Last week, Brazilian aircraft manufacturer Embraer (ERJ 3.50%) confirmed an order for 18 E175 regional jets from U.S. regional airline giant SkyWest. The order had been expected, but it is still an important milestone for Embraer to have a firm contract.
Filling in the order book
At the beginning of 2013, some aerospace analysts were worried that Embraer would need to make drastic production cuts due to a shrinking order backlog. Embraer ended 2012 with a firm order backlog of just 185 E-Jets. That represented less than two years of production.
However, Embraer only had to make modest production cuts, because it has been able to secure a raft of new orders in the past few years. Many of those orders have come from the U.S. regional airline sector.
Even as orders have outpaced production, Embraer has continued to build 90-100 commercial jets per year since 2013: less than the 106 it delivered in 2012. It now faces a tricky issue: selling current-generation E-Jets when it is developing updated models that will offer double-digit unit cost reductions. Those new models will enter service in the 2018-2020 period.
Embraer has done remarkably well despite this headwind. Embraer ended Q2 with 264 firm orders for the current-generation E-Jets: up substantially from the beginning of 2013 despite the impending arrival of the E2 series jets.
SkyWest's recent order means that Embraer will exit the quarter with a backlog of current-generation E-Jets equal to more than two-and-a-half years of production at today's rate. While some of those planes won't be delivered until after 2018, Embraer now has roughly the right amount of orders to keep its production line going through the end of 2017.
Ramping up production
However, Embraer may want to do more than just tread water for the next few years. Given that it has booked about 85 firm orders for current-generation E-Jets so far in 2015, it appears that there is still demand for those planes.
That's good, because Embraer won't be able to shift all of its production to the new models in 2018 -- there will be a transition period of several years. The strong pace of orders this year also indicates that it might be possible for Embraer to expand production starting in 2016. Embraer has several ongoing sales campaigns and its customers have hundreds of purchase options for current-generation E-Jets.
A higher production rate should unlock economies of scale, leading to a higher profit margin for Embraer (all else equal). That's in addition to the significant margin benefits Embraer will get in the next few years from the weak Brazilian real and the 2018 introduction of the second-generation E-Jets.
Going against the usual trend
Typically, aircraft manufacturers -- and their investors -- have to worry about sustaining their production rates during a model transition. Often, it's not possible, as too many customers hold out for the new models. Just two years ago, Embraer's management thought production cuts were a realistic possibility.
Instead, Embraer has been able to defy the conventional wisdom with three consecutive years of solid order trends for the current-generation E-Jets. It is benefiting from U.S. regional airlines' shift toward 76-seat jets as well as the airline industry's surging profitability, which is encouraging airlines to pursue growth.
Whatever the cause, the strong sales of Embraer's commercial jets should help Embraer produce steady revenue growth and margin expansion in that business. This will help the company weather ongoing volatility in its smaller corporate jet and defense business segments.