Embraer: Global Strategy

.

A Critical Evaluation of Global Strategies and Structure

© 2007, Jesse Kedy www.jessekedy.net

International Business Strategy University of Richmond

Introduction In a paper on developing multinational enterprises (DMNE’s) in 2006 I wrote:

“Brazil’s Embraer, now the world’s third largest aircraft maker, is revolutionizing the industry by creating cost-efficient, mid-sized jets with the leg room and overhead capacity of larger aircraft.” At the time, Embraer seemed like a fine example of a DMNE doing its best to compete in a global economy dominated by developed multinationals (MNE’s). That is no longer the case. Today, Embraer cannot be referred to as a DMNE; nothing about it (besides its home country) resembles a developing firm. Technologically, Embraer is at the cutting edge of aviation design; with about 19,500 employees, the company has a complex network of worldwide operations (Figure 1); over 96 percent of its revenues come from outside Brazil (Figure 2); it is a global player in commercial, defense, and executive aviation (Figure 3); demand for its product far outpace supply 1 (Figure 4); finally, its 2004 – 2006 sales and net income were at an all-time high (Figures 5 and 6). This analysis explores how this national champion has evolved from a 500-employee government founded organization to a global player that is nipping at the market share of Boeing and Airbus, and has surpassed Bombardier in the commercial aircraft business. The analysis reviews the following issues: the aircraft manufacturing industry, Embraer’s competencies, home country factors, Embraer’s global strategy, and Embraer’s organizational structure.

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With an order backlog of $14.8 billion (as of 31 December, 2006), orders continue to pour in.



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Reasons Not to Compete in the Global Aircraft Manufacturing Industry

The aircraft manufacturing industry is one of the few that is truly global; aircraft makers that do not employ an exceptional global strategy are doomed to failure. To emphasize this point, let us describe a few of the industry’s technical, technological, regulatory, strategic, and competitive challenges. Technically , the industry faces severe environmental variations as firms strive to meet global demand. Also, aircraft are subject to strict weight and volume restrictions, accounted for in the complicated development process. Technologically , aircraft makers must balance the simultaneous application of various state-of-the-art technologies and the need for highly qualified workers with cost restrictions; this creates complicated operational requirements. Regulatory challenges are based on the requirement for certification by each country to which an aircraft maker wishes to import its products. Strategically , to compete, aircraft manufacturers must have flawless planning and implementation systems in place, due to the extremely long time-to-market period (or developmental and testing lifecycles) of aircrafts. If we know it takes years and billions of dollars to design and produce a new car model, let us imagine what it takes to design and produce a new aircraft model, according to the specifications of multiple countries; specific airlines also demand specific customizations and modifications. Also, forming a successful strategy in this industry depends on factors such as the airline (not aircraft ) industry, commodity prices, foreign currency rates, and so on. Thus, the biggest strategic challenge is building into the firm’s operations the global flexibility that is so critical to success. There are also significant competitive hurdles in the industry. First, since the strongest aircraft manufacturing competitors are usually national champions (or in the case of Airbus, regional champions), they receive significant financial backing from homecountry governments. These nationally-backed firms provide employment for thousands, both directly and indirectly. They are also usually involved, not only in commercial manufacturing, but in the defense industry as well. Hence, governments place strategic importance on these industries and will tend to support them, even when they are no longer profitable. This has created an industry characterized by very large and influential competitors, some of which have long-term, exclusive contracts with airlines worldwide – another barrier to penetrating this market. Finally, due to heavy government subsidies, large aircraft makers – regardless of their efficiency – are able to compete on price.

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In short, to compete successfully in this industry, firms must be truly global , truly efficient , truly innovative , and truly tenacious . More than any other aircraft manufacturer, Embraer embodies these qualities. See Table 1 for a comparison to the rest of the industry.

