Pitching an airline to fellow value investors feels a bit like admitting at a dinner party that you enjoy doing taxes, which I don’t, for the record. And I get it. I’ve had the same bias my whole investing life. Airlines have deservedly earned one of the worst reputations in all of investing.

Decades of bankruptcies, brutal price competition, almost no pricing power, and enormous fixed costs. I genuinely never thought I’d sit here writing an airline pitch.

But I found a company that has, for decades, found a way to circumvent all these problems and remain highly profitable through the many years and crises that have hit the industry. It’s a best-in-class business selling at a very reasonable valuation because it's little-known and operates in an industry most investors have on their blacklist from the beginning.

I told Shawn on our episode that I had a lot of fun looking at this industry and Copa in particular. All of us have touchpoints with airlines one way or the other. And as investors, we all know it’s supposed to be this terrible business model. But few actually take the time and look at it in detail.

I love doing that because it feels a bit like learning about how the world works one business at a time. So give me a chance and tell you why Copa is different.

Let’s dive in!

— Daniel

Before I can sell you on why Copa is different, I have to depress you a little about the industry. The problem with the airline industry is that it is highly capital-intensive, mostly commoditized, and has significant operating leverage running in reverse.

Picture an airplane with 100 seats. The two highest costs for an airline are fuel and labor. And they barely move, whether the plane is full or half-empty. So the majority of the seats need to be filled just to cover the costs. Let’s say on our 100-seat plane, you need to fill 80 seats to break even on the flight. That means every flight below that threshold loses money. Usually, you wouldn’t sell a product you lose money on. But an airline can’t just cancel a flight.

To stay in business, it needs to be reliable. So even if it knows the flight will be loss-making, they have to fly. The other problem is that it can sell at most 100 seats. So the downside is wide open while the upside is capped. That’s the exact opposite of the operating leverage that we like to see with our portfolio companies.

One of the best examples of operating leverage in our portfolio is Uber. Uber’s operating profit margins have gone from more than -43% in 2020 (the 2019 number includes IPO costs) to nearly 12% today. That’s a 55 percentage point swing in six years. They have incremental insurance and driver compensation costs, but as they ramp up ride volumes, revenues can be spread across their overhead and software costs.

That dynamic doesn’t exist to the same extent in the airline industry. Every flight has the potential to lose money for the airline. And when you add competition to the mix, the picture gets even worse. Some airlines are better than others in terms of service, but generally, it’s a commoditized product. So airlines compete on price. But the lower everyone prices to stay competitive, the more seats you need to just break even. You go from 80 seats to break even to 85, and suddenly, making money becomes even more difficult.

And an airline seat is the most perishable inventory on earth. A hotel room you don’t sell tonight, you can still sell tomorrow. A seat you don’t sell before the doors close is gone forever – even if it sounds a bit dramatic. When I booked a flight to Malta recently, to visit one of our Mastermind members, I didn’t care which airline I flew. I just wanted the cheapest fare with a decent connection, and I watched the price drop as the date got closer. Buffett once mentioned, when discussing airlines at an annual meeting, that, because they are a commodity, airlines are under enormous pressure to sell the last seat at almost any price above zero. That’s not a good position to be in.

Worst of all, there’s no healthy cleanup mechanism either. When an airline goes bust, it often gets bailed out or restructures, sheds debt, and comes roaring out of Chapter 11 leaner than competitors that actually paid their bills. Even the relatively small Spirit Airlines almost got bailed out a couple of weeks ago.

The discipline that fixed the railroad industry never arrived in the airline industry. Bill Miller bet on an “airline renaissance” in 2008 and 2013. Buffett bought a basket of the four big US carriers around 2016, hoping for the same thing, but ended up dumping the entire basket at a loss in spring 2020 when COVID happened.

I know it’s not the most encouraging thing to start a pitch explaining how terrible the industry it operates in is. But it’s important that you understand the industry's pitfalls to really appreciate what Copa has built. Generally, there are three escape routes for an airline to operate profitably and avoid the rat race.

The first is to be the lowest-cost producer. Ryanair is best known for that, and Southwest has arguably been there in its prime. The second option is to own a network position nobody can copy. And last but not least, you operate in a disciplined market structure. Similar to what Buffett and Bill Miller hoped for with the U.S. airlines.

Few airlines exist that have one of these advantages. The reason I’m pitching Copa today is that it has all three.

Copa was founded in 1947 as Panama’s national airline, but the story gets interesting for us in the late 1980s, when Pedro Heilbron became CEO, a chair he held for 38 years. That tenure alone is almost unheard of in any industry, let alone this one. In our podcast episode, I bored Shawn with a football analogy about how teams that stick with their coaches the longest tend to be more successful. It seems to be similar in the airline business and, for that matter, in business generally.

