Pinnacle Airlines Corp. PNCL
November 17, 2006 - 1:26pm EST by
north481
2006 2007
Price: 9.70 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 210 P/FCF
Net Debt (in $M): 0 EBIT 0 0
TEV ($): 0 TEV/EBIT

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Description

In my opinion, the timing of this situation is getting very close to coming to the end.  Pinnacle was written up back on September 19th, 2005 by mark81 and the posting history is helpful in getting up to speed.  Since the uncertainty with Northwest is going to be reaching a conclusion soon and because I believe it has very limited downside along with a strong possibility for up to 40% in gains (and since its message board has pretty much died off recently), I think it is a timely idea. 

 

After reading the previous idea post and messages, I hope the following additional information is helpful to backing up the claim that this is a safe and cheap stock.

 

In a nutshell, the base case scenario for PNCL is that they do reach an amended ASA (Airline Service Agreement) with Northwest.  This is what I believe is going to happen.  Later I will attempt to value the floor price in the event that NWA rejects the ASA or that PNCL and NWA are unable to reach terms on an amended ASA. 

 

Currently, PNCL has been contracted to fly 139 regional jets and are only flying 124 of them.  Under the current ASA, and they have been flying under this current ASA since the first day of the NWA bankruptcy, they make about $50 million in net profit or $2.40 to $2.50 in earnings per share. 

 

Under an amended ASA, I believe it is entirely expected that they will earn somewhere between $1.25 and $1.75 per share.  The concessions they will give will likely result in a lower “targeted operating margin”, which now currently sits at 10%.  The reductions will probably result in lower aircraft rentals rates (now $175k per month that they then get to keep about $20k in profit (or 11.1% of $175k). They will also probably lower the aircraft fuel reimbursement or force PNCL to accept some fuel risk.  Those are the two biggest areas of cost savings to NWA. 

 

Under and amended ASA, I also believe that PNCL will get to either work to diversify itself away from NWA by removing the exclusivity clause in the ASA or they will negotiate growth opportunities within NWA.  Or, of course, there could be a combination of both scenarios.  Why do I believe this?  NWA has ordered 36 Bombardier 75 seat planes already.  These CRJ-900s are not to be allocated to the new regional airline subsidiary, Compass Airlines that was created as a result of NWA Pilot negotiations.  Instead, they are to be allocated to a regional partner(s) to be determined later.  PNCL will likely be flying bigger planes for NWA.  Will they lose some 50 seat planes to get to fly the bigger versions, maybe, but if NWA is thinking about removing 50 seat planes from the fleet, then why would they be bringing back the 15 50-seat planes that they took away from PNCL last fall?  I think PNCL gets to grow in some way, either inside NWA or outside or both. 

 

With this amended ASA that gives investors some earning stream certainty, PNCL likely would get a market multiple of 6 to 8 earnings.  Skywest, Rebublic and Mesa all get about 9 to 10 times multiples.  They are clearly more diversified, own their own fleets and are larger operations.  So, a discount to that multiple range is expected until PNCL is able to grow up to be a real live regional or get bought out by one.  At an earnings level of $1.25 to $1.75 per share with a multiple range of 6 to 8 times, the price of their ongoing earnings stream could be $7.50 to $14.00.  I choose to believe that the mid point is the most likely and using the lowest multiple of 6 times gets you $9 per share.  That is the ongoing earnings value.  But there is more here.

 

In exchange for accepting such a reduced earnings stream under an amended ASA, I believe that PNCL will also receive an “unsecured claim” to compensate for their economic damages that suffered plus they will also receive an “administrative claim” that is paid in full upon signing a new ASA.

 

The unsecured claim figures would be completely negotiated by NWA and PNCL, but here is a stab at what those two figures could be worth.  Assuming that they give up about $20 million per year in net profits for 11 years, we could expect that they could negotiate about half of this back.  In exchange for a new deal at lowered margins but with growth promised or allowed they probably would want due compensation for about $100 million in reduced profits over the term of the old contract.  The present value of this at an 8% discount rate would be about a $70 million unsecured claim.  The unsecured bonds are trading at about 80 cents.  The value of this unsecured claim then could be worth about $55 million or $2.50 per share.

