Embraer: 41% Upside As Vaccinations Speed Up In America And Europe

Summary

• North America and Europe are likely to reach herd immunity by the end of 2021. 81.5% of Embraer's revenue streams come from these regions.
• Target price of $15.94 by the end of 2021 seems reasonable, 41% upside from current levels.
• Key risks include new circulating COVID-19 variants and sustained international travel restrictions.

Photo by Grandbrothers/iStock Editorial via Getty Images

Thesis

Geographical segmentation of revenue shows that 81.5% of Embraer's (NYSE:ERJ) revenue originates from North America and Europe. Extrapolating on current vaccination rates, it is likely that North America and Europe will reach herd immunity by the end of 2021, restoring demand from these key geographies for Embraer and positively affecting revenue streams.

A fair share price would be $15.94 by the end of 2021.

Risks include any novel circulating COVID-19 variants that could derail herd immunity efforts and sustained international flight restrictions.

Embraer

Embraer - Empresa Brasileira de Aeronáutica S.A., is a Brazilian aircraft manufacturer, founded in 1969, headquartered in São Paulo. The company has over 12,000 employees and is one of Brazil's largest export companies. It produces aircraft for both civilian and military use. It mainly manufactures small and medium-sized passenger aircraft with a capacity of up to one hundred passengers. Embraer was originally state-owned but was privatized in 1994.

Embraer has been particularly hit by the COVID-19 crisis, as have all airline-related stocks. Embraer's recent market outlook projects 19% smaller growth until 2029.

Source: Embraer 2020 market outlook

The reduced growth rate is primarily due to the corona-induced lockdowns and global flight restrictions imposed by countries to reduce the coronavirus's spread. As such, international travel was reduced by 89% in February 2021 compared to February 2020, according to IATA.

Flight restrictiveness

Source: IATA

If we look at the global map above, we can clearly see the severe impediments in global aviation today. The pace at which these will be lifted is largely contingent on the success of each country vaccinating its population until it reaches herd immunity or the populus acquiring natural immunity.

If we analyze current vaccination rates, it is clear that mature market economies are at the forefront of having their populations vaccinated first, with Israel, the UK, Chile, and the U.S. being the leaders.

Source: Our World in Data

Since herd immunity is achieved at roughly 60% of the population acquiring immunity, it will be the mature market economies that will reach these milestones first due to ample vaccine supplies.

As the chart shows, the bottleneck is vaccine supplies that fluctuate depending on drug manufacturers' production capacity, temporarily slowing down vaccination efforts.

Emerging markets will be vaccinated after mature markets as vaccine supplies are usually distributed from the WHO's COVAX-facility, and mature market economies beginning exporting superfluous vaccine stockpiles left after their population is fully vaccinated.

If we use simple logic and look at the % of people being administered at least one dose since the beginning of 2021 or late 2020, we can see that by almost 4-5 months: 60% of Israelis, 47% of Britons, and 38% of Americans have received at least one dose. If we extrapolate these figures, we can begin to guess and perceive it is a likelihood that these mature markets will become fully vaccinated by the end of 2021.

Once this happens, vaccines will become distributed to other geographies in need of vaccine supplies. Most likely, this sharing will occur to E.U. countries as mature markets usually obtain vaccines before emerging markets due to higher purchase prices and negotiated commitments.

Understanding vaccination rates is important. It will allow us to gauge and provide a range of scenarios in estimating when flight restrictions will be lifted, acting as a proxy and barometer for plane demand. Coupled with a geographical segmentation of Embraer's revenue streams, vaccination rates will provide us with insights into when demand will pick up in select geographical areas and increase revenue streams from that area.

Source: Embraer 2020 annual report

If we analyze the geographical segmentation, we can see that North America makes up 2,532.5/3,771.1= 0.67155471878. 67% of Embraer's total revenue streams.

If we add Europe to North America, (2,532.5+544)/3,771.1=0.81580971069. 81,5% of Embraer's revenue streams are comprised of North America and Europe.

Since we already see that North America and the E.U. are most likely to reach herd immunity most quickly, it is very likely to expect revenue streams to pick up from Q2 of 2021 in the U.S. and Q2-Q4 of 2021 in Europe.

