EMBJ

Business Context and Reporting Period

Embraer S.A. (NYSE: ERJ) reported its unaudited financial results for the third quarter of 2013 (ended September 30, 2013) and the first nine months of 2013. The company operates in three primary segments: Commercial Aviation, Executive Aviation, and Defense & Security. The reporting period reflects a strategic shift in revenue mix, with increased contributions from Defense & Security and Executive Aviation offsetting a decline in Commercial Aviation deliveries.

Key Financial Metrics

Material Changes vs. Prior Period

• Revenue Decline: 3Q13 revenue fell 8.1% year-over-year to $1,288.2 million. This was driven by lower commercial aviation deliveries (19 aircraft vs. 27 in 3Q12) and a product mix shift toward smaller E-Jets (E170/E175).
• Margin Compression: Gross margin decreased to 19.2% from 25.2% in 3Q12 due to lower operating leverage and the product mix shift. EBIT margin declined to 5.9% from 7.2%.
• Backlog Growth: Despite lower deliveries, the firm order backlog grew to $17.8 billion, the highest level since 3Q2009, driven by significant orders in the Commercial Aviation segment.
• Liquidity Shift: The company moved from a net cash position of $58.0 million in 2Q13 to a net debt position of $19.6 million in 3Q13. This $77.6 million decline was primarily due to a $257.5 million increase in inventories in anticipation of higher 4Q13 deliveries.
• Expense Management: Administrative expenses decreased to $51.3 million from $58.9 million in 3Q12. Research expenses dropped significantly to $9.2 million as E-Jets E2 program costs were capitalized as intangible assets.

Guidance, Outlook, and Risks

• Outlook: Management expects Free Cash Flow to improve by year-end as inventories decrease with anticipated higher deliveries in 4Q13. The company projects 2013 Research expenses to remain below the $100 million outlook.
• Segment Strategy: Defense & Security and Executive Aviation segments are expected to represent a larger portion of total revenues in 2013 compared to 2012, aligning with the company's diversification strategy.
• FX Hedging: To mitigate exchange rate risks, the company has hedged approximately 60% of its 2014 Real exposure if the USD depreciates below R$ 2.00, with upside benefits capped at an average rate of R$ 3.50.
• Legal Contingencies: An ongoing internal investigation regarding potential non-compliance with the U.S. Foreign Corrupt Practices Act (FCPA) continues in response to SEC and DOJ inquiries. The company states it is not possible to estimate the duration, scope, or results of the investigation or quantify potential fines at this time.
• Operational Milestones: The company delivered its 1,000th E-Jet in September 2013. The E-Jets E2 family is scheduled to enter service in 2018, and the Legacy 500 is scheduled for entry into service in the first half of 2014.

Investor Verification Checklist

• Inventory Build-up: Verify the rationale and timing for the $257.5 million increase in inventories and its impact on 4Q13 delivery schedules.
• FCPA Investigation: Monitor updates regarding the scope and potential financial impact of the ongoing SEC/DOJ investigation.
• Commercial Backlog Conversion: Track the conversion rate of the $17.8 billion backlog into actual deliveries and revenue, particularly for the E-Jets E2 program.
• Currency Exposure: Assess the effectiveness of the company's hedging strategy given the volatility of the Brazilian Real against the US Dollar.
• Free Cash Flow Recovery: Confirm the projected improvement in Free Cash Flow by year-end as inventory levels normalize.