Market leadership in niche segments of the aviation industry. Customer integration and aircraft innovation by EMBRAER S.A.

Contents

Abbreviations and glossary of aviation terms III List of tables and illustrations

1. Introduction
1.1 Foreword
1.2 Focus and definitions
1.3 Target
1.4 Structure

2. An Overview of the aviation industry
2.1. Brief history
2.2 Technological developments
2.3 Economic developments
2.4 Political influence in the aviation industry

3. Embraer S.A
3.1 Organizational background and ownership
3.2 Embraer’s economic impact and state subsidies
3.3 Financial development and performance
3.4 Definition of Embraer’s markets

4. Market potentials for Embraer
4.1 Market analysis by Porter
4.1.1 Competition in the industry
4.1.2 Threats from Substitutes
4.1.3 Threats from Competitors
4.1.4 Bargaining power of the suppliers
4.1.5 Bargaining power of the customers
4.2 Comprehensive SWOT analysis
4.2.1 Strengths
4.2.2 Weaknesses
4.2.3 Opportunities
4.2.4 Threats
4.3 Conclusion

5. Embraer’s competitive strategy
5.1 The demand side
5.2 Fleet decisions of airlines
5.3 The supply side
5.4 Embraer’s strategies on other markets
5.5 Potential new market segments and strategic outlook
5.6 Conclusion

Acknowledgments

Appendix

Literature

Abbreviations and glossary of aviation terms

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List of tables and illustrations

Table I: World RPK and GDP 2005 and 2025 (forecast) by region

Table II: Forces of competition on markets according to Porter

Table III: “You bet your company curve”,

Table IV: Air traffic 2002 and additional air traffic to 2022 in RPK (in billion US$)

Table V: Expected seat capacity gap according to Embraer

Table VI: Factors affecting airline operating costs

Table VII: Total Operating Cost (TOC) comparison between ERJ family and competitors

Table VIII: SDE of E-Jet family compared to competitor products

Table IX: Categorized development of the airline industry in Europe 2000 to 2005

1. Introduction

1.1 Foreword

Since the birth of motorized aviation in Kitty Hawk, North Carolina, USA in 1903, the production of aircraft rapidly developed from a pioneering and unprofitable business to one of the world’s largest high-tech key industries in terms of employment and capital. Over the last two decades the market consolidated and many smaller aircraft manufacturing companies vanished from the market due to high financial risk in a market that was previously subsidized by national governments. The industry is involved in many civilian and military markets and is necessary for today’s global logistics infrastructure as well as the tremendous speed and comfort of modern world travel that is made possible with the advantages of commercial air transport. The air transport industry employs more than 4 million people and indirectly creates 24 million jobs with aircraft manufacturers and suppliers, resulting in a total output of nearly $1.4 trillion or 4.5 per cent of the global GDP.¹ The aviation industry developed and implemented new technologies that are benchmarks in other modern industries and critical keys to economic success and customer satisfaction. As table I shows, it is expected that air traffic in terms of Revenue Passenger Kilometers (RPK) will grow more than GDP in all world regions.

Projected Economic and Traffic Growth by Region (2006-2025) Average Annual Growth (%)

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Projected World Traffic Share by Region (%) World RPK Share

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Table I: World RPK and GDP 2005 and 2025 (forecast) by region

Source: Embraer S.A.: 2006-2025 Embraer Market Outlook, 3rd Edition, Sao Jose dos Campos, 2006

This thesis will take a closer look at a lesser known, but very profitable market segment of this highly dynamic industry. It is also intended to give a deeper insight into the complex symbiotic relationship that exists between the stakeholders within this industry.

1.2 Focus and definitions

The term “aviation industry” in its basic definition refers to:

- the commercial air transport industry, e.g. air transport companies (“airlines”) , which includes the ”whole of all procedures that serve for the purpose of relocating persons, freight or mail through the air (…) and all other directly and indirectly connected services.”²
- the airport and the aircraft manufacturing or producing industry that supplies the commercial air transport industry and other civilian and military markets with the technical and organizational assets that are necessary for aviation.
- “the aviation organizations as the whole of all institutions that determine the legal and regulatory framework for the conduction of air transport and production of the industry.”³

In the ongoing thesis the term “aviation industry” will refer to the aircraft manufacturing sector, unless otherwise noted.

