Embraer’s Creation of Value for Shareholders and the Brazilian Economy

Eleanor Broad MBA ’05

Ben Choi MBA ’05

Daniel Drum MBA ’05

Sergio Lagunes MBA/MIA ’05 Columbia Business School Columbia University School of International and Public Affairs

© 2005 by The Trustees of Columbia University in the City of New York. All rights reserved.

CHAZEN WEB JOURNAL OF INTERNATIONAL BUSINESS WINTER 2005 www.gsb.columbia.edu/chazenjournal 1. Introduction This paper will examine the story of ’s (Empresa Brasileira de Aeronautica’s) value creation, since privatization in 1994, for both its shareholders and its other constituencies in . First, we will argue that government involvement in creating and supporting the firm, after privatization, was essential to Embraer’s success. This success, in turn, created important externalities for the Brazilian economy. Second, while government support was important in helping the firm evolve into a major player in the regional market, such support has also been available to Embraer’s competitors. Embraer’s success must therefore be attributed to other competitive advantages. Third, we analyze whether the firm’s competitive advantages and increased market share have translated into a positive return on equity for shareholders. Finally, we briefly discuss the company’s joint venture in China, a complex issue that is beyond the scope of this paper. It is important, however, to consider how Embraer’s China venture might affect externalities to the Brazilian economy and returns to shareholders.

2. Overview Founded in 1969 as a government-owned domestic supplier to the , Embraer has grown into a publicly traded, international manufacturer of regional commercial jet aircraft by exploiting a growing yet underserved niche in the commercial industry. Over the past five years, with the exception of a downturn in the market in 2002 due to the attacks of September 11 and the SARS outbreak, Embraer has been Brazil’s largest domestic exporter. However, the story of Embraer is more complex and intriguing than that of a start-up identifying and filling a gap in an industry dominated by the consolidated majors and . In fact, Embraer is an example of a company that successfully used a combination of appropriately apportioned government nurturing, heavy investment in research and development, well-educated and low-cost labor inputs and prudent capital allocation decisions to create a real competitive advantage that catapulted it into a globally competitive industry. As a result, Embraer is today the world’s fourth largest airline manufacturer. In the commercial space, Embraer has discreetly focused on the design and production of regional commercial jet aircraft with fewer than 116 seats. In so doing, the company has created product-specific economies of scale that provide a defendable competitive advantage in the near term. Simply put, Embraer has produced and continues to produce efficient regional aircraft at a more affordable total cost of ownership than its larger competitors.

WINTER 2005 CHAZEN WEB JOURNAL OF INTERNATIONAL BUSINESS 1 In this paper, we analyze the fruits of this advantage, the positive externalities for the Brazilian economy and Embraer’s profitability for its shareholders since going public in 2000. The years of outright government ownership were far from efficient. Embraer was taken private, in part, to prevent a default. However, the company’s success is due, in no small part, to governmental protection and proactive policies in the company’s transformative years of the mid-1990s, which helped it compete with other global aircraft manufacturers. As to whether the investments made by the government when Embraer was a government-owned firm, and subsequent subsidies after privatization, represent an NPV- positive investment by the government on behalf of Brazilian taxpayers is a difficult question that is beyond the scope of this paper. However, it is important to mention that the government has obtained revenues from several sources thanks to Embraer, including, but not limited to, income taxes from Embraer and its employees, income taxes from suppliers and their employees, import taxes from foreign suppliers, gains on the privatization of Embraer and increases in the equity holdings in Embraer of the country’s development bank, Banco Nacional do Desenvolvimento Economico e Social (BNDES). Again, whether these government revenues represent an NPV-positive investment is an open question.

3. Embraer as a Catalyst for Economic Development in Brazil Fernando Henrique Cardoso, two-term president of Brazil from 1995 to1998 and again from 1998 to 2002, instituted a series of economic changes to reduce the government deficit and tackle the runaway inflation that afflicted the country throughout the 1980s. Among the economic steps taken to permanently reduce government expenditures were the privatization of state-owned companies and the reduction of subsidies to the country’s productive sector. As shown in exhibit 1, Brazil’s government had an aggressive privatization program in the 1990s, selling more than $9 billion in assets. The premise behind this effort and the stabilization of government finances was that they would make Brazil more attractive for foreign direct investment (FDI). The Cardoso administration expected that FDI would bring in technology and know-how that would more than compensate for any reduction in government funding.

WINTER 2005 CHAZEN WEB JOURNAL OF INTERNATIONAL BUSINESS 2 Exhibit 1. Privatization Receipts in , 1988–1995 (US$ million)

Source: World Bank in OECD “Foreign Direct Investment and Economic Development: Lessons from Six Developing Economies” Organisation for Economic Cooperation and Development, “Foreign Direct Investment and Economic Development: Lessons from Six Emerging Economies,” 1998, http://www.oecd.org/document/20/0,2340,en_2649_37461_1932948_119699_1_1_37461,00.html.

