Pinnacle Airlines 10-K 2009
Documents found in this filing:
Commission File Number 001-31898
PINNACLE AIRLINES CORP.
(Exact name of registrant as specified in its charter)
(Registrant's telephone number, including area code)
Indicate by check mark whether the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.
Indicate by check mark whether the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.
Indicate by check mark whether registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrants knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. [ X ]
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer, or a smaller reporting company. See definition of “large accelerated filer,” “accelerated filer,” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).
The aggregate market value of the voting and non-voting common equity stock held by non-affiliates of the registrant was $55 million as of June 30, 2008.
As of March 2, 2009, 18,342,334 shares of common stock were outstanding.
Documents Incorporated by Reference
Certain information called for by Part III of Form 10-K is incorporated by reference to the Proxy Statement for our 2009 Annual Meeting of Stockholders to be filed with the Commission within 120 days after December 31, 2008.
Table of Contents
Certain statements in this Annual Report on Form 10-K (or otherwise made by or on the behalf of Pinnacle Airlines Corp.) contain various forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Act of 1934, as amended (the “Exchange Act”) and the Private Securities Litigation Reform Act of 1995. Such statements represent management's beliefs and assumptions concerning future events. When used in this document and in documents incorporated by reference, forward-looking statements include, without limitation, statements regarding financial forecasts or projections, our expectations, beliefs, intentions or future strategies that are signified by the words "expects", "anticipates", "intends", "believes" or similar language. These forward-looking statements are subject to risks, uncertainties and assumptions that could cause our actual results and the timing of certain events to differ materially from those expressed in the forward-looking statements. All forward-looking statements included in this Report are based on information available to us on the date of this Report. It is routine for our internal projections and expectations to change as the year or each quarter in the year progress, and therefore it should be clearly understood that the internal projections, beliefs and assumptions upon which we base our expectations may change prior to the end of each quarter or the year. Although these expectations may change, we may not inform you if they do. Our policy is generally to provide our expectations only once per quarter, and not to update that information until the next quarter.
You should understand that many important factors, in addition to those discussed in this Report, could cause our results to differ materially from those expressed in the forward-looking statements. Some of the potential factors that could affect our results are described in Item 1A Risk Factors and in Item 7 under “Outlook.” In light of these risks and uncertainties, and others not described in this Report, the forward-looking events discussed in this Report might not occur, might occur at a different time, or might cause effects of a different magnitude or direction than presently anticipated.
Pinnacle Airlines Corp. and its wholly owned subsidiaries, Pinnacle Airlines, Inc. and Colgan Air, Inc., are collectively referred to in this report as the “Company,” “we,” and “us” except as otherwise noted. Our subsidiaries will be referred to as “Pinnacle” for Pinnacle Airlines, Inc. and “Colgan” for Colgan Air, Inc., and collectively as “our subsidiaries.”
In October 2008, two of our major customers, Northwest Airlines Corporation and Delta Air Lines, Inc., merged to form the world’s largest passenger airline. Delta Air Lines, Inc. (exclusive of its newly merged operating subsidiary, Northwest Airlines, Inc.) for historical reference purposes is referred to herein as “Pre-Merger Delta.” Similarly, Northwest Airlines Corporation and its subsidiaries as they existed prior to the merger are referred to herein as “Northwest.” Pre-Merger Delta and Northwest combined are collectively referred to herein as “Delta.”
US Airways Group, Inc. and its subsidiaries are collectively referred to as “US Airways.” Continental Airlines, Inc. and its subsidiaries are collectively referred to as “Continental.” United Air Lines, Inc. and its subsidiaries are collectively referred to as “United.”
Pinnacle Airlines Corp. was incorporated in 2003 as a Delaware corporation. As of December 31, 2008, we had two reportable segments consisting of Pinnacle Airlines, Inc. and Colgan Air, Inc.
Pinnacle operates an all-regional jet fleet, and provides regional airline capacity to Delta at its hub airports in Atlanta, Cincinnati, Detroit, Memphis, and Minneapolis/St. Paul. At December 31, 2008, Pinnacle operated 124 Canadair Regional Jet (“CRJ”)-200 aircraft under Delta brands with approximately 665 daily departures to 114 cities in 37 states and three Canadian provinces. Pinnacle also operated a fleet of 18 CRJ-900 aircraft (including seven aircraft Pinnacle is operating on a temporary basis, as discussed in detail under “Recent Developments”) as a Delta Connection carrier with approximately 86 daily departures to 34 cities in 16 states, the Bahamas, Mexico, and U.S. Virgin Islands.
Item 1. Business (continued)
Colgan operates an all-turboprop fleet under a regional airline capacity purchase agreement with Continental, and under revenue pro-rate agreements with Continental, United and US Airways. Colgan’s operations are focused primarily in the northeastern United States and in Texas. As of December 31, 2008, Colgan offered within its pro-rate operations 225 daily departures to 39 cities in 11 states. Colgan operated 14 Saab 340 aircraft as Continental Connection from Continental’s hub airport in Houston, ten Saab 340 aircraft as United Express at Washington/Dulles, and two Beech 1900 aircraft and ten Saab 340 aircraft as US Airways Express, with hub locations at New York/LaGuardia and Boston, under revenue pro-rate agreements. Colgan operated 15 Q400 aircraft providing 94 daily departures to 20 cities in 14 states and two Canadian provinces as Continental Connection at its global hub at Newark/Liberty International Airport.
Pinnacle serves as our platform for regional jet operations. Pinnacle operates regional jets under capacity purchase agreements (“CPA”s) with Delta. Our jet fleet consists of 50-seat CRJ-200 aircraft and 76-seat CRJ-900 aircraft operating in the Delta network. Our business strategy is to provide our major airline partners with cost-efficient, highly reliable operations that distinguish us from our competitors. We are focused on providing excellent customer service and providing a high quality travel experience. Pinnacle’s unit cost continues to be one of the most competitive in the regional airline industry.
Colgan serves as our platform for turboprop operations. Colgan operates under a CPA with Continental. Under this agreement, Colgan operates 74-seat Q400 turboprop aircraft, which offer superior operating performance at a lower cost than similarly sized regional jets. Colgan also operates under revenue pro-rate agreements with Continental, United, and US Airways, utilizing the Saab 340 aircraft, a 34-seat turboprop aircraft.
On October 1, 2008, Pinnacle entered into an amendment of its Delta Connection Agreement (“DCA”) with Delta to operate on a short-term basis seven additional CRJ-900 aircraft that were formerly operated by another Delta Connection carrier. Pinnacle will temporarily operate these seven CRJ-900 aircraft through the first half of 2009, and return them to Delta as Pinnacle’s seven remaining permanent aircraft enter scheduled service under the DCA. Pinnacle pays to Delta and is reimbursed a nominal amount of rent related to these aircraft. Other than aircraft ownership costs, Pinnacle receives regular compensation under the DCA related to the operation of these seven “Temporary Aircraft.”
On October 29, 2008, Pre-Merger Delta and Northwest completed their previously announced merger, forming the world’s largest passenger airline. Pinnacle is the second largest independent corporate regional partner for Delta. We do not believe that this merger will have a material effect on our operations, as our CPAs with Pre-Merger Delta and with Northwest are relatively long-term and do not contain early termination provisions that could be triggered by their consolidation.
On January 13, 2009, Colgan entered into an amendment to its CPA with Continental, whereby it will acquire and operate an additional 15 Q400 aircraft. Colgan is scheduled to take delivery of these aircraft from August 2010 through April 2011. Colgan also secured from Bombardier options to purchase an additional 15 Q400 aircraft for delivery beginning in March 2013.
As part of our agreement with Continental, we must purchase and finance the Q400 aircraft to be operated by Colgan. We have arranged for a commitment from a lender to finance certain pre-delivery payments that we must make prior to the delivery of each aircraft, and a commitment to provide permanent financing for 85% of the net purchase price of each aircraft when it delivers. These financing commitments are subject to customary terms and conditions, including various requirements related to our financial condition and liquidity at the time of each borrowing request.
Item 1. Business (continued)
On February 12, 2009, Colgan Flight 3407, operated for Continental under the Company’s Continental CPA, crashed shortly before landing in a neighborhood near the Buffalo Niagara International Airport in Buffalo, New York. All 49 people aboard, including 45 passengers and four members of the flight crew, died in the accident. Additionally, one individual died inside the home destroyed by the aircraft’s impact, increasing the total fatality count to 50 individuals. One lawsuit related to this accident has been filed against the Company, and additional litigation is anticipated. We carry aviation risk liability insurance and believe that this insurance is sufficient to cover any liability arising from this accident.
The airline industry is highly competitive. Pinnacle and Colgan compete principally with other code-sharing regional airlines. In addition, through its revenue pro-rate agreements, Colgan competes in certain markets with regional airlines operating without code-share agreements, as well as low-cost carriers and major airlines. Our primary competitors among regional airlines with capacity purchase arrangements include Comair, Inc. ("Comair"); Compass Airlines, Inc. (“Compass”); and Mesaba Aviation, Inc. (“Mesaba”) (all of which are wholly owned subsidiaries of Delta); Air Wisconsin Airlines Corporation; American Eagle Holding Corporation (“AMR Eagle”) (a wholly owned subsidiary of AMR Corporation); ExpressJet Holdings, Inc. ("ExpressJet"); Horizon Air Industries, Inc. (“Horizon”) (a wholly owned subsidiary of Alaska Air Group Inc.); Mesa Air Group, Inc. ("Mesa"); Republic Airways Holdings Inc. ("Republic"); Skywest, Inc. (“Skywest”); and Trans States Airlines, Inc.
The principal competitive factors for regional airlines with capacity purchase agreements are the overall cost of the agreement, customer service, aircraft types, and operating performance. Many of the regional airlines competing for capacity purchase arrangements are larger, and may have greater financial and other resources than Pinnacle and Colgan. Additionally, regional carriers owned by major airlines, such as AMR Eagle, Comair, Horizon, and Mesaba, may have access to greater resources at the parent level than Pinnacle and Colgan, and may have enhanced competitive advantages because they are subsidiaries of major airlines.
