Description

Embraer (ERJ) Long Thesis

Executive Summary

Investors have a rare opportunity to buy Embraer, a leading global aerospace & defense company, at an implied enterprise value of less than $2.5 billion, which equates to less than 5x 2022 core-EBITDA (excluding their pro-forma ownership of Eve). While this is an extremely attractive valuation on both an absolute and relative basis for a high-quality aerospace & defense business with significant barriers to entry, it is particularly interesting because Boeing tried to buy just Embraer’s commercial aviation business for more than $5 billion a few years ago. Going forward, we believe EBITDA will grow off currently depressed levels due to tailwinds in Embraer’s end markets. 

With a reasonable recovery in margins to still below previous peak levels, a return to pre-covid EBITDA multiple of 9x, and even a big haircut to the current implied value of their Eve business, Embraer is worth more than 100% of current levels. This opportunity exists because of investor confusion, conservative management commentary, and an underfollowed recent corporate action that unlocks meaningful value.

Why Does This Opportunity Exist

• Investors view Embraer as a sleepy Brazilian aerospace & defense company

• Embraer’s management team is conservative and has not articulated the potential upside in the business

• Ongoing arbitration and separation costs related to the Boeing transaction are not disclosed or adjusted out of earnings

• Embraer does not breakout the R&D expense related to Eve that is buried in the income statement

• Investors are not doing the math to determine the implied value of Embraer’s core business after adjusting for Embraer’s remaining stake in Eve

Situation Overview

Embraer (“ERJ”) is a global aerospace & defense company based in Brazil (but traded on the NYSE). The company has five main businesses today:

1. Commercial Aviation

2. Executive Aviation

3. Defense & Security

4. Services & Support

5. Eve (recently announced a sale to a SPAC)

For purposes of this write up, we will refer to Embraer’s “core business” as commercial + executive + defense + services.

In 2017, the WSJ reported that Boeing and Embraer were in takeover talks. Ultimately, in 2018, Boeing agreed to acquire an 80% stake in just Embraer’s commercial aviation business for $4.2 billion ($5.25 billion enterprise value). As the companies were working towards a closing, Embraer spent a significant amount of time and resources to physically separate its commercial aviation footprint from the rest of Embraer’s operations (the transaction did not include any of Embraer’s other segments). These separation costs and additional expenses were a meaningful drag on operating margins in 2019, 2020 and 2021. The pending transaction also had a negative impact on backlog as customers took a “wait and see” approach given the uncertainty as to whether Embraer or Boeing would be providing service and support going forward.

Then COVID happened, a devastating blow to global aviation. Boeing backed away from the Embraer deal despite having inked an agreement—and Embraer already incurring significant costs and business disruptions to make the separation possible. Embraer is pursuing damages against Boeing through arbitration. 

Meanwhile, Embraer has started to reintegrate their commercial aviation business and recover from trough margin levels caused by the Boeing distraction as well as COVID-related weakness.

Finally, on December 21, 2021 Embraer announced it would sell its “Eve” business (electric aviation vehicles) at a $2.4 billion enterprise value into a SPAC.

Business Background

Embraer is a global aerospace & defense company based in Brazil and traded on the NYSE. The company designs, develops and manufactures aircraft and systems for commercial, private and defense customers. Within the industry, Embraer is recognized as a leader in engineering and technology capabilities and within Brazil the company is able to recruit the absolute best engineering talent (one source told us an Embraer business card commands the respect similar to a Google business card in the US). Embraer operates through four business segments: commercial aviation, executive aviation, defense & security and services & support. The commercial aviation segment sells a fleet of regional jets that are operated by more than 100 airlines across 60 countries. Embraer’s executive aviation segment has delivered more than 1,500 best-in-class private jets that are operating across 70 countries. The defense & security segment has delivered more than 1,400 aircraft to more than 60 countries including the US. Services & support provides parts and services to the global fleet of Embraer aircraft currently in operation.

On December 21, 2021 Embraer announced it would sell Eve, its wholly owned development-phase electric vehicle business, into Zanite Acquisition (ticker: ZNTE US Equity) SPAC, at a $2.4 billion enterprise value. Embraer’s entire enterprise value today is less than $5 billion and its core business (Embraer excluding Eve) will generate more than $500 million of EBITDA in 2022. Embraer will continue to own 77% of the Eve business once it begins trading as an independent company.