However, critics of so-called neoliberal policies point to the fact that advances in technological development in Brazil have deteriorated sharply now that government funding for research and development has declined (see exhibit 2). These critics point out that FDI was directed toward the acquisition of existing companies, rather than to “greenfield” investment. As a consequence, technological innovation in the country slowed. Many existing R&D programs that had previously been managed locally for use by private or state-owned companies were slimmed down or eliminated. Companies like Alcatel, for example, acquired local companies and shut down their R&D projects. Alcatel replaced local technology with technology developed abroad. Thus, while some technologies, such as telecommunications, were able to leapfrog stages in their development by adopting more advanced technology created abroad, there is little doubt that Brazil’s ability to create and export technology-intensive products suffered from the elimination of technology-focused centers. Engineers and highly qualified personnel were redirected to less technical jobs in plant operation, marketing or sales (Cassiolato, Bernardes and Lastres 2002).

WINTER 2005 CHAZEN WEB JOURNAL OF INTERNATIONAL BUSINESS 3 Exhibit 2. Direct Brazilian Government Investment in R&D, 1996–2002 (millions of 2002 R$)

$3,630 $3,486 $3,410 $3,217 $3,155 $3,135 $3,017

1996 1997 1998 1999 2000 2001 2002

Source: Ministerio da Ciencia e Tecnología, http://www.mct.gov.br/estat/ascavpp/portugues/2_Recursos_Aplicados/tabelas/tab2_1_1.htm

Exhibit 3. National Expenditures on R&D as a Percentage of GDP, 1999–2002

Israel 4.73%

Korea 2.92%

USA 2.67%

China 1.29%

Brazil 1.00%

Spain 0.96%

Mexico 0.43%

Argentina 0.39%

Source: Ministerio da Ciencia e Tecnología http://www.mct.gov.br/estat/ascavpp/portugues/9_Comparacoes/graficos/graf9_1_1a.htm

3.1. Wisely Managed Privatization Serves as a Path to Sustainable Growth Embraer’s privatization in 1994, after several years of poor performance, was a different story. The government sold a 50.5 percent ownership in the company for total proceeds of $455.5 million,1 while retaining a golden share with veto power over critical issues such as change in control, sales to the military and relationships with employees. The 40 percent controlling ownership was acquired by a syndicate comprising Brazilian financial investors, instead of by foreign strategic investors. The main investors in this syndicate included

1 Presidencia do Brazil, “Privatization Enters A New Phase: A Guide for Foreign Investors,” Government publication to the public at www.planalto.gov.br/publi_04/COLECAO/PRIVA3.HTM.

WINTER 2005 CHAZEN WEB JOURNAL OF INTERNATIONAL BUSINESS 4 Bozano Simonsen, a Brazilian financial institution, as well as the Telebras and pension funds. Another 10 percent was reserved for the company’s employees (Goldstein 2001; Cassiolato, Bernardes and Lastres 2002). Unlike other privatization efforts, the government remained involved in Embraer’s development and actively supported the company’s transition to a producer of regional commercial aircraft for export.2 The BNDES supported Embraer through direct loans and also provided financing for Embraer customers.3 BNDES’s private-equity arm still owns approximately 7 percent of Embraer. In addition, the Brazilian military has been an important customer throughout the company’s transition to commercial aircraft production. It was not until the development in 1997 of the ERJ-145, a landmark in terms of efficiency, design and cost that was uniquely suited to the needs of regional carriers in the North American market, that civilian aircraft production overtook military aircraft production. By creating firm barriers to entry, the government ensured that Embraer would have a strong footing in the competitive world of global export and continue generating positive externalities that benefit the Brazilian economy.

3.2 Embraer Rises to Become Brazil’s Number One Exporter According to Embraer’s own records, the company exports over 90 percent of its production abroad and is Brazil’s single most important exporter. Embraer’s export sales provide an important source of dollar revenues for Brazil (see exhibit 4). Analysts expect Embraer’s sales to rise to $4 billion by 2006 with the introduction of the Embraer 170. While still engaged in the production of defense aircraft, Embraer’s revenues and future growth prospects are highly dependent on the North American and European commercial aviation markets. In 2003, the North American market accounted for 84 percent of Embraer’s total sales.4 Furthermore, the company’s commercial division relies on a relatively small world of buyers. In 2003, three buyers accounted for nearly two-thirds of the company’s total sales: Continental, 33 percent; American Eagle, 17 percent; and Republic/Chautaucqua, 14 percent.5

2 The program known as PROEX (Programa de Financiamento as Exportacoes) operated as an interest equalization system, allowing purchasers of Embraer aircraft to reduce financing costs to international, rather than Brazilian, levels. 3 According to Folha, Brazil’s influential business journal, BNDES has approved a loan of $221 mm for vendor financing of Embraer’s new EMJ-170 airplane. 4 Hoover’s Online, Embraer company profile, http://www.hoovers.com/embraer/--ID__95436--/ free-co-factsheet.xhtml. 5 Ibid.

