Delta Ends Contract with Pinnacle: What's the Impact on Regional Carriers?

Backround

On April 17, 2007 Pinnacle (PNCL) and Delta (DAL) signed an airline services agreement for which Pinnacle would fly 16 CRJ-900 jets for Delta. The CRJ-900s began being delivered to Pinnacle in December of 2007. Currently it has 9 of 16 planes in operation. On June 10th Pinnacle announced that Delta wants to exit the contract citing poor on time performance. Pinnacle will have to take the planes out of service by July 31. I have a few observations to make about this development:

Delta doing whatever it can to get out of contracts

With the increasing gas prices the airline industry is in a crisis and the major airlines are looking everywhere for places to cut costs. One way would be to cut the contracts with their regional carriers if they are unprofitable. Attempting to cut the contracts with the regionals is unsustainable for the major airlines because regionals fly passengers cheaper than the major carriers could (lower wages and pension obligations), but the majors want to focus on larger planes that drive more revenue and passengers transfer to and from longer routes via regional airlines.

I believe Delta is so desperate that it is attempting to cut the contracts with its regional carriers. I believe this is what the company is doing because it tried to cut its contract with Mesa Airlines’s (MESA) subsidiary Freedom Airlines earlier last month but that attempt was thwarted when Mesa won a federal court injunction and was able to keep flying.

Delta has said it has the right to terminate the contract with Mesa’s subsidiary Freedom Airlines because Freedom did not maintain at least a 95 percent completion rate for three months within a six-month period late last year and early this year. Delta obviously wants out of these contracts if it is willing to cite both Mesa and Pinnacle for minor and temporary operating issues that both carriers don’t have any control over.

Pinnacle’s legal rights

Pinnacle’s CEO said Pinnacle plans to "pursue appropriate remedies." Under the ASA either party can terminate the contract if one of the parties breaches any of the requirements listed in the ASA. This is the item in the ASA that Delta claims that Pinnacle breached "(vi) Operator fails to achieve any of the Operational Performance Standards set forth on with respect to the Delta Connection Flights during any two consecutive months or three months during any consecutive six month period;" Delta said "Pinnacle's operational performance has fallen below minimum levels required under the contract."

In the last call and in the 10Q Pinnacle Management said that they are no where near the minimum operating requirements which doesn’t make sense based on what Delta is saying.

Here is what Pinnacle said in the press release:

Delta contends that Pinnacle did not meet minimum arrival-time performance requirements for a period since flights began late last year. However, many factors affecting on-time performance are beyond Pinnacle’s control, said Phil Trenary, Pinnacle Airlines Corp.’s president and chief executive officer. The operational schedule created by Delta is a key factor affecting on-time performance, he said. Under the capacity purchase agreement, Delta is required to collaborate with Pinnacle to create a mutually acceptable operating schedule. Delta has created Pinnacle’s operational schedule since the beginning of operations in December 2007.

From the very beginning of our Delta Connection operations, we expressed our concern that the flight schedules Delta created were unrealistic. Our position was affirmed when recent schedule changes by Delta allowed immediate improvement in our on-time performance, well above the agreed minimum standard and above most other Delta Connection carriers.

"We believe that the attempt by Delta to terminate this contract is wrongful, and we intend to pursue appropriate remedies," Trenary said.

That is why Pinnacle kept reaffirming that it was no where near the minimum operating requirements. If Mesa was able to stop Delta from canceling the contract for completion rate then I think Pinnacle will have a strong argument in court based on what Pinnacle said above.

It will be able to argue that the poor performance was due to one of the worst spring and winter weather patterns for airlines in decades, which is obviously out of the company's control, and that Delta scheduled unrealistic routes while not collaborating with Pinnacle on routes, so in effect Delta broke the ASA as well. Once Delta made scheduling changes the on time, performance improved immediately, was above the minimum and was better then many of Delta’s other carriers which shows it wasn’t Pinnacle’s fault.

How will the loss of Delta affect Pinnacle?

First off, how much in free cash flow will Pinnacle lose? Going back to my original analysis, I concluded that Pinnacle should be able to generate $70-90 million in FCF in 2009. The amount of 2009 FCF that will be lost if the CRJ-900s are taken out of service is $14.1 million, hardly a life sentence. If the $14.1 is subtracted from my $70 million estimate, Pinnacle should still generate at least $55.9 million in FCF. Since Colgan is having some trouble, if you want to be very pessimistic you could subtract that too and it still leaves just over $50 million in FCF for 2009.

Under Pinnacle’s purchase agreement for the CRJ-900s, Bombardier won’t deliver the planes unless the contract with Delta is in full force. So, after July 31 Pinnacle will look to put these planes into service with another carrier. If it can’t it is stuck with $36 million a year in principal and interest on the planes. Pinnacle will still have plenty of cash and FCF to cover this. This is not what investors should be worried about though.

