Brazil’s embattled president is under pressure like few other political leaders. After winning a slim re-election, she has seen her popularity plummet. Brazilians don’t seem to buy her innocence regarding the corruption at state oil giant Petrobras. The country is seeing record street protests. Calls for her to step down are growing.
Meanwhile the Brazilian economy is also under pressure. The Real is down 24% this year against the US Dollar. Being a big natural resource exporter hasn’t helped either. With exports declining, even with a weaker currency the general uncertainty of doing business in Brazil has become tough.
Which brings us to Embraer, one of Brazil’s premier firms and a source of national pride for decades. Bloomberg published a story saying that Embraer is under pressure too. Noting the firm’s KC-390 military freighter program sponsored by the Brazilian Air Force is behind on $370m in payments. This has caused the company to delay the program by a year.
So how are the president’s problems and the national uncertainty impacting Embraer? What do the data really show? The answer is that while Embraer is impacted by the slowdown in defense, its commercial sector has strong a strong backlog, and the new E2 program is rapidly becoming a commercial success, offsetting that slowdown.
But the slowdown is real, and the weaker Brazilian state budget is a concern. But this has also been politicized because there are accusations Ms. Rousseff was less than forthcoming about the issue before the election. Back in May the Brazilian defense budget was cut by 25%. The lower revenues from defense in the last quarter are mainly related to currency: the payments are settled in Reals, which devalued in the period, leading the company to lower its guidance for the year in dollars. Clearly, these actions cannot and did not leave Embraer unscathed, while political and economic uncertainty is also impacting Embraer’s employees. With an unsettled environment, it is no surprise Embraer’s CEO remarked: “What we do not expect is new surprises like what we had this year.”
How Embraer actually doing and what is the company’s risk profile given this environment? The size of the KC-390 project is significant. The financial risk is large even though they have a sponsoring customer. Slowed payments will impact the company’s cash flow. The chart below demonstrates that the military side of the company’s business is about 22%, and of that the KC-390 is a part, perhaps even the biggest part. But it’s not a show stopper.
With 60% of the company’s business in commercial aviation, this is the arena where most focus needs to be. The company is doing very well in the segment. Through June this year Embraer reached a record backlog of 531 aircraft. As the chart below shows, this is not only excellent news, but indeed is based on a remarkably popular aircraft family. Embraer’s commercial aviation segment is strong.
As Embraer has pointed out in its presentations, the company has 52% of the orders in the 70-130 seat segment. Crucially it has 60% of the deliveries – so it is selling well and delivering even better.
Consequently, considering that Embraer is a key exporter of high value technology products, with a global customer base (70 customers in 50 countries) Embraer is not facing as much risk as other Brazilian firms. Moreover, it prices its products in US$, so a weaker Real does might help its cost base.
This view is underscored by the financial community:
- Embraer SA had its “hold” rating reaffirmed by analysts at RBC Capital. This came two days after its price target lowered by analysts at RBC Capital from $36.00 to $33.00 and a “sector perform” rating on the stock.
- Embraer SA had its “buy” rating reaffirmed by analysts at Deutsche Bank. They now have a $35.00 price target on the stock, down previously from $40.00.
- Embraer SA had its price target lowered by analysts at Scotiabank from $38.00 to $34.00.
Financial research firm Zacks reports six market experts have marked it as a strong buy and four analysts have rated the company at hold. This suggests that even as the financial analysts see potential impacts from an unsettled Brazilian economy, the case for Embraer looks rather strong.
The Bottom Line: Brazil sells in US dollars, and its costs are in Reals. As a result, with lower local costs compared to revenues, margins could increase. That bodes well for its continued sound financial performance.