CAMBRIAN GROUP

strategic report

CAMBRIAN GROUP

Embraer

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TEAM MEMBERS

M.D. Xiaoye Ma, Lead

Max Kroloff

Cailee Moberg

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CONSULTANT�’S DISCLAIMER Cambrian Consulting, LLC (�“Cambrian�”) has prepared this report

(�“report�”) at the request of the Client and for the sole use of the Client. This report may not be relied upon by any other party without the express written agreement of Cambrian. The use of this report by unauthorized third parties without written authorization from Cambrian shall be at their own risk, and Cambrian accepts no duty of care to any such third party.

Cambrian has exercised due and customary care in conducting this report but has not, except as specifically stated, independently verified

information provided by others, including the Client. Cambrian makes no representations or warranty as to the accuracy, completeness or correctness of the information and statistical data contained herein.

No other warranty, express or implied is made in relation to the conduct of this report of the contents of this report. Therefore, Cambrian assumes no liability for any loss resulting from errors, omissions, or misrepresentations made by others.

Any recommendations, opinions, or findings reflect the judgment of Cambrian at the date of publication and are subject to change at any time without notice. Any recommendations, opinions, or findings stated in this report are based on circumstances and facts as they existed at the time Cambrian performed the work. Any changes in such circumstances and facts upon which this report is based may adversely affect any recommendations, opinions, or findings contained in this report.

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TABLE OF CONTENTS EXECUTIVE SUMMARY�…�…�…�…�…�…�…�…�…...............................�…�….�…�…�…�…�…�…�…�…..�….1

PART I: INTRODUCTION COMPANY OVERVIEW�…�…�…�…�…�…�…�….�…�…�….�…�…�…�…�…�…�…�…�…�….�…�…�…�…�…..�…..�…..4

PART II: ANALYSIS FINANCIAL ANALYSIS�…�…�…�…�…�…�…�…�…�…�…�…�…�…�…�…�…�…�…�…�…�…�…�…�…�…�…�…�…�…�….8

Overview...............................�…�…�…�…�…�….�…�…�…�….�…�…�…�…�…�…�…�…�…�…�…�…�…..8

Profitability and Growth......�…�…�…�…�…�….�…�…�…�….�…�…�…�…�…�…�…�…�…�…�…�…....10

Liquidity�…�…�…�….......................�…�…�…�….�…�…�…�…�…�…�…�…�…�…�…�…�…................14

Solvency..................�…�…�…�…�…�…�…�…�…�….�…�…�…�…�…�…�…�…�…�…�…..�…�…�…�….�…15

Market Valuation..................................�…�…�…�…�…....�…�…�…�…�…�….....................�…16

COMPETITIVE ANALYSIS�…�…�…�…�…�….�…�…�…�…�…�…�…�….�…�…�…�….�…�…�…�…�…�…�…�…�…�…18 Internal Rivalry�…�…�…..�…..�…�…�…�…�…�…�…�….�…�…�…�…�…�…�…�…�…�…�…�…�…�…�…..18

Supplier Power.�…�…�…�…�…�…�…�…�…�…�…�…�…�….�…�…�…�…�…�…�…�…�…�…�…�…�…�…..22

Buyer Power.�…�…�….....�…�…�…�…�…�…�…�…�…�…�….�…�…�…�…�…�…�…�…�…�…�…�…�….�…23

Entry............................�…�…�…�…�…�…�…�…�…�…�….�…�…�…�…�…�…�…�…�…�…�…�…�…..�…24

Exit.............................................�…�…�…�…�…�…�….�…�…�…�…�…�…�…�…�…�…�…�…�…..�…25

Substitutes.........................................�…�…�…�…�….�…�…�…�…�…�…�…�…�…�…�…�…�…..�…25

Complements................�…..�…�…�…�…�…�…�…�….�…�…�…�…�…�…�…�…�…�…�…�…�…�…..�….30

SWOT ANALYSIS..�…�…�…�…�…�…�…�…�…�…..�…�…�…�…�…�…�…�…�…�…�…�…�…�…�…�…�…�…�…�…�…...31 Strengths�…�…�…�…�…�…�…�…�…�…�…..�…�…�….�…�…�…�…�…�…�…�…�…�…�…�…�…�…�…�…...31

Weaknesses�…�…�…�…�…�…�…�…�…�…�…�…�….�…�…�…�…�…�…�…�…�…�…�….......................32

Opportunities�…�…�…..�…�…�…�…�…�…�…�…�….�…�…�…�…�…�…�…�…�…�…�…�…�…�…�…�…...33

Threats�…�…�…�…�…�…�…�…�…�…�…�…�…�…�….�…�…�…�…�…�…�…�…�…�…�….......................34

PART III: RECOMMENDATIONS STRATEGIC RECOMMENDATIONS�…�…�…�…�…�…�…�…�…�…�…�….�…�…�…�…�…�…�…�…�…�…�…�….37

Growth Strategies..........................................�…�…�…�…�…�…�…�…�…�…�…�…�…�…�…�…37

Customer Strategies.......................................�…�…�…�…�…�…�…�…�…�…�…�…. �…�…�….46

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APPENDIX....�…�…�…�…�…�…�…�…�…�…�…�…�…..............................�…�…�…�…�…�…�…�…�….�…�…�….54

REFERENCES.�…�…�…�…�…�…�…�…�…�…�…�…�…..............................�…�…�…�…�…�…�…�….�…�…�…...56

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EXECUTIVE SUMMARY Embraer �– Empresa Brasileira de Aeronautica S.A., the Brazilian aircraft manufacturer, is a major manufacturer of regional aircrafts and executive jets. In addition, the firm actively engages in research and development in defense technologies to provide the latest support for the Brazilian Air

Force. Embraer�’s currently competing in two main markets, the 50-120 seat aircraft market as well as the business jet market. The firm has been doing well despite the 2008 financial crisis. Although deliveries have dropped, Embraer�’s backlog order remained at US $15.6 billion by the end of year 2010.

Currently, Embraer faces two main challenges. First, revenues in the regional aircraft market are diminishing and competition is expected to increase as China, Russia and Japan roll out programs to develop their own 70-110 seat aircrafts. Regional protectionism hinders Embraer�’s growth in these markets to a great extent. Second, the business jet market is highly dependent of the economy. Although the market is recovering and Embraer has achieved remarkable results with the launch of its light jets Phenom 100 and 300, Embraer needs to position itself in the market with a high-end brand image so as to differentiate itself from its main competitors Bombardier and Cessna.

Cambrian is thrilled to collaborate with Embraer to formulate growth and customer strategies for the commercial and executive aviation segments respectively. In summary, Embraer should exit the saturated 50-seat and

the declining 70-90 seat segments in the commercial jet market, capitalize its leading position in the 100-120 seat segment and actively improve the fuel efficiencies of the E-jets to maintain competitiveness. Simultaneously, Embraer should expand its market share in the fast growing high margin business jet market through continuous product development and customer base expansion. Embraer�’s customers in the commercial jet market are different than those in the business jet market. Different pricing and marketing strategies should be implemented after a thorough customer

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segmentation process. In addition, well-designed CRM strategies will assist Embraer in understanding the needs of its customers. This way, Embraer could design the aircrafts that are needed most in the future and build a brand of prestige within the aerospace industry.

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PART I INTRODUCTION

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COMPANY OVERVIEW Embraer �– Empresa Brasileira de Aeronautica S.A. is one of the world�’s leading aerospace conglomerates that manufactures small to midsize commercial, executive and military aircrafts. The design, development and manufacturing activities take place in five industrial units in Sao Paulo, Brazil. Three new units are being established abroad. The firm also opened up service centers in US, France, Portugal, China and Singapore to better

support customers in the respective regions. Its 5000 aircrafts are currently serving in 88 countries on five continents. Embraer aims to promote regional mobility, making travel cheaper and less of a hassle.

Embraer was created in 1969 as a government-owned corporation to strengthen the Brazilian military base and to encourage growth in the aeronautical industry. The firm�’s first product was the Embraer EMB 110 Bandeirante �– a 12-seater turboprop, dual engine aircraft. The Brazilian Government offered the firm multiple contracts such as a serial production of 80 Bandeirante aircrafts to stimulate its growth in the early stage. In 1978, the Brazilian Air Force (FAB) contracted Embraer to design and manufacture EMB 312 Tucano, a turboprop aircraft to bridge the gap between training and combat jets. Up till now, Embraer has provided a little over half of the FAB fleet.