If the Delta contract were to be canceled, a default under one of Pinnacle’s credit facilities would occur. It is just the debt that is related to the purchase of the CRJ-900's and the pre-delivery deposits. The amount of debt that could default is $200 million.

Pinnacle has $76 million in cash and $126 million in illiquid auction rate securities. Pinnacle will have serious trouble coming up with $200 million. The ARS could be sold for a loss of just under $10 million but Pinnacle has $60 million borrowed against them eliminating Pinnacle’s chance at coming up with the $200 million.

If Wells Fargo (WFC) wanted to, it might be able to force Pinnacle into bankruptcy. But, Pinnacle will be able to show that it could meet the interest payments even if it is unable to put the CRJ-900s into service with another carrier.

Also, in bankruptcy, Pinnacle would lose its other contracts and that would be bad for Wells Fargo. Why would Wells Fargo want to push Pinnacle into bankruptcy if Pinnacle would be able to make the interest payments? The possibility of a Pinnacle bankruptcy cannot be overlooked though.

The worst case scenario would be a Pinnacle bankruptcy. To get there, Pinnacle would have to fail to get a court injunction against Delta and then Wells Fargo would have to deliver the default to Pinnacle. I have reasons that I went through above that show why Pinnacle has a good chance of getting a court injunction against Delta and if that doesn’t work, reasons why Wells Fargo wouldn’t want to push Pinnacle into bankruptcy. But I’m not even close to ruling out the worst case scenario.

To get a possible liquidation figure I took book value + deferred revenue-intangibles-goodwill-debt issuance costs-deferred income taxes and came up with $155 million or about $7 per share. But a good chunk of the assets are in aircraft that are basically brand new. If the aircraft are sold for 10% less then they’re on the books for that would bring my liquidation figure to $120 million or $5.21 per share. This is still $50 million above today’s trading price but of course there would probably be more write downs in bankruptcy and a lot of expenses also.

I will continue to hold my shares because in looking at the possibilities of what might play out, the worst case is bankruptcy and in that case it’s probably not worth much less that what it’s trading for. I do think the odds of bankruptcy are low. I see a good possibility that Pinnacle is able to continue operating and in that situation Pinnacle is worth way more than it’s trading for.

It will most likely come down to what oil prices do. If they continue to rise, then that increases the risk that Pinnacle’s other customers will want to get out of the contracts. If Pinnacle continues to operate, it should be able to do about $50 million a year in FCF.

Comments

[MadDog]

You are very incorrect when you state that the regional airlines carry passengers cheaper than the majors. Wages and pension obligations may be lower per employee at the airline but when you spread the cost to each passenger, the cost is higher...but a more salient point is the exhorbitant cost of fuel that these small planes utilize per passenger per mile. Overall, the cost per available seat mile at Pinnacle (and other regionals) is MUCH higher that Delta.

[Vaiolation]

Michael Boyd saw this coming a long time ago when he predicted the desert would be filled with RJs due to their inefficiency and major carriers shifting back to larger aircraft.

[Diver92]

The author has a very good understanding of the debt and credit issues regarding the regionals, but a very poor understanding when it comes to RJ operating metrics. Simply look at the CASM of any RJ operator to see that it is not even in the same ballpark in terms of cost efficiency vs mainline operations. The day of the RJ and the RJ operator making fortunes on the backs of major airlines are over.

[AirlineAnalyst]

I agree with some of the other comments. This writer is way off base when it comes to understanding costs, specifically fuel CASM. How does someone get such summations published?

And who actually owns these aircraft and continues to pay or attempt to dump the leases? What about the painting/repainting and storage or other transition costs? I don't think the article addresses this either.

[xavier]

The above comments are right on the mark. In addition, the Mesa injunction is not an end all, it just delays the termination of the contract until the court hearing, when the issue will be decided. Not a save for Mesa at all.

[noeffortj]

please when stating that"regionals fly passengers cheaper than the major carriers could (lower wages and pension obligations), " please provide direct comparisons because you are way of base!

[FlyMyCRJ]

I used to work in Planning for a major airline, and I can attest that DL "forces" carriers into unrealistic schedules. They also have a computer system that figures out which flights to cancel during irregular operations - it factors in revenue, number of passengers, historical data on the flight, etc... and guess which flights gets hit most? This is one of the Mesa arguments, including the JFK Freedom ops - those were a disaster from the get-go, and not necessarily Mesa's fault... when you schedule a plane for 40 minutes, the airline tells them they need 120, Delta baulks & kicks and screams like a child, forces the airline to schedule it for 40, and then what happens when it in fact does take 120 minutes? Does Delta kiss and make up, no, it blames the regional.

the major airlines are why regionals are failing, not the regionals themselves.

