Copa Holdings Stock Has Become Interesting (NYSE:CPA)

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Felipe Gustavo S Borges

Copa Holdings (NYSE:CPA) has underperformed the market by a wide margin over the last five years. During this period, the stock has shed 46% whereas the S&P 500 has rallied 51%. The vast underperformance of the airline has resulted primarily from the impact of the pandemic on its business. However, Copa Holdings is now recovering from the pandemic and its stock has become remarkably cheap. Therefore, investors should put this stock on their radar.

Business overview

Just like all the other airlines, Copa Holdings was severely affected by the coronavirus crisis in 2020. Due to the social distancing measures taken in response to the pandemic and the reluctance of people to travel, leisure and business travel collapsed in that year. Consequently, Copa Holdings incurred an adjusted loss per share of -$6.11 in that year, its first loss in more than a decade.

On the bright side, thanks to the massive distribution of vaccines worldwide, the pandemic has begun to subside and thus Copa Holdings has greatly improved its performance. It posted a marginal profit in 2021 and has returned to high profitability this year.

On the other hand, the airline is facing another strong headwind this year, namely the surge of the cost of jet fuel, which has resulted from the sanctions of western countries on Russia for its invasion in Ukraine. Before the sanctions, Russia was producing approximately 10% of global oil output and an even greater percent of global refined products. Therefore, the sanctions have greatly tightened the market of refined products and hence the price of jet fuel has rallied to a 13-year high this year.

The impact of the multi-year high fuel cost on the results of Copa Holdings was evident in its latest earnings report. In the second quarter, the airline grew its revenue 7.5% over the pre-pandemic second quarter of 2019. In other words, the sales of Copa Holdings have recovered above pre-pandemic levels. However, its operating cost per available seat mile grew 20% due to the surge of fuel cost. Notably, the fuel cost comprised 43% of total operating cost in the quarter. Due to this headwind, the earnings of Copa Holdings plunged from $1.20 in Q2-2019 to $0.32.

However, it is critical to realize that the price of oil has probably peaked. Most countries have been severely hurt by the rally of the oil price this year and thus they are exhausting their means to diversify away from oil. Some countries have reinvigorated their coal mines and most countries are investing in renewable energy projects at a record pace. As a result, the price of oil has lately fallen below its level at the time of the invasion of Russia in Ukraine. This is a strong bearish signal for the oil price, as it illustrates that the shock from the war in Ukraine has been absorbed by the oil market.

Moreover, whenever the price of oil has reached its current highs, a slump has always ensued due to the dramatic cyclicality of the oil market. To cut a long story short, the fuel cost of Copa Holdings has almost certainly peaked, with a significant decrease likely in the upcoming quarters. As this cost comprised 43% of total operating cost in the latest quarter, it is evident that a material decrease of this cost will greatly expand the profit margin of Copa Holdings.

It is also worth noting that Copa Holdings has provided rosy guidance for the third quarter. More precisely, it expects its operating margin to expand from 6% in the second quarter to 16%-18% in the third quarter. Notably management expects the capacity in the third quarter to reach 100% of the capacity in Q3-2019. The airline issued this guidance in early August and hence it is safe to assume that the business performance in July was exceptionally strong. Overall, the company has essentially returned to pre-pandemic business performance and the headwind from abnormally high fuel costs is likely to subside in the upcoming quarters.

Most investors hesitate to invest in airlines, as they are infamous for their high cyclicality and vulnerability to recessions. Indeed, numerous airlines have gone bankrupt throughout the history of the aviation industry.

However, Copa Holdings enjoys some unique competitive advantages, which render the company more resilient than the vast majority of its peers. Copa has the base of its operations in Panama City, which is the center for financial services, shipping and commerce in the greater area. The company also benefits from high economic growth in Latin America while it serves several destinations that do not generate enough demand to drive much competition. Overall, thanks to the strategic location of its operations, Copa Holdings faces much less competition than most airlines.

Valuation

Analysts seem to agree on the sustained recovery of Copa Holdings from the pandemic and expect the airline to grow its earnings per share from $0.06 in 2021 to $6.24 in 2022. This means that the stock is currently trading at a price-to-earnings ratio of 11.2.

Such an earnings multiple may seem reasonable for an airline but it is too low if one takes into account that the recovery of Copa Holdings is only in its early phases. Analysts expect the company to grow its earnings per share to $8.85 in 2023 and $11.65 in 2024. In other words, the stock is trading at only 7.9 times its expected earnings in 2023 and 6.0 times its expected earnings in 2024. Therefore, patient investors are likely to be highly rewarded by Copa Holdings in the upcoming years.

Risks

The main reasons behind the cheap valuation of the stock are the aforementioned headwind from high fuel costs and the risk of an upcoming recession. If the price of jet fuel remains around its 13-year highs for years, it will continue to exert pressure on the margins of Copa Holdings and thus the airline may not grow its earnings as fast as analysts expect right now. However, given the high cyclicality of the oil market and the record number of clean energy projects under development, this adverse scenario is highly unlikely.

The other risk factor, which applies to all the airlines, is the possibility of a recession. Due to the aggressive interest rate hikes of central banks in response to 40-year high inflation, the risk of a recession in 2022 or 2023 has greatly increased. Airlines are infamous for their sensitivity to recessions. However, thanks to its unique competitive advantages, Copa Holdings can endure downturns much more readily than most airlines.

In addition, even if a recession materializes, it will not last forever. As experience has shown, the global economy has always emerged from recessions much stronger. To be sure, even in the Great Recession in 2009, the worst financial crisis of the last 90 years, it took global GDP only one year to recover from that crisis. Overall, a recession may show up but Copa Holdings is likely to recover strongly during the subsequent economic recovery.

Final thoughts

Copa Holdings is markedly cheap right now, especially if the economy does not fall into a recession. In the short run, the stock may decrease, particularly if a recession materializes. However, in the long run, the stock is likely to highly reward those who purchase it around its current price. Nevertheless, due to the high cyclicality of the airline industry, investors should be aware that this is not a buy-and-hold-forever stock. Whenever it approaches the technical resistance of $85-$90, which will correspond to about 8 times the expected earnings in 2024, investors should consider taking their profits.



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