Pinnacle's dismal 3Q with USD13m negative swing continues poor outlook for regionals


The impact of the changes in legacy-regional relationships, illustrated in stark relief by SkyWest Airlines on 02-Nov-2011, was shown again on 03-Nov-2011 when Pinnacle Airlines Corp posted a third quarter loss of USD3.5 million. The loss was a USD13 million swing from 3Q2010 when it earned USD9.4 million. It also projected a loss in the fourth quarter, with expectations for a loss in 2012.

Projections had expected a profit on USD317-328 million in revenues. It did meet revenue expectations posting consolidated operating revenue of USD319.8 million, a 5.8% increase largely owing to the increase in Q400 operations as well as a year-on-year increase in United Express rates.

Restructuring underway

CEO Sean Menke assured analysts the company has already implemented plans to turn the company around, which has already translated into significant improvements in operating performance. However, he also acknowledged there was much more work to do.

“I’m pleased with the progress we have made to fix those things that plague us,” he said, describing both this year and next as transitional years. In the past, the company described 2011 as the transitional year and 2012 as a recovery year.

“When I joined the company, it became abundantly clear the work we had before us and as I stated in the second quarter call many of the decisions and projects we embarked upon are stacked upon us now. These projects are all important to achieving our objectives but they are also costly and require significant oversight to execute profitably.”

He cited progress in integrating the pilot seniority list as well as a side letter with pilots to more efficiently integrate the airlines. He also pointed to its new agreement with flight attendants and the consolidation of functions at its Memphis headquarters including moving both ops centres from Colgan and Mesaba as well as a new network data centre.

“These things were not easy but they are critical to the overall business,” he said.

The company also began pulling down its pro-rate operations with US Airways and Delta, changing its original plan to redeploy the assets across the network. Eliminating them will help its recovery efforts. The US Airways operation has since gone to SkyWest. Mr Menke said the move eliminated unprofitable flying and provides additional pilots to its other operations. It also signals something all regionals are doing: drilling down into all operations and ridding themselves of unprofitable operations or those that SkyWest President Brad Rich described as “not been most productive contract”.

Drilling down for cost reduction

Mr Menke also has each of the subsidiaries under a microscope as he looks for synergies and efficiency that will lower costs. Executives will be evaluating each contractual business to ferret out cost reductions to offset the increases in labour rates. They are also evaluating a number of steps to improve reliability and as they move through the development of new business plans for the subsidiaries, he said, decisions would be made to improve the economics of the business.

He predicted higher maintenance expenses resulting from reliability problems with the Q400s and Saabs that have caused operational penalties.

Interestingly, Delta’s contract with Pinnacle imposes operational penalties for missing targets whereas it seems as if SkyWest’s does not since it only mentioned its performance problems only resulted in missed incentive payments. However, Pinnacle’s contract with United does not include bonus payments.

“We see 2012 as a transition year in which we will extract synergies and efficiencies out of the business,” he concluded. “Once the jet transfer is made to Pinnacle, the first step will be to make the changes necessary to align the work force with operations around the jet and prop operations. We expect that to be completed in the first quarter.”

After that, he added, it is ensuring the productivity improvements. “With Mesaba and Pinnacle having significant overlap at Cleveland, Detroit, Minneapolis and JFK, we believe there are synergy and productivity enhancements that can be obtained in the first half of 2012. The largest productivity savings will be the pilots group as the seniority list is integrated. Once the transfer of aircraft is completed we will increase pilot staffing to manage the number of training events that are required. We expect that to take all of 2012.”

Mesaba is closing Detroit operations and the maintenance base.

Scrapping Mesaba/Colgan merger plans

Finally, Mr Menke cited the progress made in integrating the operations. Significant work has been completed with the Federal Aviation Administration to move Mesaba’s jets to the Pinnacle Airlines certificate. The final step, then, is expected in the next couple of weeks and, once done, will clear the way for the transfer which should happen before year end.

In an abrupt change, the company decided to scrap the merger plans between Mesaba and Colgan as a result of eliminating the US Airways operation. Instead, it has elected to treat it as an asset transfer in which Mesaba’s Saab 340s will be put on the Colgan certificate. Once that is complete, it plans to continue its plans to put all the turbroprops under a single certificate using the Mesaba brand. That should be completed at the end of 2012, said Mr Menke.

