Embraer Stock Downgraded: Time to Sell?

By Markets Fool.com

Brazilian planemaker Embraer (NYSE: ERJ) just might be the most successful aerospace firm you've never heard of. The company's E-series small jets feature prominently in the fleets of American regional airlines, and even in Warren Buffett's NetJets business.

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Embraer's defense business has enjoyed some measure of success as well. With backing from American defense firm Sierra Nevada Corp, it's succeeded in selling A-29 Super Tucano fighter planes to Afghanistan, Lebanon, and multiple buyers in West Africa.

And yet, UBS just can't bring itself to love Embraer. In published opinions over the past few years, the Swiss megabanker hasn't had one nice thing to say about the Brazilian planemaker. And just this morning, UBS has downgraded Embraer stock again.

Here are three things you need to know about that.


Embraer's stock is flying backwards. Image source: Embraer.

1. What UBS said

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UBS apparently dropped coverage of Embraer stock at some time in the past (although it never published the fact). This morning, though, UBS came back and took another look at the company -- and didn't like what it saw.

Downgrading the stock from neutral to sell, UBS cut its price target on Embraer stock as well. Previously, the analyst had valued Embraer at $28 a share. Now, the most it thinks the stock is worth is $19. Granted, that's only a few cents less than the $19 and change that Embraer shares sell for today -- but seeing as most investors buy stocks in hopes they will go up, not just hold steady, UBS says you might as well just go ahead and sell Embraer today.

2. Why UBS said it

As UBS explains in a write-up on StreetInsider.com today, Embraer has sunk "nearly $2B" into development of "next generation commercial aircraft." Its current-generation business jets have already had their heyday, and sales there aren't likely to grow much. To the contrary, "competitive growth from Cessna is accelerating," as the Textron (NYSE: TXT) subsidiary tries to keep its own head above water. (Business isn't much better at General Dynamics' (NYSE: GD) Gulfstream, for that matter, either.)

With growth "slowing" at Embraer, UBS argues that even with Embraer stock selling for "a ~10% discount to aerospace peers" like Textron and General Dynamics, this discount is both "warranted" and likely to increase.

3. A history of pessimism

This isn't the first time UBS has said mean things about Embraer, and it probably won't be the last. In fact, the last time UBS published a rating on Embraer stock -- on Nov. 5, 2013 -- it was of the negative variety, a downgrade from buy to neutral. Worse news for Embraer investors: UBS was right back then as well, and Embraer stock has fallen 37% since the 2013 downgrade.

Now, UBS is predicting a smaller decline in Embraer shares -- about 5% from Monday's closing price. Given the analyst's record (UBS has a CAPS rating of 92.78, putting it in the top 10% of investors we track), investors might want to take this warning to heart as well.

The most important thing: Cash

Building airplanes is a capital-intensive business, and developing new airplane models to compete with rivals like Textron and General Dynamics takes money. Problem is, as UBS argues in its downgrade, Embraer is starting to look short of cash.

Currently, Embraer sports $1.4 billion more debt than cash on its balance sheet, and this situation is likely to get worse, not better. S&P Global Market Intelligence data show Embraer to be FCF-positive for the past 12 months, but perhaps not for long. UBS warns that Embraer is likely to be reporting "breakeven to negative FCF" in the very near future, as investments in its next-generation planes take a toll on cash production.

UBS's prediction tallies with other analyst estimates quoted on S&P Global, which show Embraer's current free cash flow turning negative as early as this current quarter -- and next year's cash profits are unlikely to reach even $50 million. Thus a stock that already looks pretty expensive today, at valuations of roughly 33 times GAAP earnings and more than 20 times free cash flow, will look even more expensive as the year draws to a close, and well into 2017 as well.

Given this frightening prospect, I think UBS is right to tell investors to sell.

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Fool contributorRich Smithdoes not own shares of, nor is he short, any company named above. You can find him onMotley Fool CAPS, publicly pontificating under the handleTMFDitty, where he currently ranks No. 330 out of more than 75,000 rated members.

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