Embraer: An Oversold Value Buy Best Positioned For The Commercial Aviation Turnaround

Eric Weiss2020-09-22

SummaryAccording to our valuation model, Embraer (NYSE: ERJ) has a significant upside potential.Although Commercial Aviation division reported big losses, the industry is showing signs of recovery.The...

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After the rapid proliferation of coronavirus and everything that came with it, the aerospace industry has taken big hits due to idleness of its production and the sharp drop in investment power, causing a drop in of order volumes and deliveries. Despite momentary losses throughout the first half of 2020 and an overall drop in confidence from the now-ended partnership with Boeing (NYSE: BA), our valuation analysis demonstrates that it is a great time to invest in this undervalued business. The underlying reason we believe in an Embraer (NYSE: ERJ) turnaround is driven by the management strategy adopted during this difficult period. The strategic plan executed during the crisis has made Embraer a leaner company, allowing it to preserve a stable and robust liquidity position, even while revenue and profit took direct hits. In a recovering atmosphere, noting the recent uptrend of the in-service fleets in the United States, we believe the worst scenario has been successfully avoided. The diversified portfolio of clients who haven't canceled orders is now ready to be gradually filled, thus returning Embraer to the profit levels expected from this innovative company. Figure 1: Embraer’s New Strategy \n Source: Quarterly Earnings Presentation, Embraer 2Q20 Decline of Commercial Aviation As the coronavirus pandemic unfolded, many nations decided to limit commercial aviation traffic, causing a direct impact on Embraer’s first half financial results. Furthermore, economic uncertainties through the aviation sector and the now-terminated strategic partnership with Boeing had a direct impact on Embraer's delivery capacity which consequentially effected the receivable from pending and delivered orders. As a result of these aforementioned pitfalls, the company presented lower revenue numbers across all its income streams compared to the first semester of the last year. Losses in its Commercial Aviation division and its related services led the way accounting for nearly 75% of the overall revenue decay. Total revenue from the first half of 2020 was US$ 1.171 billion, compared to US$ 2.202 billion year over year (Quarterly Earnings Presentation, Embraer 2Q20). Figure 2: Aircraft Deliveries, Commercial and Executive  Source: Quarterly Earnings Presentation, Embraer 2Q20 Additionally, the crisis also forced the company to slow its investments and cut 4.5% of its workforce in Brazil, as the management team opted for a leaner structure and preservation of its cash reserves. Both CAPEX and R&D investments suffered hard deteriorations during the first half of 2020 totaling -56% year over year (Quarterly Earnings Presentation, Embraer 2Q20). In our view, Embraer’s declining investment expenditure is a decisive factor that undermines the technological race against its competitors and will certainly slow down Embraer’s development programs -- the company has already rescheduled the production of it's E175-E2 jet to 2023 (SimpleFlying). While commercial aviation slowly recovers, we do expect low growth rates of the company’s value over the next five years.\n Figure 3: CAPEX and R&D Investments Comparison  Source: Quarterly Earnings Presentation, Embraer 2Q20 Turnaround Case Still, we have reason to believe that Embraer is a strong choice for long-term investors because of three important indicators: (1) the company has a strong and diversified firm order backlog that hasn't been substantially hit; (2) in-service fleets have shown strong signs of recovery the last few months, and (3) the company has managed its liquidity very well. In regards to the firm order backlog, we notice it has remained stable compared to preceding quarters, and currently stands at US$ 15.4 billion. Additionally, a diversified portfolio of clients is certainly a positive point to consider if some clients decide to cancel an order. When analyzing commercial aviation traffic, taking into consideration the U.S. in-service fleet since March of this year, we've observed a significant uptrend in the recent months since the initial drop that occurred from March to April. In combination with yet another indicator, the lead-lag effect among domestic and global air traffic, we see that the significant increase in domestic traffic has been leading all other sectors of the global commercial aviation recovery. Therefore we can easily justify that the chances of a worst scenario for this sector have come and gone and assuming there is no significant second wave of virus transmission -- the worst is in the past.  Figure 4: Domestic & Global In-Service Fleet Trends \n Source: Quarterly Earnings Presentation, Embraer 2Q20 Concluding our positive outlook as a result of current trends, Embraer reported positive results regarding its liquidity position as it successfully renegotiated its short-term debt, achieving an average debt maturity of 3.8 years and maintaining 88% of the total debt as long-term loans. Despite a rise of net debt to US$ 1.8 billion, in large part due to the available cash reduction, Embraer has a current debt-cash ratio of 2.07. Overall, we believe Embraer maintains a comfortable liquidity position and has displayed managerial prowess in relation to its cash and debt management. Valuation For our valuation analysis, we focused on two techniques: discounted free cash flow and valuation multiples. The first technique aims to forecast the fair price of ERJ by summarizing its