Air travel is booming: here’s an ambitious company set to grow
Matthew Partridge Feb 21, 2013
Despite the pall of gloom over much of the global economy, one industry is booming: air travel.
Last year, global passenger traffic grew by 5.2%. Asian and Latin American markets have seen rapid growth. Even Africa is starting to take off. At this rate, traffic will double in less than 15 years. And as world trade picks up again, firms are also spending more money on faster - and bigger - executive jets.
So how can you profit from this boom industry? Airlines are infamous for being dud investments by and large. But what about the companies who supply them?
The dominant suppliers in the commercial aviation market are Boeing and Airbus. But with both companies running into problems with key aircraft, this might not last for much longer.
And one company in particular looks set to benefit…
From basket case to rising star
At the moment, the commercial aviation sector is sewn up between Boeing and Airbus. They produce 80% of all commercial aircraft and nearly all large jets.
But this lack of competition has made them complacent. Both companies’ flagship planes have run into trouble. Boeing has been forced to ground its 787 Dreamliner due to safety concerns, in some cases forcing airlines to fall back on 30-year-old planes.
And even although Airbus’ A380 was launched in 2006, the company has had major problems with it. Production has been very slow, resulting in cancelled orders, while cracks were also found inside some wings.
These problems leave a gap in the market for an ambitious rival. And one former Brazilian basket-case company looks set to fill it: Embraer.
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In the 1990s, Embraer was a mess. It was run by the state, which meant that politics rather than profits drove decisions. One of the worst examples of this in action was when it wasted a pile of cash on a joint venture with an Argentinian rival. The companies created a turboprop plane that was advanced for its size, but it was too expensive for anyone to afford.
But things have changed. The company was privatised. No longer bankrolled by the state, it learned the importance of cost control, and of targeting customers and selling to them, rather than coming up with a grand project and worrying about the market afterwards.
So, having realised that much of the technology it had developed would be better suited to small, regional jets, Embraer started to focus on that market. An order from US airline Continental, provided the cash flow needed to turn its finances around.
It reinvested in new models, which could hold more passengers. From carrying just 20 people in the state-run days, and 50 in the 1990s, Embraer’s biggest model can now carry up to 122 passengers.
That’s very close to the 130-seat capacity that would enable Embraer to start taking a share of the crucial big jet market – which has been almost totally controlled by Boeing and Airbus up until now.
Embraer’s battle plan
So how will Embraer bring the battle to the big boys? Well, it won’t be launching any problem-prone brand new planes. Following a review of the business, the company has decided that the costs of building new aircraft from scratch are too high.
Instead, it plans to save money by making existing aircraft bigger, more fuel-efficient, and more powerful. This will enable Embraer to increase capacity gradually, so that it starts to become a feasible alternative to the smallest planes produced by Boeing and Airbus.
As well as reducing the amount of investment needed to build bigger models, this also means that Embraer will still be able to satisfy the needs of its current customers. This provides it with a fallback option in case Boeing and Airbus are able to defend their turf.
The official line is that these upgrades will happen by 2018 at the latest. However, the company has dropped broad hints that it could take place a lot quicker. The bidding and contracting process has moved quickly - already Pratt & Whitney has been selected as the engine manufacturer.
And there’s another area where Embraer is already starting to encroach on other manufacturers: freight transport. The KC-390 aircraft has expanded Embraer’s range within the lucrative military market. While it uses Boeing technology, it gives Embraer valuable experience in designing large-scale planes. It should also enable the company to benefit from increased military spending by Brazil.
Even if Embraer’s moves to expand its range are delayed, the core business is doing well. Whiles sales were sluggish for parts of last year, they picked up strongly in the final quarter. Two big customers, United Airlines and American Airways have recently cut a deal with their pilots, which is usually a prelude to an increase in fleet size.
Another key growth area is its business jet unit. In 2008, it had a 3% share of the market. That’s grown to 15%, and with its latest models, it is expected to see that double again.
Embraer (NYSE: ERJ) trades on 12.3x forward earnings, which look reasonable given its growth prospects. It’s also inexpensive on a price/book basis, compared to its rivals: it is valued at 1.9 times its book value, compared to EADS and Boeing which are valued at 3.1x and 9.7x respectively. If you want to profit from the growing market for air travel out there, this is the company to back.
• This article is taken from the free investment email Money Morning.
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