 

The administrative claim coming as a result of getting the net amount of what was owed to PNCL at the time of bankruptcy of about $55 million minus the $22 million in second month’s lease deposit that NWA is seeking, results in another $1.50 per share.

 

PNCL does owe $120 million in debt and has about $90 million in cash plus another $40 million in spare parts and $22 million in lease deposits.  In my mind, that nets to $0 of extra balance sheet value.

 

Added together, my base case value of PNCL with an amended ASA is about $13.00 or 35% higher than the $9.75 price today.  That is my base case. 

 

Now, in the event (and I believe this is unlikely) that the current contract is rejected, either by NWA or PNCL and NWA cannot reach an acceptable deal, I see the situation unfolding as follows.

 

In this situation, PNCL would seek an unsecured claim for the full value of the current ASA. The math I use in calculating the potential value of an unsecured claim is this: If they are only entitled to the 10% operating margin on the 139 aircraft leases for 11 years, this results in an entitlement of about $30 million each year from NWA. The present value of this $330 million (by the way, Mesaba has sought a similar amount already) in lost value is about $227 million at a discount rate of 8%. That rate is just a guess.  Again, this claim value is on par with other unsecured

creditors and their claims are selling for about $0.80 today.  So, $227 million x 80% is worth about $180 million or about $8.20 per share in value.  This is for the lost contract alone.  And it only assumes they are entitled to $30 million of the lost $50 million in profits each year.

 

To this, in liquidation, we can rightfully add their pre-petition claim of $50 million from payments that weren't made right before the NWA bankruptcy plus the year's worth of lost profits on 15 planes they were entitled to be compensated on during 2006.  So, again, applying the PV and then haircut for recovery as an unsecured claimant this would be an additional $30 million recoverable claim value or another $1.50 per share. 

 

They do have $120 million in debt and about $90 million plus $40 million spare parts and $22 million in lease deposits that they would get back upon a rejected ASA.  The net number there is about nothing if you say their spare parts are with 50% of book.

 

So, in total, they would likely get about $10 per share in claim value for the lost contract.  It is said that Mohnish Pabrai, PNCL’s largest shareholder, recently pegged a $9.50 floor price at the Value Investing Congress.  What I’ve also gathered from two sources is that he didn’t factor in the debt of $120 million and instead reached his floor value by saying that PNCL has $4 in cash and sells for 2 times its “normalized earnings” of $2.50 to reach that floor estimate.  So, we have similar numbers, but he possibly uses a different and not admittedly not-so-understandable process to get to that floor value. If anyone has a better understanding of what was actually said, I would love to hear it.  He won’t talk to me about it!

 

As an added twist, with the recent attempt of US Air to take over Delta while still in bankruptcy, the possibility of NWA getting acquired adds some interesting uncertainty to the PNCL story.  NWA bonds have jumped above 80% from 65% before this possible deal was announced and NWA’s common has vaulted from under $1 to about $2.50.  The uncertainty it creates is that PNCL could be swept away in the consolidation.  With my estimate of the floor price, I think we are protected here.  But an interesting question to ask is what happens if PNCL, which is an efficient, low cost operator, gets a chance to be a regional partner with a larger combined NWA/United?  This could throw the entire upside northward.  So, I actually like the possibilities here.

 

PNCL stock appears to be well protected on the downside with the reasonable possibility for significant gains over the near term.  Certainty is right around the corner and I invite you to listen to the most recent earnings call and read the 10Q for more details.  They seem very confident in the future.  Over the past month, the floor value of PNCL has climbed along with the NWA unsecured bonds and despite the doubling of PNCL’s share price off its worst moment this past spring, it actually is a better risk-adjusted value now than it was then.  I felt it was worth a new write-up in light of these changes and timing.

