Monday, March 3, 2008

Pinnacle Airlines

Business

Pinnacle is a small, regional air service provider to the major airlines. On January 18, 2007 they acquired Colgan Air. Pinnacle’s fleet consists of 133 CRJ-200's provided to Northwest Airlines, 5 CRJ-900's provided to Delta. Colgan’s fleet consists of 4 Q-400's provided to Continental, 12 Saab 340's provided to Continental, 15 Saab provided to U.S. Air, 15 Saab provided to United Airlines and 6 Beech 1900's that will be taken out of service by the end of the year. Pinnacle operates under what’s called an “Airline Services Agreement” with its customers. It may be helpful to glance over the description of how the ASA is structured and the difference between a “Capacity Purchase Agreement” and a “Revenue Pro-Rate Agreement” in Pinnacle’s annual report.


Pinnacle benefits from many competitive advantages because of the way the ASA’s are structured. These competitive advantages include:

1) Pinnacle’s contracts re only amendable in bankruptcy situations combined with the long term nature of the contracts (generally 10 yrs) provides for safe and predictable cash flows,

2) Pinnacle’s new contracts include the Q-400 turbo prop which is a plane with superior economics. This six blade turbo is as fast as a jet but quieter and it can comfortably fly 70-78 people at the same cost as a 50 seat regional jet.

3) No exposure to fuel price risk, ticket price risk and virtually no exposure to passenger load factors and,

4) Pinnacle has the lowest operating costs per mile in the industry.

The two different operating structures for regional carriers is a “Capacity Purchase Agreement” and a “Revenue Pro-Rate Agreement.” In a revenue pro-rate agreement the regional carrier carries more risk because they operate with economics fairly close to a traditional airline company. Some of the regional airlines in this category have recently destroyed a lot of shareholder value (Express Jet, MESA Air) But, on the other hand a capacity purchase agreement is a contract where the regional owns the planes and operates them for a carrier and is reimbursed for certain expenses at a margin. This is of course what Pinnacle is doing. The capacity agreements are less risky because the regional doesn’t have exposure to things that have cause airlines to traditionally be bad investments. Other companies in this category are Republic Air and Sky West. Both are good names I think but not as cheap as Pinnacle. A good write up of RJET on Value Investors Club was recently posted. Pinnacle can best be described as a capital equipment leasing company that happens to serve the airline market.

Founded in 1985, Pinnacle was a wholly owned operator of regional jets for Northwest Airlines. In 2003 Northwest sold 89% of Pinnacle in an IPO. Then, on September 14, 2005 Pinnacle’s only customer, Northwest filled for Chapter 11. The terms of Pinnacle’s ASA with Northwest specify that in a bankruptcy situation the terms of the ASA can be amended. On December 16, 2006 Northwest and Pinnacle entered into an amended ASA. Among the terms of the amended ASA were: 1) fuel will be provided for free and the margin will be eliminated, 2) the target operating margin was reduced from 10% to 8% effective Jan 1st, 2007, 3) Pinnacle can fly aircraft for other airlines with seating capacities up to 76 seats, and 4) Pinnacle received an unsecured claim meant to compensate Pinnacle for the reduction in margins and for pre-petition claims. Pinnacle received $283 million after selling the receivable to a third party and they expect to receive an addition $32 million as part of the claim.

Under the amended ASA Pinnacle can expand its customer base, diversify away from NWA and at the same time enter into the lucrative 70-76 seater aircraft operations. This has allowed Pinnacle to turn into a company with very good growth prospects. Pinnacle has recently entered into contracts with other airline companies:

• Colgan Air entered into an agreement with Continental Airlines on Feb 4th, 2007 to operate 15 Q-400's. The contract will be ten year’s in length and is expandable to 30 aircraft. The contract will have 7-9% pre-tax margins and will have similar terms to Pinnacle’s current NWA agreement. The Q-400's will enter service between December 2007 and June 2008.

