Embraer. strategic report CAMBRIAN GROUP

Transcription

1 CAMBRIAN GROUP Embraer strategic report CAMBRIAN GROUP

2 TEAM MEMBERS M.D. Xiaoye Ma, Lead Max Kroloff Cailee Moberg

3 COPYRIGHT NOTICE 2011 Cambrian Consulting, LLC. All rights reserved. This material may not be reproduced, displayed, modified or distributed without the express prior written permission of the copyright holder and the Client. 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.

4 TABLE OF CONTENTS EXECUTIVE SUMMARY PART I: INTRODUCTION COMPANY OVERVIEW PART II: ANALYSIS FINANCIAL ANALYSIS.8 Overview Profitability and Growth Liquidity Solvency Market Valuation COMPETITIVE ANALYSIS Internal Rivalry Supplier Power Buyer Power Entry Exit Substitutes Complements SWOT ANALYSIS Strengths Weaknesses Opportunities Threats PART III: RECOMMENDATIONS STRATEGIC RECOMMENDATIONS..37 Growth Strategies Customer Strategies

5 APPENDIX REFERENCES

6 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 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 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 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 seat segments in the commercial jet market, capitalize its leading position in the 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

7 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.

8 PART I INTRODUCTION

9 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 Due to the financial crisis in the early 1990s, Embraer became privatized in 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 900 th ERJ 145 jet on February 28, Embraer identified

10 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 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 oneaisled 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 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 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

11 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 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.

12 PART II ANALYSIS

13 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 $15.6 billion backlog remains healthy and is on par with that of its main competitor Bombardier (Fig 2.1). ($ billion) Backlog Firm Orders Embraer Bombardier Fig Source: Cambrian Research

14 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? Revenue (million $) Embraer VS. Bombardier Performance EBIT Margin (%) 10.0% % % % % % Embraer Revenue Bombardier Revenue Embraer EBIT Margin Bombardier EBIT Margin Fig Source: Cambrian Research

15 Profitability and Growth Table 2.1 Embraer Annual Income Statement from In Millions of USD (except for per share items) 12 months ending months ending months ending months ending Revenue Other Revenue, Total Total Revenue Cost of Revenue, Total Gross Profit Selling/General/Admin. Expenses, Total Research & Development Depreciation/Amortization Interest Expense(Income) - Net Operating Unusual Expense (Income) Other Operating Expenses, Total (9.1) (16) (78.36) Total Operating Expense Operating Income Interest Income(Expense), Net Non-Operating Gain (Loss) on Sale of Assets Other, Net Income Before Tax

16 Income After Tax Minority Interest (15.1) (13.8) (7.5) (8.18) Equity In Affiliates Net Income Before Extra. Items Accounting Change Discontinued Operations Extraordinary Item Net Income Table Growth and Profitability Margins Embraer General Dynamics Boeing Aerospace Subsector 1 Gross Margin Profit Margin Revenue Growth Table Embraer Return on Investment Margins Embraer General Dynamics Boeing Aerospace Subsector Return On Equity Return On Assets Return On Capital List of companies included in the aerospace subsector is available in the Appendix.

17 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 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 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.

18 (million $) Embraer Revenue by Segment Others Aeronautic Services Defense Executive Aviation Commercial Aviation Fig 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 is a critical year for both the airline and aerospace industries. Rising deliveries in the upcoming fiscal year means fewer cancellations and deferments.

19 (Units) Embraer Commercial Aviation Deliveries EMBRAER 190/195 ( seats) EMBRAER 170/175 (70-90 seats) ERJ 145 (50 seats) Fig Source: Cambrian Research Liquidity Table Embraer Financial Condition Margins Embraer General Dynamics Boeing Aerospace Subsector Debt/Equity Ratio Current Ratio Quick Ratio NA

20 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 shortterm 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

21 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 Embraer Market Valuation Margins Embraer General Dynamics Boeing Aerospace Subsector Current P/E Ratio Price/Sales Ratio Price/Book Value Price/Cash Flow Ratio 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 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.

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

23 FIVE FORCES ANALYSIS Force Internal Rivalry Supplier Power Buyer Power Entry and Exit Substitutes and Complements Strategic Impact High Low to Moderate Moderate to High Low 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.

24 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 The Commercial Aircraft Corporation of China (COMAC) is developing two regional jet models and plans for flight certification by 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.

25 Fig 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.

26 Business Jets Deliveries 100% 80% 60% 40% 20% 0% 3% 10% 12% 13% 19% 20% 23% 2010 Others Hawker Beechcraft Dassault Gulfstream Embraer Bombarder Cessna Fig 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 business jet deliveries were 12.3% below Sales turn-around is expected late 2011 or early 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

27 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,

28 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 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

29 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

30 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

31 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 While this

32 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.

33 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,

34 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 highspeed trains are operating at full capacity; with 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,

35 Southwest Airlines realized a 10% increase in revenue since 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

36 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 Focusing on R&D and specializing in niche market Meeting expected deliveries Government support Little proportion of unionized workers Weaknesses 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 seat aircraft market Opportunities Growing demands in emerging markets Greater demand for right-sizing fleets 33% current regional jets will need to be replaced Air leasing market Threats 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 hightech savviness made conversion of the E-Jets assembly from docks to an assembly line possible in This reduces the construction

37 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