In addition to the intensive collaborations with the FAB, Embraer has

established prominent market position in the regional jet segment. The 30-seat EMB 120 Brasilia aircraft was developed in 1980 and became a crucial milestone in Embraer�’s history. Alongside the most advanced technologies at the time, the Brasilia set the new standards for regional aviation for being the fastest, lightest and most economical aircraft in its category. The first Brasilia started servicing the Atlantic Southeast Airlines in the US in 1985. Due to the financial crisis in the early 1990s, Embraer became privatized in 1994. Shortly afterwards, it launched the EMB 145, later renamed the ERJ 145 family, a series of 37 to 50-seater pressurized regional jets with great performance and low operational costs. The ERJ 145 family was well

received throughout the world and assisted Embraer in establishing itself again in the financial markets. In only ten years, Embraer managed to deliver the 900th ERJ 145 jet on February 28, 2005. Embraer identified

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China as a potential market and formed a joint venture with China Aviation Industry Corporation II in 2009 to establish an ERJ 145 assembly facility in Harbin, China.

The Brazilian aerospace manufacturer achieved several milestones in the year 2000. First, the company launched the EMB 170/190 family, also known as the E-Jets, a series of 70 to 120-seat regional aircrafts. If the ERJ 145 ensured Embraer�’s recovery from the earlier financial crisis, the E-Jets then laid the groundwork for the current wave of success. The new �“Double Bubble�” fuselage design on these E-Jets allowed for more head space, legroom and luggage space, and eliminated the middle seats on one-aisled aircrafts. US Airways and JetBlue Airways ordered 85 EMB 170 and 100 EMB 190 aircrafts. JetBlue�’s order was a strategic signifier in illustrating the latest business model for low-cost airlines �– purchasing only one type of aircraft in their fleet to greatly cut costs in the long run.

Also in 2000, Embraer entered the business/corporate aviation market with the introduction of the Legacy jet. The Legacy comes in an executive version with 10 to 16 seats or a shuttle version with 16 to 37 seats. Additionally, the firm issues new stock on the Sao Paulo Stock exchange and made IPO on the New York Stock Exchange in the same year. To better compete in the business jet segment, Embraer revealed the Phenom 100 and Phenom 300, its new very light and light jets, at the 2005 annual convention of the National Business Aviation Association in Orlando, US. Both jets won the IDEA/Brasil design award �– one of the most prestigious design prizes in the world in 2008. Evidently, Embraer has aggressively expanded its presence in the aeronautical market by constantly transforming the latest science and technology into diversified aircraft portfolios that meet the demand of the market.

In 2009, like many others, Embraer suffered from impacts of the financial crisis. The company reduced its administrative and commercial expenses by 21% - US$134 million �– compared to 2008 while maintaining essential R&D investment. Embraer achieved the projected number of 244 deliveries (122 commercial, 115 executive and 7 defense jets), a 19.6% increase from that in 2008. Inevitably, the company also underwent substantial financial administration and restructuring to increase net cash liquidity. Together with the maintenance of a conservative cash flow, the ability to accurately

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deliver forecasted results reinforces Embraer�’s credibility in the market. This is instrumental in securing the investment grade assigned by rating agencies. Embraer currently holds a �“BBB-�” Local and Foreign Currency Corporate Credit Rating assigned by Standard & Poor�’s.

Embraer�’s active investment in research and development since its founding has yield positive outcomes over the years. Since 2000, Embraer has trained its newly hired engineers not only in aeronautics but also in market research and finance. Their high-tech savviness made conversion of the E-Jets assembly from docks to an assembly line possible in 2009. This reduced the construction cycle of the aircraft to only 12 days, again setting

an industry benchmark. The process generated significant financial savings and highlighted Embraer�’s lean manufacturing ability and state-of-the-art supply chain management.

Embraer�’s 2010 deliveries capped at 246, including 100 commercial, 144 executive and 2 defense jets. With another 248 E-Jets in the backlog and emerging markets in Latin America (7% of 2009 revenue) and the Asia-Pacific (21% of 2009 revenue) regions, the upcoming years seem promising for Embraer.

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PART II ANALYSIS

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FINANCIAL ANALYSIS Overview

After beginning in 1969 as an aircraft manufacturer for the Brazilian military, Embraer has grown tremendously over the past forty years. Such success has occurred because the firm has conducted business in a �“niche market�” within the commercial jet sector by focusing on primarily regional jets. The majority of its jets have between 50 to 120 seat-capacities and do not compete with industry titans like Boeing or Airbus. Boeing and Airbus�’s duopoly in the larger commercial aircraft business have given them exclusive advantages in achieving economies of scale in production and predatory pricing in sales. The massive size of their backlogs (3553

units for Airbus and 3375 units for Boeing) will meet the future market demand for large aircrafts, therefore keeping potential competitors out of the game. In addition, smaller players like Embraer does not have the financial capabilities to enter the large aircraft business since the production as well as the customer acquisition cost are extremely high.

Meanwhile, Embraer has managed its finances efficiently and minimized potential financial risks associated with the capital-intensive airline manufacturing industry. Embraer�’s 2010 $15.6 billion backlog remains healthy and is on par with that of its main competitor Bombardier (Fig 2.1).

Fig 2.1 - Source: Cambrian Research

18.8 20.9

16.6 15.6

22.7 23.5

16.7 16.6

0

5

10

15

20

25

2007 2008 2009 2010

($ billion) Backlog Firm Orders

Embraer

Bombardier

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Yet, in recent years, operating in these niche markets has prevented Embraer from growing further. Despite achieving better EBIT margins than Bombardier, Embraer only grew its revenue by 1.9% between 2007 and 2010 from $5.25 to $5.35 billion (Fig 2.2). A portion of its lack of growth can be attributed to the global recession. Yet, it has also failed to attain the success it has previously had as it expands into new markets. While the company sees the emerging markets as areas of potential success it has also seen substantial local resistance, especially in China after establishing a joint venture factory. Given that it has grown previously by operating in these niche markets, there appears to be a limit to its market capitalization. Thus, the question remains for Embraer; can it reverse this trend and stimulate growth or has it reached its peak?

Fig 2.2 - Source: Cambrian Research

5245 6335

5466 5355

9713 9965 9357

8614

0.0%

2.0%

4.0%

6.0%

8.0%

10.0%

0

2000

4000

6000

8000

10000

12000

2007 2008 2009 2010

EBIT Margin (%)

Revenue (million $)

Embraer VS. Bombardier Performance

Embraer Revenue Bombardier Revenue Embraer EBIT Margin Bombardier EBIT Margin

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Profitability and Growth

Table 2.1 Embraer Annual Income Statement from 2007-2010

In Millions of USD (except for per share items)

12 months ending 2010-

12-31

12 months ending 2009-

12-31

12 months ending 2008-

12-31

12 months ending 2007-

12-31

Revenue 5354.5 5466.3 6335.2 5245.17

Other Revenue, Total - - - -

Total Revenue 5354.5 5466.3 6335.2 5245.17

Cost of Revenue, Total 4264.2 4352.2 4991.7 4093.5

Gross Profit 1090.3 1114.1 1343.5 1151.67

Selling/General/Admin. Expenses, Total

572.2 496.6 625.5 596.1

Research & Development 134.5 144 197 259.73

Depreciation/Amortization - - - -

Interest Expense(Income) - Net Operating

- - - -

Unusual Expense (Income) - - - -

Other Operating Expenses, Total

(9.1) 137.9 (16) (78.36)

Total Operating Expense 4961.8 5130.7 5798.2 4870.97

Operating Income 392.7 335.6 537 374.2

Interest Income(Expense), Net Non-Operating

28.4 - - -

Gain (Loss) on Sale of Assets

- - - -

Other, Net - - - 0

Income Before Tax 413.6 276.8 437.3 575.25

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Table 2.2 2010 Growth and Profitability

Margins Embraer General Dynamics

Boeing Aerospace Subsector1

Gross Margin 22.1 18.5 19.2 25

Profit Margin 9.5 8.5 7 1.9

Revenue Growth -16.3 8.9 -7.7 3.8

Table 2.3 2010 Embraer Return on Investment

Margins Embraer General Dynamics Boeing Aerospace Subsector

Return On Equity 13.7 19.5 89.2 10.8

Return On Assets 4.3 8.1 4.8 6.3

Return On Capital 8.3 16.7 23.3 3.8

1 List of companies included in the aerospace subsector is available in the Appendix.

Income After Tax 362.1 262.3 396.2 572.51

Minority Interest (15.1) (13.8) (7.5) (8.18)

Equity In Affiliates - 0 0 0.32

Net Income Before Extra. Items

347 248.5 388.7 564.64

Accounting Change - - - -

Discontinued Operations - - - -

Extraordinary Item - - - -

Net Income 347 248.5 388.7 564.64

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Embraer�’s total sales in 2010 were $5.35 billion, which was below its total 2009 and 2008 sales. Last quarter�’s sales were $1.97 billion in comparison to $1.61 billion in the prior year. Although this increase is a slight improvement, its overall long-term growth seems to be slowing appreciably according to the financials. In fact, fourth quarter profit�’s decreased 2% from $146 million in the year earlier period to $143 million in 2010. Looking at the annual data, Embraer�’s growth is even more meager as profits fell from $565 million in 2007 to $347 in 2010 (Table 2.1). Since the 2008 financial meltdown, Embraer was able to cut cost by 14.4% from $5.8 to $5.0 billion. Clearly, the declining profits are mainly due to the 15.5% drop in revenues from 2008 to 2010.

