Pinnacle Airlines (PNCL) is a wonderful business that is trading at well under half of its intrinsic value. Holding the stock for 2-3 years is likely to yield a 2-5x return with minimal downside. For background, it would be worth reading the excellent VIC writeup (and thread) on Republic Airlines (8/2/07) and the two prior write-ups on Pinnacle Airlines (9/19/05 & 11/17/06)

 

 

 

 

The situation with Pinnacle has changed considerably since the previous two writeups. I’ll try to avoid repeating the history laid out in the earlier writeups.

 

Virtually all the major US airlines outsource their regional jet and turbo prop operations to regional carriers like Pinnacle, Republic etc. These operators, in general, can fly the airplanes for considerably less than the major carriers. American Airlines flies all the American Eagle planes themselves. They are unique and just announced a few days back they were going to spin off American Eagle into a separate business. Typically these regionals have long-term (10+ year) cost-plus contracts with the major carriers. In September, 2005, Northwest Airlines filed for bankruptcy protection. At the time Pinnacle’s only customer was Northwest Airlines. So, they were a public company with just one customer and that customer was in bankruptcy. Bankruptcy law allowed Northwest to re-negotiate its contract with Pinnacle.

 

The new contract that Pinnacle and Northwest agreed to (on Dec. 5, 2006) reduced Pinnacle’s markup from 10% to 8%. In addition they gave up all markups on fuel. Northwest now simply provides the fuel to Pinnacle. In exchange for these reductions, some of the salient concessions Pinnacle got from Northwest were:

 

1.    The ability to fly planes with upto 76 seats. Previously Pinnacle was limited to 50 seats.

2.    The ability to serve other airlines. Previously Pinnacle was limited to doing business with Northwest only.

3.    A senior unsecured claim from Northwest for $377.5 Million as part of its bankruptcy reorganization. This claim was designed to compensate Pinnacle for the reduced margin (from 10% to 8%). Pinnacle subsequently sold this claim for $311 Million (>$14/share). The income associated with this is being recognized over 10 years. Hence the taxes are payable over ten years. As will be shown later, Pinnacle won’t be paying much of the taxes due here.

 

Here is a timeline on events that have taken place since the December 5, 2006:

 

1.    On Jan 18, 2007, Pinnacle announced the purchase of Colgan Air for $20 Million. Colgan is a turbo-prop regional airline that provides regional service to Continental Connection, United Express and US Airways Express. Annual revenues are estimated at $190 Million. Pinnacle has guided that Colgan is expected to deliver pre-tax margins of 3-5%. With $5.7 Million to $9.5 Million in pre-tax income, this looks like a very smart purchase purely based on Colgan’s legacy business cash flows. However, it is an incredibly smart purchase because it has allowed Pinnacle to enter the very exciting Q400 Turbo prop market. More on that later.

 

2.    On February 5, 2007 Pinnacle announced a very significant new contract with Continental Airlines. The company’s Colgan subsidiary would be operating 15 new Bombardier Q400 Turboprops for Continental with options for Continental to add 15 more. The Q400 is a remarkable airplane and this is a terrific contract for Pinnacle to add to its range of services.

 

3.    On April 30, 2007 Pinnacle announced another significant contract to fly 16 Bombardier CRJ-900 regional jets for Delta. The CRJ-900 is the largest regional jet made by Bombardier and will be configured for 76 seats in 2 classes. Another very attractive contract for Pinnacle.

 

4.    On May 14, 2007, Pinnacle announced a $30 Million share repurchase program. In August they added another $30 Million to their repurchase program, bringing the total authorization to $60 Million. By Nov. 1, they had bought back 2 Million shares at an average price of about $17.50.

 

5.    On Nov. 30, 2007 the company announced that they bought 2,492,060 shares from Northwest Airlines for $13.22/share. PNCL closed on Nov. 29, at $15.75/share – so these shares were bought at a discount of over 16% to the previous day’s closing price. The total buyback so far in 2007 is 4,450,092 shares. Total shares outstanding are now under 18 million – down from over 22.1 Million in Q107. They have reduced the shares outstanding by almost 20% in a few months. As will be shown later, these buybacks appear to be extremely smart capital allocation decisions. In fact all the aforementioned actions by the company – the Colgan purchase, the Delta and Continental contracts and the buybacks are all extremely smart ways to allocate it’s excess capital.