Whereas the market for medium-to-(ultra-)long range commercial airliners (also “mainliners”) with more than 100 seat capacity is known as a duopoly market with only the US Boeing Corporation and the European Airbus, which is a subsidiary of the aerospace and defense consortium EADS, as competitors, the market for smaller regional aircraft has now become a duopoly as well. At this time only the Brazilian Embraer and the Canadian Bombardier Aerospace offer regional airliners (also “regional jets”).

The thesis will critically examine the growing regional aircraft market with a special concentration on the main factors that lead to the market leadership (in terms of sales) of the aircraft manufacturer Embraer S.A. from Brazil. A brief examination will also be made of related markets in the aviation industry, where Embraer has less important operations.

Despite the fact that Brazil as a developing nation in South America is normally not identified with the high-technology aviation industry, Brazil always played a major part in the history of aviation. Brazilian native Alberto Santos-Dumont was one of the first and most important pioneers of flight in the early 1900s⁴, and much of the country was explored with German Junkers airplanes in the 1920s and 1930s. As of 2005, Brazil’s GOL is the most profitable low-cost-carrier (LCC) and Embraer S.A. is now the third largest producer of aircraft in the world in terms of sales.

As with many other countries, Brazil decided to start aircraft production in the late 1940s. Following World War II, the government saw the important new role of the air force and Brazil’s vast territory made the use of aircraft necessary. The main goal was to gain independence from foreign companies as well as to establish the state-owned and -controlled production of civilian and military aircraft that were designed for the country’s special needs. Embraer S.A. (Empresa Brasileira de Aeronautica S.A.), that was funded in 1969, traces its roots back to a state-financed research and development facility to build up the needed technical knowledge, before starting the planning and construction of the first flying prototypes. With the EMB-110 Bandeirante turboprop aircraft, which was introduced in 1972, Embraer could offer the first successful product in its history. Over the years, about 500 Bandeirantes were sold to many military and civilian customers in the Americas and Europe. Eclipsing several smaller projects in Argentina, this was the first South American aircraft project of major importance. With the help of the Italian aerospace company Aermacchi, Embraer could gain experience with more sophisticated military projects. In the Mid-1980s, Embraer had become the largest aircraft manufacturer in the developing world. After a severe financial crisis and privatization in the early 1990s, Embraer made its next move into the lucrative jet- engine passenger aircraft market and is now the leading manufacturer of short- to medium-range regional and commuter aircraft. In particular, the previously untapped niche segment of 70 to 110 seat commercial airliners turned out to be highly lucrative. Success in this market niche earned the company tremendous economic growth, technological leadership in its field, and a secure position in a market that was previously known as an oligopoly market. In this short period of time, Embraer developed itself from an unprofitable state-owned company to Brazil’s largest exporter in 1999 to 2001.⁵ Embraer is a true global player that faced problems unknown to companies in industrialized nations as, for example, until the mid-1990s not all of the company’s employees were able to write and read. Today, more than 80 per cent of Embraer’s revenue comes from commercial aviation.

“While Embraer had long been the object of national pride […], these feelings seemed to have intensified recently. Brazil’s main business magazine, Exame, selected Embraer as its company of the year, describing it as a national icon and praising its success at competing with powerful foreign companies”.⁶

Many of these projects are financed together with suppliers, as it is the case with Embraer.

1.3 Target

The thesis will examine how Embraer has gained a leading position in its market segment by matching product innovations to the demands of its customers, and how this position is likely to be defended in a highly-sensitive, capital-intense, high- technology industry. Furthermore, the thesis will explore how decisions are made regarding the fleet composition of Embraer’s main customers and how their needs are integrated into Embraer’s business operations. The successful concepts of Embraer are primarily based on product families that can be offered for different markets. Thus, Embraer’s development and business practices can be critically evaluated with regard to other emerging nations, such as India and China, that will enter this or similar markets soon.

As Embraer has different strategic business units in both civilian and defense markets, this thesis will focus primarily on the company’s operations in the commercial aircraft market.