To better understand the sales performance, we break down the revenue by the product and service segments. Currently, commercial aviation contributes 58% of their current revenue. Executive aviation contributes another 19% and military contracts account for 7%. The remainder is

mainly customer support. From 2008 to 2010, the growth of aeronautic service segment remained relatively flat, while both defense and executive aviation segments experienced 32.2% and 29.1% revenue growth. The commercial aviation segment however, saw a 32.9% drop in revenue (Fig 2.3).

Revenue of the commercial aviation is determined by prices of aircrafts and number of deliveries. Since aircrafts�’ prices are determined in the contract years before the delivery of the actual aircrafts, price fluctuations are unlikely to occur. Consequently, Cambrian believes that drop in deliveries has caused the deteriorating revenues.

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Fig 2.3 - Source: Cambrian Research

Our research outcome has validated the hypothesis. Over the past three years, overall number of deliveries has decreased from 162 units in 2008 to 100 units in 2010 (Fig 2.4). Only 19 ERJ145s were delivered over the past three years. The small regional jet market is saturated and shows little demand for the aircraft. The E-jets, although being claimed to be well received by the airline industry, have also seen decline in deliveries �– 73.4% and 16.3% drop for the medium sized E170/175s and super-medium sized E190/195s. Some of the same forces that affect the airline industry also affect Embraer�’s sales. For instance, oil prices have risen and will continue to rise due to political instability, which will make flying more expensive for the average consumer. Consequently, demand for flights may decrease, and hence, demand for Embraer�’s aircrafts could drop. 2011 is a critical year for both the airline and aerospace industries. Rising deliveries in the upcoming fiscal year means fewer cancellations and deferments.

3356.94244.6

3389.12888.6

839.2

886.9

874.61145.2

367.2

506.8

492.0 669.8524.5

570.2

601.3 563.8157.4

126.7

109.3 87.1

0.0

2000.0

4000.0

6000.0

8000.0

2007 2008 2009 2010

(million $)

Embraer Revenue by Segment

Others

Aeronautic Services

Defense

Executive Aviation

Commercial Aviation

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Fig 2.4 - Source: Cambrian Research

Liquidity

Table 2.4 2010 Embraer Financial Condition

Margins Embraer General Dynamics Boeing Aerospace Subsector

Debt/Equity Ratio 2.2 1.4 23.0 2.0

Current Ratio 1.9 1.3 1.2 2.7

Quick Ratio 0.7 0.6 0.5 NA

7 6 7 6

45

64

33

17

78

92

82

77

0

20

40

60

80

100

120

140

160

180

2007 2008 2009 2010

(Units) Embraer Commercial Aviation Deliveries

EMBRAER 190/195 (98-120 seats)

EMBRAER 170/175 (70-90 seats)

ERJ 145 (50 seats)

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The current ratio for Embraer is 1.9, which is well above the major players within the aerospace subsector. The fact that the ratio of current assets to current liabilities is over 1 indicates that the company is relatively liquid. Embraer�’s quick ratio is 0.7 and does not demonstrate as strong a financial picture as portrayed by the current ratio. Because Embraer is part of a capital-intensive industry, the quick ratio is a more conservative and potentially more accurate measure than the current ratio since it excludes inventory from current assets. One important risk to consider for Embraer is that it may not be able to turn its jets into cash in the event that its short-term obligations need to be paid off immediately. Thus, the current ratio may overestimate the company�’s short-term financial strength.

Considering its position in China highlights this risk because although Embraer is producing its ERJ 145 currently, China appears to be exhibiting regional protectionism in the market. Thus, if Embraer were unable to sell some of these jets that it initially had orders for, it may not be able to meet some of its short-term costs. An even more pressing concern considering the global recession may be if its buyers are unable to pay for their initial orders. This is a very real concern considering that in January of 2010, airline Mesa Air Group filed for bankruptcy. The company�’s fleet included 36 ERJ 145 aircrafts, and Embraer was obligated for guarantees related to financing these jets. As a result of MSA�’s bankruptcy, Embraer�’s revenue experienced a 14% drop.

Despite these risks, Embraer appears to be managing its finances well in relation to its competitors within the industry. Considering the firm has approximately $1.4 billion in cash and $2.1 billion if short-term investments are included, Embraer is positioned to overcome any financial hurdles that may come its way in the near future. In fact, the large amount of cash could be used to help fund any future plans to expand into foreign markets.

Solvency

Embraer�’s long-term debt to capital ratio is 30.59%. Although a ratio under 25% would reflect well on a company�’s financial stability, it is not a pressing concern given the proximity. The average long-term debt to capital for this industry is 17.25%. The debt to equity ratio of 2.2 is consistent with the

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industry average of 2.0 (Table 2.4). The relatively high debt to equity ratio demonstrates that Embraer has been especially aggressive in financing its growth with debt. This makes Embraer a riskier choice for investors and it maintains a credit rating of �“BBB-�” assigned by Standard & Poor�’s.

Market Valuation

Table 2.5 2010 Embraer Market Valuation

Margins Embraer General Dynamics Boeing Aerospace Subsector

Current P/E Ratio 16.7 10.5 16.3 22.1

Price/Sales Ratio 1.2 0.8 0.8 1.2

Price/Book Value 2.3 2.0 18.5 2.7

Price/Cash Flow

Ratio

12.2 8.3 10.5 11.9

The current P/E of Embraer shares is 16.7, which is slightly lower than the industry average of 22.1 (Table 2.5). Simultaneously, its price to book value ratio is 2.3 compared to an industry average of 2.7. While this valuation may seem attractive at first, these measures mean that investors are assigning very little value to the company�’s ongoing business and future earnings growth. The overall lack of investor confidence is likely attributed to the company�’s failure to maintain growth in the past few years and high debt to equity ratio. Along with the other valuation measures, the price to sales ratio is 1.2, which is in line with the Aerospace industry average ratio of 1.2. One final measure to help interpret its financial picture is the price to cash flow ratio, which is 12.2. The ratio shows a strong ability to generate cash and reflects well on the company�’s stock price and liquidity. In comparison the price to cash flow ratio for the Aerospace subsector is 11.9.

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Table 2.6 2010 Embraer Stock Performance Relative to Bombardier and S&P 500

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FIVE FORCES ANALYSIS

Force Strategic Impact

Internal Rivalry High

Supplier Power Low to Moderate

Buyer Power Moderate to High

Entry and Exit Low

Substitutes and Complements Moderate

Internal Rivalry

Commercial Jets

Embraer is one of two major competitors in the Regional Commercial Jet market. Their major competitor, Bombardier, was the market leader and mainly competed with Boeing until 1996 when Boeing exited the market to focus on their larger aircraft and Embraer entered. Embraer lagged behind Bombardier in deliveries, net orders, and revenues until recent years. Although still behind in revenue, Embraer delivered 100 commercial aircraft compared to Bombardier�’s 97 in 2010 (Fig 3.1).

Despite high concentration, these two companies constantly compete for market share through product quality and price competition. The nature of large sparse contract sales to airlines motivates the firms to always maintain competitiveness; if they fall behind for even a short time, they may lose their biggest contract of the year. As a result, they invest heavily in R&D. Constant manufacturing efficiency developments, such as Embraer�’s pioneering of the assembly line, are implemented to stay price competitive. Fuel efficiency, aircraft speed, travel range, and flight turnaround efficiency technologies are main focuses of product improvement and competition.

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Internal Rivalry has increased in recent years as the two players compete in a decelerating market due to fewer new orders and increased order deferment resulting from the economic recession. In addition, the ability of both companies to maintain profits throughout the crisis attracted three new entrants which has further exacerbated competition. Sukhoi Civil Aircraft Company in Russia teamed with Alenia Aeronautica in Italy to build the Superjet 100, a regional jet that Sukhoi is marketing as a cheaper alternative to similarly sized Embraer and Bombardier models. 70 orders for the new jet have already been placed. The first delivery is scheduled for early 2011.

The Commercial Aircraft Corporation of China (COMAC) is developing two regional jet models and plans for flight certification by 2012. This project is strongly supported by the Chinese government and has received 340 tentative orders, mostly from Chinese airlines. Embraer is taking strategic steps to lock in relationships with Chinese airlines before this large and growing market sees intense competition from COMAC. In 2009, Embraer built a joint venture factory in Harbin, China with the Chinese state owned company AVIC, to assemble the ERJ145s.

Mitsubishi Heavy Industries plans to deliver the first Japanese made regional jet in 2014, targeting Japanese and North American airlines. Mitsubishi manufactures Boeing parts, a relationship which paved the way for Boeing�’s agreement to act as an advisor during Mitsubishi�’s downstream integration into regional jets. 15 jets have been ordered by a Japanese airline and a US airline has signed a letter of intent to purchase 50.

