Fitch Ratings-New York-17 May 2018: Fitch Ratings has affirmed the Long-Term Foreign and Local Currency Issuer Default Ratings (LT FC/LC IDRs) of Embraer S.A. (Embraer) at 'BBB-' and its National Long-Term rating at 'AAA(bra)'. The Rating Outlook is Stable. A full list of rating actions follows at the end of this release.
Embraer's ratings reflect its competitive positions in the commercial and business jet markets; large backlog (USD19.5 billion) covering several years of sales; several promising defense programs; and the generally favorable environment in the global commercial aviation industry. Embraer's solid liquidity profile (mostly held outside Brazil) and its large export revenues combined with some offshore operating cash flow further support the 'BBB-' ratings.
Rating concerns include the financial impact of ongoing new aircraft development programs, including the transition to the E2 and the impact on orders and backlogs in the long term; significant competition in both the commercial and business jet markets; new entrants into the commercial jet market; low operating margins in several business segments; and the weak business jet market. Off-balance sheet contingent obligations, mostly related to the weak market for regional jets with 50 or fewer seats, are also a concern, but this is mitigated by guarantee deposits partly collateralizing the exposure.
Fitch expects Embraer's credit metrics through the end of 2018 will be weak for the rating category. Embraer must successfully deliver the E2 and KC-390 while improving margins and aircraft deliveries, or the ratings could come under pressure. Several pending order campaigns and fleet reviews by key customers are items to watch over the next several quarters. The lack of scope clause changes in the United States market is a concern regarding the future of the E175 E2 model over the intermediate term.
The ongoing discussions with Boeing about a possible combination are not reflected in the ratings or affirmation. In December 2017, Embraer disclosed discussions with Boeing regarding a possible business combination. Fitch believes a combination would likely be a positive for Embraer's ratings, but potential outcomes cover the credit spectrum depending on the transaction's structure, so Fitch would be able to evaluate the ratings impact only after seeing the terms if a transaction were to occur. There is no certainty an agreement will be reached.
KEY RATING DRIVERS
Manageable Risk Exposure to Brazil
The bulk of Embraer's commercial markets are global. Approximately 90% of the company's revenue is generated from exports or from business operations based abroad. Nonetheless, Brazil's economic and political environment is a concern as the majority of Embraer's operating asset base is locally domiciled. Brazil is listed as a related party in Embraer's SEC filings as a result of the Brazilian government's 'golden share' and a direct shareholder stake (approximately 5% of Embraer) via a company controlled by the government. Positively, Embraer's exposure to BNDES' financing has been declining over the last few years. During 2017 25% of Embraer's Commercial Aviation deliveries were supported by the Brazilian export financing program, an important decline from 57% in 2016.
Fitch does not consider Brazil's country ceiling to be a rating constraint for Embraer at this time given the large cash holding by the company outside of Brazil, as well as its heavy focus on exports and growing business outside of Brazil. Based upon these factors, under Fitch's criteria Embraer could be rated up to three notches higher than the Brazilian country ceiling. Currently, Fitch rates Brazil's sovereign 'BB-'/Stable Outlook and its country ceiling 'BB'. Country Ceilings capture the risk of capital or exchange controls being imposed that would prevent or materially impede a private company's ability to convert local currency into foreign currency or to transfer foreign currency abroad to creditors.
E2 Developments and Transition
The E2 aircraft program remains one of the key credit issues at Embraer, along with the related transition away from its existing EJets (E1). The company made significant progress on the E2 in the past year and retired much risk. This includes the certification and delivery of the family's first model, the E190-E2. Overall, the program remains on time and on budget, with planned development expenditures of approximately USD1.7 billion through 2021 (net of contributions by ERJ's risk sharing partners). Three years of development is left, but the focus now turns to delivery execution and cost reduction. Fitch believes the program has a positive outlook, but there are still some important risks to be addressed.
The next year will be key to the transition from the E1 to E2 family. Fitch expects a decline in operating margins due to the ramp-up of the E2s and lower delivery volume. Aircraft development programs have frequently been the sources of credit pressures at aircraft manufacturers, so Fitch will monitor the E2's schedule, cost, and the impact on operating margins once production begins. Pratt & Whitney's GTF engine continues to be a concern industry-wide, and the engine's continued production and performance issues are now more relevant to Embraer with the E190-E2 being delivered.
The aircraft finance industry continues to look favorably on Embraer's current EJet family, and financing sources have diversified over the past several years, with EJets serving as collateral in several capital markets transactions.
Flagging Orders and Backlog
Orders have been relatively weak in the past two years, driving the order backlog down. This could have a detrimental impact on production rates if the trend does not reverse. It is possible that orders could increase now that the E2 has been delivered, but it may take more time, as the aviation industry watches the actual performance of the aircraft. A combination with Boeing could also boost orders. The backlog supports production for the next several years, in Fitch's view, but it suffers from concentration and quality. The backlog stood at 435 aircraft at the end of 2017, down from 513 planes two years ago. Skywest accounts for 142 of the planes in backlog, including all 100 of Embraer's orders for the E175-E2. Fitch also believes existing orders from Air Costa and JetBlue are items to watch. Fitch notes that the E175-E2 is currently too heavy to meet existing scope clauses in the U.S. market, so the scope clauses need to be renegotiated for this order to be viable, or orders will need to be converted to the E1. The next negotiations open at the end of 2019.
