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Charlie Munger, Vice-Chairman of Berkshire Hathaway (NYSE:BRK.A), once shared a story of a friend involved in a farming equipment business who, looking out at his field of used machinery, said, "There's my profit sitting out there." His point, and many investors' reason for avoiding airline stocks, is that you generally do not want to invest in businesses that require a lot of cash to just maintain equipment and operations because that leaves far less for us shareholders. Rather, you want to look at companies that have high returns on equity, assets, and capital while leveraging a competitive advantage in their space that will enable them to maintain the aforementioned positives. Airlines usually do not excel in those areas. Combined with the constant threat of higher fuel costs, competition, and labor issues, the entire space rightfully looks unattractive relative to others.

However, Copa (NYSE:CPA) has become an outlier in the industry and continues to prove it is the exception to most investors' broad aversion to airline stocks. Copa is a leading Latin American airline that offers more than 280 daily scheduled flights to 64 destinations in 29 countries in North, Central and South America, as well as the Caribbean with a young fleet (avg. 5.1 years old) of 77 aircraft (53 more on order). In June, Copa became a part of Star Alliance, the largest global airline network, composed of 27 of the world's major airlines.

Profit Margin

Copa leverages a significant geographic advantage from its Tocumen International Airport hub in Panama City, Panama. Every major city in North and South America can be reached within eight hours from this "Hub of the Americas." The location allows Copa to provide direct service to second tier cities otherwise unreachable to large carriers. As a result, the airline is able to offer fares lower than carriers without direct service but high enough to maintain a significant profit margin advantage because of the lack of direct route competition that cannibalizes margins in more developed markets. Tocumen International is currently the only airport with two active runways in Central America and it completed an expansion and modernization program in January of 2012 which increased capacity from 5 million to 10 million passengers a year. Copa's position here appears protected, a rarity in the industry.

Major Airline Operators (By Market Cap)

% Profit Margin

LATAM Airlines Group SA (NYSE:LFL)

5.6

Delta Airlines Inc. (NYSE:DAL)

2.4

Ryanair Holdings PLC (NASDAQ:RYAAY)

13.0

United Continental Holdings Inc. (NYSE:UAL)

2.3

Southwest Airlines Co. (NYSE:LUV)

1.1

Deutsche Lufthansa AG (OTCQX:DLAKY)

0.9

Copa Holdings SA

17.0

Tam SA (NYSE:TAM)

-2.6

Alaska Air Group Inc. (NYSE:ALK)

5.7

U.S. Airways Group Inc. (LCC)

0.5

Source: Standard & Poor's

Earnings, Growth, & Dividend

South America and the Caribbean have combined populations north of 590 million with a growth rate exceeding that of North America. Investors seeking to avoid a stagnant, debt-laden Europe and believing in the continuing Latin-American growth story would be well advised to be long such a well-positioned performer. The infrastructure currently does not exist for competitors to unseat Copa and turn the South/Central American airline market into the dogfight that the U.S. has become. Yet, the market looks to grow considerably with the rising middle class of many Latin American countries.

Major Airline Operators (By Market Cap)

1 year % Revenue Growth

1 year % EPS Growth

LATAM Airlines Group SA

27.2

-24.2

Delta Airlines Inc.

10.6

44.3

Ryanair Holdings PLC

12.0

41.3

United Continental Holdings Inc.

59.3

109.3

Southwest Airlines Co.

29.4

-62.3

Deutsche Lufthansa AG

2.7

-76.5

Copa Holdings SA

29.4

27.4

Tam SA

2.0

--

Alaska Air Group Inc.

12.7

-2.5

U.S. Airways Group Inc.

9.6

-83.1

Source: Standard & Poor's

Last quarter, Copa reported profits of $95.9 million or $2.16 a share in a very tough operating environment that hurt earnings growth. However growth is robust year over year and should continue as the South American travel market continues its expansion. Earnings per share growth have been relatively consistent; 3 year annualized EPS growth is 36.7% and 17.6% over 5 years. Sales growth for the latest four quarters is 29.5% which is in line with the company's expansion plans. So far, as the airline has added to its fleet, sales growth has risen to fill the new capacity. With an additional 53 aircraft on order, there is no doubt shareholders will be rewarded if management can execute its plans for continued expansion. Very little to date casts doubt on management's ability to execute.