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Fig 3.1 - Source: Embraer November 2010 Redburn Presentation

Business Jets

The business jet market has more players than the regional jet market but is still highly concentrated. Six companies made up 97% of 2010 deliveries. The largest, Cessna, delivered 178 business jets in 2010, followed by Bombardier�’s delivery of 150. Embraer was third with 145 deliveries (Fig 3.2). Internal rivalry pressure is lessened slightly by the differentiability of business jet interior set ups.

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Fig 3.2 - Source: Cambrian Research

Corporate profits lagged by eight quarters have proven a significant indicator of business jet sales. Sales have declined due to the economic recession as corporations opt for cheaper substitutes. 2010 business jet deliveries were 12.3% below 2009. Sales turn-around is expected late 2011 or early 2012. Internal rivalry has increased over the past several years as competitors fight for a share of the shrinking market. As a result, Avcraft, Eclipse Aviation, and Emivest exited the market.

Embraer is faring well among this competition with respect to deliveries. The newest of the three market leaders, Embraer delivered its first business jet in 2002 and has seen deliveries increase each year. In 2009 and 2010, Cessna and Bombardier suffered declining deliveries. During these years, Embraer grew the most among all competitors. Intensified internal rivalry may have actually benefitted Embraer in the long run due to the forced exit of small competitors, especially since Embraer has been able to maintain

23%

20%

19%

13%

12%

10%3%

0%

20%

40%

60%

80%

100%

2010

Business Jets Deliveries

Others

Hawker Beechcraft

Dassault

Gulfstream

Embraer

Bombarder

Cessna

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growth in this segment with the introduction of spacious and well-designed jets.

Supplier Power

Aircraft manufacturers purchase engines and parts from specialized original equipment manufacturers (OEMs) and assemble the aircrafts in company plants. There are three major inputs for both regional and business jets: jet engines, aircraft parts and equipment, and labor.

The jet engine industry is a three player oligopoly: General Electric (GE), Pratt & Whitney, and Rolls-Royce. A joint venture, CFM International SA, between GE and France based Snecma Supplier also commands significant market share. Supplier power was low in the past due to propensity for intense competition and resulting price wars among these companies. In an effort to improve profits, the suppliers began entering exclusive contracts with aircraft manufacturers for the sale of engines to particular aircraft models.

This sale process persists today. For example, The Embraer ERJ-170 and ERJ-190 models all use jet engines produced by GE, while the ERJ-145 uses Rolls-Royce. Bombardier also uses GE engines for its CRJ and Challenger series. However, because jet engine producers still compete for these long term contracts, they often discount engine prices significantly in order to secure the accompanying replacement parts and maintenance contracts which provide strong supplier power for these services after the contract is secured. Nevertheless, as demand for fuel efficient engines increase due to volatile oil prices, better engines must be designed for the aircrafts. Since engines are integral parts of the planes and modern aircrafts are designed around these technological enhanced engines, the engine suppliers possess much higher supplier power than before. With its specialization in aviation engine designs, GE Aviation has supplied its engines to all major aircraft manufacturers.

Other aircraft parts and equipment includes products such as: avionics, fuselage assemblies, wing parts, rudders, landing gear, wheels, brakes, fuel tanks, propellers, etc. These are produced by OEMs specialized in one or multiple parts. There are about 1,000 companies in this industry. However,

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it is more concentrated than this number of players suggests due to the high level of specialization by type of part produced. These suppliers have lower supplier power than engine suppliers. Overall, the aerospace component industry exerts moderate to low supplier power over the aircraft manufacturing industry pending on different components supplied.

Buyer Power

Buyer power in the regional jet market could be argued to be low for several reasons. Seller concentration is high; Embraer and Bombardier have maintained duopoly in the market since 2000. Buyer concentration in the airline industry is low, although concentration has increased recently due to mergers and acquisitions. There are about 500 commercial airlines with a growing number of them using regional jets each year. Embraer�’s customer list includes over 90 different companies. Buyers face two strong internal cost pressures to buy new regional jets. As airlines continue to employ the more cost effective hub and spoke flight model, their demand for right-sizing to a fleet more highly made up of regional jets increases. Also, as fuel costs rise, it becomes more cost effective for airlines with older less fuel efficient fleets to upgrade before they otherwise would. This pressure is strongest in the US and Western Europe, where old aircrafts take up big proportions of the fleets.

Nevertheless, buyer power could also be high if airlines are placing a big order for the first time. JetBlue ordered 100 planes from Embraer so as to maintain a low operating cost by managing the same models and achieve efficiency via learning by doing. Once the airline makes the decision, the impact of the decision lasts for decades since it will have to purchase similar models from the same manufacturer in the future. This way, future cost savings are materialized via achieving economies of scale in learning how to operate the jets, training airline pilots, staff, and maintenance, and replacing interchangeable parts. As a result, airlines will possess moderate to high buyer power in their initial contract negotiation.

Buyer power in the business jet market is higher than that of the regional jet market for two reasons. First, the seller industry is less concentrated; there are six major competitors with a market share of at least 10%. Second, the impact of economies of scale in locking a customer into consistent

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purchases from one manufacturer is less for business jet customers because the total fleet size they are purchasing is smaller. Therefore, switching manufacturers is a much more viable option.

Additionally, the buy power could also be high if Embraer is dealing with large air leasing companies which place large orders. Such firms have great credit rating and are able to finance their purchase. With such consolidated purchase, these lessors could bid the price down.

Entry

Significant entry barriers exist in the aircraft manufacturing industry and the barriers exacerbate the effects of one another. Financing is a major entry barrier. High capital investment in technology development, manufacturing facilities, and personnel training is needed. Investment in advertising to airlines and corporate clients is also necessary before any orders will be placed due to customers�’ high switching costs and the importance of reputation in the industry. Due to the complexity of technology involved, economies of scale, and the lengthy flight certification process required for each new model released, new entrants must be able to finance these initial costs for extended periods of time before any revenue is realized. Many of the recent entrants in the regional jet market have been able to endure these financing costs due to state support.

There are significant economies of scale in the industry, especially with Embraer�’s recent introduction of assembly line production. If manufacturing facilities and employees are not operating at full capacity or the number of orders is not high enough to employ efficient assembly line production, the new entrant will suffer higher costs per jet than competitors with higher production. Additionally, manufacturers receive bulk discounts on aircraft parts and equipment. This is why many of the recent new entrants to the commercial jet market are taking orders for several years before their first planned delivery.

Several first mover advantages in the aircraft manufacturing industry create barriers to entry. Regional and business jets are sold through pre-order contracts. Upon entering the market, new manufacturers face limited demand because many customers will have already placed their orders with

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veteran companies. Customers have little incentive to place orders with new entrants before their certification is complete and they are ready to begin production. If the new entrant falls behind their business development schedule, the customer risks not receiving their order on time.

Customers are very concerned with safety and reliability of the product. Airlines know that product failure could ruin their business and executives making the decision to purchase company jets are entrusting their own lives. An aircraft manufacturer�’s reputation is very important. Industry veterans have proven their manufacturing and quality control procedures are sound. Buying from a new entrant constitutes higher risk for customers.

Airlines and corporate fleets benefit from purchasing all of their jets from the same manufacturer due to interchangeability of parts and economies of scale in learning to operate the aircrafts and training operators and maintenance workers. This gives significant advantage to industry veterans because customers are unlikely to switch manufacturers due to the additional learning and training costs involved. Moreover, if they were to switch, they would have to switch their entire fleet in order to maintain their current level of economies of scale. It is unlikely that an airline would switch their entire fleet to a newly entered manufacturer due to high uncertainty risk. This switch would be more likely in the business jet market, which typically have smaller fleets.

Exit

Exiting the aircraft manufacturing industry is a difficult process. The large amount of equipment, proprietary technology, and property required for production must be liquidated. Due to the pre-order contract sales model, common practice of having high order backlog, and stiff penalties for late delivery, aircraft manufacturers may be forced to continue producing

aircrafts to fulfill their delivery commitments past the desired time of exit or face severe financial consequences.

Substitutes

Substitutes for both regional and business jets have been limited in the past due to the combination of low cross elasticity of demand and lack of

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any major cost effective alternatives. However, the economic recession and new technologies are driving customers toward emerging cheaper alternatives in both markets. The business jet segment�’s most significant substitutes are traditional commercial airline flights and used business jets. In the regional jet segment, larger jets produced by Boeing and Airbus could be a substitute but organization and cost structure of the airline industry, prevent this from occurring.

Increasingly, video conferencing and high speed trains are being considered as substitutes, but more in the regional jet market. However, Cambrian believes that neither imposes significant threat on Embraer.

