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Morningstar | Embraer Swings to Loss Due to KC-390; Boeing JV Still a Question Mark

Narrow-moat Embraer reported lower revenue and profits due to a KC-390 flight test accident, resulting in charges and a revenue reversal in its defense business this quarter. Commercial aviation and services and support margins looked solid, but executive jets came in a bit light and the business remains an area of concern. Although we modestly trimmed our 2018 adjusted operating (EBIT) margins, the time value of money offset this and we’re maintaining our $25 fair value estimate.

We’re not modeling in Boeing’s acquisition of Embraer's regional jet business, which should be consummated by the end of 2019, because we think the arrangement has about a 50/50 shot of closing. Testing the JV setup in our model shaves about 5% off Embraer's fair value, suggesting Boeing might have gotten Embraer assets on the cheap. Management continues to tout a special dividend should the Boeing deal close, but has declined to give an estimated figure.

Revenue fell 29% year over year due to declining deliveries in commercial aviation (28 aircraft versus 35 last year) and in executive jets (20 versus 24 last year) combined with an estimated $100 million revenue reversal--due to percentage of completion accounting--related to the KC-390 incident. This accident also increased program costs $127 million, which was taken as a provision this quarter, driving unadjusted EBIT margins down to 1.4%.

Both commercial aviation and services and support registered double-digit margins of 10% and 16.8%, respectively, but executive jets and defense swung to a loss. We’re concerned with executive jet profits coming in negative combined with lower deliveries at the business, despite an ongoing rebound in the light/medium business jet market. Management maintained a guidance midpoint for 5.5% adjusted EBIT margins at the group level and reiterated its confidence in business jets reaching positive profitability for the full year. We’re trimming our 2018 adjusted EBIT margins 10 basis points to 5.7%.

The value of the company's firm order backlog dropped below $18 billion for first time since 2013 due primarily to 50 E2 orders from Air Costa coming out of the backlog; we note that the backlog figures don’t reflect the Farnborough air show orders and letters of intent. Management stated that the company should finalize most of its Farnborough LOIs by year-end, at which point these will go into the firm backlog.

Adjusted free cash flow recovered sequentially from a tough first quarter that witnessed $431 million of cash going out the door, coming in at positive $48 million this quarter and management confirmed guidance for negative $100 million of free cash flow this year. Although management didn't mention it, we think firming up the Farnborough LOIs means Embraer could see an increase in customer advances, boosting free cash flow.

Embraer's outlook for deliveries remains 85-95 commercial jets and 105-125 executive jets, as usual deliveries will be back half loaded. We’re modeling 87 commercial jets coupled with 119 executive jets for 2018. Despite the challenges on the KC-390, management confirmed that it would manufacture the first production aircraft for the Brazilian military by end 2018. However, Brazil will allow Embraer to use this aircraft as part of its flight test campaign. This means entry into service will actually take place in 2019 now. Per management, future KC-390 deliveries shouldn't be affected; we concur with this view.

Lastly, we’re maintaining our very high uncertainty rating for our valuation due to the cyclical nature of Embraer’s end markets and the upcoming Brazilian elections that might put a stop to Boeing’s acquisition of Embraer’s regional jet activities. The cost of capital stands at 10.4% in our discounted cash flow model.