Embraer’s Unique Competencies Embraer has certain strategic resources than enable this it to deal with the abovementioned challenges. To help understand the true value of these firm-specific capabilities, it is helpful to think of them in terms of added value (whether the firm can exploit the resource), rarity (how common the resource is among industry competitors, if at all), imitability (the possibility, costs, and difficulty of imitating the resource), and organization (whether the firm’s organizational structure is conducive to utilizing the specific resource). Truly Global

Embraer has proven itself truly global in several ways. First, with over 1,000 aircraft operating globally, 93 percent of its sales in 2006 were outside Brazil; its $390 million in profits (on sales of $3.8 billion) came almost exclusively from the global marketplace. Second, Embraer’s operations are strategically located worldwide (Figure 1). With large operations in the Americas, Europe, and Asia, Embraer has found the best way to reach its global customers while leveraging the research capabilities of talent from multiple areas. Third, Embraer has learned that, to appease global investors, it must trade in a hard currency; it sells 95 percent of its aircraft in U.S. dollars, so its stock does not have the currency risks that Brazilian investments are notorious for. It is safe to assume that the Euro will comprise an increasing share of its revenues in the future. Truly Efficient

Embraer has also proved to be very efficient. First, its average wages are less than one third of rival Boeing. This is not to say that Embraer underpays its employees, or that this is merely due to its home country wage levels. In addition to Brazil’s low wages, Embraer employs many aeronautical engineers and technicians in its new assembly center in Harbin, China. Embraer recognizes that China has more to offer than cheap labor; China’s increasingly educated and ambitious talent pool make it a prime location for locating a capital- and technology-intensive manufacturing center. Also, Embraer has longstanding and deep ties to the Brazilian government. With these ties come the advanced engineering © 2007, Jesse Kedy www.jessekedy.net


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capabilities of Brazil’s air force aerospace program. Finally, and perhaps the best example of Embraer’s efficiency, is Embraer’s aircraft design (mentioned below). Embraer has been able to design common platforms for its aircraft.2 Without getting into detail, this means that these aircraft have up to 95 percent commonality, including spacious cabins, large cargo compartments, and superior performance capabilities. Truly Innovative

“Embraer is one of the hottest manufacturers in the industry today… They're willing to push into areas that others haven't explored.” (Donald Burr, founder People Express). Several factors make Embraer highly innovative. First was its decision, in the late 1990’s, to invest $1 billion in designing a larger plane that seats 70 to 118 passengers for rapidly growing low-cost airlines.3 This insight has been invaluable to Embraer’s success. Another sign of Embraer’s innovative mindset is its commitment to “judiciously introduce new technology” when it creates value by lowering price, reducing direct operating costs, or delivering more reliability, comfort, and safety. Embraer has pursued this commitment by investing 6 percent of revenues into research and development for the past six years; that is over $1.1 billion invested in R&D since 2001. A result of this focus is its new fuselage, the “double bubble”, which has increased head space, legroom, and luggage space, and has eliminated the infamous middle seat. What is truly innovative about this design is that it resulted from the accumulated insight of over 40 airlines, which Embraer surveyed during the design phase. Also, this new design helped Embraer surpass its Canadian rival, Bombardier. Beyond its products, several other factors complement its innovativeness. First, Embraer trains its engineers, not only in aeronautics, but also in market research and finance, allowing a broader understanding of the industry. Another unique quality is Embraer’s customer-centric strategy. While it may sound like a common quality of successful MNE’s, this is not so in an industry characterized by few leading firms. This strategy has afforded Embraer a high degree of goodwill among lowcost carriers in the U.S. and European markets. Its customers describe Embraer jets as welldesigned, reliable, and cheaper to operate. Embraer now outperforms Boeing and Bombardier in fuel-efficient, midsize jets. Also, customers appreciate the ability to 4 e g a P

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This is one of the keys to Embraer’s high degree of global integration. 3 61 percent of flights in the U.S. have passenger headcounts in that range.



customize their aircraft with an easily changeable interior design. Further, Embraer has established relationships and CSR initiatives with some airlines. For example, each time JetBlue receives a new Embraer aircraft it donates $10,000 to an Embraer program that sends poor students to college. JetBlue has ordered 101 planes, worth $3 billion. Truly Tenacious

Finally, Embraer has what I call “underdog tenacity”. This is a quality, usually unique to small firms, perhaps from less-developed economies, who are not expected to succeed, and who, hence, are underestimated. These firms tend to be less risk-averse and will seek and implement truly unusual strategies. Embraer's executive vice-president for engineering and development says it well: “Years ago our competitors said, ‘How dare those ugly ducklings from South America try to sell a jet in the Northern Hemisphere.’ Fortunately, they underestimated us.”