[Capt X]

They burn HALF the fuel of a 737, but carry 1/3rd the amount of people. Do the math. ps, not many people care what YOU believe.

[dbornh]

Like what we read everyday is the real truth!! Just a part of a long term strategic plan that we are not going to be told. First of all.... those people who say a RJ cost more per ASM are correct. However, why put a 737 on a route that can only support an RJ? Thus, the reason RJ's exist - duh. Are they going to the desert, doubt it. Probably China and India though.... or maybe Delta can get a sweet deal on them and have Comair/Skywest/ASA fly the 900's when the market is flooded with them. Time will tell, but I wouldn't believe Michael Boyd or the news we read, all rubbish.

[Gman5000]

As xavier mentioned, Freedom/Mesa got a preliminary injunction against Delta to maintain the status quo on the 50-seat flying until the court hearing. And the Freedom 76-seat flying is not affected. Nothing has been decided there on the 50-seat flying, so it does not in any way portend what will happen with Pinnacle. Pinnacle is also different in that they're flying 76-seat RJ's with First Class seating. Delta wants to rid itself of 50-seat RJ feed, as well as the number of Delta Connection carriers, and it wants to sub out 76-seaters for 50-seaters where it can. So it rids itself of Pinnacle in this situation and gets rid of a Delta Connection carrier. Here's my guess as to what happens. Delta and Pinnacle settle and Delta takes the 76-seaters from Pinnacle and gives them to another Delta Connection carrier. Why will Pinnacle agree? One, all of the default issues cited in the article. Two, and more importantly, Pinnacle is a major Northwest Airlink partner and receives a substantial portion of its income from Northwest. Delta will own Northwest in 6 months. It's better for Pinnacle not to bite the hand that will feed it.

Why will Delta agree to take 76-seaters when they're trying to reduce RJ lift? Remember, Freedom continues to fly for Delta the same 76-seaters as Pinnacle. Might Freedom settle with Delta and agree to reduce the 34 50-seaters that are the subject of the dispute, with Delta dangling a carrot of 16 more 76-seaters to add to the 14 Freedom already flies for Delta? Notice Delta didn't take this action against Pinnacle until after the Freedom injunction. Might this be "Plan B" for reducing 50-seat lift with Freedom while also reducing another Delta Connection carrier by removing Pinnacle?

[Gman5000]

One other thought. The author clearly understand finance issues better than airline industry management. Regarding the comment about RJ's being cheaper at "regional" carriers than mainline b/c of pension and salary issues, I think the author is repeating what he/she has heard elsewhere and it is out of context here. Of course ever since jet-A went over $1 a gallon (now $3.50/gal and rising quickly) the CASM on RJs has been higher than mainline aircraft, so it is cheaper to carry passengers on mainline aircraft. But regarding the pension/salary component of his comment, it is cheaper for these "regional carriers" to fly the same size jets (in this case 76-seat CRJ aircraft) than it is for Delta mainline to fly the same 76-seat CRJ aircraft. So in that since the author is right, and that's the only reason pension/salary issues at "regional" carriers has any relevance, but I don't think he really understands the airline management side of the equation so this comment is almost unrelated to the point of the article.

Bottom line: Delta (and other carriers) are trying to reduce capacity and quick, and first priority is to get rid of 50-seat and smaller jets as soon as they can. As I mentioned previously, I think this Delta move against Pinnacle is to reduce a Delta Connection carrier (Pinnacle) and then take those 76-seat aircraft and use carrot/stick to get rid of more 50-seat aircraft at other DCI carriers (Freedom) in exchange for giving that other DCI carrier these 76-seat aircraft that Pinnacle has been flying. Delta needs these 76-seat aircraft given the gaping hole in the capacity of its fleet (next biggest a/c is 142 seat MD-88s), and the cost on 76-seat CRJ-900 is far better than 50-seat RJ lift. Delta is desperately trying to reduce 50-seat flying, and I see this as a strategic move toward that end.

[flight3425]

Do you think Pinnacle wanted out of the contract. Pinnacle lost its case against ALPA with Colgan to Merge Seniority list. If Pinnacle has to merge list with Colgan, it could loose contracts with Continental Airlines due to scope. So why not ask Delta to release it from its contract and try to sell a/c to get around its Pilots union! In the long run it will save contracts and more money! I think this was all done to squash it pilots unions win over seniority and contact rights!

[Dldriver]

Dbornh,

While it's true that some markets only support an RJ, not 737's, that is partially true. The problem is that airlines have put in 5,6,or 7 RJ frequencies a day to markets where we used to fly 3 FULL 727's or 737's. With the cost of fuel, that's just not working anymore. As you readily admit, the CASM is MUCH lower on the 737, so we need to get back to the most effecient way to carry those people in those markets. 2-3 frequncies a day on 737's! The tired old phrase we always hear, "The business traveler demands frequency!" is just not viable with Jet-A north of $4 a gallon, period. I only hope my airline wakes up in time to reverse this moronic system.

