Before last Friday, Embraer (ERJ +2.46%) stock was the beneficiary of keen investor enthusiasm, having gained more than 36% year to date. After a shaky week of trading and a sell-off on Friday, Embraer's stock is now up but 24% year to date. A negatively received earnings report catalyzed Friday's selling angst. Let's review a few key themes that rose to the surface of Embraer's second-quarter 2013 earnings release.
Analysts and investors were caught off guard by deferred tax issues
Embraer follows international financial reporting standards, or IFRS, when reporting its earnings. IFRS is on the whole similar to U.S. generally accepted accounting principles, or GAAP, but differences in the treatment of certain accounting issues can occasionally cause wide variances in reported numbers between the two systems.
Embraer experienced one of those moments this week, when most analysts' expectations for earnings disregarded the effect that the recent slide in the Brazilian currency, the real, would have on deferred taxes. Essentially, by IFRS requirements, Embraer had to revalue the tax basis of some of its non-monetary assets such as inventory and fixed assets because of currency differences, and consequently took a non-cash charge of $97.1 million against earnings. The revaluation turned a $91.8 million profit into a $5.3 million loss.
Deferred tax issues are often timing issues, and non-cash charges like this can often set up favorable comparisons in the same quarter the following year. The gist of this charge is that Embraer now has a deferred tax liability on its balance sheet that investors should keep an eye on for the next few quarters.
Total deliveries were down
Embraer delivered 29 executive jets (small jets purchased by private corporations) to customers in the second quarter of 2013, which increased significantly over the prior year, in which the company saw 23 deliveries.Commercial jet deliveries decreased, however, from 35 jets delivered in the second quarter of 2012 to 22 jets delivered in Q2 2013. If there was a reason to be disappointed in this earnings report, it was the pace of production. So far this year, the company has delivered 80 total planes. Management affirmed that total deliveries for the year will land somewhere between 195 and 215 total planes, so the third and fourth quarters promise to be busy, as Embraer will have to produce at roughly 1.5 times the production rate of the first half of the year to meet the low end of its guidance.
The backlog is vibrant
As expected from the closing a number of deals in its E-Jets series during the quarter, Embraer's backlog grew handsomely, from $13.3 billion at the end of Q1 2013 to $17.1 billion at the close of Q2 2013 -- a 29% increase.According to CFO Jose Filippo, the backlog has reached 2009 levels. With the backlog being driven by an uptick in commercial jet orders, the company will do well to push as much production in this area as possible, especially as demand for the executive jet series appears soft, because of the unexpected economic slowdown in Brazil and China, which are primary markets for Embraer's private jets.
Embraer attacks a Boeing/Airbus stranglehold
One of the nuggets that came out of this transcript was Embraer's intention to take on more sales to aircraft lessors (companies that purchase planes and lease them to airlines). This is a market historically dominated by Boeing (BA +1.95%) and European Aeronautical Defense and Space's (EADSY +5.19%) Airbus.Earlier this month, Embraer announced that it had won an order for 50 E-Jets series planes from leasing giant International Lease Finance, with options to deliver 50 more.
On Embraer's earnings call, CEO Frederico Curado noted that Boeing and Airbus have up to 35% of their respective backlogs committed to aircraft lessors, and that Embraer intends to raise its current level of 16%-20% of sales to lessors closer to the percentages enjoyed by its much larger peers.This is a shrewd move for Embraer, as its popular E-Jet series, a smaller commercial airplane with a sweet spot of around 75 seats, is sought after by major domestic airlines, but also smaller regional airlines that may be more inclined to use lessors in building their fleets versus the higher upfront costs of purchasing directly.
What to make of this earnings release
While the production rate in the first half of the year leaves something to be desired, Embraer is enjoying great demand from regional airlines for its commercial jets. With a robust backlog, the company should be able to focus on speeding up deliveries and finding a few percentage points of margin from productivity initiatives currently under way. If you hold Embraer, you'll want to monitor plane deliveries for the back half of the year over the next two quarters. For now, Embraer remains a great, thematic long-term play in the airline manufacturing industry.