Problems with Q400s

COO John Spanjers reported significant issues with the Bombardier Q400s which have impacted reliability. He noted the issues were not unique to Colgan and were being experienced across the US Q400 fleet, meaning they will impact Horizon and Frontier.

It is now discussing with United any changes in the network to improve performance. The impact is principally seen at Newark and Houston as the Cleveland operations have been consolidated at Houston. He also said Bombardier was not reimbursing Colgan for the costs of its reliability problems, which seemed contrary to what should be happening since the Q400 is such a young aircraft.

He said the issues were not crew related but rather centred around maintenance reliability. “There are three buckets of challenges,” he explained. “One is structural, our network is too strung out but now that Houston and Cleveland have been consolidated the reliability will go up. We also are looking at our own internal process to ensure we are doing the right things and being proactive so we can be in front of the aircraft. The third item is the aircraft itself.”

Industry tanking

This year has proved, beyond any doubt, that the US regional industry is now a completely different industry than it was in 2008. Regionals struggling to accommodate the changes. The industry is looking at a much diminished regional sector unless regional carriers can change their business models to offset the declines on the capacity purchase side. So far, efforts to diversify have proved dismal for all the publicly-held regional airline holding companies.

The struggle is illustrated in the financial statistics and paints a very gloomy picture represented by Pinnacle Airlines Corp and SkyWest, both of which sought CPA portfolio diversification as a remedy to cost pressures from Delta.

On the other hand, Republic Airways Holdings, flush with cash in 2007 and 2008, chose to finance troubled airlines and ultimately ended up acquiring Midwest Airlines and Frontier Airlines as a diversification strategy, merging them together, only to end up with a larger, failing company. It is now, once again, fighting to avoid another bankruptcy and discussing more furloughs, both voluntary and involuntary, and selling assets such as slots and aircraft.

Ironically, former Frontier CEO Sean Menke seems to have gone from the LCC frying pan into the regional fire since he took the Pinnacle Corp helm in July.

Regardless of the prospects for Frontier, it is clear that regionals, seeing the writing on the wall, were trying to change to accommodate the growing pressure on costs from their mainline partners. Even so, both methods have failed leaving these once-powerful companies in a vastly compromised position and struggling to restructure.

It is also clear that what the majors have already accomplished in restructuring themselves to become profitable with high fuel, is now in full sway in the regional sector and it will take at least two years to turn them around, according to statements during earnings calls. Both Pinnacle and SkyWest are looking to 2013 as the recovery year.

For its part, Pinnacle makes progress in 2012 when new rates from Delta kick in but it has endured several years of struggle as Delta stalled the new rates making them effective in 2012, despite reaching an agreement long before. While the higher rates covering the higher wages begin in Feb-2012, other rate adjustments expected in mid-2012 covering other rising costs such a integration expenses on Mesaba and Colgan. Pinnacle is expecting a one-time payment of USD18-20 million while the ongoing rate increase to yield USD14-17 million annually. The new pilot contract calls for increased compensation and benefits of which USD4.9 million were in the third quarter.

Regional say they will not be impacted by changes to major capacity purchase plans because they had contracts. What has happened is the regionals, hoping to retain Delta’s business, having acted the good team players, but seen flying at or below minimums called for in the contracts and the volatile swings in scheduling that have cost them so dearly in the past year.

Mr Christie said that they were certain but pegged to the company’s costs. It is now submitting the documentation on those costs to Delta. Infuriatingly, the costs will likely become the subject of negotiations with the major carrier meaning reimbursement could slip and could, indeed, change from management expectations. Considering Delta’s shenanigans against regionals over the past few years, it is likely that this will be just as much a fight as anything regionals have been able to achieve with the carrier.

While compensation and rate increases should be sure, Delta took yet another opportunity to take another chunk out of reimbursable revenues in 2012 resulting from a new agreement on how heavy airframe maintenance will be reimbursed.

