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Executives

Phil Trenary - President and Chief Executive Officer

Peter Hunt - Chief Financial Officer

Analysts

Lily Ng - Merrill Lynch & Co., Inc.

Bob McAdoo - Avondale Partners, LLC

Pinnacle Airlines Corp. (PNCL) Q2 2008 Earnings Call August 11, 2008 11:00 AM ET

Operator

Welcome to the second quarter 2008 Pinnacle Airlines Corp. earnings conference call. (Operator Instructions) I would now like to turn the call over to your host for today, Phil Trenary, President and Chief Executive Officer.

Phil Trenary

On behalf of the more than 5600 employees of Pinnacle, I would like to thank you for your interest in our company. This call is being presented live over the internet via webcast from our website, www.pncl.com. It will also be available on our website for 30 days after this call.

This presentation contains various forward-looking statements that are based on management's beliefs, as well as assumptions made by and information currently available to management. Although the company believes that the expectations reflected in such forward-looking statements are reasonable, we give no assurances that such expectations will prove to have been correct.

Such statements are subject to certain risks and certainties and assumptions, including those set forth in our filings with the Securities and Exchange Commission which are available to our investors on our website or online from the Commission. Should one or more of these risks or uncertainties materialize or should underlying assumptions prove erroneous, actual results may vary materially from results that were anticipated or projected. The company does not intend to update these forward-looking statements before its next required filing with the Securities and Exchange Commission.

Again, good morning. We would like to start off by offering thanks to our people at Colgan and Pinnacle for turning in some really strong performance for this quarter. The Pinnacle subsidiary led all mainline carriers for the last two months and notice that Memphis was recognized as the second most on-time airport in the nation. Pinnacle has as you know a significant presence here in our on-time performance at the Memphis hub was actually over 95%.

On the Northwest system, our mechanical reliability was 99.82%, 99.47% and 99.6% for May, June and July, respectively. The flight ops reliability was 99.83%, 99.8% and 99.88%, also for those respective months. On the 900 operations for Delta for May, June, July, mechanical reliability was 99.18%, 99.78%, 99.94 % with flight operations at 99.93%, 99.93% and 99.94%.

As you know, we did make a slight alteration to our agreement with Delta that defers some of the aircraft into service under the DCA. They were originally scheduled to all be in by January, 2009. Now they will all be in by May.

During the second quarter, we took three aircraft which brings the fleet to nine at June 30, and all nine of the aircraft are actively in the schedule. In addition, we took delivery of two aircraft in late July and we are using them to support the operation. We are very pleased to have the Delta relationship and are committed to a long-term mutually beneficial partnership.

On the Colgan side, during the quarter we added seven aircraft. We now have all of the Continental aircraft in. The program is working very well for Continental. The customer acceptance has been very strong.

The folks at Colgan have done an outstanding job as well. For the May, June, July months, mechanical reliability was 99.9%, 99.3% and 99.8% of the aircraft. With flight operations virtually at 100%, they had two cancels the entire period. We did have some delays in deliveries from the manufacturing, and Peter will get more to that later as far as the $1 million penalty we had to pay in that. On the option aircraft that we have, we did push the delivery dates back to beginning of spring 2010. We did that to accommodate a change to make all of those aircraft next generation, which brings the new interior into the aircraft.

Also, we committed to our people and our investors to have a plan in place and implement the plan by the fourth quarter on the Colgan prorate operations. We are on track to meet our commitment to have those in place. We are planning for reductions of ten of the Saab aircraft, and this is in addition to the previously announced retirement of the five Beech aircraft. We do recognize that this is a very difficult process to work through, especially for the people at Colgan, but it is necessary to do this in light of the current fuel environment.

We do believe that the reductions and other modifications we are making will significantly reduce the losses we have seen. This is true even if fuel went back to its recent highs in the mid-$140 range. We have completed the move from Menassas to Dulles for maintenance operations and that is going well. Peter will tell you more about that in just a moment.

If I do not bring this up, I know we will always get a question on it, so we will talk about our negotiations with our pilots. The last couple of rounds have gone very well. We are expected to be back to the table on August 26. The federal mediator in charge has called a meeting.

