Embraer's Drop Could Be a Buying Opportunity

By Markets Fool.com

Brazilian aircraft manufacturer Embraer reported disappointing Q4 results last week, along with a relatively weak outlook for 2015. The stock briefly dropped to a new 52-week low of $30.63 following the news, although it eventually recovered to about $33.

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ERJ Chart

Embraer 1 Year Stock Chart, data by YCharts.

However, the earnings pressure can primarily be attributed to temporary factors: especially the transition of its main commercial jet family (the E-Jets) to a second-generation design. As deliveries of the new E2 series jets ramp up starting in 2018, profitability should improve.

Profit misses forecasts
In Q4, Embraer posted earnings before interest and taxes, or EBIT, of $196.3 million. This fell short of the average analyst estimate by a wide margin. It also represented a significant decline from Embraer's Q4 2013 adjusted EBIT of $315.9 million.

Embraer's management blamed the decline primarily on two factors. First, Embraer experienced unfavorable mix shifts in both the commercial aviation and executive aviation segments, as most customers opted for smaller, less profitable models.

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Most of Embraer's recent commercial jet orders have been for the smaller E-175 model. Photo source: Embraer.

Second, Embraer faced significant pricing pressure in the commercial aviation segment, due to fierce competition with top rival Bombardier. This pricing pressure is also aggravated by the planned introduction of the E2 series jets in a few years. Embraer needs to offer big discounts to convince customers to take the current model rather than waiting for the more efficient E2 models.

Looking to 2015
Embraer has projected that some of the challenging trends from 2014 will continue this year. Most notably, the smaller E-175 regional jet will continue to dominate production within the commercial aviation segment.

As a result, Embraer expects its EBIT margin to decline from 8.6% in 2014 to 8%-8.5% in 2015. The lower profit margin could be offset by modest revenue growth. In total, Embraer is projecting EBIT of $490 million-$560 million, compared to $543 million last year.

However, this forecast could prove to be conservative. The value of the Brazilian real has plummeted against the dollar over the past year, and the decline has accelerated recently. As of Monday afternoon, the value of the real had reached lows not seen in more than a decade.

US Dollar to Brazilian Real Exchange Rate Chart

US Dollar to Brazilian Real Exchange Rate, data by YCharts.

This is important because about 25% of Embraer's costs are real-dominated, but nearly 90% of its revenue is dollar-denominated. As a result, its profitability increases as the real depreciates.

Embraer's 2015 earnings forecast assumes an average exchange rate of 2.8 reals per dollar, but the real has already depreciated more than 10% from that level. If the real-dollar exchange rate merely stays near its current level, it would provide a tailwind of up to 1.5 percentage points for Embraer's 2015 EBIT margin.

Solid long-term outlook
A favorable exchange rate could offset some of the short-term headwinds that Embraer is facing. However, the long-term investment case for Embraer has nothing to do with exchange rates.

2015 will probably be the worst year in terms of product mix, as the aircraft replacement cycle at U.S. regional airlines is peaking. Embraer is in discussions with at least two serious potential customers about incremental orders that could help it fill the remaining delivery slots for first-generation E-Jets over the next five years or so.

Demand for the E2 jet models looks good so far. Photo source: Embraer.

Looking further out, the introduction of the E2-series jets will boost demand, due to fuel-efficiency improvements of up to 24%. Embraer has already bagged 210 firm orders, equal to more than two years of production at the current rate. It also has letters of intent for another 100 aircraft, most of which will likely become firm orders this year.

Additionally, both of Brazil's top two carriers are considering adding Embraer jets in order to serve smaller markets. This could provide another shot in the arm for the E2 backlog.

With several years remaining to rack up orders prior to the first delivery, Embraer is on track for a strong launch of the new E2 jets. Demand for the new models should lead to higher revenue and margins by the end of the decade. This makes Embraer's recent stock drop a great buying opportunity for long-term investors.

The article Embraer's Drop Could Be a Buying Opportunity originally appeared on Fool.com.

Adam Levine-Weinberg owns shares of Embraer-Empresa Brasileira. The Motley Fool recommends Embraer-Empresa Brasileira. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.