1.4 Structure

The second chapter of the thesis gives a short overview of the history of the aviation industry and its current situation. Chapter three shows the reader a detailed picture of particular markets and sub-markets where Embraer has operations, the state of the company, its products, and its history. The fourth chapter analyzes the primary market for Embraer, the forces of competition that occur in that market as well as the relationship between Embraer and competing stakeholders. The fifth and final chapter will describe how cost and other considerations shape airline fleet decisions, and how Embraer responds to the expectations of its main customers.

2. An overview of the aviation industry

2.1 Brief history

Over the short period of time of about 100 years, aviation underwent significant development that started with the wooden biplane constructions of the early years to the highly sophisticated airframes with digital displays of today. Technical research and development often was accelerated by the needs of the military. Different engine types, cockpit electronic systems (avionics), fuselage and wing designs were integrated into civilian aircraft manufacturing. In the first half of the 20th century, flying was a service and form of transportation that was only affordable for a very small segment of the population. Before and after the First World War, aircraft were primarily used for postal services and the exploration of remote regions. The air transport industry developed in the 1920s and 1930s in North America and Europe and was used to link Europe with colonies in Asia and Africa. After the Second World War, many new technologies also came into the civilian aerospace sector; and with the introduction of faster, bigger and pressurized aircraft new dimensions of range and altitude could be reached. “International air transport grew at double-digit rates from its earliest post-1945 days until the first oil crisis in 1973. Much of the impetus for this growth came from technical innovation. The introduction of turbo-propeller aircraft in the early 1950s, transatlantic jets in 1958, wide-bodied aircraft and high by-pass engines in 1970 and later, advanced avionics were the main innovations. They brought higher speeds, greater size, better unit cost control and, as a result, lower real fares and rates. Combined with increased real incomes and more leisure time, the effect was an explosion in demand for air travel”.⁷ These new technologies made long intercontinental flights possible, safe and comfortable for passengers. The size and speed of aircraft helped to decrease operating costs, allowing the world’s airlines to be more profitable.

Growth rates in the industry for aircraft manufacturing companies, airports, and airlines were above 15 and 20 per cent p.a. in the three decades after the war. New, efficiency-increasing technologies and the deregulation of air traffic helped the industry to grow continuously despite several economic crises since the 1970s. The supply side of the market for aircraft has consolidated and has become less diverse in the last 20 years as many manufacturers have gone bankrupt or have been bought by competitors. All markets and segments of the aviation industry experienced new economic risks and challenges due to political deregulation, especially after the end of the Cold War. Air travel became more affordable for an increasing number of people and in recent years has become even cheaper with more LCCs entering the market with ever more aggressive pricing policies.

2.2 Technological Developments

Technological changes have always been important to the aviation industry. Indeed, the industry has often pioneered the use of certain new technologies that were later transferred to other industries such as automobile manufacturing. Major advances include: The change from wooden biplane airframes to aluminum structures that allowed more stability and heavier and more powerful engines in the 1920s, the introduction of the pressurized cabin that allowed aircraft to fly in higher altitudes to avoid heavy weather in the 1940s, and civilian use of jet engine technologies from the 1950s that first led to turbo-prop engines and later to the use as a pure jet. “Higher speeds and larger aircraft have […] produced significant jumps in aircraft hourly productivity”.⁸ Auto-pilot systems helped aircraft crews to concentrate on the critical take-off and landing phases during a flight and work more comfortably on long-haul flights. The next important step was the introduction of the fully electronic steering technology “fly-by-wire” in the 1980s that made flight maneuvers easier and safer. The last 20 years showed a greater emphasis on new aircraft production methods using Total Quality approaches, Kaizen methods and, most important, the use of light-weight carbon materials that reduced aircraft net weight without reducing speed and payload.

2.3 Economic Developments

Three major economic imperatives should be mentioned in connection with the aviation industry. The first one is important for aircraft manufacturing companies. It describes the fact that planning, designing, testing and introducing a new aircraft is a major financial undertaking, and is often risky for the future of the whole company. This will be discussed in more detail in a further chapter of the thesis. The second imperative is the “paradox”⁹ of the airline industry. This industry, despite tremendous growth rates, has only been marginally profitable. This paradox, of course, also affects the supplier side of the aviation industry, the aircraft manufacturing companies.

