Description

We believe that Pinnacle Airlines (PNCL) is an extremely compelling investment, even after increasing over 450% from its irrational panic lows earlier this year. The recent 25% pullback from its highs provides a great opportunity to buy a company that is trading at about 40% of tangible book value and less than 2x free cash flow. With a market cap of roughly $100 million, we believe PNCL is worth 3x the current price – and even then would only be trading at a 20% free cash flow yield and slightly above tangible book value.

We are not newcomers to the story and have participated extensively in the discussion on timothy756’s PNCL thread over the past year. At this time, we feel that events have changed enough in that time frame that it has become an opportune time to revisit the investment story. Within the next few weeks, PNCL should report third-quarter financials that will show a SUBSTANTIALLY stronger balance sheet which ought to act as a catalyst for the stock price. As such our preference is to post it as a new idea here rather than continuing to post updates on the changed business on the older thread. For background reading, the first two write-ups of PNCL here in 2005-2006 regarded the ultimate resolution of PNCL’s claim in the Northwest bankruptcy proceedings. The third was timothy756’s post referenced above, along with a later post also by timothy regarding the merits of the convertible debt. All are worthwhile reading for the history and nature of the business.

As has been repeated several times in threads discussing PNCL, RJET, and other regionals on this site, Pinnacle should not be viewed as an airline, as it has almost zero exposure to fuel risk, load factor risk, or ticket price risk. It mostly provides capacity service to major airlines on a per-hour or per-departure basis. Historically this has resulted in significantly more stable cash flows than has been the case at the legacy carriers such as Delta, Continental, etc. For the carriers like SkyWest and Republic who have been in business as independent companies much longer, those positive cash flows date back for all but two of the last 33 years. Pinnacle has two subsidiaries, Pinnacle Inc. and Colgan. Pinnacle currently flies only capacity contracts for Delta with a fleet of 124 50-seat CRJ-200 jets and 16 76-seat CRJ-900s. Colgan operates a turboprop fleet, consisting of 14 74-seat Bombardier Q400s in a capacity purchase agreement with Continental, and 34 34-seat Saab 340s which operate under pro-rate agreements with United, US Airways, and Continental as well as EAS.

THE BIG PICTURE (important to consider before wading through the complex and misleading GAAP financials)

1) PNCL provides a cost plus (or cost indexed; including the cost of ownership) service to Delta and Continental for $650 million in annual revenue (excluding $24 million in deferred revenue) under ten year Capacity Purchase Agreements (CPAs) designed to yield target pretax margins of 7%-9%. Thus, under normal circumstances PNCL ought to earn $45-$59 million in annual pretax profit from these three CPA’s. Since PNCL pays no taxes for several years (due to MACRS accelerated tax depreciation on new planes as pointed out in timothy756’s analysis), this pretax profit is an approximation of after-tax free cash flow potential of $2.50 to $3.25 per share from this CPA business.

2) PNCL was earning an average of $65 million a year in pretax profit between 2002 and 2006 with only one of its three current CPA’s (NWA CRJ-200s). The economics of this CPA were lowered (target margins cut by 20%, planes cut by 10%, no more margin on fuel) during NWA’s bankruptcy in 2006. In return, PNCL received unsecured claims of ~$375 million from NWA for lowered economics (this is where noncash intangible deferred revenue comes from on the balance sheet and income statement – more below). The company then sold those claims in the secondary market for about 85% of face value, and note it has NO liability regarding those claims. If we conservatively assume the CRJ-200 CPA’s economics were cut in half after the NWA bankruptcy, it alone should generate over $30 million in (economic) pretax profit for PNCL. Keep in mind, this would equate to $54 million in GAAP pretax profit from this CPA alone because of $24 million in recognized deferred revenue which flows down to GAAP pretax profit - thus an 8% economic pretax profit margin at PNCL would actually be 11% on the GAAP income statement. The two additional CPAs (CRJ-900 and Q400) should add incrementally to pretax profit and free cash flow.