Business Jets

Commercial flight tickets and used business jets are obviously not new substitutes and are not projected to see significant price decreases in the near future. However, the recession has increased the appeal of these lower cost options. Many large corporations, the largest segment of the business jet market, implemented aggressive cost cutting measures during the recession. Particular attention was directed towards reducing executive perks, including business jets. As a result, the business jet sector has declined each year since 2008 as corporations opt for cheaper alternatives.

The most common low cost alternative is flying executives on commercial airlines rather than expanding the business jet fleet. This is an interesting substitute threat for companies like Embraer and Bombardier who are in both the business jet and commercial jet market because increased commercial jet traffic is ultimately good for their regional jet sales. However, higher profit margins in the business jet market make this trend bad for the aircraft manufacturers in net.

The market for used business jets directly affects the demand for new business jets. Corporations cutting costs during the recession and looking for a cheaper alternative to buying a new business jet also consider the used business jet market. This impact has been exacerbated during the recession by the increased supply of used business jets as a result of corporations selling their jets in an attempt to improve their cash flow. Used business jets comprised 14.8% of the business jet fleet in December 2010. While this

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is 1.5 percentage points lower than in December 2009, it is still above the historical pre �–recession average.

Traditional used market theory would indicate that the ability for a customer to resell the good would increase the price they would be willing to pay for the initial purchase of the good, thereby allowing the manufacturer to capture the benefit of resale. However, several aspects of the existing business jet market make the sale of used jets more detrimental to business jet manufacturers than traditional theory suggests.

The high price of both used and unused corporate jets creates a limited customer base; few consumers of used corporate jets would not have purchased a new jet if a cheaper used one hadn�’t been available. Moreover, there is low cross elasticity of demand between used and new business jets. These two market characteristics create circumstances such that one used business jet purchase likely represents on less unit of demand for new business jets. Additionally, many of the business jets being resold today were purchased before the economic crisis when the market for used jets was smaller. Therefore, the price at which the jets were purchased from the manufacturer likely did not include the perceived ability for resale.

Commercial Jets

Over the past ten years the airline flight models have shifted towards hub and spoke systems because demand for flights between two small airports was not high enough to reach break-even occupancy levels on large jets. This change required significant increase in the use of regional jets to service the spoke flights. In effect, the airline industry substituted regional jets for traditional larger aircraft produced by Boeing and Airbus. Under current market conditions, this model provides the lowest cost for airlines and therefore the chance of them substituting back to a more heavily large jet system is not a significant threat. A major increase in passenger air travel would be necessary to make this a consideration for airlines. If demand dramatically increased these spoke flights may have enough passenger traffic to make larger flights profitable. However, with existing air travel and predicted future growth, substituting larger flights does not pose a significant threat.

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High speed trains do not stand to compete with aircraft manufacturers for their immediate customers, airlines and businesses. However, they do pose a threat to the industry overall due to their potential to change the behavior of end consumers, travelers. High speed trains are unlikely to threaten Embraer�’s business jet segment. A business customer that would chose the privacy, convenience, and prestige that comes with private jets over the cheaper alternative buying commercial airline tickets would likely make the same decision over the cheaper alternative of buying high speed train tickets.

It does have the �“potential�” to impact regional jet sales. If travelers substitute high speed train travel for air travel, airlines will accordingly reduce the number of flights they offer in order to maintain profitable occupancy rates and therefore will have reduced demand for new aircraft from manufacturers. California�’s high speed train which is scheduled to begin construction in 2012 will connect Los Angeles to San Francisco and stop at other urban centers in between. This route represents a series of flights currently using regional jets. Decreased demand for this flight would reduce the airlines demand for regional jets. Yet, we believe that the threat is only tangential. Here is our rationale:

Based on our research, about 66 Amtrak trains run between Los Angeles and San Francisco every day with a load factor of 50% and maximum capacity of 1000 per train. Hence, about 33,000 passengers travel via train between L.A. and San Francisco daily. In addition, the Los Angeles to San Francisco airline route has more than 2.8 million passengers per year, which translates to 7,700 passengers per day. Combining the two segments gives us 40,700 passengers per day. That is the current passenger flow between the two cities. We ignore the people who drive for the simplicity of our estimation. High speed rail will most likely target non-driving customers to provide convenient in-State transportation. However, let�’s examine the break even volume for the high-speed rail project. The initial investment is about $45 billion without taking into the account of potential cost overruns and delays attributable to environmental and community opposition. Both airlines and Amtrak trains charge about $70 for one-way trips between L.A. and San Francisco. Assuming that the high-speed rail aims to penetrate the market with low pricing and more convenience, it should offer a competitive price around $100 for one-way trips. Currently,

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the most profitable high speed train is Sapsan from Russia. Its profit margins are about 30%, three times higher than those in China. Let�’s assume that California�’s project goes extremely well and achieves 30% profit margins. This means that profit per passenger will be $100 * 30% = $30. As such, the breakeven volume for the California High-speed rail project will be $45 billion/$30 = 1.5 billion passengers. Again, assuming that the high-speed trains are operating at full capacity; with 60 1500-seat high speed trains, we have 90,000 daily passengers on board. Hence, the entire project takes 1.5 billion/90,000/365= 46 years to break even. Evidently, this is the most optimistic yet unrealistic estimation. The actual breakeven will be much longer. Not only do the projected 90,000 daily passengers exceed the current customer volume 57,200 by almost 57%, we also assumed that the high-speed train will attract all current airline and Amtrak customers, which will never happen. Conclusively, the project is unlikely to be funded by government or private investors, given California�’s existing budget deficit as well as the long break even period. The threat of high-speed rail will not be materialized.

Improving video conferencing technology is another emerging substitute for airline business travel and therefore a potential substitute for regional jets. In an effort to cut costs, companies are increasingly choosing to have their less important and/or higher travel intense meetings over video conference. Elimination of dropped calls and lags combined with pressure on businesses to reduce their carbon footprint has magnified this impact. For example, Microsoft said they saved $90 million in 2008 on reduced travel and time costs as a result of substituting virtual meetings for in person ones. This is likely to impact the regional jet market more than the business jet market because business jets are usually used for high level executive meetings, which a company would be less willing to do over video conference. In addition, when senior executives are meeting clients for the first time, having the meeting in person is still the standard protocol and cannot be replaced by a Cisco Teleconferencing System. Even among the airlines, only the ones that are heavily reliant on business travelers will be adversely affected by such technology. When demand for business travel drop after the 2008 financial meltdown, airlines that rely on business customers are affected most. Recreational travelers on the other hand, also start switching to low cost airlines to cut expenditures. Unsurprisingly,

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Southwest Airlines realized a 10% increase in revenue since 2008. Regional airlines, being less focused on business travelers, are less affected by the financial crisis and teleconferencing technologies. Consequently, Embraer, being a regional jet manufacturer is not yet affected by teleconferencing technologies either. On the flip side, teleconferencing may actually stimulate more in-person travels between high level executives, especially after sealing a great deal. Top executives and their teams may get together with the clients or business partners to celebrate and plan for follow-up procedures. Hence, the impact of teleconference technologies on business travel is not entirely negative.

Complements

There are two main complements to commercial and business aircraft: airports and fuel costs. Even if demand for air travel is high, airlines will only purchase the number of aircrafts that the airport system can support. Moreover, if traveler demand outpaces airport construction and expansion, airports will become overcrowded and consumers will substitute other modes of travel. Additionally, if air travel demand is high in an area where no airport exists, that demand will not be realized by the airline or aircraft manufacturing industry. This complement is an important concern in emerging markets where air travel demand is increasing rapidly. Overall, airport expansion is predicted to keep up with increases in air travel demand. China�’s aviation authority plans to add 97 new airports by 2020, bringing the total to 244.

Increasing fuel prices have severely impacted profitability of the airline industry and contributed to many airlines�’ elimination of lower occupancy routes and reduction of the number of flights per day. This in turn decreases airline demand for aircraft. High fuel prices create incentives for corporations to reduce the use of their existing business jets or to sell them. New business jet customers are dissuaded from purchasing. In an effort to reduce their exposure to fuel prices and increase competitiveness, fuel efficiency has been a major focus for the aircraft manufacturing industry in recent years. Hence, we classify fuel as a compliment for aircrafts because airlines need both to provide the travel experience people desire. Since airlines have no control over the volatile fuel prices, they are forced to focus on purchasing the most fuel efficient aircrafts. To this end, high fuel prices

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are beneficial for Embraer - the firm should re-design their E-jets with the latest fuel efficient materials to meet the demands of the airlines.

