Soon after Mauricio Botelho took over as CEO of Brazil’s Embraer in September 1995, he hung a photograph of an airplane in the lobby of the corporate office in São Jose dos Campos, about 50 miles outside of São Paulo. For an aircraft maker to have a photo of a plane hanging in its lobby is not unusual, but the image that Botelho chose to display was. He picked the CBA-123 turboprop, one of the company’s biggest failures. “That picture is there to remind us of our mistakes,” he said. He explained: “The CBA-123 was developed by the company in 1990 to include all the good tricks that a pilot would want to have in an aircraft. It was very fast, very silent, low vibration-a fantastic aircraft-but it cost 50% more than the market was prepared to pay for it. We didn’t sell one.” Failures such as the CBA-123 had helped Embraer, or Empresa Brasileira de Aeronautica SA, accumulate losses of $1 billion and a debt load equivalent to 400% of equity by the time the company was privatized in December 1994. Even in the days running up to the long delayed auction, Banco do Brasil was reportedly forced to write a $30 million loan merely to keep the company afloat. Yet just four years after it was sold to a consortium comprising investment bank Banco Bozano Simonsen and pension funds like the Banco do Brasil’s Previ, Embraer has quickly cleaned up its act. For 1998, following eight consecutive years of losses, Embraer predicts record revenues of $1.4 billion, and analysts estimate that profits will be anywhere from $100 million to $135 million. Embraer paid out its first dividend in 10 years last fall and debt-to-equity fell to 105% by the end of the second quarter of last year. Embraer is now one of Brazil’s top six exporters: More than $1 billion in aircraft and parts were sold abroad last year, compared to $641 million in 1997. Embraer’s remarkable turnaround has made it the star disciple of Brazil’s privatization program and the apple of the eye of the country’s National Development Bank, BNDES, which has provided generous export and other financing to boost the company’s competitiveness. But while Embraer’s recent success has been impressive, challenges continue to dominate the future landscape, testing the company’s ability to turn short-term gains into a coherent long-term strategy. If ever there was a poster child for privatization, Brazil’s Embraer fits the bill. The company was founded in 1969 by the military government to provide aircraft to the Brazilian air force under the heady assumption that a world-class country should build its own planes. And while the company was praised for its excellent engineering, it often let technical decisions take precedence over business. By the early 1990s, years of bureaucratic management and high costs had taken their toll, causing production to stagnate and profits to plummet. Post-Cold War reductions in military spending exacerbated the company’s financial woes by taking a huge bite out Embraer’s military aircraft sales, then one of its principal revenue earners. Embraer was slated for privatization in 1992 after the failure of the CBA-123 heaped more debts on the already hopelessly buried company. In order to sanitize the books, the federal government was reportedly forced to inject $350 million into the company in a capitalization operation and assume about $700 million in debt. After a lengthy delay, the government finally auctioned Embraer in December 1994. Upon taking over, the new owners installed professional management, slashed costs and personnel, and pumped about $525 million into a capitalization program. The company has never looked back. Embraer’s success can be attributed to two factors: The overwhelming popularity of its 50-seat jet, the ERJ-145, and the strong financial support it has received from the BNDES. A $120 million loan from the BNDES revived the ERJ-145, an aircraft project that had been shelved in the early 1990s due to financial problems. And in 1995, the light and cost-effective plane took its first flight. Orders started flooding in almost immediately. US-based Continental Express was the first taker, committing to 50 airplanes with an option to buy 150 more. By the end of last year, Embraer had received orders for 233 of the 50-seaters and options for an additional 209. Confirmed sales total about $3 billion, a figure that should prove to go much higher, since an average of 90% of options turns in to sales. “It (Embraer) is an attractive property right now, because they produce a high quality product for a foreign market, but their labor costs are lower than the likes of Boeing or Airbus or Bombardier,” said Thomas Grant, director at CLSA Global Emerging Markets. “We are confident that they will be solidly profitable through 1999.”

Unfair Financing?