I have quit giving dates when I think this thing will be complete. I will say that from our pilots' perspective, the guys out there flying the line, they are doing a great job. They have indicated they, as well, would like to get a deal. The environment is as good as it has ever been to get a deal and hopefully we can bring that to a close soon.

Now I will turn the call over to our Chief Financial Officer, Peter Hunt who will review our financial results.

Peter Hunt

This morning Pinnacle Airlines Corp. did report a net loss of $11.5 million and a loss per share of $0.64. But these results do include two special charges which I will discuss in a minute. Excluding those charges, Pinnacle reported a net income of $5.4 million and fully diluted earnings per share of $0.30.

The two special charges that we took during the quarter, the first one relates to our investment in auction rate securities. The results include an $8.7 million charge to mark our auction rate security portfolio to its estimated fair value which is an approximately 6% right down from the par amount of our securities there. Last quarter, we estimated this decline in value at approximately $10 million and we recorded it through other comprehensive income.

This quarter, similar to how many other companies have approved the ARS market, we did conclude that the decline in value was other than temporary and we recorded the adjustment through earnings. Also, net income was reduced by the full amount of $8.7 million. We assumed that we would not receive a tax benefit associated with this loss, because it is a capital loss and we would not expect to have offsetting capital gains in the near-term.

The second charge was related to our Colgan subsidiary. In light of the very high fuel costs affecting the entire industry, we evaluated asset impairment at Colgan, also similar to many other airlines. And we did conclude that $10.6 million of good will and other assets were impaired. We also recorded an accrual related to maintenance return conditions of approximately $2 million, for Beeches and Saabs that we expect to remove from service early in the fourth quarter as part of the turnaround plan that I will talk about in a minute.

In total, we did record a special charge of $12.6 million for the goodwill impairment and the maintenance return conditions. That number is $8.1 million net of taxes. Just another note, we would expect to record an additional lease return accrual of approximately $1.3 million in the third quarter. Under GAAP, you would record these maintenance return costs on an accelerated basis between the points in time where you make the decision to accelerate the retirement of the fleet through that date of retirement. We do expect another $1.3 million of costs in the third quarter related to the fleet returns.

Turning to operating statistics, our Pinnacle subsidiary flew 1.6 billion ASMs during the quarter which was an increase of 6% year-over-year. We flew 112,051 block hours which was an increase of 2% year-over-year. Our stage length was 465 miles which up slightly from 461 last year. We ended the quarter with 126 CRJ-200s and nine CRJ-900s for a total of 137 aircraft.

On our Colgan subsidiary, we flew 268.6 million ASMs which were up 67% year-over-year and our block hours were 40,491 which was an increase of 31% year-over-year. We ended the quarter with 58 aircraft at Colgan. That includes 13 Q400 aircraft, 40 Saab 340s and five Beech 1900s.

Looking at the income statement, our consolidated revenue for the quarter was $221.2 million which is an increase of 10% versus the second quarter of '07. Our operating income excluding the charges that I mentioned earlier was $15.1 million which was up by about $300,000 from the prior year. Our operating margin for the quarter, again, excluding special charges, was 6.8% which was down slightly from the prior year. Looking at our two subsidiaries, Pinnacle reported operating income of $15.4 million which was an increase of $1.4 million year-over-year. Pinnacle had an operating margin of 9.9% which was up 0.5 points from second quarter of '07.

The improved performance in our Northwest Airlink operations had a big impact in the quarter. It dramatically reduced the amount of penalties that we would expect to pay Northwest for the six months ended June 30. We actually reversed penalty during the quarter instead of adding to the penalty. We had accrued $2.5 million of penalty during the first quarter of '08 and we reduced the amount of that penalty by $800,000 to an estimate of $1.7 million for the full six months ended June 30.

We also had higher utilization during the quarter. Our aircraft utilization increased 3% to almost nine hours. That also positively impacted our performance there. At our Colgan subsidiary, Colgan reported an operating loss of approximately $300,000 which was down about $1million year-over-year. The operating margin at Colgan was negative 0.5%.