SWOT ANALYSIS

Strengths Weaknesses

�• Focusing on R&D and specializing in niche market

�• Meeting expected deliveries

�• Government support

�• Little proportion of unionized workers

�• Upstream manufacturing depends on downstream health of airline industry

�• Heavily reliant on the state of economy

�• Lack of strategic operation management within different countries

�• Lack of clear customer segmentation and therefore fail to formulate customer specific sales and marketing strategies

�• Over-optimistic about growth of the 70-90 seat aircraft market

Opportunities Threats

�• Growing demands in emerging markets

�• Greater demand for right-sizing fleets

�• 33% current regional jets will need to be replaced

�• Air leasing market

�• Emerging markets are developing their own regional jets and domestic protectionism is high

�• Substitutes such as used aircrafts

�• Low credit rating

Strengths

�• Embraer places heavy focus on its research and development. The E-Jets�’ new �“Double Bubble�” fuselage design for the regional jets allows for more head space, legroom and luggage space, and eliminates the middle seats on one-aisled aircrafts. Embraer�’s high-tech savviness made conversion of the E-Jets assembly from docks to an assembly line possible in 2009. This reduces the construction

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cycle of the aircraft to only 12 days, setting an industry benchmark. Embraer also has a long tradition of developing green technology. It was the first manufacturer to build a certified ethanol-fueled airplane. Additionally, Embraer�’s Phenom 100, an entry-level business jet, was designed to cut pilot workload to a minimum so there is time to focus on the overall situation while the airplane and its systems take care of themselves. 70 percent fewer actions are required to operate the Phenom. Over the past six years, Embraer�’s business jet segment continues to grow due to active R&D as well as product differentiation.

�• The firm underwent substantial financial administration and restructuring to increase net cash liquidity during the recent financial meltdown. Together with the maintenance of a conservative cash flow, the ability to accurately deliver forecasted results reinforces Embraer�’s credibility in the market.

�• The Brazilian Government has supported the firm since it was founded. Up till now, Embraer has provided a little over half of the FAB fleet.

�• Only about 10% of Embraer�’s labor force is unionized. These employees have little bargaining power because the cost of finding and training a replacement is relatively low. 15,952 out of the total 18,628 Embraer employees are located in Brazil, where it is the only major aircraft manufacturer. Embraer laid off 4300 workers during the recession to focus on manufacturing. Labor cost would impose less risk on the firm.

Weaknesses

�• The upstream manufacturing is highly dependent on the health of the airline industry, which is determined by the state of the economy. When the airline industry was hit by the 2008 financial crisis, Embraer suffered from the triggering effect since order and deliveries went down.

�• Although Embraer has set up plants in numerous cities in the world, these global plants could have been more strategically utilized. The

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ERJ145 joint venture plant in China has limited power on deciding what planes to assemble due to stringent pressure imposed by the Chinese government.

�• Embraer serves very different clients in the commercial and executive aviation markets. Low-budget airlines are concerned with cost efficient aircrafts that maximize profits, while flight departments of corporations and government are interested in comfortable and safe executive jets. Embraer has yet to fully segment its customers, therefore its sales and marketing efforts are not customized to attract and retain customers from different segments.

�• Embraer has been proud of its E-jets since they were launched. However, deliveries and number of backlog orders have shown clear indication of dwindling interest in the E170/175s. With the recovering economy, regional airlines clearly hope to increase their fleet by having more aircrafts in the 100-120 seat capacity range. E190/195s offer better load factors than big commercial aircrafts and they also hold more passengers than the E170/175s. Embraer should consider retooling its infrastructures to focus on the production and enhancement of E190/195s. The E170/175 segment should be dropped.

Opportunities

�• Emerging nations have been major drivers of the global economic recovery while the USA and European countries are improving at much slower rates. In 2010, the GDP of China has surpassed that of Japan and will overtake the USA by 2027, according to Goldman Sachs Group Inc. chief economist Jim O�’Neill. Embraer forecasts that China will lead over the next 20 years with an average annual revenue passenger kilometers growth rate of 7.3% followed by Latin America, Asia Pacific and Russia/CIS, each with 6% per year. Africa will grow around 5% and mature economies, such as North America and Europe, around 3.5%.

�• Aircrafts in the 90 to 110-seat category improve industry efficiency through right-sizing. According to Embraer, more than 34% of

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flights depart with loads appropriate for 90-110 seat aircraft. Excessive capacity hurts the bottom line for airlines. Furthermore, the commercial fleet is ageing. More than 30% of the world�’s in-service fleet of 60-120 seat aircraft are more than 20 years old and approaching the end of their economic lives. About 700 units of these aircrafts are expected to retire soon. Older aircrafts not only consumes more fuel and are costly to maintain, they do not meet the emission standards in many markets. A newer generation of fuel efficient 70-110 seat aircraft is thus necessary to fill the gap and meet the new standards. Embraer forecasts that the world fleet of 30 to 120-seat jets will increase from 4,285 aircraft in 2009 to 7,780 by 2029. In this period, 51% of new deliveries (3,495 units) will be added to support current demand growth and 49% (3,380 units) to replace ageing equipment.

�• A recent report entitled �“World Aircraft Leasing Market�” from Frost and Sullivan, a global consultancy service, predicts that aircraft leasing will pick up steam towards the end of 2010 and the beginning of 2011. The report says new-generation aircraft rentals will increase quicker than older aircraft rentals although profitability is expected across the whole sector. Falling interest rates are contributing growth in the air leasing sector. Frost and Sullivan suggests that �“as airlines are finding it difficult to finance fleet expansion due to scarcity of funds, there is a growing trend among airlines for leasing an aircraft rather than buying it. The penetration of the leasing industry is expected to increase from the current levels of 31.53 %.�”

Threats

�• Although emerging markets look promising, the competition within these markets is intensified in the near future. The Commercial Aircraft Corporation of China (COMAC) is developing two regional jet models and plans for flight certification by 2012. For Embraer, although a joint venture factory was built in Harbin, China, the factory was limited to producing only the 50-seat ERJ 145. Embraer pushed for an upgrade for the factory to start manufacturing the EMB 190/195 with 100 over seats, but received no response by the Beijing government. Clearly, regional protectionism is eroding the

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market share of Embraer in China. In addition, Mitsubishi Heavy Industries plans to deliver the first Japanese made regional jet in 2014. Its target customers are Japanese and North American airlines.

�• Corporations cutting costs during the recession and looking for a cheaper alternative to buying a new business jet considers the used business jet market. This impact has been exacerbated during the recession by the increased supply of used business jets as a result of corporations selling their jets in an attempt to improve their cash flow. Used business jets comprised 14.8% of the business jet fleet in December 2010.

�• Embraer�’s assigned credit rating by Standard & Poor�’s is BBB-. Furthermore, Embraer�’s stock currently holds a beta value of 1.93, indicating a higher risk relative to the market. Despite being a well-praised stock, Embraer may still turn away some risk adverse investors.

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PART III RECOMMENDATIONS

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STRATEGIC RECOMMENDATIONS Growth Strategies

Embraer, just like any aerospace manufacturer, is heavily reliant on the downstream airline industry. Ever since the 2008 financial meltdown, demand for air travel dropped drastically. The firm has undergone intensive lean operation transformations to counteract cancellations and deferment of orders. The main driver for the declining profit is a drop in number of deliveries for E-jets. It is at this point that the firm needs to prioritize its growth strategies to increase orders and deliveries for E190/195s while expanding its market share in the executive aviation segment. Embraer should also channel its R&D efforts to the designing of

even more fuel-efficient aircrafts to meet the future market demand. Cambrian�’s strategic recommendations are as follows:

Commercial Jet Segment Business Jet Segment

Short Term Long Term Short Term Long Term

Re-design E190/195.

Exit E145 &

E170/175 segments.

Segment customers.

Increase aircraft

prices.

Expand in Europe and Asia Pacific.

Diversify service

offerings in China. Place new assembly

plants in emerging

markets.

Focus on high growth segments.

Expand customer base.

Conduct customer-specific marketing.

Maintain high price tag.

Improve sales and CRM

strategies.

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Commercial Jets

Re-design the E190/195s:

Commercial Aviation Product Portfolio

Small Medium Large

Embraer ERJ145

(50) E-170 (70-80) E-175 (78-88) E-190 (98-114) E-195 (108-122)

Bombardier

COMAC

MHI

Sukhoi

Airbus

Boeing

Product in Service

Product under Development

[1] Number of seats

Fig 5.1 - Source: Cambrian Research

Embraer holds comparative advantages in the regional jet market due to the wide range of products offered (Fig 5.1). At this point, the firm faces only one competitor- Bombardier. However, competition is expected to intensify over the next few years as COMAC from China, MHI and Sukhoi from Japan and Russia roll out their regional jets. We believe that while new product development is unnecessary at this point for the commercial aviation segment given the existing product portfolio, Embraer should actively engage in re-design or enhancement of their E-jets. The future of the airline industry relies on cost efficient aircrafts. Being able to operate with less fuel gives an aircraft significant competitive advantage in the near future.

Constant political instability in Libya and other parts of the world caps the oil supply, while economic growth in emerging markets drives up the

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demand for fuel/oil. According to the International Air Transport Association, the international passenger air traffic will rise in 2011 due to strong economic growth in regions such as Asia Pacific and South America. As a result, both international passenger and freight transport will increase, pushing up the demand for oil. The combined effect of less supply and more demand makes rising oil prices inevitable. As an attempt to reduce operating costs, airlines anxiously search for replacement for their existing fleet to meet their long term planning. Hence, the E-jets should be enhanced and redesigned to meet such demand.

