Company Profile, November 29, 2001

Analyst: Michael Molinski

Who would guess that the world’s fourth largest maker of commercial aircraft is based in the town of Sao Jose dos Campos in southeastern Brazil?

Embraer took advantage of a huge boom in demand for regional jets in recent years, filling a gap between the big guys like Boeing and Airbus and makers of smaller turboprop aircraft.

The company’s niche is regional jets that carry from 37 to 50 passengers. Embraer’s growth has been so sharp in recent years that it is now close to overtaking its biggest rival, Canada’s Bombardier, as No. 3 aircraft maker in the world. (Boeing and Airbus are No. 1 and No. 2). Embraer also makes military aircraft and corporate jets.

Embraer’s key to success has been aggressive management. That aggressiveness runs throughout the company, from marketing to pricing to product development. The company gained inroads to most of the world’s largest airlines by offering the right products for the right price, often undercutting the prices of an increasingly frustrated Bombardier.

Now Embraer plans to go head-to-head with Boeing and Airbus in the bottom end of the full-size jet market. Embraer is developing two larger jets that will carry between 70 and 108 passengers, in direct competition with Boeing’s popular 737 and its new 717. Those planes, the ERJ 170 and ERJ 190, are scheduled for first deliveries in December 2002 and July 2004, respectively.

Embraer’s shares lost half their value in the week after the Sept. 11 terrorist attacks on the United States. The stock recovered some later, but by the end of November the company’s American Depositary Receipts (NYSE ticker: ERJ) were still hovering at around $18 a share, well below their pre-crisis price of $24 and significantly below their all-time high of $47 on April 30, 2001.

Why were shares hit so hard? The initial hit was due to fears by investors that airline travel as a whole would see a big drop, since proven to be true. But a closer look at the aircraft industry shows that Embraer might actually benefit in some ways from the crisis over the long run, for several reasons.

First, airlines will be looking to cut costs, and Embraer has a leg up there. Its commercial jets are, on average, 15 percent less expensive than those of competitors. Second, Embraer focuses on regional jets for domestic airlines, which so far terrorists have not targeted. And third, the decline in airline travel is expected to lead to more orders for corporate jets as companies seek alternative ways to travel. Corporate jets is one of Embraer’s key markets with its new Legacy model.

Another possible benefit of the terrorist activity is a jump in demand for Embraer’s military planes. Prior to Sept. 11, Embraer officials had already estimated that military sales could rise to 20 percent of total revenue by 2005, compared with 7.6 percent in 2000. If terrorist attacks increase and violence in the Middle East escalates, smaller countries that can't afford an F-16 could be prompted to order Embraer’s lower-cost light-attack planes. Brazil, Greece, Belgium, Venezuela and Mexico already have military aircraft on order from Embraer.

How can a tiny airplane maker from Brazil compete against the likes of Boeing? There are four main answers: low costs, high quality, good management, and a little help from the Brazilian government.

Brazil’s low labor costs have helped Embraer grow to a staff of 11,000 employees, while access to cheap steel and other metals from Brazil’s plentiful raw materials helped cut costs further. Additionally, Brazil’s weak currency has played a big role in making Embraer jets competitive on the international market.

In terms of quality, Embraer’s jets have also been strong, with repair and accident records that rival those of its competitors. The company has also been quick to realize the importance of a strong customer service and training department and easy access for customers to after-market parts.

In terms of management, Embraer has come a long way since it was privatized in 1994. Embraer was founded in 1964 by the government, in part to supply planes to the Brazilian air force, which is still a big client for light-attack aircraft. A big part of Embraer’s success has been the leadership of its chief executive officer, Mauricio Botelho. Botelho was chosen to lead the company shortly after it was privatized, and is known in Brazil as a long-term strategic planner.

The company is now owned by a consortium of Brazilian investors, including financial group Bozano and pension funds PREVI and SISTEL, which together hold 60 percent of voting shares. A group of European aerospace companies - Dassault Aviation, EADS, Snecma, and Thales – jointly own another 20 percent.

Embraer’s other key advantage is the subsidies it receives from the government in terms of taxes and favorable tariffs. While those subsidies don’t add a whole lot to the company’s bottom line, they have nevertheless been a constant complaint of the Canadian government on behalf of Bombardier. The World Trade Organization, however, has so far ruled in favor of Embraer.

All of these factors have contributed to remarkable earnings growth. In the second quarter of 2001, the company earned a record $136 million on sales of 44 aircraft. Revenue was up 200 percent from the same quarter in 2000. The company is now Brazil’s largest exporter, with some $1.5 billion in export sales in the first half of 2001. And those sales have come with a remarkable increase in efficiency. Sales per employee have grown from $40,000 in 1994 to more than $200,000 in 2001.

In terms of stock performance, the company has shown strong growth relative to the rest of the Brazilian market. Its American Depositary Receipts doubled in price in the six months after their launch in New York at an initial offering price of $18 in July 2000. The stock hit a downturn, however, in mid-2001, as a weak global economy cut into orders and prompted the company to slash its estimate for total 2001 plane sales to 180 from an earlier estimate of 240.

The price-to-earnings ratio, which had climbed somewhat in late 2000 and early 2001, has now come back to around where it was a year ago. Most analysts use the ADR to gauge price, and for earnings measure EBITDA (earnings before interest, taxes, depreciation and amortization). Prior to Sept. 11, Embraer’s price versus forecasted 2002 EBITDA was around 7, and while the stock has come down since then, so have projected earnings.

In the short run, Embraer’s success will depend on the health of its export markets. More than 90 percent of Embraer’s sales are overseas, making the company Brazil’s largest exporter with 3.5 percent of the country’s total exports. Those exports are well-diversified across the U.S., Europe and Asia. Embraer could also get further gains from a continued weakening of the Brazilian real.

Down the road, though, the company’s future will depend on how well Embraer does with its new 70-seat and 100-seat jets. The company is spending heavily on development of the jetliners. On one hand, they could be a huge boon for the company. Airlines are desperate for reliable regional jets with lower price tags than those offered by Boeing and Airbus. On the other hand, the jump to larger jetliners is a big risk for Embraer. Quality is key, and a few major disasters or equipment failures could send the whole program into a tailspin.

Of course, the overall growth of the airline market will significantly affect Embraer. Although it is likely to be hit less than larger plane makers due to its low-cost niche, increased terrorist activity and a slide in air travel could undoubtedly have a negative effect on sales. Embraer’s two largest customers, American and Continental, have been severely affected by the terrorist attacks.

As we already mentioned, there’s a risk involved in Embraer’s move to larger planes. Part of the stock price already assumes some success in the 100-seat market. If Embraer fails, the stock could be hit hard.

Another down side is Embraer’s near-total reliance on exports. While it virtually isolates the company from a Brazilian financial crisis, it could hurt the company if Brazil’s economy recovers because increased labor and materials costs will only be slightly offset by larger domestic sales. A strengthening of Brazil’s currency is an added risk.

Another down side, though in our view a remote one, is regulatory risk. Pressure from the WTO or a negative ruling could cut into the subsidies of the Brazilian government.