Description
The convertible bond market has undergone unprecedented dislocation in the last few weeks. This has created opportunities, yields and pricing not seen in atleast four decades. Some of the factors that have caused this entire asset class to offer amazing returns at this time are:
1. The swift unwinding of leveraged positions and at convertible arbitrage hedge funds.
2. Higher margin requirements by prime brokers
3. Pressure from other asset classes.
4. Redemptions at Mutual funds and hedge funds.
5. Economic woes – suggesting rising defaults and lower recoveries.
This year, until recently the aggregate convert market is down some 36.7%. Historically, this has been a decent indicator of good returns in the next few years.
One convert that is a case of the baby being thrown out with the bath water is the Pinnacle Airlines $121 Million 3.25% 2025 Senior convertible notes. The salient features of this note is:
· Currently trading at about 65% of face value.
· The holders of the notes have a put option to require the company to redeem the notes for cash on Feb. 15, 2010, Feb. 15, 2015 and Feb. 15, 2020.
· Notes are convertible at $13.22/share. Holders can convert their notes only during one of the following periods:
Ø During a quarter (and only during such quarter) if the closing price of the Company’s common stock exceeds 120% of the conversion price of the Notes ($15.86 per share or the “trigger price”) for at least 20 of the last 30 trading days of the preceding quarter;
Ø During a five-day period after the Notes have traded for a five-day period at a price that is less than 98% of the equivalent value that could be realized upon conversion of the Notes;
Ø If the Company calls the Notes for redemption;
Ø If a change of control or other specified corporate transactions or distributions to holders of the Company’s common stock occurs (and in some instances, the Company may also owe an additional premium upon a change in control); and
Ø During the ten trading days prior to the maturity date of February 15, 2025.
Here is the history on how this convert has traded since it was issued in 2005:
9/30/05: 71.00
12/31/05: 73.75
3/31/06: 82.045
6/30/06: 89.5
9/30/06: 94.250
12/31/06: 141.5
3/31/07: 145.557
6/30/07: 150.15
9/30/07: 128.563
12/31/07: 136.187
3/31/08: 96.147
6/30/08: 85.0
9/30/08: 73.318
The historical high is 165 and low is 61. Note that on Sept. 15, 2005, Northwest filed for Chapter 11 bankruptcy protection. At that time, Pinnacle had just one customer, that customer was bankrupt. Also, bankruptcy gave Northwest the right to tear up or renegotiate the contract with Pinnacle. Plus their receivables were impaired etc. etc. Even then, the converts traded higher than today.
The ARS issue has been front and center at Pinnacle for a few quarters. And on June 10, Delta announced they were tearing up the contract with Pinnacle. Even that seminal announcement did not collapse the price of the convert.
Today’s pricing on the Pinnacle convert is just silly.
There are a few writeups on Pinnacle on VIC. I suggest going through them all, along with the rich Q&A threads. The latest one is:
With the stock at $3.25 and the converts at 65 cents on the dollar and the put option on 2/15/10, the odds are very high that 100% of the converts will be put to the company on that date.
Here is Pinnacle’s present liquidity position (as of 9/30/08):
Cash: $64 Million
Investments: $127 Million
TOTAL $191 Million
Pinnacle invested $136.1 Million in auction rate securities (ARS) and got caught in the ARS liquidity crunch. They bought these through Citigroup and have arranged a $80 Million line of credit by posting these securities as collateral. They have also taken a mark to market impairment charge of $8.7 Million against these securities.
The company has been in communication with Citi and has guided that they expect that they’ll get redeemed out of these securities at par sometime in 2009. If that happens, Cash goes to $120 Million (and the $80 Million note gets paid off). Citi has settled on these securities with small retail investors and is in the process of working out settlements with large holders like Pinnacle.
They have also said that they keep getting offers from buyers to take the ARS off their hands at a discount to par. They have refused all such offers so far. In the last conference call, CFO seemed confident about getting par for the entire lot and having it sold in 2009.
More on ARS worst case scenerios later.
Sources and Uses of Cash from Oct. 1, 2008 to Dec. 31, 2009:
The Q400s are fully deployed and generate $16.5 Million in FCF.
