Embraer Facing Margin Squeeze After Sales Boom: Corporate Brazil

Dec 19, 2013 3:32 pm ET

(To set a daily alert for Corporate Brazil: SALT BZCORP)

Dec. 19 (Bloomberg) -- Embraer SA, the year’s best-selling maker of regional jets, is likely to see profit margins squeezed after its 2013 order haul in the U.S. left the market saturated with aircraft.

New buyers may be hard to find before Embraer’s upgraded jet lineup debuts in 2018, following sales of 327 commuter planes in the U.S. this year, said Eric Hugel, an analyst at S&P Capital IQ Inc. in New York. He said Embraer may need to offer discounts on older models so factories stay busy.

“Once you go into that period of the new jets, who the hell’s going to want to buy those?” said Will Landers, a managing director and senior portfolio manager who oversees $4.5 billion in Latin American assets at BlackRock Inc. and recently sold the stock. “It’s a period of margin pressure, for sure.”

Geography and arithmetic shape Embraer’s predicament: About 80 percent of its firm purchases come from five U.S. customers. The Sao Jose dos Campos, Brazil-based planemaker also is already taking orders for the updated E2 versions, which account for 150 planes from this year’s haul.

With so many deals already booked in the U.S., Embraer will have a hard time landing the 40 orders a year that will have to be placed starting in 2015 to maintain current annual production rates of about 90 to 95 jets, said Hugel, who rates the American depositary receipts as hold.

‘High Hurdle’

“There is a pretty high hurdle for them to book new orders,” Hugel said. “Not only will they have to give a lower price, but look at where the demand is today, they are for the 70-seaters, which is a lower-margin product than 90-seaters.”

Paulo Cesar Silva, Embraer’s commercial aviation CEO, said “there’s no way” the company will lower prices to sell the old model jets. “We don’t expect any significant impact on margins,” Silva said yesterday in an e-mail.

Embraer fell 1 percent, the third-biggest drop among 72 companies in Brazil’s Ibovespa index, to 18.20 reais today at the close in Sao Paulo. The stock gained 27 percent this year through yesterday, after retreating from a rally of as much as 50 percent. The Class B shares of Montreal-based Bombardier Inc., Embraer’s chief rival, rose 22 percent in the same period.

Bombardier’s split sale with Embraer to American Airlines Group Inc. last week was the Canadian company’s first to a U.S. carrier since a December 2012 purchase by Delta Air Lines Inc. In the same span, Embraer sold planes to United Continental Holdings Inc., SkyWest Inc. and Republic Airways Holdings Inc. along with International Lease Finance Corp., the jet lessor being acquired by AerCap Holdings NV.

Demand Rebounds

Cai Von Rumohr, a Boston-based analyst at Cowen Securities LLC, said the recent orders offer some insurance in helping maintain future production, because those deals include options for additional planes as well as firm purchases.

“Some of those will get exercised,” he said. Embraer also may benefit in the next few years if jet demand rebounds in Europe, and the slumping business-aircraft industry is nearing a turnaround in three to six months, said Von Rumohr, who rates the ADRs as market perform.

Embraer’s operating margins have been squeezed this year. The first- and third-quarter results -- 3.7 percent and 5.9 percent -- were among the three lowest since the start of 2010, according to data compiled by Bloomberg. Margins may be crimped further as the company transitions to making new planes and winds down the older versions.

‘Very Comfortable’

“We are very comfortable with the margins we have reached and we don’t see any challenges for the coming years,” Embraer’s Silva said. “It’s important to emphasize that we are well positioned.”

“The foremost strategy will be price, price, price, price, price, price,” said George Ferguson, a senior air transport analyst with Bloomberg Industries in Skillman, New Jersey, in a telephone interview. “You’ll find them willing to move more on price to get customers to take those late airplanes -- it becomes a diminisher of returns, but that’s just something you have to manage inside this business.”

Planemakers and their customers by policy refuse to discuss the discounts they offer from list prices, which range from $38.7 million for the smallest Embraer regional model to $48.9 million for the E-195, the largest.

Embraer has been “very aggressive” in going after this year’s orders for planes with about 70 seats such as the E-175, which lists for $41.7 million, said Stephen Trent, a New York- based analyst at Citigroup Global Markets Inc.

‘Backlog Quality’

“What worries me is backlog quantities improved significantly,” Trent said in a telephone interview. “Backlog quality seems to be going in the opposite direction.”

Embraer had 140 of the current version of the E-175 on order through the third quarter, along with 100 of the so-called E2 model, a reference to the second iteration of the E-jet family, according to data compiled by Bloomberg.

The first E2 aircraft to enter service will be the updated version of the E190, with about 90 seats, in 2018, while the upgraded E-175 won’t arrive until 2020. That assumes no delays, which “seems to never happen in the industry,” said Trent, who rates the ADRs as neutral.

In the meantime, Embraer probably will work off its backlog and won’t have new purchases waiting ahead of the E2 family, said S&P’s Hugel.

“Airlines are going to be loath to order these older generation aircraft and they’ll be two or three or four years old when the new next generation aircraft comes that’ll be more efficient,” Hugel said.

Ferguson, the Bloomberg Industries analyst, said it will be critical for Embraer to make sure shareholders outside the Brazilian government understand how it will handle the future.

“Diminished profitability usually brings diminished demand from investors -- and therefore lower stock prices,” Ferguson said.

--Editors: Ed Dufner, James Callan