Our Thoughts On The Embraer-Boeing Joint Venture

|
About: Embraer S.A. (ERJ), Includes: BA
by: JP Research
Summary

Embraer announces Boeing JV worth USD 5.3 billion.

Deal unlocks a number of positive catalysts, including a special dividend or buyback.

Also catalyzes the conversion of 11 firm orders for the KC390.

Boeing will benefit from cost synergies but only over a longer term outlook.

Now that the Embraer's (ERJ) extraordinary shareholders’ meeting (EGM) is done and dusted, the terms and conditions for the creation of a joint venture to promote and develop new markets and applications for the multi-mission aircraft KC-390 have been officially approved. The next step will be to clear antitrust courts in several countries, including Brazil, the US, and China with deal close expected by late 2019.

We think the deal catalyzes a number of positive developments for Embraer – 1) higher special dividend on lower-than-expected tax expenses and separation costs, and 2) conversion of 11 firm orders for the KC390 (5 with Portugal and 6 with Skytech).

Background

Boeing (BA) will hold an 80 percent stake, and the remaining 20 percent will be held by Embraer. Note that major management, as well as strategic decision-making, will remain in Brazil.

(Source: BB Investimentos)

The transaction value for Embraer's commercial aircraft and services operations stands at USD 5.26 billion (100%), which represents a value of USD 4.2 billion for Boeing (80% stake). Embraer expects net proceeds after separation costs (taxes, warehousing and replacing) of USD 3 billion and intends to distribute the proceeds to shareholders by special dividend payment.

The JV will promote and develop new markets for the multi-mission aircraft KC-390 which Embraer will hold a 51% stake in, with Boeing holding the remainder. Per management, the deal aims to "unlock Embraer's full global sales potential" in the KC-390.

The joint venture has already been approved by the Brazil government in January 2019 and Embraer's shareholders approved the proposal in February 2019. However, the transaction is expected to close by the end of 2019 as antitrust hurdles remain to be cleared.

Rationale

Combine innovation and cost-efficient manufacturing with Boeing

Selling prices and profitability are the keys to success in this industry. The Embraer-Boeing JV will also provide manufacturing cost savings by production scale as well as market penetration. We think the participation of Boeing will be integral here. Additionally, commercial aircraft needs heavy capital expenditure in both technological and innovation to build up its competitiveness position, which we think Boeing will also be able to help with.

Strengthen executive jets platform and unlock its full potential

Embraer can leverage Boeing's global resources, sales expertise and customer relationships to support executive jets. Moreover, Embraer has a disadvantage in terms of margins vs. peers due to lower aftermarket services revenue at 15-20% compared to ~35% for Textron and ~25% for Bombardier (OTCQX:BDRBF) (after sales services are recognized as a higher margin).

Streamline executive jets and defense and security operations

Once again, Embraer can tap into new market opportunities by sharing Boeing's global relationships in both executive jets and defense aircraft, especially considering Boeing's experience in defense. Also, Embraer can tap into Boeing's customer base, which could boost sales of the KC-390 aircraft outside Brazil in addition to the annual synergies of about USD 50 million per year.

Short-term boost for shareholders

Embraer will receive USD 3 billion net from separation costs and intends to use ~USD 1.6 billion for a special dividend or stock buyback. The remainder will be used for potential investment.

Implications

We think Embraer's shareholders should be happy with the Boeing JV, especially with the prospect of a short-term special/stock buyback contributed from JV's proceeds.

However, the long-term outlook remains unclear but promising. The agreement allows Embraer to enjoy support from Boeing in scale in crucial segments such as defense & securities and the executive jet platform via access to Boeing's resources, customer base and relationships in major markets. These should help Embraer increase competitiveness and thus, improve profitability through production cost savings, leveraging on Boeing's bargaining power and supply chain.

For Boeing, we think the deal is largely neutral for earnings in the short term, but earnings should gradually increase in the medium to long term driven by cost synergies, which have been guided to USD 150 million per year. Longer term, we think the JV boosts competitiveness for Boeing in its executive aviation and defense business.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.