According to the posted vaccination rate chart, Brazil will lake a bit longer before revenue streams pick up as currently administered doses are at roughly 10%. Administration of 1 vaccine dose appears highly protective on its own (2 doses is optimal), so using it as a metric to approximate herd immunity is logical.

The company itself expects a -19% reduction in RPK growth rates, and while this might initially seem reasonable, it is important to note that these estimates tend to be revised as the outlook improves. It is therefore critical not to take these figures at face value.

If we were to make a quick approximation and analyze Embraer's share price before the onset of the COVID-19 crisis and compare to where it should be if we subtract -19%, we would arrive at something seen in the chart below.

Source: Koyfin

-19% places the stock's value at $15.92, which is 15.92/11.28=1,411.41.1% upside. Please note that this is in the event of the bleakest scenario of -19%. If we were to illustrate a range of pessimistic-optimistic scenarios regarding RPK growth rates, it would look like this.

Growth RPK (revenue passenger kilometer)	Share price $ (19.68 is Pre-COVID)	Upside from the current price ($11.28)
0%	19.68	19.68/11.28=1.74 (74%)
-5%	19.68*0.95 = 18.696	18.696/11.28=1.65 (65%)
-10%	19.68*0.9 = 17.712	17.712/11.28= 1.57 (57%)
-15%	19.68*0.85= 16.728	16.728/11.28=1.48 (48%)
-19%	19.68*0.81=15.94	15.94/11.28=1.41 (41%)

Click to enlarge

Source: Author calculations

Now I have not calculated in potential FX effects between the USD/BRL, so this is an important aspect to keep in mind. For investors wishing to obtain an understanding of how FX rates affect Embraer, I recommend reading page 18 in their latest annual report. Furthermore, this range of scenarios for RPK projections' growth could be potentially revised higher as we approach herd immunity in key geographies for Embraer.

Critically, these calculations and projections are based on a Ceteris Paribus model, meaning that they are only valid as long as the underlying microeconomic factors at the company level do not change, which could materially alter the range of target prices. Factors such as these could be rises in debt levels as an example, leading to increased interest expenses and acting as a drag on cash flows. It is important to note that Embraer's maturity profile is 3.8 years, and its cash position is strong as of their latest figures. This means that imminent debt is rolled over to later years.

Again, this is not a pure DCF-model, but rather a logical top-down analysis of the market developments currently unfolding in the space Embraer operates in. If the share price results from future discounted cash flows, then assumptions underlying the DCF-model need to be properly modeled and accounted for. I believe market participants have overlooked these factors.

Usually, a proxy for cash flows is EBITDA, but for the CapEx-intensive sectors, we could use EBITDA-CapEx. I will choose to use EBITDA to provide a slightly more intuitive understanding. Even though it might be less accurate, it will demonstrate my point more succinctly without superfluous complexity.

Let us now compare analyst estimates & target prices before the onset of COVID-19 and where we are today.

Source: Koyfin

Before the onset of the COVID-19 crisis, we can see that the average target price was at $22.5, and the high target price was at $30. It is important to note that analyst target prices of emerging market companies, such as Brazil, should be met with caution.

The long-term growth of economies fluctuates. Therefore, some projections may turn out to be a non-economic terminal growth rate. This effect can be especially strong for Emerging Markets equities as EM economies tend to have a more volatile long-term growth rate. While having volatile long-term growth rates, EM equities tend to be covered less by Equity Research Analysts so the existing research reports and price targets must be reviewed with caution.

An Introduction To Forecasting Growth and Revenues

Now arguably, one could say that Embraer is an exception to this case since the majority of their revenues are not derived in Brazil, and the sheer size of the company and prominent sell-side banks covering the company outweighs this cautionary fact. Nevertheless, for transparency, I felt it was important to mention this.

This lets us adopt a cautionary tone and analyze the $22.5 target price. Estimates for FY 2021 EBITDA were, before the Corona crisis, at $681.72m and currently at $318.69m for FY2021.