Pedro Heilbron is the person who eventually turned Copa Airlines into a hub-and-spoke model. Which means nothing more than that an airline routes flights through a single, central airport (the "hub"), instead of flying direct between two small airports.

The advantage of being located in Panama is that it’s the narrowest point of the Americas and the geographic center of the hemisphere, where North America funnels down to meet the South.

Copa’s home airport, Tocumen, sits at sea level right in the middle, and Copa routes roughly 85 destinations across 30-plus countries through that one airport. And because everything radiates from the middle, none of Copa’s routes are ultra-long-haul. That lets Copa fly the entire hemisphere using nothing but small, cheap, and efficient Boeing 737s.

And if you ask yourself why smaller planes are more efficient, let me tell you about the so-called “payload penalty.” Every plane has a maximum takeoff weight covering the aircraft, the fuel, and everything paying – passengers, bags, and cargo. On a very long route, you have to load so much fuel that there’s less weight left for paying load, so you carry less cargo and sometimes literally can’t fill every seat. Which, as we learned in the beginning, is very bad news for an airline.

So when a competitor tries to take Copa’s routes by connecting North and South America directly, they are structurally disadvantaged and more expensive because they would need large, inefficient wide-body planes.

There’s even a network-effect quality I didn’t expect to find in an airline: every new destination added to Copa’s Tocumen hub creates a connection to every other city already on the network. So, out of Copa’s ~85 destinations, it generates over 5,000 marketable city pairs.

The most important metric regarding costs for an airline is ex-fuel Cost per Available Seat Mile (CASM). Basically, what it costs to fly one seat across one mile, stripping out fuel. The idea behind stripping out fuel is that the price is roughly the same for every airline. So, in order to figure out whose business is the most profitable structurally, you look at ex-fuel CASM. If it were the exact same, you wouldn’t need to adjust for it, but there are differences because some airlines, for example, decide to hedge fuel costs.

Copa runs at about 5.8 cents ex-fuel CASM. The only other carriers I’m aware of below six cents are Ryanair, Wizz Air, and a couple of smaller Latin American peers.

One of the reasons for Copa’s low costs has come up before – it’s the fact that Copa is flying only a single aircraft family. That means you only need one pilot-training program, one set of spare parts, and one maintenance procedure. American peers, on the other hand, have to juggle Boeing, Airbus, regional jets, and wide-bodies in parallel. The other reason is that Copa pays Panamanian wages, but mostly flies international customers, whom they can charge higher international ticket prices. As a result, wages account for only 14% of Copa’s revenue, compared with ~25% at a major US carrier.

The last, and perhaps most important, cost-saving factor goes back to something I said at the beginning. An airline has to be reliable. Interestingly, you would think this matters most for customers. Shawn and I each shared our horror travel stories about canceled flights on the show, but they’re just as much of a horror story for the airline itself.

A single cancellation can cost $25,000–$60,000 once you add up the already-paid crew, rebookings, and hotels for stranded passengers. With that number in mind, the metric to watch here is the completion factor – the share of scheduled flights that actually fly. Copa’s completion factor is at 99.8%. The big US legacy carriers sit around 97–98%. At first glance, that gap might seem negligible, but at Copa’s scale, running at 97% instead of 99.8% would mean about 28,000 extra cancellations a year, potentially resulting in over a billion dollars in costs. So one to two percentage points in this metric could wipe out basically all of the company's profits.

When you look at a map, you see Costa Rica and maybe Nicaragua with similar-ish geography, so I did ask myself whether someone could come around and copy this. But the honest answer has to be no. The first-mover and scale advantage of already being the region’s dense hub is very hard to replicate. To challenge Copa, you’d have to stand up ~80 destinations and all the frequencies between them more or less at once, and burn cash for years just to reach the starting line.

Add to that the sub-six-cent cost base (a challenger can’t run more efficiently, so Copa could undercut it the whole way), Panama’s tax treatment (no tax on foreign-source income, which is essentially all of Copa’s income), its use of the U.S. dollar (no currency risk), and decades of government-to-government route rights that require national ownership and can’t be replicated quickly.

Costa Rica is actually growing flight capacity, but it’s aimed at tourism, not the transit model that Copa is running. The most plausible challenger on paper is Puerto Rico. It has a U.S. legal system, U.S. dollars, and non-U.S. wages, but American Airlines already tried a San Juan hub and had to shut it down again. While it’s close, it’s still a detour. And even more importantly, the scale and network benefits mentioned above are hard to disrupt once built.

The biggest risk, by far, is fuel. Copa has a famous policy to not hedge; it always pays the spot price. That might sound a bit counterintuitive since hedging sounds like a no-brainer. But that obviously changes when prices fall, and you’re locked into a higher contract while competitors buy cheaper and undercut you on tickets.

