Cheap Stock With Ample Growth Drivers

By Ankit Agrawal - September 16, 2012 | Tickers: ERJ, GD, LMT, NOC, RTN | 0 Comments

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The stock prices of Embraer SA (NYSE: ERJ) saw a huge downfall after the company reported its Q1 results. Despite posting strong 2Q operating results, with gross margin and EBIT margin both coming in better than expected on in-line sales, the shares have failed to recover. However, I like company’s positioning in the business jet market and the Brazilian security in its defense segment. I believe Embraer's commentary for 1X book to bill, particularly in the commercial jet portion of the company's business, will gain traction among investors. While Embraer’s shrinking backlog remains a concern at this time, the industry is highly cyclical and I believe it is a matter of time before new orders start piling up. Going forward, I believe double-digit EPS growth is achievable even after assuming lower than expected regional jet production.

Market Share Gain in Midsize Business Jets

Beginning in 2013, Embraer has plans to bring two new mid-size business jets to market. I expect any recovery in the mid-size business jet market to be driven by replacement demand postponed during the prior downturn. I believe that the introduction of these two mid-size business jets will provide a significant opportunity to capture more of the market in FY14 and FY15.

Brazil : Prime Growth Driver

Brazil represents 54% of Embraer’s total defense sales. The Brazilian Ministry of Defense seeks to match the other BRICs and protect its natural resources including the Amazon rainforest and offshore oil reserves. Therefore, they are calling for an increase in its defense budget from 1.5% of GDP currently to 2.3%. As a result, I see several years of double-digit organic growth for Embraer’s defense business (15% of total 2012 revenues) given drivers like SISFRON border security system and satellite for the Brazilian Army. The company has also entered into an agreement with Boeing Company to develop the KC-390, a new mid-size military transport and refueling aircraft.

Recovery in Regional Jets

While RJ orders have been weak, I expect a recovery from recent depressed levels as I expect upside to current industry production rates. I think Embraer can trade higher on strong relative EPS growth, along with improving RJ orders and cash generation driven by higher customer deposits and lower cash R&D spend.

Low Valuation

The following table summarizes the forward PE and expected EPS growth next year of Embraer and its peers including Northrop (NYSE: NOC), Raytheon (NYSE: RTN), General Dynamics (NYSE: GD) and Lockheed martin (NYSE: LMT):

Embraer is trading  at a forward P/E of 9.44, which seems to be on the lower side as the company's expected EPS growth is highly impressive on a forward basis. The company has also outperformed in terms of book-to bill, with a ratio above 1x in the last three years as compared to its closest regional peer, Bombardier. I believe Embraer’s discount valuation reflects overblown risk to its regional jet production rates given recent order weakness and new competitors entering the market.

I am optimistic regarding Embraer’s outlook given potential new orders from regional customers, as well as opportunities from the US defense market and better seasonality for deliveries and backlog formation in 2H12. I see double-digit growth driven by a ramp up on new bizjet models and KC-390 military aircraft, as well as increased Brazil security spend ahead of 2014 World Cup and ‘16 Olympics. Despite the prospects of continued margin gains and strong revenue growth at Defense and Executive, I think the market is overwhelmingly concerned about the commercial/regional jet division’s outlook after the poor order flow this quarter. I am bullish over this stock for long term.  

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