WINTER 2005 CHAZEN WEB JOURNAL OF INTERNATIONAL BUSINESS 5 Exhibit 4. Embraer’s Foreign Sales, 1999–2003 (US$)

$2,902,936 $2,702,000 $2,493,313 $2,052,828 $1,691,500

1999 2000 2001 2002 2003

Source: Embraer’s 2003 20-F filed with the Securities & Exchange Commission at www.embraer.com

However, this buyer concentration is somewhat misleading given the nature of equipment orders in the airline industry. Commercial airlines typically make large one-time purchases based on strategic imperatives. Not every buyer actively shops the market every year. Given the rapid growth of low-cost, regional airlines in Europe, as well as the proven success of regional point-to-point routes (the ideal use for Embraer’s equipment) by carriers such as Southwest and JetBlue in the , the company should expect continuing demand for its equipment. Increasing demand for regional services, along with the aging of the equipment serving this space (a third of which is more than 20 years old), have created what Embraer calls an “equipment gap.”

3.3. Embraer Develops National Technology Transfers and Investment Given its limited resources, especially during the reduction in direct government support, Embraer’s strategy has been to focus its R&D funds on key technologies that it can effectively produce in house. It has outsourced the production of components that other companies can manufacture more efficiently. Embraer spends vast sums on R&D to improve its aircraft: $91 million in 2001, $158 million in 2002 and $173 million in 2003 (net of R&D spent by risk-sharing partners). The increase in R&D from 2001 to 2003 was directly related to the development of Embraer’s new 170 and 190 jets. These jets have so far been received enthusiastically by North American airlines, including JetBlue and Continental Airlines. At year-end 2003, Embraer had 125 firm aircraft purchase orders for the Embraer 170 and 110 for the Embraer 190. Embraer has focused its R&D on the development, systems engineering and integration of the more than 28,000 parts and components that make up an aircraft. The company has

WINTER 2005 CHAZEN WEB JOURNAL OF INTERNATIONAL BUSINESS 6 also retained the development and production of the plane’s fuselage, arguably the most technically complex part of an airplane. To aid Embraer’s in-house technological development, the company invited international leaders in the field of aeronautics to become minority shareholders. The most important technological partners include Thales, Dessault Aviation and European Aeronautic Defense and Space Company, world leaders in electronic systems and industrial electronics in the industry. Each of these international firms currently owns only 2.2 percent of Embraer’s total shares. To offset the risk of developing and producing some of the most costly and technologically challenging components, Embraer has also formed risk-sharing partnerships. Partners make major components such as wings, flaps and engines, based on Embraer’s design specifications. These manufacturers are international firms with headquarters outside of Brazil; however, as Embraer has continued to expand, many of them have set up operations in Brazil to supply parts in a timely and low-cost manner. In 2002, C&D Aerospace of the U.S. built a plant in Brazil to supply Embraer with cabin interiors for its jets. Sonaca, a Belgian company that produces fuselage equipment, instituted Sobraer in Brazil as a subsidiary solely focused on servicing Embraer. Pilkinton Aerospace, an American firm, built a plant to supply aircraft windows. And most recently, in 2004, ENAER, a Chilean firm that supplies the rear fin and other parts, and Gamesa, a Spanish firm that makes engine parts, have built a plant in Sao Jose dos Campos, where Embraer is headquartered.6 Subcontractors that receive raw materials and designs from Embraer constitute a third level of supplier. These firms fall into two categories: the first provides highly technical project and engineering services; the second performs less technical operations such as the chemical coating of Embraer’s parts. All these companies are local firms that were initiated by former Embraer employees (Cassiolato, Bernardes and Lastres 2002). Among the most prominent are Akaer and New Plotter Engenharia, which supply project engineering; Alltec and Tecplas Industria e Comercio de Fibras, which supply composites; and Automota Industria and Camprini & Marques Industria, which supply parts and components. All these companies are located in Sao Jose dos Campos, making this one of the most dynamic and affluent areas in the country. The transfer of technology from Embraer to local firms has had mixed results. Some new firms have recently been created to supply Embraer with high-tech engineering software. One example is Fibra Forte, a firm owned and run by five former Embraer employees that supplies the company with highly technical engineering and design software. On the other hand, many companies that supplied electronic systems and

6 Information provided by ADTP (an agency of Tiete Paraná Development Agency focused on Foreign Direct Investment in Brasil), August 9, 2004, www.adtp.org.br/artigo.php?idartigo=4644.

WINTER 2005 CHAZEN WEB JOURNAL OF INTERNATIONAL BUSINESS 7 complex components to Embraer before the 1990s have disappeared and been replaced by suppliers located abroad (Cassiolato, Bernardes and Lastres 2002). For example, EDE, an indigenous Brazilian firm that used to supply Embraer with landing gear, has been replaced as a supplier by a joint venture with Liebherr International AG of Germany. To promote technology development in the field and increase the percentage of Brazilian firms that supply Embraer with parts, the remaining local suppliers have formed the Association of Brazilian Aerospace Industries (AIAB). This group is, in turn, part of a consortium called High Tech Aeronautics (HTA), which combines suppliers, technological centers and government agencies. It mission is “to identify the needs in the complex productive chain of the aeronautical segment and, in a competitive way, to develop specific solutions in order to increase our clients’ products value.”7 This consortium is actively, and successfully, lobbying the government to increase support for the development of technology in the aviation sector. Carlos Lessa, the current head of the BNDES, personally spearheaded a two-day seminar entitled “Improving the Production Chain in the Aerospace Industry.” This panel was set up to discuss ways, including additional financing by the BNDES, to develop local firms to serve the aerospace industry throughout the entire production chain.8 Lobbying by HTA and other consortiums for additional funding for technology is making headway in the government of Luis Ignacio Lula da Silva. In 2003, the administration implemented a plan to increase government R&D expenditures to 1 percent of GDP by 2003 and 2 percent by 2006.9