FCF Negative in 2018; Expected Recovery by 2019
Embraer's FCF generation exceeded Fitch's forecasts in 2017, but the combination of a tough environment in the executive jet segment, the transition period of E2 and early stages of the KC-390 program should pressure Embraer's FCF generation during 2018. Under Fitch's base case scenario, Embraer's cash flow from operations (CFFO), adjusted EBITDA and FCF for 2018 are expected to be approximately USD368 million, USD578million and negative USD243 million, respectively. For 2019, Fitch expects USD500 million, USD652 million and negative USD51 million, respectively. This improvement reflects a gradual recovery in volumes and the ramp-up of its E2 program. Fitch expects the company's total capex to be about USD550 million and USD500 million in 2018 and 2019.
Negative FCF is not atypical for aerospace manufacturers in the middle of significant aircraft development programs. All of the other commercial aircraft manufacturers rated by Fitch have experienced similar periods of investment and negative FCF.
Adjusted Leverage to Peak in 2018
Embraer's credit metrics based on gross debt are weak for the ratings, but this weakness is offset by solid metrics on net debt basis, as well as the company's liquidity position. Embraer's Adjusted leverage (Total Adjusted Debt/EBITDAR) remained high during 2017 at 6.1x, a deterioration from 2016 (4.6x). On a net basis, Embraer's adjusted net leverage (Total Adjusted Net Debt/EBITDAR) increased to 1.9x from 1.6x during 2016. Fitch makes some adjustments in Embraer's readily available cash, and without these adjustments, net adjusted leverage would remain quite conservative at 0.6x and 0.8x, respectively.
Currently, Embraer is challenged to improve operating cash flow generation to support a recovery of its leverage ratios. Fitch projects adjusted net leverage to peak at 2.7x in 2018 compared to 1.9x in 2017 and 1.6x in 2016. By end of 2020, Fitch forecasts leverage should return to below 2.0x, as operating cash flow is expected to recovery.
Like most aerospace manufacturers, Embraer has a variety of off-balance sheet or contingent obligations because of the significant amount of debt used to finance aircraft deliveries. At Dec. 31, 2017, Embraer had maximum guarantees totalling USD346 million (before provisions and before proceeds from the underlying assets), consisting of both financing guarantees and residual value guarantees (RVGs). This amount has declined from USD445 million at Dec. 31 2016. The company also has some exposure to trade-in obligations. Fitch believes Embraer has the liquidity and cash flow to meet its potential obligations.
There are several factors that mitigate Embraer's potential exposure from the contingencies. Embraer has collateralized some of its guarantees with USD394 million in guarantee deposits. Some of the exposure could possibly be reduced by selling the aircraft backed by the guarantees. There is a maturity schedule to the guarantees, at least for the RVGs, in that the obligations are typically staggered over various future periods.
Discussions with Boeing
Boeing and Embraer have been in talks over a potential combination for at least five months. The future of Embraer's Defense & Security operations appears to be a significant issue, mainly on national security grounds, and recent comments by Embraer indicate the transaction may not be an outright purchase of the company by BA, but instead a commercial aerospace combination excluding Embraer's Defense & Security segment and possibly its business jet operations. The Brazilian government is playing a significant role in the negotiations because of its 'golden share' in Embraer, as well as direct and indirect shareholdings.
If an agreement is reached, the transaction's structure and price would be the main credit drivers for both companies. Although a transaction could positively affect Embraer's credit profile, there are a number of outcomes, and Fitch would only be able to evaluate the ratings impact after seeing the terms and the structure of a transaction. Fitch believes BA's credit rating would not likely be affected given Embraer's enterprise value. In case of Embraer's bonds, depending on the final structure, a combination could trigger a change of control clause.
Combining with Embraer would broaden BA's commercial portfolio to the lower end of the narrowbody commercial aircraft market and the regional jet market with the E2 family. There would be little or no overlap with BA's existing portfolio, and a combination would provide a strategic answer to Airbus' planned takeover of Bombardier's CSeries program. Parts of the E2 program are likely to face more intense competition with Airbus running the CSeries program, and teaming with Boeing could help the E2 better compete for orders from airlines and aircraft lessors. Another benefit would be consistency with Boeing's strategic initiatives in services and vertical integration. Boeing could also gain access to Embraer's highly regarded work force, including engineering talent.
Key questions would include the transaction's valuation, integration risks, cultural differences, and timing of anticipated synergies. The reaction of various unions is another possible consideration.
