Fitch Ratings - Chicago - 28 Apr 2020: Fitch Ratings has downgraded Embraer S.A.'s Long-Term Foreign- and Local-Currency Issuer Default Rating (IDR) to 'BB+' from 'BBB-', and has affirmed Embraer's National Scale Rating at 'AAA(bra)'. The Rating Watch Negative has been removed. The Rating Outlook for the IDRs is Negative. Embraer's unsecured bonds have been removed from Rating Watch Positive and downgraded to 'BB+' from 'BBB-'. The bonds had been on Positive Watch pending the establishment of a commercial joint venture with The Boeing Company (BBB/Negative).
The rating actions reflect the strong headwinds for the commercial aviation industry due to the coronavirus pandemic, which has resulted in a high level of aircraft deferrals, lower maintenance expenditures, and strong competition in commercial and business jet market. Fitch believes this environment will lead to deterioration in Embraer's FCF generation and credit metrics during 2020-2022. The cancelation of a deal with Boeing poses additional challenges to Embraer's medium to long-term competitive position, although it does open the possibility of arrangements with other aviation companies. Embraer reported USD121 million of separation costs related to the proposed JV during 2019. Fitch's base case scenario does not include any reimbursement, given the ongoing discussion between the parties and uncertainty regarding the timing of this potential cash inflow.
The Negative Rating Outlook is driven by the high uncertainties surrounding the aviation industry and the risk of a continuation of distancing measures into the latter half of 2020 and early 2021. Embraer's ability to quickly adjust its operations and cost structure will be key to minimizing the high cash burn, which Fitch projects to be around USD1 billion. Embraer's lack of major debt amortization during 2020 and 2021 and strong liquidity position and access to credit markets in Brazil and abroad, are key credit strengths. Fitch's base case scenario foresees Embraer's net leverage moving to around 11.0x and 4.0x, during 2020 and 2021, respectively.
Embraer's ratings reflect its competitive positions in the commercial and business jet markets, robust backlog (USD16.8 billion) covering several years of sales, and Brazilian defense programs. Embraer's solid liquidity profile (mostly held outside Brazil) and its large export revenues combined with some offshore operating cash flow further support its 'BB+' ratings, which is above Brazil's 'BB' country ceiling. Rating concerns include ongoing new aircraft development programs, including the transition to the E2 aircraft, 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, and low operating margins in several business segments.
KEY RATING DRIVERS
Elevated Pressure: Amid the current scenario, with increasing level of aircraft deferrals, Fitch expects a 50% decline in commercial aircraft deliveries for 2020 and some recovery during 2021. For business jet deliveries, the decline should be lower, around 15%-20%, given different business dynamics. Fitch expects that Embraer will face additional challenges to boost the orders of its new E2 aircraft. The firm order backlog stood at 338 aircraft at the end of 4Q19, down from 435 planes two years ago. In Fitch's view, the backlog supports production for the next several years, but suffers from concentration and quality. Fitch notes that the E175-E2 is currently too heavy to meet existing scope clauses in the U.S. market; the scope clauses must be renegotiated for this aircraft to be viable or orders will need to be converted to the E1.
Modest Brazilian Risk: Approximately 90% of Embraer'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.
Fitch does not consider Brazil's country ceiling a rating constraint for Embraer currently, given the company's large cash holding outside of Brazil, as well as its heavy focus on exports and growing business outside of Brazil. Based on these factors, under Fitch's criteria, Embraer could be rated up to three notches higher than the Brazilian country ceiling.
EBIT Margin Pressured: Embraer's operating performance has been weaker than expected during the past year and should trend slightly negative during 2020. Embraer was facing pressures on its operating margins as it navigates several new development programs. The lower deliveries in commercial aviation and less favorable mix have affected the company's fixed cost dilution during 2019. In a scenario of meaningful aircraft deferrals, operating margins will be further pressured. During 2020, Fitch estimates Embraer's EBIT margin to be negative, around 1%, and will show recovery during 2021 and 2022, increasing to 4.6% and 5.8%, respectively.
Negative FCF: The poor operating cash flow generation and the ongoing capex should lead Embraer to burn around USD1 billion in cash during 2020, per Fitch's estimates. Under Fitch's base case scenario, Embraer's cash flow from operations (CFFO) for 2020 is expected to be negative by more than USD500 million, pressured by a decline in deliveries and working capital needs. Capex is estimated around USD400 million. For 2021, FCF is expected to be breakeven level, around USD71 million, after capex of USD450 million.