Our competition within our pro-rate operations includes other domestic regional airlines and, to a certain extent, major and low-cost domestic carriers that maintain operations in the markets that we serve. The principal competitive factors we experience with respect to our pro-rate flying include fare pricing, customer service, routes served, flight schedules, aircraft types and relationships with major partners. Moreover, federal deregulation of the industry allows competitors to rapidly enter our pro-rate markets and to quickly discount and restructure fares. The airline industry is particularly susceptible to price discounting because airlines incur only nominal costs to provide service to passengers occupying otherwise unsold seats.
The airline industry is highly sensitive to general economic conditions, in large part due to the discretionary nature of a substantial percentage of both business and leisure travel. Many airlines have historically reported lower earnings or substantial losses during periods of economic recession, heavy fare discounting, high fuel costs and other disadvantageous environments. In the past, economic downturns combined with competitive pressures have contributed to a number of reorganizations, bankruptcies, liquidations and business combinations among major and regional carriers. The effect on the Company of economic downturns is somewhat mitigated by the fact that most of our operations are conducted under capacity purchase agreements. Nonetheless, to the extent that our partners experience financial difficulties, they may seek ways to amend the terms of our capacity purchase agreements in a way that negatively affects our financial results. Additionally, Colgan’s pro-rate operations, which operate similarly to an independent airline, are more directly affected by changes in the economy.
The airline industry in the United States has traditionally been dominated by several major airlines, including American Airlines, Inc., Continental, Pre-Merger Delta, Northwest, US Airways and United. Low cost carriers, such as Southwest Airlines Co. ("Southwest"), JetBlue Airways Corporation ("JetBlue"), Frontier Airlines, Inc. ("Frontier") and AirTran Airways, Inc. ("AirTran"), generally offer fewer conveniences to travelers and have lower cost structures than major airlines, which permits them to offer flights to and from many of the same markets as the major airlines, but at lower prices. Low cost carriers typically fly direct flights with limited service to smaller cities, concentrating on higher demand routes to and from major population bases.
Item 1. Business (continued)
Regional airlines, such as ExpressJet, Mesa, Republic and SkyWest, typically operate smaller aircraft on lower-volume routes than major and low cost carriers. Several regional airlines, including AMR Eagle, Comair, Compass, Horizon, and Mesaba, are wholly-owned subsidiaries of major airlines.
In contrast to low cost carriers, regional airlines generally do not seek to establish an independent route system to compete with the major airlines. Rather, regional airlines typically enter into relationships with one or more major airlines, pursuant to which the regional airline agrees to use its smaller, lower-cost aircraft to carry passengers ticketed by the major airline between a hub of the major airline and a smaller outlying city. In exchange for such services, the major airline pays the regional airline either a fixed flight fee, termed "capacity purchase" or "fixed-fee" flights, or the regional airline receives a percentage of applicable ticket revenues, termed "pro-rate" or "revenue-sharing" flights.
The growth in the number of passengers using regional airlines and the revenues of regional airlines during the last decade is attributable primarily to the introduction and popularity of regional jets. Major airlines sought to add regional jets in many markets to replace smaller turboprop aircraft and slightly larger narrowbody jets. By adding regional jets, hub and spoke carriers were able to increase the scope of their network by serving markets that could not be supported by a narrowbody aircraft, reduce the operating cost in markets previously supported by narrowbody jets, and increase the level of passenger service in smaller markets previously serviced with turboprop aircraft.
Key to this strategy was the ability to outsource regional jet operations to regional airlines through the use of capacity purchase arrangements. Regional airlines tend to have a more favorable cost structure and leaner corporate structure than many major airlines. In addition, the complexities of multiple fleet types at an airline can increase costs because of the need to maintain multiple aircraft maintenance functions and multiple flight crew training functions. By outsourcing regional jet operations to regional airlines, major airlines can reduce the number of aircraft types in their operating fleet while still enjoying the flexibility and revenue production that regional jets provide to their passenger network.
Regional airlines generally enter into code-share agreements with major airlines, pursuant to which the regional airline is authorized to use the major airline's two-letter flight designator codes to identify the regional airline's flights and fares in the central reservation systems, to paint its aircraft with the colors and/or logos of its code-share partner and to market and advertise its status as a carrier for the code-share partner. For example, Pinnacle flies out of Detroit, Minneapolis/St. Paul, Memphis, and Atlanta under Delta brands. Colgan operates as Continental Connection out of Newark and Houston, United Express out of Washington/Dulles, and US Airways Express with significant operations at Boston and New York/LaGuardia. In addition, the major airline generally provides services such as reservations, ticketing, ground support and gate access to the regional airline, and both partners often coordinate marketing, advertising and other promotional efforts. In exchange, the regional airline provides a designated number of low-capacity (usually between 30 and 76 seats) flights between larger airports served by the major airline and surrounding cities, usually in lower-volume markets.
Our operating contracts fall under two categories: capacity purchase agreements (“CPA”s) and revenue pro-rate agreements. The following table presents for the year ended December 31, 2008 the percentage of our regional airline services revenue derived under each contract type and by code-share partner:
Item 1. Business (continued)
Capacity Purchase Agreements. Our preferred contractual relationships with major airlines are structured as capacity purchase arrangements. Under CPAs, our major airline partners purchase our flying capacity by paying pre-determined rates for specified flying, regardless of the number of passengers on board or the amount of revenue collected. These arrangements typically include incentive payments that are paid if we meet certain operational performance measures. Additionally, certain operating costs such as fuel, aviation insurance premiums, and ground handling are reimbursed or provided directly by the partner, which eliminates our risk associated with a change in the price of these goods or services. We believe the capacity purchase model reduces our financial risk and enables us to focus on operating our business with the highest standards, while maximizing the efficiencies of the business that we provide to our partners. Therefore, we plan to grow the percentage of our revenue derived from these types of agreements by working to structure new business with capacity purchase terms.
Pinnacle’s Amended and Restated Airline Services Agreement (the “CRJ-200 ASA”) pertaining to its CRJ-200 operations and its DCA pertaining to its CRJ-900 operations are both structured as CPAs. In addition, Colgan’s Q400 operations for Continental are under a CPA (the “Continental CPA”).
Under our CPAs, most costs we incur are classified as one of the following:
The following is a summary of the treatment of certain costs under our three CPAs.
Item 1. Business (continued)
Revenue Pro-rate Agreements. In addition to the Continental CPA, Colgan operates under contracts structured as revenue pro-rate code-share agreements, which allow for Colgan to market its operations under its partners’ brands. Under these agreements, Colgan generally manages its own inventory of unsold capacity and sets fare levels in the local markets that it services. Colgan retains all of the revenue for passenger flying within Colgan’s local markets and not connecting to its partners’ flights. For connecting passengers, the passenger fare is pro-rated between Colgan and its major airline partner, generally based on the distance traveled by the passenger on each segment of the passenger’s trip. Under these agreements, Colgan bears the risk associated with fares, passenger demand, and competition within its markets. Colgan incurs all of the costs associated with operating these flights, including those costs typically reimbursed or paid directly by the major airline under a capacity purchase agreement. In some instances, Colgan has the ability to earn incentive-based revenue should it achieve specified performance metrics.
Colgan’s revenue pro-rate agreement with Continental also contains a connecting passenger incentive designed to maintain a base level of profitability in the Houston markets that Colgan serves. The connect incentive can be a payment from or a payment to Continental, depending on certain variables such as load factors, and is designed to create a more stable income level in these markets than could otherwise be supported under a traditional revenue pro-rate agreement. The connect incentives rates are adjusted twice a year for changes in fuel prices and station/passenger related costs.
Colgan’s revenue pro-rate agreement with United includes a fixed connecting passenger incentive payment designed to subsidize some of the markets that Colgan operates in as United Express. These markets would not be profitable on a stand-alone basis without the connecting passenger incentive. The incentive amount is fixed for the three-year term of the agreement and may only be adjusted upon the concurrence of both Colgan and United. Colgan does have the ability to exit these markets to the extent that the markets can no longer be operated profitably with the fixed connecting passenger incentive payment.
In addition to operating its flights under revenue pro-rate code-share agreements, Colgan also operates some flights within its United Express and US Airways Express networks under Essential Air Service (“EAS”) contracts with the Department of Transportation (“DOT”). The EAS program provides a federal government subsidy within certain small markets that could not otherwise sustain commercial air service because of limited passenger demand.
CRJ-200 Airline Services Agreement
Pinnacle provides regional jet service to Delta operating 124 50-seat CRJ-200 aircraft under the CRJ-200 ASA. At the end of its term in 2017, the CRJ-200 ASA automatically extends for additional five-year periods unless Delta provides notice to us two years prior to the termination date that it does not plan to extend the term.
In addition to the rate-based and reimbursed payments previously detailed, our CRJ-200 ASA with Delta provides for margin payments. The current rate-based payments will be in effect (subject to indexed annual inflation adjustments) through 2012, when rates will reset. We receive a monthly margin payment based on the payments described above calculated to achieve a target operating margin. The target operating margin is 8% for 2008 and future years and our margin payments are subject to a ceiling. As of January 1, 2008, Delta does not guarantee Pinnacle’s minimum operating margin, although we will still be subject to a margin ceiling above the target operating margin. If Pinnacle’s actual operating margin for any year beginning with 2008 exceeds the 8% target operating margin but is less than 13%, Pinnacle will make a year-end adjustment payment to Delta in an amount equal to half of the excess above 8%. If Pinnacle’s actual operating margin for any year beginning with 2008 exceeds 13%, Pinnacle will pay Delta all of the excess above 13%. Margin calculations under the CRJ-200 ASA exclude amounts recognized as deferred ASA revenue, which is discussed in detail in Note 3, Code-Share Agreements, in Item 8 of this Form 10-K.