Country Factors Being a truly global firm, most do not place much importance on Brazil’s economy when judging Embraer (remember that 95 percent of its revenues are in U.S. dollars). Still, a mention of Brazil’s trade agreements and its involvement with Embraer are merited. Brazil’s main trade agreement is Mercosur (the Southern Common Market), in which it is highly influential. Mercosur’s members include Brazil, Argentina, Uruguay, Venezuela, and Paraguay. Initially, Mercosur was expected to enable regional economic growth and development, stabilizing regional political relations in the process. The agreement has succeeded on the political front, becoming a credible voice in the WTO and the FTAA. However, in terms of economic integration, its success is not impressive. Mercosur was designed to evolve into a customs union with a common external tariff, and eventually into a common market. Still, Mercosur remains an incomplete customs union with several exceptions to the common tariff. The Free Trade Area of the Americas (FTAA) is a proposed free trade area that would include the 34 nations of the Western Hemisphere (all but Cuba). The FTAA has been under consideration for years, but talks have been stalled since 2003. Differences in opinion between Brazil and the U.S., are the co-chairs of the Trade Negotiations Committee, are to blame. The U.S. is most concerned with an agreement that includes © 2007, Jesse Kedy www.jessekedy.net


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negotiating investment, services, intellectual property rights, and other issues. Brazil wishes to influence market access, and U.S. agricultural subsidies. Brazil is also involved in the World Trade Organization (WTO) as a vocal leader of the G-20, representing developing-country interests. Brazil insists on addressing reduction of barriers to agricultural trade, especially export and production subsidies. It is also concerned with enabling the production of certain proprietary drugs by generic makers, to enable access to those who need it most in developing countries. The Brazilian government has had a strong affect on Embraer. As mentioned, the company was founded by the government in 1969. Before its privatization in 1994, Embraer had established several partnerships abroad and was very focused on exporting its aircraft to new markets. Naturally, Embraer was not run like a multinational. It had international operations, but was far from being truly global until 1999, the first year of major activity after its privatization. Embraer began 1999 by launching a new family of aircraft and four midsized models: EMBRAER 170, 175, 190, and 195. This was done through a partnership agreement with large aerospace contractors worldwide (some 16 risk-sharing partners and 22 suppliers); its budget was $850 million. Also, Embraer established partnerships with a group of European aerospace and defense firms (EADS, Dassault, Thales, and Snecma), which acquired 20 percent of its common stock (7.7 percent of the firm). Finally, in a joint venture with Liebherr Group (Switzerland), Embraer established Embraer Liebherr Equipamentos do Brasil S.A. (ELEB), an engineering and manufacturing unit in Europe. Since 2000, Embraer has undergone many more global activities, many of which have been through strategic partnerships. The point is that the Brazilian government’s leadership was in no way decisive to Embraer’s global success. The government lacks the allimportant entrepreneurial buzz that currently characterizes Embraer. Note, however, that the Brazilian government does have some strategic power over the company. Though it is not a majority stakeholder, it has the ability to veto certain decisions (see Embraer’s New Capital Structure below).

