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.
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.
Lastly, United’s recently completed pilot agreement allows it to increase its fleet of large regional jets to 255 in the next few years, up from just 153 today. The near-term opportunity at United is thus approximately 100 planes. United will presumably use its new scope flexibility to replace some of its more than 350 regional jets with 50 or fewer seats. Moreover, United’s pilot contract allows it to increase the use of 76 seat regional jets even further if it also adds small narrowbodies to its mainline fleet. Embraer’s E-190 and E-195 aircraft are two of the three prime candidates to do this mainline flying.
As a result, Embraer could see a significant additional opportunity at United within a three- to five-year time horizon — perhaps 150 units, taking the current Delta “re-fleeting” initiative as a baseline. Of course, there is no guarantee that United will add small narrowbodies to its fleet, and it could also opt for competitor Bombardier‘s CSeries jets. However, with Delta reducing its 50-seat regional jet fleet to 125 by 2015, United will feel competitive pressure to reduce its small regional jet fleet to that ballpark as well. The economics (and lack of comfort) of 50-seat regional jets will make it problematic for United to be more reliant on them than competitors. Thus, while Embraer will still have to beat out Bombardier (and possibly new entrant Mitsubishi) for the contract, there will probably be significant demand for aircraft in the 70- to 110-seat range at United.
Conclusion
As I mentioned, growth in Embraer’s private jet and military businesses is helping to diversify Embraer’s revenue. Defense gains have been particularly strong recently, and Embraer recently won a key contract from the U.S. Department of Defense for supplying light aircraft. Nevertheless, the commercial-jet segment still represents 52% of revenue, and so its health is critical for Embraer’s overall financial success. Fortunately, there will be strong demand in the next few years from U.S. carriers for large regional jets. As long as Embraer can win its fair share of those contracts, the company will be just fine.
The article Is Embraer Finally in the Clear? originally appeared on Fool.com.
Fool contributor Adam Levine-Weinberg owns shares of Delta Air Lines and is short March $14 calls on Delta Air Lines. He’s also short shares of United Continental Holdings (NYSE:UAL). The Motley Fool recommends Embraer.
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