Item 1. Business (continued)
The CRJ-200 ASA provides that we will be required to negotiate with Delta an adjustment to our rates to the extent that we establish operations with another major airline. Upon reaching a certain level of operations outside of our CRJ-200 ASA, and to the extent that we have realized operating cost efficiencies from combining overhead in such outside operations, we will negotiate a rate reduction to the fixed payment that we receive under our CRJ-200 ASA related to our overhead. The method of calculation, timing and extent of Delta’s rate reduction have not yet been determined. To the extent that we cannot agree on the amount of a rate reduction with Delta, the parties have agreed to pursue binding arbitration to determine the rate reduction.
To the extent that Pinnacle operates regional jets on behalf of another major airline, Delta may remove one aircraft for every two aircraft that Pinnacle operates for another partner above an initial base of 20 regional jets. Delta may remove no more than 20 aircraft subject to this option and no more than five aircraft in any 12-month period. Delta may only exercise this option if the removed aircraft are not operated by or on behalf of Delta after their removal.
Delta may terminate the CRJ-200 ASA at any time for cause, which is defined as:
Delta may also terminate the agreement at any time upon our bankruptcy or for any breach of the agreement by us that continues uncured for more than 30 days after we receive notice of the breach. However, in the case of a non-monetary default, Delta may not terminate the agreement if the default would take more than 30 days to cure and we are diligently attempting to cure the default. In addition, both Delta and we are entitled to seek an injunction and specific performance for a breach of the agreement. In addition, in the case of any other termination of the CRJ-200 ASA, Delta will have the right to require us:
In general, we have agreed to indemnify Delta and Delta has agreed to indemnify us for any damages caused by any breaches of our respective obligations under the CRJ-200 ASA or caused by our respective actions or inaction under the CRJ-200 ASA.
Item 1. Business (continued)
Delta Connection Agreement (“DCA”)
Pinnacle provides regional jet service to Delta operating 76-seat CRJ-900 aircraft under the DCA. The DCA provides that Pinnacle operate 16 CRJ-900 aircraft under a capacity purchase agreement. As of December 31, 2008, Pinnacle operated 18 CRJ-900 aircraft (including the seven Temporary Aircraft) under the DCA. We placed three additional CRJ-900 aircraft into service under the DCA during the first quarter of 2009 and expect to place the final two CRJ-900 aircraft into service during the second quarter of 2009. The DCA allows Delta the option to add an additional seven CRJ-900 aircraft to the fleet.
The DCA provides for Delta to pay pre-set rates based on the capacity we provide to Delta. We are responsible for the costs of flight crews, maintenance, dispatch, aircraft ownership and general and administrative costs. In addition, Delta reimburses us for certain pass-through costs, including landing fees, most station-related costs (to the extent that we incur them) and aircraft hull and general liability insurance. In most instances, Delta will provide fuel and ground handling services free of charge. We earn incentive payments (calculated as a percentage of the payments received from Delta) if we meet certain performance targets. The DCA also provides for reimbursements to Delta annually to the extent that our actual pre-tax margin on our Delta Connection operations exceeds certain thresholds.
The DCA terminates for each aircraft upon the tenth anniversary of the in-service date of such aircraft. Upon the sixth anniversary of the agreement date, which is April 27, 2013, either party has the right under the DCA to remove up to 20% of the CRJ-900 aircraft in service from the terms of the agreement each year thereafter.
To the extent that either party materially breaches the DCA and such breach remains uncured for a period of 30 days, the non-breaching party may terminate the agreement. In addition, Delta may temporarily suspend or terminate the DCA in the event of certain force majeure events that prevent either party from performing its obligations under the DCA. Delta may also terminate the DCA upon certain corporate transactions such as a merger or change of control involving the Company, our failure to maintain a certain level of safety, our failure to maintain certain specified operational performance standards, our failure to maintain various governmental operating regulations, certifications and authorities, a material breach by us of our purchase agreement for our CRJ-900 aircraft with the manufacturer, or our failure to maintain specified levels of insurance. Delta may also terminate the DCA if Pinnacle commences operating a fleet type that causes Delta to be in violation of the collective bargaining agreement with its pilots.
Continental Connection Capacity Purchase Agreement (“Continental CPA”)
Colgan operates 74-seat Q400 turboprop regional aircraft predominantly out of Continental’s hub at Newark Liberty International Airport. Colgan entered into the ten-year Continental CPA on February 5, 2007, which expires on December 1, 2017. Operations began on February 4, 2008, and we currently operate 14 Q400 aircraft under the Continental CPA. As previously discussed, on January 13, 2009, we amended the Continental CPA to add an additional 15 Q400 aircraft. We will purchase and finance these aircraft, which are expected to deliver between August 2010 and April 2011.
The Continental CPA provides that we are compensated at pre-set rates for the capacity that we provide to Continental. We are responsible for our own expenses associated with flight crews, maintenance, dispatch, aircraft ownership and general and administrative costs. In addition, Continental reimburses us without a markup for certain reconciled costs, such as landing fees, most other station-related costs to the extent that we incur them, aircraft hull and passenger liability insurance (provided that our insurance rates do not exceed those typically found at other Continental regional airline partners) and passenger related costs. Continental will also provide fuel and ground handling services at its stations to us at no charge. Continental may request that we provide ground handling for our flights at certain stations, in which case, we will be compensated at a predetermined rate for these ground handling services. The Continental CPA also provides for the ability to earn additional incentive-based revenue based upon achieving operational and financial performance targets.
Item 1. Business (continued)
The Continental CPA provides for a rate reduction to Continental to the extent that we begin operating Q400 aircraft for another major airline. The rate reduction is designed to share the overhead burden associated with the Q400 aircraft across all of our potential Q400 operations and is only applicable for the first 15 aircraft that we add with another airline.
Continental may immediately terminate the Continental CPA following the occurrence of any event that constitutes cause. Cause is defined as the following:
To the extent that either party materially breaches the Continental CPA and such breach remains uncured for a period of 60 days, the non-breaching party may terminate the agreement. Continental may also terminate the CPA upon certain corporate transactions such as a merger or change of control involving the Company, our failure to maintain a certain level of safety, our failure to maintain certain specified operational performance standards, or our failure to maintain various governmental certifications and to comply with various governmental operating regulations and authorities.
Continental Connection Pro-Rate Agreement
We operate 14 Saab 340 aircraft based in Houston, Texas under a code-share agreement with Continental (the “Continental Agreement”). Colgan entered into the Continental Agreement in January 2005 for a term of five years. The Continental Agreement is structured as a pro-rate agreement for which we receive all of the fares associated with local passengers and an allocated portion of the connecting passengers’ fares. We pay all of the costs of operating the flights, including sales and distribution costs. However, we also receive connect incentive payments from Continental for passengers connecting from Colgan operated flights to any flights operated by Continental or its other code-share partners at Houston/George Bush Intercontinental Airport. The connect incentive payments are designed to maintain a base level of profitability in the markets that we fly out of Houston, and can result in a payment to us or from us depending on our passenger load factor in these markets. The connect incentives are modified every six months to adjust for prospective modifications in fuel prices and certain station expenses.
US Airways Express Agreement
We operate ten Saab 340 aircraft under a code-share agreement with US Airways (the “US Airways Agreement”). As of December 31, 2008, we also operated two Beech 1900D aircraft, which have since been removed from service. Colgan entered into the US Airways Agreement in 1999 to provide passenger service and cargo service under the name “US Airways Express.” The US Airways Agreement provides us use of the US Airways flight designator code to identify flights and fares in computer reservations systems, permits use of logos, service marks, aircraft paint schemes, and uniforms similar to those used by US Airways and coordinated scheduling and joint advertising. The US Airways Agreement is structured as a revenue pro-rate agreement for which we receive all of the fares associated with our local passengers and an allocated portion of connecting passengers’ fares. We pay all of the costs of operating the flights, including sales and distribution costs. We control all scheduling, inventory and pricing for each local market we serve. The current US Airways Agreement became effective on October 1, 2005 under terms similar to the 1999 agreement and has a three-year term. At the end of the three-year term, the US Airways Agreement automatically extends for multiple six-month periods until either party provides notice to terminate.
Item 1. Business (continued)
United Express Agreement
In October 2003, Colgan entered into a code-share agreement with United Air Lines to include the United Air Lines flight designator code on all United flights operated by Colgan. In October 2005, Colgan entered into a separate code-share agreement with United to provide services as a United Express carrier (the “United Express Agreement”). The United Express Agreement was amended and restated effective November 1, 2008. Colgan currently operates ten Saab 340 aircraft under the name “United Express.” The United Express Agreement expires on November 1, 2011 and is structured as a pro-rate agreement for which we receive all of the fares associated with local passengers and an allocated portion of the connecting passengers’ fares. In addition, United pays us a set passenger connect incentive fee for certain of the markets that we operate under the United Express Agreement. The passenger connect incentive may only be adjusted during the three-year term by mutual consent of the parties. We do have the right, however, to cease serving certain of these markets to the extent that our operations are not profitable. We pay all of the costs of operating the flights, including sales and distribution costs. We jointly coordinate with United all scheduling, inventory and pricing for each local market we serve.
Item 1. Business (continued)
As of December 31, 2008, we had 5,644 employees. Flight attendants and ground operations agents included 256 and 954 part-time employees, respectively. The part-time employees work varying amounts of time, but typically work half-time or less. The follow table details the number of employees by company and by group:
Labor costs are a significant component of airline expenses and can substantially affect our results. Approximately 78% and 57% of Pinnacle Airlines, Inc. and Colgan Air, Inc. employees, respectively, are represented by unions.
The following table reflects our principal collective bargaining agreements and their respective amendable dates:
The Railway Labor Act, which governs labor relations for unions representing airline employees, contains detailed provisions that must be exhausted before work stoppage can occur once a collective bargaining agreement becomes amendable.
