AZUL - Copa Continues To Excel But The Macro Environment Has Some Challenges

Summary

• Copa surpassed sell-side expectations again in the fourth quarter, with a double-digit operating income beat and stronger margin guidance for 2023.
• The recovery in international air travel demand continues, though business travel has continued to lag leisure travel.
• A weaker macro environment, including weaker consumer confidence, is a modest threat in 2023, as is more aggressive competition on price.
• Copa trades well below the value that long-term mid-single-digit revenue growth and low/mid-teens FCF margins can support.

In terms of controlling what is within their power, I continue to believe that Copa Holdings ( CPA ) management is among the best in the business. Relative to the last quarter before the pandemic, capacity is up, yields are up strongly, and costs are down significantly. At the same time, air travel is not yet back to normal in Latin America, but continues to improve.

Copa shares are up a bit since my last update , which is disappointing relative to the underlying performance, but really not bad at all compared to the performances of other Latin American carriers like Volaris ( VLRS ) (down 45%), Gol Linhas ( GOL ) (down 66%), and Azul ( AZUL ) (down 72%), as well as other carriers I respect like Alaska Air ( ALK ) (down 16%).

I do see elevated economic risk over the next year or so, as well as a risk of more aggressive behavior from regional competitors. Even so, if mid-single-digit long-term revenue growth and low-to-mid-teens free cash flow margins are valid long-term targets, these shares remain meaningfully undervalued.

Strong Numbers To Close The Year

Copa stock posted good financial results for the fourth quarter of 2022, as well as healthy guidance for 2023. I’d also note that the 2023 guidance had a little more detail than has been the trend recently, suggesting to me that management likely feels a little more confident that 2023 will see the business continue to trend back toward normal.

Revenue rose 55% from the prior year and 10% from the prior quarter in the fourth quarter, beating by 1% and also representing 31% growth relative to the fourth quarter of 2019. While a 1% revenue beat isn’t that exciting, it’s worth remembering that Copa’s monthly traffic reports give analysts enough information to dial in the quarterly top-line reports.

Passenger revenue rose 58% yoy in the quarter, with traffic (revenue passenger miles) up 32% and passenger revenue per available seat mile up 24% to $0.131. Overall yield improved 19% yoy and 7.5% qoq to $0.15, and that is 20% above the Q4’19 level, on a 6% increase in available seat miles. Load factor remains fairly steady, improving almost three points from the year-ago level (86.6% vs. 83.5%), but down 20bp from the prior quarter.

Copa continues to do an excellent job of managing controllable costs. Overall cost per available seat mile (or CASM) was up 27% yoy and down 2% qoq to $0.103, while CASM ex-fuel rose 18% yoy and 3% to $0.061, down 24% from Q4’19. EBITDAR rose 31% (with margin down about six points to 32.6%) and operating income rose 42% (with margin down 340bp to 24.7%), beating by 7% and 12%, respectively.

Further Growth In 2023

Management guided to 12% to 14% capacity growth for 2023, a bit below Street expectations of around 15%, but revenue per available seat mile was guided at $0.121, slightly above the Street and about 12% above 2019’s level, as demand remains quite healthy. Management also guided to stable CASM ex-fuel, with an EBIT margin of 17% to 19% versus Street expectations of 16.9%.

Copa management has typically been relatively conservative with guidance in the past, so I would regard this as an “opening bid” on a strong 2023, albeit one with a few challenges.

First, LatAm air travel still hasn’t fully recovered. Family travel rebounded relatively quickly, helping airlines like Volaris initially, but gains have come a little slower of late. As of the most recent IATA data, overall LatAm air traffic is about 11% below pre-pandemic levels, while international travel (far, far more relevant to Copa) is down about 18%. Go back to June of 2022 and those numbers were down 13% and 27%, respectively, which is why I make the point that Copa has benefited from ongoing international traffic improvement while domestic demand has flattened a bit.

I do think 2023 could see some challenges to demand. Economies are slowing around the world, and about three-quarters of Copa’s recent demand is leisure, which is typically more economically-sensitive. At the same time, some of Copa’s rivals are getting a little more aggressive, so I do see a modest risk of more aggressive price competition in 2023, which would push Copa to either lower fares in response or accept weaker load factors (and it typically makes more sense to lower fares).

On the cost side, I don’t have many concerns about Copa’s ability to hit its near-term targets. Jet fuel prices are always a variable to consider, but a weaker global macro backdrop typically isn’t bullish for oil/fuel prices. I do wonder if, over the long term, Copa may need to be a little less aggressive on costs. The company has done a good job of pulling multiple levers to reduce salary costs, but at some point you risk alienating valuable employees if you push too hard.

The Outlook

At its core, I still really like the Copa story. Management has shown over and over again that it can execute on costs, as well as grow its fleet responsibly (including recent additions of new, more efficient, 737-MAX 9’s). It also operates an attractive hub-and-spoke system from Panama City, where there are difficult-to-replicate geographic and weather advantages and where the capacity for competition is relatively limited.

It is certainly possible that business travel will never fully normalize post-pandemic; many businesses have seen that they can use teleconferencing to replace in-person visits for at least some functions, and they may well be loath to fully return to pre-pandemic levels of travel spending. That said, many businesses have commented that the sales experience isn’t the same without face-to-face interaction, and I still believe economic growth across Mexico, Brazil, and other LatAm economies will drive travel demand (leisure and business) in the years to come.

Copa has exceeded my prior expectations for normalizing revenue back to pre-pandemic levels (and beyond), but I haven’t changed my core expectation that the airline will see long-term core revenue growth in the mid-single-digits. I’m not expecting significant share gains for Copa (so my revenue growth assumptions are close to my underlying traffic growth assumptions), but I do think the company has the option to compete more in certain domestic routes if it chooses to do so.

On the margin side, I expect 30% EBITDAR margins in 2025 and I still believe Copa could achieve and sustain low-to-mid-teens FCF margins on a sustained basis. I do believe year-to-year volatility in free cash flow is just something investors have to expect and live with, as fleet expansion/delivery schedules will create some meaningful year-to-year moves in capex. I also note, though, that management has gotten back to returning capital to shareholders and will likely expand these returns in the coming years.

Discounted free cash flow suggests a fair value close to $130, and that’s with a double-digit discount rate to reflect the added risks of operating in the airline industry and across multiple Latin American markets. I get an ever higher fair value on the basis of a 7x forward EBITDAR multiple – a 10% discount to the company’s trailing average (largely to reflect maturation of the business) and a significant premium to the current industry multiple (around 5.5x).

The Bottom Line

Copa is actually trading pretty close to that industry average now, and I think that’s just too low for a company with above-average growth potential (from underlying demand growth) and a proven ability to control costs. I can appreciate that this may not be the best time to own an airline (with declining consumer confidence), but given the long-term potential, I think it’s still a worthwhile consideration at today’s price.

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