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Is Brazil's Embraer Ready To Take On Boeing

Embraer is Brazil’s biggest exporter of industrial products and the only emerging-markets enterprise to break into the top ranks of aircraft manufacturing. Embraer is the world's third-largest maker of commercial airplanes by sales and when the sales mix includes business jets, it ranks fourth.

A tropical sun beams down on Brazilian aircraft maker Embraer’s sprawling headquarters in São José dos Campos, an industrial city 50 miles northeast of São Paulo. In an air-conditioned, hangarlike factory twice the size of a football field, a fuselage of the company’s workhorse commercial jet, the E-190, inches along an assembly line as technicians and mechanics rivet together body sections and plug in wiring panels. In a nearby hangar a half dozen versions of the 98- to 114-passenger regional aircraft await delivery to the company’s client airlines in Latin America, Asia, Europe and the U.S.

The manufacturing facility represents a remarkable feat of economic development. On what once were farm fields, the Brazilian government in 1969 founded Embraer with the ambition of transforming the country into an industrial powerhouse. Beginning with a small turboprop model seating just 19 people, the company grew steadily in size and sophistication over the ensuing decades, overcoming no small amount of turbulence along the way: one bankruptcy, years of hyperinflation and repeated economic crises that stymied Brazil’s potential.

Today the economy is thriving after a decadelong boom, and few companies exemplify this renaissance like Embraer. It is Brazil’s biggest exporter of industrial products and the only emerging-markets enterprise to break into the top ranks of aircraft manufacturing. Embraer is the third-largest maker of commercial airplanes by sales, behind Airbus Industrie, an arm of the European Aeronautic Defense and Space Co., and U.S. giant Boeing Co. When the sales mix includes business jets, the company ranks fourth behind Boeing, Airbus and Canada’s Bombardier.

Embraer’s rise is impressive indeed, but the company, like its products, can’t afford to lose momentum. For Embraer to continue to grow its market share, it needs to expand beyond its E-Jet family of regional airliners and develop a larger plane. Company executives are considering launching a new model capable of carrying 130 or more passengers, in what would be their boldest move yet. Such a plane would allow Embraer to finally compete on some of the busiest, most lucrative short-haul routes in the world: along the U.S. eastern seaboard, between European capitals or even the shuttle between São Paulo and Rio de Janeiro. Doing so, however, would put Embraer into direct competition with industry behemoths Airbus and Boeing, whose A320 and 737 models, respectively, dominate the global market.

The choice will be momentous. It would cost billions of dollars to develop a new aircraft, with no guarantee that the company could recoup those costs. But if Embraer postpones or rules out a larger plane, it will lose out to ambitious rivals like Bombardier, which is developing its own short-haul aircraft, and possibly to competitors in China, Japan and Russia, which are also looking to enter the market. “We will have to take a decision as soon as this year,” says Frederico Curado, Embraer’s chief executive officer. “To go up against the competition with our existing products isn’t very wise.”

That decision won’t be made any easier by other dilemmas that the company faces. Brazil’s currency has risen sharply over the past year or so as international investors looking to increase exposure to emerging markets have taken advantage of the country’s high interest rates and liberal exchange rate regime, which contrasts with the managed currencies of fellow BRIC nations China, India and Russia. The real has risen by 8.9 percent against the dollar over the past 13 months, to trade at just over 1.59 to the dollar late last month, forcing Embraer to cut costs and raise productivity to maintain its competitiveness. Then there is the drop in demand for business jets, an increasingly important business for Embraer, generating 21.3 percent of sales in 2010. Deliveries of business jets globally fell by 28 percent between 2008 and 2010 and have yet to recover much.

Reflecting those pressures, Embraer’s net income fell 27.9 percent in 2010, to $345 million, as revenues dipped by 2.4 percent, to $5.4 billion. The company delivered 244 aircraft last year, up slightly from 237 in 2009; its order backlog declined 6.6 percent, to $15.5 billion. Bombardier, Embraer’s main rival in the regional jet market, had $8.6 billion in airplane revenues in the 12 months that ended on January 31, down from $9.4 billion in the previous year. By contrast, Boeing’s commercial airplane division had operating earnings of $3 billion last year on sales of $31.8 billion, while Airbus’s commercial arm had earnings before interest and taxes of €291 million ($418 million) on sales of €27.1 billion.

