Feasibility Analysis Report for the Purchase of Embraer.

by Juan J Cajas, M.Sc. ERAU-Worldwide Student

September 26, 2012

CONTENTS

FIGURES AND TABLES .iii EXECUTIVE SUMMARY .iv 1. INTRODUCTION ....1 2. ANALYSIS ..................1

2.1 Collected Data ...1 2.1.1 Company Basic Information and Highlights .1 2.1.2 Main Financial Indicators and Projected Growth 2 2.2 Feasibility Analysis ...5 2.2.1 SWOT Analysis of the Purchase .6 2.2.2 Benefit-Cost Analysis of the Investment ..11 3. CONCLUSSIONS AND RECOMMENDATIONS ...14 4. REFERENCES ....15 APPENDIX A .. 16

ii

FIGURES AND TABLES

Figure 1 Figure 2 Figure 3 Figure 4 Figure 5 Figure 6 Figure 7 Figure 8 Figure 9 Table 1 Table 2 Table 3 Table 4 Table 5

Embraers Global Pressence .2 Aircraft Deliveries, Evolution by Year 2 Annual Evolution of Net Revenue .3 Forecast views of New Commercial Aircrafts ..4 Narrow Body Demand Forecast 5 Product Line Opportunity Market for Embraer ..10 Industry Competitiveness .10 Narrow Body Market Share Projection ...16 Embraers Regional Customer Distribution 17 Embraers Main Financial Indicators .3 SWOT Analysis 7 BCA Data and Result 13 Original Projected Embraers Market Share .16 Modified Projected Embraers Market Share 17

iii

EXECUTIVE SUMMARY

Empresa Brasileira de Aeronautica S.A. (Embraer) has been identified as an emerging original equipment manufacturer with global presence and operations in America, Europe, and Asia. Embraer includes in its product line the manufacturing of narrow body aircrafts, and because narrow body business opportunity represents a market value of around US$1.7 trillion in the coming 20 years. This report discusses and analyzes this business opportunity, and finds that because of Embraers strengths and opportunities it may obtain at least 9.9% of the market share. The analysis concludes that Embraer represents an attractive investment purchasing 50% of the company. The investment will produce a ROI of 20% with the possibility of higher profits in the future.

iv

1. INTRODUCTION
As part of the Riddle Investment Companys business strategic plan, the Board of Directors has required to identify promising companies which might be candidates to be acquired in the short term. During the research we identified Empresa Brasileira de Aeronautica S.A. (Embraer) as an emerging original equipment manufacturer (OEM) of medium size aircrafts, with a sustained growth of units delivered during the 2005 to 2010 period (Embraer, 2012 September), sustained positive net income results during the last decade (Embraer, 2012 September), and a projected market share of 6.9% in the next 20 years (Valuentum, 2011 May). Therefore, Embraer has been selected as one of the candidate companies to be acquired, and the present document contains the feasibility analysis report for this option. The analysis is divided in two parts; the first one provides basic information about Embraer, a brief discussion about its main financial indicators and its expected market share growth. The second part presents a brief strength, weaknesses, threats and opportunities (SWOT) analysis of the purchase of Embraer, and a simplified benefit-cost analysis (BCA) of the investment. Finally, the report elaborates several conclusions about the convenience of the investment and states some recommendations for future research. 2. ANALYSIS 2.1 Collected Data 2.1.1 Basic Company Information and Highlights Embraer is an OEM multinational Brazilian company with headquarters in Sao Jose Dos Campos, Brazil. The company has a global presence with operations in America, Europe, and Asia (see figure 1).

Figure 1 Embraers Global Pressence Source: Embraers website.

According to Embraers website (2012, September) the company employs more than 17,000 persons worldwide and it reported revenue over US$5,803 million in the 2011 year. Some important highlights are the increasing trend of aircrafts delivered which is shown in the figure 2, the resulting increase in net revenue experienced which is shown in figure 3, and the product line expansion including military, regionalexecutive, and narrow body-single aisle aircraft models.