The third and last imperative that must be mentioned is the socio-economic dimension that is significantly important to the aviation industry. Even in the best of times the aviation business fluctuates according to travel trends that are continuously changing with the seasons. Couple this with one or more abnormal events such as SARS in 2003 or the recent avian flu, terrorist attacks, wars, or high oil prices that affect business operations globally, and you have an industry that is more highly dynamic and unpredictable than other industries. Obviously, this risk affects every market within the industry; airlines, airports and manufacturers.

2.4 Political influence in the aviation industry

The entire aviation industry has been highly influenced by political decisions, and is seen by most countries as a strategic asset. Since the birth of scheduled air transport service, simply because it is truly an international business, airlines have been seen as symbols of national prestige and political influence. The birth of the so called “flag-carrier” led to market monopolies for state-owned airlines within their home market. During the 1980s and 1990s, most of the “flag-carriers” were privatized and had to start non-subsidized profitable businesses. In the manufacturer market, the same picture can be observed. Most companies became private entities in the last 10 to 20 years, especially after the end of the Cold War in the early 1990s. Still, state subsidizes and other forms of “hidden” influence are huge as can be seen by the examples of Boeing, Airbus and others. Both airlines and manufacturers remain strategic assets of national states as possible troop carriers in war time and as suppliers for the national or allied armed forces.¹⁰

Another important fact is the high regulation in the aviation industry, in terms of rights to use air space, landing rights and others (so called “freedoms of the sky”) as well as export regulations for aircraft and aircraft parts. Both forms of regulations have decreased in recent years, although political pressure to buy aircraft from a domestic manufacturer, and therefore to support the domestic economy, still leads to unfair competitive factors.

3. Embraer S.A.

3.1 Organizational background and ownership

The global headquarter of the corporation is in the city of Sao Jose dos Campos in the Brazilian state of Sao Paulo. It has five plants in Brazil, one of these, Gavião Peixoto in Sao Paulo state, has the longest runway in South America. Other facilities are located in Fort Lauderdale, USA, Villepinte and Le Bourget in France, Alverca (location of the recently aquired Portuguese company OGMA) in Portugal, Singapore, Beijing and Harbin (place of the only production facility outside of Brazil) in China.

As of September 2005, Embraer has about 17.000 employees with 13.500 employed in Brazil. The order backlog in September 2005 was $10.4 billion. President and CEO of the company is Mauricio Botelho, who has led the company since its privatization in 1994. Embraer is the 100% parent company of Embraer Aircraft Maintenance System Inc. (EAMS) in Nashville, USA as well as of Indústria Aeronáutica Neiva in Sao Paulo state. The latter produces the EMB 202 Ipanema aircraft. Industria Aeronautica Portugal S.A.(OGMA) is also part of Embraer now and will be reorganized as a maintenance facility for Europe as EAMS is for the US and Canada. There are two joint-ventures. Embraer Liebherr Equipamentos do Brasil S.A. (ELEB) is a JV with Germany’s Liebherr and produces landing gear and hydralics for Embraer aircraft. The second one is Harbin Embraer Aircraft Industry (HEAI), in Harbin, China, which produces the ERJ 145 family of airplanes for the Chinese market. All other aircraft are assembled in Brazil and are flown to their customers around the globe.

Funded as a governmental initiative, it is now a S.A., a Brazilian sociedade anônima, which is comparable to the US corporation or the German Aktiengesellschaft. The company’s shares are publicly traded on the New York and Sao Paulo stock exchanges. Most of Embraer is controlled by two Brazilian pension funds and one Brazilian bank, each with 20 per cent of the voting shares. Another 20 per cent is held by a European group (EADS, Dassault Aviation and Thales Group hold 5.67% each, and SNECMA holds 2.99%). This European consortium offers Embraer access to its technology as it seeks to improve its position in the Brazilian and Latin American defense market. The rest of the shares are publicly traded. A veto right can be exercised by the Brazilian government through a golden share, that allows the government to prevent certain deals involving military hardware or technology transfer to foreign countries. This underscores the importance of Embraer as a strategic asset for Brazil. As of April 1, 2006 Embraer’s capital structure was composed of 738,611,820 common shares, after only one type of share (common share) was introduced in March 2006.

