March 2004 Northwest’s 10% Solution By Richard Daverman
Maybe Memphis-based Pinnacle Airlines is the safest airline investment you could ever make. Or maybe its business model is a communist plot.
Or perhaps the best way to look at Pinnacle Airlines is as an extreme example of out-sourcing—an airline (Northwest) contracts with another (Pinnacle) to do its flying. If this seems strange, consider the business model for this regional airline. It’s also just a little different from what you might expect.
Because of its contract with Northwest, Pinnacle doesn¹t depend on passenger revenues to make a profit. All the ticket money goes
to Northwest, the former owner of Pinnacle. Pinnacle flies many
of the spokes in Northwest’s hub-and-spoke arrangement of flights. (Pinnacle flies out of all three Northwest hubs: Memphis, Detroit, Minneapolis.) In other words, Northwest gets to fly the long routes in large aircraft, while Pinnacle flies the short hauls in smaller ones.
Furthermore, Pinnacle doesn¹t care if fuel costs go (even further) through the roof. Or if fares for flights drop out of bed. Because Northwest reimburses Pinnacle for all its expenses and pays the company an extra 10% for its trouble. A cost-plus contract.
Should you invest in this company? Though its industry is a poster child for risk, Pinnacle¹s business model passes most of that to Northwest. And Pinnacle has decent prospects for growth inside its fairly well-defined niche. Besides, it is a low-cost provider of
an important commodity. So, Pinnacle definitely merits a look.
Flying as Northwest AirLink, Pinnacle offers Northwest an economical
alternative to its own high-cost structure. Everyone knows that pilots make a lot of money. But it is less well known that only major airline pilots make a killing. Working for regional airlines is much less lucrative.
For example, a beginning Pinnacle first-mate makes only about $19,000. As a captain, he or she will do better, with an average salary of about $60,000 and a max of about $110,000. Still, this is very “competitive” when compared to Northwest’s scale, where a 12-year captain flying wide-body aircraft earns $240,000.
For that and similar reasons, Northwest is happy to pay Pinnacle 10% over its costs. Pinnacle’s lower cost structure is its reason for being, according to Doug Abbey, partner with Velocity Group, an industry consultant.
Even though much of the contract is cost-plus, Pinnacle still must bid for access to aircraft that Northwest rents. Pinnacle guarantees Northwest a rate for all the costs it does control‹things like people, processes and procedures. The other things—fuel, aircraft rental, maintenance, landing fees, insurance—are transacted on a pass-through basis.
Does this mean that Pinnacle has locked in a 10% profit? Not quite. Taxes must come out of the operating margin, leaving profit. Currently, taxes take about 40% of the operating margin, leaving Pinnacle with a 6% profit on its revenue.
Technically, 65% of Pinnacle’s revenue is strictly pass-through. The other 35% is reimbursed according to the number of hours the airline flies and the number of take-offs/landings it performs. In the airline industry, when a major carrier contracts to pay a regional for its flights, the model is called capacity purchase, and Pinnacle’s contract is similar to the model used by other semi-captive regional airlines like Sky West and Express Jet, which operate as regionals affiliated with a major.
At first blush, this business model may seem almost anti-capitalistic. After all, Pinnacle isn¹t rewarded for being efficient, but remember that the company must make the initial bid on 35% of the cost.
In this model, to increase its profits, Pinnacle must fly more hours. This increases revenue and proportionately increases the 10% that comes to the penultimate line.
Thus, in a way, Pinnacle is a safe investment. It will make a predictable profit.
Further, it will grow. Northwest has promised Pinnacle a fleet of 129
airplanes, up from its current 81, by mid-2005. That represents a compound growth rate of 24% (figured from its initial public offering in November 2003). Northwest has options on an additional 175 jets, for delivery after 2005, and probably will make a decision on them by late 2004. In other words, for almost two years, investors have clear visibility on earnings growth. After that, Pinnacle continues to have growth prospects, but there’s no guarantee on them—no different from other companies in that regard.