Catalyst

Amended Agreement with Northwest is right around the corner
    sort by    

    Description

    In my opinion, the timing of this situation is getting very close to coming to the end.  Pinnacle was written up back on September 19th, 2005 by mark81 and the posting history is helpful in getting up to speed.  Since the uncertainty with Northwest is going to be reaching a conclusion soon and because I believe it has very limited downside along with a strong possibility for up to 40% in gains (and since its message board has pretty much died off recently), I think it is a timely idea. 

     

    After reading the previous idea post and messages, I hope the following additional information is helpful to backing up the claim that this is a safe and cheap stock.

     

    In a nutshell, the base case scenario for PNCL is that they do reach an amended ASA (Airline Service Agreement) with Northwest.  This is what I believe is going to happen.  Later I will attempt to value the floor price in the event that NWA rejects the ASA or that PNCL and NWA are unable to reach terms on an amended ASA. 

     

    Currently, PNCL has been contracted to fly 139 regional jets and are only flying 124 of them.  Under the current ASA, and they have been flying under this current ASA since the first day of the NWA bankruptcy, they make about $50 million in net profit or $2.40 to $2.50 in earnings per share. 

     

    Under an amended ASA, I believe it is entirely expected that they will earn somewhere between $1.25 and $1.75 per share.  The concessions they will give will likely result in a lower “targeted operating margin”, which now currently sits at 10%.  The reductions will probably result in lower aircraft rentals rates (now $175k per month that they then get to keep about $20k in profit (or 11.1% of $175k). They will also probably lower the aircraft fuel reimbursement or force PNCL to accept some fuel risk.  Those are the two biggest areas of cost savings to NWA. 

     

    Under and amended ASA, I also believe that PNCL will get to either work to diversify itself away from NWA by removing the exclusivity clause in the ASA or they will negotiate growth opportunities within NWA.  Or, of course, there could be a combination of both scenarios.  Why do I believe this?  NWA has ordered 36 Bombardier 75 seat planes already.  These CRJ-900s are not to be allocated to the new regional airline subsidiary, Compass Airlines that was created as a result of NWA Pilot negotiations.  Instead, they are to be allocated to a regional partner(s) to be determined later.  PNCL will likely be flying bigger planes for NWA.  Will they lose some 50 seat planes to get to fly the bigger versions, maybe, but if NWA is thinking about removing 50 seat planes from the fleet, then why would they be bringing back the 15 50-seat planes that they took away from PNCL last fall?  I think PNCL gets to grow in some way, either inside NWA or outside or both. 

     

    With this amended ASA that gives investors some earning stream certainty, PNCL likely would get a market multiple of 6 to 8 earnings.  Skywest, Rebublic and Mesa all get about 9 to 10 times multiples.  They are clearly more diversified, own their own fleets and are larger operations.  So, a discount to that multiple range is expected until PNCL is able to grow up to be a real live regional or get bought out by one.  At an earnings level of $1.25 to $1.75 per share with a multiple range of 6 to 8 times, the price of their ongoing earnings stream could be $7.50 to $14.00.  I choose to believe that the mid point is the most likely and using the lowest multiple of 6 times gets you $9 per share.  That is the ongoing earnings value.  But there is more here.

     

    In exchange for accepting such a reduced earnings stream under an amended ASA, I believe that PNCL will also receive an “unsecured claim” to compensate for their economic damages that suffered plus they will also receive an “administrative claim” that is paid in full upon signing a new ASA.

     

    The unsecured claim figures would be completely negotiated by NWA and PNCL, but here is a stab at what those two figures could be worth.  Assuming that they give up about $20 million per year in net profits for 11 years, we could expect that they could negotiate about half of this back.  In exchange for a new deal at lowered margins but with growth promised or allowed they probably would want due compensation for about $100 million in reduced profits over the term of the old contract.  The present value of this at an 8% discount rate would be about a $70 million unsecured claim.  The unsecured bonds are trading at about 80 cents.  The value of this unsecured claim then could be worth about $55 million or $2.50 per share.

