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Embraer's Creation of Value for Shareholders and the Brazilian 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 Embraer’s (Empresa Brasileira de Aeronautica’s) value creation, since privatization in 1994, for both its shareholders and its other constituencies in Brazil. First, we will argue that government involvement in creating and supporting the firm, even 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 aircraft 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 Brazilian Air Force, Embraer has grown into a publicly traded, international manufacturer of regional commercial jet aircraft by exploiting a growing yet underserved niche in the commercial aviation 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 Boeing and Airbus. 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 $9 billion in assets. The premise behind this effort and the stabilization of government finances was that they would make Brazil more attractive for foreign direct investment (FDI). The Cardoso administration expected that FDI would bring in technology and know-how that would more than compensate for any reduction in government funding. WINTER 2005 CHAZEN WEB JOURNAL OF INTERNATIONAL BUSINESS 2 Exhibit 1. Privatization Receipts in Latin America, 1988–1995 (US$ 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 Banco do Brasil 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 regional jet in terms of efficiency,
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