An Airline With Fewer Risks and More Upside

Who would want to own an airline with slumping business travel, a weakening consumer, and rising unemployment?

Warren Buffett fans know that he specifically singled out the airline industry as destroyer of capital in his last letter to Berkshire investors. There are several decades industry losses and numerous bankruptcies to support his claim. All that being said, recently, I have begun building a position in Pinnacle Airlines (PNCL) which is not a traditional airline and has a compelling valuation. Pinnacle Airlines currently trades at a less than 25% of tangible book value and less than 2X normalized free cash flow. At current prices the shares presents an attractive risk reward proposition for a growing airline that has significantly more stable earnings than a traditional airline.

COMPANY DESCRIPTION
Pinnacle Airlines is a regional jet operator with 135 jets and 56 turboprop aircraft flying over 1,000 flights per day serving 144 cities under the Northwest Link, Delta Express, Continental Express, and US Airways. Pinnacle was spun out of Northwest Airlines in 2003 where it flew under the name Northwest Link. At the time of the spinoff, Northwest was Pinnacle’s only customer. Today, Northwest is still their largest customer and will account for approximately 62% of 2008 revenue and Delta, who acquired Northwest this year, will account for another 11%. Like other Regional airlines serving the “major” carriers, Pinnacle’s value proposition is its lower cost structure.

LOWER RISK AIRLINE
In 2008, 75% of Pinnacle’s revenue was generated under “Capacity Purchase Agreements”. This is a cost plus model where Pinnacle’s airline customers such as Delta/Northwest assume many of the risks that typically make airline earnings cyclical and volatile. Pinnacle does not assume fuel risk or consumer demand risk and is reimbursed for costs such as insurance and airport landing fees. Pinnacle is paid based on the flight, not the passenger, with fuel provided by their airline partner. For “Capacity Purchase” flights Pinnacle makes virtually the same profit per flight if oil is at $145 a barrel or at $45 barrel. Likewise, they make the same profit if the plane is full or empty. There are some incentives in their contracts for items that are in their sphere of control, such as on-time arrival and customer satisfaction. For 75% of Pinnacle’s business, they have a far more predictable revenue and expense structure than a traditional airline.

In 2007 Pinnacle purchased Colgan, which operates under “Revenue Pro-Rate” agreements with Continental, United Air Lines, and US Airways Group. Colgan’s operations are focused primarily in the northeastern United States and in Texas. On “Revenue Pro-Rate” flights, Pinnacle assumes fuel risk and has the ability to set ticket prices. The earnings and operations are more like a traditional airline. For nine of the markets served by Colgan, there are guaranteed minimum payments from the Federal Government’s “ESA” program which guarantees Pinnacle minimum revenues to make serving smaller markets economically attractive.

POSITIVE RECENT DEVELOPMENTS
The airline industry has a long tradition of destroying investor capital. It is capital intensive and jet fuel is a large input that is volatile. In the past 6 months, Pinnacle’s stock price has declined 63%, however its operating earnings and earnings prospects have remained strong. Pinnacle is clearly in the penalty box because of its holding of Auction Rate Securities, debt that needs to be refinanced or paid off in 2010 and Delta threatening to cancel part of their contract in July. However, there are also a series of positive developments that do not appear to be priced into the stock.

Strong December Numbers – Despite the weakening economy, Pinnacle’s planes are actually carrying more customers y/y. For the Coglan flights where the company is paid by the passenger rather than the flight, their load factors were up 31% in December.

Better Routes – Pinnacle has renegotiated contracts, stopped flying out of Pittsburgh and has gotten better routes out of Dulles Washington , increasing traffic and reducing maintenance and overhead costs.

Transition to larger more fuel efficient planes – Over the past year, Pinnacle has begun a transition to larger more fuel efficient planes. In particular, they are retiring their smallest eleven passenger planes from the Colgan acquisition and adding 74 seat Bombadier Q400 planes under the Continental Contract.

Higher ESA reimbursements – In the fall of 2008 Pinnacle renegotiated higher ESA rates in nine markets from the Federal Government. Pinnacle threatened to pull out of eleven markets and got to rebid them with the Federal Government.

Lower Fuel Costs/Healthier Partners – Pinnacle was profitable in the 3rd quarter of 2009 with an economy in recession and oil well over $100 per barrel. Of greatest concern was the economic viability of its largest customer, Delta Airlines.

Recent Contract Expansions – This month, Continental Airlines agreed to expand their partnership with Pinnacle by adding 15 additional planes starting next year.

Large Tax Refund – Pinnacle had a large one time gain from the sale of a claim related to Northwest’s bankruptcy. The net result was a $100M tax bill. Under current tax law, the company is able to “claw back” their payment if they are able to generate a tax loss. Due to the structure of their new contracts and the planes which they are taking on their books, Pinnacle is able to generate $30M in tax refunds that should be received in 2008 and 2009. Almost $4 per share in cash will be returned to the company in the form of a tax refund in the next year and a half.