3) PNCL does not own its 124 legacy CRJ-200 aircraft. In fact, Delta is dependent on PNCL to operate these legacy CRJ-200 aircraft at the lowest cost possible since Delta has ultimate responsibility for these planes (it leases them from a third party and subleases them to PNCL), and 50% of PNCL’s revenue is fixed (i.e. not dependent on flying the aircraft). PNCL recently purchased 16 CRJ-900 and 14 Q400 aircraft at interest rates below 7% (15% down) with cash received from NWA’s bankruptcy claim. As a result of these purchases, PNCL will have recouped over half of its $120 million plane downpayment in the form of a tax refunds by April 2010 as well as shielded itself from income taxes until 2011+. PCNL’s tax shield should last beyond 2013 once it purchases an additional 15 Q400s for Continental beginning in 2010.

4) PNCL’s net tangible book value is approximately $14 per share: $88 million in GAAP book value - $47 million in intangible assets + $210 million in intangible liabilities (deferred revenues). These deferred revenues are NOT real liabilities because they have no future cash cost and were simply booked to be amortized into revenue over 10 years as a result of selling the $300 million claim from NWA. Thus, PNCL’s stock trades at less than 1/2 of tangible book value even though the company is quite profitable!

5) The CPA regional industry has a long history of profitability through recessions and client bankruptcies. This is due to the fact that these CPAs cannot be cancelled without cause or client bankruptcy (in the latter case, a large unsecured claim is due). In addition, there are high switching costs for large contracts (such as PNCL’s 124 CRJ-200 contract with DAL) that give the incumbent provider a huge advantage in the event of a client bankruptcy. It is unlikely PNCL’s two major clients will face bankruptcy in the next year or two given that both Delta and Continental are currently FCF positive with huge cash balances.

6) The remaining $160 million in annual revenue comes from at risk prorate and subsidized EAS flying at Colgan. Management has guided that this business should generate 3%-5% pretax margins over the long-term although it is likely to be breakeven in 2009. Keep in mind that this Colgan business was restructured to be profitable at $150 oil.

RECENT HISTORY

What has happened since timothy756’s writeup (12/3/2007)? We posted on all of the following at length in that Q&A thread, if you wish to read it in detail, but will sum up those events below:

1) Pinnacle made the unfortunate mistake a few years ago of plowing a significant amount of its cash into the Auction Rate Securities market that completely froze in early 2008. As that market froze, PNCL had to reclassify about $135 million of cash as a long-term investment and take an impairment on it. The company was able to get an $80 million margin loan from the dealer against those securities, but at that point $50 million of cash essentially became unusable.

2) The company faced horrible winter weather in ’07-08 and performance slipped noticeably. Monthly on-time performance for all the airlines which report can be tracked here: http://airconsumer.ost.dot.gov/reports/atcr09.htm Just change the ‘09’ at the end of the link to ‘08’ or ‘07’ to see prior years. Note that after the first few months of 2008, PNCL returned to performing consistently at the top of all mainland carriers. As oil was reaching its heights in mid-2008, Delta was scrambling to save money anywhere it could and attempted to cancel its CRJ-900 contract with Pinnacle based partially on the aforementioned performance issues. (Note that the CRJ-200 contract was with Northwest, which only later merged with Delta, and that was not at risk here.) Pinnacle claimed Delta had set schedules which were impossible for Pinnacle to meet. In fact, Delta had tried the same tactics with MESA, who obtained an injunction preventing cancellation as the judge noted Delta had acted in bad faith. Pinnacle’s stock hit a free fall.

3) Pinnacle has a $121 million convertible note maturing in 2025 outstanding, but holders were entitled to put the notes back to the company at par on February 15, 2010. The conversion price was a little over $13 so as the stock drifted well below said price, the odds grew higher and higher that the company would face a liquidity event in early 2010, sending the stock further downward.

4) About a month after Delta signaled its intentions to cancel PNCL’s CRJ-900 contract, Pinnacle reached a resolution in which it merely delayed the implementation of those aircraft. Over and above that, Pinnacle was also later awarded temporary flying of 7 additional CRJ-900 jets that it was transitioning from another carrier. (The additional flying was phased out this past spring.)