.
Figure 2 Aircraft Deliveries, Evolution by Year Source: Embraers website.

Figure 3 Annual Evolution of Net Revenue (IFRS) US$ Billion Source: Embraers website

2.1.2

Main Financial Indicators and Expected Growth After its privatization in 1994, Embraer did a capital restructuring in 2006. This event allowed the company to obtain access to capital markets to sustain its growth (Wikiinvest, n.d.). Moreover, after solving several growths operational issues experienced in 2007, Embraer has continued reporting positive financial results during the last years, as shown in Table 1.
Table 1 Embraers Main Financial Indicators
IFRS Revenues EBIT EBIT Margin % EBITDA EBITDA Margin % Adjusted Net Income Net income attributable to Embraer Shareholders Earnings per share - ADS basic (US$) Net Cash in millions of U.S. dollars, except % & per share data 2010 2011 2Q2012 YTD2012 5,364.1 5,803.0 1,717.3 2,873.2 391.7 318.2 197.4 283.2 7.3 5.5 11.5 9.9 610.9 557.0 265.2 413.4 11.4 9.6 15.4 14.4 358.9 196.6 186.5 251.7 330.2 111.6 54.3 117.0 1.8252 0.6169 0.2996 0.6452 691.8 445.7 290.2 290.2

Source: Embraers website & PR Newswire website

Although some financial deceleration has been seen in the last three years, Embraers positive numbers accompanied by the expected growth of the market are good signals of compensation for shareholders in the future. Referring to the expected growth, Embraer (n.d., p. 6) forecasts a 5.0% year-peryear increase in Revenue Passenger Kilometer (RPK) for the commercial aviation sector during the next 20 years. This translates into 32,800 new aircrafts, amount from which Embraer plans to gain a significant market share. Indeed, according to Harrison (2011, p. 18) new aircraft demand is forecasted to double toward 2029, being the growth driven by the narrow body segment as shown in figure 4.

Figure 4 Forecast views of New Commercial Aircrafts - As projected by different Manufacturers Source: Congressional Research Service Report.

Likewise, Valuentum (2011, May) agrees that the demand of new aircraft will be leaded by narrow body (single-aisle) models in the next 20 years, see figure 5.

Figure 5 Narrow Body Demand Forecast Source: Seeking Alpha website.

This narrow body business opportunity which represents a market value of around US$1.7 trillion (Valuentum, 2011 May) is supported by the fact that 58% of aircraft retirements in the next 18 years will correspond to narrow body airplanes (Flight Global Insight & Achieving the Difference, 2012, p. 4). Moreover, according to Flight Global Insight & Achieving the Difference (2012, p 3) 15% of these new aircrafts will come from Airbus and Boeing competitors. Valuentum (2011, May) is more aggressive with his prediction and forecasts a 33.8% of units delivered by the new OEM entrants. Therefore, an investment in the OEM industry looks attractive, and Embraer represents an interesting option as is discussed in the following sections.

2.2 Feasibility Analysis. Being known the projected growth of the aviation industry in the next decades and the specific growth of the OEM sector (driven by new narrow body deliveries), this report 5

uses statistics from two non-OEM sources: the Global 2012-2031 Commercial Fleet Forecast (CFF) summary report (Flight Global Insight & Achieving the difference, n.d.); and stock market expert opinion found in the article The Future of the Narrow Body Airplane Market (Valuentum, 2011 May) to assess the importance of an investment in the aircraft original equipment manufacturer (OEM) industry. Then, the analysis concentrates in the convenience and feasibility of purchasing one of the new entrant companies. In this regard, because of the advantages that Embraer has considering its characteristics of flexibility in design, service and innovation, and truly global presence in the aviation market, it is good candidate respect the other companies.

