Case Study Embraer

ISB PGPMAX Brazil Term

Embraer: in Search of Sustainable Competitiveness Prof. Carlos Arruda; Prof. Georges Blanc; Profa. Erika Barcellos Revised Version January 2011

PRODUCING AIRCRAFT FOR THE WORLD IN BRAZIL EMBRAER: IN SEARCH OF SUSTAINABLE COMPETITIVENESS

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PRODUCING AIRCRAFT FOR THE WORLD IN BRAZIL EMBRAER: IN SEARCH OF SUSTAINABLE COMPETITIVENESS “Some years ago our competitors used to say: How dare these “ugly ducklings” from South America try to sell an aircraft in the Northern Hemisphere? Fortunately, they underestimated us.” Satoshi Yokota, Vice-President of Engineering and Development of Embraer 

“Embraer is a company that is trim, aware and competitive.” Michael Boyd, chairman of the Boyd Group, consultancy company in aviation

The Chinese, the Russians and the Japanese are developing aircraft. They are countries that are trying to develop their own aircraft industry and that will obtain slices of the market, especially in their own countries.” Mauro Kern, executive vice-president of Embraer 

In June 2008, Embraer had climbed to third position among the world manufacturers of  commercial aircraft. With a backlog of orders of up to four years for some of its commercial and executive jets and growing domination in the sector of commercial aircraft of 70 to 120 seats, the company had overtaken the Canadian Bombardier, occupying a position nearer Airbus and Boeing, the two largest manufacturers of commercial aircraft in the world. In spite of this success in the business, the value of its shares continued low (Annex 1). With head office in São José dos Campos, around 100 km from São Paulo, Embraer possessed five factories in three municipalities of the state of São Paulo. Abroad, it was present through subsidiaries, offices, technical assistance and parts distribution centres, located in Australia, China, Singapore, the United States and France. In factory terms, it operated in Europe with a maintenance and repair structure for civil and military aircraft and, since 2003, has been operating its first complete industrial unit located outside Brazil, under the Harbin Embraer Aircraft Industry joint venture – HEAI – in the North-East of  China (Annex 2). Intended for the assembly of aircraft of the ERJ 145 family, in 2007 the  joint venture was already a profitable concern. In the global industry of aircraft manufacture, Embraer had the position of a low cost manufacturer focused on the narrow market of regional jets, which represented around 8% of the world aircraft market. Its suppliers were large international companies such as Honeywell, Liebherr, General Electric, Kawasaki, Parker, Gamesa and Hamilton Sundstrand. These companies were risk partners, which not only supplied more than 85% of the parts, but favoured Embraer cost control. In this way, the Brazilian company was successful in putting in first place dedication to aircraft projects, and the coordination of product development. 3

In spite of its more than 40 years’ experience as a commercial jet manufacturer, Embraer was still small in comparison with the two global leaders. While its revenue in 2007 had been US$5.2 billion, Boeing’s sales and those of the controlling company of Airbus had reached US$67 billion and US$60 billion, respectively. With sales of commercial aircraft representing almost 70% of its business, the Brazilian company had decided to invest in the market of executive aviation. Its objective was to become one of the five largest manufacturers of executive jets in 2015, and, with this intent, it had already initiated the development of five aircraft. Embraer also sought expansion of its global reach and had announced, in May 2008, its plans to invest US$50 million in the construction of a factory for the assembly of executive  jets in the airport of the city of Melbourne, in the state of Florida. The intention was to transfer orders from American companies and individuals to the USA unit, by getting closer to its principal market. Another objective, in view of the fact that the increase in value of  the Brazilian currency against the Dollar had caused a negative impact on Embraer’s financial results, was to reduce company costs in Reals. In the United States, the company already maintained one business unit in Fort Lauderdale (Florida) and maintenance centres in Texas. Expansion of activities abroad also included the assembly of three new after-sales service centres (substitution of parts, maintenance, etc...) for executive jets in the United States, and another in France. Other investments were directed towards warehouses for stocking parts in Singapore and China. In addition, in partnership with the Canadian CAE – manufacturer of flight simulators – a training centre was planned for pilots and mechanics of jets belonging to the executive aviation segment. In addition to operating in the commercial and executive aviation markets, which corresponded to 64.4% and 16.6% of net revenues in 2007, respectively, Embraer supplied aircraft for the defense and government markets (6.6% of net revenues in 2007) and aviation services (10.1% of net sales in 2007). Other related business represented 3.0% of  the net sales of US$ 5,245 million in 2007(see 2010 data in Annex 7). The company had its shares negotiated on the São Paulo Stock Exchange since 1996 and, from 2000 on, American Depositary Receipts – ADRs – negotiated on the New York Stock Exchange. In 2006, it was included in the Business Sustainability Index – ISE – of the São Paulo Stock Exchange. In the same year, after becoming a company with pulverized capital, without the figure of the Controlling Group or shareholder, it had obtained Investment Grade with Moody’s and Standard & Poor’s (Annex 3). In 2007, when it obtained a net profit of US$ 489 million, Embraer was employing approximately 23,700 people, of which 88% were located in Brazil (Annex 4).

