Summary Thesis

I believe that Copa (CPA) at the current share price of $45 per share is an attractive investment that could generate a total return of 80% over the next two to three years with downside of 30% in a negative scenario. I think that even if the stock declines 30% from current levels, it will not result in a permanent loss of capital for investors who have the ability to ride out the volatility. 

Copa is a strategically advantaged airline that is currently going through a deep cyclical downturn.  The company has attractive long term growth prospects. It is run by a capable, shareholder friendly management team. And, its balance sheet is conservatively financed. The opportunity to buy such a high quality business at an attractive valuation exists because earnings are cyclically depressed.

Copa has been a popular and successful short since 2014. From its high of $160 per share, the stock is down 72% as 2015 consensus earnings estimateshave declined from $14.80 per share in May 2014 to $4.80 per share today. Earnings are expected to decline further in 2016 to $4.62 per share. Hunter Keay at Wolfe Research, who is a very good airline analyst,is at the low end of the range with an estimate of $4.00 per share. I would not be surprised if numbers for 2016 come in closer to his estimate. The bears, with whom I do not disagree at least in the short term, believe that the Latin America’s economies and currencies will continue to weaken and that there is no “visibility” into the timing of a potential recovery. It is impossible to know exactly when and where earnings will trough. In my downside scenario I have them going as low as $3.50 per share. However, I believe that they will trough in the next twelve months and that the stock will begin to discount a recovery thereafter.

The company is well positioned to ride out the downturn. It has a healthy balance sheet and possesses strategic advantages which will enable to recover its profitability.  Although I don’t think the company will be able to reach its peak level of profitability for a very long time if ever (historical ROE average of 28%), I believe that, given its competitive positioning, profitability can recover to a15 to 20% ROE by 2018. This would equate to $6 to $8earnings per share.

Business Description and History

Copa is a Latin American airline that operates a hub a spoke model with a modern fleet of 101 aircraft, comprised of Embraer-190’s and Boeing 737NG’s. From its strategically located position in Panama, Copa provides service to 74 destinations in 31 countries across the Americas.Via its Star Alliance membership, Copa passengers have access to flights to more than 120 other destinations through codeshare arrangements. Copa’s business model is grounded on its ability to leverage the density of its hub and spoke network to serve markets that do not have sufficient demand to attract point to point service.

Copa was established in 1947, and initially served three domestic destinations in Panama. In the 1960’s, Panama began offering international services with flights to Costa Rica, Jamaica and Colombia. In 1986, Copa was purchased by a group of Panamanian investors. In 1998, Continental acquired a 49% stake in Copa, which led to an alliance with Continental providing for code-sharing, joint marketing, technical exchanges and other cooperative initiatives between the airlines. At the time of the IPO in December 2005, Continental reduced its stake from 49% to 27%,  andit subsequently exited its entire position in May 2008. Copa is controlled by a group of Panamanian investors who own the shares  through a holding company called CIASA. The group is led by led by Copa Chairman, Stanley Motta, and Copa CEO, Pedro Heilbron. Collectively they own a 25% economic interest in the company and have 100% of the votes through super-voting, privately held Class B shares. The group has a long history of value creation across multiple businesses.

The stock is down 72% from its recent high in July 2014. Despite the sell-off, an investor in the Copa IPO in December 2005 at $20 would have attained a 156% total return, compared to 102% for the S&P Index. Since going public on the NYSE in 2005, Copa’s revenues have grown at a compounded annual growthrate (CAGR) of 18% and EPS at a 17% CAGR. Meanwhile return on equity has averaged 28% andoperating cash flow has exceeded net income every year.Despite continued network expansion,management has maintained a disciplined approach to capacity. Copa has grown earnings both through topline growth and ongoing reductions in cost per available seat mile(CASM), ex fuel. Copa has aconsistent history of returning cash to shareholders. The company pays out 40% of the previous year’snet income via dividends; assuming CPA hits Street 2016E EPS of $4.87, implies $1.95 dividend or 4.3% dividend yield on $45 stock.

Tocumen Hub

Copa benefits from a geographically advantaged hub and spoke network architecture. Copa operates from a single hub at Tocumen International Airport in Panama City, Panama. Copa accounts for 80% of the airport’s daily operations. The hub is strategically located enabling the company to connect markets in North, Central and South America and the Caribbean. At Tocumen, Copa aggregates fragmented traffic from multiple destinations, serving many city pairs thatlack sufficient demand to justify point-to-point service. For example, 76% of the markets served by Copa have 20 or less passengers per day each way (PPDEW).  On 73% of Copa’s flights, the number of passengers sharing the same final destination is less than 20. Tocumen’s size, low altitude, and favorable weather conditions, contribute to on-time, efficient operations. Low altitude reduces fuel consumption significantly versus competitors’ higher altitude hubs such as Bogota, Colombia. This unique geographic position and favorable route characteristicsgive Copa a competitive advantage relative to other players in the region.