It may seem strange that Northwest/Pinnacle wants to expand at all. Since 9/11, the airline industry has found itself with too much capacity. Pinnacle’s niche is the difference. Flying smaller, but very efficient jets, Pinnacle serves smaller cities. It can do so because of its 44- and 50-seat planes. “Nobody’s ever gone broke
flying smaller aircraft,” says Phil Trenary, Pinnacle’s president and CEO. If it serviced these smaller cities with larger planes, Pinnacle wouldn’t make money.
Industry reputation aside, all airlines aren’t dummies—the fragmented nature of the market is well known. So-called low-cost companies like Southwest and JetBlue (which have point-to-point route maps) are making money, and so are the regionals. For a few years, there were so many regional jets on order, some observers doubted the market could absorb them, according to Joseph Sweiterman, an observer of the airline industry at DePaul University. While not dummies, airlines do
tend to use price to get market share, much to the detriment of their
shareholders. Nevertheless, the overcapacity questions have passed as orders have declined to more normal levels.
In the airline business, it’s expensive to take off and land. Longer routes are inherently cheaper to run. And bigger airplanes are less expensive per seat than smaller ones—but only if they are filled. Ideally, the size of the plane is tailored exactly to the need. That’s where Pinnacle fits in. Pinnacle makes a lot of money for Northwest, flying small planes to smaller cities with a less expensive cost structure. The exact amount, however, remains a secret.
To get to this profitable point, Pinnacle has made a remarkable journey. Northwest bought Pinnacle, then called Express Airlines, for a relatively paltry $33 million in 1997. At the time, the airline flew a rag-tag bunch of Saab turbo-props, which were known for both their dilapidated interiors and chronic lateness. Northwest brought in Trenary, once the CEO of Ft. Worth-based Lone Star Airlines, to overhaul operations. Pinnacle became the best (most on-time) and most efficient (lowest cost) operator of Saab aircraft. Over the past few years, Pinnacle has gotten rid of its Saabs, replacing them with sleek Bombardier twin-jets, complete with very up-to-date winglets that
make the aircraft more efficient. The new planes, absent the old turbo-prop noise and knock-your-fillings-loose vibrations, resemble full-size commercial aircraft, and being faster, they are capable of flying longer routes than the old turbo-props. The pilots affectionately call them lawn darts, a tribute to their agility.
Next, in 2003, Northwest decided to spin off its now-spiffy, all-jet
Pinnacle subsidiary. Like other airlines, Northwest was in post-9/11 trouble and wanted to preserve cash. Instead of making a cash contribution to its employee pension plan, it gave the pension 88.6% of the outstanding shares of Pinnacle. Understandably, Northwest wanted to avoid the bankruptcy axe that befell its compatriots, United and US Air.
The employees, seeing that a Northwest default would render Pinnacle
worthless (too few people get fed into the three hubs), wanted the company to go public—it preferred cash, not a potentially worthless (à la Enron)bunch of stock. So the company did its IPO, in a fairly hostile market, with 88.6% of the cash raised in the IPO going to the pension plan. (Northwest holds the other 11.4%.) Pinnacle got zip.
In fact, Northwest took cash out of Pinnacle before it sold the company. It issued itself a $200 million dividend, in the form of a note, which Pinnacle must pay off. Subsequently, Northwest forgave $50 million of the debt and offered the company an additional $50 million revolving credit agreement so that Pinnacle would have the cash to operate. Pinnacle still owes about $120 million to Northwest, plus it has about $10 million out on the revolver.
Even though Northwest made a $299 million gain on Pinnacle’s sale—a
combination, apparently, of the loan and its gain on the gift to the pension plan—Northwest still needs to cut costs. The airline lost about $565 million from continuing operations in 2003 and is looking to cut about a billion dollars out of its costs—specifically, its employee costs. Like the other majors, it has a sometimes contentious relationship with the unions.
Thus, it’s not surprising that Pinnacle’s contract with Northwest contains a clause setting the entire contract aside if Pinnacle’s unions shut down the airline to 50% of capacity for 10 days or 30% for 20 days.