 

 

In order to fully appreciate the very positive long-term future of Pinnacle Airlines, one needs to appreciate the Q400. Before Pinnacle bought Colgan Air, it only operated Regional Jets. And Colgan only operated Turboprops. The Turboprobs Colgan operates are 42 Saab 340s and 7 Beech 1900s. The Beech 1900s are being retired fully by the end of 2008. The Saabs deployments and routes will be adjusted to do all the flying.

 

However, now Colgan will by flying 15 Q400s for Continental. And the Q400 is a big deal. Thanks to some leading-edge noise cancelling technology, the Q400 is actually about 4dB quieter than a typical regional jet. In addition, with a seating capacity of 74, it is big. Both the Q400 and the next generation regional jets like the Embraer 170 or CRJ 900 have much larger cabins than previous vintages of smaller regional jets. Their comfort approaches that of a Boeing 737. And with no middle seats some would argue, superior to the 737. In addition, unlike ANY other Turboprops, these have a range of 1500+ miles. That is a big deal. It is huge advantage when coupled with the jet-like comfort, jet-like quietness, jet-like speed (over 400 mph – much faster than ANY other Turbo-prop).

 

The total cost of ownership of a 74-seat Q400 is about the same as a 50-seater regional jet. That is a big deal. The Q400 burns 30-40% less fuel than a 70-seater regional jet. As fuel prices rise, the Q400 gets even more competitive and valuable.

 

Among turboprops, the only competitor to the Q400 is the ATR. While the ATR is cheaper it lacks the speed, comfort and range of the Q400. All three are important considerations for airlines like Continental. While Pinnacle will start with 15 Q400s, they have options on another 30. 15 of those 30 are likely to go to Continental. Continental will start getting experience with the Q400s in January and Pinnacle management expects that they’ll make a decision on the additional planes by 1H08.

 

Recently some Q400s have had their landing gears malfunction and SAS (the Q400 launch customer in 2000) has grounded its entire Q400 fleet. Bombardier temporarily grounded all Q400s worldwide with over 10000 cycles in Sept., ’07 as it wanted to inspect all the planes carefully. The investigation found that the problem was corrosion of a bolt in the landing gear which was not previously subject to inspection before 15,000 cycles. After they fixed the problem on all the grounded planes, it is business as usual. Other than SAS, no other carrier has stopped using or stopped ordering Q400s. In fact Qantas order 12 more Q400s on Nov. 12. Pinnacle’s CEO also advised on the most recent conference call that the Q400 was a very safe aircraft with no unaddressed issues.

 

Here is a recent Time Magazine article on the Q400 and the new Turbos:

 

 

 

In this business, the customers (major airlines) care deeply about costs and quality. Since markups can be pretty similar for the various regional carriers, they look carefully at the quality of each one’s service and the cost structures embedded in their businesses.

 

At 9 cents per CASM, Pinnacle is one of the lowest-cost regional operators. As they add more of the Q400s and CRJ-900 with more seats and longer ranges, this will drop further. Here is what Mark81 had to say about Pinnacle’s approach to cost in his 9/19/05 writeup:

 

 

Their annual report every year consists of just a simple cover around the 10-K. Phil Ternary’s (CEO) letter is on the inside cover and he has used the same B&W picture of his on the annual report for several years. They ain’t spending any of the shareholder’s cash on frivolous stuff.

 

Pinnacle has guided that the 15 Q400s and the 16 CRJ-900s have an aggregate purchase price of $663 Million to Pinnacle. I have assumed that each Q400 was bought for $18.8 Million (versus a list price of $25.4 Million) and each CRJ-900 was bought for $23.8 Million (versus a list price of $36.6 Million).

 

Pinnacle has also guided that all the planes are being bought (versus being leased) due to favorable tax treatment and accelerated depreciation allowed for tax purposes. They are putting 15% down per plane and have additional costs of approximately $1 Million per plane for spares and startup costs.

 

For each Q400, the company invests $2.8 Million + $1 Million = $3.8 Million.

 

The depreciation schedule for tax purposes is MACRS 7. Here is how the depreciation schedule looks for tax purposes on both the Q400 and CRJ-900:

 

Year             Percentage Depreciation

 

1                             14.29%

2                             24.49%

3                             17.49%

4                             12.49%

5                             8.93%

6                             8.92%

7                             8.93%

8                             4.46%

 

For the Q400, the absolute tax depreciation numbers are:

1                             $2,686,520

2                             $4,604,120

3                             $3,288,120

4                             $2,348,120

5                             $1,678,840

6                             $1,676,960

7                             $1,678,840

8                             $838,480

They have also guided that the interest rate they are paying on these airplanes is between under 7%. Principal+Interest every year is $1,723,593.