The collective bargaining agreement between Pinnacle and the Air Line Pilots Association (“ALPA”) became amendable in April 2005. Pinnacle has been actively negotiating with ALPA since that time. In August 2006, Pinnacle filed for mediation with the National Mediation Board. Since then, Pinnacle has met with the federal mediator assigned to its case and with ALPA, but has not reached resolution on an amended collective bargaining agreement.
Item 1. Business (continued)
Using a combination of FAA-certified maintenance vendors and our own personnel and facilities, we maintain our aircraft on a scheduled and as-needed basis. We perform preventive maintenance and inspect our engines and airframes in accordance with our FAA-approved preventive maintenance policies and procedures.
The maintenance performed on our aircraft can be divided into three general categories: line maintenance, heavy maintenance checks, and engine and component overhaul and repair. Line maintenance consists of routine daily and weekly scheduled maintenance checks on our aircraft, including pre-flight, daily, weekly and overnight checks and any diagnostic and routine repairs.
Pinnacle contracts with an affiliate of the original equipment manufacturer of its CRJ-200s to perform certain routine heavy maintenance checks on its aircraft. Pinnacle also contracts with a third party to perform engine overhauls on its CRJ-200 fleet. These maintenance checks are regularly performed on a schedule approved by the manufacturer and the FAA. In general, both the CRJ-200 and CRJ-900 aircraft do not require their first heavy maintenance checks until they have flown approximately 8,000 hours. Therefore, we do not expect our CRJ-900 regional aircraft to require such heavy maintenance checks for several years. The average age of the CRJ-200 and CRJ-900 regional jets in our fleet as of December 31, 2008 was approximately 5.7 years and 0.7 years, respectively.
Colgan performs its own heavy maintenance airframe checks for its Saab fleet at its maintenance facility in Houston, Texas, and occasionally contracts with third-party vendors for heavy maintenance airframe checks on an as-needed basis. Colgan contracts with third parties to perform engine overhauls and propeller maintenance on its Saab fleet. Colgan plans to use a combination of internal and third-party resources to complete heavy maintenance requirements on its Q400 fleet. In general, the Q400 aircraft do not require their first heavy maintenance checks until they have flown approximately 4,000 hours. Therefore, we do not expect our Q400 aircraft to require such heavy maintenance checks for several years. The average age of the Q400 aircraft in our fleet as of December 31, 2008 was approximately 0.7 years.
Component overhaul and repair involves sending parts, such as engines, landing gear and avionics to a third-party, FAA-approved maintenance facility. We are party to maintenance agreements with various vendors covering our aircraft engines, avionics, auxiliary power units and brakes.
Pinnacle performs the majority of its flight personnel training in Memphis, Tennessee both at its Corporate Education Center and the simulator center operated by FlightSafety International. FlightSafety International, at Pinnacle’s request, provides some overflow training at various other simulator centers throughout the U.S. and Canada. The Memphis simulator center currently includes three CRJ full-motion simulators. Under Pinnacle’s agreement with FlightSafety International, Pinnacle has first priority on all of the simulator time available in the Memphis center. Instructors used in the Memphis center are typically Pinnacle employees who are either professional instructors or trained line pilot instructors.
Colgan’s flight personnel are trained at various simulator centers throughout the U.S. and Canada under a contract with FlightSafety International. Non-simulator training is conducted near its corporate headquarters in Manassas, Virginia.
We provide both in-house and outside training for our maintenance personnel. To control costs and to ensure our employees receive the best training, we take advantage of manufacturers’ training programs offered, particularly when acquiring new aircraft. We employ professional instructors to conduct training of mechanics, flight attendants and ground operations personnel in Memphis and Manassas.
Item 1. Business (continued)
We are committed to the safety and security of our passengers and employees. One of our most important Guiding Principles is “Never Compromise Safety.” For example, we have implemented the Flight Operational Quality Assurance (“FOQA”) program. FOQA programs involve the collection and analysis of data recorded during flight to improve the safety of flight operations, air traffic control procedures, and airport and aircraft design and maintenance. In addition, we have implemented the FAA’s Aviation Safety Action Program (“ASAP”). ASAP’s focus is to encourage voluntary reporting of safety issues and events that come to the attention of employees of certain certificate holders.
Since the September 11, 2001 terrorist attacks, Pinnacle and Colgan have taken many steps to increase the safety and security of their operations. Some of the security measures we have taken, along with our code-share partners, include: aircraft security and surveillance, positive bag matching procedures, enhanced passenger and baggage screening and search procedures, and securing of cockpit doors. We will continue to comply with future safety and security requirements.
As required by our code-share agreements, we currently maintain insurance policies with necessary coverage levels for: aviation liability, which covers public liability, passenger liability, hangar keepers’ liability, baggage and cargo liability and property damage; war risk, which covers losses arising from acts of war, terrorism or confiscation; hull insurance, which covers loss or damage to our flight equipment; directors’ and officers’ insurance; property and casualty insurance for our facilities and ground equipment; and workers’ compensation insurance. Our code-share agreements require that we maintain specified coverage levels for these types of policies.
Our aviation liability and hull insurance coverage is obtained through a combined placement with eight other airlines. We are reimbursed in full for aviation insurance under our three capacity purchase agreements.
We were given the option under the Air Transportation Safety and Stabilization Act, signed into law on September 22, 2001, to purchase certain third-party war risk liability insurance from the U.S. government on an interim basis at rates that are more favorable than those available from the private market. As provided under this Act, we have purchased from the FAA this war risk liability insurance, which is currently set to expire on March 31, 2009. We expect to renew the policy upon its expiration.
Our subsidiaries operate under air carrier certificates issued by the FAA and certificates of convenience and necessity issued by the DOT. The DOT may alter, amend, modify or suspend these authorizations if the DOT determines that we are no longer fit to continue operations. The FAA may suspend or revoke the air carrier certificates if our subsidiaries fail to comply with the terms and conditions of the certificates. The DOT has established regulations affecting the operations and service of the airlines in many areas, including consumer protection, non-discrimination against disabled passengers, minimum insurance levels and others. Failure to comply with FAA or DOT regulations can result in civil penalties, revocation of the right to operate or criminal sanctions. FAA regulations are primarily in the areas of flight operations, maintenance, ground facilities, security, transportation of hazardous materials and other technical matters. The FAA requires each airline to obtain an operating certificate authorizing the airline to operate at specific airports using specified equipment. Under FAA regulations, our subsidiaries have established, and the FAA has approved, a maintenance program for each type of aircraft they operate that provides for the ongoing maintenance of these aircraft, ranging from frequent routine inspections to major overhauls.
Item 1. Business (continued)
As with most airlines, we are subject to seasonality, though seasonality has historically had a lesser effect on our capacity purchase operations than it has on our pro-rate operations. Mainline carriers use capacity purchase agreements because these arrangements allow them to expand their operations at lower fixed costs by using a regional’s lower cost structure for operating aircraft. Because regional aircraft have lower fixed and variable costs than larger aircraft, mainline carriers tend to maintain regional aircraft utilization during seasons of reduced demand. Conversely, our financial results can be materially affected by the level of passenger demand for our services operated under pro-rate agreements, under which we more directly bear the risk of decreased demand for our services. Our results can materially vary due to seasonality and cyclicality. For example, Colgan has historically reported significant losses or significantly lower income during the first and fourth quarters of each year when demand for air travel is generally lower, and higher income during the second and third quarters of each year when demand for air travel increases.
Our website address is www.pncl.com. All of our filings with the U.S. Securities and Exchange Commission (“SEC”) are available free of charge through our website on the same day, or as soon as reasonably practicable after we file them with, or furnish them to, the SEC. Printed copies of our Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, and Current Reports on Form 8-K may be obtained by submitting a request at our website. Our website also contains our Code of Business Conduct, which contains rules of business conduct and ethics applicable to all of our directors and employees. Any amendments to or waivers from the Code of Business Conduct in the future will be promptly posted to our website.
Risks Related to our Financial Condition
If the holders of our 3.25% Senior Convertible Notes Due 2025 (the “Notes”) exercise their right to require us to redeem their Notes, our liquidity could be adversely affected or we may issue additional stock, which would dilute existing shareholders.
Holders of the Notes may require us to purchase all or a portion of their Notes for cash on each of February 15, 2010, February 15, 2015 and February 15, 2020 at a purchase price equal to 100% of the principal amount of the Notes to be repurchased plus accrued and unpaid interest, if any, to the purchase date. While at December 31, 2008 all $121.0 million of the Notes were outstanding, during January 2009, we repurchased $12.0 million of the Notes for approximately $8.9 million. As of March 2, 2009, $109.0 million of the Notes remain outstanding.
Due to our significant investment in the purchase of our CRJ-900 and Q400 aircraft and the current illiquid state of our auction rate securities, our financial leverage has significantly increased and our liquidity has been reduced. Further limiting our ability to refinance this obligation is the current illiquid nature of the overall credit markets due to the existing poor condition of the economy and the financial markets. If the holders of the Notes exercise their right to require us to repurchase all of their Notes in February 2010, we will be required to repurchase the remaining Notes for approximately $109.0 million in cash. No assurance can be given that we will have sufficient resources to repay this obligation. One option to obtain additional cash resources that we might be required to employ would be to issue additional common stock, either directly to holders of the Notes in satisfaction of our cash repayment obligation (although holders are not contractually obligated to accept such shares in lieu of cash) or through a secondary public offering to raise capital. Such an issuance would dilute existing shareholders.
Our investment portfolio is primarily composed of auction rate securities, or ARS, which have become illiquid and impaired. For reasons beyond our control, we may be unable to comply with our financial covenants contained in our credit facility associated with our ARS portfolio. Failure to comply with our financial covenants could increase the losses that may be realized on the sale of our ARS.