3.2 Embraer’s economic impact and state subsidies

As stated before, Embraer was Brazil’s largest exporter from 1999 to 2001. “Since 1995, the year following its privatization; Embraer has exported $17 billion in products and services […].During this 10 year period, the company accounted for more than $6.6 billion of the country’s trade balance.”¹¹, according to the annual report of 2004. In 2004, Embraer’s exports totaled $3.4 billion and accounted for about 4 per cent of Brazil’s trade balance.¹² Through Embraer’s influence and synergy effects, new high-tech companies started operations in the southern Brazilian states of Sao Paulo, Rio de Janeiro and Minas Gerais. “The US is Embraer largest parts supplier, with companies from more than 15 US states supplying components and material. The US is also Embraer’s largest customer, accounting for more than 60 per cent of the purchases.”¹³ This makes the high demand for Embraer’s products a valuable and critical factor for its US suppliers such as GE Engine Company, Honeywell, Hamilton Sundstrand, C&D and BF Goodrich.

As a form of state subsidy, “public sector institutions such as BNDES and FINEP (Financiadora de Estudos e Projetos, part of the Ministry for Science and Technology) have actively supported this process, contributing 22 per cent and 100 per cent of the development costs of the ERJ-145/135 family and of the AL-X light-attack jet fighter respectively. Also important has been the extension of export subsidies to Embraer by BNDES (through Finamex) and Banco do Brasil (through the Programa de Estímulo às Exportações, Proex). The rationale of this “interest rate equalization program”, which provides up to a 3.5 per cent cut in interest rates on loans to purchasers of exported Brazilian aircraft, is to offset the so-called Custo Brasil, i.e. the higher risk of doing business in the country due to a number of structural factors.”¹⁴

3.3 Financial Development and Performance

In 2005, Embraer had total revenues of $3.83 billion and a return on equity of 26.76 per cent. The aircraft manufacturing industry’s average ROE was 13 per cent. Net income in 2005 was $445.73 million on the 2005 balance sheet, the Total Debt to Equity ratio is 1.30.¹⁵ This results from the fact that during the last four years major investments with outside financing were undertaken. Reasons for such an impressive return included the development of the Embraer 170 family, as well as new projects in business aviation. Nevertheless, short-term debt was around 38 per cent in 2004 compared to about 50 per cent in 2003. “In 2006, Embraer had first quarter net sales of $808.3 million and net income of $65.3 million […] The firm order backlog as of March 31, 2006 totaled $10.4 billion. While net sales increased by $45.0 million in the first quarter of 2006, gross margin decreased to 28.7 per cent, compared to 35.1 per cent in the same period in 2005. When compared to 4Q05, gross margin increased by 50 basis points despite the 2.4% appreciation of the real against the U.S. dollar during the first quarter of 2006.”¹⁶

The company achieved profitability in 1998 with earnings of $109.2 million. When Embraer began trading on the New York Stock Exchange, the share price was $18.50. The current price is over $34 as of the end of June 2006.

3.4 Definition of Embraer’s markets

The company currently operates in two defense markets and three civilian markets. The first defense market is the turbo-prop trainer market which is the smallest market for military aircraft in terms of revenue. This market includes two-seat aircraft with high performance turbo-prop engines that are primarily used in the basic to advanced training of future fighter jet pilots. Aircraft of this category normally can be armed for training or COIN-purposes.

Another defense market where Embraer currently offers aircraft is the market for surveillance aircraft. Aircraft in this very specialized category are either used in the AEW&C or maritime surveillance role.

Embraer’s most important market in terms of sales, revenue and profit is the commercial aviation market with two regional jet segments. One segment includes jet aircraft for short to medium ranges with a seat capacity of 37 to 50. These aircraft are used on lower demand routes in domestic and international services.