BRAZILIAN INDUSTRIAL POLICY AND THE FOUNDATION OF EMBRAERi

The history of Embraer is an intrinsic part of the efforts of the Brazilian Government to set up a strong local aeronautical industry. In 1941, the Brazilian Government created the Ministry of Aeronautics to supervise both civil and defense aviation. In the mid-40s and 4

mid-50s, the Air Force Technological Centre – CTA –, for the purpose of carrying out projects in the aircraft industry area was set up, together with the Air Force Technological Institute – ITA –, to train aeronautical engineers, and an institute of research and development, the IPD, to take in 50 German specialists in aeronautics contracted after the end of the Second World War. All these institutions were set up in São José dos Campos – SJC –, a small town 88 km from São Paulo, the most important industrial centre in Brazil. In August 1969, the Brazilian Ministry of Aeronautics created Embraer, to produce military and commercial aircraft in São José dos Campos. Embraer was to combine the resources of  a state company with the business agility of a private one. The most important of the proponents of the new company, Ozires Silva, graduated from the ITA and an officer in the air force, became its first president. The presidential decree that instituted Embraer stipulated that the Brazilian Government would control at least 51% of its capital. It also granted to the company some special privileges. Federal institutions should buy from Embraer, instead of from its competitors, whenever possible. Embraer would not pay taxes or charges for the importation of raw materials, parts and equipment not available locally. In addition to this, Brazilian corporations could invest annually 1% of their obligations relative to federal income tax in Embraer shares. This scheme helped the company to raise capital estimated at $350 million between 1970 and 1985. Embraer quickly entered three segments of the aviation business: regional passenger aircraft, military aircraft and aircraft for special purposes. Among the first products were the Xavante (1971), a jet aircraft for training and ground attack assembled under licence from the Italian company Aermacchi to fulfil an order from the Brazilian Air Force – FAB; the Ipanema (1972), an aircraft for crop spraying that the IPD research institute of the CTA had started to develop, and the Bandeirante (1973), a turboprop aircraft with a capacity for 19 passengers, also derived from an IPD project. In two years, Embraer sales started to take off due to the orders for the Bandeirante made by Brazilian regional aviation companies.

EXPANSION

With the support of the government, Embraer signed a licensing contract to manufacture the Piper aircraft in Brazil. In exchange for the license, the Brazilian Government increased from 7% to 50% the charges on the import by competitors of the Piper. As a result, Embraer sold more than a thousand Piper aircraft in the four subsequent years. This irritated Cessna, which had dominated the Brazilian market previously and that, subsequently, lobbied against the attempts of Embraer to sell the Bandeirante to North American airline companies. Embraer’s first export orders came from Uruguay and Chile, but the company soon started to scan the horizon further. At the end of the 70s, it embarked on a wave of exportations after obtaining the certification for the Bandeirante in the United States, France and the United Kingdom. Sales in the American market, for example, grew by five aircraft, in 1979, by 39, in 1981, the year in which Embraer created a subsidiary entirely controlled by her in the United States to concentrate the sales efforts there. At this time, Embraer had already 5

captured 46% of the turboprops regional aviation market and the Bandeirante, nicknamed Bandido (bandit, in English), had overtaken the former leader, a Fairchild. After the success of the Bandeirante, Embraer started to work on the Brasília, a pressurized double turboprop, with a capacity for thirty passengers. Certified in 1985, the Brasília, when launched, was the fastest and lightest aircraft in the 30 to 40 seat segment. In military aviation Embraer developed, in the 70s the Embraer EMB-312 Tucano, a turboprop training and light attack aircraft. Its first flight was made in 1980, and the first units were delivered in 1983. Designated in the Brazilian Air Force (FAB) as the T-27, it was intended for the intermediate training of pilots, and also used as a light attack aircraft being designated the AT-27. A modern aircraft with seats in tandem (back seat higher than the front), it was one of Embraer’s greatest successes, with a production of over 600 units of which 127 went only to FAB. At the start of the 80s, Embraer established a partnership with Aeritalia (later known as Alenia-Aeronáutica) and Aermacchi, both Italian aircraft manufacturing companies, to develop a supersonic combat jet. This project, known as the AMX Program, allowed the access of Embraer to new technologies, which played an important role in its future.

