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David N. Frazier: Headwinds May Keep Embraer Stock Grounded for Now

By    |   Friday, 08 August 2014 07:04 AM

After following Embraer (ERJ) over the past few months, I thought now might be a good time for stock market investors and speculators to allocate a portion of their financial market assets to that company’s stock.

The fact that Brazil’s Bovespa Index had rallied sharply over the past four months, and that it had broken above 55,638, a key price-resistance level on July 17, seemed to support my thinking.

Meanwhile, my thorough understanding of economic cycles, and my familiarity with some significant economic developments in Brazil, suggested to me that the economic downturn that began in that country during June 2013 might be nearing an end.

Therefore, I decided to take a closer look at São Paulo Brazil-based Embraer, whose stock tends to move in the same direction as the Brazilian economy and that country’s major stock market index.

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Before discussing my findings, let’s review Embraer’s operations.

Company Description

Embraer is one of the world’s larger manufacturers of commercial aircraft and executive jets, with its sales accounting for approximately 50 percent of the worldwide regional jet market during the year ended Dec. 31, 2014.

Although the company was founded during 1969 to build airplanes for Brazil’s military, Embraer was privatized and transformed into a publicly-held corporation during 1994 when it began developing commercial aircraft.

Since then, the company has become the world’s third largest jet maker for commercial and executive aviation, behind Boeing and Airbus, and the world’s largest manufacturer of commercial jets in the up to 120-seat category.

Embraer’s commercial customers include some of the larger regional airlines in the world, such as American Airlines, JetBlue Airways, American Eagle, Express Jet, Lufthansa, Air Canada, Republic Airlines, KLM and Regional (a subsidiary of Air France). More than 85 airlines from over 50 countries fly the company’s jets.

In addition to being the leading supplier of military aircraft to Brazil’s Air Force, the company also sells military aircraft to armed forces in Europe, Asia, the United States and other Latin American countries.

Over the past several years, the company focused much of its attention on the development of executive jets, which are based on its regional commercial jet platform.

The company’s ERJ 135/145, which seats 37-50 passengers, served as the foundation for its first executive jet, the Legacy 600, which was introduced during 1999. Since then, Embraer has developed 6 other executive jets – the Phenom 100, Phenom 300, Legacy 450, Legacy 500, Legacy 650 and Lineage 1000.

The Phenom series, which was introduced during 2008, carries 4-9 passengers and has a range of 1,178-1,971 nautical miles. The Legacy series, which carries up to 13 passengers, has a flying range of up to 3,840 nautical miles.

Embraer’s Lineage 1000, which is a variant of the company’s 190 regional commercial jet, is an "ultra-large" business jet that seats up to 19 passengers. With a larger fuselage cross-section than comparable business jets offered by the company’s competitors, the Lineage 1000 has a flight range of up to 4,500 nautical miles.

With industry experts projecting that the demand for executive jets will increase considerably over the next several years, Embraer appears to be in an excellent position to capitalize from any such trend.

The company also appears to be favorably positioned to take advantage of the increasing demand for mid-sized commercial jets from regional airlines around the world, with many of those airlines seeking to expand their fleet and/or to increase their penetration in higher density markets by adding longer routes.

A similar opportunity exists for Embraer to increase its sales of the company’s smaller commercial jets to low-cost airlines that serve dense routes in regional markets.

For the year ended Dec. 31, 2013, sales of the company’s commercial aircraft accounted for 53 percent of Embraer’s revenues, while sales of executive jets and military aircraft accounted for approximately 26 percent and 19 percent of the company’s revenues, respectively.

In regard to regions of the world where Embraer generates its revenues, approximately 29 percent, 22 percent and 21 percent of the company’s revenues were generated from sales in North America, Europe and Brazil, respectively, during 2013. Approximately 15 percent of its revenues were generated from sales in Asia and 13 percent of its revenues were generated from sales in various other companies.

Recent Economic Developments in Brazil, the United States and Europe

As I mentioned in the introduction to this article, the rally in Brazil’s Bovespa Index over the past four months – from March 18 to July 22 – suggested to me that the economic downturn in Brazil might be nearing an end.

Unfortunately, I came to a different conclusion after doing further research, with the most-recent statistics on that country’s retail sales, industrial production and manufacturing activity indicating that Brazil’s economy will grow at a very sluggish pace, at best, through the end of this year.

Recent readings on numerous economic indicators for the United States and Europe, where Embraer derives approximately 51 percent of its total revenues, suggest that the pace of economic growth in those regions of the world will also be sluggish over the next several months.

Because stock prices, in general – especially stocks of manufacturing companies – tend to move in the same direction of any given country’s overall economy, my initial thinking on Embraer has changed.

Specifically, instead of thinking that now would be a good time to allocate some money to that company’s stock, my research indicates that now would be a very risky time to buy the company’s stock. The stock closed Thursday at $33.37.

Embraer’s Revenues, Earnings and Financial Outlook

Recent comments from Embraer’s management seem to support my thinking, with the company stating on February 26, and again on July 31, that it expects its revenues to be in a range of $6 billion-$6.5 billion for the year ending Dec. 31, 2014. That revenue outlook would translate, at best, into a year-over-year increase of only 4.3 percent, or a decline of up to 3.8 percent. Any such changes would follow a revenue increase of only 1.1 percent for Embraer during 2013, as compared to the prior year.

In light of the fact that Embraer’s revenues declined by 12 percent for the first six months of this year, as compared to the same period a year ago, I think there’s a better likelihood of the company’s full-year revenues declining than of them increasing.

Meanwhile, Embraer’s net income declined by a whopping 49.7 percent for the six months ended June 30, 2014, as compared to the same period a year ago.

So, even though my research indicates that the longer-term outlook for Embraer appears to be favorable, I would advise investors and speculators alike to not put any of their financial market assets into ERJ at this time.

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David N. Frazier has an extensive background in the investment securities industry and has invested in the financial markets for more than 25 years.

In addition to working as a business analyst, merchant banking analyst and equity research analyst, he’s held positions in sales and marketing at institutional investment firms, including William O’Neil & Co., TDAmeritrade, and Merrill Lynch.

David now serves as the President and Chief Market Strategist of Frazier & Mayer Research, LLC (dba www.TheMarketMonk.com), an independent investment research firm that provides research and analytical services to hedge funds, investment advisory firms, and other investment newsletters.

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After following Embraer (ERJ) over the past few months, I thought now might be a good time for stock market investors and speculators to allocate a portion of their financial market assets to that company's stock.
embraer, stock investing, david n frazier, market monk
Friday, 08 August 2014 07:04 AM
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