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Global Strategy Embraer does not differentiate between global and home-country strategies; it is all global . Still, Embraer’s global strategy does have several locally adaptable components. The company’s overall strategy is based on two dimensions: its business drivers , which encompass its tangible operations, and its corporate culture , which includes the values and attitudes it wishes to espouse within the company, and throughout its environment. Embraer’s business strategy dimension includes four drivers. First, Embraer wishes to achieve continuance of growth . In 2005, the firm adopted a dispersed share ownership capital restructuring. This has enabled using its shares in acquisition and international expansion while maintaining the government’s strategic rights. Second is an emphasis on globalizing operations . Embraer recognizes that new markets are essential to its growth, and that it must establish a physical presence in these markets, such as manufacturing, after-sale support, and customer service. Embraer has had international operations since the 1970’s; this goal however goes beyond internationalization. For example, in 2003 Embraer formed a joint venture with the Aviation Industry of China – a separate entity, based in China, called Harbin Embraer Aircraft Industry (HEAI). Also, in 2005 the company acquired OGMA (“Indústria Aeronáutica de Portugal”) and began constructing aircraft maintenance facilities in Nashville, TN. The third business driver for Embraer is increasing its presence in strategic markets . Embraer claims that it does not enter a new market without “thorough analyses of market opportunities and return on investment.” For example, the company has identified executive aviation as a strategic market and its next main focus. 4 Finally, Embraer considers its strategic partnerships as a key business driver. Embraer continually seeks new companies who are leaders in their business segments. When entering a partnership, Embraer focuses on flexibility, risk-sharing, and anticipated results. Embraer’s softer strategy includes six drivers, the first two of which are arguable the most important. First, Embraer emphasizes ethics and compliance with the requirements of the countries in which it operates and to which it exports. Broadly, this goal also applies to relations with customers, shareholders, suppliers, competitors, and employees. Second is customer satisfaction, which Embraer considers demanding and the driving force behind its development, production, and support. This customer-centric approach has led Embraer to develop some highly successful models. The remaining cultural drivers are fairly standard 7 4

The executive aviation market is expected to reach $144 billion in the next ten years.



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and are not unique (or uniquely stated); they include transparent shareholder relations , recognizing employees , negotiation, and sharing of results, and social responsibility .

Organizational Structure An issue of major significance within any multinational firm is its organizational structure; namely, how that structure relates to its overall strategy. One would expect this issue to be of importance for Embraer because of its complex operations. Embraer does not merely produce aircraft in Brazil and export the finish product. Doing so would be extremely expensive and, as mentioned, Embraer puts a lot of effort into reducing costs and increasing efficiency. Instead, Embraer has set up facilities throughout the world (Figure 1) in which value-chain activities are completed. This includes design and assembly. It is less clear, however, how much manufacturing is done abroad, though we know that Embraer does source materials globally. For these reasons, it is surprising that there is little mention of Embraer’s operational structure. One possibility is that a restructuring is currently underway, but not finalized. Indeed, the restructuring proposal was only approved in 2006. What is mentioned is that Embraer will turn into “the first large Brazilian Company with dispersed corporate control,” implying a strong reliance on subsidiaries. Embraer’s website gives a list of executives which makes it possible to deduce the new structure. At the top is its board of directors, followed by the President and CEO. Next comes a list of nine executives: Executive VP, Airline Market; VP, Executive Aviation Market; Executive VP, Defense & Government; Executive VP, Engineering & Development; Executive VP, Industrial Operations; Executive VP, Corporate & CFO; Executive VP, Corporate Communications; VP, Organizational Development & Personnel; and VP, External Relations. The first three positions pertain to Embraer’s core product lines, while the others refer to horizontal functions. Based on this, it seems that Embraer is adopting a matrix structure , based on product and function. While these are important, a strong case would have to be made against having regional divisions as well. Embraer’s global operations are very dispersed; they are also very important to its strategy. It is arguable that the most appropriate form would be a matrix structure, centered on product and regional divisions.

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Embraer’s New Capital Structure At a Shareholders’ meeting in March, 2006 shareholders approved Embraer’s restructuring proposal, turning it into “the first large Brazilian Company with dispersed corporate control .” .” The new structure should provide improved access to capital markets, making it easier to finance and develop new programs. This fits into Embraer’s strategic goal of achieving “ sustainability, growth and continuity of [its] businesses and activities .” .” Also, the restructuring is expected to improve management’s ability to adopt optimal corporate governance practices while maintaining the government’s rights.5 As part of the restructuring, Embraer will offer only common shares, enabling all shareholders to vote, as well as allowing it to become a member of the São Paulo Stock Exchange’s New Market Mercado Novo). ( Mercado The government’s strategic rights are through its ownership of “the Golden Share”, a special class of share which gives it veto powers over specific issues relating to Embraer’s business decisions. The restructuring will not affect the government’s strategic control.