The next market segment is very new, with Embraer as the first company to enter it. It compromises smaller commercial airliners with a seat capacity between 70 to 110 seats that also can be used on higher demand regional routes. In the markets from 30 to 120 seats, Embraer holds a market share of 46 per cent as of December 2005, which is based on total aircraft delivered and on backlog.¹⁷

A relatively new market for Embraer is the corporate aviation market with the segment of very-light to super-size long-range corporate aircraft. It includes 5 to 37+ seat jet aircraft that are in use by individuals, corporations and governments for business and VIP travel. The last important market of Embraer is the agricultural aviation market which includes small (turbo) prop aircraft with one or two seats for crop dusting duties. In this market, Embraer’s subsidiary Neiva has successfully opened a new market niche with the first production-series ethanol fueled aircraft. Today, about 80 per cent of Embraer’s revenue comes from civilian markets. In the following context, short-haul routes range from 400 km to 1000 km, medium-haul 1001 km to 2000 km and long-haul from 2001 km to 5000 km.¹⁸ Routes over 5000 km should be considered ultra-long-haul routes.

4. Market potentials for Embraer

4.1 Market analysis by Porter

4.1.1 Competition in the industry

Following Porter’s concepts about competitive strategy and competitive forces in markets, the next chapter is going to analyze the current situation of Embraer’s main market segments, future growth and Embraer’s position in the market. As stated before, Embraer has operations in different markets of the aviation industry. From this point on, the thesis will focus on the commercial aviation market with its segment of regional jets and commercial airliners from 37 to 118 seats. Since the privatization of the company in 1994, these markets were responsible for the company’s economic recovery and restructuring and new levels of profitability from 1998 and after. In 1994, 76.14 per cent of total revenue was generated in this segment.¹⁹

Defense markets are particularly difficult to analyze since they are influenced by political and security issues to an even greater degree than civilian aviation markets.

According to Porter, four different forces combine to shape a market in a competitive free market environment. In the centre of any consideration is the particular company with its respective competitors and other competitive forces in a specific market. This image of a competitive market is surrounded by the threat of new competitors, threats from substitutes and the bargaining power of suppliers and customers.

The most important customers of the four biggest commercial aircraft manufacturers (Boeing Corp. of the US, Airbus of the European EADS consortium, Canada’s Bombardier and Brazil’s Embraer) are the world’s air transport companies (e.g. airlines). Therefore, both markets are directly correlated. Growth and crisis within the airline industry always affects the aircraft manufacturing industry. As the airline business is a cyclical industry²⁰, positive traffic growth of airline passengers normally leads to increased orders for commercial aircraft. Another issue aircraft manufacturers must face is the fact that there are relatively few airlines as customers. In the market for regional jets, Embraer is offering commercial aircraft families for two (sub) segments with 37 to 50 and 70 to 118 seats that will operate on short- to medium haul routes. On average there are only three to four possible customers in a market the size of Germany, two in markets the size of Italy, one in smaller, wealthy countries such as Austria and none in smaller or less wealthy countries (in terms of GDP per capita). Markets with more than four airlines as possible customers for regional jets can only be found in countries such as the US, China or India.

These growth rates show a high market potential over the next 20 years in passenger demand as well as the growth in aircraft orders, especially in such emerging markets as Latin America and South East Asia. There are only two, established competitors for the regional jet market in 2006. Bombardier Aerospace of Canada with its family of Canadair Regional Jets (CRJ) and Embraer define a competitive duopoly market with both companies being subsidized directly or indirectly by their state and regional governments.

Porter describes five criteria²¹ that confer competitive advantages in a market, and that make the market entry of new competitors difficult:

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Table II: Forces of competition on markets according to Porter

Source: Porter, Michael E.: Competitive Strategy, 7 th Edition, Frankfurt/Main, New York, 1992, p.26

The first criterion is “economies of scale“. These occur “…if the unit cost of a product […] with increasing number of units produced decrease per time unit.”²² Overhead costs can be distributed on a larger number of units over a fixed time period. Obviously, this is only possible, if a competitor is established in a market and holds a large market share that allows greater numbers of units to be sold.

“Economies of scale” can also create advantages for other departments such as marketing, distribution or the acquisition of supplies and parts by ordering larger quantities. When combined with the high cost of materials (certain metals, advanced electronic parts, large carbon parts), this may lead to a competitive market where only large companies can survive.