Let us now assume that North America and Europe become fully vaccinated by the end of 2021. Since we know that they make up 81.5% of Embraer's total revenues by geographical segmentation and factor in different reductions in the total market growth of RPK, we can arrive at an approximation of different ranges of EBITDA.

EBITDA estimate FY2021 - 2020-01-01	North America + Europe, % of total revenues	RPK projected growth rates	Estimated FY2021 EBITDA for North America + Europe
$681.72m	0.815	-19%	$681.72m * 0.815 *0.81= 450.037458m
$681.72m	0.815	-15%	$681.72m * 0.815 * 0.85= $472.26153m
$681.72m	0.815	-10%	$681.72m * 0.815 * 0.9=$500.04162m
$681.72m	0.815	-5%	$681.72m * 0.815 * 0.95= $527.82171m
$681.72m	0.815	0%	$681.72m * 0.815= $ $555.6018m

Click to enlarge

Note that these calculations factor in a range of scenarios. It is not certain if North America or Europe in combination would show these reductions as I assume in RPK growth rates, meaning that it could be lower or higher. But the table provides one with insights as to what would happen with estimated EBITDA for 2021 as vaccinations accelerate in North America and Europe.

It is evident by analyst estimates that EBITDA in Q3 and Q4 of 2021 accelerates, but the question remains at what pace. I believe that analyst estimates have not accurately factored in the swift vaccination rates currently unfolding in North America and Europe.

If we use EBITDA as a proxy for cashflows, and all else is equal, $450m is quite a steep number, not seen for several years in Embraer's history. The last time EBITDA was near $450m was almost 6 years ago. Obviously, these figures seem rather far-fetched as they are counter-intuitive to the pandemic we are currently experiencing.

$450m in FY2021 EBITDA (North America + Europe) in comparison to current FY2021 EBITDA estimates at $318.69m (All geographies), is 450/318.69=1.41. 41% higher than current EBITDA estimates.

Risks

One of the key risks in these calculations is the assumption that vaccines are immune to any mutating strains currently circulating. If COVID-19 variants emerge that circumvent vaccine-acquired immunity, there is a likelihood that these calculations fail to materialize and that all equity markets take a nose-dive, irrespective of sector or Embraer.

I consider this possibility to be low, as new variants have shown some signs of surpassing immunity but not to the extent of causing massive issues.

Furthermore, one of the key risks in my calculations is the assumption of factoring in that demand in North America, and Europe will show a -19% reduction, whilst it could, in reality, be more nuanced and complex. Just because projections are -19% for the entire market does not necessarily mean that it is the same figure for select geographies such as North America and Europe.

Furthermore, these RPK estimates tend to change as global developments change, altering the illustrated scenarios. Also, using EBITDA as a proxy for cash flow is not always ideal, with DCF-models being more accurate or EBITDA-CapEx for more capital-intensive industries being more accurate.

I find my own EBITDA estimates to be slightly counter-intuitive as well as current analyst estimates. So these should be taken with a grain of salt.

Particularly, taking the $19.68 * negative RPK growth rate scenarios, concerns with all key markets in Embraer being fully vaccinated. The EBITDA estimate calculations are more for calculating potential EBITDA for North America and Europe.

It is important to note that given the nature of forward-looking markets, it could very well be that these calculations and estimates are wrong for 2021 but materialize in 2022 and subsequent years. In other words, just as the markets begin seeing herd immunity in the U.S. and Europe, they could price in growth in other parts of the world before they start materializing just on the basis of positive developments in Northern America and Europe.

Summary

Embraer has, as all airline stocks have been, particularly hit by the current COVID-19 crisis, but it shows positive signs of recovering. Vaccination rates in the U.S. and Europe, are a very positive sign for the stock, as 81.5% of Embraer's revenue streams by geographical segmentation come from these areas.

If we extrapolate current vaccine rates, there is a very high likelihood that the U.S. and Europe will reach full herd immunity by the end of 2021.

Current projections of reductions in RPK are at -19% until 2029. In such an event, the stock is underpriced by 41% from current levels and is poised to move higher. In other scenarios, there is more room for bullish estimates of the stock.

I would set a target price of $15.94 by the end of 2021, and $16.728-$19.68 for 2022.

Analyst’s 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.