2.2.1

SWOT Analysis of the Purchase. The table 2 contains a brief SWOT analysis resulting of the purchase of Embraer.

Table 2 SWOT Analysis Strengths Investment in an OEM firm with years of experience and global presence including the AsiaPacific region. Lower manufacturing cost due to overseas operations and global sourcing. Company Culture & values equivalent to western firms. Financial presence in the western business market. Governmental support of emerging economy Opportunities Investment in an industry of confirmed growth with acceptable ROI figure in the long run. Investment in a firm within the sector with potential of market share growth in the long run. Smaller company easier to change and adapt according to strategic plan. Threats Price competition with Chinese manufacturer. Financing competition with bigger companies like Boeing and Airbus. Drain of human resources to bigger companies. Weaknesses After sales support with few years of experience. Technical unreliability image to be changed.

A discussion of some of the statements of the SWOT analysis follows:

Strengths and Opportunities Because of the well known growth and good financial results of Embraer already discussed in the previous sections due to its strategic business strengths, the report concentrates in the opportunities of Embraer to gain market share from the other competitors. During the last years the OEM industry has seen the coming of new competitors: Irkut from Russia, Comec from China, Bombardier from Canada and Embraer from Brazil. All of them with the Boeing and Airbus duopoly confront the fierce competition for the narrow body jet market. However, the competition is concentrated in the third place because Boeing and Airbus will dominate the market at least for the next 15 years (Jones, 2011 March). Therefore, we will first analyze the marketing strengths of Embraer compared to the other new entrants in every region, and second we will analyze the opportunities of growth of Embraer looking at technical and service aspects including the duopoly. First we consider Bombardier, although the C series might be the most likely purchasing option (instead of the re-engined Boeing 737 Max and Airbus A320neo) in the North American and European markets (Jones, 2011 March), it may find many road blocks to expand in developing countries markets like the ones in Asia-Pacific, Latin America, and Africa due to price competition. Thus, the price factor is an advantage for Embraer. Talking respect Irkut, according to Richard Aboulafia, Teal Groups Vicepresident, there is no threat to the global suppliers from Russia's airliner industry (Jones, 2011 March), this looks logical if we consider that even the local Russian airliners have preferred the replacement of their old Russian models for new Boeing 737 and Airbus A320 models. Therefore, although Embraer might not find a market to gain in Russia, at least it will not find a competition from Irkut in the Asia-Pacific region.

Furthermore, the main competition Embraer may face in developing countries comes from Comac. However Comac may have an advantage in its local Chinese market, the company lacks a serious of advantages that Embraer has respect financial and investment incentives. Although Embraer does not have a substantial share in the narrow body aircraft market now, its sustained growth trend during the last 5 years visualizes a reachable participation up to 9.9% of the market share or greater depending on the future market conditions. Second, an analysis of the technical product and service opportunities to gain additional market share follows. The figure 6 shows the range of product line offer for all the narrow body OEMs. We can notice that Embraer E-Jets series product line is not deployed for seating configurations above 120 seats as shown in figure 6. Besides, if we consider Embraers strengths on factors like local responsiveness and product innovation (Kedy, 2007) respect the less favorable condition of Bombardier, Airbus and Boeing (see figure 7), we may see an additional opportunity to boost Embraer market share above the 10%.

Figure 6 Product Line Opportunity Market for Embraer. Source: Seeking Alpha website

Figure 7 Industry Competitiveness Source: Jesse Kedys Embraer Slide Share presentation.

10

In conclusion, although Bombardier and Comac may represent a more attractive investment option, a long run view should consider the maximization of the price per value alternative.