But while Embraer’s entrance into the regional jet market was applauded by investors, it was watched with caution by Canada’s Bombardier. Besides having a natural cost advantage, the ERJ-145 is priced $2.5 million below its closest competitor, Bombardier’s CRJ-500. Embraer also benefits from the BNDES’s Proex and Finamex export financing programs, which were developed to provide both suppliers and clients with internationally competitive interest rates. Under Proex, the BNDES provides export financing by effectively discounting 3.8% off annual interest for terms up to 15 years. Under the Finamex program, the development bank provides an importer with a credit line of up to 100% of the export product at a fixed interest rate of five-year Libor plus 1% a year for 15-year terms. Canada, acting on Bombardier’s behalf, eventually complained to the company about its BNDES support. Bombardier claimed that the development bank’s export financing schemes amounted to an unfair subsidy of about $2.5 million per plane, a violation of World Trade Organization rules. Embraer denies the claim, saying that the BNDES is merely leveling the playing field by giving the company access to otherwise unavailable international interest rates. “Under OECD rules, the member companies can provide sales finance at a maximum of Libor cost,” said Botelho. “We Brazilians have to pay Libor plus a spread that is much over and above anything that the developed countries have to face-8%, sometimes 10%. If we are forced to support Libor we will be submitted to a burden that we could not tolerate.”When the companies failed to reach a compromise, Canada filed a formal complaint with the WTO, which was soon seconded by the US and the European Union on behalf of the US-German aircraft manufacturer Fairchild-Dornier. Brazil, in turn filed a counter-complaint, alleging that the Canadian government provides Bombardier with development and production subsidies that add up to about $7 million per plane.The case is expected to be adjudicated in early March. Although the outcome of the dispute is anybody’s guess at the time of this writing, most industry-watchers agree that the Canadians have a strong case. If the WTO agrees and rules in Canada’s favor, the BNDES may be forced to reduce or completely eliminate its export financing package. It is unclear how such a move would affect Embraer in the medium term, although one possibility is that the company may be forced to lower the price of its planes in order to make up for increased client financing costs. Whatever the final outcome, though, the decision would only begin to affect orders booked after the WTO ruling, buying Embraer some time to seek out other financing options. In its favor, recent improvements to the company’s capital and debt profiles have reduced the cost of funding from 23.7% in December 1995 to 8% through September 1998.

Fierce Competition
Despite popular new products such as the ERJ-135, there is little time for Embraer to rest on its laurels. With industry giants such as Boeing and Airbus fighting tooth and nail for customers, international aerospace is a highly competitive, increasingly consolidated market, where only the most innovative will survive. “They have basically two products, the 145 and the 135,” said David Wheeler, director of Bear Stearns do Brasil. “There is a big question mark over what is next. That is what everyone is waiting for.”Botelho says that the company has been studying for more than a year the viability of a 70-seat jet in the ERJ series and he is confident that development will eventually be given the go-ahead. But Embraer would have tough competitors in the 70-seat market-three international companies are expected to have similar aircraft developed by 2002. Although Botelho acknowledges that the environment for the 70-seater will be more competitive, he remains optimistic.”When we moved into the 37-seater market, our main competitor had been in the market for four years,” he said. “We just produced a better product, as far as the market was concerned.” Product development, however, costs money, something Embraer has had precious little of up until now. Still, the company has recently announced that it will invest $220 million in 1999, $120 million for development and the remaining $100 million to increase productivity. Botelho says that a portion of that expenditure will come from cash. He also points to recent bond issues, a $70 million securitized deal in the second half of last year and a similar $50 million issue in 1997, as proof that external markets are still relatively open to the company. But Embraer shelved an equity issue that it had planned for late last year, citing market conditions.Embraer also uses suppliers to help finance project development in exchange for long-term contracts. The company, which is largely an assembler of aircraft, imports plane interiors from US-based C&A, dorsal fins from Chile’s Enaer, fuselages from Belgium’s Sonaca, and wings from Spain’s Gamesa. Embraer also counts on a number of its suppliers to share in project risk, with companies being compensated only when the aircraft is sold and paid for. According to Banco Pactual, the BNDES is also expected to contribute an additional $40 million or so to Embraer’s development efforts, although the aircraft maker is concerned that current financial turmoil in Brazil may limit development bank funding in the future. The BNDES, which also funds about 50% of Embraer’s exports, has said that it will have $20 billion to allocate this year, not enough to cover its expected demand of $25 billion in funding. The development bank also recently announced that it would be using Embraer export receivables to securitize its own funding efforts in a $150 million test issue planned for the first quarter of this year.Roberto Bernardes, senior analyst at São Paulo think-tank SEADE, who wrote his doctoral dissertation on Embraer’s future, says that while talk of bringing in a foreign partner to bolster investment is “complicated,” Embraer must at the very least step up its attempts to forge strategic alliances with other international aircraft manufacturers. Botelho does not disagree, and the company has most recently been in talks with SAAB to develop a new military aircraft. He points out, though, that Brazil will never be able to compete with the US or other developed countries in their levels of industry support, and should not waste its energy aspiring to. He said that the key will be to globalize Embraer’s production in such a way that utilizes piecemeal international expertise where the company needs it most. In the meantime, Embraer, like all Brazilian companies, continues to labor under the so-called “Brazil Cost,” which just got significantly higher after January’s devaluation of the real. The company, with its large dollar-denominated export base, was significantly hedged against foreign exchange risk, and should weather the currency volatility. Exports should also benefit from a cheaper real. But Botelho was unable to predict what effects increased borrowing costs and higher domestic tax rates would have on the aircraft maker.