Every day, Wall Street analysts upgrade some stocks, downgrade others, and "initiate coverage" on a few more. But do these analysts even know what they're talking about? Today, we're taking one high-profile Wall Street pick and putting it under the microscope...
Last month, Brazilian plane maker Embraer (ERJ -1.28%) confirmed a deal to sell 80% of its commercial aviation business to Boeing (BA 0.11%) for $3.8 billion, to potentially force Boeing to buy the rest of the commercial airliner business in 10 years, and to offload "a good amount" of Embraer's debt to boot.
Investors reacted poorly to the news -- as my fellow Fool Adam Levine-Weinberg commented at the time, probably because they were expecting Boeing to bid roughly 50% higher than it did for its stake in Embraer. Whatever the reason, investors have subtracted about 29% from Embraer's market cap since the deal was announced in the first week of July.
One analyst thinks that's a mistake -- and an opportunity.
Embraer's Super Tucano fighter plane is one asset Boeing won't get from its deal to buy (most of) Embraer. Image source: Embraer.
Upgrading Embraer
This morning, analysts at investment bank Morgan Stanley announced they're upgrading Embraer to overweight. Morgan Stanley is also assigning the stock, which currently trades around $19.50 a share, a new target price of $23.50, according to a write-up on StreetInsider.com (subscription required). This implies that investors buying Embraer today could earn as much as a 20% profit on the stock over the next year.
What makes Morgan Stanley so optimistic about Embraer when everyone else is seemingly so pessimistic?
In four words: defense and business jets.
Three sides of Embraer
Embraer's business comprises three main types of aircraft:
- Commercial jets, which bring in about $3.25 billion in annual sales and is the division that Boeing is buying into;
- business jets, Embraer's second-biggest division at $1.45 billion in sales, according to S&P Global Market Intelligence;
- and defense, a $920 million-a-year business for Embraer.
Valuing those businesses
Now, with $5.6 billion in annual sales and $3.5 billion in market capitalization, Embraer already looks undervalued at a price-to-sales ratio of just 0.6. (For context, the historic usual valuation for aerospace and defense stocks like Embraer is closer to 1 times sales.) Thus, if the deal with Boeing ultimately falls through, there's a strong argument to be made that Embraer stock is a bargain should it remain independent.
On the other hand, if the deal with Boeing goes through, and Embraer collects $3.8 billion from its new partner, well -- that's more money than all of Embraer is currently worth. Investors would stand to make about a $300 million profit, and get to keep Embraer's business jet division, its defense division, and 20% of its commercial aviation business -- for free.
Granted, you can quibble that the company's $1.3 billion net debt load puts Embraer's enterprise value at closer to $4.8 billion. But even viewed from that perspective, Boeing's $3.8 billion payment would cover at least 79% of the company's enterprise value, and depending on how much debt Embraer offloads as part of the deal, probably more than 79%.
Plus, Embraer would still end up owning two businesses with $2.3 billion in annual sales in their entirety, as well as 20% of a business with $3.25 billion in sales.
The upshot for investors
It's not often I say this about a Wall Street upgrade, but as I look at the numbers, I honestly don't see how Morgan Stanley could be wrong about this one. It seems to me clear as day that Embraer stock is undervalued, whether Boeing succeeds in winning approval to buy 80% of the commercial business or not.
And it seems clear as day that Morgan Stanley is right to upgrade Embraer stock.
