Embraer (NYSE: ERJ) didn't exactly deliver blowout results in the third quarter. On Tuesday, the world's third-largest commercial aircraft manufacturer reported that revenue sank 11.5% to $1.15 billion last quarter, while adjusted operating profit plunged 23.1% to $45.4 million.
However, most of the weakness in Embraer's results came from its commercial aviation segment. Given that Boeing (NYSE: BA) plans to buy 80% of this business next year, this division's quarter-to-quarter results have become much less important for Embraer investors. Meanwhile, profitability is improving in the executive jet and defense businesses that will remain wholly owned by Embraer.
Image source: Embraer.
Turbulence hits the commercial jet business
A year ago, Embraer warned investors that 2018 would be a year of transition for the company's commercial jet franchise. Earlier this year, Embraer delivered the first of its second-generation E-Jets, which have been in development for five years. The new jet models will initially be more expensive to manufacture, temporarily weighing on the jet maker's profitability. In addition, demand for first-generation E-Jets is slowing, leading to fewer commercial jet deliveries.
Last quarter, Embraer delivered just 15 commercial jets, compared to 25 a year earlier. This led to a steep 45% drop in segment revenue. While a few deliveries were rescheduled to the fourth quarter, that clearly wasn't the only factor driving the massive declines.
The lower delivery volume caused the commercial aviation segment's operating margin to come in at 1.1% last quarter. That compares to 10% just one quarter earlier. For 2018 as a whole, Embraer expects to deliver about 90 commercial jets, down from 101 in 2017. Thus, the level of revenue and margin declines will be smaller on a full-year basis than in the third quarter, but it will still be significant.
Additionally, Embraer's firm order backlog plummeted from 360 commercial jets as of mid-year to just 251 at the end of last quarter. The biggest driver of this change was that Embraer had to remove an order for 100 E175-E2s from its backlog due to uncertainty about whether SkyWest will be permitted to fly a jet of that size for its major airline partners. JetBlue Airways also canceled the remaining 24 E190s it had on order.
Embraer is working hard to rebuild its backlog by finalizing a handful of deals announced at this summer's Farnborough Airshow. Chief among them was a letter of intent from regional airline Republic Airways for at least 100 E175s.
The Boeing deal is on track
While Embraer's commercial aviation segment remains in flux, that business will be much less important to the company once it sells an 80% stake to Boeing. Investors got good news on that front this week, as Embraer said it expects to receive approval from the Brazilian government by year end. That was the biggest potential hurdle to finalizing the Boeing joint venture.
The exact terms of the agreement with Boeing haven't been announced: most notably, how much of Embraer's debt will be assumed by the new commercial aviation joint venture. What we do know is that Embraer will get $3.8 billion of cash from the deal.
Part of that windfall will be used for debt reduction, but a lot will be returned to shareholders through dividends and buybacks. Considering that Embraer's market cap has hovered around $4 billion recently, this will be a game changer for investors.
The rest of Embraer's business is on the mend
While Embraer's overall results for the third quarter didn't look so good, its executive jet and defense segments continue to improve. Given that those will constitute the bulk of Embraer's business following completion of the Boeing deal next year, this is great news for investors.
Executive jet revenue jumped 43% year over year, while defense revenue surged 48%. Most importantly, both divisions were profitable, generating segment margins of 4.1% and 2.4%, respectively. For comparison, Embraer lost money in the executive jet and defense segments during the second quarter. (In the first quarter, the defense business posted a 4% segment margin, but that was more than offset by a -16.7% segment margin in executive jets.)
Embraer expects further improvement in these businesses next year. The company's recent focus on protecting its profitability in the executive jet business rather than chasing market share is already paying off. Meanwhile, Embraer will start delivering its most important defense product -- the KC-390 military tanker/transport aircraft -- in the first half of 2019.
With the lucrative Boeing joint venture deal moving closer to completion and Embraer's other divisions heading in the right direction, Embraer shareholders should be relatively satisfied with the company's current position.
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Adam Levine-Weinberg owns shares of Embraer and JetBlue Airways and is long January 2019 $10 calls on JetBlue Airways. The Motley Fool recommends Embraer and JetBlue Airways. The Motley Fool has a disclosure policy.