As a frequent reader, and now small-time contributor, to the Berkshire Hathaway group over at MSN, created and wonderfully maintained by Sanjeev Parsad, I was intrigued by a recent post regarding the dumping of Pinnacle Airlines (PNCL) by Mohnish Pabrai. Before I begin, I want readers to understand that Mohnish is one of my idols in the investing world, and I believe that his short term pain will be reversed and success resumed. His framework is too good to fail. My only goal here is to explain the possible workings of an investment now in distress, and how we might avoid a similar fate. If I’ve stated inaccuracies, let me know and I’ll make the edit.
Now, if you’re a long time reader of my blog (long term being not so long, April), one of my very first posts was about a SmartMoney article with Pabrai. In the SM article, Pabari’s #1 idea was Pinnacle. He argued that the company was worth several times its then price, $15/share. By this point, I was already familiar with Pabrai’s thesis on Pinnacle, as he had written up an extraordinarily detailed thesis on Value Investors Club late last year.
I’d also read up on the business myself to try and glean the facts. In the end, I didn’t make a purchase because it came down to some variables that I wasn’t comfortable with. What happens if their business providing regional service to Northwest Airlines is shut down? What are these airplanes worth in liquidation? Why will their cash flows improve over time? I couldn’t get a good grip on the risks. From his writings, it seemed Mohnish did.
From a total of about 3.3mm shares in the 13F for the period ended 6/30, Form 4’s filed by Pabrai now show the sale of about 430k shares total since the beginning of August, representing nearly 13% of his position. That’s a big chunk, and it doesn’t seem to be abating at this point, instead accelerating from first filing to the more recent filing. The stock has gone from $15-16 down to $6 1/2 per share.
So the question now remains, Why is it that Mohnish is selling down what he recently called his best idea? Is it fund redemptions, reallocation to another position, or some non-invesment related issue? Or, has Mohnish lost faith in the investment thesis itself?
When thinking about this, it’s hard to assert at this point that the selling is due to re-allocation or meeting redemptions. Why sell your best idea, which is now 50-70% cheaper, to find a better one? If your original thesis was that company X is selling at 1 and worth 3, then when it goes to $.40, you should be backing up the truck, not selling. Pabrai knows this. So if the case is that one of his many newer positions, Sears (NASDAQ:SHLD), Wellcare Health (NYSE:WCG), etc. is a better idea, there must have been material deterioration to a business he thought was worth 3-5x his cost.
Even if he was receiving investor redemptions, I would think the first sale is Berkshire Hathaway (NYSE:BRK.A), a position Pabrai has long dubbed a “placeholder.” Also, in his book The Dhando Investor, Pabrai mentioned a “3 year rule” in which he wouldn’t sell a position for 3 years unless it reached full valuation or the intrinsic value had deteriorated to the point where his margin of safety had eroded away. If my opinion is that Pabrai isn’t selling due to redemptions, then it doesn’t make much sense that he would be selling for any other reason beside business deterioration.
Now, besides the large contract to fly regional jet service for Northwest Airlines (NWA), PNCL maintained small contracts with other carriers, one of them being Delta. In June, Delta came out with its intent to cancel their contract with Pinnacle. Supposedly, these contracts were pretty ironclad, set in stone. Besides that, Mohnish argued, the economics of PNCL’s service made too much sense for a carrier to want out of a contract. Underperformance by PNCL could trigger a breach in the contract, according to Delta.
Pinnacle Airlines Corp. said Tuesday that Delta Air Lines Inc. (NYSE:DAL) intends to cancel a contract with the operator’s subsidiary on July 31, citing Pinnacle’s failure to meet minimum on-time requirements.”
When Delta came out with this announcement, it seemed that a major underpinning of Pabrai’s thesis was thrown into question. If these guarantees were so strong, if the economics were so right, why in the heck would Delta want out? It wasn’t the absolute dollar loss of business that scared PNCL investors as much as the loss of confidence in a major piece of their thesis, in my opinion.
