Description

Pinnacle Airlines (PNCL) is an event-driven, value investment that has been marred by the bankruptcy of its only customer, Northwest Airlines (NWAC). PNCL is currently trading at less than 3x free cash flow and EPS; under a worst case scenario, PNCL is trading at 5x free cash flow and earnings.

Northwest’s bankruptcy filing last week has highlighted the uncertainty surrounding the ultimate margin on a revised airline service agreement between PNCL and NWAC (“ASA”) and has thus pressured PNCL shares. Based on PNCL’s current stock price, the market is expecting a new ASA with an operating margin target of 5% (assuming a discount rate of 10%); is assuming PNCL will not fly any additional jets for NWAC or any other airline; and is assuming that PNCL will have no terminal value post 2017. I believe these assumptions are incorrect.

Business Description

PNCL is a low-cost regional jet carrier that provides service to Northwest under the Northwest Airlink name. PNCL has an airline service agreement (ASA) with NWAC which provides for operating margins of approximately 10% (with an average margin adjustment in 2008 based on the then market margin of a basket of regional carriers). The company takes no fuel risk.

Industry Margin Profile

The regional jet industry is currently generating operating margins in the 9-12% range. The most recent deal, finalized less than a month ago between NWAC and Mesaba (MAIR) for 15 RJs had undisclosed margins in 2006 but had margins resetting to the average operating margin of certain regional airlines in 2007. Only one regional airline, Mesa Air, has bid a new contract below 9% and Mesa is considered by most industry observers to be the poorest of the regional operators.

Pinnacle Cost Profile

PNCL primary foci are performance and cost. A visit to PNCL headquarters best exemplifies their cost focus. The offices are located in a strip mall near the Memphis airport and would be kindly described as drab. Based on Morgan Stanley research, PNCL’s labor cost structure is among the best in the regional industry with average first officer and captain pay 6-12% below the average for its regional peers. In fact, Morgan Stanley ranks them 2nd in costs behind Chautauqua (US Air).

Northwest bankruptcy – The Positives

Although NWAC’s bankruptcy filing was not positive for PNCL, it will probably yield three significant benefits to PNCL -

a) a revised contract with a much healthier entity (NWAC is probably an investment grade credit post bankruptcy filing) which significantly reduces any risk of default

b) the elimination of the “scope” clause which will allow PNCL to fly additional types of planes (ie. 70 seaters) for Northwest or other airlines and

c) NWAC may rely more heavily on regional carriers and PNCL is one of two currently operating for NWAC.

Discount Rate

The discount rate an investor will apply on a new PNCL contract with NWAC will be significantly lower than the previous contract as any new contract entered into post-bankruptcy is senior to all pre-petition debt. In the past, if a 10-15% discount rate was appropriate, today a 6-10% discount rate may be more reasonable as a new contract can be viewed as senior debt on a relatively unlevered asset heavy company.


Why NWAC will continue to use PNCL as a Regional Partner:


Switching Cost for NWAC

Based on discussions with PNCL management, the barriers to switching are high for NWAC. It would cost NWAC or a new regional partner $100mm in capital to recreate PNCL and would take over two years to get to a point where another regional carrier would be able to fly the full 139 jets currently flown by PNCL. NWAC has publicly disclosed that they earn money on the flights flown by PNCL under the current margin structure, so NWAC would lose the current income and would create a significant (2 year) disruption in service should they move to another carrier. The financial impact to NWAC of this service vacuum would be significant as it would materially reduce load factors on long-haul NWAC flights (hub and spoke model). In addition, NWAC still owns 11% of PNCL.


Renegotiate current contract vs. New Regional Flier

New Flier Economics

A new Regional Airline competing for PNCL’s contract would most probably have a cost disadvantage relative to PNCL and would require a return on investment above its cost of capital. Assuming a 5% operating margin, the investment for a new flier would be barely NPV positive assuming discount rates ranging from 5-11%. As a result, I believe it very unlikely that a third-party would be willing to bid on PNCL’s business at a margin below 7%-8%.



NWAC’s Economic Incentive to Switch Regional Carriers

NWAC’s benefit from a new regional partner at 5% operating margins would be fairly minimal as it will cause significant disruptions to service and nominal positive NPV’s at 5-11% discount rates. However, if NWAC were to renegotiate its contract with PNCL, the results would be significantly positive for NWAC. With a margin of 7% - 9% on a reduced revenue base (to exclude above market lease payments), NWAC would generate NPV’s of 240-480mm without any service disruptions. The result of the my analysis is that NWAC would be better off taking a 9% (or even 10%) margin from PNCL than taking a 5% margin from another regional jet carrier. As a result, I would expect that PNCL should ultimately secure a new deal at a price level higher than the market currently expects. Based on a range of 7-10% operating margins, PNCL should generate earnings (and free cash) of $1.55 – $2.26 per share vs. the current contract of 2.62 and is trading between 3 – 4.5x eps and free cash flow.