During 2008, our investments in ARS became illiquid. In order to improve our liquidity during the period of time our ARS remain illiquid, we obtained financing, secured by our ARS holdings, consisting of a fully drawn $90.0 million revolving credit facility, which we refer to as the “Credit Facility,” with a final maturity in January 2010. The Credit Facility contains covenants related to both a loan-to-par value and a loan-to-fair value ratio. During 2008, we recorded $16.8 million in impairment charges related to declines in the fair values of our ARS, and we may record additional impairment charges in future periods if we determine that the ARS have further declined in value. While we are able to control compliance with the loan-to-par value covenant, should the fair value of our ARS holdings (as established by secondary market trades) continue to decline, we may fall below the minimum required loan-to-fair value threshold. We have no control over the fair values, and the current market volatility may lead to further declines. In such instances, we would have the ability to maintain compliance of the loan-to-fair value ratio by repaying a portion of the Credit Facility. The Credit Facility also includes a net worth test. While the calculation of this covenant excludes the effects of our derivative transactions and declines in the fair value of our ARS, special charges such as goodwill and other intangible asset impairment charges or poor operating results could cause us to fall below the minimum net worth value. Failure to comply with these covenants would result in a default under the Credit Facility.
If we were unable to obtain a waiver or otherwise mitigate a default of any covenant, the financial institution could exercise its right to sell all or a portion of our ARS holdings, which at December 31, 2008 had a par value of $133.7 million. While we are seeking ways to minimize the actual losses which would be realized upon the sale of ARS by holding the investments until their values recover, if we do not comply with debt covenants and the financial institution then attempts to sell all or a portion of our ARS, the actual losses realized upon the sale may exceed the $16.8 million impairment charges already recognized. Additionally, if the net proceeds from the sale of our ARS fail to fully satisfy the $90.0 million obligation, we could be required to repay any shortfall.
For further discussion of our ARS investments, please refer to Note 9, Investments, in Item 8 of this Form 10-K. For further discussion of our financial covenants and the status of our year-end compliance, please refer to Note 10, Borrowings, also found in Item 8 of this Form 10-K.
Item 1A. Risk Factors (continued)
The global financial crisis may have an impact on our business and financial condition in ways that we currently cannot predict.>
Over the past twelve months, the financial and credit markets have been extremely volatile, and certain components of the capital markets have become illiquid. Many companies with debt obligations or capital needs have been unable to access components of the capital markets during this time. The continued credit crisis and related turmoil in the global financial system has had, and may continue to have, an impact on our business and financial condition. For example, our investments in auction rate securities have become illiquid during this period. Going forward, our ability to access the capital markets to either monetize assets or raise capital may be severely restricted, which could have an impact on our ability to meet our obligations and react to changing economic and business conditions. See also our risk factors related to our Notes and investments in ARS for additional discussion of this risk and its potential effect on our business. Also, while we currently have no outstanding hedges, the credit crisis could affect future hedging contracts if counterparties are forced to file for bankruptcy or are otherwise unable to perform their obligations.
Our fleet expansion program will require a significant increase in our leverage and the related cash outflows.
The airline business is capital intensive and, as a result, we are highly leveraged, as are most airlines. During the year ended December 31, 2008, our mandatory debt service payments totaled $85 million, and our mandatory lease payments totaled $156 million. Our current growth strategy involves the acquisition by purchase or lease of at least 17 more aircraft through April 2011, which includes two CRJ-900 aircraft expected to deliver in the second quarter of 2009 and our recently announced purchase or lease of an additional 15 Q400 aircraft that we will operate under related capacity purchase code-share agreements. We expect to finance a substantial portion of the purchase price related to these aircraft, which will significantly increase our future mandatory debt service payments. Additionally, at December 31, 2008, we have approximately $1 billion of future minimum lease obligations, which run through 2017 and primarily relate to the lease of our CRJ-200 aircraft from Delta. The majority of these lease obligations would terminate if our CRJ-200 ASA were terminated prior to its 2017 expiration date.
There can be no assurance that our operations will generate sufficient cash flow, or that our ARS situation will provide us sufficient additional liquidity to enable us to obtain the necessary aircraft acquisition financing and to make such payments. If we default under our loan, lease or aircraft purchase agreements, the lender/lessor/manufacturer has available extensive remedies, including, without limitation, repossession of the respective aircraft and other assets. Even if we meet all required debt, lease, and purchase obligations, the size of these long-term obligations could negatively affect our financial condition, results of operations and the price of our common stock in many ways, including:
If we need additional capital and cannot obtain such capital on acceptable terms, or at all, we may be unable to realize our current plans or take advantage of unanticipated opportunities and could be required to slow or stop our growth.
We are currently under audit by the Internal Revenue Service, and the results of the audit could materially affect our financial statements and liquid assets.
The Internal Revenue Service, or “IRS,” is currently examining our federal income tax returns for years 2003 through 2005. The IRS has focused on several key transactions that we undertook during those periods and the IRS has proposed adjustments. Should the IRS prevail on any proposed adjustment, the impact on us could be significant. While we believe that we have recorded reserves that are appropriate for each identified issue, our liquid assets and our net earnings could be significantly reduced if the IRS examination ultimately overturns our positions.
Item 1A. Risk Factors (continued)
Our stock price is volatile.
Since January 2007, the market price of our common stock has ranged from a low of $1.69 to a high of $19.88 per share. The market price of our common stock may continue to fluctuate substantially due to a variety of factors, many of which are beyond our control, including:
announcements concerning our partners, competitors, the airline industry or the economy in general;
● strategic actions by us, our partners or our competitors, such as acquisitions or restructurings;
● media reports and publications about the safety of our aircraft or the aircraft types we operate;
● new regulatory pronouncements and changes in regulatory guidelines;
● general and industry specific economic conditions, including the price of oil;
● changes in our leverage and liquidity;
● changes in financial estimates or recommendations by securities analysts;
● sales of our common stock or other actions by investors with significant shareholdings; and
● general market conditions.
The stock markets in general have experienced substantial volatility that has often been unrelated to the operating performance of particular companies. These broad market fluctuations may adversely affect the trading price of our common stock. In the past, stockholders have sometimes instituted securities class action litigation against companies following periods of volatility in the market price of their securities. Any similar litigation against us could result in substantial costs, divert management's attention and resources and harm our business.
We are increasingly dependent on technology in our operations, and if our technology fails, our business may be adversely affected.
Our subsidiaries’ systems operations control centers, which oversee daily flight operations, are dependent on a number of technology systems to operate effectively. Large scale interruption in technology infrastructure that we depend on, such as power, telecommunications or the internet, could cause a substantial disruption in our operations.
Risks Related to our Code-Share Agreements
We are at risk of adverse publicity stemming from any accident involving our aircraft.
While we believe the insurance we carry to cover losses arising from an aircraft crash or other accident is adequate to cover such losses, any accident involving an aircraft that we operate for one of our code-share partners could create a public perception that our aircraft or operations are not safe or reliable. Such a perception could harm our reputation, result in the loss of existing business with our code-share partners, result in an inability to win new business and harm our profitability. For a description of the Colgan Flight 3407 accident, see Legal Proceedings in Part I, Item 3 of this Form 10-K.
We are highly dependent upon our CRJ-200 ASA with Delta due to the concentration of our total revenue related to this agreement. During 2008, our CRJ-200 operations with Delta generated approximately 67% of our consolidated regional airline services revenues. Termination or modification of our CRJ-200 ASA by Delta would significantly reduce our consolidated revenue, result in a material decline in our earnings, and affect our ability to continue operations.
As discussed in greater detail in Item 1, “Business,” Delta may terminate for cause the CRJ-200 ASA at any time for any breach of the agreement by us that continues uncured for more than 30 days after we receive notice of the breach. A termination of our CRJ-200 ASA would have a material adverse effect on our financial condition, operating revenues, and net income unless we are able to enter into satisfactory substitute arrangements whereby, because we sublease our CRJ-200 aircraft from Delta, we would acquire aircraft to operate under a regional airline service agreement with another major airline. In addition, we would be required to obtain airport facilities and gates, and provide the same variety of third-party services presently provided by Delta, or alternatively, take the necessary steps to operate as an independent airline. We may not be able to enter into substitute code-share arrangements, and any such arrangements we might secure may not be as favorable to us as our current agreements.
Item 1A. Risk Factors (continued)
Additionally, our CRJ-200 ASA is a complex document containing many provisions subject to interpretation. Delta has disputed certain provisions of the CRJ-200 ASA in the past in an attempt to reduce the payments it makes to us. Two such matters are currently unresolved, as further described in Note 3 to Item 8 of this Form 10-K. Typically we would agree to a dispute resolution process such as arbitration to resolve these types of disagreements. The current unresolved matters, or future disagreements over interpretation of the CRJ-200 ASA, may result in materially unfavorable adjustments to our revenue and profitability related to our CRJ-200 operations.
Unlike our CRJ-200 operations under which we sublease our aircraft from Delta, we bear the aircraft ownership risk associated with our CRJ-900 and Q400 operations. Termination of either the DCA or the Continental CPA would materially impede our ability to meet our debt obligations.
As discussed in greater detail in Item 1, “Business,” Delta and Continental may terminate for cause the DCA or Continental CPA, respectively, for any breach of the agreement by us that continues uncured for more than the time allotted in the agreement. A termination of either agreement would have a material adverse effect on our ability to fund our debt obligations, including our aircraft debt obligations. Failure to meet these obligations could lead to the loss of our aircraft and the equity investment we have made in the purchase of the aircraft. Additionally, termination of either agreement would adversely affect our financial condition, operating revenues, and net income unless we are able to enter into satisfactory substitute arrangements with another major airline. In addition, we would be required to obtain the necessary airport facilities and gates, and provide the same variety of third-party services presently provided by Delta and Continental, or alternatively, take the necessary steps to operate as an independent airline. We may not be able to enter into substitute code-share arrangements, and any such arrangements we might secure may not be as favorable to us as our current agreements.
We are highly dependent upon the services provided by our major airline partners.
