Last Wednesday, Embraer (NYSE: ERJ) reported subpar results for the first quarter of 2019. Revenue and adjusted earnings per share both missed analysts' estimates by a wide margin.
Not surprisingly, Embraer shares slumped following the earnings report. While the stock has recovered a bit since then, it continues to sit near a 52-week low at around $18. However, the timing of aircraft deliveries caused the earnings weakness last quarter. Embraer's underlying business trends are far more positive than the company's recent results would seem to suggest.
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Another weak quarter
Last quarter, Embraer's revenue plunged 14.3% year over year to $823 million. Analysts had been expecting revenue to surpass $1 billion. That said, the revenue decline shouldn't have come as a shock, given that Embraer reported earlier this month that it delivered just 11 commercial jets and 11 executive jets in the first quarter, compared to 14 and 11, respectively, a year ago.
Embraer's gross margin improved to 19.9% last quarter from 15.6% a year earlier, as stronger profitability in its executive aviation and defense segments more than offset the drag from fewer commercial aircraft deliveries.
On the other hand, the sharp revenue decline made it harder for Embraer to cover its operating expenses. Operating expenses increased last quarter due to factors including higher impairments on used commercial jets and separation costs related to the sale of an 80% stake in Embraer's commercial jet business to Boeing (NYSE: BA). As a result, the company's operating loss widened to $15.2 million from $5.3 million a year earlier, and its adjusted loss per share ticked up by a penny to $0.34. Analysts had expected an adjusted loss per share of $0.13.
A question of timing
While Embraer's sharp revenue decline and big loss may seem jarring to investors, it's important to remember that the first quarter tends to be seasonally weak for the company. Furthermore, the timing of aircraft deliveries can have a big impact on revenue and profitability.
Despite delivering just 11 commercial jets last quarter, Embraer still expects 85 to 95 deliveries for the full year. That means Embraer should be better able to cover its fixed costs in the last three quarters of 2019. In fact, as of May 16, Embraer had already delivered 15 commercial jets in the second quarter.
Timing factors also made the executive jets business look less healthy than it truly is. Executive jets segment revenue totaled just $117 million last quarter, but Embraer booked more than $300 million of new orders during the period, boosted by the popularity of the new Praetor 500 and Praetor 600 models, which will become available later this year.
The outlook is bright
Assuming that the Boeing commercial aviation joint venture is completed at the end of 2019 as expected, Embraer plans to use $1.6 billion of the proceeds to pay a special dividend that would amount to nearly $9 per share. That means the remainder of Embraer is currently being valued at roughly $1.7 billion: less than $10 per share.
This valuation seems far too low. First, Embraer will continue to own 20% of the commercial jet business. For the next 10 years, it will have a right to sell that stake to Boeing for $1.05 billion, adjusted for inflation. After that, the potential sale price would be set at fair market value, which is likely to be significantly higher, due to the scale benefits Boeing can bring. Second, Embraer expects to have $1 billion of net cash after the deal closes, even after paying its special dividend.
Thus, Embraer's current market valuation is less than the sum of its planned special dividend, future net cash position, and the value of its stake in the Boeing joint venture. In other words, investors are getting the executive jets and defense businesses for free.
Neither of those segments has made much money in recent years. But the executive jets business is improving rapidly, thanks to a focus on protecting pricing and the pending arrival of upgraded models. The defense business is set for strong growth too, as the first delivery of the segment's flagship product -- the KC-390 multirole aircraft -- will happen within the next few months. The KC-390's entry into service and a new defense partnership with Boeing will likely stimulate sales to export markets.
Over the next few years, improving results in Embraer's two remaining wholly owned businesses could unlock big gains for shareholders.
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