3.4. Employment Opportunities and Human Development Embraer was a major employer in Brazil in the 1980s, employing over 12,000 workers 1989. Many positions were redundant and subsidized. The bloated payroll became unsustainable as the government was forced to reduce expenditures to service its debt burden. The number of employees plummeted in 1990, reaching a low of 4,000 in 1996. Employment has increased since, mostly as a result of organic growth, and stood at 12,941 employees by the end of 2003. Some engineers and technicians who left the company during the 1990s have returned (Cassiolato, Bernardes and Lastres 2002). Moreover, the entirety of the executive board is Brazilian, indicating that the firm has sought to utilize local talent who understand local working conditions.

7 High Tech Aeronautics (HTA) Web site, www.hta.com.br. 8 Banco Nacional do Desenvolvimento Economico e Social (BNDES), O Adensamento da Cadeia Produtiva da Indústria Aeronáutica, April 15 and 16, 2004, http://www.bndes.gov.br/conhecimento/publicacoes/catalogo/s_aero.asp. 9 Republica Federativa do Brasil, “Ciencia y Tecnologia para o desenvolvimento nacional,” http://www.brasil.gov.br/ac_infr10.htm.

WINTER 2005 CHAZEN WEB JOURNAL OF INTERNATIONAL BUSINESS 8 According to Embraer’s statistics, 93.4 percent of the firm’s employees are employed in Brazil, 25 percent as engineers.10 While Embraer hires its engineers from several schools in the Sao Paulo region, an important supplier has historically been the Instituto Tecnológico Aeronáutico (ITA), a university set up as part of the government’s effort to create an educational infrastructure for the development of the aeronautical industry in Sao Jose dos Campos.11 This infrastructure includes not only the ITA, but also the Technological Airspace Center (CTA) and the National Institute of Space Research (INPE). The ITA graduates master’s students, doctoral students and specialists in mechanical engineering, electronics, computer science, aerospace infrastructure, industrial engineering and physics. The CTA and INPE employ researchers in the fields of aeronautics and also provide graduate programs in the field (Cassiolato, Bernardes and Lastres 2002). It is worth noting that the number of scholarships provided for scientific education is growing. Exhibit 5 shows that funding in scientific education from the Ministry of Science and Technology (Ministério de Ciencia e Tecnológia) has increased dramatically since the crisis years of the 1980s and early 1990s. The top line in blue represents the number of students who received scholarships from government ministries for the study of science, including computer science, between 1980 and 2002. The middle line in red represents the number of workers who received scholarship from government ministries to gain additional technological expertise from 1980-2002. The bottom line in green represents the number of students who received scholarships from government ministries for the study of technological and engineering studies, starting in 1989 until 2002.

10 Embraer 2003 20-F financial statement registered with the Securities and Exchange Commission (SEC) at www.embraer.com 11 Instituto Tecnologico de Aeronautica, http://www.ita.br/online/main.html, and Embraer 20-F financial statements

WINTER 2005 CHAZEN WEB JOURNAL OF INTERNATIONAL BUSINESS 9 Exhibit 5. Number of Students and Workers Receiving Government Scholarships, 1980–2002

20000

Scientific Studies 15000

Technological Studies 10000 Special Training Programs 5000

0

1980 1983 1986 1989 1992 1995 1998 2001

Source: Ministério de Ciencia e Tecnológia, http://www.mct.gov.br/estat/ascavpp/portugues/4_Bolsas_de_Estudo/tabelas/tab4_1_3.htm

4. Competitive Advantages Competitors have claimed that Embraer’s competitive advantage is unfair, sustained only by ongoing direct and indirect government support. Certainly government support was essential to the company’s formative years and growth in the international marketplace. However, the relationship between Embraer and the Brazilian government is not unique, nor is it the sole source of the company’s competitive advantage. Moreover, governments have historically played a significant role in the development of aircraft manufacturing worldwide, and other major economies have had their own “national champions”: • Airbus was originally established in 1970 as a consortium of French, German and (later) Spanish and U.K. companies in order to compete effectively with the U.S. giants. A quasigovernmental “grouping of national economic interests” for 30 years, Airbus formally became a stand-alone corporation, the European Aeronautic Defense and Space Company (EADS), in 2001. The company was effectively delivered into private hands when it launched its IPO that same year. • Boeing Airplane Company also benefited greatly from government support. The firm was founded by William Boeing, who used his wealth from trading forestlands in Washington to develop airplanes at the University of Washington. The company’s first order, of 50 Model C seaplanes, was made for and paid for by the U.S. Navy in 1917. It was this order that enabled Boeing to flourish and have 337 employees on its payroll by 1918. In subsequent years, military purchases continued to represent the largest source of income

