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Morningstar | Downgrading Embraer's Moat; It's Becoming a Business Jet and Military Aircraft Company

We’ve moved down our moat rating on Embraer to none from narrow due to the pending divestment of the company’s commercial aviation business to Boeing via a JV. Embraer’s remaining business portfolio will be dominated by no-moat businesses. Our moat rating downgrade pushed our fair value estimate down to $21 per ADR from $23. We’re already modeling in the Boeing JV starting in 2020 because we think it will be consummated at the end of 2019.

Our previous narrow moat rating rested on Embraer’s regional jets, which boast the number-one position in commercial aircraft between 70 and 130 seats. However, the Airbus A220-200 represents an existential threat to Embraer’s larger E2 jet offerings and persistent scope clause issues continue to weigh on U.S. demand for what should be Embraer’s flagship product: the E-175 E2 variant. We think the Boeing JV will bolster Embraer’s competitiveness, and we still rate the commercial aviation business as narrow moat due to our belief that intangible assets and switching costs are at work. That said, Embraer will only retain 20% of this moatworthy regional jet unit.

Embraer will continue to own and operate its executive aviation, defense & security, and services & support businesses; we do not believe these activities possess moats. Despite Embraer’s commanding market share in light business jets, the executive aviation business has struggled to achieve respectable levels of profitability. Indeed, operating margins have only breached 5% three times since 2006. Margins in the services & support segment are also subdued for business jets, sitting at about half the level of the regional jet services work that Embraer is divesting to Boeing. Lastly, we’re hesitant to award a moat to the defense & security business because its potential to generate excess returns rests on the KC-390, which has failed to garner significant traction yet internationally, and there is no certainty that Embraer will ramp-up production profitably.