Shares of Brazilian aerospace company Embraer (ERJ +6.09%) have underperformed the market in the past year as the company's sales growth has stagnated.
Embraer 1-Year Stock Chart, data by YCharts.
Embraer relies heavily on a single family of commercial aircraft -- the E-Jets -- which has produced more than half of the company's revenue in recent years. Embraer is approaching a model transition to the second-generation of E-Jets, and this has made it more difficult to sell the current models.
Fortunately, Embraer appears to be on track for a relatively smooth transition to the second-generation E-Jets. As Embraer switches over to production of the new jets over the next five years, its revenue growth and profit growth should accelerate due to stronger demand and higher selling prices.
Marking time
In 2008, before the global financial crisis caused airlines to rein in aircraft orders, Embraer delivered more than 150 E-Jets. Since then, annual deliveries have gradually trended downward. In 2014, Embraer delivered 92 E-Jets, roughly in line with its 2013 numbers.
In the past several years, high fuel prices have caused airlines to shift their orders toward larger, more fuel-efficient models, a market segment dominated by Boeing and Airbus. Embraer reacted by launching the second-generation E-Jets in mid-2013, with a planned entry into service between 2018 and 2020.
The second-generation E-Jets will enter service between 2018 and 2020. Source: Embraer.
So far, the E-Jets E2 program has received a solid market reception. Embraer has accumulated 210 firm orders and 220 options with several years to go before the first delivery. However, the announcement that improved E-Jets are coming near the end of the decade further dampened demand for the current generation.
Building a production bridge
It's typical for the announcement of a new or upgraded aircraft model to cannibalize demand for the existing model. For example, Airbus recently announced it will reduce production of its A330 widebody jet in 2015 and then again in 2016 because of cannibalization from the A350 (which entered commercial service last month) and the recently announced A330neo.
That said, the A330 is just one of several aircraft families produced by Airbus, whereas more than half of Embraer's revenue comes from E-Jets sales. This makes it all the more important for Embraer to build a production bridge -- i.e., sell enough current-generation aircraft to bridge the gap until the second-generation E-Jets are ready for mass production.
Embraer has bridged the gap to the second-generation E-Jets with strong sales of the E-175 to U.S. regional airlines. Source: Embraer.
So far, Embraer has done an admirable job on that front. Since the beginning of 2013, Embraer has won orders for 246 additional current-generation E-Jets: more than the number it has delivered in that time. This allowed it to exit 2014 with an order backlog for the current-generation E-Jets covering more than two years of production.
Most of these sales have gone to the U.S. regional airline sector, which is upgrading rapidly from 50-seat jets to 76-seat jets (mainly Embraer's E-175). Embraer now needs to sell only 30-40 current-generation E-Jets per year for the next few years to keep output steady.
Expanding the market
In the long run, the introduction of the second-generation Embraer E-Jets should lead to higher sales volumes. The key driver here is Embraer's decision to enlarge the next-generation E-195.
The first-generation E-195 was only slightly larger than the E-190. Airlines mainly standardized on the E-190 -- to date, cumulative sales of the E-190 total 580, compared to just 145 for the E-195.
However, Embraer is lengthening the second-generation E-195, allowing airlines to fit 12-14 extra seats. This will let Embraer attack a new market segment of 120-136 seats. It will also allow the E-195 E2 to burn 24% less fuel per seat than the current-generation E-195.
As a result, the second-generation E-195 will be much more competitive against the smallest Boeing and Airbus planes (and Bombardier's CSeries family) than Embraer's current lineup. Its significantly lower unit costs will also allow Embraer to charge more and earn higher margins.
The second-generation E-Jets should allow Embraer to maintain its leading position in the regional aircraft market while making bigger inroads with mainline carriers. Patient investors who are willing to ride out some volatility in the next few years could make big gains in Embraer stock following the model transition.