The stock currently trades at a price to earnings ratio of 10.6. Despite a stock price that is nearer the high end of the range since the company's 2005 initial public offering, the P/E ratio is historically on the low end. From 2005 to 2011 the P/E ratios based on fiscal year date were 14.1, 15.0, 10.1, 11.1, 10.0, 10.7, and 8.4 respectively, illustrating the company's continuing growth. Today's 10.6 seems reasonable based on those numbers, but conservative investors willing to wait for a pullback should be able to own the company closer to its 2011 8.4 multiple.

The company's operating revenue for the first quarter was $543.3 million which represents a 29.5% increase over the same number a year ago. The largest component of that increase, passenger revenue, increased at a slightly higher 30.7% assisted by a 6.4% increase in passenger yield. For the remainder of 2012, the company projects an operating margin of 18% to 20% which is roughly in line with the 21% of 2011. With growth in both aircraft and routes, if the company can maintain operating margins, earnings per share should continue to pick up. The company recently added routes direct from Panama to Recife, Brazil; Las Vegas, United States; Liberia, Costa Rica; and the Island of Curacao. Additionally, management's assessment may be conservative with regard to fuel prices and a drop in such could provide shareholders with upside earnings surprises.

Last quarter Copa had fuel hedges in place representing 26% of its consolidated volume. Continuing with the execution of its fuel hedge policy, the company currently has hedged approximately 24% in 2Q12, 20% in 3Q12 and 17% in 4Q12. For 2013, the Company has hedged approximately 10% of its forecasted fuel consumption. Investors should look at these fuel hedges as limiting the risk of potentially higher fuel prices rather than increasing margins substantially. The company's current hedging activity is not overbroad and will still enable it to reap the benefits of lower oil prices well into 2013. Investors will want to keep an eye on fuel prices and may be rewarded by the company's earnings going forward if prices do indeed come down.

Copa keeps labor costs lower than its industry peers, particularly those in the United States. Pension expenses currently have little impact compared to many North American carriers despite the airline being around since 1944. Nothing indicates a change here but it is always something to keep an eye on. An interesting note that also appears to give the company an advantage is its effective tax rate. Copa pays one of the lowest effective tax rates in the airline industry at 11.6%. The reasons for this are beyond the scope of this article, but for comparison: Southwest pays 39.1%, Jet Blue pays 40.7%, and Spirit pays 37.8%. Tax advantages can provide a company with a substantial edge and should be taken very seriously by investors. Copa's pre-tax margins are still well above those of the competition anyway (over 7% higher).

Copa's dividend is extremely impressive for the airline industry especially considering the company's growth prospects. Representing 30% of consolidated net income in 2011, the $2.10 per share dividend signals an inclination on the part of management to put shareholders ahead of trying to grow at all costs. Airlines have a tendency to over expand, often into markets where either there is too much competition to succeed or where others have recently failed (the new player rarely achieves a different result). Over time this can become a substantial drag on earnings but Copa has not shown an appetite for such moves despite weakness in regional players such as TAM (in fact they have cooperated with TAM).

Two Key Operating Metrics

Airline operating metrics are a great way to get an accurate snapshot of operations and make comparisons within the group. In the first quarter of 2012 Copa achieved a load factor of 77.2% with a breakeven load factor of 61.2%. These numbers show that Copa is filling aircraft at a solid rate and that even in an elevated cost environment Copa's breakeven load factor is a low 61.2% (according to the Bureau of Transportation Statistics a 61.2% BLF is historically below the level needed for airlines to maintain profitability during economic downturns). This, combined with low debt levels, speaks volumes to Copa's ability to remain profitable in adverse economic climates helping limit downside risk.