On the Colgan side, our RASM in our prorate operations was very strong; it was up 8.5% year-over-year. The big story there as everyone knows is fuel costs. Our fuel expense year-over-year increased by $5.4 million. Our average price per gallon was up 69% to $3.79. Also, effecting the quarter as Phil mentioned, we had some aircraft delivery delays during the quarter. And we incurred approximately $1 million in costs for payments to Continental associated with those delays. Except for those penalties, our Q4 operations are meeting our expectations and they are performing fairly well.

Just one note also about the subsidiary operating income that I am reporting to you, last quarter we did not allocate corporate overhead, because we were still evaluating the appropriate way to allocate those overhead costs. This quarter we have allocated the corporate overhead. When you look at the margins that we are reporting, they are not comparable to what we reported in the first quarter because they do include that corporate overhead. The margins are comparable on a year-over-year basis if you look at our press release in the 10-Q that we will file later today.

Turning to non-operating expense, excluding the ARS charge, we had $6.9 million of net non-operating expense, primarily all interest expense associated with our new aircraft. The interest expense does include approximately $400,000 for hedge ineffectiveness related to the unsettled hedges that we have in our portfolio. As of June 30, we had two hedges remaining on our future aircraft deliveries that were unsettled.

One of those settled in July. The second one is scheduled to settle in October, The ineffectiveness was larger this quarter than in previous quarters where it has been fairly immaterial, primarily because of the delaying and the aircraft associated with that hedge. Once that hedge settles, we would expect the ineffectiveness will become final and we would not have any ongoing fluctuations in our P&L related to ineffectiveness. On a net basis, our net loss again was $11.5 million. But excluding those special charges, it was $5.4 million.

Looking at cash flow, we ended the quarter with $65.2 million in unrestricted cash and cash equivalents. We actually generated cash of $16.2 million from operating activities. That includes $3.4 million of collateral deposits related to our interest rate hedging program that was returned to us during the quarter for open hedges and $12.8 million of cash flow from regular airline operations. We used $11.2 million in investing activities, all primarily related to capital expenditures. We used a net of $16.7 million of cash for financing activities during the quarter. That number was made up of $36.7 million of debt payments, net of $20 million of additional financings that we drew down on our line of credit with Citigroup.

Looking at our turnaround plan at Colgan, as we talked about on our call last quarter, we have been working very hard over the last several months to determine what makes sense and what can be sustainable at our Colgan prorate operations even with fuel at the very high cost that it has been at over the last quarter. We did announce today that we are exiting ten aircraft from the fleet in the fourth quarter. Eight of those aircraft are on lease. Those leases expire through the middle of the first quarter of 2009.

They are all exiting the fleet fairly much on schedule and we plan to sell at least two aircraft. We may sell more than two to the extent that we find a strong market for Saabs and extend a couple of leases that will give us additional flexibility going forward. But at a minimum, it is a total of ten aircraft and it looks like probably eight that our leased will come out to that we will sell.

We are exiting a total of 12 markets. Those markets are concentrated in our operations at United and US Airways, as US Airways Express and United Express. Our operations with Saabs in Houston as Continental Connection are not affected by the reduction that we are announcing today. The contract we have with Continental is a prorate agreement. As I have mentioned before, has a connect incentive component for it, where we receive a connect incentive for every passenger that connects onto a Continental flight. That connect incentive is indexed to changes in fuel prices.

In the long term, we do believe that the Continental operations will work with the contract we have in place in the short-term, because that change on the connect incentive happens every six months. When fuel is very volatile, it could effect months in a quarter-over-quarter basis or could reflect results in a quarter-over-quarter basis. In the long run, we do believe because of that protection on fuel price with the index in our connect incentive that our Continental operations work.

The essential air service markets that we fly, both as United Express and US Airways Express, there are a total of 15 markets there. We rebid 13 of those markets with the government. Out of those 13, seven of those markets have been rewarded to Colgan and they were awarded with a $4 million annual increase in subsidy. In addition, we will decrease capacity in some of those markets. It is a total of about 25% decrease in capacity. Not only are we getting a revenue increase from the government, but we will actually reduce our operating costs by lowering the number of round trips that we are making in those markets.

