A Great Model And Growing Markets Powering Copa Holdings

By Stephen D. Simpson, CFA | September 03, 2013 AAA

This year has turned into a challenging one for emerging market investors, as China remains weak (at least relatively so), Brazil and Mexico seem to be turning in the wrong direction, and multiple Southeast Asian markets sell off on macroeconomic worries. Even so, business continues on at Copa Holdings (NYSE:CPA), where a strong and savvy business plan has led this Latin American airline to not only strong margins and good growth, but solid prospects for the coming years.

An Old Model with New Profitability
Copa operates a familiar, tried-and-true hub-and-spoke model, serving 65 destinations in 29 countries. A large percentage of the company's business goes through Panama City, where the company has more than 85% market share, and this is a logical geographical hub for connecting flights from/to North America, Central America, and South America.

What's a little unusual about Copa is that so many of its routes are thinly traveled. Roughly 75% of the company's routes average fewer than 20 passengers per day. You might think that serving such tiny markets would be terrible for the financials, but Copa does a good job of matching its capacity to its demand. It does such a good job, in fact, that the company's operating margins are the highest in the world among publicly-traded airlines – well ahead of Latin American comparables such as LATAM Airlines (NYSE:LFL), GOL Linhas (NYSE:GOL), not to mention American operators like Southwest (NYSE:LUV) and high-margin carriers like Japan Airlines and Turkish Airlines.

Not only are those routes profitable, but that thin passenger traffic keeps rivals at bay. The demand and opportunity for direct routes is relatively limited across Central and South America, leaving the company with relatively low risks on those routes.

Expansion and Competition
Copa's main challenge will be managing its future growth. The company has expanded its operations in Colombia, bringing it into competition more often with Avianca, and it is likely that LATAM Airlines, GOL, and Aeromex will factor more into the company's competitive picture going forward. As investors have seen over and over again in the U.S. airline sector, competition is rarely ever a good thing, and although Copa's model seems straightforward, it remains to be seen how far the company can extend before competition starts chewing into that robust operating margin.

Still, Copa can ride a generally rising tide. As the economies of countries like Panama and Colombia grow, air travel demand is also increasing. As individual incomes and wealth improve, air travel demand increases and so too do the expectations of those travelers – service quality, safety reputations, and so on make more and more of a difference, and that should work in favor of well-established larger carriers like Copa and LATAM Airlines. To frame the argument a little more definitively, while Latin America has about 9% of the world's population, IATA statistics indicate that it accounts for only 5% of global air passenger volume – even just closing half of that gap would represent a significant increase in the number of passengers for airlines in the region.

Strong Loads, but Fuel Is Always a Risk
About a month ago, Copa reported second quarter earnings that saw revenue rise 15% despite a 2.5% decline in revenue per available seat mile that was driven by lower yields (down almost 5%). The load factor was pretty good, though, as it rose 1.7% to over 75%. As I said before, one of the positives to the Copa model is that they make sure they don't fly empty seats.

On the profits side, operating income jumped almost 35% as fuel costs declined more than 7% and ex-fuel unit costs declined nearly 3%. That speaks well to the company's cost focus, though fuel prices are an ongoing risk for every airline operator.

The Bottom Line
Between a strong operating model and rising demand, I believe Copa is in a good place for the long-term.

My only real issue is valuation, not surprising given the stock's 70% rise over the past 12 months. I suspect that my long-term revenue growth estimate of 8% may be on the low side, given the revenue growth rates seen at Southwest and Alaska Airlines (NYSE:ALK) over the past decade (more than 12% and 7%, respectively), but that revenue growth estimate and cash flow growth of roughly 17% suggest a fair value of around $140. Bump the revenue growth estimate for the next decade to 12% and the price target soars to $185, but investors may want to note that even the very bullish Wall Street analysts don't project that much growth and it may prove hard to maintain mid-teens free cash flow margins with the capacity additions that sort of growth would need.

Disclosures: As of this writing, the author has no financial positions in any companies mentioned.

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