Brazilian jetmaker Embraer's (NYSE:ERJ) going through turbulence as its business jet deliveries have tumbled. The effect is visible on revenue, margins, and cash flows that Embraer reported in the latest third quarter.
Investors are concerned with this turn of events as there's a major transition going on in the commercial jet segment with the phasing out of E-Jets and introduction of E2-EJets. So delivery numbers are likely to remain flattish there. In such a situation it's the defense and executive jet businesses that has to drive growth till E2-Ejet deliveries gain traction. Let's find out what's going on with Embraer's executive jets.
Embraer Legacy 650. Source: Embraer
Deliveries are in jeopardy
As investors can see in the above chart deliveries have slumped in the business jet segment. The company delivered just 15 planes in the third quarter versus 25 in the year-ago period. All 15 planes delivered belonged to the light category -- one Phenom 100, and 14 Phenom 300s.
Embraer is struggling to find takers for its medium- and large-sized Legacy and Lineage jets. This is surprising because there's good demand for the larger business jets. So far in 2014, Bombardier has delivered 105 of its Challenger and Global series of business jets, while Embraer's tally for medium- and large-sized jets stands at only 10. Embraer expects to deliver around 25-30 large business jets in fiscal year 2014, which means it has to deliver 15-20 jets in the coming quarter. The target looks quite aggressive, and most likely could be missed.
Embraer's fourth quarter is the busiest of all quarters as deliveries tend to be highest. But this time things may turn out differently due to a labor strike that took place in the first week of November and operations came to a standstill.
But, what's more worrying is that Embraer is facing slowing demand in two important markets: Brazil and China. Brazil's economy has been battling recession and the new government is trying hard to better the situation. So the weakness in this market could linger before things get back to normal. China's rich are under rigorous scanner because of the anti-corruption campaign being run by the government. This has curbed spending on luxury items, and jets have fallen prey. Although management sees it as a temporary hiccup, market conditions could remain uncertain in China for a while.
Margins could remain under pressure
Embraer executed strict cost control during the quarter and, as a result, operating expenses came in lower than the year-ago, as well as prior-quarter, levels. But the quarter's EBIT margin fell to 5.5% from 5.9% in the year-ago quarter because of weak deliveries and a lack of high-margin larger executive jet deliveries.
Margins in the fourth quarter could be slightly better as Embraer's latest offering – the mid-size Legacy 500 – has got the Federal Aviation Administration's certification, which will allow the company to sell the jet in North America. Delivery of Legacy 500 jets to its launch customer started in October after attaining certification from the Brazilian aviation authorities in August. But, for a meaningful margin improvement Embraer will have to start selling larger jets in decent numbers.
One unit of light jet Phenom 300 sells at a list price of $6.65 million, while a super mid-size Legacy 650 lists at $27.5 million. Selling one Legacy would equal the revenue generated from four Phenoms. Embraer's also not having much luck with its large Lineage 1000 jet that even after discounts fetches a good $40.5 million. The company's trying to boost sales by launching new models such as Legacy 500, Legacy 450 , and the super luxury Lineage 1000E Skyacht One jet that will list at $83 million.
Cash flows could be volatile
Source: Embraer. Slide number: 19.
Embraer's reported negative free cash flow in four out of the last five quarters. The only time it reported positive numbers was in the fourth quarter of 2013 -- the last quarter tends to be the busiest for the company owing to seasonality. We could expect a similar trend in the current quarter unless the November strike has a big impact. The company expects to receive roughly $300 million from a defense contract in the fourth quarter.
From a more long-term perspective, Embraer can generate steady positive cash flows only when its deliveries stabilize. The deliveries of Legacy 500 and the service entry of Legacy 450 may inject new life into Embraer's business jet sales. The company would also hope that sales of the new Lineage 1000E that it launched in October 2013 pick up at some point as that's where the money is.
The uncertain 2014 delivery outlook of business jets and margin pressure could affect Embraer's performance in the near term. Improvement in the segment's revenue, profitability, and cash flows hinges on one key factor -- a pick-up in sales of larger jets. Embraer is doing its part by bringing out new models, but success will ultimately depend on whether the new models are able to attract buyers. Investors could keep an eye on the progress of new orders to make an informed decision about the stock.
ICRA Online and Eshna Basu have no position in any stocks mentioned. The Motley Fool recommends Embraer-Empresa Brasileira. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.