Shares of Brazilian aircraft manufacturer Embraer (ERJ 7.33%) have been under pressure for the past few years -- at least until merger speculation sparked a rally a few weeks ago. Investors have been worried about weakness in the business jet market, a declining backlog for Embraer's current-generation jets, and slow sales of the company's next-generation products.
Back in October, Embraer offered a downbeat outlook for 2018, lending credence to some of these concerns. (That said, management vowed that results would improve dramatically thereafter.) But based on Embraer's solid 2017 performance -- especially the strong sales of its current-generation E-Jets -- the company could surpass its preliminary guidance for 2018.
Demand for Embraer's older models remained solid in 2017. Image source: Embraer.
Embraer warns investors about 2018
On its third-quarter earnings call, Embraer provided a preliminary outlook for 2018. It expects relatively stable results in its executive jet and defense segments. However, it forecast that the commercial aviation segment will be negatively impacted by the transition to its next-generation E2-series jets.
First, Embraer projects that commercial jet deliveries will fall to around 85-95 in 2018, compared to an average of just over 100 deliveries annually for the past few years. Lower production will hurt the segment's profitability, as fixed costs will be spread over a smaller number of units.
Second, Embraer will deliver the first E190-E2 models this year, accounting for about 10% of its total deliveries. New models are more expensive to produce initially, so this will also be a drag on profitability.
E-Jet orders have rebounded since September
Based on Embraer's backlog as of mid-2017 and its plans to ramp up E2 output slowly, the company could have been forced to slash production dramatically this year. At the end of June, Embraer had just 132 firm orders for first-generation E-Jets. Excluding 24 E190s ordered by JetBlue Airways (JBLU 1.53%) -- which are likely to be canceled or converted to E2 models -- its 108 firm orders represented barely more than a year of production.
JetBlue is unlikely to take delivery of the remaining 24 E190s it has on order. Image source: JetBlue Airways.
Fortunately, Embraer has reeled in several sizable E-Jet orders since September. U.S. regional airline leader SkyWest ordered 25 E175s in September and another 20 in early October. Later in October, American Airlines ordered 10 additional E175s. Finally, Embraer received an order for 15 E175s from an undisclosed customer and an order for a single E195 from Belavia in Q4.
The net result is that Embraer ended 2017 with 155 firm orders for its current-generation jets (or 131, excluding the JetBlue order), despite delivering 48 commercial jets in the back half of the year.
This increases the likelihood that Embraer will meet or exceed the high end of its preliminary guidance for 85-95 commercial jet deliveries in 2018. That in turn should help the company protect its profitability.
Order momentum is the key for 2018
During the five years since Embraer launched the E2 program, it has been remarkably successful in selling the outgoing first-generation model. The U.S. regional airline sector has accounted for most of these orders. By contrast, orders for E2-series jets have been few and far between.
This continued to be a problem last year. In fact, Embraer finished 2017 with just five net firm orders for E2-series jets. Additionally, more than half of its 280 "firm" orders for E2-series jets are at risk of being canceled due to changes in customers' requirements.
It is more important than ever for Embraer to demonstrate some order momentum in 2018. The company believes that order activity will accelerate if the E190-E2 successfully enters service this spring. It's also worth noting that Embraer has received several commitments for E2-series jets in recent years that could potentially be finalized in 2018.
However, JetBlue Airways represents Embraer's biggest E2 sales opportunity this year. JetBlue recently postponed making a decision on the future of its E190 fleet, after originally planning to finalize a long-term fleet strategy by the end of 2017.
Upgrading to the E190-E2 and E195-E2 would allow JetBlue to significantly reduce its fuel and maintenance costs. Furthermore, the "full expensing" provision of the recent U.S. tax reform law creates a big incentive to buy new planes sooner rather than later. Still, the competing CSeries jets represent a serious alternative for JetBlue. Securing JetBlue as a major customer for the E2 program is the single most important thing Embraer could do in 2018 to reassure investors about the company's long-term trajectory.