Related to our dependence on our capacity purchase agreements is our reliance on our major airline partners for the services they provide to support our current operations. We currently use or rely upon Delta's, Continental’s and our pro-rate partners’ systems, facilities and services to support a significant portion of our operations, including airport and terminal facilities and operations, information technology support, ticketing and reservations, scheduling, dispatching, fuel purchasing and ground handling services. Were we to lose any of our operations with these partners, particularly related to our DCA and Continental CPA agreements with Delta and Continental, respectively, for which we bear the ownership risks associated with the aircraft, we would need to replace all of the services mentioned above and make the other arrangements necessary to fly as an independent airline. We may not be able to replace in a timely fashion all of the services provided by our partners, or enter into substitute code-share arrangements, and any arrangements we might secure may not be as favorable to us as our current agreements. Additionally, operating our airline independent from major partners would be a significant departure from our business plan, and may require significant time and resources, which may not be available to us.
There are risks associated with our regional jet strategy, including potential oversupply.
Under our capacity purchase agreements, our major partners bear the risk of increases in certain operating costs such as fuel expense. When fuel costs rise, the “cost per available seat mile” increases more dramatically for 50-seat regional jets (such as the CRJ-200 aircraft we operate for Delta) versus larger aircraft. While the cost of fuel fell in the second half of 2008, we have no assurance that the cost will remain low. In fact, if the overall economy improves, prices could potentially return to record high levels. Consequently, these cost pressures reduce the economic advantage of 50-seat aircraft, prompting major airlines to seek ways to reduce the number of these aircraft operating within their fleets.
The Delta system includes more than 400 50-seat aircraft, the most of any major carrier. Pinnacle currently operates 124 of these aircraft for Delta. As such, the concentration of 50-seat aircraft within Pinnacle’s operations increases our exposure to the risk that Delta will seek to reduce the size of its 50-seat fleet, which would have a material adverse result on our future profitability.
Item 1A. Risk Factors (continued)
Reduced utilization levels of our aircraft under our capacity purchase code-share agreements would reduce our revenues and earnings.
During 2008, approximately 50% of the revenues from our capacity purchase code-share agreements were derived from block hours, departures and certain reimbursable expenses that we incur only when we operate the aircraft. Similar to the risk of a potential oversupply of 50-seat regional jets, if our code-share partners seek ways to decrease the size of our fleet or seek to reduce the utilization of our fleet, our revenues and profitability would decrease.
Under our capacity purchase agreements, our code-share partners are solely responsible for scheduling our flights and could decide to significantly reduce the utilization levels of our fleet in the future. During 2007, for example, construction delays at the Minneapolis/St. Paul airport prompted Northwest to cancel numerous Pinnacle flights in order to allow its own aircraft to utilize the available airport and runway capacity during the construction period. Similarly, any disruption in the operations of one of our code-share partners, such as may be caused by strikes by various employee groups, could adversely affect our fleet utilization, and thus reduce our revenue and profitability.
Further increasing the significance of this risk are the recent economic events prompting major carriers to announce their intention to reduce capacity and/or utilization. While the announced capacity reductions have not included aircraft we operate, we have no assurance that future capacity reductions will exclude our aircraft.
The rate-based revenues we receive under our capacity purchase code-share agreements may be less than the controllable costs we incur.
Under our capacity purchase code-share agreements with Delta and Continental, the major airline bears the risk related to reimbursable expenses, which include expenses for which our code-share partner is obligated repay in full to us. With respect to other costs, often called “rate-based,” our code-share partner is obligated to pay to us amounts based, in part, on pre-determined rates. If our controllable costs exceed our rate-based revenue, our financial results will be adversely affected. During the year ended December 31, 2008, approximately 26% of our total costs were pass-through costs and approximately 74% of our costs were controllable costs related to our rate-based revenue.
Our ability to operate profitably under Colgan’s pro-rate code-share agreements is heavily dependent on the price of aircraft fuel. Continued periods of historically high fuel costs or further increases in fuel costs could have a significant negative impact on our operating results.
Under our pro-rate code-share agreements, we bear the risk associated with fares, passenger demand, and competition within each market. We incur all of the costs associated with operating these flights, including those costs typically reimbursed or paid directly by the major airline under a capacity purchase agreement. For example, Colgan’s pro-rate agreements provide that Colgan pay for its own fuel. Year-over-year, the average cost of jet fuel increased 41%, with the average cost of one gallon of jet fuel increasing from $2.36 in 2007 to $3.33 in 2008. While fuel prices have recently fallen, we cannot predict if or when they may rise in the future. Additionally, due to the competitive nature of the airline industry, we may not be able to increase passenger fares to offset the increases in fuel prices. While we do have the ability to earn incentive-based revenue should we achieve specified performance metrics, to the extent that we incur expenses that exceed the revenue we receive from passenger fares and incentive-based revenue, our financial results will be negatively affected.
Our efforts to restructure Colgan’s pro-rate operations may fail to eliminate the net losses incurred.
Colgan operates under revenue-sharing pro-rate agreements with Continental, United, and US Airways. Unlike our capacity purchase operations under which we are insulated from many of the revenue and cost risks that affect major and low-cost airlines, under our pro-rate agreements we bear the risks related to items such as passenger demand, yield, fuel cost, aircraft rent or ownership costs, ground handling and airport-related charges.
During 2008, we further executed on our publicly announced strategy to improve the profitability of our pro-rate operations by reducing the scale of these operations, eliminating unprofitable routes and shifting routes to partners that maximized passenger connection opportunities. We also worked with our code-share partners to increase certain revenues such as the incentive revenue earned when a Colgan passenger connects to or from a major partner’sconnecting flight, and we must continue to take steps to generate additional revenues and to reduce our costs. While the financial performance of our pro-rate operations improved during the second half of 2008 subsequent to a further execution of our turn-around strategy, we have no assurance as to the adequacy and ultimate success of our initiatives to generate additional revenues and reduce our costs. Moreover, whether our initiatives will be adequate or successful depends in large measure on factors beyond our control, notably the overall industry environment, including passenger demand, yield, industry capacity growth and fuel prices.
Risks Related to our Labor Costs and Collective Bargaining Agreements
Increases in our labor costs, which constitute a substantial portion of our total operating costs, may directly affect our earnings.
Labor costs are not directly reimbursed by any of our code-share partners. Rather, compensation for these costs is intended to be covered by the payments based on pre-set rates for block hours, departures and fixed costs. Labor costs constitute a significant portion, ranging from 26% to 28%, of our total operating costs. Pressure to increase these costs beyond standard industry wages, and therefore beyond the limits intended to be covered by the fixed payments we receive from our code-share partners, is increased by the high degree of unionization of our workforce (71% unionized at December 31, 2008) and the ongoing negotiations between Pinnacle and ALPA for a revised collective bargaining agreement. Pinnacle’s pilots are currently paid at rates less than the industry average for similarly sized aircraft, and an amended collective bargaining agreement with ALPA is expected to contain higher rates of pay for Pinnacle’s pilots. We expect our salaries, wages and benefits costs to materially increase as a result of an amended collective bargaining agreement with Pinnacle’s pilots. In addition, while we have not offered retroactive compensation to Pinnacle’s pilots during the negotiation process, an amended collective bargaining agreement may contain a material signing bonus. An increase in our labor costs over standard industry wages could result in a material reduction to our earnings, and could affect our future prospects for additional business opportunities.
Strikes or labor disputes with our employees may adversely affect our ability to conduct our business and could result in the termination, or a significant reduction of the benefit, of our code-share agreements.
If we are unable to reach an agreement with any of our unionized work groups on the terms of their collective bargaining agreements, we may be subject to work interruptions, work stoppages, or a fleet size reduction. Work stoppages may adversely affect our ability to conduct our operations and fulfill our obligations under our code-share agreements. Several of our code-share agreements, including our Continental CPA, our DCA, and our CRJ-200 ASA, contain provisions granting our partners the right to terminate our agreements in the event of a work stoppage or labor strike. Additionally, our CRJ-200 ASA contains a provision allowing Delta to reduce the size of our CRJ-200 fleet in the event of a work stoppage or labor strike.
Pinnacle’s collective bargaining agreement with its pilots became amendable on April 30, 2005, and Pinnacle is currently engaged in discussions with ALPA representatives. Both the union and management continue to engage in labor talks that are governed by the National Mediation Board, and the parties have not been released from these talks.
If we are unable to attract and retain key employees, our business could be harmed.
We compete against the other major and regional U.S. airlines for pilots, mechanics and other employee groups essential for providing airlines services. Several of the other airlines offer wage and benefit packages that exceed ours. We may be required to increase wages and/or benefits in order to attract and retain qualified employees or risk considerable turnover, which could negatively affect our ability to provide a quality product to our customers and therefore negatively affect our relationship with our customers. Similarly, as we further expand our Q400 operations for Continental, our need for qualified pilots, mechanics and other airline-specific employees increases. For example, Pinnacle’s ongoing negotiation with ALPA for an amended collective bargaining agreement may complicate our ability to both attract and retain pilots, one of our key employee groups. If we are unable to hire, train and retain qualified pilots we would be unable to efficiently run our operations and our competitive ability would be impaired. Our business could be harmed and revenue reduced if, due to a shortage of pilots, we are forced to cancel flights and forego earning incentive-based revenue under our code-share agreements. During the first half of 2007 we failed to earn $2.9 million of incentive-based revenue under our ASA in part due to an industry wide pilot shortage.
All staff comments received from the Securities and Exchange Commission were resolved as of the date of this filing.
As shown in the following table, the Company’s aircraft fleet consisted of 145 Canadair Regional Jet (“CRJ”) aircraft and 53 turboprop aircraft at December 31, 2008.
Item 2. Properties (continued)
The Company had the following significant dedicated facilities as of December 31, 2008:
Our significant maintenance facilities are located in cities that we serve based on market size, frequency, and location. These facilities are used for overnight maintenance; however, Memphis and Dulles are also used during the day. We have additional smaller maintenance facilities in Fort Wayne, Indiana and South Bend, Indiana. The facilities are highly utilized with an average turn around time of seven to ten hours. We believe that our existing facilities are adequate for the foreseeable needs of our business.