Copa is very profitable now, but still has plenty of room on the upside to increase load factor as growth continues on its Latin American routes. An increase in load factor to the U.S. average of around 85% would have an extremely positive effect on earnings. Most recently, last month's load factor for international service came in 3.7% below that of June 2011 but domestic load factors increased 3.8%. Investors need to keep a diligent eye on these numbers. Concerning here is that when considered together, June load factors were down -3.4% indicating how reliant Copa is on its international service. If this slight decrease holds, it may be offset by lower fuel costs in the coming quarter.

Cash Position & Debt

Last quarter the company closed with $647.8 million in cash and $1.1 billion in debt. Every penny of the company's debt is a result of aircraft and equipment financing. Holding a cash position that is over half of the company's entire debt load while paying a dividend that represents 30% of annual consolidated net income is an indication of how well managed Copa has been. Copa's debt levels rival those of the industry's most efficient operators and the company's cash position is superior to most given the company's size. Despite the great dividend the airline is on pace to continue growing its cash position which will give it flexibility to both survive downturns and take advantage of new opportunities.

Major Airline Operators (By Market Cap)

Debt to Capital

LATAM Airlines Group SA

0.7

Delta Airlines Inc.

1.0

Ryanair Holdings PLC

0.5

United Continental Holdings Inc.

0.8

Southwest Airlines Co.

0.3

Deutsche Lufthansa AG

0.4

Copa Holdings SA

0.4

Tam SA

0.8

Alaska Air Group Inc.

0.5

U.S. Airways Group Inc.

1.0

Source: Standard & Poor's

Risk

Further consolidation in the industry is a highly covered topic and Copa has been discussed as a potentially attractive acquisition for larger carriers attempting to better avail themselves of the Latin American market. However, with a market cap of $3.3 billion this seems highly unlikely and investors would be well advised not to wait on such a deal. Rather, various sharing and partnership agreements with other carriers remain far more likely in the short term.

As with any airline stock future fuel costs remain an unknown variable. Historically, Copa has hedged very effectively but this cannot be counted on indefinitely. A lot of this analysis goes out the window if oil begins rising well over $100 a barrel, but relative to other companies in the sector, Copa is well positioned to survive such an environment. Copa's somewhat niche market and fortuitous position within its region allow it to operate more efficiently than competitors while making it easier to pass costs on to the passenger.

Additionally increased competition is always a risk, but this is mitigated by the strong geographic position mentioned earlier. Continental previously owned 49% of the company which kept competition to a minimum and led to cooperation between the two airlines. Whether or not the new United Continental will seek similar agreements remains to be seen as Continental no longer holds its 49% stake. How American Airlines emerges from bankruptcy is also an unknown factor that will be relevant because of the strong presence American has sought in South America. If aggressive expansion in the region becomes a priority for the new American Airlines, it may cut into Copa's margins on some routes.

Growth stocks tend to fall precipitously at the first sign of slowing expansion so how investors perceive Copa going forward (growth or value) will help determine how stable the stock price will be. There is no predicting investor perception, but Copa's dividend, solid cash position, and advantageous footprint should protect long investors from the aftermath a missed quarter brings to a pure growth play. Investors should still keep an eye on the two key metrics mentioned earlier to stay on top of any erosion in demand; the numbers are available monthly via Copa Investor Relations.

Conclusion

Copa has clearly shown its ability to maintain profitability with elevated oil prices. Near $75 a share, the stock is nearer the high end of its historical range (though not so based on the multiple). However if fuel prices come down significantly it may still outperform. The stock is up just over 10% on the year with a 52-week low of $55.80 and a high of $86.50.

Investing in airlines is tough, but within the space Copa appears to be a company with a solid footing and significant growth prospects. The stock will begin looking very attractive if the macro picture takes it back below $68. If the global economy slows, Copa should be able to remain profitable and may actually benefit from the lower fuel prices that often accompany a downturn. Long investors who are patient and reinvest Copa's rising dividends are likely to reap substantial returns as it expands in a vibrant market and overtakes competitors with inferior management.

Data Provided by Standard & Poor's Compustat Reports

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

Source: Copa Holdings: The One Airline To Get Long