Weaknesses & Threats Although the weak aspects of the purchase of Embraer may require additional expenses to improve technical and service issues of the products, the weaknesses are far less critical than the market threats the company should face. Lets begin with the Chinese menace, however the competition seems unfavorable, Embraer may take advantage of improved reliability results if proper investments are done. Therefore, Embraer may not compete pricewise but it may make a difference for airlines willing to favor safety rather than short run profit. In addition, innovation in engines using new bio-fuels may find a good opportunity in Embraer because Brazil already has a big ethanol industry, this can make a difference for many airlines willing to reduce their carbon footprint if stringent regulations take place in the next decades. In the other hand, Embraer faces the threat of more favorable financing options of legacy OEMs (Boeing and Airbus), but Brazil emerging economy may back up the growth of its former company. What really represents an important issue is the always existing threat of drain of brains; an emerging company as Embraer with hundreds of employees willing to succeed and learn more might decide to switch to the competition in search of better salary, benefits and professional growth. This is something Embraers owner needs to address in the future.

11

2.2.2

Benefit-Cost Analysis of the Investment. It requires enormous amount of time and analysis to elaborate a financial analysis of the convenience of purchasing a firm or part of it. Due to the time limitations to prepare this report, I am presenting a BCA of the purchase of 50% of Embraer. First, we need to state some assumptions: 1. Company value is USD$5.07 billion (Yahoo Finance, 2012, September 7) which includes debt; the investment considered corresponds to 50% of the company value. 2. Discount rate is set at 10%. 3. Research & Development expenditures will continue at 6% of annual revenue during the 2013-2030 period 4. Actual aggregate production capacity is 240 aircraft per year, of this amount narrow body production capacity is estimated in 150 units per year. Thus, no additional capital expense is overseen for the next 18 years. 5. Embraer will reach 9.9% of the narrow body market during the 2012-2030 period. Appendix A includes the rationale of this assumption. 6. Due to the market share increment, revenue and EBIT will increase 10.5% in the 2012-2030 period. 7. Deliveries are equally distributed in the 2012-2030 period.

The result of the BCA analysis is shown in Table 3. Therefore, the investment is recommended because the net present value (NPV) is positive and representing 20% of return over the investment (ROI). Indeed, comparing the 13% internal rate of return (IRR) versus the 10% capital cost set, it is confirmed the convenience of the investment. Normally, a sensitivity analysis should follow these findings but due to the commented time restrictions such analysis is pending for future research and analysis.

12

Table 3 BCA Data and Result

Year 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023 2024 2025 2026 2027 2028 2029 2030

CAPEX Benefit Total (MUSD$) (MUSD$) Benefits 2,535 0.35 0.35 0.35 0.35 0.36 0.36 0.36 0.36 0.37 0.37 0.37 0.37 0.37 0.38 0.38 0.38 0.38 0.39

Present Value (MUSD$) 318 -2,217 -2,217 320 320 291 322 322 266 324 324 243 326 326 223 328 328 204 330 330 186 332 332 170 334 334 156 336 336 143 338 338 130 341 340 119 343 342 109 345 344 100 347 347 91 349 349 83 351 351 76 353 353 70 356 355 64 Net Present Value = 507

13

3. CONCLUSSIONS AND RECOMMENDATIONS Along this report the purchase of Embraer was analyzed. It can be concluded that: 1. Embraer represents an attractive investment purchasing the 50% of the company, because considering the BCA the ROI is 20% with NPV over USD$500 million, and an IRR bigger than the capital cost represented by the discount rate of 10%. 2. The investment only up to the 50% of the company is logical sounded because Embraer keeps strong ties with the Brazilian government, and this is one of the strengths when financing comes into play. 3. The ROI of 20% is based in a market share of 9.9% only in the narrow body segment. Thus, any additional income in the military and executive jets segments contributes over the ROI. 4. The 9.9% market share for the narrow body segment is feasible if Embraer concentrates its marketing efforts in the regions where already it has an important presence and reputation, like Latin America, Europe, and North America. 5. Although the Chinese market is not going to represent an easy one to penetrate because of the influence of Comac and the prevalence of the duopoly, the investment already done in a new production plant in China will maintain its strength in lower manufacturing cost. If an initial positive decision is given to this investment project, it is recommended to continue analyzing more detailed aspects in the operations-logistics, marketing and financial aspects of the company.

