ERJ - Embraer

[chesko182]

Came across this idea last week from (you’ll never guess) Bank of America Research. Embraer is the third largest aircraft manufacturer in the world, but much smaller than the industry dominants Boeing and Airbus. It is based in Brazil and has three segments: commercial planes, executive jets and defense/military planes. A month ago Boeing announced it had entered into a non-binding agreement to form a Joint Venture with Embraer for their commercial planes business, where Boeing will own 80% and Embraer the remaining 20% (effectively acquiring the business), as a result Boeing is set to pay Embraer $3.8bn for the 80% stake, valuing it at $4.75bn. Embraer expects to receive $3.1bn after-tax and return a chunk of that to shareholders via buybacks and dividends. Debt is expected to be around 400mm after the transaction, so approximately 2.7bn will be available to return to shareholders, management has stated that they intend to return at least 1.7bn or $9 per ADR.

 

The stock (ADR) had been trading around $24 and has promptly sold off to $19, in part due to broad selloff of Brazil and EM related stocks. That leaves the “stub” (19-9) valued at $10, where you basically get: 1) Embraer’s stake in the JV 2) Executive Jet business 3) Defense business 4) any remaining cash that is not returned to shareholders (assuming they return 1.7bn it would be 1bn (net of debt)

 

To be clear, I have to do more work on the value of the other two businesses, but from a first peak it looks like the stub is trading very cheap.

 

JV value (20%): 950mm

Cash after tax, net of debt: 2,700mm (prior to any distributions)

Executive Jet + Defense biz: 1,250mm (very quick math...management expects 2.5bn of revenues between these two segments, 5% profit margin and 10X multiple assumed, which I think are conservative)

Total 4.9bn vs current market cap of 3.3bn roughly 50% upside.

 

The big question is if the Brazilian government/regulators will approve the transaction. There will be presidential elections in October, and this may be a large determinant. If the right wing candidate wings the odds of this passing are higher than if the left wing candidate wins. Currently the right-wing candidate is leading the polls.

 

Clearly I need to do more work but I found this interesting, would love to hear anyone's thoughts on this.

 

[Pondside47]

Thanks for the idea. The prospect of defense and executive jet business seem to be on the upside since both are at cyclical trough. Without the injection of cash from Boeing, the commercial unit is on its way to generate significant amount of cash in the near future as investment level comes down. It could be a double with one bird already in hand if management will return the cash to shareholder.

[Guest Own The Rails]

Thanks for sharing, very interesting opportunity.

 

FT piece on the deal's uncertainty: https://www.ft.com/content/15b2f0e2-8095-11e8-bc55-50daf11b720d

 

One thought: While Bolsonaro (right-wing) is definitely a pro-business candidate, he is also a staunch nationalist. So I'm not sure how his base would react if he supported giving up control of a proudly Brazilian enterprise (may be oversimplication but feels similar to how Trump has lambasted US-based industrials reliant on foreign manufacturing).

 

The fact that the government is also an equity holder makes me a bit uneasy. Do we know what their approx share is?

[chesko182]

From the news articles I've read, it seems like Bolsonaro (right-wing) would approve the deal and Ciro Gomes wouldn't. From WSJ article:

 

"The front-runner in Brazil’s elections, Jair Bolsonaro, a right-wing former army captain, has largely backed the partnership with Boeing. Brazil, one of the most closed emerging-market economies, “cannot isolate itself from the world,” he said in a recent television interview."

 

It is also possible this closes before the new president gets inaugurated in January. Another possibility is that Boeing increases the price (if shareholders are not satisfied) as Boeing is also being "forced" into this deal given that Airbus and Bombardier already formed a partnership and this is the only other major company left in the smaller planes segment.

 

Not sure how much % the govt owns, but it's called a "golden share" and they can veto any decision. Boeing originally wanted to buy the whole company but the government doesn't want to give up control of the military/defense business. It seems that this came into play in their decision to structure the deal in a way that only included the commercial business. I'm guessing they held talks with the government and figured this had a better chance of going through.

 

I've initiated a small position, seems like a decent bet, market is pricing no chance of this going through at the moment.

[Guest Own The Rails]

Looks like Lula has a ton of pent up support: https://www.reuters.com/article/us-brazil-election-poll/brazil-poll-shows-jailed-lula-extending-lead-for-october-election-idUSKCN1L51J3

[mjm]

would not dividends have 25% tax withholding? would they qualify for 15% tax treatment?

[chesko182]

Deal approved by brazilian government, up 10% pre-mkt. Pending is now board and shareholder approval, Brazil and US antitrust. I don't see any issues here. Prob another 10-20% upside left.