ERJ - Embraer: An Undervalued Contender Primed For Expansion

2023-09-29 07:27:40 ET

Summary

• Embraer, a Brazilian aerospace company, boasts a diverse market presence spanning commercial, executive, and defense aviation.
• Embraer's recent financing efforts and strong Q2 results indicate a favorable outlook for the company's growth and stability.
• While Embraer shows promise, it faces challenges tied to customer concentration, global competition, and demand volatility, alongside its sensitivity to global economic conditions.

The Brazilian Embraer (ERJ) holds a prominent position in the global aviation industry. This esteemed company manufactures regional aircraft, luxurious business jets, and state-of-the-art defense and security products. Beyond its impressive hardware offerings, Embraer provides a comprehensive array of essential services supporting its installed base.

Embraer's journey has seen it transform from a state-owned enterprise producing aircraft for the Brazilian Air Force ((FAB)) to one of the largest publicly traded companies producing commercial, executive, and defense aircraft.

Throughout this year, Embraer's shares have appreciated by nearly 30%, despite the ups and downs that have paralleled the bullish trend on the Ibovespa (Brazilian stock exchange).

However, Embraer also grapples with challenges tied to its customer base, global competition, demand fluctuations, and debt levels. It will rely on effective risk management and growth strategies to sustain its market standing.

Furthermore, besides the promising outlook that the company will likely meet its annual guidance, there is encouraging news regarding financing to support its growth compared to its industry peers. Embraer continues to trade at multiples significantly lower than its peers in all the aviation sectors it operates in.

Key Strengths of Embraer

Embraer has several positive points contributing to its prominent market position. Its comprehensive presence in the commercial aviation, executive aviation, and military equipment segments promotes solid diversification within the sector, allowing the company to adapt to different market conditions.

In addition, Embraer is widely recognized globally for its excellence in developing small and medium-sized aircraft, which places it in a leading position in this segment.

The Commercial Aviation segment is the company's main business, accounting for 34% of revenue in 2022. This was followed by the Services and Support unit, which accounted for 27.9%, Executive Aviation (27.4%), Defense and Security (9.9%), and other businesses, with 0.8% of revenue.

The company's international presence is an additional factor contributing to its stability. Embraer can dilute geographical risks by operating in several countries and continents, minimizing dependence on any specific market. In addition, its active participation in the supply of military equipment gives Embraer a relevant role related to national security, creating a captive market that can be more resistant to economic fluctuations.

As for the regions with the highest sales volume, 62.9% of net revenue came from customers in North America, followed by European customers (19.5%) and Brazil (11.1%) in 2022.

The Brazilian government is the largest customer in the Defense and Security unit, representing around 42.5% of this business unit's revenue in 2022. As such, any decisions made by the government, such as reducing the value of the KC-390 Millennium aircraft contract in 2021, affect the company's order backlog.

Latest Results

In the second quarter , Embraer demonstrated robust performance, delivering 47 jets, comprising 17 commercial aircraft and 30 executive jets (19 light and 11 mid-size). This marked an impressive 47% increase in deliveries compared to the same period in the previous year (2Q22).

The company's revenues for the quarter reached a substantial US$ 1,292 million, reflecting a remarkable 27% growth compared to 2Q22 and an impressive 80% surge compared to the first quarter of 2023. Within this, Commercial Aviation witnessed an incredible double-digit growth of 57%, while Executive Aviation surged by 42% year-over-year.

Embraer's firm order backlog remained stable in the second quarter of 2023, ending at a substantial US$ 17.3 billion. Particularly noteworthy was the growth in the Executive Aviation segment, driven by robust sales performance.

While the strong performance resulted in an adjusted EBIT for the quarter of 7.7%, a slight decrease from 8.0% in the second quarter of 2022 was observed. This decrease can be attributed to a different revenue mix, aligning with the company's expectations.

Moreover, the adjusted EBITDA decreased from 12.2% to 11.5%; however, the company still exceeds its 2023 guidance, which ranges from 10% to 11%.

In the second quarter of 2023, Adjusted Free Cash Flow ((FCF)) nearly reached breakeven, with a cash consumption of US$ 10.7 million. This strategic decision was made in preparation for higher deliveries in the upcoming quarters.

Additionally, Embraer successfully executed liability management efforts, resulting in a reduction of gross debt by US$ 500 million and an extension of maturity. There were also notable improvements in the company's leverage, as the Net Debt/EBITDA ratio decreased from 4.7x to 3x annually.

With quarterly results meeting the company's expectations, Embraer is reaffirming its operational and financial guidance for 2023, underscoring its commitment to sustained growth and stability. In the first half of the year, the company successfully delivered 24 commercial aircraft, with a projected delivery range of 65 to 70 aircraft for the full year. In the executive aviation segment, 38 aircraft were delivered in the first six months, and the guidance for this segment anticipates a range of 120 to 130 units to be delivered in total for the year.

Company executives have noted delivery delays due to challenges some suppliers face in coping with increased production from last year to this year. However, they have assured that these delays are not expected to impact yearly deliveries significantly. It's worth mentioning that supply chain disruptions also affect the defense segment, postponing some 2Q23 deliveries to 3Q23 and 4Q23.