Oct, ’08 and Nov ’08: 13 CRJ 900s - $2 Million FCF
Dec. ’08 through Dec. ’09: 16 CRJ 900s - $15.9 Million FCF
Legacy CRJ-200 Flying (124 aircraft): $37.9 Million
Legacy Colgan Flying: This is highly likely to be cash flow positive with the reduced fuel cost and enhanced contracts with the government and United. Assume it is zero.
Tax Refund Expected in Q109: $30 Million
TOTAL Cash Receipts: $102.3 Million
Maintenance Capex: $12.5 Million.
5 CRJ 900s are yet to be received. These will be in by Q209. Total cash outlay (at 15% down) is $17.9 Million. They have deposits with the manufacturer of $12.9 Million. So net add’l cash out is $5 Million.
Case 1: Status Quo on ARS securities
Cash at 12/31/09 is $64MM + $102.3MM -$17.5MM = $148.8 Million
Pinnacle is generating over $14MM in FCF every quarter. So, their cash balance would be down to about $30 Million after paying over the convert in full, but they do not need this cash for working capital. This would work for the company.
Case 2: ARS Resolved with 100% payment (Likely Case)
Cash at 12/31/09 is $64MM + $135.6MM + $102.3 - $80 MM - $17.5MM = $204.4 Million
After paying off convert, they have $83.4 Million in cash.
Case 3: Sell off the ARS at a discount and buy off the notes at a discount
This would be a good option for Pinnacle. If their ARS trade at 90% of face and they can sell those and peel off the converts with open market purchases with those proceeds, then it is likely that what they lose on ARS, they more than makeup on the convert discount. So, sell $5MM face, then go on open market and buy off converts. When done, sell another $5MM and keep going. This way the max one can get stuck with is a loss of $500K on an ARS sale with no corresponding gain. They can also apply all FCF that’s coming in toward buybacks of converts at a discount.
The converts are at 65 cents today. Maybe they can get 30% of them at upto 80% of face. This would mean total outlays drop from $121 Million to $114 Million.
Under this scenerio, cash is around $90 Million after paying off the converts entirely.
Worst Case Scenerio:
Pinnacle is expected to generate FCF of about $72 Million (before cap-ex) by 12/31/09. What if this went to zero? This is highly unlikely as Delta just gave them more flying. But under a zero FCF scenerio, they are short about $40 Million if the ARS issue is resolved.
They could look at leasing the remaining CRJ-900s, instead of buying them. This would free up about $18 Million.
They could get a line of credit based on receivables and other hard assets (spares, etc.) There is about $170 Million of net hard book value here. Today credit markets are frozen, but it is possible that they could find a lender willing to give them some $$$ based on the pristine collateral.
Worst case, in a bankruptcy filing and liquidation, a buyer of the converts would still not lose money as recoveries are likely to be over 100%.
If cash flows got even slightly impaired, the converts would really sell off – perhaps to 50 cents on the dollar. In that scenerio, they could take them out at a discount without taking any of the above actions and still have cash available after the converts are gone.
The sensible thing for management to do is to keep peeling away at the converts at a discount while selling ARS at a discount and applying cash flows to convert purchases. These actions would send the converts close to par (and investors would be golden).
Pinnacle Equity as an Investment
As shown above, the Pinnacle converts represent a simple way to get a 40+% annualized return – and get long-term capital gains treatment with no taxes due till 2010.
After the convert is paid off, you have a business generating over $50 Million in FCF (which goes up if they get more customers for the Q400 or CRJ-900 etc.). That is nearly $3/share in FCF on a stock trading at $3.25 with a book value of over $10/share. The equity has a bit more risk, but a vastly higher upside.
While Pinnacle has long-term, airtight contracts, as we saw this summer, when fuel goes to $145/barrel, the likes of Delta tried to reneg. So, one clear risk is fuel prices. If they soar again, it puts pressure on Delta and Continental to try to reduce costs. One could manage this risk by hedging the fuel risk.
Disclaimer: We do not own the Pinnacle converts. We own the stock. Please do your own, independent and thorough due diligence on this idea before committing any capital. We have been wrong (and have had permanent loss of capital) in the past on several investments in the past and expect to be wrong on several investments in the future. We may buy or sell the stock or the converts in the future with no obligation to report on VIC or elsewhere.
Catalyst
As the cash pours onto Pinnacle’s balance sheet, the converts will go to par. Worst case, they go to par in February, 2010 for a 40+% annualized return.