Doing some catch up on this stock. I dropped Embraer (ERJ) from the Jubak Picks 50 long-term portfolio (see my post http://jubakpicks.com/2011/01/18/6215/ ) on January 18, but this is the first time I’ve had an opportunity to explain why in detail or to actually remove it from the portfolio. I’m working on explaining the other sells and buys announced on January 18 from that group over the next week or so.
Successful strategies don’t work forever. And at Brazil’s Embraer (ERJ), the fourth largest airplane maker in the world, the strategy of moving from small to larger regional jets looks like it’s going to force the company to go head to head with some increasingly tough competition.
Embraer’s strategy has worked like this. The company, which built its business around the ERJ 145 family 37- to 50-seat of regional jets has gradually moved up to the larger 70-122 seat regional jet market (ERJ 170/190 family.) Smart move. The larger jets let airlines looking to reduce capacity (unfilled seats) by flying something smaller than the standard offerings from Boeing (BA) and Airbus use Embraer’s planes and still offer customers a jet instead of a propeller-driven aircraft. Embraer’s offerings also matched the heyday of short-haul feeder operations designed to funnel traffic into long-haul hubs.
That strategy produced average annual revenue growth of 24.2% for the five years that ended in 2008. And it let Embraer take over the top ranking in the regional jet market from Bombardier with Embraer’s share climbing to 46% from 23% in 2002.
But Embraer is about to see competition really step up in that market. The company’s traditional rival Canada’s Bombardier has a 100-seat regional jet just entering the market and its C Series, seating 110-130, is scheduled to go into service in 2014. But the company also faces big challenges from new competitors: Chinese aircraft maker COMAC has a 90-seat regional jet ready to enter the market, Russia’s Sukhoi, a 95-seat regional jet, entered service in 2010, and Japan’s Mitsubishi is planning to bring a 75-96 seat regional jet into service by 2015.
The Chinese competition will be an especially tough test for Embraer since China is one of the world’s fastest growing markets for air travel and the company formed a joint venture in 2002 to sell aircraft into China.
The timing of this challenge could be better for Embraer. The company doesn’t have a new regional jet model set to go into service against these new offerings from competitors.
The company had an order backlog of $15.3 billion as of September 2010—that’s roughly three year’s revenue. But the backlog has been in a steady decline since a peak of almost $22 billion in 2008.
Faced with increasing competition and rising commodity costs, operating margins will slip in 2011, Standard & Poor’s calculates, from 7.2% in 2010 to 6.8%. In 2011 what S&P projects as a 20% increase in sales should balance out that decline in operating margins.
That should be enough to let Embraer meet Wall Street estimates for earnings growth of 23% in 2011. (The current price to earnings ratio is 24.) But it’s the time period after that and the pickup in competition that I have to worry about in the long-term Jubak Picks 50 portfolio. Which is why I sold the stock out of my long-term portfolio on January 18.
Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund, may or may not now own positions in any stock mentioned in this post. The fund did not own shares of Embraer (but it did own shares of Boeing) as of the end of December. For a full list of the stocks in the fund as of the end of December see the fund’s portfolio at http://jubakfund.com/about-the-fund/holdings/