• On April 27, 2007 Pinnacle signed a 10 year contract with Delta Airlines to operate 16 CRJ-900 aircraft. The aircraft will be delivered between October 2007 and February 2008. The contract is similar to the agreement with Continental and NWA and it’s expandable to 23 aircraft.

Valuation

Management has stated that they are purchasing the planes instead of leasing them because of the favorable tax treatment. Management stated that because of the depreciation for tax purposes on the new contracts Pinnacle will pay no taxes between 2008-2010.

Management expects that the pre-set rates it has negotiated with Continental and Delta will provide for (EBITDAR) that will approximate $2.6 million for each Q-400 and $3.1 million for each CRJ-900 per annum, over the life of the ten-year contract.

The worst case assumes 15 Q-400's and 16 CRJ-900 aircraft are in service by Jan 1, 2009 and the best case assumes 30 Q-400's and 23 CRJ-900 are in service by Jan 1, 2009. Note: all but one of the CRJ-900's will be delivered by January 1, 2009. I am assuming that all the CRJ-900 will be delivered by Jan 1, 2009 for ease of calculation.

In 2009 total EBITDAR of $88.6 for the worst case and $149.3 million for the best case.

The total purchase commitment for the 15 Q400 and 16 CRJ-900 aircraft that the Company has on order is approximately $660 million. Pinnacle is financing 85% of the purchase price at 7% over 25 years. Total principle and interest for the 15 Q400 and 16 CRJ-900 aircraft at 7% is $61.7 million a year. For the best case if the options on the additional aircraft are exercised, the interest cost would be $92.6 million ($61.7 *1.5).

Cash flow from Pinnacle’s new contracts is $26.9 million worst case and best case would be $56.7 million.

In addition to the new contracts Colgan’s current operations and Pinnacle’s NWA business must also be added. Management is guiding that Colgan will obtain 3-5% pre-tax margins in 2009 after some cost saving initiatives are implemented during the first quarter of 2008. At a $190 million revenue run rate Colgan will contribute $5.7 (worst case), $9.5 million (best case). Management has also guided that the rest of Pinnacle’s NWA contract will generate around $48 million pre-tax.

In total the 2009 FCF would be: $26.9-$56.7 (new contracts) + $5.7-$9.5 (Colgan) and $48 (NWA) minus $10 million in capital expenditures (company estimate). The total 2009 FCF is $70.6 - $104.2 million. This compares to managements FCF guidance of $87 million in 2009.
I think Pinnacle is worth 10 times 2009 FCF of $90 million or 900 million ($44 per share).

Other Items

For the new contracts (Q-400 and CRJ-900) Pinnacle will make a cash expenditure of $99 million or the planes plus $15 million for spare parts and $8 million in start up costs for total investment of $122 million. These contracts will provide $26.9 million in FCF. So, the return on Pinnacle’s investment is 22%.

In January Pinnacle purchased Northwest remaining investment in Pinnacle which consisted of 2.5 million shares at $13.22 per share. Pinnacle has repurchased about 20% of its stock since May 2007. At the current price of $11.48 Pinnacle is trading for $240 million.

A rough liquidation value calculation yields $11.8 per share. I took book value minus intangible assets and goodwill plus deferred revenue related to the unsecured ASA claim that has already been monetized.

Two issues Pinnacle is facing are the negotiations with ALPA and the disputed items in the NWA ASA. The first item refers to the Airline Pilots Association, the union that Pinnacle pilots are in. Pinnacle has had some trouble negotiating wages with ALPA and the final result of this could have a negative effect on Pinnacle’s costs. The second item is the possible reclassification of certain expenses in the ASA. There are three items of interest. The first is a rate adjustment that could affect results positive or negative $2.8 million. The second is an increase ground handling expenses that could reduce operating income $1.5-$2 million a year. The third is a disagreement of penalties that were expensed in the first quarter of 2007. NWA wants one million more in addition to the $2.4 million already paid by Pinnacle. Pinnacle and NWA disagree about the classification of these items in the ASA and the final outcome will be resolved with arbitration.