AAL - Embraer: Eyes On The Future

2023-06-30 18:21:05 ET

Summary

• Embraer's ability to secure orders is somewhat constrained at this point.
• Sales in the small narrow body segment are slow for all OEMs.
• The Paris Airshow was not the big test for Embraer.
• The real test will be in the years to come with replacement demand speeding up in Europe and growth potential in Asia.

The Paris Airshow was held earlier this month. Embraer (ERJ) was one of the three big airplane manufacturers that had order announcements to share, detailed our interactive airshow order tracker . In this report, I will be discussing the order activity for Embraer. More importantly, I will provide a dollar value of the orders which is relevant to investors even more so in a time where original equipment manufacturers have stopped sharing list prices even though in a model agreement those list prices do matter for down payments. Furthermore, I will discuss which orders are actually accretive to the order book and I will explain why Embraer's order inflow might be somewhat underwhelming at this stage. I wrote a similar report covering Boeing ( BA ) and Airbus ( EADSF ).

Embraer: No Big Buzz

In total, there were 28 orders and announcements valued $1 billion. The orders and announcements included 21 Embraer E2 Family airplanes and seven Embraer E1 family airplanes. For the smaller jet makers, it's a challenge to stand out with the bigger peers taking much of the buzz. Embraer saw its order and announcement flow fall by 50 units compared to the previous edition of the Paris Airshow, so it definitely was not a great airshow for the Brazilian jet maker.

The composition of the orders also wasn’t quite favorable with 15 orders and announcements valued around $575 million actually being Azorra identified as the customer for an existing order. The actual new business included seven Embraer E175s ordered by American Airlines ( AAL ) and Binter Canarias ordering six Embraer E195 E2 airplanes.

The Bigger Picture For Embraer

The fact that Embraer did not have more announcements might be somewhat surprising given that it forecast demand for more than 11,000 turboprops and jets valued $650 billion in its market segment and it had some recent positive momentum in Asia and the Middle East. The question that might rise is why Embraer is not selling more jets. I wouldn’t look at the Airbus A220 as the reason for a lack of sales. Airbus had just one incremental order for the A220 during the show. So, it's not the case that the Airbus A220 stole the show.

The problem for Embraer lies more in the element of timing and the delivery mix. Embraer has delivered 1,661 E1 family airplanes of which 730 airplanes are E175s with a major operator base of US regional airlines. Due to the scope clause, there virtually is no next-generation replacement for E175s even if they require replacement. This simply means that Embraer cannot count on this installed base for replacement orders. Furthermore, the pilot shortages among regional airlines makes growing the E175 fleet challenging. Opting for the bigger regional jets would be a positive for potential E175 sales but regional airlines first have to solve their pilot shortages before they really can look into how they will transform their regional fleets over the longer term. Even more so since regional airlines tend to serve thin markets the E175 would not always make business sense even though within the regional bracket it would provide the highest capacity possible per pilot. So, the lack of any next generation replacement for the E175 coupled with the pilot shortage problem is making selling airplanes in the regional bracket a major challenge.

Furthermore, we see that the oldest E190s that are still flying are around 18 years and following typical retirement patterns the retirement age of these jets would be around 27 years. The first E190/E195 airplanes were delivered in 2004 suggesting that post 2030 the fleet renewal deliveries would start kicking in. In other words, Embraer cannot count on E175s replacement or fleet growth orders in huge quantities due to the current state of the regional market and for E190 and E195 replacement orders it's simply too early.

If we look at the most recent backlog update from Embraer, it also becomes clear that particularly the E175 and the E190 are the in-demand models. So, it's really not that odd that Embraer does not have a major inflow of orders at this point. Furthermore, we see that the E195-E2 is the more popular model of the E2 family following the trend of upgauging to increase capacity and reduce per seat costs. The addition of 13 orders would add around 5% to the backlog, which is what we more or less saw with Boeing as well. So, not great and not bad either. Embraer anticipates around 70 commercial airplane deliveries this year and that would indicate a backlog spanning 4.2 years. A backlog of three to five years is considered healthy. The current production rate is healthy, but we also note that Embraer needs to see some uptick in orders as it plans to produce 100 commercial airplanes per year by 2025 meaning that the company should aim to cumulated a backlog of 400-plus planes.

Conclusion: Embraer Should Aim For More Sales

I have a buy rating on Embraer stock and I'm maintaining that buy rating as I believe that Embraer can significantly improve its performance as cost efficiency is more embedded in the system now and higher production rates do provide meaningful upside to margins. We also should keep in mind that the jet maker needs to sell more jets if it wants to increase production in a sustainable way. That provides a risk that might scare away some investors, but given the significant demand for airplanes in the future I do think the Embraer E195s should be in demand. The jet enjoys significant lessor support which typically is an indicator of wide operator support for a particular aircraft type. So, the Paris Airshow might not have been big for Embraer but the real test will be in the years to come when European airlines start looking for E1 family replacements or replacements of other jets while the Asian market provides sales opportunities as well to connect secondary cities.

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