WINTER 2005 CHAZEN WEB JOURNAL OF INTERNATIONAL BUSINESS 10 for the firm.12 Today, Boeing continues to benefit from military orders and transfers of technology. In spite of its Fortune 100 status, Boeing still relies on the United States Export-Import Bank, affectionately known by critics of government subsidies as the “Bank of Boeing,” for a substantial portion of financing of international aircraft sales. • SAAB Aerospace was created in 1937 after the Swedish government decided to promote a domestic defense industry. From 1939 to 1998, the majority of the company’s sales of defense models were financed by the Swedish Air Force. In 1995, SAAB Aerospace was established as a joint venture with British Aerospace; it began exporting to other countries in 1998. The company’s first true success in the civilian aircraft market occurred in 1988 with a high-speed . Unable to compete with Bombardier and Embraer regional jets, SAAB cancelled production of its once popular turboprop commercial airplanes and is now focusing solely on the defense market.13 • Similarly, Bombardier launched its aircraft business in 1986 with the purchase of the largest aerospace company in Canada, the government-owned Canadair. Thus, Bombardier’s aerospace operations were at one time developed, owned and run by the Canadian government.14 Today, despite federal loans from the Canadian government, the firm is owned, controlled and operated entirely by the Bombardier family as a private interest. Bombardier closely leads Embraer in the regional commercial jet aircraft space and is set to continue as its closest rival. Critics often claim that government support is behind any competitive advantage an aircraft industry player might gain over its competitors. Again, however, this ignores that government financing has been, and continues to be, a major source of support for all major players in the industry. The fact is that design and cost advantages are what improve an airplane manufacturer’s competitiveness. For example, Boeing’s recent first-time loss of market leadership to Airbus has spurred public complaints about the loans Airbus receives from European governments. But this ignores the great success of the Airbus A380 double- decker’s design and cost efficiencies. In turn, Airbus has complained to the European Union about Boeing’s tax breaks and support from the U.S. government.15

4.1. Bombardier Goes to the WTO In Bombardier’s case, the loss of market share prompted a legal suit against Embraer with the World Trade Organization (WTO), even though support from the Canadian government was part of Bombardier’s own historical success. The Canadians charged that

12 Boeing Web site, http://www.boeing.com/history/boeing/building.html. 13 SAAB Web site, www.saab.se/node1445.asp. 14 Bombardier Web site, http://www.bombardier.com/index.jsp?id=0_0&lang=en&file=/en/0_0/0_0_1_6_2.html. 15 Business Week On-Line, “Boeing vs. Airbus: it’s getting ugly,” September 20, 2004, http://yahoo.businessweek.com/magazine/content/04_38/b3900083_mz054.htm.

WINTER 2005 CHAZEN WEB JOURNAL OF INTERNATIONAL BUSINESS 11 Embraer profited unfairly from export subsidies offered by the government, while Brazil argued that export subsidy rules did not apply because it was a developing country. Additionally, upon the request of Dornier Luftfahrt GmbH, a manufacturer of regional aircraft with close ties to the German government, the European Commission launched an investigation into the BNDES loan scheme.16 In 2000, the WTO ordered Embraer to stop using these BNDES credits. Consequently, the European Commission concluded that, based on the WTO’s recommendation, there was “no immediate need for further Community action” to aid Dornier (EC 1999). Bombardier then insisted that Embraer’s competitive advantage came from BNDES subsidies under PROEX (Programa de Financiamento as Exportacoes, see footnote 2), and that such subsidies were continuing despite the WTO ruling. Embraer subsequently brought a WTO suit against Bombardier, challenging the legality of its receipt of government loans from the Export Development Corporation (EDC) and Technology Partnership Canada (TPC), which had enabled Bombardier to win a $1.68 billion contract from Wisconsin Air by reducing the cost of each airplane by $2 million.17 The WTO ruled against Canada in the case brought by Brazil, forcing the two countries to negotiate and reach a resolution. The final settlement appears to allow both countries to continue supporting their national manufacturers with export financing loans. However, tit-for-tat disputes about the export financing and government subsidies received by both companies are unlikely to subside given the potential rent-capture in the event of an ultimate winner. It is difficult to discern which firm might be receiving more aid and how this affects the competitive landscape. However, Air Canada’s acquisition of 45 aircraft from Embraer and 45 from Bombardier may signal that the benefit of export financing received by one or the other might be canceling out. According to research reports, Air Canada’s precarious financial position was forcing the company to shed its historical preference for Bombardier, unless the latter could provide financing terms similar to those offered by Embraer.18

4.2. Embraer’s Competitive Advantages How is Embraer faring in its competition against Bombardier in the commercial aircraft market? Exhibit 6 shows that Embraer is slowly pulling ahead of the Canadian company, thanks to the design and production of its new 170 and 190 aircraft.

