The Boeing Company (BA): Is Embraer SA (ADR)(ERJ) Finally in the Clear?

Regional jet manufacturer Embraer SA (ADR) (NYSE:ERJ) gave investors a scare in late 2012, when slow sales of E-Jets aircraft for the 70- to 110-seat market raised the specter of production cuts. The company’s order backlog was only $12.5 billion by the end of 2012, down nearly 20% from the beginning of the year. At only 2 times annual revenue, Embraer SA (ADR) (NYSE:ERJ)’s order backlog is much lower than the comparable figures for competitors such as The Boeing Company (NYSE:BA) , which has a backlog equal to seven years of revenue.

Embraer SA (ADR) (NYSE:ERJ) does expect somewhat slower commercial aircraft production in 2013 with 90 to 95 deliveries, compared with 106 in 2012. However, the growing popularity of two class regional jets for the big U.S. network carriers creates a significant opportunity for Embraer SA (ADR) (NYSE:ERJ) to fill open delivery slots for the next few years while rebuilding its order backlog. Furthermore, the company is diversifying its revenue base by growing its private jet and military segments; combined, these will reach nearly half of total company revenue in 2013. These trends may have finally put Embraer SA (ADR) (NYSE:ERJ) on the upswing.

The growing American opportunity

While the U.S. aviation market is mature, demand for large regional jets such as Embraer SA (ADR) (NYSE:ERJ)’s E-Jets is very robust today. This is the result of three factors. First, the rapid rise of oil prices over the past decade has made fuel efficiency critical, and large regional jets burn much less fuel per seat than 50-seat and smaller regional jets. Second, large regional jets can accommodate a first-class section and/or premium economy seating and are more comfortable than 50-seaters in general. These amenities can help attract higher-yielding business passengers. Third, the “Big Three” airlines — Delta Air Lines, Inc. (NYSE:DAL) , United Continental Holdings Inc (NYSE:UAL) , and American Airlines — have all successfully negotiated with their pilots over the past year for the ability to increase usage of large regional jets.

Delta is the furthest ahead on this strategy and is in the midst of executing a plan that will reduce its 50-seat regional jet fleet from 313 at the end of 2012 to just 125 by the end of 2015. Many of those will be replaced by Boeing 717 mainline aircraft, but there will also be an increase in large regional jet flying.

United and American will see even more growth in large regional jet flying. According to a recently signed pilot agreement, American is permitted to operate more than 300 76-seat regional jets (such as the Embraer E-175), compared with just 47 previously. Embraer has already benefited from this change, as it recently received an order from Republic Airways Holdings Inc. (NASDAQ:RJET) for 47 E-175s to be operated for American. Deliveries will run from mid-2013 through 2015, and Republic has options for another 47 aircraft. American and its merger partner US Airways Group, Inc. (NYSE:LCC) will probably look to grow their 76-seat fleet further to better compete with Delta, which gives Embraer a good chance of converting these options to firm orders.