Embraer is the market leader for commercial jets with fewer than 150 seats. Its aircraft are known for their engineering, commonality across models, and interior design. The company had 435 jet firm orders in backlog at the end of 2017, including jets in the new E2 family, and net orders in 2017 were 86 jets, for a book to bill ratio of 0.9x. Embraer's total backlog, including contracts from all segments, was USD19.5 billion at end of 2017. Embraer's weaker competitive position than major global peers, notably Boeing and Airbus, based on scale and financial strength, is partially offset by its good business position in the niche of commercial jets with fewer than 150 seats, and its manageable financial profile. Embraer compares favorably versus its competitor Bombardier in the areas of leverage, margins, and liquidity, but Bombardier has more business diversification. The company also operates in the executive jet and defense segments. Embraer's bulk of operations are in Brazil, but the company is shifting much of its executive jet assembly to the U.S. Fitch's Rating Above Country-Ceiling Methodology is being applied.
Fitch's Key Assumptions Within Our Rating Case for the Issuer
--Embraer's key development programs, the E190-E2 and KC-390, remain on time and budget;
--Embraer's commercial deliveries decline to approximately 85 in 2018 but stabilize or begin to rise in 2019 as Embraer continues the shift to the E2 family of commercial jets;
--The business jet market continues to be weak and shows little growth;
--Total revenues decline in the low single digits in 2018, then begin to rise in 2019 as the E2 and KC-390 ramp up;
--EBITDA margin moves down to around 10% in 2018, marginal improvement in 2019 and more progress during 2020 as the dilutive impact of the new programs is realized;
--Embraer generates negative FCF in 2018, then marginally begins to improve it by 2019, with neutral to slightly negative cash flows during 2019;
--Investment expenditures are around USD550 million in 2018 and USD500 million 2019;
--The company pays down maturing debt through the forecast period;
--Embraer maintains strong liquidity throughout the forecast period.
Developments That May, Individually or Collectively, Lead to Positive Rating Action
Given the challenges in the short to medium, Fitch does not foresee rating upgrades in the near term.
Events that could trigger a positive rating action in the intermediate term include successful retirement of risk in the development of the E2 and KC-390 programs, reduction in debt levels, and EBIT margin consistently above 9%.
Developments That May, Individually or Collectively, Lead to Negative Rating Action
--Significant delays and cost increases on the E2, KC-390 or other programs;
--Failure to sufficiently reduce costs in the event of an aviation downturn or aviation shock (disease, terror, war etc.);
--Substantial order cancellations in the E1 and E2 programs; continued low commercial orders in 2018 could also pressure the ratings;
--Substantial declines in liquidity without commensurate debt reductions;
--Multiple notch downgrade of Brazil's sovereign rating, along with a similar reduction in the country ceiling;
--EBIT margin falling below 7% for several years;
--FFO adjusted net leverage remaining consistently above 2.5x, after transition period of the E2.
Fitch views Embraer's financial flexibility as relatively conservative given its liquidity position, a key factor supporting the ratings. Embraer has a policy of maintaining healthy liquidity, which Fitch considers appropriate given the cost of periodic development programs and the nature of the commercial aerospace industry. Fitch expects that the company will remain disciplined with its liquidity position and will maintain its proactive approach in liability management to avoid exposure to refinancing risks. Embraer does not have a revolving credit facility, which is not uncommon for Latin American corporate issuers.
Total cash and investments at the end of 2017 were USD3.9 billion, but under Fitch's analysis Embraer's readily available cash position of USD2.9 billion is sufficient to support debt amortization up to at least 2022. Fitch's calculation of readily available cash excludes USD500 million related to Fitch's assumption for ERJ's minimum required cash for ongoing operations. The calculation also assumes a 30% discount to structured notes held as investments by ERJ, as well as other haircuts to other investments. These haircuts total $450 million.
As of Dec. 31, 2017, the company had USD4.2 billion of debt, which includes USD42 million of a net position of USD364 million of debt at the SPE level and USD321 of offsetting sales financing guarantees (guarantee deposits). Scheduled debt maturities in 2018 and 2019 are $407 million and $182 million, respectively. The bulk of Embraer's debt matures beyond 2023. The company's debt is mainly composed of cross-border bonds (70%), BNDES (8%) and working capital lines (22%). Approximately 84% of Embraer's debt is denominated in U.S. dollars, 15% in Brazilian real and 1% in euros. At Dec. 31, 2017, approximately 77% of the company's cash, equivalents and financial investments were in U.S. dollars. Embraer is in compliance with the financial debt covenants in its debt agreements, and Fitch forecasts this will remain the case in the forecast period.
FULL LIST OF RATING ACTIONS
Fitch has affirmed the following ratings:
--Foreign currency Long-Term IDR at 'BBB-';
--Local currency Long-Term IDR at 'BBB-';
--Long-term National Rating Scale at 'AAA(bra)';
--Senior unsecured debt at 'BBB-'.
Embraer Overseas Limited
--Senior unsecured debt at 'BBB-'.
Embraer Netherlands Finance BV
--Senior unsecured debt at 'BBB-'.
The Rating Outlook is Stable.