FIRST CRISISii

The end of the1980s and the start of the 1990s were bad for Embraer in the same proportion as the previous years had been good. The end of the Cold War, which led to drastic reductions in worldwide disbursements with defense, the new Constitution of 1988, which reduced the support of the Brazilian Government to the aeronautical industry, combined with a global recession, were the principal challenges faced. Embraer, initially, reacted to these challenges intensifying action that had worked in the past. Historically, the in-house executives looked on Embraer as an engineering company, believing that the manufacture of aircraft based on high technology was sufficient to guarantee success. This strategy led the company to try to extend and perfect the line of  turboprops. US$280 million were invested in an exceptional model, the CBA 123 in partnership with the Argentine FMA, even although the market had started to order short range jets instead of turboprops. The jets made less noise, were faster, flew higher (avoiding the bad weather) and had a reputation of being safer. “It made more sense for us to develop a jet version than to set off on the Brasília project, but we continued to do what had worked in the past”, says one Embraer engineer. Two prototypes of the aircraft were built that made their inaugural flight on 18 July 1990. Considered one of the most modern aircraft of its time, it included cutting edge technology in avionics, aerodynamics and propulsion. The prototypes were dismantled after the premature end of the project that came about because of the high costs that made the aircraft unfeasible for the civil market. Even so, the knowledge acquired resulted in the modelling of the very successful jet, the Embraer ERJ-145.

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PRIVATIZATION

At the start of the 90s, with sales in free fall and debts scaling new heights, Embraer was passing through the worst crisis of its little more than two decades of history. In 1991, after five years out of the company, Ozires Silva returned, took a series of measures to make the company economically feasible and started to prepare the privatization process. Ozires Silva reduced the number of staff from 9,000 in 1991, to 6,200 in 1994, he interrupted the CBA 123 program (keeping part of the technology for use in a jet version of the Brasília). He also managed to persuade the government to assume US$700 million in debts and inject US$350 million cash into the company before its privatization, in 1994. The company president could have taken more drastic steps, but was under restrictions from the government, which wanted to preserve jobs. Privatization occurred in 1994, when the share control was assumed by a consortium formed by the BozanoSimonsen group and by the two largest Brazilian pension groups: Previ – the pension fund of the staff of the Bank of Brazil and Sistel – the equivalent for Telebrás. Privatization has changed the situation of Embraer, which was soon obliged to become slimmer due to the financial problems faced. The government, however, continued exercising influence in the management of Embraer, even after privatization. The participation in some strategic decisions (veto on the change in the main business of  the company, veto on the change of the name, creating or altering defense programs, change in the share control, etc..) continued to be possible through the rights inherent to the Golden Shares that it held.

NEW MANAGEMENT

In September 1995, MaurícioBotelho took over as principal executive of Embraer. This mechanical engineer was already an experienced executive, coming from the Board of  Directors of the principal member of the consortium that had bought Embraer. Botelho soon concluded that Embraer had concentrated too much in perfecting its technology, and had consequently lost sight of the customers and the capacity to develop products that met the needs of these customers. To stress the importance of orientation towards the customer, Maurício Botelho took as an example the CBA 123, an Embraer aircraft that was not sold in spite of its technological superiority. According to the president, the CBA 123 was an aircraft modelled by engineers for pilots, and ignoring the customer. They say that Botelho insisted on having a photo of  the CBA 123 in the Embraer offices, as a constant reminder of the dangers of forgetting the customer.

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Building organizational agility at Embraer  August 24, 2010 5:59am | http://blogs.ft.com/donsullblog/2010/08/24/buildingorganizational-agility-at-embraer/ 

As a state-owned enterprise, Embraer had long suffered under stifling bureaucratic processes. One long-time employee recalled, “Embraer was subject to many procedures, norms and government audits, which contributed to bureaucratizing the company, setting barriers to its efficient operations.” Founder and long-time CEO Ozires Silva initially wanted to establish Embraer as a private firm, and resorted to government funding only after failing to persuade private investors to finance such a risky enterprise. Under Silva’s leadership, Embraer was not as bad as many other state-owned enterprises in Brazil: bloated infrastructure, over-politicized appointments and lack of long-term financing. But it still suffered from the bureaucracy that often plagues state-owned enterprises. However, government influence prevented Embraer from promoting employees based on merit, responding quickly to changing market conditions, or developing sophisticated financial engineering strategies. Nevertheless, his successor dramatically increased the organization’s agility through a number of steps. - Delayer and organize around customers. To reduce the distance from the top to the bottom of the organization, Botelho reduced the number of managerial levels from seven to five. By 1996, Botelho transformed the hierarchical structure into a matrix organization in which teams were organized around projects designed to increase autonomy, participation and flexibility. Project teams were organized to solve specific customer needs. Labor stations were made up of cross-functional teams working for specific customers. Top management constantly stressed that what mattered most were not the traditional “lines” of reporting but one line that went from customers to shareholders.

- Manage ad hoc projects and initiatives as a portfolio. During a transformation, many companies are overwhelmed by initiative overload that dissipates resources and stretches employees too thin. To coordinate various projects and initiatives, Embraer launched an Organizational Transformation Project around the implementation of enterprise resource management software. The project - based structure and increased employee participation  – allowed Embraer to reduce time to develop new projects and increase its reaction speed to new information.