Simultaneously, many emerging markets have scattered and smaller airports. They could be better accessed by regional jets like E195 with relatively smaller sizes but sufficient cargo and passenger capacities. To a certain extent, this is why high-speed train is not a substitute for regional aircrafts. The upfront investments of laying railways between towns and cities make such projects too expensive to be launched.

Embraer should develop an aircraft for cargo transportation. It is already designing a state-of-the-art military cargo transporter �–KC390, for the Brazilian Air Force. With some tweaks to the model, Embraer could introduce this cargo transporter to airlines that hope to enter freight transportation markets in developing countries. Conclusively, Embraer should continue to develop larger fuel efficient regional jets for transporting passengers and freights in the future.

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Exit the small and medium segments:

Number of Commercial Aircrafts Deliveries (Growth)

2008 2009 2010

Category Embraer Bombardier Embraer Bombardier Embraer Bombardier

Small

(ERJ145)

-14.3% NA 16.7% NA -14.3% NA

Medium

(E-170/175)

42.2% -14.1% -48.4% 10.0% -48.5% -19.8%

Super-

Medium

(E-190/195)

17.9% NA -10.9% NA -8.5% NA

Fig 5.2 - Source: Cambrian Research

The ERJ 145 segment has experienced no substantial growth given the saturation of the market (Fig 5.2 & 5.3). Embraer should exit this segment to focus on the re-design of its E190/195s or expansion in emerging markets. Although Embraer believes that there are market potential for the medium category (70-90 seat E170/175), Cambrian recommends Embraer to exit this market segment as well. The growth for this segment has been negative 50% over the past two years, indicating a declining market interest in the E170/175s. There are currently only 50 backlog orders for E170/175 while the backlog order for E190/195 remains at 200 units.

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Fig 5.3 - Source: Cambrian Research

Focus on Europe and Asia Pacific:

Embraer ought to aggressively expand into geographical regions with huge new market potential and rapid natural growth �– Latin America, Europe, Middle East and Asia Pacific. Embraer should focus on Europe and Asia Pacific specifically, due to their outstanding revenue growth of 53.4% and 137% in 2009 (Fig 5.4).

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

2007 2008 2009 2010 2007 2008 2009 2010 2007 2008 2009 2010

Small (50 seats) Medium (70-90 seats) Large (100-120 seats)

Commercial Aviation Market Share

Other

BA

ERJ

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Fig 5.4 - Source: Cambrian Research & Embraer 2010 Redbum Presentation

50% 57%49%

40%

62%

12%

50%

20%14% 31%

6%

33%

49%

39%9% 8%

25%7%

21% 21% 20%29%

5%

32%

11%

0%

50%

100%

World North America

Latin America Europe Middle East China Asia Pacic

Embraer's Commercial Jet Deployment (Up till Nov 2010)

Right-sizing New Markets Replacement of old Jets Natural Growth

2412.8 2724.1

1257.2

1258.81140.3

1749.2

629.4 633.5

382.6

209.8253.4

601.3

314.7

1140.3

1147.9419.6

443.5

328.0

0.0

1000.0

2000.0

3000.0

4000.0

5000.0

6000.0

7000.0

2007 2008 2009

(million $) Embraer Revenue by Geographical Region

North America Europe Brazil

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Diversification in China:

Embraer and China�’s joint venture ERJ-145 factory is considering an upgrade so as to produce the more profitable E-jets. Unfortunately, the Beijing Government made no decision to green-light the proposal as an attempt to protect its own product ARJ21, which is scheduled to be delivered in 2016. With its superior aircraft assembly technology, Embraer should negotiate with the Chinese government to license such technology to the Chinese aircraft manufacturers and become a service and technology provider.

Business Jets

Focus on high-growth segments:

Executive Aviation Product Portfolio

Light Medium Large

Embraer Phenom100

(4)[1] Phenom300

(6)

Legacy 450 (7-

10)

Legacy 600 (13)

Legacy 650 (13)

Legacy 500 (15)

Lineage 1000 (19)

Bombardier

Cessna

Dassault

Gulfstream

Hawker Beechcraft

Product in Service

Product under Development

[1] Number of Passengers

Fig 5.5 - Source: Cambrian Research

Embraer�’s business jets cover all three sub-categories �– light, medium and large (Fig 5.5). A remarkable increase of deliveries is observed for

CAMBRIAN GROUP

Embraer�’s business jets as compared to its primary competitor Bombardier. Phenom 100 was introduced in 2007 and has become the best-selling business jet of all times, achieving 100 deliveries in 2010 alone (Fig 5.6). The Phenom 300 also experienced a 34% growth in deliveries in 2010, indicating a strong market interest in the aircraft (Fig 5.7).

Fig 5.6 - Source: Cambrian Research

Number of Executive Aircrafts Deliveries (Growth)

2008 2009 2010

Category Embraer Bombardier Embraer Bombardier Embraer Bombardier

Light NA -13.6% 4600.0% -37.1% 34.0% 6.8%

Medium -5.7% 11.7% -45.5% -28.7% -44.4% -23.2%

Large NA 4.2% NA 0.0% 166.7% -34.0%

Fig 5.7 - Source: Cambrian Research

93 100

26

35 33

18

10

3

8

1

0

20

40

60

80

100

120

140

160

2007 2008 2009 2010

(Units) Embraer Executive Aviation Deliveries

EMBRAER 175 (78-88 seats)

Lineage 1000 (13-19 seats)

Legacy 600 (10-14 seats)

Phenom 300 (6 seats)

Phenom 100 (4 seats)

CAMBRIAN GROUP

Embraer�’s dominance in the light jet category (Fig 5.8) helps the firm achieve leading reputation in the industry. Its spacious Lineage 1000 offers twice the amount of space than its competitors�’, therefore gradually picking up market share in the large jet category. Although Embraer�’s performance in the medium jet category is declining, the firm actively engages in research and development to enhance current models. With the introduction of Legacy 650 and 500, Embraer will come back strong this year. Cambrian recommends Embraer to continue to market its Phenom 100/300 and Lineage 1000 in both existing and new markets since both segments are still growing rapidly (Fig. 5.7).

Fig 5.8 - Source: Cambrian Research

Expand customer base:

Embraer should look into emerging markets with increasing high net worth individuals. Merrill Lynch and Cap Gemini estimated in their 2010 World Wealth Report that the population of High Net Worth Individuals (HNWI), i.e. people with financial assets of $1 million or more, grew by 17.1% in 2009. The Asia-Pacific HNWI population rose 25.8% overall to 3 million,

0%

20%

40%

60%

80%

100%

2007 2008 2009 2010 2007 2008 2009 2010 2007 2008 2009 2010

Light (4-9 seats) Medium (10-14 seats) Large (13-19 seats)

Executive Aviation Market Share

Other

BA

ERJ

CAMBRIAN GROUP

catching up with Europe for the first time. The HNWI population in Latin America grew 8.3% to 0.5 million. Most of the world�’s HNWI population (53.5%) and wealth remains highly concentrated in U.S., Japan and Germany. In 2008, HNWI accounted for 10% to 20% of business aircraft sales and should be a target market for Embraer.

Customer Strategies

Embraer is competing in two industries with very different customer groups. The firm needs to identify the customer segments, understand their needs and implement efficient pricing, sales and customer-relationship management strategies.

Commercial Jets

Segment customers:

Currently, Embraer serves more than a hundred customers across the globe in all major regions. Most of them are regional airlines and the rest are air leasing companies. Embraer should separate its customers into two categories �– ones that need planes for right-sizing, the rest that need planes for replacement of existing fleet. Sales teams should be deployed to target these two types of customers separately and marketing campaigns should be designed differently to attract the interests of the two groups (Fig 5.9).

Customer Marketing Theme

Interested in Right Sizing Benefits of the 100-120 seat capacity, Potential boost in bottom line

Interested in Fleet

Replacement

Fuel efficiency, Greener emission, Higher load factor

Fig 5.9 - Source: Cambrian Research

CAMBRIAN GROUP

Increase commercial jet prices:

Price (million $)

Embraer

EMBRAER 170 (70-80 seats) 26.5

EMBRAER 175 (78-88 seats) 28

EMBRAER 190 (98-114 seats) 32

EMBRAER 195 (108-122 seats) 40

Bombardier

CRJ700/705 (60-79 seats) 26.7

CRJ900 (80-90 seats) 38.93

CRJ1000 (100 seats) 46.37

CS100 (100-125 seats) 42

Boeing

Boeing 737 600 (108-130 seats) 57

Airbus

A318 (107-132 seats) 45

Fig 5.10 - Source: Cambrian Research

Since Bombardier and Embraer are the two major manufactures in the regional jet market, Embraer retains a competitive advantage as long as it keeps its jet prices below those of Bombardiers. Bombardier�’s CSeries will not enter into service until 2016; Embraer should increase price for its E-195 model since there is no competition (Fig 5.10). Additionally, the other Embraer models also have potential for price increase since similar models from Bombardier are priced much higher. A quick estimation shows that Embraer could have increased profits by half a billion with existing backlog orders without losing customers due to over-pricing (Fig 5.11).