So far, Embraer has held off any decision on a new plane to see what Boeing does in this market segment. The U.S. company faces growing pressure to modernize or replace its 737 model because of the recent success of Airbus’s new A320neo (short for “new engine option”). That aircraft, a variant of Airbus’s popular A320 short-haul plane, will use new turbofan engines and winglets to provide greater fuel economy and extended range when it enters service in 2015. Since launching the A320neo in December, the European company has booked commitments for more than 1,000 aircraft, including 667 worth $60.9 billion at the Paris Air Show last month.

Boeing executives have promised to make a decision on the 737 — either updating it with new engines or developing a full-scale replacement — by late this year or early next. Whatever the choice, Embraer hopes that Boeing will focus its efforts on the larger end of the short-haul market: 150 to 210 seats, the range of the A320neo. That would leave the Brazilian company more leeway to launch a new model with between 110 and 150 seats. “We are waiting to understand exactly where Boeing is headed,” says CEO Curado.

The short-haul market looks promising. Forecasts by Airbus and Boeing predict demand for 25,000 new jets in the 100- to 200-­passenger range, worth $2 trillion, between now and 2030. The competition for that business is about to intensify dramatically, though. Bombardier is developing a new CSeries jet with 110 to 130 seats, which is due to enter service in 2014. The aircraft will use the same turbofan engine as the A320neo, and its fuel efficiency threatens to eat into sales of Embraer’s existing E-190 and E-195 planes, which can seat between 98 and 122 passengers. Commercial Aircraft Corp. of China aims to challenge Boeing and Airbus directly with the C919, a jet with 150 to 190 seats that’s scheduled to come into service in 2016. Even Russia is getting in on the act with United Aircraft Corp.’s 150- to 200-seat Irkut MS-21, also slated for delivery in 2016.

Unlike its rivals, Embraer doesn’t have a new model coming out in the next few years. Getting a plane from the drawing board to the runway takes at least five years. “Right now the earliest Embraer can get a new aircraft into service is 2017,” says Joseph Nadol, a New York–based aerospace analyst for J.P. Morgan Securities. “That means they are going to have to decide sooner rather than later, and maybe without knowing what Boeing is going to do.”

Moving up to the big leagues won’t be easy, or cheap. Developing a new short-haul plane would cost Embraer about $2 billion in research and development, according to an August 2010 research report by Credit Suisse. (Embraer does not disclose its cost estimates.) A faster, less expensive option would be for the company to extend the body and passenger capacity of its largest existing model, the E-195, but such reengineering often doesn’t meet airlines’ criteria for comfort and efficiency. In 2009, Bombardier introduced the CRJ1000, a 100-seat extension of its CRJ700 model, but sales have been disappointing. “It is difficult to believe that Embraer with its current E-Jet platform will be able to achieve the necessary economies,” says Edigimar Maximiliano, a São Paulo–based aircraft industry analyst for Bradesco BBI. “They will have to invent a new platform to meet the competition.”

The notion that Embraer might compete with Boeing would have been regarded as quixotic when the company was founded in the late 1960s by the Brazilian government, then a military dictatorship. Embraer’s first plane was the twin-turboprop EMB-110 Bandeirante, named after the Portuguese pioneers who pushed settlement into Brazil’s savannas and rain forests from the 16th to the 18th centuries. The Bandeirante was an ideal aircraft for short- to middle-distance routes into Brazil’s interior, where agricultural and mining development was eating away at the Amazon forests.

São José dos Campos, home to Embraer’s headquarters and factory, was a sleepy community of 50,000-odd inhabitants that largely serviced the surrounding corn, rice and cotton plantations. Today, thanks to the explosive growth of the aerospace industry, the city’s population has mushroomed to 838,000, and apartment and office towers rise high above the farm fields. “We are by far the largest local employer,” says Embraer spokesman Carlos Camargo.

About 60 percent of Embraer’s labor force, or some 10,000 people, work in São José dos Campos. Most of them alternate on two eight-hour shifts at the giant assembly lines. On an adjoining airfield, customer pilots spend several days learning to maneuver the aircraft before taking them away. “Embraer planes are easy to handle and cheap to maintain — that’s what we hear from the airlines,” says Bradesco BBI analyst Maximiliano.

Clients weren’t always so laudatory. In the 1980s, Embraer teamed up with an Argentinian state-owned company to develop a new turboprop plane, the CBA 123, even as other regional aircraft makers were shifting to jet-powered craft. “It was a perfect plane, but we didn’t sell a single unit,” recalls Camargo. “We just didn’t listen to our customers.”