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- Bring in new blood. Embraer’s senior executives further increased flexibility by replacing hidebound employees with new managers and workers. Botelho started at the top, and replaced most of Embraer’s senior managers, bringing half of them from outside and promoting the rest from within. Over time, he also shifted the composition of the workforce. At the time of the privatization, 80% of employees had worked for more than 10 years and 50% for more than 20 years. The initial headcount reductions targeted senior employees, who were eventually replaced with younger employees. By 2001, Embraer had more employees than it did before privatization (11,500), at an average age of 34 years. To attract new employees, Embraer adopted an aggressive profit-sharing programme in which workers as a group could receive the equivalent of 25% of the dividends paid out to shareholders. - Invest in training general managers. Embraer has further increased the flexibility of the workforce by increasing their average educational attainment. More educated workers can be transferred between functions more easily. In 2002, 37% of all employees had undergraduate degrees, and 7% held a masters or PhD diploma. The company also invested over $60 million over three years in training at all levels. The company established an inhouse MBA course that trained 35 of the most promising leaders per year. A school specialized in aeronautical engineering was also established, where 200 recently minted engineers spent a year and a half on supplemental studies of aeronautics. The first class received 6,000 applicants, a number that increased to 9,000 for the second class. •

ERJ 145

Consultancy studies carried out before privatization demonstrated that the regional jet segment should expand drastically over the following years, propelled by the growth of the small air companies that had arisen after deregulation of the field in the United States. In addition to this, the company could benefit from the growing pressure of passengers for companies to exchange their turboprops for jets, more comfortable and less noisy, in spite of being less economical in terms of outlay with fuel. Embraer therefore started to concentrate its efforts on a new product, the 50 seat jet ERJ 145, appropriate for the regional jets market. The rapid development of the ERJ 145 gained the status of Embraer’s principal effort, and was called the “program of salvation” of the company. Unlike Bombardier, Embraer had no old jet to redesign, which allowed the engineers to accomodate the suggestions of customers, such as the division of the seats two-one, so as to give passengers more space. Ironically, the competencies in CAD/CAM and other innovations that had increased considerably the costs of development of the turboprop CBA 123 were ideally suited for the project and construction of the ERJ 145. In parallel, Bombardier simply widened their executive jet, turning it into a commercial jet with 50 seats, so that the new aircraft carried more than one and a half tons of extra load, offering outdated systems and unnecessary operational characteristics. In 1996, Embraer concluded the development of the ERJ 145 commercial jet and, to ensure proximity with their 75 main customers, opened offices in Australia (1997), China (2000), 9

Singapore (2000) and a new distribution centre in Dallas. The comfortable modern regional  jet, launched three years after the entry of Bombardier in the market, was two tons lighter, three million dollars cheaper and 15% cheaper to operate than Bombardier’s $21 million model (Annex 5). The principal objective of the company became customer satisfaction, in the attempt to sell new aircraft. I knew that the ERJ was a good aircraft… but aircraft are very similar. You can have one better than the other under specific conditions, but technologically speaking they  are very similar products. So what I said was that, if we had 75 customers, then we should know their names, their nicknames, their families, how they run their business, what each demands, which is what is needed to know them profoundly, to understand  their deepest desires and to react accordingly.” (Maurício Botelho)

Although not the first in the market (Bombardier had already been in the market for three years), Embraer started to obtain enormous success with the sale of the ERJ145. Embraer delivered one hundred aircraft in the two years that followed its launch, a mark that Bombardier took five and a half years to reach. In 1997, the regional jets already accounted for 60% of Embraer sales, making the company profitable once again. •

Development of the Internal Processes

From then on, the strategic focus turned inwards again, in the search for efficiency and the improvement of managerial processes. In 1996, the hierarchical structure of the company was transformed into a matrix organization in which teams were formed around projects conceived to increase autonomy, participation and flexibility. The project teams were organized to resolve specific customer needs. Work stations were set up with multifunctional teams specific for each customer. The adoption of a projects-based structure and the increase in staff participation helped Embraer to reduce the development period of new projects, increase the speed of reaction to new information and improve the loyalty of its staff(see Donsullblog/Building organizational agility at Embraer). The company was reorganized into five new profit centres. Three of these centres were focused on specific geographical regions; the fourth was for light aircraft and the fifth for government sales. Each profit centre was placed under the responsibility of an executive, with the specific task of developing relationships with customers. No drastic changes in personnel were made. For example, instead of bringing in new professional marketing personnel, the option was made of training the company engineers themselves in the development of ability to understand customers' needs and expectations. However, staff that still adhered to the old, outmoded ways of working were substituted by new managers and workmen who were open to new approaches. MBA Programmes were also launched for the company managers, in addition to other programmes to increase the average educational level of the workforce. 10