CAMBRIAN GROUP

Backlog (Dec 2010) Price Increase ($ million) Additional Profit Realized ($ million)

EMBRAER 170 10 0 0

EMBRAER 175 40 2 80

EMBRAER 190 157 2 314

EMBRAER 195 41 2 82

Total: 476

Fig 5.11 - Source: Cambrian Research

We have yet to take into account of the economies of scale and learning by doing achieved by Embraer. The E-jets were introduced in 2004 and

Embraer�’s variable cost of producing these aircrafts should decrease over time, hence the actual additional profits realized by price increase may be higher.

Furthermore, large air leasing companies with great credit ratings place big orders and possess strong buyer power, pushing the price tag down. Embraer should perform detailed cost-benefit analysis before signing up these large lessors. Instead of selling large units of aircrafts to them,

Embraer should target multiple regional airlines in emerging markets such as the Asia Pacific or Latin America. These airlines have low buyer power and are less likely to enter price negotiations with Embraer.

CAMBRIAN GROUP

Place new assembly plants in emerging markets:

Fig 5.12 - Source: Cambrian Research

If more aircrafts are delivered to emerging markets in the next two decades, it is probably better to have an assembly plant located closer to the customer base. This cuts costs and provides timely post-sale services and maintenances of the aircrafts to the customers. Since China�’s ERJ145 plant is having trouble upgrading in light of the obstacle created by the Chinese Government, Embraer should choose alternative sites in the Asia Pacific region to house its assembly plant. Our team will map out potential aircraft component OEMs within emerging markets. Then we shall rely on our GIS system to map out areas where distance to both aircraft components OEMs and customer base is minimized. These overlaying areas could be considered as the primary sites for Embraer�’s new assembly plants.

41 1 1

1

1 1 2

1

1 2

2

23

10

1

3

0

5

10

15

20

25

30

Latin America North America Europe South Africa China/Asia Pacic

(Units) Embraer Global Presence 2010

Plant Ofce Service Center Authorized and Hired Service Center

CAMBRIAN GROUP

Business Jets

Conduct customer-specific marketing:

The business jet market has four customer groups, the high net worth individuals, flight departments of traditional corporations or governments, charter companies and fractional owners. Each customer segment has its priority when choosing which private jet to purchase. Embraer should approach each segment differently so as to best market their jets. Cambrian will conduct a detailed customer survey in the upcoming weeks and expect a plot as shown bellow (Fig 5.13).

Fig 5.13 - Source: Cambrian Research

If the HNWI segment is more price-inelastic and concerned with comfort and design, Embraer should mark up the price and market their Phenom

0

1

2

3

4

5

Interior design/Cabin space

Safety

Fuel EfciencyUltra-long distance

New aircraft program

Executive Jet Customer Priority Comparison

HNWI Flight Department Chartered Companies Fractional Owners

CAMBRIAN GROUP

100 to these wealthy individuals. On the other hand, if flight departments of corporations and governments are serious about choosing a private jet that saves money, Embraer�’s marketing team could formulate marketing strategies to persuade customers in this segment to pay more now for the Legacy 600 and save more for fuel in the future.

Maintain high pricetag:

Price (million $)

Embraer

Phenom 100 (4 seats) 3.6

Phenom 300 (6 seats) 6.65

Legacy 600 (13-14 seats) 26.93

Lineage 1000 (13-19 seats) 43

Bombardier

Learjet40/45XR (7 -9 seats) 9.6

CL300 (8-16 seats) 20.97

G5000 (8-19 seats) 48

Cessna

Citation Mustang (4-5 seats) 2.77

Citation X (8-12 seats) 21.72

Hawker-beechcraft

Premier 2 (6 seats) 8.25

Hawker 4000 (8-12 seats) 21.72

Dassault

Falcon 50EX (8-9 seats) 18

Falcon 2000DX (8 seats) 28.55

CAMBRIAN GROUP

Falcon 2000LX (8 seats) 30.77

Gulfstream

G150 (8 seats) 14.5

G200 (10 seats) 23.33

G500 (19 seats) 42

G650 (19 seats) 62

Fig 5.14 - Source: Cambrian Research

Instead of penetrating the business jet market with lower prices like what they did in the commercial jet segment, Embraer consistently priced above competitors (Fig 5.14). Embraer should continue to adopt the price skimming strategy when negotiating for new contracts in the future. Not only will this help Embraer recover R&D costs, it also serves as a tool of signaling. Higher prices are correlated with better design, comfort, quality and social status. A higher mark-up on the smaller jets may attract growing proportions of high net worth individuals. A smaller mark-up on the medium and larger business jets could serve as an indication of excellence and prestige. Pricing strategies in this particular segment is critical for Embraer�’s brand image. Embraer should consider the possibility of limiting the production of its business aircrafts and target more wealthier customers within each sub-category to grant them exclusive VIP experience.

Improve sales and CRM strategies:

Customer Marketable Products

HNWI Phenom 100/300

Flight Department Phenom100/300 Legacy 600 series Lineage 1000

Chartered Companies Phenom 100/300 Legacy 600 series Lineage 1000

Fractional Owners Phenom 100/300 Legacy 600 series

CAMBRIAN GROUP

Embraer needs to establish a more active sales team for the executive jets segment. The team�’s primary responsibility is to communicate with potential customers from each category to promote Embraer�’s jets. If possible, teams of sales force should be deployed to potential VIP customers for deal and price negotiations. These customers are busy individuals and Embraer�’s sales force should make them feel welcomed and well served right from the start. Although additional costs are incurred with the expansion of sales force, it could be offset by the high margins of these business jets should deals become successful.

Customer service centers should also engage with customers on a monthly

basis after purchase. This increases potential sales on maintenance services, but more importantly, it provides a platform for customer feedback. Customers�’ opinions should be archived and analyzed by internal business analysts. Quarterly customer reports should be sent to Embraer�’s senior management for review. Embraer needs to understand the changing

demands of its business jet customers in a timely manner. This way, newer models could be designed to meet the needs. Understanding what the customers want in the future is crucial for Embraer�’s sustainable growth in the long term. Marketing is crucial, but it is effective only when Embraer fully comprehends its customers.

CAMBRIAN GROUP

APPENDIX Name of Companies

Name of Companies

AAR Corporation Goodrich Corporation

Aerosonic Corporation HEICO Corporation

AeroVironment Hexcel Corporation

Alliant Techsystems Honeywell International

American Defense Systems Kaman Corporation

Astronics Corporation L 3 Communication

Astrotech Corporation LMI Aerospace

BE Aerospace Lockheed Martin

Breeze-Eastern Corporation Moog

CAE Orbital Sciences Corporation

CPI Aerostructures Rockwell Collins

Curtiss-Wright Corporation SIFCO Industries

Ducommun Smith & Wesson Holding Corporation

Edac Technologies Corporation Spirit AeroSystems

Elbit Systems TASER International

Embraer TAT Technologies

Esterline Technologies

Corporation

Teledyne Technologies

FLIR Systems The Boeing Company

Force Protection Transdigm Group

CAMBRIAN GROUP

General Dynamics Corporation Triumph Group

Global Defense Technology and

Systems

Smith & Wesson Holding Corporation

CAMBRIAN GROUP

REFERENCES 1. Embraer Timeline. <http://www1.embraer.com.br/timeline/english/>

2. Embraer 2009 Annual Report.

3. Interview with Embraer CEO Frederico Curado. <http://www.youtube.com/watch?v=ZlBynH2AAc8>

4. Bloomberg Businessweek, Embraer-An Ugly Duckling Finds Its Ways. http://www.businessweek.com/magazine/content/06_31/b3995007.htm

5. Google Finance and MSN Money Central

6. http://www.embraer.com/en-US/ConhecaEmbraer/EmbraerNumeros/Pages/Home.aspx

7. Tortoriello, Richard. S&P Industry Survey of Aerospace & Defense. Feb. 10, 2010.

8. Embraer 2009 Annual Report

9. http://www.gama.aero/files/GAMA_DATABOOK_2011_web.pdf

10. http://www.airliners.net/aircraft-data/

11. http://www.hoovers.com/industry/aircraft-engine-parts-manufacturing/1802-1.html

12. http://www.cahighspeedrail.ca.gov/newsfacts.aspx

13. http://blogs.hbr.org/winston/2009/08/will-videoconferencing-kill-business-class.html

14. Bombardier 2010 Annual Report