High Leverage: Fitch forecasts Embraer's net leverage (net Debt/EBITDA) to increase to 11.0x in 2020, to decline to 4.2x in 2021 and to 3.8x during 2022. This compares to 2.0x in 2018 and an average of 1.0x during the 2015-2017 period.
Embraer is one the market leaders for commercial jets with fewer than 150 seats. Its aircraft are known for their engineering, commonality across models and interior design. The company had 338 firm jet orders in backlog at the end of Dec. 31, 2019, including jets in the new E2 family. Embraer's total backlog, including contracts from all segments, was USD16.8 billion at Dec. 31, 2019. Embraer's weaker competitive position compared with 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 Inc. (CCC) in leverage, margins and liquidity; however, 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.
--Embraer's key development programs, the E190-E2 and KC-390, remain on time and budget;
--Embraer's commercial deliveries decline to approximately 50% in 2020 and 20% (versus 2019) in 2021 but stabilize or begin to rise in 2022;
--The business jet market deliveries decline 20% in 2020 and 15% (versus 2019) in 2021, following a more resilient trend for this segment;
--EBIT margin to be in the negative territory during 2020 (around 1.3%) and then slightly recover during 2021 and 2022;
--Embraer to generate negative USD1 billion in FCF in 2020;
--Investment expenditures are around USD400 million in 2020 and 2021;
--The company is able to raise around USD1 billion in new long-term debt to fund negative free cash flow generation during 2020 at attractive financial costs;
--Embraer maintains strong liquidity throughout the forecast period.
Factors that could, individually or collectively, lead to positive rating action/upgrade:
--A revision of the Outlook to Stable could occur if Embraer's performance during 2020 and mid-2021 leads to net leverage of around 3.5x during 2021;
--An upgrade to investment grade level would is dependent on a return to net leverage below 2.5x on sustainable basis, in addition to maintenance of a strong liquidity position with no major refinancing risks in the medium term;
Factors that could, individually or collectively, lead to negative rating action/downgrade:
--Substantial order cancellations in the E1 and E2 programs and business jet segment;
--Significant delays and cost increases on the E2, KC-390 or other programs;
--Failure to sufficiently reduce costs and post larger than expected FCF generation;
--Net leverage remaining consistently above 3.5x by end of 2021;
--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.
BEST/WORST CASE RATING SCENARIO
International scale credit ratings of Non-Financial Corporate issuers have a best-case rating upgrade scenario (defined as the 99th percentile of rating transitions, measured in a positive direction) of three notches over a three-year rating horizon; and a worst-case rating downgrade scenario (defined as the 99th percentile of rating transitions, measured in a negative direction) of four notches over three years. The complete span of best- and worst-case scenario credit ratings for all rating categories ranges from 'AAA' to 'D'. Best- and worst-case scenario credit ratings are based on historical performance. For more information about the methodology used to determine sector-specific best- and worst-case scenario credit ratings, visit https://www.fitchratings.com/site/re/10111579.
LIQUIDITY AND DEBT STRUCTURE
Strong Liquidity: Fitch views Embraer's financial flexibility as relatively conservative given its liquidity position, which is 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.
Embraer had USD3.4 billion of debt as of Dec 31, 2019, which includes net position of USD271 million of debt at the SPE's level and USD282 million of sales financing guarantees (guarantee deposits). Total cash and investments at the end of the period were USD2.7 billion, which is sufficient to support debt amortization up to at least 2023. The bulk of Embraer's debt matures beyond 2023. At Dec. 31, 2019, approximately 86% of the company's cash, equivalents and financial investments were in U.S. dollars.
REFERENCES FOR SUBSTANTIALLY MATERIAL SOURCE CITED AS KEY DRIVER OF RATING
The principal sources of information used in the analysis are described in the Applicable Criteria.
The highest level of ESG credit relevance, if present, is a score of 3. This means ESG issues are credit-neutral or have only a minimal credit impact on the entity(ies), either due to their nature or to the way in which they are being managed by the entity(ies). For more information on Fitch's ESG Relevance Scores, visit www.fitchratings.com/esg.