Low Operating Costs

Despite it being a full service airline, Copa is one of the lowest cost operators in the world. Copa’s CASM (cost per available seat mile) ex fuel is 30% lower than the US legacy carriers (Delta, United, American)  and 15% lower than the average US based low cost carrier (LCC), Jetblue, Southwest, Hawiian, and Alaska.  Copa’s CASM ex fuel is 15% higher than that of the ultra low cost carriers (ULCC’s) such as Spirit and Allegiant, but the level of service and cabin layout  is not comparable. The two primary sources of Copa’s cost advantage versus its peers are lower labor costs and and lower landing fees.  Copa’s largest direct competitor, Avianca  (AVH), has a CASM ex-fuel of 11.1 USD cents versus Copa’s 6.6 USD cents. Copa also benefits from a 10% effective tax rate due to its Panamanian domicile.

Earnings Decline

Copa’s earnings peaked at $11.15 per share in 2014. At the peak, Venezuelan ticket sales accounted for roughly 15% of total revenues. Due to a loophole, Venezuelan passengers were able to purchase tickets at a favorable exchange rate which inflated both demand andticket prices. In January 2014, the Venezuelan Government closed that loophole, de facto devaluing theexchange rate available for airline ticket purchases. In response to the new demand reality, Copa reduced capacity to the country by half and now operates Venezuelan Bolivar neutral to avoid repatriation issues. These Venezuela ticket sales represented very high margin business for Copa. By my calculations, at the peak, they accounted for  roughly$3.00 of incremental earnings per share. These earnings are not coming back.

The second leg of the earnings decline has been driven by a deep, regional recession and significant currency devaluations. Sixty percent of Copa’s revenues are transacted in Brazilian Real (15%), Colombian Peso (10%), Argentine Peso (6%), Chilean Peso (5%), and Mexican Peso (4%). SinceJanuary  2014, the Brazilian Real is down 40% versus the USD. The Colombian Peso is down 40%. The Chilean Peso is down 26%. The Mexican Peso is down 28%. And, the Argentine Peso is down 52%. This has resulted in a decline in passenger yield from 18 cents at the peak to slightly below 12 cents currently. Copa’s current passenger yields are 35% below US legacy carriers and below those of ultra low cost carrier Spirit Air (SAVE)despite serving some of the least competitive city pairs in the world.After cutting Venezuelan capacity in 2014, Copa has been steadily cutting Brazilian capacity in 2015. After growing ASM 10% in 2014, and 5% in 2015, Copa is slowing to 3% ASM growth in 2016 with flexibility to reduce ASM growth further, if needed.

 Recovery

My investment thesis for Copa is grounded on the view that the company’sproblems are cyclical not structural. Over the past few years there have been new competitors in select markets, such as Viva Colombia  (9 airplanes) to the south and  Aeromexico and Volaris to the North. Low cost airlines such as Viva Colombia have introduced point to point service to select city pairs such as Panama City/Bogota and Panama City/Cartagena. However, the competitive dynamics for Copa have not changed significantly.  Avianca and Latam Airlines are the largest competitors in terms of route overlap. To a lesser extent Copa competes with Gol, Delta, American Airlines, Spirit, and Jetblue. Relative to these players, Copa has a more attractive route portfolio with a larger number of exclusive and highly profitable city pairs. Many of Copa’s most profitable city pairs are shielded somewhat due to the low number of passenger per day each way (PPDEW).  Furthermore, Copa has one of the lowest costs per available seat mile. It has significantly lower costs that Avianca and Latam Airlines with which it has the greatest overlap. Both Avianca and Latam Airlines have behaved rationally during the downturn, reducing capacity and maintaining or increasing prices in local currency terms.Both Avianca and Latam Airlines are run by owner/operators who have behaved rationally in the past.  Copa also has the lowest tax rate, 10% versus 35% for US carriers.  It has one of the youngest fleets. And, it has one of the strongest balance sheets. These factors have resulted in Copa having industry leading levels of profitability in the past, even if one excludes the inflated profits from Venezuela. Therefore, if Copa cannot make a decent return on capital given its competitive advantages,  it will be difficult for anyone to operate profitably in these markets.

Long term Latin America has one of the most attractive growth prospects in the world according to the IATA. Given the low penetration of  air travel in Latin America relative to countries with similar income levels combined with the dramatic growth in trips per person per year that countries exhibit when they go from low to middle income countries (www.iata.org/whatwedo/Documents/economics/20yearsForecast-GAD2014-Athens-Nov2014-BP.pdf), the region should resume its growth trajectory once the economies  stabilize.   The IATA expects Latin America passenger air traffic to grow at a compounded annual rate of term of 4.7% through 2034 (https://www.iata.org/pressroom/pr/Pages/2015-11-26-01.aspx). Boeing, in its 2015 Outlook, expects Latin American intraregional traffic to grow at an even faster rate of 6.6% compounded for the next twenty years. Even in the midst of this deep recession, traffic has continued to grow, albeit at a more subdued rate than recent years. Copa’s traffic is up 3% in 2015.