RISKS
Customer Concentration: The recent combination of Delta and Northwest was a merger of Pinnacle’s two largest customers. For 2009 approximately 73% of Pinnacle’s revenue will come from the combined company. The business is secured by a contract which expires in 2017. However, there are several situations where the contract can be renegotiated. In particular, a Delta bankruptcy, would provide Delta with the opportunity to renegotiate. In addition, this past summer when oil was $145 a barrel and Delta was bleeding cash, they threatened the cancellation of a portion of the contract for performance related issues. As oil prices declined, Delta and Pinnacle resolved the issue and even temporarily increased the number of planes Pinnacle flies for Delta. It is inescapable, that currently, the long term viability of Pinnacle Airlines is tied to the financial health of Delta Airlines. This risk can be largely hedged out through puts, credit default swaps on Delta debt, or shorting of Delta shares. In the short term, there is little correlation between the share prices of the two companies. In the past six months Delta has benefitted from the decline in oil prices and its shares are is up 26% while Pinnacle has declined 63%.

Convertible Notes Feb 2010 – Pinnacle has $121M in convertible notes due in February 2010. The company should have ample liquidity to meet this obligation in 2010. The company exited the last quarter with $68M in cash. In addition, there is $100M in equity in airplanes, a $30M tax refund due in 2009, $50M in spare engines and parts, $45M in unencumbered Auction Rate securities. In addition, they should be cash flow positive in 2009 and be due a similarly large tax refund in the coming year. However, in the current environment where debt coming due is a red flag, Pinnacle appears to be overly penalized for their debt. This seems to be the most intense area of focus for investors.

Pilots Contract – Pinnacle is currently operating without a pilots contract, they are in mediation with their union. The company has stated that their salaries are approximately 5% below the industry average for regional carriers. There is both the possibility of higher wages as well as a retroactive payment to the union. Bringing pilot salaries to their peer average will cost the company between $5M and $10M per year. A retroactive payment covering three years could be higher.

CATALYSTS
Resolution of ARS Holdings – Pinnacle Airlines holds $136M in Auction Rate Securities. These securities were purchased before the market seized up as the company reached for yield. Pinnacle has taken a $9M write down and moved the securities to the long term investments section of the balance sheet. Citigroup was their broker and has provided $80M line of credit against the securities, leaving $45M unencumbered and not written down, which is substantial given the $37M market capitalization of the company.

Stock Buyback - Pinnacle has the flexibility on their balance sheet to repurchase a substantial number of outstanding shares given the company trades at a discount to the cash on hand, and has significant assets in ARS, tax refunds due, spare parts, and equity in their planes.

Repurchase of Convertible Notes – Shares should react positively to any news of Pinnacle buying back their convertible notes in the open market. The notes have been trading at 30% below par. Pinnacle can both retire debt at 70% on the dollar, as well as reduce the size of the debt coming due. There is some precedent for this within the industry, as Jet Blue has recently been a purchaser of their debt.

Continued Earnings Growth, Revenue Growth, and Cash Generation - As Pinnacle continues to earn even in a weakening economy and build their cash reserves , their ability to repay their short term debt should diminish and provide less of an overhang on the stock.

Insider Buying – Due to the timing of their quarter ends, conference calls, earnings releases and audits, the window for insiders to purchase stock is currently closed and may not open again until April, however at current prices insider buying would serve as a strong signal to the market regarding the viability of the model.

INEXPENSIVE VALUATION
Pinnacle Airlines is inexpensive by any objective measure. For example, the company currently has a forward PE of 1.21. Pinnacle also trades at a substantial discount to tangible book value when the appropriate adjustments are made to the stated book value. The largest adjustment is the removal of their deferred revenue liability of $216M. This relates to the sale of Northwest Airlines bankruptcy claim that Pinnacle sold two years ago. There is no obligation to deliver any services associated with the deferred revenue. There is however a deferred tax asset associated with the revenue that should be eliminated as well to get a more precise picture of Pinnacle’s current financial health.

At first pass, Pinnacle appears to have weak free cash flow. The traditional calculation of Free Cash Flow that simply subtracts capital expenditures from operating cash flow yields negative $12M free cash flow. However, this calculation understates the free cash flow because it includes two one-time events, $20M in hedging payments related to the financing of aircraft acquired and approximately $15M of the capital expenditures were related to growth. On a normalized basis, the company would have generated over $1.25 per share in cash YTD, or a Free Cash yield in excess of 50%. The one metric Pinnacle trades at a premium to its regional jet peers of Republic and Sky is on an EV/EBITDAR basis where Pinnacle trades at 6.6 vs. 5.9 for Republic and 4.8 for Sky West. However 2/3 of the calculated EV for Pinnacle relates to capitalized leases which Pinnacle has no obligation for if Northwest cancels their contract, making it a difficult comparison with traditional airlines that retain the capital lease obligation.

Pinnacle should earn approximately $1.75 per share next year on approximately $900M in revenue. Since becoming a public company, Pinnacle has traded as high as 12X forward earnings with a historical mean of 5X. In the current environment of multiple compression and a decimated consumer, a lower multiple is appropriate. However, a forward multiple of 1.21 should rise as the financing cloud lifts off of Pinnacle. Applying a modest 3.5X forward multiple yields over a 200% return. Valuing the company based on its tangible book value would yield a return in excess of 300%. Given the stability of the capacity purchase agreement contracts and strong cash flows, at current prices Pinnacle presents an interesting risk reward, particularly for investors that hedge out the Delta risk via puts.