Given the constraints within the supply chain, the company has exercised caution, bearing in mind that this year's guidance already factored in these limitations. In addition, Embraer has revealed its strategy to concentrate approximately 60% of this year's deliveries in 2Q23, focusing on the final quarter of 2023. This approach aligns with plans for increased production the following year and anticipates a robust 1Q24 compared to the expected performance in 2023.

Important Steps to Strengthen Working Capital

Embraer recently secured financing of R$2.4 billion targeted at aircraft exports by the company.

Within this total amount, R$1.4 billion will be directed towards financing the purchase of 14 E-175 aircraft by the U.S.-based airline Republic Airways. Additionally, another R$1 billion is associated with a credit line offered by the bank to support the production of new commercial jets by Embraer destined for export, including models 175-E1, 190-E1, 190-E2, and 195-E.

Regarding Embraer's delivery target of 65 to 70 commercial aircraft, the 28 aircraft to be financed by BNDES (the Brazilian National Bank for Economic and Social Development) represent a proportion ranging from 40% to 43% of the goals set by Embraer for this year. In the previous year, Embraer reported that the bank had financed nine units out of a total of 57 aircraft produced, representing approximately 16% of the commercial aircraft manufactured by the company in 2022.

However, this measure is highly favorable in my view, as it helps Embraer obtain financing on good terms, contributing to the strengthening of its working capital (the current ratio has been declining since 2021), which is necessary to finance its operations competitively.

This occurs when Embraer is experiencing growth, boasting competitive jets in the executive aviation sector and solidifying its position in the defense segment with the C-390 aircraft, filling the void left by the C-130. Furthermore, the company is capitalizing on the resurgence of commercial aviation, reflecting a positive and strategic trajectory across multiple market segments.

Key Risks to Consider

On the flip side, the company faces significant challenges. Embraer's customer base is relatively small, making it susceptible to the weaknesses and difficulties of its buyers. In a global competitive environment, the company must also contend with the threat posed by competition from worldwide firms, necessitating a continual pursuit of innovation and efficiency.

In the Commercial Aviation segment, the risk lies in the concentration of aircraft sales to specific key customers. At the end of 2022, 88.9% of orders for Embraer 170/190 jets came from Republic Airlines and Horizon Air/Alaska ( ALK ), while 83.1% of orders for the E-Jets E2 line were concentrated only with Azul ( AZUL ), AerCap ( AER ), AirCastle, AirPeace, Porter, and Azorra. It is evident, therefore, that severing ties with a significant customer could significantly impact the company's results.

Moreover, demand for new aircraft, particularly in the Business Aviation unit, is highly volatile and closely linked to international economic activity. Economic fluctuations can substantially impact the need for business aircraft, affecting the company's performance.

In the short term, several factors come into play for the company. In Commercial Aviation, there is a shortage of pilots in the United States, the primary destination for sales, which could affect the demand for new E175-E2 series projects. In Business Aviation, there is an anticipated record demand for orders in 2023. In Defense and Security, an increase in global defense spending is expected due to international tensions, positioning Embraer favorably in the market.

Valuation

Embraer currently trades at a forward P/E ratio of 16x for 2023 and a forward EV/EBITDA of 7.3x, significantly below its major peers in the aviation industry with similar market capitalization levels, such as Mercury Systems ( MRCY ), AeroVironment ( AVAV ), AAR Corp. ( AIR ), and Rocket Lab ( RKLB ).

Despite trading at an EV/EBITDA multiple of 16x, approximately 37% above the industry average, this metric remains 74% below Embraer's historical average over the past five years.

Embraer's low forward EV/EBITDA ratio, compared to its major peers, is noteworthy, especially considering the high growth expectations for EBITDA. This growth is supported by the anticipated recovery in commercial aircraft deliveries over the coming years.

This leads me to believe that, despite Embraer's stock appreciation throughout this year, the market may not be accurately pricing in the expectations for the recovery of Embraer's commercial division, which constitutes approximately 38% of Embraer's total enterprise value.

However, it's essential to recognize that comparing Embraer with global peers can be misleading due to varying market cycles and distinct top-line dynamics. Nevertheless, when evaluating Embraer alongside peers in the Commercial, Executive, Defense, and Services segments, its target multiples remain below those of its peers.

In the commercial and executive aviation industry, Embraer's forward EV/EBITDA multiples present a relative discount compared to Airbus ( EADSY ) and Boeing (BA). Additionally, they show a similar level of discount in comparison to Textron ( TXT ) and are on par with Bombardier ( BDRBF ).

Delving deeper into the comparison, when we assess Embraer against the major players in the Defense and Security aviation sector, the Brazilian company seems undervalued compared to Lockheed Martin ( LMT ) and Mitsubishi Heavy Industries ( MHVYF ). It is only slightly less discounted than Leonardo S.p.A ( FINMY ).

The Bottom Line

Embraer appears to be on course to achieve its guidance this year, supported by strong Q2 results and positive news about securing advantageous financing. This should help maintain the company's relatively healthy liquidity, enabling it to remain competitive.

Although there are still risks associated with the company potentially missing its guidance, and given that demand for new aircraft is highly volatile and linked to global economic activity, operationally, the company seems to be on the right track. Currently, its valuation, while not exceptionally low, is noticeably discounted compared to nearly all of its peers from different aviation segments. Therefore, I consider Embraer a "buy" with promising long-term prospects.

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