Description

1. Copa is the best airline in the world; Copa’s competitive advantage is durable due to the unique location of Panama City and the network effect of the hub-and-spoke model

2. Copa has had an eight-year streak of exceptionally bad luck; the next eight years are, in a base case, likely to be much better

3. Valuation is attractive – I can see 1-year upside of ~40% (10x 2025 EPS) and 5-year upside of 100% (15% BVPS compounding and 2x 2028 BVPS)

4. Risks abound, but they are manageable and compensated by upside cases

Part 1: Copa is the best airline in the world; Copa’s competitive advantage is durable due to the unique location of Panama City and the network effect of the hub and spoke model. 

While airlines are notoriously bad businesses (low barriers to entry, high competition, high capital intensity, cyclical demand), Copa has generated more value through the cycle than any other airline in the world: 

*Methodological note: I adjust BVPS in each period up assuming dividends can be reinvested at 2x P/B. This is a realistic assumption in the sense that Copa is often trading near 2x P/B, and an investor can literally use a dividend to buy more book value. A 15% BVPS compounding is consistent, for example, with 19% ROE and 40% dividend payout ratio (19%*40%/2 + 19%*60% = 15%). This is, in fact, what I think Copa’s long-run financial algorithm is, and it implies 11% growth in revenues and book value through time, 19% ROE, and 40% payout ratio (or share repurchases). 

I have selected the airlines in the above table somewhat randomly – I could have chosen dozens more. Few airlines have grown book value per share through the cycle. And a very small number have grown BVPS at an attractive rate >10% for over 15 years (Alaska Air and Copa are the only two I know of globally). Even the highly-esteemed Ryanair, with all its innovation and operational excellence, has through-cycle returns far inferior to Copa. Copa’s numbers evidence a great business.

So what accounts for Copa’s high returns? 

• Copa operates from Tocumen International Airport, in Panama City, which was basically designed for (and in large part by) Copa. Copa accounts for 80% of Tocumen flights. Tocumen, compared to nearby hubs such as Bogota and San Salvador, has the benefit of friendly and stable government, central location between North and South America, good weather for flying, and sea level runways, which lowers the cost of jet fuel at takeoff. 

• Quoting a 2016 VIC writeup, “at Tocumen, Copa aggregates fragmented traffic from multiple destinations, serving many city pairs that lack 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.” This is a network effect advantage, and cannot be eroded by marginally adding capacity because one needs the whole network to be able to serve city pairs with thin demand. 

• Panama has favorable labor laws, labor markets, and tax structure for Copa to operate at quite a low cost given service / product (low costs while offering full-service experience).

So we have strong evidence that Copa will continue to generate good returns:

• Copa’s history of high through-cycle book value compounding 

• Conceptually compelling explanations for Copa’s competitive advantage 

Alternatively, a VIC short pitch from 2021 argued that increasing ULCC competition and longer-range narrow-body planes would erode Copa’s competitive advantage. I believe this to be unlikely for several reasons: 

• No hub is as well developed as Tocumen, and therefore no hub can serve thin routes efficiently as Copa

• No hub has the structural advantages of Tocumen as discussed above (friendly government, sea level, location, weather)

• ULCC competition is worthy of concern, but it’s also somewhat beneficial that Copa is increasingly the only full service carrier in the region; some passengers prefer a full service experience

• More often-than not, high return business stay as high return businesses

Lastly, I suggest that the results since the above-mentioned short write-up speak for themselves in that Copa has delivered outstanding operating margins, which are also superior  vs. all peers:

Part 2: Copa has had an eight-year streak of exceptionally bad luck; the next eight years are, in a base case, likely to be much better:

Let’s review the past eight years for Copa:

• 2015: Copa lost > $400M trapped in Venezuela and devalued into worthless Bolivars