In connection with our code-share partners, we maintain contract service agreements with Delta, Continental, United and US Airways allowing for the use of terminal gates, parking positions and operations space at Atlanta, Boston Detroit, Houston, Minneapolis/St. Paul, Newark, New York LaGuardia and Washington Dulles airports, as well as many of the stations we serve from these hub airports. We believe the use of the terminal gates, parking positions, and operations space obtained from our code-share partners will be sufficient to meet the operational needs of our business.
Pinnacle and Colgan are defendants in various ordinary and routine lawsuits incidental to our business. While the outcome of these lawsuits and proceedings cannot be predicted with certainty, it is the opinion of our management, based on current information and legal advice, that the ultimate disposition of these suits will not have a material adverse effect on our financial statements as a whole. For further discussion, see Note 18, Commitments and Contingencies, in Item 8 of this Form 10-K.
September 11, 2001 Litigation. Colgan is a defendant in litigation resulting from the September 11, 2001 terrorist attacks. The Company believes it will prevail in this litigation; however, any adverse outcome from this litigation would be covered by insurance and would therefore have no material adverse effect on the Company’s financial position, results of operations and cash flows.
Colgan Flight 3407. On February 12, 2009, Colgan Flight 3407, operated for Continental under the Company’s Continental CPA, crashed in a neighborhood near the Buffalo Niagara International Airport in Buffalo, New York. All 49 people aboard, including 45 passengers and four members of the flight crew, died in the accident. Additionally, one individual died inside the home destroyed by the aircraft’s impact, increasing the total fatality count to 50 individuals. One lawsuit related to this accident has been filed against the Company, and additional litigation is anticipated. We carry aviation risk liability insurance and believe that this insurance is sufficient to cover any liability arising from this accident.
Item 3. Legal Proceedings (continued)
We are subject to regulation under various environmental laws and regulations, which are administered by numerous state and federal agencies, including the Clean Air Act, the Clean Water Act and the Comprehensive Environmental Response, Compensation and Liability Act of 1980. In addition, many state and local governments have adopted environmental laws and regulations to which our operations are subject. We are, and may from time to time become, involved in environmental matters, including the investigation and/or remediation of environmental conditions at properties used or previously used by us. We are not, however, currently subject to any environmental cleanup orders imposed by regulatory authorities, nor do we have any active investigations or remediations at this time.
We are subject to regulation under various laws and regulations which are administered by numerous state and federal agencies, including but not limited to the FAA, DOT and Transportation Security Administration (“TSA”). We are involved in various matters with these agencies during the ordinary course of our business. While the outcome of these matters cannot be predicted with certainty, it is the opinion of our management, based on current information and past experience, that the ultimate disposition of these matters will not have a material adverse effect on our financial condition as a whole.
The shares of our common stock are quoted and traded on the Nasdaq Global Select Market under the symbol “PNCL.” Our common stock began trading on November 25, 2003, following our initial public offering. Set forth below, for the applicable periods indicated, are the high and low closing sale prices per share of our common stock as reported by the Nasdaq Global Select Market.
As of March 2, 2009, there were approximately 37 holders of record of our common stock. We have paid no cash dividends on our common stock and have no current intention of doing so in the future.
The information under the caption “Securities Authorized for Issuance under Equity Compensation Plans,” appearing in the Proxy Statement for our 2009 Annual Meeting of Stockholders, anticipated to be filed with the Commission within the 120 days after December 31, 2008, is hereby incorporated by reference.
Our Certificate of Incorporation provides that no shares of capital stock may be voted by or at the direction of persons who are not United States citizens unless such shares are registered on a separate stock record. Our Bylaws further provide that no shares will be registered on such separate stock record if the amount so registered would exceed United States foreign ownership restrictions. United States law currently limits to 25% the voting power in our company (or any other U.S. airline) of persons who are not citizens of the United States.
Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities (continued)
The following graph compares total shareholder return on the Company’s common stock over the five-year period ending December 31, 2008, with the cumulative total returns (assuming reinvestment of dividends) on the American Stock Exchange Airline Industry Index and the NASDAQ Composite Index. The stock performance graph assumes that the value of the investment in our common stock and each index (including reinvestment of dividends) was $100 on December 31, 2003. The graph below represents historical stock performance and it not necessarily indicative of future stock price performance.
You should read this selected consolidated financial data together with the audited consolidated financial statements and related notes contained in Item 8, Management’s Discussion and Analysis of Financial Condition and Results of Operation contained in Item 7, and Risk Factors in Item 1A of this Form 10-K.
Item 6. Selected Financial Data (continued)
Item 6. Selected Financial Data (continued)
Item 6. Selected Financial Data (continued)
Certain Statistical Information:
The following tables present our operating expenses per block hour and operating expenses per available seat mile. While not relevant to our financial results, this data is used as an analytic in the airline industry. Please see Results of Operations in Item 7 of this Form 10-K for more information on our operating expenses.
During 2008, we further executed on our growth plan by adding 15 Q400 aircraft at our Colgan subsidiary and 13 CRJ-900 aircraft at our Pinnacle subsidiary, with two additional CRJ-900 aircraft scheduled to deliver in the second quarter of 2009. With this phase of our growth plan essentially complete, we intend to focus on controlling costs, maintaining our strong operational reliability, and strengthening our balance sheet. The regional airline industry is facing a period of slower growth and pressure from major airline partners to reduce costs and potentially reduce some regional airline capacity. While we do not expect significant adjustments in our fleet size in 2009, we do expect to experience significant cost pressure during this period of low growth. Specifically, we anticipate higher costs in 2009 resulting from an expected new collective bargaining agreement with our pilots at Pinnacle, higher levels of flight crew staffing at Pinnacle, higher health care costs, increased landing fees and facility rental expense at the airports that we serve, and general inflationary pressure within the rest of our cost structure.
In addition, our pro-rate operations are susceptible to fuel price volatility and changes in passenger demand. During the first half of 2008, we experienced an unprecedented increase in the price of fuel within our pro-rate operations, and as a result, Colgan incurred an operating loss of $7.9 million during 2008 (which includes $13.5 million of non-recurring charges related to goodwill impairment and lease return costs). In response, we implemented a turn-around plan during the second half of 2008 to improve the results of our pro-rate operations. Key components of the plan included eliminating our Beech 1900 fleet, reducing our Saab 340 fleet by six aircraft, eliminating our worst performing markets, rebidding markets that we serve under the federal government’s Essential Air Service program (“EAS”) to increase the subsidies we receive, and renegotiating a connect incentive fee that we receive from United for certain markets that we serve as a United Express carrier. While these steps and the recent decline in fuel prices have reduced the operating losses of our pro-rate operations, our pro-rate operations are not yet profitable. Additionally, the airline industry is beginning to experience the effects of the current recessionary environment in the United States. Industry revenue and demand dropped during the fourth quarter of 2008, and we are beginning to see trends of lower unit revenue within our pro-rate operations. We cannot predict how severely the recessionary environment will affect us in 2009, but we do expect a significant drop in our unit revenue within our pro-rate operations.
Further magnifying the cost pressures previously discussed, we will not receive an increase in the rates Delta pays us under our CRJ-200 ASA. The CRJ-200 ASA contains a provision to adjust rates annually based on the change in the Producers Price Index (“PPI”), as published by the United States Department of Labor, Bureau of Labor Statistics. Our rates could increase by up to 5% annually, but in no case would they decrease. The PPI declined from December 2007 to December 2008, and as a result, our rates will not increase in 2009.
To offset some of the increased costs and pro-rate operations risk that we expect to incur in 2009, we recently announced an internal initiative to create costs savings and additional revenue opportunities of at least $10.0 million. We expect to achieve this through a combination of reducing our operating costs, adjusting capacity in our pro-rate operations to match the demand environment, identifying new pro-rate markets with stronger revenue prospects, potentially reducing the scope of our pro-rate operations by retiring additional Saab aircraft as necessary, and increasing ancillary third party business such as ground handling. We have not yet fully identified these initiatives, and there can be no assurance that we will attain our target of at least $10.0 million in improvements. We believe it is critical to reduce our costs not only to increase our current profitability, but to also remain competitive long term in the regional airline industry.
The collective bargaining agreement between Pinnacle and the Air Line Pilots Association (“ALPA”), the union representing Pinnacle’s pilots, has been amendable since April 2005. We have met with ALPA, both with and without a mediator, many times since April 2005, but we have not reached an agreement for a new contract. It is of utmost importance to us to reach an agreement with ALPA that is consistent with our company-wide philosophy of industry-average pay and benefits with enhanced employee productivity. Wage rates for Pinnacle’s pilot group are currently below industry average, and a new collective bargaining agreement is expected to contain an increase in pay for Pinnacle’s pilots. Such increase could be substantial, and may also include a considerable one-time signing bonus. The increase in pay for Pinnacle’s pilots will likely reduce our profitability in 2009 and in future periods. In addition, Colgan’s pilots recently elected representation by ALPA. We have not begun discussions or set a timeline with ALPA to commence negotiations of a collective bargaining agreement covering Colgan’s pilots. While we intend to vigorously pursue obtaining a fair contract with ALPA at both of our operating subsidiaries, the timing of the resolution of these matters cannot be predicted.
While we expect 2009 to be a challenging year, we are positioning ourselves for success in 2010 and beyond. We recently agreed with Continental to expand our Continental CPA by adding 15 Q400 aircraft from August 2010 through April 2011. In addition, we acquired an additional 15 Q400 options from the aircraft manufacturer, thereby increasing the total number of our Q400 options to 30. These options, if exercised, provide for the delivery of 15 Q400s in 2011 and the remaining 15 in 2013. The Q400 aircraft has become a very competitive product within the regional airline industry. The purchase price of the Q400 is significantly less than that of comparably sized regional jets, and the Q400 uses up to 30% less fuel. As a result, we can offer our airline partners a large, passenger-friendly regional aircraft with a lower operating cost than similar regional jets. Several of our partners have indicated interest in the Q400 aircraft, and we continue to market our option positions to them.