Four of the 13 markets were awarded to competitors and we will exit those markets in the fourth quarter. Those markets are included in the 12 total markets that will be coming out of Colgan. There were two bids that are still open. We are expecting to hear from the DOT soon.

As Phil mentioned, we completed the move of our maintenance operations to Dulles. We do believe this should have a very positive impact on our operating costs. It will eliminate a lot of ferry flights that we had in the system previously associated with having our maintenance at Manassas. In addition, we are working with United to reduce some distribution costs that we have in the United Express network.

Both parties are cooperatively approaching this. We want to find a solution. To the extent that we can reduce the cost more than expected, it is very possible that United may ask us to fly some of the markets that we are looking at exiting. If we are unable to reduce the costs at a level that we have assumed, we may actually announce one or two additional market exits in the future.

Upon completion, we will have 12 aircraft with Continental and 16 aircraft flying in our prorate operations with United and US Airways, and two aircraft that are designated as maintenance aircraft in the system for a total of 13. The turnaround plan will involve some transition costs in the third and fourth quarter. First, we will have the lease return costs that I have already mentioned, $2 million that we accrued in the second quarter, an estimated $1.3 million to $1.4 million that will happen in the fourth quarter.

We also would expect when we get into the fourth quarter and the capacity comes down, that we would have some reduced productivity with our prorate operations, as we move employees to the right locations, as we retrain employees for fleet types and as we sort out and rationalize the amount of variable costs that we have in our system to match what is going on with the reduction in capacity. Also, I will point out that these reductions will come in the winter which historically is the low point seasonally for unit revenue. We likely will not see a profitable prorate operation until next spring, but we would expect that this winter the results would be less severe than they were as compared to last year.

Looking at future aircraft deliveries, we took as Phil mentioned, the remaining two Q400s that were scheduled to us in July, so we are up to our full compliment of 15 aircraft operating as Continental Connection in Newark. The options and firm cancelable aircraft have been delayed until the spring of 2010. They would to the extent that we exercise them, they would be delivered from the spring of 2010 through the fourth quarter of 2011. The final two CRJ-200s that are being returned to Northwest are exiting the fleet in the third quarter, and then we will be at our core level of 123 aircraft in the Northwest system. We took two CRJ-900s in July, so we now have a total of 11 aircraft. We are using those two to support our current operation.

As we previously announced, we do expect that we will incur approximately $2 million of unreimbursed ownership costs in the third and the fourth quarters. We will look for revenue opportunities to offset some of that. We will look at charters. We will also look at ad hoc support of the Delta network to the extent that Delta would request that from us. We would hope to make some of that $2 million back through finding some places to put these aircraft to work over the next few months.

Again as Phil mentioned, also we will add three CRJ-900s under our Delta connection agreement in January of '09. We will add two in February of '09 and we will add two in May of 2009. Then we will be at the full complement of 16 aircraft under our DCA.

We would like to open it up for questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Lily Ng - Merrill Lynch & Co., Inc.

Lily Ng - Merrill Lynch & Co., Inc.

My first question is regarding your underlying assumptions. When you make the statement that Colgan could possibly break even for the full year, things such as more fuel prices you are assuming or maybe are there any assumptions that the Saab aircraft is going to you will be able to sell more of the Saab aircraft?

Peter Hunt

To be clear, Colgan will not break even for 2009. Colgan already has a significant cumulative six-month operating loss, primarily from the prorate operations. While the second quarter was much better and we would expect the third quarter to be much better, as I mentioned, there will be some transition costs in the fourth quarter. We really will not see the full effect of this, in terms of it being a sustainable operation, until '09.

The assumptions that we have made there, we did model this looking at the high point of fuel costs that we hit in the late second quarter, early third quarter, of high 140s of crude oil. What we looked for was markets that we thought could not only cover direct costs, but also cover aircraft ownership costs and contribute positively to the overhead of Colgan. The markets that we are keeping are markets that we think cover all of those costs, the costs of the aircraft as well as the direct costs, and that actually do have a positive benefit to Colgan on an annual basis and with fuel in the 140s.

Lily Ng - Merrill Lynch & Co., Inc.

More looking at, when you say it being a viable part of it, you are thinking of it much more on a, when all of this stuff has been implemented on a go-forward basis, you should have a positive operating margin?