If this was true - Delta could and would be willing to cancel its contract - what was the fate of the Northwest agreement? The agreement was structured in such a fashion that Northwest would take on the “fuel price risk” from Pinnacle. Thus, Pabrai argued, PNCL’s business model was a much stronger one. I agree. However, one logical question proceeding from this assertion is such: Why would Northwest let PNCL profit during their demise? If PNCL was reaping profits from the avoidance of fuel price risk and customer risk, why couldn’t Northwest change the agreement in a way that would be derimental to Pinnacle and beneficial to Northwest? Delta had already demonstrated that they wanted out from PNCL, why couldn’t Northwest follow?
Another wrinkle was added a few months back: plans for Delta and Northwest to merge. The merger was said to be the first of many in the airline industry, but up until today has remained the sole airline consolidation effort in the United States. How would the merger affect Pinnacle? Would the NWA-Delta alliance still require its service? With Delta having put their agreement with Pinnacle in doubt, there was no question that Pinnacle could be decimated by the merger.
Likewise, as the price of oil spikes, the airline industry continues to suffer. Thus, any regional carrier exposed to a major airline suffers alongside. How would PNCL be affected by this spike in oil? The answer is not clear, but the risk remains, and the market has priced it into the stock.
The story today stands as such: Delta is now back on board, resuming their contract, and oil is falling. Great. But PNCL still sells for $6 1/2, down from the $15-16 where Pabrai bought in and recommended the company. This depression stems from overall uncertainty and doubt. Some of it is likely to be unfounded. But it seems that some real risk is inherent now for PNCL, with Delta throwing the certainty of PNCL’s advantages for major airlines into whack.
Are these risks being manifested by Pabrai’s wholesale selling of his shares? I think so, but it seems we might never know, as it is certainly possible that Pabrai stops selling and continues to hold, and the investment works out in a terrific fashion. I don’t know the company well enough to make that judgment. But here we stand, Mohnish selling PNCL at distressed prices.
It seems to me that PNCL is victim of a common problem: customer and/or revenue concentration. In these days, it also seems that no matter how “ironclad” a contract or a guarantee may seem, most are breakable, or susceptible to questioning. By making an investment that mostly relies on a legal guarantee with one customer that may or may not be reliable, in a time of distress for the general industry, you open yourself to all kinds of risk, known and unknown.
I made a similar mistake in First Marblehead (NYSE:FMD), the student loan originator. In many ways, dependence on the credit markets is akin to revenue concentration. If you’re a big securitizer, the capital market indeed is a customer. One big, huge, customer. If he goes down, well then you’re SOL. For PNCL, when you find out those contracts aren’t so tight, and the economics of the business you provide isn’t so right, well again you’re SOL. If your entire livelihood depends on one or two companies performing, companies that are in a horrible industry to begin with, the probability that you take a hit rises dramatically. Sears will be okay in the long run because people will always need retail stores, and if not, will always be interested in great brand names and millions of sq footage in real estate. Sherwin Williams (NYSE:SHW) will probably be okay for a long time because people will always want to buy quality paint. But major airlines can decide overnight that using a regional carrier is no longer economic, and investors in the regional are finished. Risk.
So I guess the final question is thus: Is it worth taking on those risks? This is a question better answered by each individual, but it is clear that a difficult to judge risk can lead to disastrous results for the investor. Avoiding those risks, I’ve learned, might be a better approach in lots of situations
There is a good opposite argument here, but what I’ve learned from my short experience is that the "Yellowstone risk," ironically one that Pabrai has detailed himself, might pop up where you’re not expecting. Yellowstone refers to the small chance that Yellowstone National Park will erupt with volcanic activity again some day. High revenue concentration and customer reliance might just be one of those risks, and the unfinished story of Pinnacle Airlines gives us an preview of how things might go wrong. May we have the skepticism to see these risks before they hit.
Be careful, though, of becoming Mark Twain’s cat who once sat on a hot stove and thereafter wouldn’t sit on any stoves, hot or cold. There will be opportunities to invest in companies with high customer concentration [see: Americredit’s (ACF) reliance and success in the securitization market], but know that accurately determining the probability of losing those one or two customers is extremely important to the ultimate success of your investment. That risk is all too often ignored or misjudged, but can be the one thing determining whether you win or lose the bet.