16 Dornier began as a supplier of military aircraft to Germany during and after World War I. In 1974, the company regained its stature by producing the Alpha Jet with Dessault, a project sponsored by the French and German governments. The company was acquired by Fairchild Aircraft in 1996 and became insolvent in 2002. 17 Canadian Department of Foreign Affairs and International Trade, “WTO Issues Report in Aircraft Dispute,” press release, December 23, 2002, www.ic.gc.ca, and Gregory Polek, “Air Wisconsin, Bombardier seal sweetheart CRJ deal,” Aviation International News, May 2001, http://www.ainonline.com/issues/05_01/ may_2001_airwisconsinpgr1.html. 18 Peter A Rozenberg and Gordon Lee, “Regional Jets,” UBS Investment Research, October 17, 2003.

WINTER 2005 CHAZEN WEB JOURNAL OF INTERNATIONAL BUSINESS 12 Exhibit 6. Bombardier vs. Embraer Future Aircraft Deliveries Bombardier (a) Embraer (b) CRJ Series Total Ordered Total Delivered Total Backlog Total Backlog CRJ 100 226 226 - Commercial Market CRJ 200 766 654 112 ERJ 145 134 CRJ 440 75 13 62 ERJ 135 17 CRJ 700 Series 701 244 88 156 ERJ 140 20 CRJ 900 45 21 24 Embraer 170 125 Challenger 800 24 4 20 Embraer 190 110 CRJ Series Total 1,380 1,006 374 Embraer 195 15 421 Q Series Q 100 299 299 - Q 200 96 95 1 Q 300 211 210 1 Q 400 114 85 29 Q Series Total 720 689 31 Totals 2,100 1,695 405 Total (a) 421 (a) Based on August 31, 2004 reports from Bombardier; does not include corporate market (b) Based on 2 qrt. 2004 press release; does not include 27 corporate market and 88 defense aircraft on backlog, nor any aircraft without "firm order" status

With the introduction of the 170 and 190 models in 2004, Embraer is betting that regional and low-fare airlines will extend their routes, creating competition with the legacy airlines and a demand for larger regional aircraft. So far, this bet has paid off, and Embraer is successfully supplying 90 to 120 passenger jets. JetBlue recently put in a firm bid for 100 Embraer 190 aircraft.19 As sales of the 50-seat regional jets that fueled Bombardier’s growth in the 1990s decline, it is expected that this company will also enter the 100-plus-seat passenger market. Even so, transportation consultant Ray Jawarowski, of Forecast International, estimates that over the next decade, Embraer will produce 1,426 regional jets for a 38.8 percent global share of the regional jet market, while Bombardier will make 1,210 for a 32.5 percent share.20 We believe Embraer’s competitive advantages will allow continued growth in the 70- to 110-seat market. However, no advantage is unique and, in the long run, each can be replicated. As a result, Embraer will have to share this market with competitors from above (Boeing, Airbus) and below (Bombardier). In the following list, we analyze the competitive advantages that support our assertion that Embraer is in a solid position to gain from overall market growth in the future and continue to consolidate its market leadership in the short term. • Limited first-mover advantage—UBS Investment Research estimates Embraer has a three- to five-year lead-to-market advantage in the 100-seat market, estimated at 2,500 aircraft.21 Bombardier has already indicated that it plans to enter this market; saturating demand

19 JetBlue, 2003 10-K financial statement filed with the SEC. 20 Raymond Jaworowski, “Regionals Faring Better Than the Majors”, press release, Financial Post, September 1, 2004. 21 Peter A Rozenberg and Gordon Lee, “Regional Jets,” UBS Investment Research, October 17, 2003.

WINTER 2005 CHAZEN WEB JOURNAL OF INTERNATIONAL BUSINESS 13 for its 50- to 70-seat regional jets in the coming years will force it to take action. It is important to note that Embraer has been able to steal a 46 percent market share in the 50-seat market, despite Bombardier’s three-year lead to market. Bombardier should be able to do the same after its late entry into the 100-seat market, as will Boeing and Airbus should the market become large enough. • Commonality in the 70- to 110-seat market—An important advantage that Embraer can use to leverage its first-mover advantage is the commonality design of the new 70- to 110-seat jet family. Commonality is a set of shared parts and interfaces, which allow airlines to scale maintenance and spare parts inventory across several jet types in the same family. Commonality also allows airlines to avoid retraining pilots for different cockpit designs. Bombardier estimates that commonality features in its planes can save airlines 10 to 15 percent on operating costs. This strength will be especially important in the more dense markets of Europe, Asia and, eventually, the U.S. • Lower R&D and production costs—Clearly, Embraer benefited in its early development from significant government R&D subsidies. Continuing government assistance for military contracts supports development efforts for commercial jets as well. To a limited degree, Embraer may enjoy lower R&D costs due to the centralized supply network it developed over the past decade. Lower labor costs in Brazil helped contribute to Embraer’s EBITDA margins of 18 to 22 percent, compared to Bombardier’s 5 to 10 percent margins. This competitive advantage will likely dissipate as other governments continue to subsidize their national aircraft manufacturers and as the Brazilian labor market develops. In addition, China, with its lower labor costs, could displace the advantages Brazil currently holds as a manufacturing center. Bombardier could move production to China and exploit that county’s labor cost advantage. Embraer could also increase its production capacity in China through its joint venture with Harbin to retain competitiveness. However, a relocation of Embraer’s production from Brazil to China would reduce Embraer’s positive externalities to the Brazilian economy. • Easy access to financing—Finally, Brazil’s weak currency helps Embraer price its jets very competitively. In addition, generous government export financing terms facilitate transactions, although this is true for competitors like Bombardier as well. Both companies secured $1 billion in government equity guarantees for export financing in the past year, indicating the commitment of both Brazil and Canada to financing their respective domestic aircraft manufacturing industries.