     

    The administrative claim coming as a result of getting the net amount of what was owed to PNCL at the time of bankruptcy of about $55 million minus the $22 million in second month’s lease deposit that NWA is seeking, results in another $1.50 per share.

     

    PNCL does owe $120 million in debt and has about $90 million in cash plus another $40 million in spare parts and $22 million in lease deposits.  In my mind, that nets to $0 of extra balance sheet value.

     

    Added together, my base case value of PNCL with an amended ASA is about $13.00 or 35% higher than the $9.75 price today.  That is my base case. 

     

    Now, in the event (and I believe this is unlikely) that the current contract is rejected, either by NWA or PNCL and NWA cannot reach an acceptable deal, I see the situation unfolding as follows.

     

    In this situation, PNCL would seek an unsecured claim for the full value of the current ASA. The math I use in calculating the potential value of an unsecured claim is this: If they are only entitled to the 10% operating margin on the 139 aircraft leases for 11 years, this results in an entitlement of about $30 million each year from NWA. The present value of this $330 million (by the way, Mesaba has sought a similar amount already) in lost value is about $227 million at a discount rate of 8%. That rate is just a guess.  Again, this claim value is on par with other unsecured

    creditors and their claims are selling for about $0.80 today.  So, $227 million x 80% is worth about $180 million or about $8.20 per share in value.  This is for the lost contract alone.  And it only assumes they are entitled to $30 million of the lost $50 million in profits each year.

     

    To this, in liquidation, we can rightfully add their pre-petition claim of $50 million from payments that weren't made right before the NWA bankruptcy plus the year's worth of lost profits on 15 planes they were entitled to be compensated on during 2006.  So, again, applying the PV and then haircut for recovery as an unsecured claimant this would be an additional $30 million recoverable claim value or another $1.50 per share. 

     

    They do have $120 million in debt and about $90 million plus $40 million spare parts and $22 million in lease deposits that they would get back upon a rejected ASA.  The net number there is about nothing if you say their spare parts are with 50% of book.

     

    So, in total, they would likely get about $10 per share in claim value for the lost contract.  It is said that Mohnish Pabrai, PNCL’s largest shareholder, recently pegged a $9.50 floor price at the Value Investing Congress.  What I’ve also gathered from two sources is that he didn’t factor in the debt of $120 million and instead reached his floor value by saying that PNCL has $4 in cash and sells for 2 times its “normalized earnings” of $2.50 to reach that floor estimate.  So, we have similar numbers, but he possibly uses a different and not admittedly not-so-understandable process to get to that floor value. If anyone has a better understanding of what was actually said, I would love to hear it.  He won’t talk to me about it!

     

    As an added twist, with the recent attempt of US Air to take over Delta while still in bankruptcy, the possibility of NWA getting acquired adds some interesting uncertainty to the PNCL story.  NWA bonds have jumped above 80% from 65% before this possible deal was announced and NWA’s common has vaulted from under $1 to about $2.50.  The uncertainty it creates is that PNCL could be swept away in the consolidation.  With my estimate of the floor price, I think we are protected here.  But an interesting question to ask is what happens if PNCL, which is an efficient, low cost operator, gets a chance to be a regional partner with a larger combined NWA/United?  This could throw the entire upside northward.  So, I actually like the possibilities here.

     

    PNCL stock appears to be well protected on the downside with the reasonable possibility for significant gains over the near term.  Certainty is right around the corner and I invite you to listen to the most recent earnings call and read the 10Q for more details.  They seem very confident in the future.  Over the past month, the floor value of PNCL has climbed along with the NWA unsecured bonds and despite the doubling of PNCL’s share price off its worst moment this past spring, it actually is a better risk-adjusted value now than it was then.  I felt it was worth a new write-up in light of these changes and timing.