[TXnews-Master]

While we see the airline industry losing power on take off, it amazes me to speculate about regional flying and not notice that charter like airlines such as Sun Country might survive. The truth is that we could see Sun Country Airlines dissolve by end of summer. Northwest Airlines has monopolized the midwest and has turned Minnesota into a grobling state begging to give them more money only to stay. Meanwhile Delta has brainwashed the rest of these bloggers into a frenzy of regional loss. This is not true. Pinnacle Airlines has continued to deliver what they promise and stand true to under an ASA. Airlines like Air Tran, Sun Country keep trying to maintain while this is all taking place. Don't you see what is happening? The new NWA also called "Delta" is shifting debt to these low cost carriers as far as routes go. Now I beleive in strategy and equality. However, NWA and Delta have the same model to strip competition by taking a perfectly great regional like Pinnacle and leaving them to fend while combining a route structure that will leave thousands jobless and the governement with the bill. How does any of this make sense? It doesn't! We need to support regional flying and keep the playing field fair while focusing on safe aircraft rather than fighting in courts all day long when we could be spending money on the safety, security, and efficiency of our airline industry. This will become more clear to people putting down regional flying as unefficient! The real fact is that regional flying does work when the airline scheduling them knows how to schedule them! That is the bottom line! How can you say that they cost too much when you schedule them to fly 3 hour segments? They were meant to stay local and scheduled under 2 hours. A 50-seat rj will accomodate small cities that need the frequency to do business or expand business to keep the economy rolling. Frequency is key to attract fortune 500 companies into these cities. They won't come if an airline doesn't support. Wow what a concept. With fuel rising, maybe its time to take a 50-seater between 250 miles 6 times rather than 700 miles twice. Any thoughts? People in small, small, small towns can equal big profits for major cities and create jobs by the hundreds of thousands. 76 - seat rj's are good for just over 2 hours maybe 2 hours and 15 min because then they become costly when a 165 seat 737 can accomodate over double. It still makes sense to think how many are coming out of a city so this all falls under research and a better model to connect. Direct flights should become more common to destination rather then hub and spoke. Hub and spoke fails more often than succeeds. So there you have it! Lastly, advice to people buying airline tickets, think about the airline you are booking on before you buy since they could be out of business soon!!!

[Philip- CA]

Okay its time to blind the public again! If you have never seen the greedy devil before then look no further than the CEO Doug Steenland. His decision to cut Pinnacle Airlines from aircraft because they decided to try and pursue more flying to stay in busniess is absurd! All airline crews are now comfortably deceived and will remain that way until the flying public does something to change this. NWA has bullied for the last time and I really believe this airline will not only be liquidated even after a merger but only then will the good people who work for them figure out that you can't trust an airline ever again. No city, no state, nowhere!!! If we ask our government for anything it should not be money but laws in place to stop these kind of crimes by CEO's. Decisions based under false pretense and nothing to back it up leaves liars in suits. Why does an airline that put itself in bankruptcy get to call the shots and take bonuses? The reason I bring this up is because it has everything to do with Pinnacle losing footing in the twin cities and they were the only regional that served the best on-time performance among any regional. Mesaba could not even compare. Compass? What a joke! I call to the Legacy carrier who wants to stay strong in business to pick up Pinnacle Airlines and let them help you soar through tough times while these other guys watch and catch your vapors. Plus JD Power and Associates awards will not only prevail but other rewards such as public views and trust! The legacy carriers seem to not understand what it takes to run an airline but into the ground! If you take a plane out of service, then you lose revenue even if fuel prices are high. If you keep a plane in service you win, because the cities you are flying to depend on where they should place an office or warehouse or hotel or convention center or manufacturing plants. This will become more apparent when you change your structure to keep smaller craft local and not flying them beyond wide body legs. Regional aircraft were meant to keep your airline in business not hurt it. I think investors need to rethink the officer slots and put some of us young thinkers with vision and passion. If I didn't have the answer I wouldn't be writing!

[Alex Bossert]

It seems as though some readers took issue with my comments about the regional airline industry particularly about the lower operating costs enjoyed by the regional airlines compared to the major carriers. The issue has very little to do with the point of my article and regional carriers do have lower operating costs then the major airlines. The regionals were an effective structure for the major airlines because the regional’s labor expenses are less and they’re shielded from the high pension expenses of the major carriers. Pilots and flight attendants on regional carriers typically make less money than workers with the same seniority at mainline carriers. You can check out airlines pay rates here: www.aviationinterviews...

The comments above meant to trash my article are very off base. The issue has almost nothing to do with the purpose of my article. By the way Pinnacle was able to work out its contract issues with Delta and Pinnacle will continue to fly for Delta.