WINTER 2005 CHAZEN WEB JOURNAL OF INTERNATIONAL BUSINESS 14 4.3. Superior Profitability at Embraer In this section, we will evaluate Embraer’s success in turning its competitive advantages into returns for its shareholders, comparing the company’s return on equity (ROE)22 to its cost of equity (kE). Exhibit 7 presents Embraer’s ROE since 1997. It is important to note that the downturn that affected the airlines after the September 11 terrorist attacks also impacted Embraer, as the demand for airplanes declined. Demand for airplanes hit its lowest point in 2003, but has improved now that more airlines, including the fast-growing low-cost airlines, are expanding their fleets to include Embraer jets in an attempt to improve efficiency.

Exhibit 7. Embraer’s Return on Equity, 1997–2004

1997 1998 1999 2000 2001 2002 2003 LTM 6/30/2004 ERJ Return on Equity %23 14.7% 31.5% 79.1% 55.8% 35.8% 21.1% 12.0% 22.7%

To calculate kE, we amended the traditional CAPM with a country risk premium for

Brazil: kE = rf + _E(rm-rf) + rC. Using the Brazilian C Bond (denominated in U.S. dollars), we calculated the country-specific default risk premium as the difference between the yield on the Brazilian C Bond and the U.S. 10-year treasury bond (rC = rBrazil C Bond - rf). As of

September 2004, this gives Brazil an rC of 3.46 percent. To calculate Embraer’s equity beta, we used Bombardier, Boeing and Thales as comparables. Airbus and several other competitors in adjacent markets are either subsidiaries or private corporations for which beta information is not available. We calculate Embraer’s equity beta as 1.56. Our calculations are shown in Exhibits 8–10.

Exhibit 8. Asset Beta Calculation

Company _E D/E Mar Tax _A Embraer 1.9 239.7% 34% 0.74 Bombardier 1.8 326.2% 21% 0.50 Thales 0.66 13.1% 20% 0.60 Boeing 0.72 33.6% 27% 0.58 Average 0.60

22 1 ROE is calculated by the following formula: Earnings from Continuing Operations ÷ /2(2003 Total Equity + 2002 Total Equity). 23 Embraer financial statements filed with the SEC, available at www.embraer.com.

WINTER 2005 CHAZEN WEB JOURNAL OF INTERNATIONAL BUSINESS 15 Exhibit 9. Equity Beta Calculation

Marginal tax rate T 34.0% 2002/2003 Statutory Tax Rate Debt/Equity ratio D/E 239.7% ERJ 2003 Statements

Asset beta _A 0.60 Simple average of similar firms' unlevered _

Equity beta _E 1.56 _E = (1+(1-t)*( D/E))* _A

Exhibit 10. Cost of Equity Calculation

Risk free rate rf 4.18% 9/10/2004; US 10 yr Treasury

Risk premium (rm-rf) 5.00% Assumed

Country default risk rC 3.46% Brazil C-Bond; Bloomberg, 9/10/04

Cost of equity kE 15.4% kE = rf + _E(rm-rf) + rC

Based on these calculations, Embraer had a cost of equity of 15.4 percent at the end of 2003. Excluding 2003 ROE, Embraer’s ROE has consistently exceeded its cost of equity. ROE for the 12 months prior to June 30, 2004, was 22.7 percent, more than 7 percent above the cost of equity. We believe this 7 percent return beyond Embraer’s cost of equity reflects the competitive advantages developed by the company over the past decade.

5. The Road Ahead: How Will Embraer Stay Above the Competition? To date, Embraer has clearly provided superior returns for shareholders and developed significant positive externalities for the Brazilian economy as its number one exporter. But will Embraer be able to sustain this advantage in the future given the weight of its competition? In an age of considerable corporate consolidation and globalization, aircraft manufacturing continues to be a truly international industry dominated by four main players: Boeing (United States), Airbus (European Union), Bombardier (Canada) and Embraer (Brazil). A key area of future competition for regional jets will be the battle to enter markets outside the largely saturated markets of Europe and North America. In 2002, hoping to gain an early footing in the growing and underdeveloped Asian market, Embraer formed a joint venture to manufacture 50-seat planes with Harbin, China’s fourth largest plane maker.24,25 For Embraer, the single greatest advantage of partnering with a local

24 Embraer is seeking to enter new markets in Asia, particularly China where the company has signed a joined venture with Harbin Aircraft Industry Co., Ltd and Hafei Aviation Industry Co., Ltd, both companies of China Aviation Industry Corp. The joint venture, Harbin Embraer Aircraft Industry, is Embraer’s first outside of Brazil and will serve to produce the ERJ 135/140/145 aircraft for the Chinese market. 25 Embraer Press Room, “Embraer Sets Up Join Venture in China with AVIC II”, press release, December 2, 2002, at www.embraer.com/english/content/imprensa/press_release.asp?press_release_id=481&ano=2002.