5) The sharp rise in oil prices early in 2008 - after Pinnacle had absorbed Colgan - substantially affected the cash flows of the pro-rate business. As the Q400s were only just being phased in, the cash flow woes of the pro-rate business had an outsized effect on operations, leading to poor financial results for a stretch. So despite the resolution with Delta, these issues also weighed on shares.

6) As major airlines implemented capacity reductions across the board last year, they specifically targeted 50-seat flying in a big way. These worries added yet another burden to the share price: while Pinnacle’s exposure to 50-seat flying is declining as it ramps up the new business, it is still the biggest cash contributor for them. The one cushion Pinnacle has, though, is that its CRJ-200 jets are actually subleased from Delta (originally through Northwest), and those jets are in turn leased from another party. As such, Delta has to make the payments on those leases, regardless of use (and they can’t be operated by anyone else under the CPA). This lowers the chance that those Pinnacle-operated jets will be targeted for early capacity cuts, and that has borne out over the past year as we have only recently begun to see some small utilization declines in that portion of the business. In fact, many formerly mainline routes have been converted to regional ones due to lowered passenger demand. If concerned about utilization levels, however, you can track both of PNCL subsidiaries’ daily flights on www.flightstats.com, as well as monthly performance releases from the company and DOT.

7) Back to the Colgan situation: over the fall and spring, the company cut significant costs out of that business, re-bid certain rural markets it served under the DOT’s “Essential Air Service” (EAS) subsidies, and dropped other EAS markets altogether. Combined with oil coming back down to earth from $150, within a few quarters Colgan was back to generating positive EBIT once again.

8) Colgan increased its business in an environment in which no one expected regionals to find any growth, as in January it obtained a contract with Continental to operate 15 additional Q400 aircraft beginning in late summer 2010. Meanwhile, its capacity contract with Continental was extended 3 years out to 2020.

9) In late February, just as things were starting to look up for the company, Colgan flight 3407 crashed in Buffalo, killing all 49 aboard and one on the ground. This event, while tragic, should not have a significant financial impact on the company as insurance covered the aircraft hull and liability. We will discuss this in further detail below, but as one would expect the incident led to the shares drifting to an ultimate low of under $1. PNCL has booked a liability of $300 million in “other liabilities” and an offsetting insurance receivable of $300 million in “other assets.”

10) The company was in a dispute with the IRS over certain tax issues that could have resulted in a penalty of up to $35 million. The company had reserved $16 million for this contingency, but in April of this year, managed to settle that dispute for a mere $3 million.

11) As expected, the company received a $33 million tax refund from the IRS on April 1 of this year, substantially strengthening its balance sheet.

12) In August, PNCL obtained a $25 million term loan collateralized by its spare parts, effectively guaranteeing that it would be able to meet the convertible put in February. The same day, the company announced its having reached an agreement with its pilots union on a contract that had been in negotiation since early 2005.

13) Also in August, the company reached an agreement with its ARS dealer to get out of the securities at a slight discount, all while retaining a three-year option to buy them back at the same discount should the market ever recover. Thus the margin loan of $84mm was wiped off the balance sheet, netting $27mm of additional cash. The company simultaneously turned around and bought back $78mm face of the $109mm remaining outstanding on the convert (the company had already bought back $12mm face in January). In other words, $162 million of debt was wiped off the balance sheet that day, yet the stock was flat. The $6.85 close that day was almost 20% higher than where you can buy it today, at $5.75. 

14) The only notable development since then came a few weeks ago, when 58% of Pinnacle’s pilots voted not to ratify the contract their union leaders agreed to for them, so it’s back to the drawing board there. We do not believe the company is at risk of a strike, as it operated from April, 2005, when the contract became amenable, to the present without interruption. Further, the company signed its CRJ-900 contract with Delta while in the midst of said negotiations, so while not having an amended pilots contract may be a slight hindrance on growth, it clearly does not preclude growth altogether. The negotiations are currently being mediated by the NMB, and given that management held up its end of the bargain in reaching an agreement, we think it is highly unlikely the NMB will release the pilots for a strike (which would be highly detrimental for the pilots given the dearth of jobs). At this stage the union itself has to sort out why its leadership is evidently not properly representing its constituents.

