Embraer Stock: Filling The Boeing Gap? (NYSE:ERJ)

Summary

As part of my continuing coverage of Embraer (NYSE:ERJ) I have updated estimates and valuation post 4Q23 results and provided an overview of the developing investment case. My view on ERJ has improved from the previous article more from de-risking the balance sheet and the company’s ability to generate free cash flow than from revenue or earnings growth. This de-risking plus an increased order book has led to ERJ recuperating its valuation multiplies.

Embraer (ERJ) completed a multi-year turnaround that dragged on longer than anticipated due to the pandemic and the impact on airlines and suppliers. In fact, engine suppliers are still not able to keep up with the demand and may limit deliveries in the next few years. However, the company´s cost structure has improved to reach EBITDA margins of over 10% on the current delivery and backlog forecast. The 2024 guidance points to 20% revenue and EBITDA growth and should generate over US$200m in free cash flow. The stock has greatly incorporated this turnaround as well as strong new order flow across all its business segments which in my view leaves reasonable upside for 2024 but with the potential for positive surprises, especially in the commercial aircraft segment given Boeing´s (BA) and Airbus´s (OTCPK:EADSF) production constraints while the eVTOL subsidiary, Eve Holdings (EVEX), is a hidden asset.

Risks to the investment case

The two risks to ERJ maintaining its order book and deliveries are 1. Supply chain disruption, mostly likely the inability to source engines in quantity and on time. 2. Oil prices rise to a level that reduces air travel demand and or impacts airline margins. 3. As a Brazilian company, it does not benefit from USA or EU cheap export financing for its client base as BA or Airbus do. Airlines need to fund the aircraft at market rates, which is a competitive disadvantage. 4. Competition, both Airbus and BA have a far larger assortment of aircraft to offer airlines and can bundle smaller versions into large orders with very competitive prices. Finally, ERJ has a finite R&D capacity and may be challenged to develop alternative fuel aircraft to meet ever stricter Co2 emissions, this could lead to product obsolescence.

4Q23 Results

While 4Q23 was in line with consensus and had solid margins, especially in the opaque defense segment, the results were mixed in my view with the main negative in commercial aircraft that reported weak gross margins, impacted by lower deliveries. Embraer has a high fixed-cost production structure and lower quarterly deliveries impact margins. Only the defense segment posted revenue growth with the delivery of one of the company’s newest cargo aircraft.

Performance

The stock has performed well since bottoming in mid-2022 up over 130% in the last 3 years only outpaced by corporate jet maker Textron (TXT) and in line with Airbus. The seeming never-ending crises at BA have naturally hurt its share price.

Guidance & Backlog

ERJ provided a set of positive growth guidance figures for 2024 that at the top of the range suggest over 20% revenue and EBITDA growth driven by a 20% increase in commercial and corporate deliveries. It has been my experience that ERJ and many companies provide conservative guidance to better manage expectations. The delivery expectations are driven by an increase in order backlog that grew 5% in 2023 to US$13.1bn or 4 years’ worth of revenue.

Operating Model

I am using the top of the guidance range for deliveries but assuming flat average prices in 2024 and forward which may be conservative given the high demand for aircraft exasperated by BA´s production and safety issues. The higher level of units built and sold should drive gross margins higher while the service segment´s Pratt Whitney agreement may result in over US$500m in added revenue by 2026 and make this the main EBITDA generator long term. The Defense segment has always been a black box with volatile revenue and margins, however, the entry of the C-390 (which competes with the aging C-130) may begin to add some sustainability.

Valuation

I updated estimates post 4Q23 results incorporated company guidance and arrived at a YE24 price target of US$31.1 +22% that includes a US$5 valuation for Eve. This valuation uses an EV/EBITDA target multiple of 7.5x which is the 20-year historic level and also in line with peers and is above the 6x I assigned for 2023 when ERJ was still in a turnaround situation. The consensus (from Capital IQ) is using 8.5x and many analysts utilize a sum-of-the-parts method with higher multiples for the service and executive jet segment.

Consensus Comps

My estimates are in line with the consensus for Revenue and EBITDA while net income is substantially higher on lower financial cost as ERJ reduces net debt and mostly likely attains full investment grade. The market estimates are in line with Embraer guidance for 2024 and then widened in 2025 before converting in 2026 on lower data points.

Conclusion

I rate ERJ a BUY. The Brazilian aerospace company has completed a turnaround and is now set for higher growth with profitability that may be further driven by BA´s production difficulties as well as an eventual entry into the eVTOL market via 70% owned EVEX. The market has become increasingly positive the company’s investment case which may allow for further multiple expansions in my view.