Last week, Embraer (NYSE: ERJ) reported a larger-than-expected loss for the fourth quarter of 2018. The company's adjusted net loss came in at $6.6 million for the quarter, bringing its full-year adjusted net loss to $54.2 million. Furthermore, 2019 isn't likely to be better, with Embraer projecting that its adjusted operating margin will be around breakeven.
However, Embraer is in a transitional period right now. It is working to complete the sale of an 80% interest in its commercial aviation business to Boeing (NYSE: BA). It is also beginning serial production of its KC-390 multirole military jet and launching a joint venture with Boeing to promote KC-390 sales to the U.S. and its allies. Lastly, Embraer is transitioning to a new lineup of upgraded business jets in its executive aviation division.
In the short run, these developments are pinching Embraer's profits. However, they are setting Embraer up for long-term success.
Reviewing the fourth-quarter results
Last quarter, Embraer delivered 33 jets in its commercial aviation segment, up from 23 a year earlier. By contrast, executive jet deliveries fell to 36 last quarter from 50 in the prior-year period and defense revenue plunged by more than 50%. The net result was that total company revenue fell to $1.67 billion from $1.73 billion in the fourth quarter of 2017.
While the decline in revenue was relatively modest, Embraer's adjusted operating profit plunged to $42.5 million last quarter from $117.2 million a year earlier. An unfavorable mix shift in the commercial jet business and additional costs related to a mishap during KC-390 ground testing drove this margin deterioration.
The KC-390 development program incurred another one-time charge last quarter. Image source: Embraer.
One bright spot was a significant improvement in the profitability of Embraer's executive jets business. The company's decision to hold the line on prices even at the risk of losing market share appears to be paying off.
A portfolio transition is underway
Over the past few years, Embraer's profitability has been quite erratic due to margin pressure in the executive jets unit and a series of cost increases incurred during the development of the KC-390. That's set to change in the near future.
In the executive jets business, Embraer has two upgraded models set to debut later this year: the Praetor 500 and Praetor 600. Customer interest has been high, and Embraer is already sold out of slots for the Praetor 600 this year. As a result, the company expects a return to growth in the executive jets segment this year, and that growth could accelerate in 2020. New U.S. regulations that will require expensive upgrades for older business jets could also boost demand next year, as many business jet owners may choose to trade up to a new model.
Meanwhile, Embraer has nearly completed the certification process for the KC-390. The first delivery to the Brazilian Air Force is scheduled for later this year. That will put an end to the one-time charges that have weighed on the defense segment's profitability recently.
Defense margins should improve steadily over the next few years as KC-390 production ramps up and unit costs decline. Furthermore, the new joint venture with Boeing should enable Embraer to capture much greater market share with the KC-390 than it would have otherwise obtained. Indeed, Boeing already has several significant prospective buyers lined up.
Two promising businesses for free
Embraer expects the sale of 80% of its commercial aviation business to Boeing to close at the end of 2019. It will receive net proceeds (after taxes and separation costs) of at least $3 billion. Of that, $1.6 billion will be returned to shareholders through a special dividend, while the other $1.4 billion will be used to pay down debt, leaving Embraer with net cash of $1 billion.
The planned $1.6 billion special dividend and the $1 billion of net cash that Embraer will hold entering 2020 together account for two-thirds of the company's current market cap. Furthermore, Embraer will still own 20% of the commercial aviation business. It can sell that stake to Boeing at any time in the next 10 years for $1.05 billion plus an inflation adjustment. After that point, Embraer will be able to sell its joint venture stake at its fair market value -- which the Brazilian aerospace company currently estimates at $1.5 billion, including the value of merger synergies.
This 20% stake in the commercial aviation joint venture could thus be worth over $1 billion after tax, accounting for most of the remaining third of Embraer's market cap.
In other words, investors are currently valuing Embraer's executive jet and defense businesses at next to nothing. But while these divisions have produced uneven profits recently, they are poised for better results going forward, driven in part by new products that will enter service in 2019. If these overlooked businesses can meet their full potential in the coming years, Embraer stock will have plenty of upside.
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