WINTER 2005 CHAZEN WEB JOURNAL OF INTERNATIONAL BUSINESS 16 manufacturer is to avoid the significant import tax duties levied on imported aircraft—China charges a 17 percent VAT on imported items and a 6 percent sales tax. While Bombardier turned down a joint venture with Harbin based on its prediction of weak demand in China for 50-seat planes, Embraer foresaw a more solid demand for these aircraft. Furthermore, Embraer calculated that having a first-mover advantage in China would put it in a good position to move into the manufacture of other aircraft for Asia in the future. However, if the Chinese government drops or reduces the 17 percent VAT as part of its concession to enter the World Trade Organization, the barrier Embraer has raised around itself in China will be weakened and the conditions of entry into the Chinese market will be more encouraging for its competitors. What will this increasing focus on the attractive Asian market mean for Embraer’s stakeholders in Brazil? As the North American market saturates and Embraer looks to benefit from Asia’s continued economic expansion and competitiveness, will it begin to move some of its production from Brazil to lower-cost China? While there are currently no plans to transfer aircraft production to China for markets other than the Chinese market, we would argue that a gradual, long-term shift in the company’s overall production is highly probable. To maintain its competitive margins of 18 to 22 percent, Embraer will need to continue to focus on low-cost production. These margins rely not only on lower- cost inputs such as labor but also on manufacturing aircraft as close to the marketplace as possible. Thus, as the market in Asia gains more importance, so too will Embraer’s manufacturing facilities in Asia. If Embraer’s stated goal of growth26 in Asia is realized, shareholder returns will benefit. How will this shift affect the Brazilian economy? While externalities for the Brazilian economy in the form of low-cost production labor may suffer in the short term, technical expertise and human development in engineering will continue to grow as Embraer develops its new 50- and 150-plus-seat segments, enters new markets and improves its international competitive position. However, it is becoming increasingly difficult for Embraer to strike that delicate balance between nurturing a national champion for the benefit of the national economy and creating a globally competitive player for the benefit of shareholders.

26 UBS Investment Research, “Regional Jets,” October 2003, 26.

WINTER 2005 CHAZEN WEB JOURNAL OF INTERNATIONAL BUSINESS 17 6. Conclusion Unlike other privatizations in Brazil, the majority stake in Embraer was sold to Brazilian shareholders. The government maintained an important role as a minority shareholder, client and source of financing. In addition, minority foreign investment was welcomed for additional capital and technology transfers. This innovative privatization that left Embraer’s future in the hands of Brazilians allowed the company to develop domestically to a greater extent than would otherwise have been possible. While Embraer has relied on international firms for significant technology, the company continues to develop important proprietary technology of its own. Embraer’s undeniable recovery and success since the 1990s have created important positive externalities to the Brazilian economy. As discussed previously, these include the export of dynamic and technology-rich goods, the creation of new businesses (many by former Embraer employees) to supply Embraer and the development of a dynamic and well-educated work force. Additionally, there are signs that Embraer’s success has influenced the Brazilian government to promote an economic development plan that is more supportive of indigenous enterprise. Embraer is today one of the leading aircraft manufacturers in the world. It has achieved this position while others have not because of competitive advantages that go beyond government support. Government support is available to all major aircraft manufacturers, but it is Embraer’s superior ability to read the needs of the market, to design a high-quality jet and to produce it at a lower cost that have allowed the company to win important international orders and overtake Bombardier in market share. These competitive advantages have also translated into a positive return on equity to shareholders. The positive externalities to the Brazilian economy and the positive returns to shareholders make Embraer an example of what a well-defined government policy to develop local enterprise, coupled with private sector insight and management, can accomplish.

WINTER 2005 CHAZEN WEB JOURNAL OF INTERNATIONAL BUSINESS 18 References Cassiolato, Jose E., Roberto Bernardes and Helena Lastres. 2002. Transfer of Technology for Successful Integration into the Global Economy. United Nations, New York and Geneva. Damodaran, Aswath. 2003. Measuring Company Exposure to Country Risk: Theory and Practice. Stern School of Business, New York, September. Embraer. 2003 20-F filed with the SEC, 2004 10-Q Interim Financial Statements filed with the SEC and other company information found at www.embraer.com. European Commission (EC). 1999. Examination procedure regarding the Brazilian export financing program PROEX as applied to the regional aircraft sector. Directorate General for Trade, Brussels, October 21. Gianbiagi, Fabio, and Marcio Ronci. 2004. Fiscal Policy and Debt Sustainability: Cardoso’s Brazil, 1995-2002. IMF Working Papers, August. Goldstein, Andrea. 2001. From National Champion to Global Player: Explaining the Success of Embraer. OECD Development Center, Paris.

WINTER 2005 CHAZEN WEB JOURNAL OF INTERNATIONAL BUSINESS 19