Embraer's Guidance Cut Is No Big Deal

An Embraer KC-390 in flight

The past several years have been turbulent for Embraer (NYSE: ERJ) . A long downturn in the business jet market, stiff competition from Airbus and Boeing (NYSE: BA) in the commercial jet market, and some mishaps in its defense business have combined to sap Embraer's profit.

This downward trend culminated in Embraer cutting its 2018 guidance last week. At first glance, its outlook for 2019 and 2020 doesn't look good. However, the pending sale of a majority stake in Embraer's commercial aviation business to Boeing will allow the Brazilian aircraft manufacturer to reward its shareholders as they wait for its other growth initiatives to start paying off.

Guidance comes down

In conjunction with an investor day event last week, Embraer acknowledged that it fell short of its targets in several respects during 2018. Defense revenue was 25% below the bottom of its guidance range, after one of its KC-390 test planes was heavily damaged during ground testing , causing delays to that key program. Meanwhile, Embraer delivered just 91 business jets in 2018 -- well below its estimate of 105 to 125 -- as it cut back on discounting.

As a result, total revenue fell to around $5.1 billion, or roughly 10% below the midpoint of Embraer's prior guidance. Furthermore, Embraer expects operating profit (excluding special items) to come in around $200 million, far below its prior guidance range of $270 million to $355 million. EBITDA will miss the company's forecast by a similar margin. The company also burned about $200 million of cash during the year -- about double its prior estimate.

For 2019, Embraer expects revenue to rebound to a range of $5.3 billion to $5.7 billion. Yet operating profit will fall to around zero, due to costs related to the Boeing joint venture deal. And assuming the Boeing deal is completed, revenue will fall to a range of $2.5 billion to $2.8 billion in 2020, with a meager operating margin between 2% and 5%.

This would seem to be a big red flag for investors. However, the outlook isn't as gloomy as it may appear.

Embraer is about to get a big windfall

First, Embraer expects to net at least $3 billion after taxes and transaction costs from selling 80% of its commercial aviation business to Boeing. Of that $3 billion, the company confirmed that it plans to pay out about $1.6 billion as a special dividend. That amount works out to nearly $9 per share -- more than 40% of Embraer's recent trading price.

Second, the other $1.4 billion of cash proceeds will enable Embraer to dramatically improve its balance sheet. In fact, it will end up with about $1 billion of net cash (after deducting all of its debt), giving it plenty of flexibility to invest in its remaining businesses.

Third, Embraer will continue to own 20% of its commercial aviation business. The new joint venture will have to pay ou t dividends starting five years after the deal closes. Furthermore, Embraer will have the option of selling its 20% stake. For the next decade, the price would be set at $1.05 billion, adjusted for inflation. After that point, Embraer would be able to sell for fair market value. Including expected synergies from working with Boeing, the company estimates that its 20% stake will have a market value of around $1.5 billion -- and that could rise if Boeing manages to boost sales and production.

Plenty of room for growth in the executive jet and defense markets

The cash that will be paid out to shareholders upon closing the Boeing joint venture deal and the value of Embraer's 20% stake together account for the vast majority of the company's current market value. Investors aren't attributing much value to its business jet and defense segments.

However, while neither business is expected to generate much profit in the next year or two, they have substantial revenue and earnings growth potential. For example, the executive aviation division revealed two upgraded models last year: the Praetor 500 and Praetor 600. The early sales results look good for these new aircraft, which will be available later this year. Plus, used business jet inventory is finally declining, which should gradually lead to an upturn in sales and profitability for this segment.

Meanwhile, the defense business has ample room for growth as production of the KC-390 tanker-transport aircraft ramps up over the next few years. A separate joint venture with Boeing to market and support the KC-390 for the U.S. and its allies could be the key to unlocking growth in the international market. The F-39 fighter program (in cooperation with Saab) will start contributing to Embraer's results within a few years, as well.

Embraer's executive jet and defense businesses will also get a modest profit boost from cost synergies related to cooperating with Boeing. Furthermore, any uptick in volume could drive a substantial improvement in profitability, due to the high-fixed-cost nature of the aerospace industry. Considering the company's very modest valuation, a little bit of growth for the executive jet and defense businesses could go a long way toward lifting Embraer stock out of the doldrums in the coming years.

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Adam Levine-Weinberg owns shares of Embraer. The Motley Fool recommends Embraer. The Motley Fool has a disclosure policy .

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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