discounted free cash flows for the next ten years while excluding the company’s net debt. Alternatively, we used the valuation multiples to compare the value of Embraer against its competitors in an effort to analyze how undervalued or overvalued the company is by comparison. We assume three conservative scenarios for cash flow growth: (1) Recovery scenario with low growth rate (2021-2025); (2) Stable scenario with a mature growth rate; and (3) perpetual scenario with the lowest growth rate. The recovery scenario corresponds to the impact caused by the coronavirus, which has severely damaged the aviation sector causing Embraer to reduce the size of its organizational structure and investment capacity. The stable scenario refers to an environment where most COVID-19 effects are controlled, and the industry can keep its normal operations according to its natural limitations. Finally, the last scenario simulates a perpetual growth consistent with the physical limits of the aerospace industry and the expected increase of competitors, reducing the profit margin. The formula and inputs are described below: \n  Free cash flow (LTM) is US$ 99,900,000 Net debt is US$ 1,800,700,000 Shares outstanding are 183,870,000 Free cash flow to shares is 0.54 Debt to shares is 9.79 Discount rate is 7.18% (1) Growth rate (2021-2025) is 2.00% (2) Growth rate (2026-2030) is 2.50% (3) Perpetual growth rate is 1.50%  We defined very conservative growth rates and preferred to use the average cost of capital of the aerospace & defense industry monitored by Aswath Damodaran at the NYU to represent an overall mature and stable discount rate for this market. Table 1: Discounted Free Cash Flow to Shares  Source: Created by the author Given the above inputs, the fair price for Embraer shares (NYSE: ERJ) is US$ 6.54, representing a 40% potential upside from the closing price on September 21, 2020 (US$ 4.67). The last time we saw a closing price above $6.54 was on June 19 of the current year. Moreover, we see this target price as a resistance zone in the short term. Table 2: Valuation Multiples, Embraer vs Competitors             Market Cap EV/Revenue Book/Market Cap Price/LTM Sales Forward P/E Ratio   Embraer $867 million 0.5 3.4 0.6 -2.4   AAR Corp. $700 million 2.0 1.3 0.3 77.4   Lockheed $106 billion 1.8 0.0 1.7 16.3   Raytheon $90.5 billion 1.5 0.7 1.1 23.8   Spirit Aero. $2.07 billion 0.6 0.6 0.4 -4.7   Textron $8.13 billion 0.9 0.7 0.6 25.6    Source: Created by the author, data retrieved from Finbox Looking at the multiples comparison among companies with different sizes within the aerospace & defense industry, we observe that Embraer is relatively undervalued. It has the worst multiples when we check the following indicators: Enterprise Value to Revenue, Book Value to Market Cap, and Forward Price to Earnings while landing in the middle of the field for Price to LTM Sales.\n Risks We believe the worst scenario for the aerospace/defense industry is over, however, it is important to highlight the subsequent effects after this first wave of coronavirus transmission. The situation should not be celebrated as severe restrictions and guidelines for the mobility of citizens are still in place. From a conservative standpoint, we can estimate that global air traffic could take over a year to normalize because the U.S. in-service fleet is slowly recovering, and, as we saw, United States is the leading country for this indicator. Furthermore, the true financial impact may take time to fully materialize in regards to solvency and technological developments. We are sure that this crisis has delayed most technological advancements within the industry, which certainly postpones or prevents Embraer and its competitors from accelerating their true growth. Likewise, the possibility exists for a second transmission wave that could further enhance harm to Embraer’s clients and limit their capability of realizing payment on their order log. Conclusion As a result of the valuation analysis presented above, we present a long buy of ERJ shares, which is undervalued compared to its growth potential and its competitors. Alternatively, one could consider purchasing the $2.5 strike LEAP calls expiring 01/20/23 last priced at $2.55. We believe we have exposed fully the financial impact caused by the world health crisis in the first half of Embraer’s performance and the reasons to trust a reversal in the mid and long term with solid management decisions and a privileged market position. In summary, as investors, we considered a very conservative forecast that resulted in a target price of US$ 6.54, approximately 40% above the current price as of September 21, 2020.\nDisclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.","kind":null,"is_publish_news":true,"is_publish_highlight":false,"is_publish_live":false,"is_publish_wemedia":null,"editions":null,"column":"","sentiment":"0","news_tag":"","news_rank":0,"symbols":[],"gpt_button":1},"commentList":[],"isCommentEnd":true,"newsSizeData":{"likeSize":1,"commentSize":0,"repostSize":0,"favoriteSize":0,"likeStatus":false,"favoriteStatus":false},"APP":{"userAgent":"Mozilla/5.0 AppleWebKit/537.36 (KHTML, like Gecko; compatible; ClaudeBot/1.0; +claudebot@anthropic.com)","isDev":false,"isTTM":false,"deviceId":"web-server-community-laohu8-v3","version":"4.29.1","shortVersion":"4.29.1","platform":"web","vendor":"web","appName":"laohu8","isIOS":false,"isAndroid":false,"isTiger":false,"isTHS":false,"isWeiXin":false,"isWeiXinMini":false,"isWeiBo":false,"isQQ":false,"isBaiduSwan":false,"isBaiduBox":false,"isDingTalk":false,"isToutiao":false,"isOnePlus":false,"isHuaWei":false,"isXiaomi":false,"isXiaomiWebView":false,"isOppo":false,"isVivo":false,"isSamsung":false,"isMobile":false},"href":"/m/news/2069070987"}