Embraer (ERJ +2.16%) has had an unlucky run over the past few years. Brutal competition from Boeing (BA +1.24%) and Airbus and the bankruptcies of several key customers have weighed on sales of its new commercial jet line (the E2-series E-Jets). A downturn in the business aviation market and development delays for its biggest defense project (the KC-390 military tanker) added to the pressure. Finally, Boeing offered to buy the company at a big premium, but Brazil's government vetoed that move.
Boeing and Embraer settled for a less ambitious (but still promising) pair of joint ventures. Boeing plans to buy an 80% stake in Embraer's commercial aviation business and a 49% stake in a joint venture to develop new markets for the KC-390 (also known as the C-390 Millennium). Those transactions have also been delayed due to regulatory issues.
However, 2020 could finally be the year that Embraer's long-term strategic plans start to pay off. The long-awaited joint venture deals with Boeing are likely to close sometime this year, and the remainder of Embraer's business is finally gaining momentum.
A delayed deal is better than no deal
Most global regulators have already approved the Boeing-Embraer joint venture plans. The proposed commercial aviation tie-up has faced numerous legal challenges in Brazil, but it has held up each time. (The most recent favorable ruling came just a few days ago.)
A long-running regulatory review by the European Commission is the only remaining obstacle to completing the JV deals. The commission has requested over 1.5 million pages of documentation, and it has repeatedly stopped the clock on its review of the commercial aviation joint venture due to Boeing and Embraer not providing requested information quickly enough.
Boeing wants to buy an 80% stake in Embraer's commercial aviation business. Image source: Embraer.
There is no guarantee that the European Commission will ultimately approve the JV agreement. However, there isn't much factual basis for an antitrust challenge. There is no overlap between Boeing and Embraer's commercial jet lineups: Embraer's largest model (the E195-E2) is more than 10% smaller than Boeing's smallest offering (the 737 MAX 7).
Two years ago, Airbus was allowed to purchase a majority stake in Bombardier's CSeries aircraft program, which was far more of a direct competitor to Boeing's and Airbus' smallest models. An attempt to block the Boeing-Embraer deal would reek of favoritism toward local player Airbus, inviting retaliation by the U.S. As a result, the odds favor eventual approval of the joint venture.
As of a year ago, Embraer expected to pay a special dividend of about $1.6 billion to shareholders (nearly $9 per share) following completion of the joint venture deal. More recently, Embraer has changed its estimated payout to $1.3 billion to $1.6 billion, acknowledging that the delayed closing could impact its finances. Still, even the low end of that range would be a substantial sum relative to Embraer's $3.3 billion market cap.
The rest of the business is looking healthier
After the joint venture deals with Boeing close, Embraer will get the majority of its revenue from its executive jets business, with the defense segment also providing a significant contribution. Fortunately for shareholders, these parts of the company appear to be returning to health at last.
On Wednesday, Embraer reported that it delivered 46 executive jets in the fourth quarter, including the first three Praetor 500 jets. This gave it 109 executive jet deliveries for the full year -- just shy of the high end of its guidance for 90 to 110 deliveries. In 2018, it delivered just 91 business jets.
Embraer's executive jets business had a good year in 2019. Image source: Embraer.
Furthermore, Embraer said it ended 2019 with a firm order backlog worth $16.8 billion, up from $16.3 billion a year earlier. This backlog increase came despite Embraer having 30 fewer commercial jet orders in its backlog (338 as opposed to 368).
In other words, the business segments not being sold ended 2019 with much larger backlogs than they had entering the year. That's a very good sign for investors, as it implies that Embraer's new products in the executive aviation and defense markets (particularly the former) are selling well.
Plenty of risk, but plenty of reward
Back when it expected the Boeing JV deals to close by the end of 2019, Embraer projected that it would produce between $2.5 billion and $2.8 billion in revenue in 2020, with a 2%-5% operating margin. Between its strong 2019 business jet delivery total and backlog growth, the high end of that target range seems achievable (excluding the results of the commercial business that is set to be sold).
In other words, Embraer's business going forward could produce up to $140 million in operating income this year. There's plenty of room for growth in the years ahead, particularly in the defense segment. (The Boeing defense joint venture could help accelerate that growth.)
Meanwhile, the pending special dividend, the value of its remaining 20% stake in its commercial jet business, and its planned post-divestiture net cash position of $1 billion account for virtually all of Embraer's minuscule $3.3 billion market cap. Embraer stock could still struggle if the European Commission unexpectedly blocks the commercial aviation joint venture with Boeing. But if that deal goes through, the upside for Embraer shareholders would be substantial.