To generate motivation, the company adopted an aggressive programme of profit sharing, which earmarked the equivalent of 25% of the dividends paid to shareholders for the employees. •

Strategic Alliance

In 1999, Embraer formalized a strategic alliance with a group formed by the largest European aerospace companies (Dassault Aviation, EADS, Snecma and Thales), which acquired 20% of the voting capital of the company. This initiative was related to the intention to reduce the dependence on the sales to commercial aviation companies, expanding the defense product line. Contracts in this area had been vital for the Company up to the end of the Cold War, when they plummeted to less than 5% of revenue. However, the attempt to increase the share of defence in its business was to consume a large initial investment, and the project of new products was to create technical risks and risks related to customer satisfaction. The association with the European companies allowed Embraer to diversify its sources of revenue. The company also managed to share with the partners the risks of development and the market. In 2002, the company delivered to the Amazon Surveillance/Vigilance System– SIVAM – its first aircraft endowed with advanced systems of intelligence, surveillance and reconnaissance.The aircraft is based on the ERJ 145 structure. •

Financial Management

In July 2000, Embraer started to negotiate paper on the New York Stock Exchange, raising US$446 million. The company also adopted a very conservative financial posture, avoiding going into debt and accumulating a capital stock that reached US$696 million in its June 2001 balance sheet. The critics said that Embraer’s financial policy was too cautious for an expanding market, particularly at a time when competitors were becoming massively indebted.

THE E-JETS (EMBRAER 170/190)

After the success of the ERJ 145, Embraer ordered a survey, in 1998, with the 50 largest airline companies that, together, represent more of the half of the market. The survey was conceived to test demand for a larger regional jet. The conclusion of the study was that there was an enormous hiatus in the demand for jets in the 70 to 110 seats range. The reason for this gap had nothing to do with technology and everything to do with the airline employees’ trades unions. In the United States (the largest air transport market in the world), many agreements with pilots trades unions restricted the number of smaller aircraft that each company could operate. These pilots’ contractual clauses prevented the air companies from operating regional jets, as the pilots received higher salaries for flying larger aircraft. If regional aircraft became more common, the pilots would receive lower salaries or the air companies would have to employ new pilots prepared to fly regional jets, reducing, in this way, the flight times of the pilots of larger aircraft. Embraer foresaw that the restrictions would end in the near future, as the airline companies were pressured by the shareholders to reduce costs and, in many cases, to avoid bankruptcy. 11

In January 1999, the company Board of Directors approved the business plan for the Embraer line 170/190 of larger size regional jets (denominated E-Jets), for 70/78 and 98/108 passengers. The company then started to compete not only with Bombardier (its traditional rival), but also with the smaller Boeing and Airbus aircraft. Development costs were estimated at US$850 million to conceive a new platform from scratch, instead of trying to adapt another model. This made-to-measure project could produce benefits in weight and in ideal design, and the Embraer executives believed that the aircraft would be significantly more economical than those of their competitor. In addition, they built a larger regional jet with the concept of family, with a large number of  parts in common, so that the airline companies that used the complete range of products could economize in components stocks and training. This allowed Embraer to offer a complete family of regional jets from 37 to 108 seats. Embraer’s experience in working with partners that share the risk helped it to follow up the opportunity offered by the larger size jets. The company executives knew that one key factor in the success of a new family of aircraft, in a most competitive market, would be the speed of its development and the need to integrate the most advanced technologies into the product. To develop the new product line, the company increased the number of strategic partners responsible for the delivery of complete subsystems instead of just components, in this way encouraging the development of closer relationships with a reduced number of  suppliers. The series of medium regional jets developed from 1989 to 1996 used 350 suppliers and only four risk partners. For the larger regional jets, the normal number of  suppliers was reduced to 22, and the number of risk partners was increased to 16. These partners bore 66% of the total development costs, against 33% of the previous generation, being responsible for the project and the supply of the structural segments and the aircraft systems. The risk partners would receive a previously agreed amount per unit sold, updated in accordance with cost indexes relative to the industrial sector, plus the larger part of the spare parts business. However there was no profit or revenue sharing with the suppliers. Embraer, being responsible for the integration of the whole project, in addition to the design and development of the aircraft, the manufacture of part of the fuselage and the assembly of all the parts, identified and involved partner companies to act in the conception and development of the other components. In the structural part, Kawasaki Heavy Industries, from Japan, participated, as also the Belgian company Sonaca, the French Latécoère and the company Gamesa, from Spain. The interior was supplied by the American company C&D Aerospace. (Annex 6) As to the main systems partners, in addition to GE, which developed a new turbine model, also part of the program were Hamilton Sundstrand, Honeywell and Parker, all American, in addition to the German Liebherr, which, like Sonaca and C&D, opted to set up in Brazil, nationalizing part of its supply, reducing the cycles involved. 12