The biggest earnings headwind, in addition and related to the regional economic weakness, has been the significant currency devaluations. Therein lays the key to the recovery of Copa’s profitability.  Historically, real effective exchange rates (REER’s) have been relatively stable. In other words, currencies can devalue significantly relative to other currencies in nominal terms, but when adjusted for inflation differentials and thus purchasing power, they simply oscillate within a wide range. What I have observed over prior devaluations in Latin America is that in dollar terms, the prices of products decline precipitously during periods of dramatic currency devaluations, but eventually long term dollar denominated prices revert back to where they were before. One can see this, for example with cable TV prices, hotel prices in major cities, and cement prices. Once the currencies and the economies stabilize, one generally sees a recovery in unit prices of tradable goods in and even in most non-tradable goods in USD terms. I think that airline ticket prices will be no different over the long term. This past weekend, The Economist published an updated Big Mac Currency Index in which it showed that the currencies to which Copa is most exposed are now 50% below where they have traded historically in real terms relative to the US Dollar. The adjustment of the current account in countries like Brazil suggest to me that the rate of further devaluation will be much gentler going forward.

Valuation

Below are my earnings estimates for Copa in which I model an improvement in passenger yield starting in 2017.

Assuming normalization in yields, Copa could generate ~$7 of EPS in 2018. This is based on an increase in yields of 8% in 2017 and 1% in 2018, consistent with how yields responded following the downturn in 2009. Since it went public in 2002, the stock has traded between 7x (2013) and 17x (2013) forward earnings.My price targets are based on a multiple of 11x forward earnings which is where the stock has traded on average. The company has consistently paid about 40% of its earnings in dividends which equates roughly to a 4% dividend yield based on current depressed earnings. Applying an 11x forward PE to my 2018 earnings per share estimate of $7.21 would yield a $79 price target by the end of 2017 plus an additional $4 to $5 per share of dividends. This would equate to a total return of 84% over two years.

On Bloomberg, Copa actually screens as trading below book value for the first time in its history. However, if you adjust for the $428mm of long-term investments, which is primarily cash in Venezuela pending repatriation (I am assuming Copa never sees this cash), Copa is trading at 1.2x BV. This is still the lowest the stock has ever traded. From a downside protection perspective, Copa’s net asset value on the balance sheet at book value (airplanes + net working capital – net debt) is $36 per share (20% downside).

According to Citi’s Copa Analyst, Steve Trent, Copa is currently trading well below the estimated residual value of its owned aircraft less net debt. Citi estimates $2.7bn of net value compared to current market capitalization of $2.0bn. This would indicate that the market no longer sees value in Copa’s business model. This analysis is purely theoretical, and there is always risk that residual values decline. However, I am pretty confident that, if that were the case, the management would seek to realize some of that value through asset sales

Sources of Additional Upside

Copa began developing its own loyalty program in 2015 and incurred $20 million of upfront costs which were expensed in the year. This resulted in a $0.40 drag to earnings per share in 2015. I think once this program is running it will be additive to earnings. Assuming a benefit of $3 per passenger per year, in line with the industry, that would equate to an incremental $.50 in earnings per share in the future.

 Copa has been slow to unbundle fares to the degree that competitor Avianca has, and it lags the industry in terms of ancillary revenues per passenger. In 2015 Copa began to implement Sabre’s SabreSonic Customer Sales and Service (CSS) reservation system with the objective of targeting fare unbundling and ancillary revenues. It’s difficult to quantify the impact. For reference, the big three US legacy carriers generate an average of $10 per passenger and Jetblue generates an average of $8.50 per passenger. Assuming $5 per passenger for Copa would equate to $.80 of incremental earnings per share for Copa at some point in the future.

 Neither of these two are factored into my earnings estimates (nor will they be the deciding factor for this idea working or not working).

Risks

Competition: The competitive environment takes a turn for the worst. I have not seen any evidence of a deteriorating competitive environment, but this is something that must be monitored closely. Some investors cite Viva Colombia as a threat, but Viva Colombia is currently primarily a domestic Colombian airline with nine aircraft. Further capacity additions need to be monitored as well as pricing.

 Further economic and currency weakness: I think the bulk of the devaluations has occurred, but I could be wrong. The economies of Colombia and Brazil have been in recession for a few years.  I do not expect them to improve nor does the market.

 Earnings disappointment: This is key. There is no visibility into earnings. The company could guide down for 2016 when it reports fourth quarter earnings. It will be important to see how the stock reacts to the next earnings results.

 Multiple contraction: The stock traded at 7x earnings in 2009. It could trade there or lower especially in the near term.