Last week, Boeing (NYSE:BA) officially announced plans to buy an 80% stake in Embraer's (NYSE:ERJ) commercial jet business. The deal mostly followed the outlines that had become public through various leaks and media reports over the past few months.
This deal amounts to a sale of the majority of Embraer's business. Last year, the commercial aviation segment accounted for 58% of Embraer's revenue and virtually all of its profit.
Investors weren't impressed by the details of the commercial aviation joint venture agreement: Embraer stock fell by more than 10% on the day it was unveiled. However, it's too early to say for sure that Embraer shareholders are getting a raw deal.
The structure of the deal
Boeing initially hoped to buy all of Embraer. However, Brazil's government vetoed an outright acquisition, as Embraer's defense business is a cornerstone of Brazil's national security. This forced Boeing and Embraer to turn to a joint venture structure instead.
Under the agreement disclosed last week, Boeing will pay $3.8 billion in cash for 80% of a joint venture consisting of Embraer's commercial aviation business. This puts the equity value of the joint venture at $4.75 billion.
The new commercial aviation joint venture will have its own management structure based in Brazil. Embraer will have the right to sell its 20% stake to Boeing after 10 years. The two companies also plan to form a separate defense-focused joint venture that will be controlled by Embraer. This could help spark sales for new products like the KC-390 tanker/transport plane.
The price seems to be low
Embraer shares soared by as much as 31% on Dec. 21, 2017, after The Wall Street Journal reported that Boeing was in talks to acquire Embraer at a large premium to its market value. (Before the news, Embraer stock was trading for about $20.) Today, with a deal confirmed by both sides, the stock price is lower than it was the day after the first rumors came to light.
Shareholders are disappointed because Embraer is only receiving $3.8 billion of cash from Boeing, and about 20% of that will go to taxes. Thus, the net proceeds will be around $3 billion, or less than $17 per share.
Indeed, the $4.75 billion valuation assigned to the commercial aviation business under this agreement is well below what many analysts -- including me -- expected. I had estimated the unit's value at $6 billion to $7 billion. Additionally, the joint venture agreement probably won't close until late 2019, and there is still a risk that a new government in Brazil could torpedo the deal.
The upside is in debt transfer
The cash proceeds of this joint venture agreement may be smaller than most people expected, but that doesn't fully capture the benefits to Embraer. The joint venture will also assume some of Embraer's debt, which will significantly improve the company's balance sheet.
During a conference call following the deal announcement, Embraer executives noted that the joint venture will assume all of the commercial aviation division's debt. This represents a "good amount" of the company's debt, according to Flightglobal, but Embraer couldn't provide any more detail than that. Embraer will also contribute cash to the joint venture.
The exact amount of cash and debt that will move over to the joint venture matters a lot for Embraer investors. As of the end of March, Embraer had $3.4 billion of cash and investments on its balance sheet, offset by more than $4.5 billion of debt.
Until Embraer specifies how much of its debt and cash will go to the joint venture, it will be hard to evaluate whether the Boeing deal is good for shareholders. If Embraer gets rid of most of its debt while holding on to the majority of its cash, it will be able to return most of the $3 billion in net proceeds to shareholders.
That's a substantial sum compared to Embraer's current market cap of $4.3 billion. Furthermore, Embraer will still own 20% of the commercial jet division, which could become even more successful under Boeing's ownership, plus the rebounding executive jet and defense segments. Thus, the Boeing joint venture could still lead to a windfall for Embraer shareholders -- but it will all depend on how much cash and debt Embraer retains in the deal.