Shares of Brazilian aircraft manufacturer Embraer (NYSE: ERJ) lost more than half of their value between late 2014 and mid-2017. Order activity for the company's commercial aircraft started to slow during this period, while profit margins plunged at Embraer's executive aviation and defense segments.
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However, Embraer stock rallied more than 3% on Wednesday, after the company announced a firm order for 25 jets from top U.S. regional airline SkyWest (NASDAQ: SKYW). In total, the stock has jumped by about 30% since late June.
Indeed, the SkyWest order announced on Wednesday is a critical shot in the arm for Embraer. It could singlehandedly allow Embraer to salvage what would otherwise have been a very weak 2018 performance.
2018 was shaping up to be a bad year
Embraer's larger rivals, Boeing and Airbus, have each been forced to drastically cut production of certain aircraft models in recent years as part of the transition to next-generation products. The lead time for a redesigned jet tends to be about five years. It's often hard to find enough buyers for the old model to keep production steady when a more fuel-efficient version of a given plane is already in development.
By contrast, Embraer has done an admirable job of holding E-Jet production steady at about 100 units per year as it prepares to start deliveries of the upgraded E2-series jets next year. The only weak spot for the company has been 2018, the last year for which E1-series jets are likely to represent the majority of Embraer's production.
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As of a year ago, Embraer had sold about 65% of its production capacity for 2018. It sold about a dozen additional current-generation E-Jets in the first half of 2017. However, that still left it with about a quarter of its 2018 production unsold.
Embraer wins another big E175 order
On Wednesday, Embraer announced an order from SkyWest for 25 current-generation E175 jets. Fifteen of the jets will be delivered in a special low-density configuration with 70 seats. SkyWest will operate these planes for Delta Air Lines (NYSE: DAL) under the Delta Connection brand.
The unusual 70-seat configuration is probably necessary because of provisions in Delta Air Lines' pilot contract. However, the planes can be easily reconfigured with a more standard 76-seat setup if Delta is able to change the scope clause in its pilot contract.
The other 10 jets will be operated for Alaska Air (NYSE: ALK), which is already set to receive nearly two dozen E-Jets at its Horizon Air subsidiary during the 2018-2019 period. Most of these jets will be used to replace 15 turboprop planes that Horizon Air is retiring. The SkyWest deal will allow Alaska Air to expand its regional fleet faster to take advantage of various growth opportunities. It will also help Alaska hedge against the risk that a current pilot shortage at Horizon Air can't be resolved.
Crucially, all 25 of the planes ordered by SkyWest are scheduled for delivery in 2018. That represents roughly a quarter of Embraer's annual E-Jet production. This removes most of the risk that Embraer would have to reduce its output next year.
Plenty of room for further earnings growth
While this week's deal with SkyWest will allow Embraer to keep its commercial-jet production roughly steady in 2018, the company will suffer some short-term margin pressure. The ramp-up of E2 production is expected to cause some inefficiencies initially, which is normal for new aircraft models.
However, even if Embraer faces some earnings pressure in 2018, EPS should quickly return to strong growth. An increased focus on margin performance in the executive-jets unit should drive an earnings rebound in that segment. Meanwhile, the entry into service of Embraer's new KC-390 tanker will catalyze strong growth in the defense segment beginning next year.
By the end of the decade, all three of Embraer's business units should be producing better results. In a best-case scenario, EPS could nearly double in the next few years. With Embraer stock still trading for about 15 times earnings, it's not too late for investors to get on board with this turnaround story.
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