Copa Dinged By Some Macro And Competitive Worries, But Still Operationally In Good Shape

Although a well-run company, Copa Holdings (CPA) is the sort of stock thats more likely than not to give investors multiple second chances. Between exposure to a host of Latin American economies, oil prices, and the often irrationally competitive airline industry, even a well-run airline like Copa is going to have its challenges. And so it seems to be now, as the shares have slid about 15% from the time of my last article and underperformed over the past year or so due to worries about increasing low-cost competition, increasing oil prices, and issues related to Venezuela.

Copa is never going to be a safe stock, but the combination of growing demand, growing capacity and pricing, and good cost control seems like one that should work well. With that, I think this is a name to consider for investors who can stomach the elevated risk and volatility.

Operationally, Things Look Good

I havent seen anything in the last two quarters that troubles me much about Copas core operations. Revenue rose 16% yoy in the first quarter after rising 12% in the fourth quarter, with the first quarter of 2018 seeing a nice pick up yoy in unit revenue along with ongoing growth in capacity and capacity utilization. Copa unfortunately doesnt give a lot of information about the breakdown of its passenger revenue, but looking at competitive flight prices, it looks like at least some of the uplift is coming from new ancillary revenue sources like baggage fees and preferred seating.

Copa has long done a good job with managing costs and running its fleet efficiently, and that remains the case. Unit costs rose less than 6% despite a 28% increase in the overall cost of fuel, with ex-fuel unit costs up just 1%. Management also noted a 6% yoy improvement in utilization to 12.0 hours, a roughly 12% improvement from the first quarter of 2016. These improvements helped drive 15% growth in EBTIDAR and 23% growth in operating income in a quarter where the average price of fuel increased by almost 18%.

Its The External Stuff That Is Causing The Problems

In terms of controlling what they can control, I think Copa management continues to do a very good job. The issue recently has been those items and issues they cannot control.

At the top of the list is Venezuela. The government of Venezuela threw another temper tantrum back in April, suspending economic ties with Panama and suspending Copas flights for 90 days. This decision was reversed about three weeks later, and Copa was able to reinstate about 60% of the canceled flights, but it still had impacts on the companys system and it has led management to guide full-year operating margin toward the lower end of its guidance range (17% to 19%). While Venezuela is a problem child for the region, it is arguably worth the hassle to Copa although flights to and from Venezuela represent only about 2% of capacity, they generate about 5% of the companys revenue.

Fuel prices are another macro issues over which management has at best limited control (fuel hedging is an option). Copa runs a relatively modern fleet and runs it pretty efficiently, and that helps to control fuel costs. It also helps that Copa keeps non-fuel expenses tightly managed, which gives it some leeway to absorb fuel price increases along the way. I think the better way to think about this is in terms of a full cycle there will be boom years where the benefits of lower fuel prices boost profits, and there will be years where the company gives some of that back, but Copas all-in cost efficiency compares quite favorably across the industry over long periods of time.

The final external issue today is the rise and growth of low-cost carriers (or LCCs) in Copas operating region. There are now about a half-dozen relatively new LCCs in South America, but given that most of them stick to domestic flights in Argentina, Chile, and Peru, theyre more of a problem for LATAM (LTM) than Copa. Volaris (VLRS) is stepping up with more flights from Central American locations to the U.S. that could put some pressure on Copas routes, but direct overlaps are still rare and its difficult for airlines to compete with many of Copas routes given that they typically have very thin connecting hubs (20 or fewer passengers today). There is a risk that lower-cost airlines will look to replicate Copas model (using a different central hub than Copas Panama City), but that risk has been in place for some time without all that much impact to Copa.

The Opportunity

I never rest all that easy with airline stocks, as this industry has a history of competitors who are willing to commit the pricing equivalent of murder-suicide to keep their planes full and flying. Right now in Brazil, while domestic load factors are okay among LATAM, GOL (GOL), and Azul, the pace of international capacity additions doesnt look so reasonable or responsible (while Copa is a small player in Brazil, it represents more than 10% of the companys revenue base). Likewise, while I think Copa will be handle to handle Volariss new Central America-to-U.S. routes well, there are no guarantees and Volaris could prove very disruptive to pricing.

Copa continues to grow its business and to do so in what I believe is a responsible fashion. Management is targeting high single-digit capacity growth this year and has been adding service to locations in Brazil (two new served cities) and the Caribbean. There are still a lot of places Copa could fly, and the overall trend for airline traffic in the region seems favorable.

My annual modeling assumptions work out to a long-term revenue growth rate of around 8%, with a more moderate pace of FCF growth given what I believe will be some competitive pressures that squeeze margins and the ongoing capital needs to support the growth of the business. I also like the outlook for high single-digit to low double-digit EBITDAR growth.

The Bottom Line

I see upside to Copa shares in both my DCF and EV/EBTIDAR models, with what I believe to be fair value for the shares between $125 and $135. I should also mention that I dont believe the shares go to that range and just stop; I believe the growth in DCF and EBITDAR should support healthy annualized returns for shareholders for some time. Although Copas volatility is there in the charts for all to see, I think this recent decline looks like a second-chance opportunity, albeit one with well above-average risks.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.


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