Thesis

ERJ presents a compelling investment opportunity due to the following reasons:

1. Embraer’s sale of Eve to Zanite Acquisition ascribes a $2.4 billion valuation to the Eve business (nearly half of Embraer’s enterprise value today)

2. Embraer’s regional jet business, operating in a duopoly, was nearly acquired by Boeing in 2020 for $5.25 billion (more than the entire enterprise value of Embraer today)

3. Embraer’s executive jet business is best-in-class and currently benefitting from the best demand trends the industry has seen in more than a decade

4. Recent financial performance is not indicative of the true earnings power of Embraer

5. ERJ stock is cheap on an absolute and relative basis

We believe the risk/reward is heavily titled towards the upside over the next 12-24 months as Embraer’s earnings continue to grow and the market begins to recognize the extremely low implied valuation for Embraer ex Eve. Applying a below-peer group multiple of 9x to Embraer’s core business 2022 EBITDA results in nearly 100% upside.

Embraer’s sale of Eve to Zanite Acquisition ascribes a $2.4 billion valuation to the Eve business (nearly half of Embraer’s enterprise value today)

On December 21, 2021 Embraer announced it would sell Eve, its development-phase electrical vehicle business, into a SPAC at a $2.4 billion enterprise value. Strategic investors participating in the SPAC PIPE include: BAE Systems, SkyWest, Republic Airways, Rolls Royce, Azorra and Bradesco (note: the transaction is not dependent upon financial investors in the PIPE). Eve is developing an eVTOL (Electric Vertical Take-Off and Landing) that is expected to enter service in 2026, and currently has 17 customers and a $5.2 billion pipeline of orders.

Given Eve is currently pre-revenue and in development phase, Embraer’s income statement is burdened with R&D expense that results in a reduction of consolidated EBITDA and earnings. Investors ascribing a multiple to Embraer’s Eve-burdened consolidated EBITDA has resulted in a reduction of Embraer’s enterprise value.

Pro forma for the transaction, Embraer will own ~77% of Eve. The current implied market cap of Eve (via ZNTE) is $2.9 billion ($10/share x 288.4 PF shares) resulting in $2.2 billion of value to Embraer. The implied enterprise value of Embraer ex Eve (commercial + executive + defense + service) is $2.4 billion and should generate more than $500 million of EBITDA in 2022.

While we are generally skeptical of SPACs, we applaud management for the transaction as it gives Embraer a public mark on a business that was not previously receiving any credit. Additionally, being an independent company with its own currency provides Eve access to the capital markets and is not reliant upon Embraer cash flow for future investment.

Embraer’s commercial aviation business, operating in a duopoly, was nearly acquired by Boeing in 2018 for $5.25 billion (more than the entire enterprise value of Embraer today). 

Embraer’s commercial jet business is a global leader in regional jets (up to 150 seat aircraft). The end market is effectively a duopoly with Bombardier’s regional jet business (now owned by Airbus) and has extreme barriers to entry. We believe recent trends coming out of the pandemic will lead to airlines focused on greater efficiency, which favor regional jets on certain routes given their lower operating costs.

In December 2018, Boeing and Embraer announced a transaction in which Boeing would acquire 80% of Embraer’s commercial aviation business for $4.2 billion (leaving the rest of Embraer’s businesses inside of ERJ). The rationale behind the deal was for Boeing to add Embraer’s regional jets to the Boeing portfolio for a complete solution for airline customers (regional + narrow body + wide body). Industry experts also believe motivation for the deal was to gain access to Embraer’s engineering and research talent, which are recognized as leaders in the aerospace industry. Boeing, one of the most sophisticated and knowledgeable aerospace players in the world, ascribed $5.25 billion of value to Embraer’s commercial aviation business in the deal. The entire enterprise value of Embraer today is less than $5 billion (which includes ERJ’s Eve stake, the executive jet business and the defense business – none of which were included in the Boeing transaction).

Ultimately the transaction with Boeing was called off in early 2020 given Boeing’s uncertainty surrounding 737 Max issues and the onset of the global pandemic. The companies are currently in arbitration and we believe Embraer is seeking compensation from Boeing for walking away from the transaction. As an aside, Embraer is not adding back costs related to the ongoing arbitration to an adjusted earnings figure.

More info on the Embraer / Boeing transaction can be found here: https://embraer.com/global/en/news?slug=1206485-embraer-and-boeing-approve-the-terms-of-strategic-aerospace-partnership-and-seek-brazilian-government-approval and here: https://en.wikipedia.org/wiki/Boeing%E2%80%93Embraer_joint_venture

Embraer’s executive jet business is best-in-class and currently benefitting from the best demand trends the industry has seen in more than a decade.

Embraer’s executive jet business sells the Phenom and Praetor series jets and has delivered more than 1,500 jets since 2000. The Phenom 300 is the best-selling light jet for the past nine years straight. The Praetor 500 and Praetor 600 offer best-in-class flight range and are the most disruptive and technologically advanced midsize and super-midsize business jets.