So there is no right or wrong answer. But the exposure is quite scary. Copa burns roughly 380 million gallons a year, so a $1 move in jet fuel swings $380 million straight through operating profit. Considering the total operating profit is in the $800-million range, volatile fuel prices can swing roughly half the operating profits.

For perspective, though, fuel prices sat between $2.00 and $2.50 from 2005 to 2021, then spiked toward $5 and settled in the $3.50s. So a $1 swing is rare, maybe once a decade.

Another risk is the Boeing dependence. Copa has a multi-billion-dollar 737 MAX order book stretching out for years. The new planes are more efficient and certainly help with keeping costs as low as possible in the years ahead, but Boeing’s delivery record has been somewhat shaky, and the 2024 MAX 9 grounding showed how a Boeing problem quickly becomes Copa’s problem too.

And speaking of things outside Copa’s control, we are still talking about an emerging-market player where geopolitics can change quickly. In the past, problems involving Venezuela have led to flight suspensions in the region, and similar things could happen in many other countries as well.

Besides that, the hub-and-spoke model surrounding Copa’s Tocumen airport is its biggest strength, but also a major concentration risk. Should anything happen to that airport or city, Copa’s entire business breaks down. All of these risks are unlikely to ever play out, but if they did, the impact would be devastating.

Before we move on to our valuation section and investment decision, I want to get back to the management team and the CEO, Pedro Heilbron, in particular. He not only did a phenomenal job over the last four decades, but he also owns a large stake and is highly aligned with shareholders. Although the structure is a bit complex.

Voting control runs through supervoting Class B shares held by a Panamanian entity called CIASA, which, in turn, is controlled by Heilbron and some of the best-connected families in Panama – the Mottas, Heilbrons, and Arias. I talked to one of our Mastermind members who lives in Panama, and he told me these are among the most powerful families in the country and, at the same time, very capable managers. Which, I think that’s fair to say, is proven by their track record.

Obviously, that’s a different dynamic from what we’re used to in Western companies, but I like the alignment. Their cash payment is not excessive at all. The combined bonuses and stock grants for the whole management team total under $10 million, so they make their money the way you and I would – through a rising stock price and a steady dividend. The dividend yield is about 4-5% right now, implying a 40% payout ratio.

On the balance sheet, which I always check first in a bankruptcy-prone industry, Copa carries an adjusted net debt-to-EBITDA ratio of roughly 0.6x, compared with the 2–3x considered healthy for most airlines, with interest coverage around 9x. I expect the dividend to be a priority going forward, given that this is how the controlling families make their money here. However, the first priority is to reinvest in the business and the fleet. Buybacks are done with whatever is left. The ~$900 million MAX order, paid through 2028, has temporarily compressed free cash flow, but operating cash flow is at an all-time high.

With that, let’s talk valuation and our thoughts on a possible airline investment. Never thought I’d say this… But again, Copa is not like your typical airline. Its financials are so stable, you could think you’re valuing a software company.

My base case is simply business as usual, revenue growing 7%, which is the median of the last decade, broadly stable margins (maybe a touch lower for a year or two, given fuel, then back to normal), and a 40% payout ratio. I use a 10% discount rate – partly because this is LATAM, partly because it’s still an airline – and a 20% margin-of-safety haircut. At a 9x multiple, which I think is fair for a business this consistent, I get an expected return of about 15%, including the ~5% dividend yield.

In my bear case, you could argue that the industry wins. It’s hard to model a bear case with a secular decline simply because I don’t see what should cause that. However, you could imagine some form of exogenous shock. Or perhaps higher fuel prices for longer, which would hit Copa harder than competitors due to not hedging its exposure.

If we imagine such a scenario, I could see passenger growth slow due to higher prices, to, say, 3-4%. The even bigger impact, though, would be margins compressing. If we assume a 17% operating margin, it could drag the net margin into the low teens. Management might decide to protect the balance sheet by cutting the payout ratio for the dividend to 25%, and the market reacts by re-rating the stock down to 7x earnings. That could result in a major pullback for the stock of about 40-50%.

I apologize to all Copa shareholders for what I’m about to say, but as an investor, I would actually love to see that. That’s when we could buy a phenomenally managed business with a deep moat at a dramatically depressed price. An 8x multiple might sound cheap, but you are still buying an emerging markets airline. Perhaps the best in the world, but still.

I came away very pleasantly surprised by the quality of Copa, and I believe I could convince Shawn of the quality, too, but we did agree that we would want to buy Copa at a deep discount. Right now, it might be fairly priced and, after the rally in the past month, perhaps even on the more expensive side.

So we are holding off for now, but we have put Copa high up on the watchlist. And while we are not hoping for a short-term headwind for the company, we would welcome it as an entry opportunity.

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