In addition to growing Colgan with the Q400 aircraft, we expect to find other long-term opportunities to increase the number of regional jets that we operate at Pinnacle. Capacity purchase agreements for over 400 50-seat regional jet aircraft at our competitors are set to expire between 2009 and 2015. While many of these regional jets will likely no longer operate within the networks of the major U.S. airlines, we believe some of these contracts will be renewed or offered to other regional airlines and some will be replaced with larger regional jets. We intend to actively compete to obtain profitable regional jet flying during this period of transition within the industry, and we believe our history of quality performance at a competitive price well positions us to succeed. Our capacity purchase contracts do not begin to expire until December 2017.
Auction Rate Securities
We continue to own approximately $133.7 million par amount of auction rate securities (“ARS”). Due to unprecedented events in the credit markets during 2008, these investments became illiquid and have suffered a decline in fair value. We reported these investments as noncurrent assets on our consolidated balance sheet at December 31, 2008 at their estimated fair value of $116.9 million. We continue to earn interest on all of our ARS, and the majority of our ARS are still rated AAA/Aaa by the credit rating agencies. Most of the banks that structured and sold ARS to investors have entered into settlement agreements with various state and federal regulatory authorities that provide for the repurchase of ARS at par value from retail investors and small businesses over the next 24 months. In addition, some banks have made offers to larger institutional investors to repurchase ARS at par value in 2009 and 2010 to the extent that institutional investors have been unable to sell their ARS. We have not yet received such an offer from the financial institution that structured and sold to us our ARS, and we have no assurance that we will receive such an offer. However, we anticipate that to the extent most major banks make settlement offers to their institutional clients, we would be made a similar offer for settlement related to our ARS holdings.
The collapse of the ARS market has had a significantly negative impact on our liquidity and the strength of our balance sheet. To partially offset this effect, we arranged for a $90.0 million margin loan facility (the “Credit Facility”) to be used to support our aircraft purchases and other working capital requirements. Although the Credit Facility has a maturity date in January 2010, we anticipate that the Credit Facility will remain outstanding until we receive an offer to repurchase our ARS or otherwise monetize our ARS portfolio. While we have effectively obtained the use of $90.0 million of our ARS through this Credit Facility, we do not have access to the remaining $43.7 million par amount of our ARS to support our liquidity needs. We do not know when we will be able to monetize our ARS portfolio, and we may have no choice but to sell our ARS at current distressed prices or to hold our securities until maturity, which could be 17 years or longer.
$121 Million Senior Convertible Notes
In addition to actions noted above to improve our operating income longer term, we are focused on conserving cash in 2009 in advance of the first date that holders of our $121.0 million 3.25% senior convertible notes (the “Notes”) may contractually require us to repay the Notes. Although the Notes have a final maturity date in 2025, holders of the Notes may tender them to us on February 15, 2010 for a cash payment equal to the par amount. While we anticipate positive cash flow from our operations during 2009, we do not believe that we will have sufficient cash resources to fully repay this obligation in February 2010 without raising additional capital. We are focused on obtaining the resources we need to settle this obligation without raising capital through a shareholder dilutive action such as an offering of our common stock. Some alternatives we are reviewing include asset financings, such as the financing of our rotable and expendable spare parts inventory, raising additional capital collateralized by ARS, or the sale of some or all of our ARS.
We repurchased $12.0 million par amount of the Notes for approximately $8.9 million in January 2009. The Notes are relatively illiquid, but the few recent trades we have observed have been at prices substantially below par. We may purchase additional Notes during 2009 to the extent that Notes are offered for sale and to the extent that our resources allow.
Colgan Flight 3407
On February 12, 2009, Colgan Flight 3407, operated for Continental under the Company’s Continental CPA, crashed in a neighborhood near the Buffalo Niagara International Airport in Buffalo, New York. All 49 people aboard, including 45 passengers and four members of the flight crew, died in the accident. Additionally, one individual died inside the home destroyed by the aircraft’s impact, increasing the total fatality count to 50 individuals. One lawsuit related to this accident has been filed against the Company, and additional litigation is anticipated. We carry aviation risk liability insurance and believe that this insurance is sufficient to cover any liability arising from this accident.
Results of Operations
The following represents our results of operations, by segment and consolidated, for the year ended December 31, 2008.
The following discussion provides an analysis of our consolidated results of operations and reasons for material changes therein for the year ended December 31, 2008 compared to the same periods in 2007 and 2006. The acquisition of Colgan was completed on January 18, 2007. As such, Colgan’s 2006 data is not presented and Colgan’s 2007 data includes the period from the acquisition date through December 31, 2007, which represents approximately 94% of that year.
2008 Compared to 2007
Operating revenue of $864.8 million for the year ended December 31, 2008 increased $77.4 million, or 10%, over the year ended December 31, 2007. This increase was primarily related to an increase in our capacity purchase revenue. During 2008, we added 15 Q400 aircraft and 17 CRJ-900 aircraft, including the seven Temporary Aircraft, to our operating fleet. This was partially offset by a 7% decrease in the average number of CRJ-200 aircraft we operate under our CRJ-200 ASA. Our pro-rate revenue increased slightly as a result of a 15% increase in average fare, offset by an 11% decrease in passengers. These changes are discussed in greater detail within our segmented results of operations.
Operating expenses increased by $84.2 million, or 11%, during the year ended December 31, 2008, primarily due to increases in block hours and departures associated with the growth in our operating fleet. In addition, operating expenses increased as a result of increased fuel prices related to our pro-rate operations, increased depreciation expense following the addition of our recently purchased CRJ-900 and Q400 aircraft, increased unreimbursed maintenance costs incurred on our aging CRJ-200 fleet, impairment charges primarily related to Colgan’s goodwill, Colgan’s lease return costs, and increased compensation expense resulting from the addition of employees to support the growth of our business. These changes are discussed in greater detail within our segmented results of operations.
Net nonoperating expense of $44.3 million for the year ended December 31, 2008 increased by approximately $42.9 million over net nonoperating expense of $1.4 million during 2007. This increase is attributable to the $25.8 million increase in interest expense, primarily related to the financing of the CRJ-900 and Q400 aircraft, the majority of which were delivered and financed during 2008. Interest income decreased by $4.7 million, due to a lower average invested balance throughout 2008 as compared to 2007. In addition, we recorded a $16.8 million impairment charge related to the decline in the fair values of our ARS portfolio. Net nonoperating expense for the year ended December 31, 2007 was affected by a $4.1 million loss related to the sale of our remaining Northwest unsecured claim.
Income Tax Expense
For the year ended December 31, 2008, our income tax expense decreased by $10.2 million, primarily related to the decrease in pre-tax income as compared to 2007. Partially offsetting the decline of income tax expense is the valuation allowance we recorded against the tax benefit related to the $16.8 million ARS impairment charge. This valuation allowance was recorded because the loss cannot offset ordinary income, and we expect no capital gains during the carryforward period of this loss.
2007 Compared to 2006
Operating revenue of $787.4 million for the year ended December 31, 2007 decreased $37.2 million, or 5%, over the year ended December 31, 2006. The decrease in revenue was primarily due to the decrease in revenue associated with expense reimbursements from Northwest and a reduction in Pinnacle’s target operating margin of 10% in 2006 to 8% effective January 1, 2007. The most significant decreases in reimbursable expenses were aircraft fuel and aircraft rent. Under the CRJ-200 ASA, jet fuel is provided to Pinnacle at no cost, whereas in 2006, jet fuel was a reimbursable expense. Also under the CRJ-200 ASA, our aircraft rental expense has been lowered to a rate that approximated market rates at that time. These changes to the CRJ-200 ASA caused a decrease of revenue of $323.8 million. These decreases are offset by the recognition of deferred CRJ-200 ASA revenue of $22.6 million. For more information regarding deferred CRJ-200 ASA revenue, see Note 3 in Item 8 of this Form 10-K. The remaining 6% increase is related to the 6% increase in block hours and departures due to an increase in Pinnacle’s fleet compared to 2006. In addition, these revenue decreases are offset by the addition of $192.4 million in revenue related to Colgan. These changes are discussed in greater detail within our segmented results of operations.
Operating expenses increased by $37.9 million, or 5%, during the year ended December 31, 2007, primarily related to the addition of Colgan’s operating expenses, which totaled $197.5 million for 2007. In addition, Pinnacle’s operating expense increased as a result of the 6% increase in block hours and departures. This increase was offset by a decrease of $242.9 million in fuel and aircraft rent expense, primarily related to the aforementioned changes to our CRJ-200 ASA. These changes are discussed in greater detail within our segmented results of operations.
Net nonoperating expense decreased by $1.6 million, as compared to the same period in 2006. The increase was caused by a $3.3 million increase in interest expense, largely attributable to Colgan’s operations, offset by $2.9 million of capitalized interest, primarily related to the acquisition of our Q400 and CRJ-900 aircraft. In addition, miscellaneous expense increased by $4.1 million related to the $4.1 million loss we recorded on the sale of our $42.5 million bankruptcy claim against Northwest during the second quarter of 2007. Further offsetting the increase in nonoperating expense is a $9.1 million increase in interest income from our significantly larger ARS portfolio. The increase in our portfolio relates to the investment of proceeds received from the assignment of our Northwest and Mesaba claims.
Income Tax Expense
For the year ended December 31, 2007, our income tax expense decreased $30.4 million, primarily related to the decrease in pre-tax income as compared to 2006. In addition, due to the tax free interest income on our ARS portfolio, the Company’s effective tax rate decreased by 5.5 points.
The following represents our results of operations, by segment, for the years ended December 31, 2008, 2007 and 2006 (in thousands):
Pinnacle Operating Statistics