The result of all this effort of integration was the fact that the Embraer 170 made its first flight in February 2002, 30 months after the launch, in June 1999: a record development time for products in this field. Outsourcing permitted Embraer to obtain greater quality and cheaper components worldwide in relation to its more verticalized competitors and horizontally integrated, like Bombardier. This strategy also resulted in greater flexibility for dealing with inevitable market recessions, according to Satosho Yokota, vice-president of engineering and development of Embraer: “ We have a more flexible model. All our assembly of parts is outsourced. Bombardier does this internally. With our chain of suppliers and assembly   process it is very simple to determine the rate of production. Not much investment is necessary to increase our production speed .” The Embraer 170 enjoyed wide acceptance in the international market, in spite of the crisis in the aviation sector that started in 2001.

SECOND CRISISII

After the terrorist attacks of 11 September, the aeronautical industry, as a whole, witnessed a severe decline in air travel. This was translated into acute reductions in aircraft purchases and cancellation of sales contracts, while aircraft manufacturers, like Embraer, had already committed significant resources to construct aircraft. Infour months, from 31 August to 31 December 2001, inventories at Embraer grew from US$600 million to US$1.1 billion, draining half a billion dollars in cash. The president of the company stresses: “ if we hadn’t had ready cash and were not flexible, we would probably be dead now”. The operational improvements in Embraer also provided the flexibility to respond to the market crisis, which forced the company to dismiss 1,800 staff (14% of the total) and to reprogram its production line. Embraer also sought to take advantage of the growing demand from the defense sector that followed on the terrorist attacks. These adjustments allowed the company to stay in the black in 2001 and 2002, at the same time as it balanced its efforts to produce the new family of jets on schedule.

SUCCESSION

In April 2007, Botelho passed the executive baton over to Frederico Curado, the successor that he had prepared, and stayed on as Chairman of the Board of Directors, which made it possible for him to continue contributing to the formulation of strategy. Frederico, who had already worked in several areas of the company, had been prepared in a planned way to be Botelho’s successor. When I came in, he was commercial director. I made him vice-president of strategic  planning, planning and organizational development, placing him at my side, so that  he could see at first hand all the stages of the turnaround. Afterwards I learnt that he had almost died of frustration through me taking him out of the front line to work in 13

an internal area. But he started to look at the issues like a businessman and to develop. After four years, he returned to the front line, with a wonderful piece of  work. Today he is ready for this cut-throat competition in the area – so cut-throat that  today we have four manufacturers of world-class level; 20 years ago, there were 15.  And the Russians, Chinese, Japanese are coming along, with plans for the 70 to 90 seat aircraft category ”, affirms Botelho.

CAPITAL PULVERIZATION

In March 2006, Embraer became the first Brazilian company of some size with pulverized capital, doing away with the figure of the controlling group or shareholder, maintaining, however, the Golden Share of the Brazilian Government. This was the most important corporate change since the privatization of the company, because it created a basis for sustained growth and company’s long term sustainability, in giving it free access to the world stock market, thus increasing its capacity to obtain funds to sustain the development of expansion programs. “We had one big problem: I could no longer call capital. The corporate structure was such that we had 34% of ordinary shares, 66% of preference shares, with no more space for the issue of only preference shares, because the corporation law establishes a minimum proportion of one third of ordinary to two thirds of preference. I could  likewise no longer call ordinary capital, because, within the group of three controlling companies, there were two pension funds, Previ and Sistel, with rules that limited  their investment to the maximum of 20% of participation in any company and to 5% of their net worth. These two funds already had reached their limit. And it would not  be possible for only Cia. Bozano to subscribe the capital increase, because this would  alter the balance between the three controllers”, says Botelho.

The change also prevented the entry into the company of controlling shareholders with another profile that would change the focus of the management, as the shareholders' agreement came due in July 2007 and it was possible that it would not be renewed.

EXECUTIVE JETS

At the end of the 1990s and start of the 2000s, analysts forecast a growing market for microjets – small aircraft with a capacity of less than 20 passengers. These aircraft were, normally, acquired by companies for their top executives, or by operators of air taxi services, in spite of some being bought for personal use also. Executive jets, however, were not necessarily small, in spite of being utilized for such purposes. At this time, Embraer started a survey process to evaluate the opportunity of expansion for this segment. In July 2000, the company announced its entry into the executive aviation segment. 14

