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Embraer Stock Upgraded 3 Times in 2 Months: What You Need to Know

Rich Smith, The Motley Fool

Every day, Wall Street analysts upgrade some stocks, downgrade others, and "initiate coverage" on a few more. But do these analysts even know what they're talking about? Today, we're taking one high-profile Wall Street pick and putting it under the microscope...

I did it. I took my own advice, and bought Embraer (NYSE: ERJ) stock.

Last month, after learning that investment banker Morgan Stanley had recommended buying shares of Brazilian plane maker Embraer, I decided to take a look at the stock myself. Morgan Stanley, you see, was of the opinion that investors were "attributing too little value to ERJ's Executive/Defense Divisions," and the banker was attracted by the stock's sell-off after Boeing bid less than expected to acquire control over Embraer's larger commercial division.

I concurred: "It seems to me clear as day that Embraer stock is undervalued, whether Boeing succeeds in winning approval to buy 80% of the commercial business or not." After waiting a couple of weeks to comply with The Motley Fool's ironclad disclosure policy, I bought the stock.

And now yet another analyst is saying that's the right call.

Silhouette of airplane with sun setting in the background

Image source: Getty Images.

Three upgrades in two months

Embraer's actually been pretty fortunate in scooping up analyst upgrades these past couple of months. In addition to Morgan Stanley's mid-August endorsement, StreetInsider.com's rolling tally of upgrades and downgrades (subscription required) shows that Embraer won an upgrade (to hold) from Santander a week later.

Today, it racked up its third endorsement when Brazil-based Banco Bradesco announced that it is also upgrading the stock (to outperform). In fact, Bradesco is assigning the highest price target of the bunch -- $28 a share, or about 42% more than the stock costs today.

Explaining why Embraer's a buy

Why all the enthusiasm for Embraer shares? Let's recap the argument in Embraer's favor.

We'll start with valuation, which is the key to deciding whether any stock is cheap enough to buy. With a $19.30 share price, Embraer stock carries a market capitalization of $3.4 billion. But Boeing just bid agreed to pay $3.8 billion to acquire just 80% of one of Embraer's three business divisions, commercial aviation.

That right there gives you your first clue that Embraer stock is worth more than it's selling for on the market -- the fact that aviation giant Boeing is willing to pay more than the stock is selling for on the market.

Of course, the actual argument in Embraer's favor is a bit more complicated than that.

For example, although Embraer's market capitalization is only $3.4 billion, the company also carries about $1.3 billion more debt than cash on its balance sheet, which raises its enterprise value to $4.7 billion. Viewed from that perspective, Boeing paying $3.8 billion (80% of $4.7 billion) looks like just about the right price to acquire 80% of a $4.7 billion enterprise.

Explaining why Embraer's still a buy despite that

And yet, here's the thing: As Morgan Stanley (and I) argued last month, and as Banco Bradesco points out today, "The current stock price attributes zero equity value to Embraer's executive aviation and defense businesses." These two businesses, which combined account for about 42% of Embraer's annual sales, are valued at precisely zero based on Boeing's purchase price.

Admittedly, this is not without reason. Bradesco concedes that "these two divisions have reported disappointing operational performance." And how! Last year, data from S&P Global Market Intelligence show that both defense and security and executive aviation produced operating losses for Embraer.

Then again, over the five preceding years, these same two divisions generated combined operating profits of $566 million for Embraer. That worked out to about a 4.5% average annual operating profit margin -- unremarkable perhaps, but still more than twice the operating profit margin that Airbus' defense division, for example, produced last year. What's more, Bradesco notes that "as part of the agreement with Boeing the gains of scale in commercial aviation will be shared with the executive aviation and defense areas, resulting in higher operating margins" for these two divisions -- a fact that argues in favor of their being worth...well, at least more than nothing.

(There's also the 20% of Embraer's commercial aviation unit that Boeing isn't buying to consider. Like the defense and business jet divisions, that one's currently being valued at zero dollars, zero cents, by the market.)

How to value Embraer

How much more than nothing are these two-and-a-bit-more divisions worth? Here's one way to look at it:

Last year, Embraer's defense unit generated sales of $919 million. Executive aviation produced a bit more than $1.4 billion. Twenty percent of commercial aviation's haul was $650 million and change. Add it all up, and that's almost $3 billion in sales that aren't currently reflected in Embraer's $3.4 billion market cap.

Even at the historical average one times sales valuation that the market ascribes to defense and aerospace stocks (they've been selling for quite a bit more, lately), I'd therefore suggest that Embraer could be worth as much as $3 billion more than its stock sells for today. Even if I'm wrong about that, though -- even if I'm off by, say, 50%, and Embraer is worth "only" $1.5 billion more than its current market cap -- this still implies that Embraer should be worth close to $4.9 billion.

Which coincidentally, is almost precisely what Bradesco says it's worth.

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Rich Smith owns shares of Embraer Brazilian Aviation Co. The Motley Fool recommends Embraer Brazilian Aviation Co. The Motley Fool has a disclosure policy.