In Oct-2011, Pinnacle and Delta reached a tentative settlement related to a dispute regarding the reimbursement of certain heavy airframe maintenance costs, costing Pinnacle USD3.3 million in revenue during the quarter. However, beginning 01-Oct-2011 a new deal continues Delta’s reimbursement of heavy airframe maintenance but it also increases Pinnacle’s risk as a portion of the costs will be treated as rate-based costs. This will result in an annual reduction in 2012 revenues from reimbursable costs of about USD6 million. Pinnacle said this increase in un-reimbursable costs will then be factored into the increase in the CRJ 200 base rates when the contract rate reset occurs on 01-Jan-2012. But, that only means more negotiations.

What used to be a slam dunk investment, is now a industry in turmoil waiting patiently for a new normal that is some years away.

For its part, Pinnacle, at the behest of Delta, acquired Mesaba Airlines and in the third quarter recorded USD2.98 million in integration expense, severance and contract implementation expenses, primarily attributable to bonuses payable under its new, five-year flight attendant deal which was recently ratified by the company’s 870 members represented by the United Steelworkers. It also recorded USD0.8 million in severance payments not related to the integration plan. The ironic outcome of its Mesaba acquisition is Delta reducing Mesaba’s role in its capacity purchase plan reflecting the old adage that 'with friends like that, you don’t need enemies'.

Part of the special items included severance, totaling USD618,750 over 18 months for VP and COO Doug Shockey who was replaced by Mesaba executive John Spanjers.

As with SkyWest, Delta scheduling changes wrought havoc on expenses, which included USD5.1 million in the quarter. It has become clear that Delta is whipsawing its regionals knowing their Delta Connection business is too big for regionals to forego, making those diversification plans that much more critical. Their only defence then becomes cutting costs.

Also as with SkyWest, the crew-related expenses at Pinnacle included premium pay, hiring, training and crew overnight accommodations. It is entirely unclear whether regionals will be able to receive compensation for these expenses. And, as with SkyWest, Pinnacle is also trying to negotiate for more optimal network schedules. In the meantime, it has adjusted near-term, block-hour production and increased its pilot staffing levels to address the issue. It expects the “inefficiencies” and other related costs to mitigate in the fourth quarter.

Pinnacle also cited a 40% year-on-year increase in subsidiary Colgan’s fuel price per gallon but said it was partially offset by a 15% decline in consumption. Still, Colgan’s pro-rate operations were negatively impacted by USD1.2 million in the third quarter.

Total operating expenses reached USD313.2 million compared to USD276 million, largely on the Mesaba acquisition and increasing crew and training costs. The company flew 1% fewer available seat miles (ASMs) at 3 billion. It does not report yield or passenger revenue per available seat mile (PRASM) for the company or for individual subsidiaries.

During the quarter, Pinnacle completed 207,902 block hours and 137,541 departures down 3% and 4% year-on-year, respectively. The company cited the elimination of its Saab 340 operations as well as reduced regional jet flying with Delta. These, however, were partially offset by increases in the United/Continental express Q400 operations at Colgan.

Consolidated operating revenue reached USD319.8 million, a 5.8% increase to USD17.4 million largely owing to the increase in Q400 operations as well as a year-on-year increase in United Express rates.

Third quarter operating income reached USD2.6 million, down 12.9 million. The operating margin tells the tale. Posting a 1.6% operating margin, Pinnacle’s 3Q2010 was 9.6%.

Mesaba reported break-even operating results during the quarter compared to USD3.1 million in operating income and a 4.3% operating margin in 3Q2010. The new pilot contract increased expenses by USD0.9 million in the quarter. While it anticipates reimbursement from Delta, the revenue from the rate adjustment will not be recorded until final determination of the amount with Delta, expected in the fourth quarter.

The Pinnacle Airlines subsidiary reported third quarter operating income and an operating margin of USD2.6 million and 1.6% down from the USD12.9 million and a drop of eight points on the increased wage rates, crew and training expenses.

Colgan posted operating income and operating margin of USD6 million and 7.1%, down USD1.1 million and three points, respectively. The decline in margin was attributable to increase pilot labour costs and the 40% jump in fuel year-on-year.

Non-operating expense was USD11.5 million for the quarter up from USD10.3 million in 3Q2010.

Pinnacle ended the quarter with USD81.8 million in unrestricted cash and cash equivalents. It generated USD11.4 million in cash from operating activities.

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