For their part, Northwest’s pilots union engineered a protective clause in Pinnacle’s contract. With the advent of the all-jet fleet, Pinnacle could conceivably fly all of Northwest’s shorter routes. The new jets have considerably longer range than the old Saabs and could encroach on some middle-length routes, currently being flown by Northwest. By provision,however, Pinnacle is limited to planes that carry fewer than 60 passengers (their Bombardier twin jets seat 44 and 50 passengers), making them less desirable—and more costly per seat—than larger planes flying between major cities. In other words, the unions are very active as they seek to protect their turf.
So, to some extent, Pinnacle is not captain over its own fate. Northwest is. Trenary avers that the business model creates no conflicts of interest between Northwest and the smaller regional. Maybe so. But to protect its interests, Northwest also issued to itself one share of preferred stock, the only such share of preferred stock issued. That share confers on Northwest the right to veto any takeover of Pinnacle or other combination with some other entity. It doesn’t make Pinnacle seem entirely autonomous.
No matter. In the future, Pinnacle will make its 10% margin, but we don’t know how much revenue it will make 10% on. Northwest may rent more airplanes after 2005, but Pinnacle will have to live with Northwest’s choice, whichever it is.
“If Northwest exercises its options on the next Bombardier craft, that would be our first choice for growth,” Trenary explains. “It’s easiest. We have the infrastructure in place.” Of course, Northwest could elect to allocate the jets to Mesaba Air, a company that, much like Pinnacle, provides air service to Northwest under the AirLink name. So far, however, Mesaba hasn’t received any jets from Northwest, and Mesaba¹s relationship to its unions is more troubled than Pinnacle’s.
If Pinnacle receives no jets from Northwest, Pinnacle will have to look
elsewhere, toward other carriers, to get bigger. There is a small problem with this. In its contract with Northwest, Pinnacle must show the numbers it proposes to other airlines. If they are lower than the ones Northwest receives, Pinnacle must cut its costs to Northwest. “There are some carriers that are excluded because they enjoy ‘most favored nation’ status,” says Trenary, but the provision holds for the rest.
Pinnacle doesn’t have much cash to grow. After all, it didn’t get any of the IPO, and it is saddled with $150 million in debt (it has paid off $30 million so far). Thus, Pinnacle sports a negative net worth of $58.2 million. It must pay down $12 million of its Northwest debt each year. Once its cash flow climbs over $50 million annually, the excess cash must go to Northwest. Using these numbers, William Greene, an analyst with Morgan Stanley, which brought the company public, estimates Pinnacle will pay off the note by 2007.
Until that time, it will have a hard time raising the cash it needs to
Expand—if the expansion is going to be outside Northwest. It won’t be impossible, just more difficult.
In 2003, Pinnacle earned a $35.1 million profit, equal to $1.60 per share. With a stock price hovering around $15, it sports a P/E of 9.3. Given that it expects to earn $2.15 in two years—with a fair degree of certainty—it will have a P/E around 7. That’s downright cheap, compared to the rest of the stock market, though you must subtract something from the average market multiple because of the pall that hangs over the airline industry. If you compare it to other regionals, it’s about average, airline stocks not falling into the “much-loved” category lately.
Past that, things get murkier. Since the company doesn’t have much in the way of assets (everything is leased), Greene of Morgan Stanley figures the present value of the cash Pinnacle will generate—based only on its promised 129 planes from Northwest—then subtracts the money it owes to Northwest, and finds the present value to equal $15 per share. In other words, the market isn’t looking for Pinnacle to grow past the 129 jets, or to continue as a viable business when its contract with Northwest ends in 2017. Doing the same analysis for competitors Sky West and ExpressJet, he finds the same situation with Sky West, but a fairly substantial terminal value for ExpressJet—equal to about 44% of
its present capitalization. If you put Pinnacle halfway between these two,the market value of the stock should be about $20.
Voodoo economics, perhaps. Nevertheless, Pinnacle is undeniably a strange bird. Its revenues are safe, but its growth is limited and largely determined by Northwest. Trenary makes the point that Pinnacle’s future is probably no different from other companies: it isn’t known. An investor must like the company and the industry. From Trenary’s perspective, if you think regional airlines have a future, then Pinnacle is a buy. He’s probably right.
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