Current
Worst Case - No Growth
Revenues 900 900 900 900 900
Revenue Reduction 81.6 81.6 81.6 81.6
PF - Revenues 818.4 818.4 818.4 818.4 900

Margin 7% 8% 9% 10% 10.50%
Operating Income 57.29 65.47 73.66 81.84 94.50
Interest Expense (3.30) (3.30) (3.30) (3.30) (3.30)
Tax Rate (19.98) (23.01) (26.03) (29.06) (33.75)
Net Income 34.01559 39.17151 44.32743 49.48335 57.45915



EPS $ 1.55 $ 1.79 $ 2.02 $ 2.26 $ 2.62

Scope Relief and New flying

PNCL is subject to the “scope clause” in NWAC’s contract with its pilots that prohibits NWAC from contracting with its regional partners to fly planes with more than 50 seats. To appease its Pilot’s Union, NWAC has contractually limited PNCL’s ability to fly aircraft larger than 50 seats for any prospective customer. This has been problematic for PNCL as the growth in the regional jet market is expected to come from 70-90 seaters which are economical alternatives to the 90-110 seaters that are currently unprofitably operated by the legacy carriers. I expect that through bankruptcy, NWAC will gain relief from this “scope clause” and even if they do not gain scope relief, I expect NWAC to provide scope relief to PNCL which will allow PNCL to diversify away from NWAC. If NWAC receives scope relief, I would expect PNCL to garner a piece of the new NWAC 70/90-seater fleet. In their first day motions, NWAC rejected the contracts on most of its 110 seat DC planes. This is probably the first step in outsourcing these medium sized planes to regional carriers. Based on 8% margins, I think NWAC scope relief, coupled with a contract for 50 planes for PNCL could add 80 cents of eps per year.

Margin 7% 8% 9% 10% 10.50%
EPS $ 1.55 $ 1.79 $ 2.02 $ 2.26 $ 2.62
Additional Flying EPS - 2008 $ 0.83 $ 0.83 $ 0.83 $ 0.83
Total 2008 EPS $ 2.38 $ 2.62 $ 2.86 $ 3.09



Liquidity and Cash Balances

As part of the bankruptcy filing, NWAC did not make a 40mm payment to PNCL on September 15th. As PNCL has the right of set-off against money due to NWAC as part of its ASA, the net missed payment was 22mm. The Company has told us that NWAC may also try to characterize 13mm of payments due in the second half of the month as pre-petition amounts. Of the 35mm in total expected missed payments, some may be stayed as part of the bankruptcy (will receive a recovery similar to other unsecured claims) and some may be repaid. Assuming all 35mm is lost, PNCL’s trough cash balance will be 24mm on October 2nd but should end the year with 64mm in cash (until a new contract is negotiated and executed, PNCL will continue to operate under the current contract). The significant variability in liquidity is due to the timing of payments. PNCL receives payments on the 15th and 30th of every month and makes a lease payment to NWAC on the 2nd of every month. To the extent the right of set-off is not enforced (which I believe is unlikely), trough liquidity could decline by an additional 18mm.








July August September October November December
Cash Balance 66.5 71.5 76.4 49.3 54.2 59.2
Payment - Leases (25.0) (25.0) (25.0) (25.0) (25.0) (25.0)
Liquidity 2nd Day of Month 51.4 24.3 29.2 34.2
Payment - NWAC 40.0 40.0 18.0 40.0 40.0 40.0
Cash Costs - First Half (21.1) (21.1) (21.1) (21.1) (21.1) (21.1)
Taxes - First Half (2.4) (2.4) - (2.4) (2.4) (2.4)
Cash Balance - 15th 58.0 63.0 48.4 40.8 45.8 50.8
Payment NWAC 35.0 35.0 22.0 35.0 35.0 35.0
Cash Costs - Second Half (21.1) (21.1) (21.1) (21.1) (21.1) (21.1)
Taxes - First Half (0.5) (0.5) - (0.5) (0.5) (0.5)
Balance End of Month 71.5 76.4 49.3 54.2 59.2 64.2

Worst Case Month End Liquidity 31.3 36.2 41.2 46.2
Best Case Month End Liquidity 62.3 67.2 72.2 77.2




Dividends and Stock Repurchases

PNCL has a good management team and understands the history of airlines as destroyers of value. As soon as the company resolves the NWAC contract, I would expect the company to begin some type of shareholder friendly action (ie. share repurchase or dividends). I have expressed to management my belief that at least 50% of all free cash generated annually should be used for stock repurchases or dividends and I believe management is in general agreement. If my advice is heeded, under my worst case scenario, PNCL could institute a 75 cent annual dividend.

Valuation

Pre-any new flying for NWAC or any other airline and pre-recovery of any stayed cash payments, my DCF valuations for PNCL, based on operating margins of 5% - 10%, and discount rates of 8-10%, yield values ranging from $6.50 (-5%) to $19.00 per share (180%). Assuming some additional flying, values improve to $9.50 - $25.00

Catalyst

Revised Contract with NWAC
Dividend or share buyback
New contracts with NWAC or other Carriers after scope relief is obtained