Embraer products were respected for their technological quality and performance. Its experience qualified it for going forward, but did not guarantee that potential buyers would include the Embraer brand in the list of alternative executive jets. Were it not for the wings and turbines, it would be possible to say that executive and commercial jets are two totally different worlds. Commercial jets were sold in lots to corporate entities in search of  a good product that would meet their needs. Then, the brand of the airline company was fixed on it. The case of executive jets was different, as these were sold to individuals, and one at a time. Because they are a status symbol, they demanded glamour. The brand that mattered was that of the manufacturer of the aircraft – the same phenomenon as luxury cars. In this field, the competition was heavy: Bombardier (world leader of this segment), Cessna, Gulfstream, Dassault. Instead of discussing only the cargo compartment, the owner of a small jet wanted a place for his golf bag. Quality was merely the entry ticket to this world. The studies of Embraer Market Intelligence team focused a lot on this challenge. And they came to the conclusion that there were niches in the executive aviation segment as important as that of the most expensive executive aircraft. Among them were corporate aviation, charter flights and air taxi companies. In record time in the industry of aviation, the company’s first executive model, the Legacy 600 jet, based on the platform of the ERJ 145, flew eight months after its announcement, in March 2001. It was a 16 seat aircraft with a range of 3,250 nautical miles, which competed with Bombardier’s model Canadair Challenge. In the month of September following, the first aircraft was delivered. Up to mid-2007, there were 110 Legacy jets flying in 20 countries. In their Supermidsize category, the Legacy reached 13.6% of market participation, with a forecast of reaching and staying at 15% in the next ten years, considering the firm orders booked. The second step of the strategy took a concrete form in May 2005, with the announcement of the launching of two others jets in the categories “Very Light” and “Light”: the Phenom 100 and Phenom 300, both with a capacity of eight or nine passengers. The aircrafts of the Phenom family were conceived with an intelligent fuselage, providing greater space in the cabin. The Phenom 100 made its first flight in July 2007. The cabin’s interiors have been designed by BMW Design Works, of the United States, and, according to Embraer, have an elegant and modern appearance. The first Phenom 100s were delivered in December 2008 with prices from 2.95 million dollars. This was considered a low investment and low operating costs in the executive jet aviation category. The Phenom 100 opens this market to new customers. The first Phenom 100s were delivered, for example, to the air taxi Algar Aviation, of Uberlândia, Minas Gerais, to Wellborn Participations, of Londrina, in Paraná, and to LocarGuindastes e Transportes Intermodais, of São Paulo. Up to mid-2010 158 aircraft of this category had been delivered and there were still more than 600 aircraft on the order book. The Phenom 300, launched in the light jet category, is priced from 6.85 million dollars and its first delivery occurred in December 2009. 15

In May 2006, the executive jets’ family gained its fourth member: the Lineage 1000, in the “Ultra Large” category, a model that gave priority to luxury and comfort. It could take up to 19 passengers in 115.7 cubic meters of cabin space. It is equipped with two engines and, with eight passengers on board, it can fly, non-stop, from London to New York, Moscow to Tokyo or Quebec, from New York to Paris, and so on. In its basic design, the value was 42.95 million dollars. The company made delivery of the first aircraft in May 2009 to HE Aamer Abdul Jalil Al Fahim, of Abu Dhabi, in the United Arab Emirates. In an interval of only six years, the company launched four aircraft for the eight categories identified in the executive segment. The aggressive strategy of launches showed to the market an unequivocal position and an effective commitment to executive aviation. The revenue from executive jets in relation to that of the other areas of the company more than doubled in 2006, in relation to the previous year: from 7.3% to 15.7% of total invoicing. In spite of continuous absolute growth, this percentage reached 14% in 2010, considering the strong growth of services these 4 last years (Annex 7). Based on firm orders for executive jets on its books, Embraer was planning to establish itself as one of the principal players in the segment by 2015. However, the competition in this segment would probably be intense. Some of the companies that manufactured microjets were Eclipse Aviation, Cessna Aircraft, Adam Aircraft and Honda Motors. •

The futureiii

In spite of Embraer having presented an excellent performance since its privatization, there were doubts about whether its future would be calm. Since the start of the 2000s, the majority of air companies were negotiating with their pilots to remove some of the contractual restrictions imposed to the operations of regional jets, but little progress had been made. The only companies that did not have problems with scope clauses were nonunionized air companies, especially the low cost ones, like JetBlue. The fact of the ERJ 170 being spacious was one factor that could help. The intelligent design of the fuselage allowed the jets to have ample front space, like those found in larger jets, providing more comfort for the pilots, as for the passengers. Another question potentially problematic for Embraer was the return to popularity of the turboprop aircraft, more economical over short flights, in the context of the increase in fuel prices in 2003-2004. In 2004, delivery and backlog of turboprops increased after a decline that had lasted several years. (Annex 8) In 2005, orders for turboprops manufactured by Bombardier and ATR increased 240 per cent to 151 aircraft, while new orders for small regional jets were 25. An increase in demand for smaller jets was expected in growth markets, such as China, Russia and Africa. Embraer and Bombardier were suspending their production of small regional jets. It was expected that the growing interest in turboprops would cause a greater impact on Embraer than on Bombardier, as the latter was manufacturing turboprops as much as jets. Embraer, on the other hand, which had stopped manufacture of turboprops after its privatization, was analysing, in 2008, the possibility of  16

