Is It Time to Bail Out of Embraer?

I'm looking to the sky to save me
Looking for a sign of life
Looking for something to help me burn out bright

-- Foo Fighters, "Learn to Fly"

When will Embraer (NYSE: ERJ  ) learn to fly? Not soon, if the numbers from the second-quarter earnings report are to be believed.

The Brazilian jet maker reported an 11.3% increase in revenue, but profit took a nosedive, declining by roughly 50% as higher production costs combined with increased labor costs and a 9% jump in the value of the Brazilian real versus the dollar.

A bulging backlog
But those are excuses. Here's the truth: Embraer hasn't yet perfected its new production line and isn't close to meeting tremendous demand for its E190 regional jet, which has captured imaginations at JetBlue (Nasdaq: JBLU  ) and U.S. Airways (NYSE: LCC  ) , among others.

Witness the company's backlog. It sat at just $10.2 billion at this time last year. Today, it's $15.6 billion, a 53% increase! Record or no, this isn't a good number. Why? More backlog means more stress for an already overworked and still-green production line. What we really want to see is Embraer turning orders into revenue, and the only way to do that is to deliver aircraft.

So far, it isn't doing that. Just 61 aircraft had been delivered as of June 30, or just 37% of the minimum 165 deliveries planned for 2007. It shipped 63 aircraft in the first half of 2006 and 130 in all of last year.

Cruising toward higher altitudes
Still, there was good news to report. Return on capital and earnings from continuing operations showed improvement for the first time in several quarters:

Metrics

Q2 2007

Q1 2007

Q4 2006

Q3 2006

Q2 2006

Earnings from cont. ops margin

6.1%

3.1%

11.5%

6.9%

13.6%

Return on capital

1.9%

0.3%

4.5%

2.4%

8.3%

Source: Capital IQ, a division of Standard & Poor's.

There's also the balance sheet. Even after accounting for heavy investments in staff and in its manufacturing capabilities, Embraer maintains more than $1.9 billion in cash and investments versus $2.4 billion in total debt. Pretty reasonable for a capital-intensive business.

And, yeah, as much as the backlog bothers me, I am impressed by Embraer's client roster. Recent customers include Northwest (NYSE: NWA  ) , which is adopting the 175 (a predecessor to the 190 and 195), and Air France KLM (NYSE: AKH  ) , which will use both the 170 and the 190 for regional routes.

Do executives still want to fly in style?
For me, Embraer is a textbook case of the curse of growth. Orders are coming in the door far faster than they can be processed.

But it's actually worse than that. The firm is experiencing heavy growth in two distinct areas of its business: regional jets and executive jets. These are very different businesses with very different production requirements.

Remember, too, that aviation firms tend to be specialized. That's why you don't see Boeing (NYSE: BA  ) building regional jets. And it's why you don't see Textron's (NYSE: TXT  ) Cessna group building a better 737. Certainly both projects are feasible, but at what cost?

Embraer, on the other hand, believes that it can serve a broader swath of the aviation industry than its peers. I believe it can, too, thanks to successful tests of the in-development Phenom 100 executive aircraft. We just shouldn't forget that this is a massive -- and largely unprecedented -- undertaking that will need time to succeed.

Make sure the nose is up before takeoff
How much time is anyone's guess. But we can measure progress. Management has given us investors an excellent tool for the job: deliveries.

To meet its 2007 goal of at least 165 deliveries, Embraer will have to produce 104 planes in the second half -- equal to a little more than one aircraft every two days. For perspective, consider that Boeing says it will be able to produce one new 787 every three days when production is fully ramped up.

So it's probably a long shot. But, with the stock trading for just 12 times next year's expected earnings, I don't see the harm in giving management a chance to prove it can fly. Show us a sign of life, Embraer.

Embraer and JetBlue are Stock Advisor recommendations. Get a 30-day free pass to the service to find out how David and Tom Gardner have engineered a 36-point drubbing of the S&P 500 over the past five years. There's no obligation to subscribe.

Fool contributor Tim Beyers didn't own shares in any of the companies mentioned in this article at the time of publication. Find Tim's portfolio here and his latest blog commentary here. The Motley Fool has a disclosure policy.


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