VALUATION

PNCL has 18 million shares outstanding, thus its market cap is $104 million as of today’s close. As we described above, PNCL has a tangible book value of approximately $250 million. We estimate the current enterprise value as approximately $650 million (as of an estimated 3Q09 balance sheet) = market cap ($104) + long-term plane debt ($506) + pre-delivery payment facility ($5) + senior convertible notes ($31) + current maturities of long-term debt ($34) + spare parts facility ($25) + PV of capitalized operating leases ($58 at 10% discount rate; excluding DAL’s CRJ-200s) – cash ($80) – 2010 tax refund receivable ($33). Since nearly all of PNCL’s debt is asset backed and its profitability is buffered by long term cost indexed contracts, we believe free cash flow is a better valuation measure than EV/EBITDA.

The following are current annualized earnings and cash flow based upon the first half of 2009 excluding $24 million in deferred revenue recognition, $10 million in noncash convertible note interest, and one time items:

EBITDA of $93 million (7x EV/EBITDA)

- D&A of $35 million

= EBIT of $58 million (11x EV/EBIT)

- net cash interest of $32 million

= Pre-tax (and after-tax) profit of $26 million (P/E of 4x economic profit)

CFO of $60 million (excluding $33 million tax refund)

- maintenance capital expenditures of $6 million

= FCF of $54 million (52% FCF yield)

Now, why is this trailing pre-tax profit only half of the potential $45 to $60 million described earlier? PNCL can improve its pre-tax profit margin (and FCF) dramatically over the next year or two as the following issues subside:

1) We estimate that unreimbursed onetime maintenance expenses have been a drag of potentially more than $10 million – “it is expensive but necessary” according to management. Replacement of engine blades and upgrades to flap actuators to improve reliability on the 124 CRJ-200s will be “done by November” 2009.

2) PNCL received no cost inflation adjustment in 2009 because the PPI index was down yoy in Dec 2008 (they can get as much as a 5% annual increase but reimbursement will never decrease). This impacts 3/4 of their expense reimbursements. We are skeptical that the PPI index is going to be positive yoy in Dec 2009 but management has said “we want a rate adjustment in 2010” which may signal negotiations on the matter. Every 1% reimbursement increase over their associated actual cost increases could equal approximately $5 million in additional pretax profit and FCF.

3) The new CPAs with DAL and CAL for the CRJ-900s and Q400s, respectively, will take time to achieve their 7%-9% pretax target margins because “the revenue associated with aircraft ownership costs will not vary from period to period, yet [PNCL] will recognize significantly higher interest expense associated with the financing of these aircraft in the early periods of the CPA as compared to later periods.” In addition, there appears to be lower utilization than estimated on the CRJ-900 aircraft. Management originally guided to annual revenue per CRJ-900 of $6.1 million while it appears they only achieved $4.2 million annualized in 2Q09. Here is the 8-K in which management gives EBITDA and revenue per plane guidance: http://www.sec.gov/Archives/edgar/data/1166291/000095014407004066/g07014be8vk.htm

4) Overstaffing of pilots has been a $5 million drag according to management. This should be moderating by the end of 2009.

5) $3.5 million in convertible cash interest (and $10 million in noncash GAAP interest) is gone completely after Feb 15, 2010, although $2.2 million in new interest expense from the spare parts facility will remain unless paid off early.

6) The company has indicated that it is pursuing further cost cutting measures.

When looking at PNCL's subsidiary results, we caution you to remember that the EBIT margin on the CRJ-200 CPA is equal to the pre-tax margin (since there is no interest payment for leased planes) whereas the EBIT margin on the CRJ-900 and Q400 contracts will be much higher than the pre-tax margins because the plane ownership costs are accounted for through interest. This dynamic between owned versus leased planes and CPAs can be seen in differing EBIT margins for RJET and SKYW but similar pretax margins. Combined with the $24 million in deferred revenue recognized each year, we would expect PNCL's GAAP EBIT margin to approach the low teens once it is earning close to its 7% pre-tax margins.

