delta airlines photoElie Rosenberg is a value investor based out of Dallas, Texas. He is the founder and editor of Value Slant

Pinnacle Airlines (PNCL) operates regional flights, mainly for Delta and United. The stock has gone from $8 to $2.30 over the past year as they have experienced a variety of expense increases that have decimated profits. While the stock has been left for dead, there are several catalysts in the form of contract rate resets on the horizon.

Regional airlines such as Pinnacle operate short haul flights under the banner of major carriers like Delta. The typical arrangement is a multi-year “capacity purchase agreement” in which the major carrier guarantees a fixed fee payment per hour flown as well as reimbursement for some variable costs, most notably fuel. This should provide the regional carrier with steady business that is not subject to the passenger load or fuel price risk that plagues the airline industry.

The regionals boomed in the 90s with the proliferation of regional jets that replaced the prop planes previously used to fly short routes. The main advantage the regionals have is cheaper labor than the legacy carriers who have to deal with stronger unions and a more senior labor base. The regionals can operate the shorter routes more cheaply than the majors, and the majors use the regionals to feed passengers from smaller cities into their large connecting hubs.

While the regional airlines have grown to now fly almost one in every four air passengers in the US, they are facing a variety of challenges. At higher fuel prices shorter routes become less economical and many major airlines are eliminating routes typically outsourced to regionals. This has also led to a partial reconfiguring of the traditional hub and spoke system, which hurts the regionals as they bear the expense of moving around flight crews to meet the major’s demands. And as the regionals age, both the maintenance expenses on older planes and labor costs of a more senior work force go up. There still appears to be a place at the table for regionals, but it will consist of larger planes and longer routes. Drastic changes to the fleet and network will be hard to deal with while experiencing sharply declining profitability.

Pinnacle’s results year to date are a microcosm of the industry’s headwinds. Operating income was down $35.1 million YoY through the first three quarters of 2011 despite revenues increasing nearly $200 million due to the Mesaba Airlines acquisition. PNCL has highlighted the following hits to operating income:

  • $16.1 million due to “crew-related expenses, including premium pay, hiring, training, and crew overnight accommodations, as a result of the distribution of our crews across the network due to partner schedule changes and the expenses associated with staging impacted crews at various destinations”. This is mainly due to Delta network changes.
  • $13.7 million due to a new labor agreement with the pilot’s union.
  • $8.5 million in expenses relating to integrating the Mesaba acquisition.
  • $4.5 million due to a dispute with Delta regarding engine maintenance reimbursement.
  • $4.4 million due to performance penalties stemming from inclement weather as well as network scheduling changes.
Pinnacle does have the following rate increases from Delta coming in 2012 (with estimated dollar amounts):
  • PPI increase- $13 million
  • Rate reset for higher pilot labor costs- $13 million
  • 1 time payment for pilot training/displacement resulting from Mesaba acqusition- $18-20 million
Pinnacle will still be dealing with the Mesaba integration and pilot retraining expenses next year. So even with those payments they will probably only hit about break even in earnings before taxes, unless new CEO Sean Menke can drive some cost efficiencies as they combine their current three operating airlines into two. (Earnings before taxes is a rough proxy for free cash flow as D&A approximates the effective maintenance capex of amortization on plane debt, and Pinnacle is not a cash tax payer due to accelerated depreciation on their planes.)

In January 2013 Pinnacle is due for a contractual rate reset on their two largest contracts- the Pinnacle CRJ200  and Mesaba CRJ900 contracts with Delta. These contracts were structured to yield an 8% pre-tax margin for Pinnacle based on their costs at the time of the contract inception. The rate resets are meant to realign rates with Pinnacle’s actual costs to yield the target margin. Pinnacle missed out on their last rate reset due to Northwest (the original contract counterparty before they merged with Delta) going into bankruptcy, and clearly the current rates do not get them even close to 8% margins. In theory this rate reset should bring PNCL’s EBT margins up to 8%  for about two-thirds of their $1 billion in revenue. So even if they can just break even on the rest of their business they should earn $50 million in free cash flow in 2013. PNCL has a current market cap of $45 million, so that would less than 1X FCF!

What is the catch? While you might guess the balance sheet, and it does look bad at first glance, I don’t think that is the major risk. Pinnacle does have about $800 million in debt, but all but about $40 million of that is secured by their plane assets. And while they also have operating leases, the planes flown for Delta are putable back to Delta if they should walk away from the contract.

I think the larger concern is PNCL’s relationship with Delta. Delta has been phasing out their 34 seat flying as smaller planes becomes markedly inefficient to operate with persistent high fuel prices. And it is no secret that the 50 seaters such as those employed on the CRJ200 contract are next. I doubt Delta, who has been very aggressive with PNCL on much smaller issues, will readily acquiesce to an above market increase in rates for routes that are probably not very profitable for them. The rate increase is contracted, but of course everything is subject to negotiation, especially when one side has most of the leverage in the relationship like Delta does. My guess is that the sides will negotiate a settlement to phase out the 50 seat business in return for Delta promising PNCL a contract for 70+ seat flying. In the nearer term,  it remains to be seen whether PNCL can deal with the constant network changes the majors are hoisting upon them and whether they can efficiently integrate Mesaba. CEO Menke does have a very good reputation in the aviation industry, and many think he can right the ship.

With PNCL one of the few big regional players left (along with Skywest and Republic) I think they have a good shot of being a viable entity once the industry figures out a new workable model for the major/regional relationship. If Menke can reorganize their cost structure and come to terms with Delta then this could be a home run. The next few quarters’ numbers will still probably be ugly, but I will be on the look out for progress on these fronts.

Disclosure: No position