Copa Holdings, S.A. (CPA)

In April of 2005 the company purchased Aero Republica which is Columbia’s second largest carrier. Since that time, CPA has been working hard to restore the small carrier to profitability and is well on its way to transitioning the aircraft fleet from MD 80’s to more efficient E190’s. While the transition requires upfront capital, the savings over the life of the firm should more than make up for the hassle now. As a business unit, Aero Republica is expected to continue to post a loss for the first half of 2008, but will swing to profitability in the second half. In fact, the profits gained during the second half will likely be enough for Aero Republica to post full year gains instead of losses.

One of the major factors working in Copa’s favor is the thriving economy in Panama. Forecasts place Panama as the fastest growing economy in Latin America. As local citizens gain discretionary income to travel, and business men and women find it necessary to travel to the region, traffic should continue to expand. The company recently added Port of Spain, Trinidad & Tobago as their 41st destination and continues to increase the percentage of international flights. Since international destinations bring in stronger margins, this expansion should have a healthy effect on the overall firm.

Copa has a young fuel efficient fleet of aircraft serving the rapidly growing Latin America market. Less competition than U.S. carriers allows them to grow profitably. Copa has managed to stay nicely profitable while other airlines are losing money due to higher fuel costs. Any fuel price relief will significantly boost bottom line. PE of 10 discounts any future growth.

Over 1Q 09, Copa reported a robust increase in Available Seat Miles (ASMs), while load factors registered a modest decline. As a result, Revenue Passenger Miles (RPMs) increased, although lower than the ASM growth rate. Copa’s passenger yields in 4Q 08 also increased, reflecting continued robust air travel demand to and from Panama. However, going forward, we believe such growth in yield is unsustainable, given our expectation of the continuation of the grim economic scenario. This would be further compounded by the dismantling of fuel surcharges hinted at by Management. Therefore, we expect Copa’s yields to remain weak throughout FY 2009. Despite the continued economic development in Panama, boosted by the Panama Canal expansion project, we expect Copa’s load factors to drop considerably in the remaining quarters of FY 2009, given the recent outbreak of the swine flu virus in neighboring Mexico. However, on the profitability front, we expect Copa to continue to gain from lower operating costs, especially fuel prices, reservation and sales expenses, flight operation expenses and landing and other fees. We expect Copa to gain from lower fuel prices relative to historically high levels in FY 2008 coupled with a largely un-hedged fuel requirement in FY 2009. We also expect lower commissions to travel agents in FY 2009, in line with the global industry trend to save costs. Most of the operating expenses indicated above are variable expenses and therefore a decline in sales will results in a decline in these cost items. Subsequently, we expect margin improvement in FY 2009. In FY 2010, we expect revenues to benefit from the emergence of the global economy from recession, benefiting the company’s load factor and passenger yields. However, margins are expected to decline y-o-y in FY 2010, given our expectations of an increase in fuel prices compared to FY 2009 levels, compounded by extremely low fuel hedging levels (5%). Copa’s cash balance declined marginally in FY 2008 and we expect this trend to extend well into FY 2009, given the expected flat bottom-line. However, we are not significantly concerned about the company’s high debt/equity ratio (D/E ratio) of 1.90x (inclusive of capital leases), given the low interest rate applicable on this debt (3.7%). We expect Copa’s free cash flow to be benefited by low capex levels (according to company guidance; US$153 mn in FY 2009, US$93 mn in FY 2010 and US$233 mn in FY 2011). Therefore, not withstanding the significant negatives expected in FY 2009, we believe that Copa’s NYSE common stock has enough legs to generate a significant upside going forward.

Copa has 18% of its 2Q 08 fuel volumes hedged, while it has hedged 25% of its fuel volumes for 2H 08. It has hedged approximately 25% of 1Q 09 fuel requirement, 19% of 2Q 09 fuel requirement and 10% of 3Q 09 fuel requirement. Markets were encouraged by the company’s fuel hedging strategies and therefore pushed its prices upwards for a while coupled with declining crude oil prices. This rally in Copa's prices came to an halt with the Lehman Brothers collapse and the subsequent crash in markets. However, there is reason to believe that benefits from low crude oil prices will be partially offset by increased passenger servicing expenses as AeroRepublica expands internationally and serves higher number of international passengers. This may be slightly margin erosive in the near term, but surely prove to be margin accretive in the longer term.