LIQUIDITY AND STOCK BUYBACK

When PNCL’s stock plunged to $1, it was clear there were concerns of impending bankruptcy due to the convertible note put and illiquid ARS portfolio. These issues have been resolved and it is clear that PNCL has plenty of liquidity: the company should have roughly $80 million in cash as of the end of 3Q09 plus a tax refund of over $33 million to be received before the end of April 2010. In addition, PNCL has over $30 million in unencumbered accounts receivable that it could potentially borrow against (it recently paid off a $9 million facility that expired). PNCL will need $31 million to satisfy its remaining convertible note obligation on February 15, 2010. In addition, it may need up to $45 million to buy 15 additional Q400’s for Continental CPA in second half 2010 (although management may decide to lease some to lower this). Management has guided that PNCL needs approximately $20 million in cash to deal with intra-month draw downs. We have suggested that management begin a stock buyback with its excess cash, but their conservatism may preclude this in the near term. That said, management appreciates that if the stock remains low, they have the option to buy back stock and lease planes as opposed to owning the planes outright (with a 15% equity down payment).

CRASH LITIGATION, INSURANCE, AND LEGISLATION

Although PNCL’s operations remain unaffected (except for one less plane), the unfortunate crash of a Colgan Q400 in Buffalo has lead to inevitable litigation and Congressional legislation. PNCL has substantial liability insurance covering this litigation. In fact, PNCL shares the same insurance policy as Delta with a $1.75 billion per occurrence limit. You can read about it here: http://www.businessinsurance.com/article/20090213/NEWS/200015410

PNCL has recorded a $300 million “other liability” as well as an offsetting $300 million “other asset” insurance receivable. The only scenario in which this insurance policy won’t cover all the liability is one in which sizeable punitive damages are awarded by a jury and upheld on appeal. To our knowledge, there has never been a punitive damage paid out in the airline industry due to a crash. In addition, the parent company may be shielded from such awards (i.e. get dismissed from litigation, leaving only the Colgan subsidiary liable) if this indeed were the first time they were awarded in history. Most if not all of this litigation will likely be settled with insurance in the next two years as has typically been the case with airline incidents in recent years.

For example, Comair (Delta sub) flight 5191 crashed on August 27, 2006, killing all 47 passengers. As a result, Delta recorded a liability and offsetting insurance receivable, saying they believed insurance would cover it all. As of September 30, 2008, Delta (the parent co) had been released by a judge from all litigation (corporate shield) while Comair had settled with families of 46 of the 47 passengers (none of which included punitive damages). Another example is the November 12, 2001, American Airlines Flight 587 crash killing 265 people. American Airlines stated that they believed insurance would cover all liability and took a $637 million liability and offsetting insurance receivable. American finalized these settlements in 2008 for $381 million.

Lastly, we don’t believe that the pending Congressional legislation will materially impact PNCL’s business and profitability since most of its changes have already been implemented by PNCL and it will affect all regionals equally.

RISKS

1) Another crash could raise systematic safety concerns at PNCL and give PNCL's partners a chance to potentially terminate its CPAs for cause.

2) Utilization declines get substantially more aggressive (though we believe investors are being compensated for that by the massive free cash flow yield and safety in tangible book value). Even if the planes are grounded, most fixed costs continue to get reimbursed under the CPAs, including interest and principal on plane debt.

3) Settlements for the crash go substantially outside the bounds of insurance, which seems tremendously unlikely.

4) Weather-related performance issues like the winter of 2007-2008 could recur. PNCL seems to have righted the ship, however, having made it through the past year and a half without many missteps. In addition, PNCL has spent considerable amounts of money on unreimbursed maintenance over the past 9 months to improve the winter performance of its CRJ-200 fleet.

5) The largest shareholder, Mohnish Pabrai, has been selling down his position of nearly 2mm shares (a bit over 10% of the float). We have not spoken with him, but from comments we have heard, he appears to be uncomfortable with the fact that PNCL is able to make money off its customers while those very customers are losing money. It’s an understandable concern to us, but one with which we are willing to live. 

Catalyst

• Third quarter financials
• $33+ million IRS tax refund received by April 2010
• Potential stock buyback authorization
• New pilots contract ratified in 2010
• CHEAPNESS