…And the vultures arrive… Pinnacle has been written up before but I believe the specific dynamic situation now has created by far the most compelling risk/reward that this stock has ever seen.  It is cheaper and more valuable now than even in early 2009 when a very real liquidity crisis almost forced it into bankruptcy, it increased by a factor of 5 in roughly 6 months then.  Due to a scheduled lump sum payment from Delta by the end of February, I think that we will know within 6 weeks or less if this is going to be a 10X+ return over the next year.  If not, then we’re headed to the courts like with HearUSA for a messier process that still may end up in a significant return to equity.

I look for investments where the perception is very bad but upon deeper inspection the reality is much better.  This is because the perceived risk is because of some non-economic or irrational reason.  There are several huge misunderstandings with Pinnacle in addition to the current dynamic with labor negotiations that are causing this stock price to be absurdly cheap.  There are potentially ways this can fail which I will illustrate and the main purpose for sharing this post is for anyone else who wants to participate in the scavenger hunt in finding ways that we can get screwed (and try to avoid it).

Current ugly looking situation: The stock plummeted in December when the CEO said that they need to restructure their costs or it will be a very difficult time over the next year.  Sell side analysts said that “it is very difficult to restructure without bankruptcy and in bankruptcy, equity usually goes to zero” – with this sage assessment, SELL.  In December, management asked unions for a 5% pay cut with no promise of increase later and if the unions ratified it by early January, they would take a 5% cut also.  The deadline passed, nothing happened.  Just a few days ago, management said that things are very dire and they may be required to file bankruptcy if they do not get concessions then asked for a 7% pay-cut that would snap back in one year.

Misconception 1: The deferred revenue liability of roughly $150M is actually NOT real – it is a complete accounting fiction, it is just GAAP rules from the effective gain-on-sale of the Northwest bankruptcy claim in 2005 and there is nothing owed.  This means that the tangible book equity is approximately $210M vs. a current $15M market cap.

Misconception 2: The 50-seat CRJ-200’s are NOT recourse to Pinnacle.  They are included and passed through the operating contract with Delta.  Comparisons to Mesa’s bankruptcy are wrong because they had the planes stuck to them.  All of PNCL’s aircraft that are recourse to it are 70 seaters – I have heard so far that there are basically zero grounded 70 seat regional jets (compared to many worthless CRJ-200’s).  This point is huge because if the 50’s were recourse to PNCL then in a chapter 11 filing the equity is 100% wiped out – I do not believe this is true for the 70-seaters.

Misconception 3: The business is NOT cost-minus (at least for the main Delta contract) – costs have risen faster than the PPI contractual inflator over the last 9 years but the rate reset Jan 1, 2013 will improve this.

(Potential) Misconception 4: They are currently in labor negotiations.  Opposite to a run on the bank, it is possible the direr the management make the situation appear, the more likely they are to get labor concessions and stay solvent.  Recent public statements by management have been very negative.

Value after the Jan 1, 2013 rate resets: Really rough conservative numbers (since at this price, all the focus is just on figuring out the downside):

-High case: $1B revenue, 8% EBIT margins = $80M EBIT * 5X = $400M EV - $50M unsecured debt / 20M shares = $17.50/share

-Medium case: $650M revs @ 6% EBIT margins + 350M revs at 0% margins = $39M EBIT * 5X - $50M debt / 20M shares = $7.25/share

-Low ball case: $650M revs @ 6% EBIT + 350M revs at -4% margins = $25M EBIT * 5 - $50M /20M =$3.75/share.

*The 650/350 split is for the Delta contracts that are contractually obligated to reset to 8% EBIT margins Jan 1, 2013, the $350 covers the 70-seat planes that are potentially going to operate at a loss.

The outcome over the next year of between 5X and 20X return means the upside is obvious.  Let’s get to the important part and figuring out the failure modes!

Potential Scenarios with key failure modes highlighted:

• Best Case: They don’t file bankruptcy and make it to the “light at the end of the tunnel” Jan 1, 2013 for the contractual rate reset and the stock goes up 5X to 20X.  Great!
• They receive their $20M catch up payment March 1 from Delta.  Also over 2012 get rate increases of $20M in PPI adjustments and $15M in pilot wage increases from agreement with Delta.  (pilot union agreement was ratified 11 months ago and they agreed that they would catch them up and increase their reimbursement rate in a year).
• Bad Case: They file chapter 11
• They file because of a liquidity issue breaches a covenant:
• The ONLY 2 credit agreements that could force this I am aware of are the ~$45M Mesaba note from Delta and the $37M CIT spare parts credit line.  I do not believe there is any other mechanism such as Frontier’s credit card processors pulling liquidity away from them.  It is undisclosed but rumor is that they need $40M cash on hand vs. $80M current.
• So either CIT needs to force the company into bankruptcy and collect spare parts or Delta needs to use the vendor financing it just gave to PNCL to force it into CH11.  CIT seems highly likely to not want to deal with this so let’s say that 1) Delta could claim a breached covenant and cause CH11. (to examine later)
• The 2 lenders waive minimum liquidity balances but they actually run out of cash.   This seems highly unlikely:
• In the last 9 months they had FCF of about $30M vs $43M of normal debt payments, say $20M annualized cash burn ignoring aircraft purchases (which they have none currently scheduled).
• Even if they did not get the $20M lump sum payment, the $15M pilot rate increase, or $20M PPI increase, it seems hard to imagine how they could burn through $80M in cash in 5 quarters before the rate reset.
• They should have liquidity sources with the owned aircraft: ex. They did 2 sale-leasebacks of Q400’s (they have 29 more) for $6M last summer.
• 2) Alternatively, the directors could strategically decide to file chapter 11.
• I think this is a real risk.  I have seen a number of bankruptcies – including Mesa Air – which had massive real value destruction, where the insiders were able to significantly increase their own personal stake through bankruptcy.
• They file bankruptcy because Delta renegs on their obligations
• This would normally be a risk to delve into and was key with NWA.  However, Delta is in excellent financial shape at the moment and it seems highly unlikely that will change in the next 12 months.  There does not seem to be an oversupply issue in the US airline industry currently.  EVEN in the NWA bankruptcy case, the legal ruling was highly in PNCL’s favor and they got a $300M unsecured claim for the lost profits which were sold for $250M cash.

So with step one of this analysis is that I think it is fairly clear that if they do not file chapter 11 in the next 11 months – and more likely if it happens it will be in the next 6 weeks revolving around this ~$20M catch up payment from Delta.

Let’s examine the two potential failure modes in depth:

1)      Delta could claim a breached covenant and cause CH11

• Delta clearly has huge negotiating leverage with PNCL under any circumstance but this seems to potentially give them the power to force it into bankruptcy.  The question is – does it make sense for Delta to do this?
• What is the cost/benefit for Delta to push PNCL into CH11? (*call for comments*)
• PNCL in BK means that Delta can walk from their contractual rate reset in a year that will start costing Delta more money.
• This would leave Delta with 3 options:

1)      Ground the currently worthless 50-seat planes (how much longer is the lease for GECAS, 5 more years?) and replace regional flying with 70-seaters.  Est cost: $1B+, huge service disruptions?

2)      Find another operator for the 50-seat planes that’s better than PNCL. Est: impossible?

3)      Restructure things with PNCL so they lower their costs more (ex. lower labor costs by $20M/yr) and renegotiate their contract to a lower margin.  Seems like they could just do this w/o ch11 which I think is consistent with the labor negotiations from mgmt now, I suspect the pressure is from Delta who will ultimately bear the cost.

4)      Steal the company, take some equity.  *I don’t think it is possible for Delta to own Pinnacle because that defeats the whole savings of having a separate cheaper labor pool.  They may want 10% of the equity or something but this doesn’t need CH11.

• *Of these 3 options, grounding the 50-seaters seems most interesting but is hugely costly, I can’t imagine the much cheaper decision isn’t to wait until they can put them back to GECAS in 2017 (I think, not sure if disclosed) and change then.

2)      Alternatively, the directors could strategically decide to file chapter 11.

• If the cost/benefit is best to the management personally is to file chapter 11, it’s a very high probability. 
• Personal benefits to filing BK:

1.                                                                i.      My general thought is that life sucks as a CEO with creditors breathing down your neck and life becomes a lot more comfortable if you just file.  That’s the benefit side.
2.                                                              ii.      Increase equity ownership by filing to get more economic upside – this has happened in Mesa, Tronox, Chemtura, and GSI Group.  *This potential upside can be significantly reduced by an activist equity committee should they file (and hopefully made clear to mgmt to consider before they file).