Other Issues There are three additional threats that Embraer must cope with if it wishes to maintain its growth. First, it must find a way to increase its European sales . The biggest market for the 1999 Embraer 170/190 project was meant to be Europe, where routes are short and frequent. However, there has been a general decline in demand from the EU since the events of September 11 th. Second, Embraer must find a way to deal with U.S. union resistance from pilots, air, and ground crews, who are paid more for operating larger jets (another reason for the inefficiency of large planes). Finally, Embraer’s competition in the 170/190 class will increase, as Bombardier launches a commercial aircraft program to rival to these aircraft. Embraer must capture as much of the market while it is the only real competitor in this category.

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It is not hard to imagine the conflict between optimizing corporate governance while the government has a degree of strategic control over the company.



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Conclusion Throughout its recent history, Embraer has been faced with some major competitive challenges. Nonetheless, it has continued to thrive through constant innovation, rapid learning and adaptation, and swift implementation of its new programs. By recognizing its need to be entrepreneurial (after its 1994 privatization), Embraer has exposed itself to many new opportunities, which it would have otherwise been blind to. Still, Embraer’s dominance of the small to midsized regional jet market will no longer go unchallenged. As large commercial airlines continue to struggle with fuel costs and other inefficiencies, aircraft makers will increasingly realize that they must meet the growing demand for smaller, more cost-effective jets. Embraer will attempt to remain competitive through its focus on airline input, such as the need for aircraft customization and comfort. It will also increase its R&D efforts and continue exploring new frontiers, such as its recent focus on the executive jet market. Embraer’s ability to continually and successfully forecast future global demand and its ability to meet that demand in unique and innovative ways will be the keys to its future success.

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Figure 1: Global Operations

Figure 2: Revenue per region

Figure 3: Revenue per segment

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Figure 4: Firm order backlog

Figure 5: Net Sales

Figure 6: Net Income

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Table 1: Selected Financial Information for Embraer and Key Competitors6

Key Numbers

Embraer

1

Airbus Bombardier

Gulfstream Aerospace

Annual Sales ($ mil.)

3,440.5

26,409.9

14,726.0

2,538.0

Employees

19,300

55,000

55,922

6,750

--

--

--

--

Market Cap ($ mil.)

Profitability

Embraer

Airbus Bombardier

Gulfstream Industry Market Aerospace Median Median

Gross Profit Margin

34.10%

--

--

--

18.50%

51.60%

Pre-Tax Profit Margin

14.30%

--

--

--

3.60%

6.50%

Net Profit Margin

11.10%

--

--

--

2.90%

5.10%

Return on Equity

30.1%

--

--

--

12.4%

9.6%

Return on Assets

6.3%

--

--

--

3.0%

1.5%

Return on Invested Capital

8.4%

--

--

--

5.7%

4.2%

22.7%

--

--

--

30.0%

29.6%

Interest Coverage

3.99

--

--

--

6.44

5.36

Dividends Per Share

0.75

--

--

--

0.48

0.64

Working Capital Per Share

8.43

--

--

--

2.85

0.58

Book Value Per Share

7.32

--

--

--

5.19

5.05

Total Assets Per Share

32.88

--

--

--

14.33

10.46

Effective Tax Rate

Growth 12-Month Revenue Growth 12-Month Net Income Growth

Embraer

Airbus Bombardier

Gulfstream Industry Market Aerospace Median Median

60.5%

--

--

--

8.5%

12.4%

179.5%

--

--

--

11.0%

15.3%

4.5%

--

--

--

0.0%

0.0%

12-Month Dividend Growth Source: Hoovers (http://premium.hoovers.com/ )

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Only sales and employee data are provided for competitors; most of the data compares Embraer to the overall industry. © 2007, Jesse Kedy www.jessekedy.net


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Embraer: Global Strategy

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