sublease or lease all of our aircraft from Continental |
| In addition, the regional jets subject to our remaining firm orders will be leased by Continental and then subleased to us |
| If Continental terminates the capacity purchase agreement for cause, it will have the right to terminate our leases and subleases for aircraft covered by the capacity purchase agreement at the time of termination |
| Additionally, if Continental’s financial condition deteriorated and it filed for bankruptcy protection, it would have the ability to reject the leases or subleases on our aircraft |
| There can be no assurance that Continental will have sufficient liquidity to fund its future operations and other financial obligations, especially in the event additional adverse factors beyond its control occur, such as terrorist attacks, adverse regulatory rulings or higher fuel prices |
| Additionally, with the aircraft reduction notice and the potential to terminate for any reason, we may lose access to some or substantially all of our airport facilities and other services that Continental currently provides to us, as well as our take-off and landing slots and route authorities |
| Continental leases most of the airport facilities that we use |
| We may be required to vacate the terminal facilities (or all facilities if the termination results from our material breach of the capacity purchase agreement) that are subleased to us by Continental, and to use commercially reasonable efforts to assign to Continental or its designee any lease in our name |
| Consequently, to offer airline services, we would have to arrange to use the same or other airport facilities, take-off or landing slots, route authorities and other regulatory authorizations used for scheduled flights at potentially higher rates |
| We cannot provide any assurance that we would be able to gain appropriate access to airport facilities, slots or other authorizations, or would not incur a significant increase in our costs to do so |
| We may not be able to successfully replicate the current passenger, traffic handling services, administrative and other infrastructure services provided by Continental In connection with the capacity purchase agreement and the administrative service agreement, Continental provides a number of important passenger, traffic handling, corporate infrastructure, aviation insurance coverage, environmental compliance matters and administrative services to us |
| Should we elect to insource or outsource these services to other third parties, we might not be able to replace these services on a cost-effective basis, which could have a material adverse effect on our operating results and financial condition |
| Additionally, under the current regulatory environment for public companies, the corporate infrastructure and administrative system and process changes might result in control deficiencies in our internal control over financial reporting, which could result in qualified audit opinions or disclaimers for internal control over financial reporting and for the financial statements |
| We may not be successful in retaining qualified personnel to maintain the current level of customer service and reliability and to design and execute our strategies in response to Continental’s aircraft reduction notice Wage rates, in general, are increasing |
| Therefore, our employees may elect to seek other employment opportunities, thereby increasing our recruiting and training costs |
| We cannot guarantee that we will be able to find qualified personnel to fill our vacancies |
| Additionally, our negotiations with our flight attendants, represented by the IAM, were temporarily placed in recess by the mediator mutually requested by IAM and us, with no specified deadlines or dates for continued negotiations |
| We can provide no assurance that a mutually acceptable agreement can be reached with our flight attendants |
| The ultimate outcome of these negotiations is unknown at this time |
| ______________________________________________________________________ [69]Table of Contents We may not be successful in implementing any diversification strategy away from passenger related airline services In addition to our focus on Continental’s recent aircraft reduction notice, we continue to evaluate various diversification strategies away from passenger-related airline services (such as aircraft maintenance, ground handling, crew training, etc) |
| Substantial risks accompany these strategies, including: • our inexperience in other industries; • our ability to integrate these business models into our passenger airlines business model; • our ability to create the infrastructure necessary to support new operations; • our ability to obtain and finance any expansion at acceptable rates of return; • the condition of the US economy; and • unanticipated competitive responses of new entrants |
| We may be responsible for additional taxes as a result of our tax agreement with Continental We have a tax agreement with Continental that provides, among other things, for our payment to Continental of all or a significant portion of the tax benefits we realize as a result of an internal reorganization effective prior to our initial public offering in 2002 |
| Since that time, we have made net payments of approximately dlra98dtta8 million to Continental under the tax agreement and could pay Continental as much as an additional dlra257dtta4 million through 2017 |
| “Financial Statements and Supplementary Data – Notes to Consolidated Financial Statements – Note 9” for a detailed discussion of our income taxes and such agreement with Continental |
| If it were determined, as a result of an income tax audit or examination, that a significant amount of these tax benefits should not have been available, thus requiring us to pay additional taxes, interest and penalties to one or more tax authorities, and if at that time Continental were unable to indemnify us for these amounts, then we could be responsible for such tax payments, interest and penalties |
| We may be unable to obtain all of the aircraft, parts or related support services we expect from Embraer to operate the aircraft As we operate a single fleet type produced by a single manufacturer, our operations could be materially adversely affected by: • Embraer’s inability to fill our aircraft orders or provide sufficient parts or related support services on a timely basis especially in light of its announcement to cease the production of our current fleet type; • the issuance of FAA directives restricting or prohibiting the use of Embraer regional jets or parts; • unscheduled or unanticipated maintenance requirements; or • force majeure events that prevent Embraer from performing under the lease agreement |
| Our wage rates will likely increase as the number of aircraft under our capacity purchase agreement decreases We may experience an increase in wage rates if we are required to furlough employees due to the reduction in flying for Continental |
| Any furloughs would necessarily affect more junior employees under our collective bargaining agreements first, resulting in the retention of more senior employees at higher wage rates |
| Our board of directors has implemented a long-term incentive plan to incentivize management employees as we seek to replace revenues from the capacity withdrawn by Continental |
| If Continental terminated the capacity purchase agreement, it might be necessary to take additional steps to ensure an orderly wind-down of that agreement |