• 2015 / 2016: Copa suffered due to the deep recession in South America, especially in Brazil; Brazilian GDP fell ~7% over the two years, far worse than in the 2008/2009 financial crisis (when GDP was flat for 2009, but quite healthy in 2008 and 2010); Brazilian and Colombian currencies deteriorated

• 2018: Copa discovered and disclosed that they had been under-accruing depreciation on their fleet for over ten years and took a 1x charge of nearly $200M

• 2020: COVID shut down air travel; Copa assumed a dilutive equity raise (convertible debt) just at the bottom of the market and their stock price

I’m not saying that this sequence of challenges represents a once-in-100-years kind of adverse circumstances for an airline. However, this is a string of adverse events that should be considered bottom quartile type of conditions. Some of the conditions could have been avoided through better management (Venezuela cash and under-accruing of depreciation), and some were truly unpredictable (COVID). 

As a result of different periods with different conditions, we can see that Copa’s book value compounding can be separated into very different periods:

When conditions are unfavorable, Copa survives and muddles through. When conditions are favorable, Copa prints money. These periods, respectively, can last long periods and swing unpredictably. Importantly, however, these periods are self correcting through the capital cycle: if things get bad enough, they trigger financial stress amongst Copa’s over-levered peers, which results in bankruptcy (sometimes), lower capacity, and more favorable conditions. Furthermore, Copa has the financial strength and business model strength to emerge healthy from these challenging periods, as they did even through all the catastrophes of the 2014 - 2021. The largest single-year hit to their book equity came in 2015 and 2021 (both about -30%), and in both cases I found bankruptcy highly unlikely at the time. 

I don’t feel brazen enough to predict either that the 2023 favorable conditions will persist, and nor that the 2015/2016/2020 woes will return. Rather, I model a middle ground, on which I find valuation attractive. 

Part 3: Valuation is attractive I can see 1-year upside of ~40% and 5-year upside of 100%:

Considering valuation in two different ways, I am struck in both cases that valuation is attractive:

• Valuation is attractive on the basis that Copa trades at 2.0x P/B. If Copa continues to grow adjusted book value per share (with dividends reinvested) at 2x P/B, one’s book value will double in just five years, and one’s investment at 2x P/B today would be 1x 2028 book value. One’s investment will outperform in this scenario (Copa would likely trade over 2x P/B in five years under this scenario, meaning that one’s investment would double in five years)

• Valuation is attractive in that Copa trades for 6.0x 2023 EPS (which I assume has cyclically high margins) and 6.9x 2025 EPS (which I assume has normal margins of 16%). I think Copa will trade up to 10x 1-year forward earnings, implying upside to $140 by year-end 2024.

Part 4: Risks abound, but they are manageable and compensated by upside cases: 

The largest risk today is that Copa’s competitors, especially Avianca, but also to some extent Latam Airlines, Viva Air, and others are adding capacity rapidly in Copa’s markets. Demand is very robust in Copa’s markets, evidenced by their above-normal 23% 2023 operating margins. Consequently, everyone is adding capacity. 

This cycle is rather normal, and can persist for many years. In the 2005 - 2014 period, for example, capacity growth by Copa and peers was low-double-digit, and yet demand kept pace, with Copa earning excellent returns. Latin American air travel is underpenetrated and can grow quickly. 

Alternatively, if demand falls or flatlines, margins will fall hard. The good news is that supply can also react quickly, especially given that Copa’s competitors are over-levered and have high borrowing costs. Unless global demand suffers a simultaneous shock, competitors’ planes can be sold to carriers in other regions. 

These cycles of demand and supply, moreover, are rather normal, and not likely to be long-lived. 

Other risks are easy to imagine just by studying Copa’s history (political instability, natural disasters, pandemics, etc). However, Copa’s history makes clear that periods of stability are slightly more likely and very, very profitable. At 6x 2023 P/E, I’m willing to take the risk on the market conditions. 

Catalyst

Another 1-2 years of solid results will help investors forget the awful period from 2015 - 2020, and rather focus on the strength of Copa's business.