developing a new commercial turboprop aircraft for the small regional aircraft market. Orders for the ERJ 145 family had declined drastically from 2004-2005, and the company had only registered net positive orders for its E-jets family in 2005. The family of E-jets however also had its own problems. The certification of the E-170 delayed almost two years due to complications involved in the integration of its electronic systems with other systems. However, in mid-2006, most problems with the E-jets had been resolved and the air companies that used them demonstrated satisfaction with their performance. A growing competition was forecasted in the regional jets market with the entry of  manufacturers from Russia, from the countries of the Commonwealth of Independent States and from China. The joint venture of Embraer in China, however, facilitated its access to the Chinese market and avoided the 6% Chinese taxes for imported aircraft. In addition, it provided a good base for Embraer to manufacture aircraft for other air companies from the growing market of the Asiatic region. Analysts affirmed that Bombardier would have to cut costs drastically to be able to compete with Embraer in China. On the other hand, after the decision of the WTO in relation to subsidies on Brazilian exports, it would be more difficult for Embraer to compete on the basis of low prices. The great dependence of Embraer in relation to exportations in general and specifically to the commercial aircraft market was a concern, due to the great sensitivity in relation to the currencies changes in the international economic scene (Annex 9). For example, the devaluation of the dollar in relation to the real, of around 8% in 2006, had a negative impact on the company, that had 95% of its revenue and 85% of its costs tied to the dollar. Another problem was that the air companies generally made many isolated purchases, only when they needed to update their fleets. Consequently, there were large fluctuations in sales from year to year. However, in 2005-2006, Embraer announced that it would increase systematically its focus on the defense and government aircraft sector, with the goal of expanding the contribution of this segment from 11% to 20% of its sales. In 2005 Embraer announced the signature of  a Memorandum of Understanding with the Defense Research and Development Organization – DRDO- of the government of India, to provide support for the development of the new AEW&C system (Airborne Early Warning & Command/Control) of the Indian Air Force. The new system has its base the platform EMB 145 ISR (Intelligence, Surveillance/Vigilance and Reconnaissance), one of the most sold in the world. Embraer’s great experience in similar projects had been a key factor in the decision of the DRDO. Analysts said that this agreement represented a return of Embraer to its roots, as it had started its operations with military contracts. In 2007, Embraer commenced the development of the military aircraft KC-390 (Annex 10), whose market potential was estimated at 700 aircraft for 77 countries, with focus on the spare parts market. The aircraft competing with the KC-390 available in the market had prices between US$35 million and US$120 million for the transport, respectively, of 37 tons to 10 tons of cargo. The estimated price of the KC-390 of Embraer is US$50 million. The first take-off is planned for November 2014. The first flight of a series-produced unit will be 17

made two years later, in 2016. The FAB (Brazilian Air Force) is the main investor in the program. In April 2009, R$ 3.028 billion were authorized for the development of the project and the production of the two preliminary models, with a duration of seven years. In July 2010 the FAB announced its intention to acquire an initial number of 28 KC-390 aircrafts. Using the current value of the equipment of the same class, this business is estimated at R$ 3.04 billion. Other countries including South Africa, Argentina, Chile, Colombia, France, Portugal, Czech Republic and Sweden expressed interest in evaluating and buying the new aircraft for tactical transport to substitute the aircraft Lockheed C-130 Hercules developed in the 50s and with more than 2,200 aircraft operating in around 60 countries. After entering the medium-sized aircraft sector with success, carving out a share of 46% in the 30 to 120 seater aircraft sector, Embraer could consider, in the future, the development of larger aircraft, such as those of Boeing and Airbus (Annex 11). However, most analysts believe that Embraer still has a long way to go before it can be considered in the same class as Boeing and Airbus. The main question is the need of very large investments for the design and manufacture of large aircraft and the fact that Embraer would have difficulty in obtaining financial resources in the low-developed stock markets of  Brazil. Capital pulverization of the company, carried out in 2006, could, however, help in this sense. i

This part was adapted from: GHEMAWAT, P.; HERRERO, G. A.; MONTEIRO, L. F. Embraer: The Global Leader in Regional Jets. Case Study. Harvard Business School Publishing , Boston, 2000. ii

This part was adapted, but directly extracted from: SULL, D. N.; ESCOBARI, M. E. Sucesso made in Brasil: os segredos das empresas brasileiras que dão certo. Rio de Janeiro: Elsevier, 2004. iii

This part was adapted, but directly extracted from: REGANI, S. Embraer – The Brazilian Aircraft Manufacturer’s Turnaround and Growth. Case Study. IBS Research Centre, The ICFAI Business School, Kolkata, 2007.

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