| This likely increase in wages could cause our cost structure to be less competitive when compared to other regional carriers |
| ______________________________________________________________________ [70]Table of Contents Maintenance costs will likely increase as the average age of our fleet increases Similar to other air carriers in our industry, as the average age of our fleet increases, the maintenance costs of our fleet will likely increase |
| We emphasize preventive maintenance, in addition to the inspection of our aircraft engines and airframes at intervals required by the FAA We perform line and heavy maintenance at our eight primary maintenance facilities and satellite stations located throughout the Midwest and Eastern parts of the United States |
| Additionally, we have a power-by-the-hour agreement with Rolls Royce to maintain the engines on our aircraft through April 2015 |
| Under the agreement, we are charged a fixed rate based on flight hours incurred during a month |
| The rates are subject to annual revisions based on specified labor and material indices |
| We also have power-by-the-hour agreements with other vendors to cover various components and systems on aircraft, and will continue to evaluate and implement other such agreements, as long as the terms are favorable |
| We believe that these agreements, coupled with our ongoing maintenance programs, reduce the likelihood of unexpected levels of maintenance expense during the terms of our aircraft leases or subleases |
| Additionally, we continue to maintain an inventory of aircraft spare parts to ensure the reliability of the operation and utilize a computerized tracking system to increase maintenance efficiency and to avoid excess inventories of spare parts |
| However, our average maintenance costs could increase and adversely impact our results of operations in the event that we have to address new FAA and/or Embraer maintenance directives or if Continental takes back the newer aircraft in our fleet |
| We are not aware of any directives, changes, or out-of-the ordinary requirements from Continental related to the return of the aircraft at this time that could adversely affect our maintenance costs |
| We compete with both low-cost carriers and other regional carriers, and our cost structure may not be competitive Because we do not control our own flight schedule under the capacity purchase agreement, only 43prca of our costs related to Airlines are controlled by us |
| All other costs are driven by the flight schedule determined by Continental, Continental’s own cost structure or factors that are outside our control, or in some instances even Continental’s control (such as aircraft rent, fuel, insurance, property taxes, etc) |
| As a significant portion of our costs are allocated and/or inherited from Continental, we may not be able to restructure our costs effectively to compete with other low-cost and regional carriers |
| Our business is subject to extensive government regulation and we may incur additional costs to comply with such regulations Our business is subject to extensive government regulation |
| As evidenced by the enactment of the ATSA, airlines are subject to extensive regulatory and legal compliance requirements that result in significant costs |
| The FAA and other governmental agencies such as the EPA from time to time issue directives and other regulations relating to the maintenance and operation of aircraft that require significant expenditures |
| Some requirements cover, among other things, retirement of older aircraft, security measures, collision avoidance systems, potable water standards, noise abatement and other environmental concerns, commuter aircraft safety and increased inspections and maintenance procedures conducted on older aircraft |
| We expect to continue incurring expenses to comply with these regulations |
| In addition, if any of these regulations caused us to cancel flights, the resulting reduction in our revenue would not be taken into account in any reconciliation payment made under the capacity purchase agreement to maintain our operating margin within a specified range |
| Additional laws, regulations, taxes and airport rates and charges are proposed from time to time that could significantly increase the cost of airline operations or reduce revenue |
| Such laws, taxes and regulations have affected all facets of our operations from security at airports, restrictions on landing, take-off, routes, restrictions on international routes, which can change spontaneously depending on the current arrangements between the United States and the foreign governments, and increases in landing fees and other airport facility charges |
| We cannot be certain that current laws or regulations, or laws or regulations enacted in the future, will not adversely affect us |
| ______________________________________________________________________ [71]Table of Contents We may be adversely affected by factors beyond our control, including weather conditions and the availability and cost of fuel Generally, revenue for airlines depends on the number of passengers carried, the fare paid by each passenger and service factors, such as timeliness of departure and arrival |
| During periods of fog, icy conditions, storms, hurricanes or other adverse weather conditions, flights may be cancelled or significantly delayed |
| Under our capacity purchase agreement with Continental, we are substantially protected against cancellations due to weather or air traffic control |
| However, if we decide in the future to operate our aircraft for another airline or under our own flight designator code, we may not be protected against weather or air traffic control cancellations, which could adversely affect our operating results and our financial condition |
| In addition, if we operate our aircraft for another airline or under our own flight code, we could be exposed to the volatility of fuel prices |
| Both the cost and availability of fuel are subject to various economic and political factors and events occurring throughout the world |
| Significant changes or extended periods of high fuel cost or fuel supply disruptions would materially affect our operating results |
| Our ability to pass on increased fuel costs through fare increases would be limited by several factors, including economic and competitive conditions |
| Additionally, under the capacity purchase agreement, if the unavailability of fuel causes us to cancel flights, our incentive revenue would be reduced |
| The cost and availability of adequate supplies of fuel could have a material adverse effect on our operating results and our financial condition in the future |
| Our operations and financial condition could be adversely affected as a result of an aviation accident An accident or incident involving one of our aircraft could involve repair or replacement of a damaged aircraft and its consequential temporary or permanent loss from service, as well as significant potential claims of injured passengers and others |
| We are required by the DOT to carry liability insurance |
| In the event of an accident, our liability insurance may not be adequate and we may be forced to bear substantial losses from the accident |
| Substantial claims resulting from an accident in excess of our related insurance coverage would harm operational and financial results |
| Moreover, any aircraft accident or incident, even if fully insured, could create a public perception that we are less safe or reliable than other airlines |