Brazilian aerospace firm Embraer (NYSE:ERJ) has become the leading regional jet maker in the world over the past decade. Its E-175 jet has become the standard for regional airlines, especially in the U.S.
This hasn't boosted Embraer's stock price, though. Demand for its two largest (and most profitable) models -- the E-190 and E-195 -- has been sluggish as of late. These models are small mainline aircraft, and airlines have gravitated to larger, more fuel-efficient jets from Boeing (NYSE:BA) and Airbus as fuel prices have risen.
However, Embraer has high hopes for its next generation of commercial jets, which will arrive starting in 2018. The E2-series E-Jets will offer fuel-efficiency gains of up to 24%. And China is the key market where Embraer sees a huge long-term growth opportunity.
Embraer's sales challenges
Embraer's E-Jets, serving the 70-120 seat jet market, sold well between the type's introduction in 2004 and the arrival of the Great Recession. Deliveries peaked at more than 150 in 2008. But demand withered in subsequent years, with annual deliveries hovering around 100 from 2010-2012.
By the beginning of 2013, Embraer's order backlog was down to just $12.5 billion: the lowest level since 2005. This equaled about two years of revenue and stood in sharp contrast to the bulging backlogs at Boeing and Airbus. Boeing ended 2012 with a backlog of $390 billion -- equal to nearly five years of revenue at the time. Boeing's backlog has continued rising, eclipsing $500 billion by the end of 2014.
Embraer's shrinking backlog led many to believe it would need to dramatically slash production. However, it has won several large orders since the beginning of 2013, primarily from U.S. regional airlines and their mainline partners. This has allowed the company to continue building 90-100 E-Jets annually.
The downside of these orders was that strong competition from Bombardier forced Embraer to offer big discounts. Additionally, these orders from the U.S. regional airline industry have been for the E-175, which is less profitable than the larger E-190 and E-195 jets. These two factors have combined to put pressure on Embraer's profit margin.
The new generation
To reignite sales, Embraer announced an updated version of its E-Jets family in 2013. The new models will enter service between 2018-2020, and Embraer has already secured 210 firm orders, boosting its backlog to more than $20 billion again.
The E-Jets E2 series will offer significantly reduced unit costs compared to the first-generation E-Jets. Embraer is also expanding its market opportunity by stretching the next-generation E-195 to increase its capacity.
However, established airlines have continued to show a strong preference for Boeing and Airbus narrowbodies: because they are somewhat larger (allowing airlines to spread costs over more passengers) and because they are already more common. Indeed, Embraer only has four firm customers for the E-Jets E2 series, along with conditional orders from a few others.
For the program to succeed, it will need to dramatically broaden its customer base. Last week, the head of Embraer's commercial jet business stated that China alone is expected to need 900 jets over the next two decades in the 70-130 seat range covered by Embraer's E-Jets. Demand in that category from the Asia-Pacific region as a whole is projected at 1,500 jets.
Embraer hasn't closed any major deals for E2 series aircraft in almost a year. Embraer's CEO believes that many airlines have so many outstanding orders with Boeing and Airbus right now that they are holding off on making additional long-range commitments.
Embraer expects the pace of new orders to pick up within the next couple of years, as the entry-into-service date for its new jets approaches and airlines determine their late-decade fleet needs. However, the biggest opportunity may come from the growth of regional aviation in China, as airlines expand into smaller cities and begin point-to-point service between mid-size cities.
This is likely to be a long, drawn-out process, since the Chinese regional airline industry is very underdeveloped today. But there are green shoots. For example, Tianjin Airlines -- China's biggest regional airline -- already has a large fleet of E-190s and has a conditional order for 20 of the second-generation E-Jets.
Within the next decade or so, China could become Embraer's biggest market. This will help diversify its revenue base away from the U.S. while offering a big opportunity for margin-accretive growth.
Adam Levine-Weinberg owns shares of The Boeing Company and Embraer-Empresa Brasileira. 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.