 

Let’s take a look at Pinnacle tax situation with this one airplane for the first 8 years. Note that a negative number implies a tax credit to offset income in other parts of Pinnacle’s business. Management has also guided that the EBITDAR for the Q400 is $2.6 Million/year and $3.1 Million per year on the CRJ-900. So taxes due, at 35% is $2.6MM less Interest Less Depreciation.

 

Taxes Payable (Tax Credit)

 

Year 1          ($421,792)

Year 2          ($1078,130)

Year 3          ($601,670)

Year 4          ($255,700)

Year 5          ($3,294)

 

For the first five years, the Q400 generates no taxes. Pinnacle invested $3.8 Million. They pay Principal+Interest on the loan of $1,723,593/year. After-tax Free cash flow per airplane for the first five years is $876,407 plus the add’l tax credits. The Q400 generates a 23% FCF return on invested capital for the first five years. It is a very good business. Each Q400 also saves Pinnacle about $2.4 Million in taxes during the first five years elsewhere in its business.

 

The present value of this $2.4 Million plus the present value of the excess residual value of the Q400 after ten years could approximately be equal to the $3.8 Million it invested in the first place. So the $3.8 Million “bond” pays off the principal via tax credits and aircraft residual value. The interest this bond pays for the first 5 years is 23%.

 

 

Here is the MACRS7 Tax depreciation schedule for a CRJ-900:

 

1                             $3,401,020

2                             $5,828,620

3                             $4,162,620

4                             $2,972,620

5                             $2,125,340

6                             $2,122,960

7                             $2,125,340

8                             $1,061,480

 

 

Taxes Payable (Tax Credit)

 

Year 1          ($600,992)

Year 2          ($1,431,888)

Year 3          ($828,709)

Year 4          ($390,726)

Year 5          ($71,191)

Year 6          ($45,761)

Year 7          ($20,276)

 

The management guided EBITDAR number is $3.1MM for the CRJ-900. Cash out the door is just P&I of $2,181,996. There is again no taxes payable for 7 years. Free cash flow is $918,000 per year versus a cash investment of $4,570,000 or a ROI of about 20%.

 

Management has guided that they do not expect Pinnacle to be a cash tax payer from 2008-2010. In 2011, some $28.1 Million in taxes are sheltered. In the next 4 years, if Pinnacle adds just 30 more planes, it will be a few more years before they pay taxes. See this presentation on the company’s website for a table on the tax shields (refer to Page 31)

 

 

They have options on 30 more Q400s and Delta might add 7 or more CRJ-900s. Continental is likely to decide on 15 more Q400 by the 1H08.

 

 

The new regional jets by Embraer and Bombardier and the amazing Q400 have led to a very strong demand for these 70-110 seaters over the next decade. The regionals, like Pinnacle, can fly these airplanes for considerably less than even Southwest with its 737s. Consider the following stats:

 

·         60% of all US domestic flights depart with load factors more appropriate to 70-110 seat aircraft.

 

·         95% of all narrow-body flights are within 1,700nm range.

 

·         85% of all city pairs around the world are served with less than two frequencies a day.

 

·         35% of total fleet is more than 20 years in service and shall start to be replaced in the coming years.

 

·         Older/smaller Regional Jets and Turbos are inefficient and expensive aircraft to operate. High incentive to upgrade.

 

·         New regionals like CRJ-900 and Q400 offer near 737-class comfort plus no middle seats.

 

·         Over the next ten years Embraer forecasts about 800+ new 61-120 seaters will be added in the United States alone. There are just a handful of regional carriers and it is quite likely Pinnacle will end up with 100-150 of these additions at a minimum – adding 10-15 aircraft a year for the next decade.

 

·         The Q400 offers vastly superior economics to a 74 seater Embraer Jet. It costs 1/3 less in total cost of ownership than an Embraer. It has similar range, speed, quietness and cabin comfort. And as fuel prices rise, the economics keep getting better and better versus the Embraer.

 

We will see lots of orders placed for these airplanes. And the carriers will all outsource as much of the flying to the low-cost regionals due to superior economics. Pinnacle is likely to see very strong growth in this area in the coming years and is highly unlikely to be a tax payer for a very very long time.