In 1994, Embraer ran up $337 million in losses and was declared bankrupt. The government sold a 55.4 percent stake for $161 million to a group that included Brazilian investment bank Banco Bozano Simonsen, Wasserstein Perella & Co. and Previ and Sistel, the pension funds of Banco do Brasil and Telebrás, respectively. Today private investors hold 81.7 percent of its shares, including Bozano with 6.04 percent and New York–based OppenheimerFunds with 9.21 percent. The government, which holds a single seat on the 11-member board, owns a golden share that gives it veto power over ownership of the company, technology transfers and air force contracts. The government also wields considerable indirect influence through two state-owned institutions: the Brazilian National Development Bank (BNDES), which holds a 5.49 percent stake in Embraer, and Previ, which owns 12.62 percent.

Public influence over Brazil’s private companies has become a hot issue because of a conflict between the government and giant mining company Vale. Government officials have criticized Vale for pursuing foreign takeovers rather than investing more heavily in Brazil. In April state-owned investment vehicles orchestrated the replacement of Vale’s CEO, Roger Agnelli, by Murilo Ferreira, a longtime company executive who left Vale in 2008 and enjoys a closer relationship with Brazilian President Dilma Rousseff.

Embraer’s Curado insists that state influence isn’t an issue at his company. “The veto power of the golden share has never been used in the 17 years since Embraer was privatized,” he says. “So I have no reason to be afraid of state intervention.” Despite its center-left, pro-labor stance, the government declined to exercise its veto in 2009 when Embraer slashed its workforce by 22 percent because of falling demand for aircraft. Instead, the government stepped up financing for Embraer’s sales through BNDES. The bank financed nearly 50 percent of the company’s sales last year, up from about 35 percent before the financial crisis. “We will continue to depend on their support for our clients’ financing needs,” says chief financial officer Cynthia Benedetto.

Embraer is on its own, however, when it comes to coping with Brazil’s strengthening currency. Over the past two years, the real has strengthened from 2.1 to just under 1.6 against the dollar. Almost 100 percent of Embraer’s revenues are dollar-linked, while 30 percent of costs are real-linked — mainly the workforce and R&D. That’s why the company “has been obsessed with cost-cutting,” says Bradesco BBI’s Maximiliano. “And that’s why they have been able to maintain their margins even though the real has appreciated so much.” In fact, last year’s 7.3 percent operating margin was an improvement over the 2009 margin of 6.9 percent.

The cost-cutting at Embraer takes place at every level and operation, large and small. “We started three years ago to review every single process on the manufacturing line and in services to figure out how to save money,” Benedetto says. The company found some of the largest savings on the final assembly line of the E-190, its most lucrative plane. Embraer used to employ the so-called dock system, in which the plane stays in one place as laborers assemble the fuselage and install wings, engines and other equipment. Beginning in 2007, Embraer shifted production to a traditional assembly line, slashing the time it takes to produce an aircraft in half, to ten days. “That’s a huge impact, not only in terms of time but also in the inventories linked to the working process,” says the CFO.

Embraer was far more affected by the global recession than the Brazilian economy, which was buoyed by commodity exports. With worldwide aircraft sales plunging, the company was compelled to slash its workforce from a 2007 peak of ?21,843 to the current 17,253. Some jobs will never come back. For example, wing production is largely automated for the Phenom 100 and 300, Embraer’s most popular business jets.

In addition to the exchange rate pressure, the company must deal with rising labor costs. Wages in Brazil climbed by more than 10 percent last year. “It is very hard in an industry like ours with no pricing flexibility to absorb 10 percent in a year,” says CEO Curado.

Surprisingly, Embraer uses only limited foreign currency hedging. “We use our payables and receivables to offset each other on a daily basis, trying to reduce the exposure to currency volatility,” CFO Benedetto says. “We try to get the rest of the offset from productivity. In the short term we are managing to cope with costs associated with currency risk. In the long term we believe that currency appreciation won’t go on forever.”

While commercial aviation generated 53 percent of Embraer’s revenues last year, the business jet segment contributed a healthy 21 percent. Embraer entered the market in 2001 with the Legacy 600, a 16-seater derived from its ERJ-135 commercial plane, but the company only made a serious commitment to business jets in 2005. “That’s when we announced a ten-year plan to become a major player — and we already achieved that goal,” says Luis Carlos Affonso, chief executive of the business jet division. In the past six years, Embraer has launched six new models and raised the company’s share of the global market from 2 percent to 6.9 percent.

By 2015, Embraer will offer a full lineup, from its entry-level model, the $4 million, eight-seat Phenom 100, to the top-of-the-line Lineage 1000, a $50 million, 19-seat plane with a range of 5,180 miles — about the flight distance between New York and Buenos Aires. Embraer is putting the strongest emphasis on the middle-market segment, with planes like the seven- to 11-seat Legacy 450 and 500, which will carry price tags of ?between $10 million and $20 million.

