Assuming that Embraer's (ERJ -3.02%) deal to sell an 80% stake in its commercial aviation business to Boeing is completed next year, the Brazilian aerospace company will refocus on its executive jet and defense segments. These two divisions are significantly smaller than the commercial aviation segment and have struggled to make money in recent years.
Embraer Executive Jets is the larger of the two main business units that will remain, with projected 2018 revenue between $1.35 billion and $1.5 billion. By contrast, Embraer Defense & Security is only expected to produce sales of $800 million to $900 million this year.
The defense segment does have room to grow. Embraer will begin delivering its KC-390 military tanker/transport aircraft next year, and it is considering a wide-ranging partnership with Boeing that could potentially pave the way for orders from the U.S. and its allies. Nevertheless, it will be imperative for the executive jet segment to increase its sales and especially its earnings. The company hopes that two new models unveiled last weekend will help it achieve that goal.
The business jet market has been weak -- until now
For much of the past several years, the business jet market has been quite awful. Economic weakness across much of the world and a focus on cost savings among U.S. corporations caused demand to sag. A glut of used jets on the market put further pressure on sales and pricing.
As a result, business jet sales have stagnated at Embraer, even though it has steadily introduced new models and updated others. Deliveries totaled 119 in 2013, 116 in 2014, 120 in 2015, 117 in 2016, and 109 in 2017. The company's 2018 guidance calls for 105 to 125 deliveries in the executive jet unit. Market conditions were even worse than these delivery figures suggest, as Embraer was propping up its volume with margin-killing discounts up until last year.
Fortunately, the market is turning around. Used business jet inventory has declined significantly. Meanwhile, federal tax reform -- particularly a provision that allows companies to immediately deduct the full cost of capital investments (like corporate jets) -- and buoyant corporate profits have caused demand to spike in the U.S.
Enter the Praetor 500 and Praetor 600
With this backdrop, Embraer revealed two new business jet models on Oct. 14: the Praetor 500 and Praetor 600. They will compete in the midsize and super-midsize segments, respectively. As such, they serve as successors to Embraer's Legacy 450 and Legacy 500 executive jets.
Increased range will be one of the biggest selling points of these new aircraft. The Praetor 500 will have up to 3,250 nautical miles of range. That's more than enough for transcontinental routes. It will also allow the aircraft to fly between Europe and the West Coast with only one stop.
The Praetor 600 is even more impressive, with up to 3,900 nautical miles of range. That's enough to fly between London and New York.
Embraer's newest business jet models will also benefit from a slew of other improvements. The interior has been upgraded, high-speed Wi-Fi can be installed, and various technical changes will allow the airplanes to offer a smoother and more comfortable flight.
The base prices for the Praetor 500 and Praetor 600 are just $1 million higher than those of the Legacy 450 and Legacy 500, respectively. So while Embraer is still selling the Legacy 450 and Legacy 500 -- at least for now -- they will effectively become obsolete when the new models become available less than a year from now.
Will the new models sell -- and will they have staying power?
Business aviation experts seem to agree that the Praetor 500 and Praetor 600 will be compelling offerings, relative to their competition, in terms of price and performance. Yet that doesn't guarantee that they will be financially successful.
One risk is simply that the upturn in U.S. business jet demand doesn't last. In a weak market, it would be tough to earn high margins even on great products.
An even bigger risk is that competitors will respond to these product upgrades by making even bigger improvements to their midsize and super-midsize offerings. The Legacy 450 and Legacy 500 models were introduced less than five years ago. The delivery total for the two models combined currently stands at roughly 100: not very impressive considering that the Praetor 500 and Praetor 600 will supersede them next year. Embraer probably hasn't come close to earning enough profit from the Legacy 450 and Legacy 500 jets to cover the cost of their development.
The investment in the Legacy 450 and Legacy 500 hasn't been a total loss, since the new Praetor models are derivatives of them. But this time around, Embraer will need a longer production run so it can capitalize on its massive investments in research and development. Given the importance of Embraer's business jet segment going forward, shareholders should be watching closely to see if upgraded products and better market conditions can drive improved results for Embraer Executive Jets.