14

4. REFERENCES Embraer. (2012, September). Embraer in Numbers. Retrieved from http://www.embraer.com/en-US/ConhecaEmbraer/EmbraerNumeros/Pages/Home.aspx Embraer. (n.d.). Market Outlook 2012-2031. (9th Edition). Retrieved from www.embraercornmercialavjatjoo.com Flight Global Insight & Achieving the difference. (n.d.). Global 2012-2031 Commercial Fleet Forecast (CFF) summary report. Retrieved September 4, 2012, from www.flightglobal.com/forecast Harrison, G.. (2011). Challenge to the Boeing-Airbus Duopoly in Civil Aircraft: Issues for Competitiveness. Washington, DC: Congressional Research Service. Jones, M. (2011, March) Can new entrants take on Airbus and Boeing. Flightglobal Insight. Retrieved from http://www.flightglobal.com/news/articles/boeing-admits-concern-over-newentrant-narrowbody-manufacturers-353227/ Kedy, J. (2007). Embraer a Critical Evaluation of Global Strategies and Structure. Retirieved September 6, 2012, from http://www.scribd.com/doc/15629359/Embraer-Global-Strategy

Wikiinvest. (n.d.). Retrieved September 7, 2012, from http://www.wikinvest.com/stock/EmbraerEmpresa_Brasileira_de_Aeronautica_(ERJ Valuentum. (2011, May). The Future of the Narrowbody Airplane Market. Retrieved from http://seekingalpha.com/article/272454-the-future-of-the-narrowbody-airplanemarket Yahoo Finance (2012, September 7). Embraer S.A. (ERJ). Retrieved from http://finance.yahoo.com/q/ks?s=ERJ

15

Appendix A Market Share Analysis

The figure 8 below depicts the Valuentum (2011, May) view of the future market share for narrow body segment. He assigns a conservative 6.9% of the market to Embraer. Although his analysis seems right respect the chances for the duopoly Airbus and Boeing, I consider his projection is unfair respect the chances Embraer has to enhance his presence in the regions where it actually behaves well.

Figure 8 Narrow Body Market Share Projection Source: Seeking Alpha website

In this regard, Table 4 breakdowns Valuentum forecast by region.

Table 4 Original Projected Embraers Market Share delivered units

Asia Europe N. America L. America M. East Russia Africa Totals

ComacUnits Bombardier Duopoly 5,315 2,658 2,126 4,261 426 3,196 4,103 349 3,077 1,426 291 570 871 178 348 451 34 169 333 80 133 16,760 4,015 9,620

Irkut Embraer 266 266 309 330 338 338 282 282 172 172 226 23 80 40 1,673 1,452

Total 5315 4261 4103 1426 871 451 333 16760

16

For the BCA a modified market share projection is considered. According to Embraer (n.d.) its actual customers are distributed as shown in Figure 9. Therefore considering all the stated in the SWOT analysis and its actual customer base distribution we may see strong presence in Europe, North America and Asia Pacific.

Figure 9 Embraers Regional Customer Distribution Source: Embraers website

Then, corrections are introduced to Valuentums forecast increasing its share only in North America, Europe and Latin America. A reduction is introduced in the Middle East region because of the prevalence of Airbus and Boeing in the region and the low influence of price as a factor on purchase decisions.

Table 5 Modified Projected Embraers Market Share delivered units

Asia Europe N. America L. America M. East Russia Africa Totals

Units 5,315 4,261 4,103 1,426 871 451 333 16,760

ComacBombardier Duopoly 2,658 2,126 320 3,196 492 3,077 214 570 209 348 34 169 80 133 4,006 9,620

Irkut Embraer 266 266 266 479 10 523 43 599 157 157 226 23 80 40 1,047 2,086

17