Embraer will have to work hard to sell those models. The low end of the market has been particularly weak, with a glut of barely used aircraft selling at discounts of as much as 30 percent below new aircraft. “It probably will take until the second half of 2012 for the numbers of preowned aircraft to fall back to normal levels and for prices to rise,” says Affonso.

Financing is also a problem. Before the crisis about 75 percent of all business aircraft purchases were financed with bank loans. Today close to 90 percent of buyers are self-financed, and the vast majority are in the top half of the market, according to Teal Group Corp., an aerospace consulting firm based in Fairfax, Virginia. Not only are banks reluctant to issue unsecured loans for business aircraft, many corporations find it hard to defend the expense of private air travel to their shareholders. The image of Detroit’s chief executives arriving in Washington on business jets in 2009 to plead for an auto industry bailout still grates.

Before the crisis, Embraer generated 80 percent of its business jet revenues from the U.S. and Europe. Today that share is just 50 percent. The company believes those markets need to rebound to restore healthy growth to the business. “Their recovery is very important,” Affonso says. “Five years from now, we think, 70 percent of our sales will still be in the mature markets.”

There are fewer than 700 business jets in service in Brazil, Russia, India and China, compared with more than 10,000 in the U.S., according to analysts at Goldman Sachs Group. BRIC potential may be enormous, but so are the obstacles in those countries. Consider the situation in China. In mid-April on the southern Chinese resort island of Hainan, Brazilian President Rousseff joined the leaders of China, India and Russia as well as newcomer South Africa to issue a statement calling for reform of the dollar-dominated international trade system and celebrating the ascendancy of the BRICs in the global economy. But meetings only a few days before between Rousseff and Chinese officials in Beijing offered ample evidence that Brazil could use a lot more clout in its economic relations with China, its biggest trading partner. Rousseff, accompanied by a large business delegation, pushed for the sale of far more industrial products to China, which seems to want only minerals, grain and oil from Brazil.

“The current paradigm of importing Chinese manufactured goods and exporting Brazilian commodities isn’t what Brazil has in mind for a long-term relationship with China,” says Embraer CEO Curado, who was in Rousseff’s entourage. Over the past decade, Brazil’s trade with China has soared 18-fold, to $56 billion in 2010, overtaking the $45 billion in Brazil-U.S. commerce last year. Brazil had a $5.2 billion surplus with China in 2010, but commodities made up 84 percent of Brazilian exports to China, while manufactured goods accounted for 98 percent of Chinese exports to Brazil.

This skewed relationship has had a devastating impact on Brazil’s currency. The Chinese government has artificially depressed the value of the renminbi, keeping prices low on its manufactured exports. According to a J.P. Morgan report in May, China’s trade-weighted exchange rate rose by only 20 percent over the previous seven years, while the Brazilian rate soared by 119 percent. “Being a BRIC is irrelevant,” says Alberto Ramos, a New York–based senior economist on Latin America for Goldman Sachs Group. “This is not a club of friends. These are fierce competitors.”

Embraer is one of the few Brazilian industrial companies to have gained a foothold in China. But it has been a tough battle that has forced Embraer to lower its expectations. In 2003 it scored a coup by signing an agreement with state-owned Aviation Industry Corp. of China (AVIC) for a joint venture to build Embraer’s 50-passenger commercial jet, the ERJ-145, in Harbin for sale in China. The Brazilian manufacturer hoped to extend the joint venture in 2010 for an additional five years, replacing the now-obsolete ERJ-145 with the 98- to 114-passenger E-190.

But having learned as much as it could from the Harbin venture, AVIC announced it had developed a commercial plane with specifications similar to the E-190, which it plans to deliver to domestic carriers beginning in 2014. To soften the blow, China agreed to purchase 20 E-190s manufactured in Brazil for $840 million, with an option for a further 15 aircraft for an additional $630 million. After protracted negotiations the Chinese government also agreed to allow Embraer to continue its joint venture with AVIC in Harbin, but to convert the facility to the manufacture of Embraer’s business jets, the 14-passenger Legacy 600 and 650. A Legacy carries a $29 million price tag, about $13 million less than the E-190’s. Moreover, the market for business jets has just gotten started in China, and its growth remains uncertain.

