Pinnacle takes off on new Northwest deal; Red Hat climbs on stronger than expected quarter

By Kenneth Lim

Boston, Dec. 22 - Pinnacle Airlines Corp. soared through the roof on Friday in an otherwise quiet convertible bond market, carried by a surge in the stock after the company worked out a service deal with Northwest Airlines.

Red Hat Inc. also gave outright investors a welcome present for the holidays, climbing on the back of stronger than expected sales.

The rest of the convertible bond market was lifeless, as the year-end holidays come knocking on the door.

"You're not going to find anyone doing anything today," a sellside convertible bond trader said. "It's a ghost town. Guys with enough sense have packed up and gone home for the holidays. And next week's going to be the same, or worse."

Pinnacle heads for peak

Pinnacle's 3.25% convertible due 2025 improved by about 35 points outright on Friday after the company reached a deal with Northwest on a service contract that will last to 2017 at the least.

The convertible traded at 142 against a stock price of $16.50. Pinnacle stock (Nasdaq: PNCL) jumped 56.54% or $6.05 to close at $16.75.

"Talk about a Christmas surprise," a sellside convertible trader said.

Memphis, Tenn.-based Pinnacle, a regional contract carrier for Northwest, said late Thursday that the two airlines had agreed to amend their service agreement. The new deal will let Pinnacle continue to fly for Northwest through at least 2017 and fly for other carriers as well.

Pinnacle will also be able to fly aircraft with up to 76 seats, more than the 56 allowed previously. Pinnacle will redeem the class A preferred stake owned by Northwest for $20 million, eliminating Northwest's influence on Pinnacle's board. Pinnacle will also be allowed an unsecured claim of $377.5 million in Northwest's bankruptcy proceedings, but will give up its previous claims against Northwest and fuel-surcharge revenue and accept a lower target margin rate.

The new deal still requires approval from the bankruptcy court.

"It's obviously great for the convert," the trader said. "The conversion price is about $13.22. There's contingent conversion at 120%, but that's not going to matter if the stock stays where it is. Yesterday the stock was at a 20% discount to the conversion price, today you're looking at a 27% premium. And these things can't be called until 2010."

A sellside convertible bond analyst said the new contract will be good for Pinnacle's cash balance.

"What Pinnacle gets out of this is potentially quite a bit of cash, if their claim is approved. They may not get all the $377.5 million, but it's still a lot considering their market cap is only about $370 million," the analyst said.

"The other nice thing about the contract is now Pinnacle not only will continue to provide services for Northwest for another 10 years, it also gets to go out and look for other customers," the analyst said. "From a credit standpoint, that's also positive."

Pinnacle stock received a number of upgrades on Friday following the news. Prudential equity analyst Bob McAdoo upgraded Pinnacle's common stock to overweight from underweight, on expectations that the claim could be worth $7.75 per share for Pinnacle. Benchmark Co.'s Helane Becker also upgraded Prudential stock to buy, citing the cash injection expected from the claim.

Red Hat rises on sales

Red Hat's 0.5% convertible due 2024 gained about 4.5 points outright on Friday after the company reported stronger than expected sales for its fiscal third quarter.

The Red Hat convertible was 101.9375 bid, 102.75 offered against a stock price of $20.50 early Friday, but rose as the day progressed to changed hands at 103.75 versus a stock price of $21.07 later in the day. Red Hat stock (NYSE: RHT) rose 25.06% or $4.50 to close at $22.46.

"Red Hat was pretty active in the morning, picked up a few points because of its earnings," a sellside convertible bond trader said.

Red Hat, a Raleigh, N.C.-based developer of Linux-based software and operating systems, reported net income of $15.5 million, or 7 cents per share, for its fiscal third quarter, down 37% from the $24.5 million, or 12 cents per share, earned in the year-ago period. Earnings adjusted for stock options and tax expense would have been 14 cents per share, about 2 cents above Street estimates.

Revenue for the quarter rose 45% to $105.8 million, from $73.1 million a year ago. Red Hat said it added 12,000 new customers in the quarter, when competing services from Oracle Corp. and a partnership between Microsoft Corp. and Novell Inc. were introduced.

"I think people expected the quarter to be softer for Red Hat because of the new competition from Oracle," a sellside convertible bond analyst said. "But they reported stronger sales and new customers, which is why the stock's up so much today."

But the analyst noted continuing concern about Red Hat's outlook.

"One concern is that their new revenue is costing them more," the analyst said. "Their operating income margin was lower for the quarter, so they probably cut prices or spent more to get those new customers. The question is how this is going to affect them later."

The analyst was less concerned about Red Hat's credit.

"Red Hat credit is pretty solid," the analyst said. "These results aren't going to affect it that much."

Credit Suisse equity analyst Jason Maynard on Friday raised his target price for Red Hat stock to $18 from $14, but maintained his neutral rating. Maynard said the better results were probably a result of "aggressive discounting and extended contracts" that would only buy Red Hat more time amid the more intense competitive landscape.

"We continue to rate the shares of Red Hat as neutral given our concerns about the longer term impact of pricing and margin compression on their core business," Maynard wrote in a note. "Our $18 price target is based on a 12x EV/CFO [enterprise value to cash flow from operations ratio] multiple on our FY08 cash flow estimate of $233 million. We are not comfortable owning the stock since we think management needs to increase their investment levels to respond to increased competition."

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