One of the most successful investors and the second (now third?) richest man in the world Warren Buffett did not mince words when expressing his thoughts about investing in airline companies:
If a capitalist had been present at Kittyhawk back in the early 1900s, he should have shot Orville Wright. He would have saved his progeny money. But seriously, the airline business has been extraordinary. It has eaten up capital over the past century like almost no other business because people seem to keep coming back to it and putting fresh money in.
You've got huge fixed costs, you've got strong labor unions and you've got commodity pricing. That is not a great recipe for success. I have an 800 (free call) number now that I call if I get the urge to buy an airline stock. I call at two in the morning and I say: “My name is Warren and I'm an aeroholic.” And then they talk me down.”
Sure, there are exceptions to this rule such as Southwest Airlines (NYSE:LUV), SkyWest (NASDAQ:SKYW) and British Airways (OTC:BAIRY), but this general rule of thumb has been pretty much accurate. Have the companies that actually supply aircraft to airlines companies fared any better? When you look at a 5 year chart of Boeing and Airbus parent EADS, you realize that the very competition that hurts the airlines proves highly beneficial to the aircraft makers as it translates into new orders.
Despite being plagued by delays in releasing its A380 "super jumbo" plane, the stock of EADS is still up over the last five years, a period of time defined by bankruptcies of many US airline companies. The only airline companies that have done well recently are small domestic airlines in emerging countries or large ones that cater to international long haul traffic.
Instead of investing in risky, capital intensive and often difficult to obtain small international airline stocks, investors could instead choose to invest in aircraft companies like Brazil based Embraer (NYSE: ERJ) that happens to be in one of the BRIC (Brazil, Russia, India and China) nations and primarily satisfies the need for small and regional jets with 30 to 120 seats. The kind that I tend to fly a lot. Embraer also makes executive jets such as the Legacy 600 and has recently started moving into the red-hot ultra-light jet market with its Phenom series, the smallest of which the Phenom 100 is priced at just $2.98 million.
Embraer does not appear to be content by catering to these two segments and has bigger plans for the future by building larger planes that can compete with offerings from Boeing and Airbus. There is certainly a lot of execution risk in this strategy but I do not expect the company to attempt anything on the scale of the Boeing 787 Dreamliner or the Airbus A380. I would expect Embraer to focus on the small end of the large airplane segment like the highly popular Boeing 737. To get a glimpse into just how hot this segment of the market is, check out this story titled Stocks, bonds... or jets in Fortune magazine that details how difficult it is to get hold of a 737 and how hedge funds and private equity firms are getting in on the action.
Embraer currently gets a majority of its business from North America but is looking Eastward for growth from countries like India and China.
In addition to the incumbent state-owned airlines like Air India and Indian Airlines, the airline industry in India has been booming over the last few years with various new entrants such as Damania (now defunct), Kingfisher, Jet Airways and Air Deccan. This increased competition has led to a wave of mergers recently with Air India merging with Indian Airlines, Jet Airways acquiring Air Sahara for $300 million and Kingfisher Airlines attempting to acquire Air Deccan.
However, as many observers have noted, this consolidation may be a little premature as the airline industry in India is expected to experience tremendous growth in the future. A burgeoning middle class and rising salaries will shift some traffic from Indian Railways, which is currently the primary means of domestic travel to airlines, which have reduced fares to a point where they are within the reach of the middle class. Embraer is slowly beginning to make inroads into the Indian market though regional discount carriers like Paramount Airways.
The story is similar in countries such as China that are experiencing similar trends. Embraer and China Aviation Industry Corporation (OTC:AVIC) created a joint venture called Harbin Embraer Aircraft Industry (HEAI) in 2002 to manufacture Embraer jets locally in China to meet domestic demand. Embraer received a large order of 100 regional jets in September 2006 from China’s Hainan Airlines for $2.7 billion.
Embraer did see some shifting in its order backlog recently when JetBlue decided to delay delivery of 16 Embraer 190 jets from 2013 to 2015. However the pipeline for the company look very strong with an order backlog of $15.6 billion as of the second quarter of 2007. Embraer has been lagging the Brazilian Bovespa index year-to-date but as you can see from this glimpse into the future the company provided in November 2006, the company expects to fly high for years to come.
Note: If you adhere to the principles of socially responsible investing, please note that Embraer derives 5.9% of its revenue from defense aviation.
As the third largest aircraft maker in the world, Embraer faces competition from industry behemoths Boeing (NYSE:BA) and Airbus as it attempts to build higher capacity planes. Embraer also faces direct competition from the CRJ line of commercial jets from Bombardier as well as the plethora of companies like General Dynamics (NYSE:GD) (maker of the popular Gulfstream jets), Textron (NYSE:TXT) (maker of the Cessna Mustang) and privately held Eclipse that are active in the light jet sector.
At 32 times earnings, Embraer may appear to be pricey until your consider the order pipeline and the fact that this company is selling for less than 12 times 2008 earnings. The PEG (Price/Earnings/Growth) ratio is a low 1.02. The company has over $2 billion in cash and short term investments on its balance sheet and $893.8 million in current/short term debt.
After posting double digit sales and earnings growth from 2003 to 2005, both sales and earnings declined in 2006. This drop was on account of production issues related to wing assemblies that lead to a delay in the delivery of 15 airplanes that were originally slated to be delivered in 2006. For further details, including a month to month breakout of events, check out the very well put together and easy to navigate 2006 annual report.