The executive jet industry has been a beneficiary of the pandemic, as demand for private jet travel has taken a step function higher due to business and HNW travelers seeking alternatives to commercial air travel. NetJets, Executive Jet Management and Jets.com all suspended card sales last year given the spike in private jet travel demand. Inventory of executive jets available in the secondary market, which has historically competed with OEMs for new aircraft sales, is at the lowest level in 15+ years. In October of 2021 Embraer and NetJets announced a deal for up to 100 Phenom 300s valued at $1.2 billion, the equivalent of nearly two years of Embraer’s Phenom 300 deliveries (these deliveries won’t start until 2Q’23). On its last earnings call, Embraer shared that the company’s delivery scheduled is sold out until at least the first quarter of 2023.

The strong underlying demand trends should drive growing annual jet deliveries and improved profit margins, which had been depressed in the years leading up to the pandemic. 

Recent financial performance is not indicative of the true earnings power of Embraer.

We believe the last few years of performance are not representative of Embraer’s true earnings power due to 1) the pandemic and 2) the Boeing transaction. It will not come as a surprise that the pandemic wreaked havoc on Embraer’s commercial airline customers. Revenue in the commercial segment was nearly cut in half and operating profit swung to a substantial loss in 2020, as commercial jet deliveries were down 50% on customers deferring deliveries. Commercial jet deliveries remains depressed, but the company has expressed confidence in the delivery schedule slowly returning.

Furthermore, the Boeing transaction was also significantly disruptive to Embraer’s financial performance. In preparation for the transaction to close, Embraer had to physically separate its commercial business from the rest of Embraer, which had many shared functions. This resulted in significant duplicative expense in the income statement as the companies worked towards a closing. The company is still working to pull out these Boeing-related stand up expenses and right-size its cost structure, which should be a tailwind in 2022. In addition to the additional expense burden, Embraer’s backlog suffered as many airline customers paused Embraer orders while they awaited the Boeing transaction to close. Management focused on 2021 as laying the groundwork for a turnaround after the crisis in 2020, with growth and improved cash flow expected in 2022-2026 to capture Embraer’s full potential.

While the commercial jet business is showing signs of a recovery, and the backlog is now the highest it has been since the pandemic started, we do not need the business to recover fully to pre-pandemic levels for the stock to have significant upside from current levels.

ERJ stock is cheap on an absolute and relative basis.

Consolidated Embraer currently trades at less than 9x 2022 EBITDA, a slight discount to the peer group median of ~10.5x EBITDA. However, we believe 2022 EBITDA doesn’t reflect the true earnings power of Embraer due to Boeing transaction related expenses and arbitration, depressed commercial aviation deliveries and Eve R&D expense consolidation – all masking the true profitability of the core business. 

Using a sum of the parts valuation methodology and ascribing value to ERJ’s ZNTE ownership and the core business, we believe there is nearly 100% upside in ERJ shares. If one were to take a more bearish view of the ZNTE SPAC, and assume ZNTE trades down 50% post-close we still see nearly 50% upside in ERJ shares. Assuming 9x 2025 EBITDA with zero value ascribed to the Eve business, ERJ has more than 100% upside to current prices and a ~30% IRR.

In the below analysis, we sensitize the value of the Eve business (ZNTE shares). As shown below in the bear case, even if you ascribe zero value to Eve we still see a very attractive IRR.

Conclusion

ERJ shares present an extremely compelling opportunity to invest in a best-in-class aerospace & defense business at a very attractive price. Given the Eve SPAC transaction, investors can buy ERJ’s core business at less than 5x EBITDA today. Even assuming zero value for ERJ’s remaining ownership of Eve, ERJ shares present a ~30% IRR today. Improving trends across Embraer’s core businesses will provide tailwinds to growth over the next several years.

Risks

• Ongoing pandemic concerns impacting travel industry leading to commercial aircraft delivery deferrals

• Mitigant: we do not assume a rapid recovery in commercial aircraft deliveries in our base case. We model deliveries returning to pre-pandemic levels in 2025.

• Embraer’s defense business is negatively impacted by the Brazilian government’s cancellation of KC390 aircraft orders

• Mitigant: we assume zero growth in Embraer’s defense segment through 2025.

• Eve transaction with Zanite Acquisition does not close, or ZNTE shares trade down significantly post de-SPAC

• Mitigant: if we assume ZERO value for Embraer’s Eve ownership stake (the deal does not close or immediately trades to $0), we still model to a ~30% IRR on our base case EBITDA through 2025.

• Mitigant: the PIPE investors in the Eve transaction are sophisticated strategics that make very long term decisions. 

Catalyst

-Recovery in margins

-2022 Guidance