Peter Hunt

That is correct.

Lily Ng - Merrill Lynch & Co., Inc.

Peter, the impairment you took on the ARS. Does that effect any terms of the loan that you took out with ARS as the collateral?

Peter Hunt

It does not. The loan does have a net worth test incorporated into it, but we specifically excluded any charges that we would take related to auction rate securities. It seemed appropriate, given that Citibank sold us the securities that if we recorded a loss on them that it should not affect the loan. Both we and they agreed to that, so the net worth test is not affected by that charge.

Operator

Your next question comes from Bob McAdoo - Avondale Partners, LLC.

Bob McAdoo - Avondale Partners, LLC

You said there is $2 million of CRJ ownership costs. Is that per quarter or for the balance of the year?

Peter Hunt

That is the total for the rest of the year.

Bob McAdoo - Avondale Partners, LLC

When you talk about Colgan and you say it will or will not make money or it is not going to make money this year or not going to make money later this year. Is that including netting against it the positives that come out of the Continental side? Or is that just the prorate side that you say will not make money?

Peter Hunt

We are mostly looking at the prorate side. Again, we are still estimating how attrition will work and how we will be able to get the variable costs out in the fourth quarter. We know long-term we will be. But we are not 100% confident of how much variable costs we can get out as soon as we pull the network down in October, Bob. And also given that it is the fourth quarter, I would not expect the prorate piece to be profitable in the fourth quarter.

Bob McAdoo - Avondale Partners, LLC

But you want to give us any clue as to whether the Continental side of profit is going to be bigger than the loss on the prorate side?

Peter Hunt

I certainly hope so. The Continental piece is working fairly well for us. That is the piece of the business we plan to emphasize going forward. We do hope to exercise those options and grow that piece of the business. It will be, absolutely, a positive income contributor to us in the fourth quarter. No question about that.

Bob McAdoo - Avondale Partners, LLC

And on the ARS securities, you took a, or you have available a line of credit against those. How does the line of credit size compare to the total amount of those securities? Is there a 50% draw available or what..?

Peter Hunt

We have drawn the max that is included in the facility. The facility also has a 75% LTV maintenance test which is today, what we have drawn as we meet that with no problems. What I will just simply say, though, about that facility is that to the extent that we think that we have additional liquidity needs, I think with what is happening with Citigroup and UBS and Merrill and the other banks that have sold these auction rate securities in the announcements last week associated with settlements with the government is that we do expect that Citi would be very cooperative with us to the extent that we thought we needed more liquidity. Apparently, we do not think that we do.

Bob McAdoo - Avondale Partners, LLC

You have not really tried to see what they will do with their new agreement, but it is certainly a reasonable assumption, you think, that they are going to be a lot more cooperative and a lot easier to deal with in today's world?

Peter Hunt

Yes. We do think so. And they have been cooperative with us up until now. They have been very supportive.

But I do think that given what has been announced and we are trying to clarify with Citi how it might affect us. I think currently it probably does not affect us immediately, because the announcement seems to focus more on taking care of the small guys, the retail investors and small companies. It does seem like there are also some promises of assistance to larger companies over time as well. We do think that there could be some positive outcomes there with Citi. That does not change the fact the asset is impaired, though, which is why we have taken the charge this quarter.

Operator

There are no further questions in the queue at this time.

Phil Trenary

Thank you very much. In way of summary, again, we need to thank our folks. We made a commitment to return to industry-leading performance which we have.

We are on track to fix Colgan's pro-rate business and the Q400 side of Colgan is doing very well. Although we have a very close, up-front seat to some historically restructuring of our industry, we feel very good about Pinnacle. We have chosen the right aircraft. The CRJ900 is the most fuel efficient and the most cost effective of the 76-seat aircraft, so we do plan to grow that fleet.

On the Q400 side, we do have the options available and are very confident that we will be able to exercise those options. It is interesting to note that the Q400 is actually doing a bit better from a fuel perspective than we actually thought it would when we were looking at purchasing the aircraft. With that, thanks for your interest in our company and we will see you next time.

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Source: Pinnacle Airlines Corp. Q2 2008 Earnings Call Transcript
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