CPA - Copa Holdings: Underfollowed Underappreciated Undervalued

2023-11-27 07:49:16 ET

Summary

• Copa Holdings reported strong third-quarter results, with industry-leading operating margin, cost controls and strong revenue performance.
• The company continues to pay an attractive dividend and recently authorized a new share repurchase program.
• Its performance continues to be largely dismissed by the market, but over time should become clearer as core operations drive results.

I previously wrote about Copa Holdings, S.A. ( CPA ), and the company recently reported its third quarter results . In a market where some airlines are starting to see a pullback in demand or more, the company continues to outperform, and its share price has rebounded a bit from recent lows after falling by roughly a third from its highs of a few months ago. I continue to be a believer in the company's long-term prospects, for various reasons that I detail below.

Review of 3Q 2023 results and forecast

Copa's third quarter was stellar. Despite a small decline in unit revenues, CASM-ex fuel declined quarter-over-quarter and year-over-year, and overall unit costs declined significantly more than revenues, driven by falling jet fuel prices. In addition, the company's revenues were up 7% year-over-year while its operating profits were nearly 40%, in large part, but not solely, driven by the decline in the airline's fuel cost from last year's levels. As a result, its operating margin increased from an already stellar 18% in the third quarter of 2022 to nearly 24% in 2023, a figure which continues to be among the highest among airlines worldwide.

Copa management will provide its 2024 projections early next year when it reports full-year results. My 2024 forecast can be found below:

I think that the company can earn $11-13 per share next year notwithstanding its elevated share count, and even in a case which involves lower load factors and higher fuel costs, a still respectable $8-9 per share. This would mean that shares are trading for just over 7x my base case and 10-11x my downside case. There is a further downside case which would involve pressure on revenues, not just on loads, but even there I'd still expect $6-7 in EPS. And given what I view as strong prospects for the company long-term, as I've detailed previously, I would see this as a more temporary rather than permanent decline in the company's earnings power. Longer term I believe that regular earnings of $14-15 are very much within reach, with potential upside in the event that the revenue side firms further.

Retirement of convertible notes

Copa finally called the convertible bonds that it issued in 2020 during the beginning of the COVID-19 pandemic. This was the major capital raising exercise that the company completed which, when combined with the near hibernation of the entire operation for several months, allowed the airline to navigate the crisis particularly well. However, the repayment also resulted in the issuance of over 3 million shares, raising the overall share count to approximately 42 million. This is less than a 10% increase, so is not terribly dilutive. And more importantly, it will remove the significant quarterly volatility in Copa's earnings resulting from the mark-to-market of the convertible notes and the hedging transactions the company entered into related to the issuance, allowing the strength of its core operations to shine through.

Strong balance sheet and financial performance

Despite the over $300 million of funds needed to repay its convertible notes, plus continuing share buybacks, the company ended the third quarter with cash and short-term investments of $992 million, over 20% of its last twelve months' revenues and nearly $60 million above where it started the year. Its net leverage remains at or below 1.0 times debt to EBITDAR and well below 1.0 times debt to equity, each of which is among the best in the entire industry. These are investment-grade type metrics, even though the airline does not have any publicly rated debt, or appetite for capital markets issuance, which it would need a rating(s) to access. It is fair to say that this combination of a fortress balance sheet and sustained profitability bodes well for the resilience of the company through the inevitable cyclicality of the airline business.

Financing cost advantage

In addition to (and due to) its sterling balance sheet, Copa's relatively modest capital expenditures - approximately $2.5 billion through 2028 - are at a manageable level and are very efficiently funded by the company. Copa's average cost of debt was an incredible 3.4% at the end of the third quarter, with nearly 80% fixed rate and so insulated from this year's rise in interest rates. In addition, it's already secured attractive financing for ten of the fifteen aircraft it will take delivery of next year via the Japanese Operating Lease with Call Option (JOLCO) market. Management has advised that the cost of this financing is approximately 5%, which with Treasury rates well above 4%, is exceptionally attractive. This JOLCO market is not especially deep, but clearly, Copa has been able to maximize its exposure to the product, which allows it to have one of the most attractive costs of debt, not just amongst Latin American airlines, but in the entire industry globally.

Share buybacks and dividends

The company exhausted the funds from its prior share repurchase authorization and instituted a new $200 million program in parallel with its earnings. They're also paying a run-rate quarterly dividend of $0.82 per share, which combined equates to capital returns approaching 7-8% of the company's market capitalization, which is significant. Based on my projections, the company should have a substantial ability to reward shareholders in the coming years through some combination of dividends and share repurchases.

Risks to investment thesis

1. Economic recession.

2. Fuel costs and other potential cost pressures.

3. Significant delay in aircraft deliveries negatively impacting capacity growth.

Conclusion

Copa is on the right track notwithstanding the recent underperformance of the stock. They continue to emphasize capital returns to shareholders and are prudently growing the business while focusing on keeping a lid on costs. I continue to be a believer in the company and think it has a chance to outperform its peers as its strategy continues to bear fruit.

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