The second criterion is product differentiation. The questions “why to choose a certain product” and “why continue to buy this product in the future” are critical strategic consideration. This competitive advantage may depend on the size of a competitor. Competitors with a bigger market share can develop and hold the strong loyalty of both suppliers and customers. In addition to that, they are able to create a market brand that differentiates the product emotionally from others. Embraer established itself as a well-known, engineering focused supplier of reliable aircraft starting in the 1970s when the company still was under government control. During the 1970s and 1980s, the company had to face the “image” problem that occurred when airline passenger boarded a plane that was “Made in Brazil”. Airlines decided against the purchase of Embraer aircraft because their customers did not have confidence in Brazilian aircraft. Today, Embraer has strengthened its image with very good safety statistics, to the extent that some passengers say they like flying on a Brazilian made aircraft. This is known as the “underdog-image” that occurs with the few global players from emerging countries. These passengers, and therefore the respective airlines, want to support a company that originates from an emerging country rather than a company from a “rich, western country”.²³

Embraer was also the first company to enter the 70 to 118 seat commercial jet market segment that fills the gap between regional jets and mainline airliners. This offers Embraer at least a temporary monopoly in this segment of regional jets.

Diversification takes place, when well-known and successfully used airframes such as the ERJ 145 and the Embraer 170 families are brought into other markets. This was done with the introduction of both airframes in the corporate aviation market, and with the development of the ERJ 145 modifications for the defense market. No additional or new assembly lines had to be built, and approximately 90 per cent of aircraft parts can be used in commercial, corporate or defense market jets. Together with the system commonality within these two jet families, this decreases overhead and direct costs of production.

The third criterion is the needed capital input in a certain industry. The entire aviation industry can generally be seen as a high-capital industry. Aircraft manufacturers such as Embraer invest large sums into R&D of new products. Only after an aircraft manufacturer has developed and reached break-even, can some of these investments are used for new R&D projects (e.g. testing facilities, supply chains, intellectual property as big R&D departments) in the future. In civilian markets, the four above mentioned companies are the only ones with that competitive advantage today. When analyzing competition in Embraer’s markets, it must be acknowledged that the development and marketing of a new aircraft or aircraft family is a major financial risk for a manufacturer. This has been named the “you bet your company curve”.²⁴

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Table III: “You bet your company curve”, 1985

Source: http://adg.stanford.edu/aa241/intro/origins.html

Today, the initial investment required to start a new aircraft development is more then $25 billion for a medium-sized commercial mainline aircraft. Larger commercial aircraft or modern multi-role fighter jets may cost much more to develop. Many of these projects are financed together with suppliers, as it is the case with Embraer.

The fourth criterion is the costs of transition. If high transition costs occur as a result of a customer changing its supplier, other suppliers must either offer cheaper or more advanced goods or services to compensate these additional costs. In the case of Embraer, this might occur, if a customer (e.g. airline) stops purchasing Embraer aircraft and changes its fleet to another aircraft manufacturer. The whole surrounding infrastructure must be changed, including such items as aircraft simulators or training contracts, new crew training, change in ground personnel and procedures and possible spare part contracts. Non-determinable costs can occur if passengers do not want to fly on new, unknown aircraft. As established manufacturers, both Embraer and its biggest competitor Bombardier have this competitive advantage.

The last criterion is access to distribution channels. As distribution between the supply and the demand side of the aircraft market is rather direct (airlines purchase directly from the manufacturer), this criterion is not as important in the competitive strategy of this industry. Nevertheless, the increasing importance of aircraft leasing made it necessary for the world’s aircraft leasing companies to become familiar with manufacturers and their aircraft (e.g. specifications, common problems of aircraft while in service and the trust of airlines in certain aircraft). New competitors may face difficulties here if leasing companies know little or nothing about them or their products.

Embraer has competitive advantages in the market that are not directly related to Embraer’s market share. Porter also differentiates between five criteria.²⁵

The first one is the access to and the possession of key technology. Key technology is defined here as the necessary technology to develop new products that are unique and protected from competition. Because Embraer started as a company that was more technology-focused than focused on effective managerial decisions, Embraer could create a technological know-how that was unique in Latin America. The region around Sao Paulo also developed into an industrial center, where other high- tech industries were built up. This created positive synergy effects for Embraer. The ground-up development of the company went from core-designs of aeronautically simple aircraft to license-built military jets to original aircraft designs that are technically sophisticated in every aspect. To gain this competitive advantage in a high-tech industry is extremely difficult and rare and will most likely afford some protection in the market against new competitors.

