Embraer SA Earnings: Another Weak Quarter in the Midst of Big Changes

Embraer (ERJ 1.72%) shares have been on a wild ride in recent years. Investors have struggled to balance the company's sliding revenue and plummeting earnings power against Embraer's status as a potential M&A target and the possibility of a rebound as new aircraft under development enter production.

This volatility continued over the past three months in what was a particularly busy quarter for Embraer. While the Brazilian aerospace company reported another big drop in revenue and a steep earnings decline for the quarter, it also reached an important tentative agreement to sell 80% of its commercial aviation business to larger rival Boeing (BA 0.39%).

Embraer results: The raw numbers

Data source: Embraer Q2 earnings releases. Chart by author.

Understanding Embraer's profit decline

During the second quarter, Embraer's revenue plunged nearly 30%, with declines across all of its major business segments except for its services division. However, more than half of its revenue decline came from the defense and security segment, where revenue plunged 89% year over year to $34 million.

This sharp decline in the defense business was driven by two things. First, Embraer participated in a Brazilian satellite launch during the second quarter of 2017, which produced about $100 million of revenue at a high profit margin. Second, Embraer took a $127 million charge against revenue in its defense and security segment last quarter, after one of its KC-390 test aircraft suffered major damage during ground testing in May.

Meanwhile, commercial aviation revenue fell 19% on a 20% year over year decline in deliveries. However, Embraer was facing a very tough year-over-year comparison, as the 35 commercial jets it delivered in the year-ago period constituted the high-water mark for 2017.

Excluding the special charge in its defense business, Embraer posted a perfectly respectable 8.7% adjusted operating margin last quarter. That's well above its full-year adjusted operating margin guidance of 5% to 6%. Adjusted net income and adjusted EPS fell to barely more than breakeven, but this was due to an increase in interest expense and foreign exchange losses.

The Boeing deal is moving forward

In early July, Embraer reached a tentative agreement to sell an 80% stake in its commercial aviation business to Boeing for $3.8 billion. Embraer and Boeing still have a lot of work to do to complete the deal. They are currently finalizing the terms of the agreement. Then, they will have to get official approval from the Brazilian government, the boards of both companies, and antitrust regulators in various countries. Embraer and Boeing hope to close the deal in 2019.

Somewhat surprisingly, Embraer stock has plunged since the Boeing tentative agreement was announced. Many investors were expecting a higher price tag for Embraer's commercial jet division. That said, Embraer still hasn't specified how much debt it will be offloading to the new joint venture, which means investors don't know the true sale price yet.

Many investors think Boeing is underpaying for Embraer's commercial jet business. Image source: Embraer.

The one thing we know is that Embraer expects the Boeing deal (if approved) will allow it to substantially reduce its debt load while also returning a lot of cash to shareholders. Going forward, Embraer would focus on its executive jet and defense segments, while retaining a 20% stake in the commercial aviation joint venture.

Looking ahead

Embraer reaffirmed all aspects of its 2018 guidance on Tuesday. The company still expects to achieve revenue of $5.4 billion to $5.9 billion and an adjusted operating profit of $270 million to $355 million this year. Cash burn should be no worse than $100 million.

In the past month, Embraer's commercial jet division has seen a resurgence in order activity. A firm order for 25 E175s from United Continental has filled in most of Embraer's remaining 2019 delivery slots. Republic Airways also signed a letter of intent for 100 E175s (with another 100 options). This deal will give Embraer a lot more certainty on its 2020 and 2021 production.

Even more importantly (in light of the proposed Boeing joint venture), Embraer will begin deliveries of its KC-390 military tanker-transport aircraft to the Brazilian Air Force in 2019. The company is also in talks with Boeing about the possibility of deeper cooperation in the defense business, which could help drive international sales of the KC-390. With the defense business likely to become Embraer's main growth driver in the years ahead, finding customers outside of Brazil will be critical to the company's long-term success.