PNCL ($6.83) <Pinnacle Airlines > by mark81

**blast_investor** Fri Nov 04, 2005 3:05 am

PNCL ($6.83) <Pinnacle Airlines > by mark81
9/19/2005 6:12:00 PM PNCL ($6.83) <Pinnacle Airlines > by mark81 Rating 6.2 (16 users)

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 ...More

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

**blast_investor** Fri Nov 04, 2005 2:41 pm

9/19/2005 6:12:00 PM PNCL ($6.83) <Pinnacle Airlines > by mark81 Rating 6.2 (16 users)

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