“China is a must-have market,” says Bradesco BBI analyst Maximiliano. “But at this point, the business jet market there isn’t big enough to affect Embraer’s valuation.” The world’s fastest-growing major economy has fewer than 130 business aircraft, about half of them registered in Hong Kong. The mainland lacks most of the infrastructure that facilitates private jet use in the West, such as fixed-base operation companies to take care of flight plans and service aircraft, and special exits for business passengers at commercial airports. “In China none of this exists,” says business jet chief Affonso.

So, Embraer is not counting on quickly ramping up to a full capacity of ten units a year at its business jet facility in Harbin. “We don’t yet know if market demand will be higher than that,” Affonso says. Even at the current low level of demand, the competition in China is fierce. Gulfstream Aerospace Corp., the leading U.S. business aircraft manufacturer, has 58 planes operating in China thanks in part to its higher brand recognition. “This goes very consistently with the Chinese culture of brand awareness,” CEO Curado said recently at a news conference to announce Embraer’s first-quarter results. “I would love to say [the Harbin production facility] solidifies our position as the major partner of the Chinese in business aviation, but I do not think we can say that.”

In the years ahead, Bombardier will also be a formidable rival in China. The Canadian company got a foot in the door with its train manufacturing division and is working with the Chinese government to build rail transportation infrastructure. Bombardier already is in partnership with the Chinese to build the fuselage for a 100- to 140-seat commercial jet in Shenyang beginning in 2013.

Both Bombardier and Embraer have signed large financing agreements with the Chinese. In December 2009, Embraer inked a three-year deal with China Development Bank for as much as $2.2 billion to finance the sales or leasing of Embraer planes in China and elsewhere in Asia. This was followed in April of this year by a similar five-year deal with Agricultural Bank of China for up to $1.5 billion. But Bombardier has trumped Embraer with even bigger financing agreements. In March it signed a deal with Industrial and Commercial Bank of China to provide as much as $8 billion in financing for the leasing of Bombardier aircraft; that followed a $3.85 billion deal with China Development Bank in March 2010.

For some analysts, the figures indicate a clear tilt by the Chinese toward Bombardier. “Aerospace is an industry in which China has decided to become a major player,” says J.P. Morgan’s Nadol. “Down the road, China and Brazil will be competing on the global stage. That means that for the Chinese it is easier to cut a strategic deal with a Canadian company than a Brazilian one.”

To balance its commercial and business aviation expansion, Embraer has in recent years committed itself to a major push in defense aircraft. The segment accounted for 13 percent of last year’s revenues, or $590 million. Embraer aims to raise military sales to 18 to 20 percent of revenues by the end of the decade, selling to both Brazilian and foreign military clients. A key part of this strategy is to raise the company’s profile at big trade fairs like the biennial Latin American Aerospace and Defence (LAAD) Expo.

The latest LAAD Expo, held in April at the Riocentro convention and exhibition center on the outskirts of Rio de Janeiro, attracted more than 25,000 visitors over three days. They reviewed aircraft and military equipment from producers from 40 nations, including Brazil, China, France, Israel, Italy, Russia and the U.S.

Embraer already sells several electronic-surveillance planes adapted from its ERJ-145 commercial jet, as well as a single-turboprop trainer and fighter-bomber, the Super Tucano. But the buzz at Riocentro was dominated by Embraer’s announcement of a partnership with Argentina and the Czech Republic — soon to include Chile and Colombia — for the joint manufacture of the KC-390, a largely Embraer-built military transport aircraft. The KC-390 poses a direct challenge to the famed Lockheed Martin C-130 Hercules, which created the market more than a half century ago. “Maybe we cannot compete with them globally, but it will be possible in South America, Africa and some parts of Asia where we have good political relationships,” says Luiz Aguiar, Embraer’s chief executive for military aircraft, who estimates that some 700 military transport aircraft will be replaced across the world over the next decade.

Bottom-line considerations are even more important than politics. The twin-jet KC-390, developed largely from Embraer’s bigger commercial jets, can transport the same 20-ton payload as the four-turboprop-engine Hercules and will carry a $50 million price tag, compared with the U.S. plane’s $62 million. The Brazilian Air Force has ordered 28 KC-390s, while the air forces of Embraer’s four foreign partners have either ordered or signed letters of intent for 26.

Taking on defense and commercial aviation segments now occupied by heavyweights like Lockheed Martin Corp. and Boeing while dueling with Bombardier and Gulfstream for a bigger share of the business plane market would give pause to any aircraft manufacturer. But CEO Curado insists that Embraer won’t stretch its resources on these multiple battlefronts. “We know the importance of having a strong balance sheet in a cyclical business like ours,” he says. • •

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