    Catalyst

    Amended Agreement with Northwest is right around the corner

    Messages


    Subjecttaxes?
    Entry11/20/2006 06:43 PM
    Memberotto695
    the 180M claim (8.20/share) if the contract is rejected you suggest would be before taxes, I assume or no? if so, would they have a tax bill on that which might change your floor?

    SubjectPabrai presentation.
    Entry11/24/2006 12:59 PM
    Membernorth481
    Just wanted to let those who care know that my earlier comments in my writeup on Mohnish Pabrai's floor analysis was not exactly what I heard from a couple of attendees who heard his talk.

    I now have the presentation in hand that he gave at the Value Investing Congress and while he does state that PNCL has $4.09 in "excess liquidity" and he says it's net PE Ratio is 2x based on its full current earnings, it does not imply that those two factors should be simply added to get to a floor value.

    Instead, he just presented that his "liquidation value" is $210 million or $9.55 per share. How he reached that $210 estimate is not clear from his presentation notes.

    So, I don't want to to leave the impression that he somehow reached his conclusion of the downside for PNCL differently that me - he may in fact have reached his conclusion quite similary.

    SubjectPabrai.
    Entry11/29/2006 01:54 PM
    Membernorth481
    Are you asking me if I know if he is a member? If so, I of course don't know although he does seem to be aware of the past VIC ratings on PNCL - so if he isn't a member, he certainly knows someone who is.

    SubjectTaxes
    Entry12/04/2006 05:51 PM
    Memberdiesel844
    I was wondering whether you have considered taxes into your liquidation scenario to get at the floor value? If so, what is the right way in your opinion?

    So when you go through the liquidation math of $227mm * 80% = $180mm or $8.20/share, do you then have to tax this distribution?

    If so, doesnt it reduce the floor value significantly?

    Thanks.

    SubjectMy apologies. I should have s
    Entry12/05/2006 12:08 PM
    Memberdiesel844
    My apologies. I should have seen the earlier post. As an FYI, my liqidation NPV is also ~$230mm, but I assume a "normalized" EBIT stream based on what it looks like 2006 EBIT will be, and then step down to an an 8% "market" margin beginning in 2008. I then use a 15% discount rate and assume a 65% recovery. I know this is below where the unsecured claims are trading after the USair bid for Delta, but I want to be conservative and so have taken it back to the pre-bid level. I also know that the discount rate is a guess, but I think that 8% is just too low given all the uncertainty. I also make an adjustment for the 15 incremental planes that they should be flying this year but arent. On a pre-tax basis, this works out to $7.58. Taxing it at 35% reduces this to $4.92. I agree that there may be some offsetting adjustments to the tax liability that would reduce it. I am waiting for the company to get back to me on this. But absent any adjustments, it seems to me that the tax liability issue makes the downside in liquidation significant when added to the net of the other claims and assets vs. liabilities. Also, I think my valuation represents a "ceiling", as I think it is a reasonable basis from which PNCL would argue the value of the contract. NWA would likely negotiate this number down.

    SubjectWorth more than 18?
    Entry12/22/2006 08:29 AM
    Membernorth481
    Thanks. Timing was everything here and we did own it for a while so this feels really good. Based on quick math, with the claim amount and now some possible growth - it is probably worth north of 18, but I really don't want to think about it right now - time to feel happy and stupid - at least for 15 minutes.

    Subjectnew agreement
    Entry12/22/2006 08:53 AM
    Memberotto695
    what do you think the value is now given new agreement? thanks for the idea.

    SubjectA Stab at Value.
    Entry12/22/2006 01:14 PM
    Membernorth481
    I think the stock is worth $18 to $20 based on what I see here. There are factors that could push it north and their are things that can cap it. So, this is my best estimate now.


    Subjectagree w/David, but more upside
    Entry12/22/2006 02:43 PM
    Memberotto695
    i agree with david's math, but suggest, pncl could attract closer to an 8 multiple (rather than 6) given possible growth opps which didnt exist before. So, I am suggetsing 23.50 as possibility here.
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