The next criterion is easy and cheap access to production resources. In the early days of Embraer, the company had easy access to all kinds of natural resources due to its status as a government owned entity. Nowadays, this advantage has lost some of its importance and technological knowledge has become more and more important. Higher education that is focused on Embraer’s needs (e.g. aeronautical engineering) is supported by the company and there are several graduate programs that secure the future supply of these human resources. Human resources also are cheaper while having productivity comparable to that in North America or Western Europe.

The third criterion is cheap geographical locations. Porter defines this as a company location that was bought before the current competitive forces raised the prices. The location in Sao Jose dos Campos with its proximity to industry suppliers and a cheap, but educated workforce contributes to Embraer’s competitive advantage. The wide territory and low population density in most areas of Brazil helps Embraer to have enough locations for its needed testing facilities.

[...]

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¹ see IATA Annual Report 2005, Montreal, 2005, p.5

² Translated by the author from: Pompl, Wilhelm: Luftverkehr, 3rd Edition, Heidelberg, 1998, p.10

³ Translated by the author from: Pompl, Wilhelm: Luftverkehr, 3rd Edition, Heidelberg, 1998, p.10

⁴ See also: US Centennial of Flight Commission: www.centennialofflight.gov/essay/Dictionary/Santos- Dumont/DI41.htm, Washington DC, 2003

⁵ Embraer S.A.: Annual Report 2004, Sao Jose dos Campos, 2004, p.5

⁶ Ghemawat, Pankaj and Herrero, Gustavo A.: Harvard Business School: Embraer: The Global Leader in Regional Jets, Boston, 2000, p. 15

⁷ IATA Official Website: http://www.iata.org/about/history_3.htm?iata=iata, May 2006

⁸ Doganis, R.: Flying off course-The economics of international airlines, 3rd Edition, New York, 2002, p.9 See Appendix Illus. 1

⁹ See: Doganis, Rigas: Flying off course-The economics of international airlines, 3rd Edition, New York, 2002, p.4

¹⁰ See: Pompl, Wilhelm: Luftverkehr, 3rd Edition, Heidelberg, 1998, p.52-54

¹¹ Embraer S.A.: Annual Report 2004, Sao Jose dos Campos, 2004, p.6

¹² Embraer S.A.: Annual Report 2004, Sao Jose dos Campos, 2004, p.58

¹³ US Commercial Service, CS Brazil Country Commercial Guide January 2006, p.14

¹⁴ Goldstein, Andrea: From National Champion to Global Player: Explaining the Success of Embraer, Paris, 2001, p.20

¹⁵ See Reuters Online Service: http://www.investor.reuters.wallst.com/stocks/overview.asp?ticker=ERJ, London, 2006

¹⁶ Embraer S.A.: First Quarter 2006 Results (US-GAAP), Sao Jose dos Campos, 2006, p.1

¹⁷ Embraer S.A.: 4Q05 and FY2005 Earnings Results Embraer, Sao Jose dos Campos, 2006, p.6

¹⁸ See Sterzenbach, Ruediger: Luftverkehr-Betriebswirtschaftliches Lehr- und Handbuch, 2nd Edition, Munich, 1999, p. 74

¹⁹ Embraer S.A.: Annual Report 2004, Sao Jose dos Campos, 2004, p.59

²⁰ See Doganis, Rigas: Flying off course-The economics of international airlines, 3rd Edition, New York, 2002, p. 15-20

²¹ See Porter, Michael E.: Competitive Strategy, 7th Edition, Frankfurt/Main, New York, 1992, p.29-37

²² Translated by the author from: Porter, Michael E.: Competitive Strategy, 7th Edition, Frankfurt/Main, New York, 1992, p.29-30

²³ See Goldstein, Andrea: From National Champion to Global Player: Explaining the Success of Embraer, Paris, 2001, p.9

²⁴ Alonso, Juan and Kroo, Ilan: Stanford University: http://adg.stanford.edu/aa241/intro/origins.html, Stanford, 2006

²⁵ See Porter, Michael E.: Competitive Strategy, 7th Edition, Frankfurt/Main, New York, 1992, p. 34-35