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Embraer Stock Upgraded: What You Need to Know

Every day, Wall Street analysts upgrade some stocks, downgrade others, and "initiate coverage" on a few more. But do these analysts even know what they're talking about? Today, we're taking one high-profile Wall Street pick and putting it under the microscope...

Thursday was a good news-bad news kind of the day for investors in the stock of Brazilian plane maker Embraer (NYSE: ERJ). On the plus side, analysts at Swiss bank Credit Suisse announced this morning that they are upgrading Embraer stock from neutral to outperform. The upgrade even came with a price target of $25 per share, implying approximately 25% upside to Embraer stock, which currently sells for less than $20.

Now here's the bad news: Credit Suisse used to think Embraer was worth $35 a share. Here are three things you need to know about that.

Will everything be smooth flying for Embraer once its E190-E2 airplane takes off? Image source: Embraer.

1. What Credit Suisse said

Embraer shares have shed 17% of their value over the past month. According to a write-up on StreetInsider.com (requires subscripton), Credit Suisse believes that this pullback provides investors with "an attractive entry point" -- but investors may have to wait a while to profit from such a purchase.

Embraer, you see, has embarked upon an aggressive spending program to develop new aircraft, and that spending has sapped cash profits -- and hurt Embraer's stock. Last year, for example, Embraer generated no cash whatsoever from operations, while spending more than $415 million on capital investments. In total, free cash flow in 2016 ran negative to the tune of more than $510 million.

Credit Suisse hope that sometime around 2020, this development program will pay off, and Embraer will be firmly free cash flow-positive again.

2. Commercial aviation

For Credit Suisse's investment recommendation to pay off, two things have to go right for Embraer. First, commercial aviation. Embraer is currently in the process of developing a new E190-E2 family of commercial passenger jets in the 100-seat range to replace its current E-jet family of aircraft, where business has been slowing.

At last report, Embraer had booked more than 130 firm orders for E190-E2 and E-195-E2 aircraft, on top of 100 orders for the smaller E175-E2. The company expects to deliver its first E190-E2 in April of next year. Sales in the commercial aviation division, which over the past 12 months have exceeded $3.7 billion, with strong operating profit margins of 13.7% (according to data from S&P Global Market Intelligence), will depend heavily on the E190-E2's success.

3. Defense and security

Embraer's commercial division could also use some help from its defense and security division, which recently received a bit of good news of its own. As DoDBuzz.com reported just this morning, the US Air Force just placed an order with Sierra Nevada Corp., which co-produces Embraer's A-29 Super Tucano fighter plane for foreign militaries, to deliver six more Super Tucanos to the Afghan Air Force. No value was stated for this contract, but the last time USAF ordered Super Tucanos for the Afghans, it paid $427 million to buy 20 of the turboprops -- about $21.4 million per fighter. That implies about a $128 million value for the instant contract, or nearly 19% of the revenue booked by Embraer's defense and security division last year.

Embraer's defense division, by the way, collected revenue of $992 million over the last 12 months -- but scored a profit margin of only 4.1%, making it much less profitable than the commercial side of the business. What Embraer could really use here is a bit more scale of production, to help get its profit margins up.

Bonus thing: Time to get out of business jets?

Finally, a word about business jets. I've written several times now about the state of the global market for business jets, which is... not good. It's particularly not-good for Embraer, which over the past year earned only a 1.1% profit margin on the $1.8 billion in sales from its executive aviation division.

Over the past five years, business jets have become a bigger and bigger part of Embraer's business, growing 77% in size by revenue, but shrinking by nearly two-thirds in terms of the profits Embraer earns on said revenue. Credit Suisse thinks it sees a path to consistent, long-term positive free cash flow at Embraer, but if you ask me, if there's one thing Embraer could do that would have the most immediate, positive effect on Embraer's profits, it would be to sell off or shut down its executive aviation division.

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Rich Smith has no position in any of the stocks mentioned. The Motley Fool recommends Embraer-Empresa Brasileira. The Motley Fool has a disclosure policy.