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Mistakes in merging Pinnacle and Mesaba lead to bankruptcy

Pinnacle failed to integrate Mesaba into its operations in a timely and cost-effective manner.

Pinnacle Airlines, which operates Delta Connection flights out of MSP, has filed for Chapter 11 bankruptcy.

Top management at Pinnacle Airlines yearned for years to expand its business, so it thought it had the right growth vehicle in 2010 when it bought Mesaba Airlines for $62 million.

But Pinnacle’s business model started to unravel even before its executives finished moving into new offices last year in downtown Memphis.

The regional airline, which flew about 4 million passengers in and out of the Twin Cities last year, filed for bankruptcy protection this week in New York.

Pinnacle failed to integrate Eagan-based Mesaba into Pinnacle’s operations in a timely and cost-effective manner, which is one of the main reasons that Pinnacle was forced to file for Chapter 11.

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The majority of Pinnacle’s revenue comes from flying passengers on Delta Connection flights, and many Minnesotans are familiar with Pinnacle by flying on 50-seat jets.

While Delta Air Lines generated net income of $854 million during 2011, Pinnacle Airlines was swimming in red ink last year – losing $8.8 million during the first nine months.

John Spanjers, who was Mesaba’s president when that carrier filed for bankruptcy in 2005 in Minneapolis, is Pinnacle’s chief operating officer. Spanjers explained how Pinnacle ended up in dire financial straits in a filing with the U.S. Bankruptcy Court in New York.

“For many years, regional airlines enjoyed profit margins under contracts that offered protection against rising fuel costs and other market risks,” Spanjers said. “This is no longer the case. As major carriers have aggressively cut costs and decreased capacity, they have transformed the market for regional air service, consuming and paying less and demanding more from their regional partners. The result has been a race to the bottom, as [Pinnacle] and other regional airlines have been forced to bid ever-lower rates and accept increasingly unfavorable contract terms to win the business of major carriers.”

Contracts with Delta

Pinnacle does most of its flying for Delta, and Spanjers said that two of the three service contracts with Delta were “potentially viable,” but he indicated there was a need to renegotiate with Delta. Pinnacle has money-losing contracts with United and US Airways and it plans to wind-down that flying during 2012.

Pinnacle also was drowning under the expense of operating three subsidiaries — Pinnacle, Mesaba and Colgan, a small turboprop operator that it purchased in 2007. The cost savings that are supposed to flow from mergers were slow to materialize for Pinnacle. The delayed integration and lost synergies have amounted to “tens of millions of dollars,” Spanjers said in the court filing.

Pinnacle had planned to consolidate Mesaba’s jet operation under its Pinnacle operating certificate by May 2011, but that was delayed until January 2012 and Pinnacle ended up spending more money to reach that merger goal. Maintenance and flight operations aren’t expected to be fully integrated until early 2013.

The company also experienced operational problems. For the first half of last year, Pinnacle Airlines Corp. incurred contract penalties of $3.7 million “associated with poor performance by Pinnacle and Colgan,” Spanjers wrote.

In the court filing, Pinnacle lays blames for much of its financial woes at the feet of the Air Line Pilots Association (ALPA). Pinnacle management signed a labor agreement with the pilots union in February 2011, but it now appears frustrated with the cost of the deal and the implications of bringing the Pinnacle, Mesaba and Colgan pilots under an integrated seniority list.

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“This integration has had severe, disruptive and expensive consequences on the filling of pilot vacancies and associated training costs,” Spanjers wrote.

Pinnacle employs more than 7,500 people, and roughly 70 percent are represented by unions. About 1,200 Minnesotans were employed by Pinnacle as of January, and that number included many Mesaba employees who went through the concessionary bargaining of the 2005-2006 Mesaba bankruptcy.

Pay cuts

In the months preceding the bankruptcy filing, Pinnacle sought pay cuts and work rule changes from the pilots union, but failed to reach a deal. Management discontinued talks with other labor unions when it couldn’t come to terms with ALPA.

Now Pinnacle has the power of the bankruptcy laws to pressure the unions into agreeing to cutbacks. If the unions resist concessions, the airline can file a motion to abrogate the labor contracts and impose new pay rates and work rules.

A company action taken March 20 will make the next round of labor talks even more contentious. Pinnacle raised the base salary of CEO Sean Menke, who joined the company last summer, from $425,000 to $675,000 a year. Meanwhile, the annual base pay of Spanjers was boosted from $275,000 to $400,000.

In a regulatory filing, the company said the salaries were increased to “reflect additional responsibilities relating to the Company’s restructuring initiatives and the impending departure of the Company’s Chief Financial Officer.”

That rationale was not persuasive with the United Steelworkers, which represents 2,677 flight attendants and ground crew workers.

“With the company giving hundreds of thousands of dollars in raises to its top two executives on the eve of seeking bankruptcy protection, management’s call for other workers to accept cutbacks rings hollow,” USW International President Leo Gerard said in a statement. “In fairness, Pinnacle cannot expect our members to sacrifice without a commitment from top management to do the same.”

At this early stage, it’s tough to predict how long Pinnacle will linger in bankruptcy. But it appears Pinnacle’s board had no choice left other than seeking the shelter of bankruptcy.

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In his statement to the court, Spanjers said that the carrier continues to “operate at a significant loss ” and that it was “projected to run out of cash by mid-April absent this Chapter 11 filing.”

Late last year, Pinnacle tried to raise $40 million to improve its liquidity and support an out-of-court financial restructuring. It didn’t get financing because lenders required Pinnacle to reach “favorable agreements” with Delta, United and the labor unions, and none of those deals were achieved.

When it became clear that Pinnacle would have to follow the Chapter 11 path, it attempted to line up debtor-in-possession financing. Eighteen lenders and funders were contacted, but only Delta Air Lines was willing to offer financing. Delta is providing $74.3 million in financing for one year at an annual interest rate of 12.5 percent, and $44.3 million must be used to repay Delta for a secured promissory note.

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