• For the downside cost of filing side

1.                                                                i.      Usually look at stock ownership, which here is not promising because insider ownership is quite low.  The one positive offset is that the CEO comp was set up as $ of shares instead of # of shares, so he had an incentive to make the stock as low as possible for Jan 1 to get the maximum number of shares.
2.                                                              ii.      Reputation/ego: After the unfortunate Frontier experience does Sean really want to go into bankruptcy again if he isn’t forced to and risk being typecast?
3.                                                             iii.      Legal liability: Though the shareholder base seems very passive, perhaps some enterprising shareholder will illuminate the fact that shareholders may personally sue the directors for breaching their fiduciary duty should they ‘strategically’ file for bankruptcy.  It seems like there would be a strong case given the imminent rate reset.

• Overall I think the balance is that they would not want to strategically file. This balance could be made stronger and the risk reduced with shareholders informing the board that an equity committee would be created to ensure a re-org plan with no special comp for directors and that they will be potentially sued for breach of fiduciary duty.

OK so that’s the analysis about whether they file for bankruptcy – Let’s say these don’t pan out the way we hope and they DO file for chapter 11: what does that look like?

PNCL in Chapter 11:

This is just the balance sheet from the sept 30, 2012 10Q, I removed deferred revenue and deferred taxes (13M asset, 24M liability side) which I believe go away though I could be mistaken.

So in a CH11 we have over $200M of tangible equity to work with for equity.  There will clearly be justification for an equity committee which worse case should get a nuisance value claim.

The key is the other potential claims that arise that chip into this equity:

• Advisor fees: $50M?
• Labor claims: $0??  Mesa actually had zero claims filed as they just used attrition rather than firing and it is my understanding that unlike a factory with career workers, flight crew rarely get a large claim.  *Any estimates on what the labor claim would be to lay off 100% of the work force?
• Pension: $0?

The 3 big factors are:

                1) Aircraft claims.  This are usually the largest in any airline bankruptcy but due to misconception #2, PNCL actually has an unusually favorable situation here.  They only actually lease 2 aircraft on their own: the 2 Q400’s they did a sale-leaseback last year.  Since these are brand new, there should be a minimal claim for rejection.  All of the 50-seat planes and the CRJ-900’s are subleased through Delta as part of the contract.  The owned aircraft are 29 Q400’s and the owned CRJ-900’s and the majority of this tangible equity is indeed the equity in these aircraft.  Considering that these are highly fuel efficient and in demand, it seems likely that these aircraft can be put to profitable use or sold with a minimal haircut.  There is only 15% equity in the aircraft, so a 15% haircut does wipe out the equity but this seems extreme for an in-demand aircraft.  I think I am comfortable the problem does NOT come from this factor.

                2) Potential “reverse-rejection” claim on the unprofitable Q400 contracts (*request for comment*).  This part I am the least certain on and is unusual.  Normally the claim would come like with NWA and PNCL where NWA is paying PNCL cash and PNCL provides a service.  NWA cancels or amends, saying they will pay less, PNCL makes a claim to NWA for the cash that it was promised.  This case is reverse and I have not seen examples of it before.  PNCL has effectively signed 10-year cost-minus contracts to operate planes for United Air.  If PNCL tears up this contract because they realized they were dumb, what claim does United have against PNCL?  In theory it should be for the specific performance, but how do you put a $ number on this in chapter 11?  Does United get to bid it out to the market, pay that, and PNCL owes them the difference?  I haven’t seen examples of this – please comment if you have!  Delta had a $67M claim against Mesa’s Freedom Air unit that may be similar but I don’t have many details on that yet.

                If it were possible for this to be a significant liability it would seem akin to the management signing away the value of the company in one contract like selling a $500 strike call option on gold for $0.  This just doesn’t seem possible but I want to look deeper.

Questions I do not have great answers to (a call for comments):

     1)  Why are they even pushing hard for a 5% or 7% (recently) labor reduction?  This only adds up to roughly $20M over the whole year which seems fairly immaterial compared to $80M in cash and the $55M in rate increases already contractually scheduled between the pilot wage and training increase and PPI.  After one year, it should be irrelevant because the reimbursement rate resets to the cost and is passed on to Delta.  - The only explanation I can think of here is that Delta is pressuring them to do this.

     2)  What is going on in CEO, Sean Menke’s head?  He is young and energetic and I think he feels burned by what happened with Frontier and wouldn’t want to go through it again, though this is largely speculation on my part - I haven't had a beer with the guy or his close friends.

     3)  What other claims could come up in a chapter 11?  The way I am looking at this it looks like even a chapter 7 liquidation could be good for equity at this price if the new 70-seat aircraft are money good.

     4)  How is it possible that the 50-seat terribly inefficient planes are so much more profitable for them to operate for their partners than the 70-seat fuel efficient planes that in total should be so much more cost-effective for their partners?  Seems like it should be the reverse...