 

 

Colgan’s legacy business is at a $190 Million a year run-rate with projected 3-5% pretax margins in 2009 (guided by the company). So Colgan’s pre-tax contributions are expected to be $5.7 to $9.5 Million after the expensive/inefficient Beech 1900s are removed in 2008. In 2006, Colgan earned about $2.5 Million pretax. The rest of Pinnacle’s Northwest legacy business is estimated to generate about $45 Million pretax. The total Colgan and Pinnacle legacy business worst case is $47.5 Million (if Colgan generates just $2.5 Million a year) and best case $54.5 Million in 2009 and beyond.

 

Note that all the CRJ-900s will be in be Feb. 2009. For simplicity I’m assuming they are all in by 12/31/08.

 

15 Q400’s generate $876.4K * 15 = $13.2 MM

16 CRJ-900 generate $918K * 16 = $14.7 MM

Legacy Business: $47.5-54.5MM

 

Total: $75.4 - $82.8 MM

 

I’m assuming $10 Million in Capex/year excluding airplanes.

 

FCF: 65.4 – 72.8 Million

 

If we assume that excess capital approximately cancels out their $120MM outstanding convert, then, at a 12x or 15x multiple, Pinnacle is thus worth between $43.60 to $60.70/share in 2009. This is the base low-end case.

 

What if Pinnacle places all the additional 30 Q400s and Delta adds the add’l 7 CRJ-900s? It’s reasonable to assume that all these may be in service by the end of 2009. In that case, the 2010 cash flows are:

 

45 Q400’s generate $876.4K * 45 = $39.4 MM

23 CRJ-900 generate $918K * 23 = $21.1 MM

Legacy Business: $47.5-54.5MM

 

Total: $108 - $114.7 MM

 

Assume $10 Million in Capex/year excluding airplanes.

 

FCF: $98 – $104 Million

 

At 12x to 15x multiples, the intrinsic value is between $65.33 - $86.67 per share in 2010.

 

Company Guidance is for $107 Million in FCF 2009. They are assuming 10% YoY growth from ’08 to ’09. In ’08, they have 195 aircraft, so, they are assuming about 15-20 planes being added in ’09.

 

If you take their $107 Million in FCF in 2009, at a 12x to 15x multiple, that is an intrinsic value of $71.33 to $89.16

 

All 15 Q400s will be deployed by June 2008. Theoretically, the company could add 15 every 6 months. So 45 could be deployed by mid-2009. 

 

Thus in the 2009/10 timeframe, the worst-case intrinsic value at at 12x multiple is $43.60 and the best case at a 15x multiple is $89.16/share.

 

Rounded off, Pinnacle is worth between $43 and $89 per share in 2-3 years.

 

Given all the advantages of the Q400 and the 60-120 seater aircraft, it is well within the realm of possibilities that Pinnacle could add a lot more than the aforementioned to its fleet. It could easily add 20-40 planes a year for several years. Each add’l airplane helps offset taxes in the legacy business. The company is also very underleveraged. They could continue to be aggressive with buybacks of their undervalued stock by adding, for example, $100 Million of debt to its pristine balance sheet.

 

 

Gatsby expressed this very well in his write-up on Republic. I am going to use his words and just replace Republic with Pinnacle as the facts are the same:

 

·         PNCL bears absolutely NO fuel price risk (yet often trades w/ airlines that trade inversely with skyrocketing oil prices!)

·         NO exposure to volatile ticket prices & frequent fare wars.

·         NO exposure to increased airport landing fees or domestic security fees.

·         Virtually NO sensitivity to passenger load factors.

·         Long-term contracts of generally 10 years provide substantial earnings visibility & downside protection.

·         Contracts contain fixed price escalators to help offset increases in labor or input costs.

·         These agreements are not subject to renegotiation (outside of bankruptcy).

 

Just one caveat for Pinnacle on the above, the Colgan legacy business is not  a “capacity purchase agreement,” it is a “revenue pro-rate agreement.” See the company’s filings for details. However, these revenues comprise thus 20% of the pie today and will keep reducing as a percentage as more Q400s and CRJ-900s come online.

 

Pinnacle trades presently at less than a 5 multiple to worst-case 2009 cash flows. Against the best case 2010 cash flows, it presently trades at less than a multiple of less than 3.

 

Disclaimer: This is not a solicitation to buy or sell securities. Please do your own independent research and thorough due diligence BEFORE buying or selling any shares in Pinnacle (or any other stock). We may or may not own shares in Pinnacle. We may buy or sell shares of Pinnacle in the future and are under no obligation to provide any update or details on VIC (or elsewhere) on our trading activities.