Embraer: Defying Gravity - [Business Breakdowns, EP.158]

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0:45This podcast is for informational purposes only, and should not be relied upon as a basis for investment decisions. This is Matt Russell and we are back in the world of aviation today breaking down Embryer. Now commercial aviation is one of the most famous duopolis in the world. You have Boeing and Airbus that dominate all the headlines and those large commercial jet orders. Yet Embryer has carved out this interesting niche manufacturing, regional jets, business jets and military aircrafts. In comparison, Embraer has about a $5 billion market cap and did about $5 billion in sales last year as of the time of this recording in the spring of 2024.

1:29And that's about a tenth of the size of Boeing and Airbus on both of those metrics respectively. Our guest today is Richard Abelafia, managing director at Aerodynamic Advisory and long time aviation analyst and consultant. And we want to give a special shout out to the AdLots podcast. We heard Richard tease the intrigue of Embraer on a recent episode. And naturally, we needed to learn more. So we break down how this aviation success story grew out of Brazil. Talk about the evolution of the regional jet market, the business jet market, tap a little bit into military aircrafts. And of course, we cover the opportunity presented by Boeing today.

2:07As Richard puts it so well, it would take the company type approach if they were really go after Boeing's market position. And whether or not that's realistic, I really like the framing and it's a fun thing to think about. So please enjoy this breakdown of Embray Air. All right, Richard. I'm excited to talk Embray Air today in the world of aviation and aircraft manufacturers. It's often categorized as duopoly with Boeing and Airbus, but there is space for others clearly. And I thought we could just start there with how Embryer fits into the ecosystem. Yeah, Embryer is a fascinating story and we can talk about its origins and what that all means.

2:51But in terms of the here and now, it's a deeply respected niche player in three different areas. One is business jets, the other is military, and finally commercial, where it had regional jet origins, actually regional prop origins and then regional jet origins, and then came up with its current family of E2 series, which almost get into the bottom end of AirBus and Boeing territory, but not quite. Their great products, they're certainly relevant for the markets they address, but in terms of challenging AirBus and Boeing, they're just not quite there in terms of range and capacity. You mentioned there, interesting origins, businesses based in Brazil, came from Latin in America.

3:35I typically think of the commodities industries where they have mining operations. You have a lot of oil and gas businesses come out of that region, certainly banking sectors to support economies, but not too many manufacturing businesses like this. So maybe you can bring us back to the start and what created or what was the idea behind launching a business like Embraer. If I could come up with one phrase that describes the origins of Embrayer and its implications in meeting for the future would be, don't try this at home. This very strange story, not to belittle it, but it was kind of a fascist hunter -hobby shop back in the late 60s.

4:13One popular theme in Latin America and economics and politics back in the 60s and 70s was autarky. The idea that they should cultivate homegrown industries that would allow them to effectively sustain themselves and generate economic growth. 99 .9 % of this failed miserably. Embraer, however, worked out pretty darn well. It began as a way to build military systems in some very basic small transports, the kind of thing an emerging nation might need, circa 70 or 80 years ago, whatever it was. And well, it evolved, it worked out. And back when things were getting really good in the 90s, they made the incredibly smart move of privatizing.

4:57And that brought them discipline, that brought them great management. But two things about it, again, don't try this at home because every other cockameme otarkies game in the region pretty much failed with a couple of other exceptions, but 99 % failed. And more relevantly, globally, this idea failed. The idea that, hey, kids, let's build a factory in the jungle and build aircraft. There were a lot of new market entrants. Even next door in Argentina, there was an effort, Chile, the most spectacularly Indonesia had IPTN, and all of them either failed outright, nobly sometimes, sometimes is cash -sucking corrupt parasites on society.

5:40Embrayr is the only company, and Brazil is the only country to successfully enter this business over, well, pretty much since 1960s. It's an incredible story, but again, don't draw larger lessons from this because, frankly, everyone else you tried it failed miserably. The outliers are always dangerous to pull lessons from. I was wondering, was there a key individual or personality behind these efforts that really led to that success, any key players in the history? Obviously, my memory is a bit more recent. I joined the industry in the late 80s. Where's your boatello? I believe was a very key player.

6:22He was the last to enjoy the lavish resources associated with the government -owned Operation, but he also began to recognize that hey the winds of privatization are coming and it's probably for the best So he was a key player Fred Carrotto I believe was if not his immediate successor, but right after that But he really did fantastic things for the company especially back late 90s really 2000s introduced the current $191 .95 series. And I believe he also played a role in diversification because the business jet part of the company was relatively late. They didn't do that till the 2000s. Before that, it was military and commercial, but not biz -ev.

7:02So that was a key move because that tends to be a more lucrative segment of the world aviation industry. When I think about that, Aright, you've mentioned where their origin story was, the uprise of some more regional based airlines, Yeah, that's right. They're breaking to the US market was with the EMB 120, the Brazil, I believe, in the 1980s. And at the time, post -eregulation, a lot of regional passenger operations were growing to feed hubs for the large legacy airlines. As a 30 -seater, the 120 was cheap and cheerful and lots of people adopted it. So that was their entry into the North American market.

7:45It allowed them to grow their product support infrastructure and of course, sales infrastructure. And it made them realize that their past, again, Brazilian hobby shop for local needs was not their future. Their future was an export business. It also established one of the most important principles of Embraer's evolution, which is the Dell computer model that really they don't want to do everything. They don't want to be vertically integrated. They don't want people to transfer technology. They simply want their engineers to go shopping for the best systems, best value for money as a principle.

8:20And you contrast that with China, it's the exact opposite. People ask, well, China'd be the next Embraer. The answer is, oh, hell no, they're doing it all wrong. Basically, Embraer said, we want to integrate your systems. We don't want the technology. We simply want to provide best value. So it was that period then that they established that as they're operating principle. How does that compare to a Boeing or Airbus just in terms of the integration side of things? Pretty much the same. It's just that a lot of people who want to do it on their own, be it Indonesia or whoever else, India, China most notably, have this notion that, well, we need to be truly autarkic.

9:04We need to create it in country. In country engines, in country avionics. The way to do it is Airbus and Boeing and also Embraer. You integrate other people's systems and you don't demand technology transfer because that leads people to bring you their latest and best from 20 years ago. They're not going to trust you. So Airbus and Boeing are that standard. Embraer tends to be a bit more pro outsourcing, although of course these are cycles that Airbus and Boeing go through? The regional jet market, comparing that to when I think of the larger aircraft that Boeing and Airbus tend to dominate, can you just paint a little bit of a picture in terms of maybe popular flights, obviously something like New York to Boston, I would assume, is on a regional jet.

9:55How far does that span out? And then how would you just classify those two markets next to one another? New York to Boston is a trunk route. It's going to be thick. It's going to have bigger jets on it. Really what we're talking is say, oh, Burlington to New York. Secondary cities eating into the primary hubs. It's funny back when there were six or more large legacy airlines. As you can imagine, this was huge business. In the 90s, the idea of a regional jet, oh my goodness, if you can imagine, regional service with a jet before that it was all props pretty much with a few small exceptions. But Embraer, along with their archnemesis Bumbardi A at the time, got there first with a regional jet, which effectively used the tube of the 120 with new wings, new engines, whatever else, new cockpit, and created the 145 series.

10:49And this was huge. This was their real breakthrough. It was that combination of being in the right place at the right time with the one four or five coupled with privatization, they took place simultaneously that allowed Embraer to be the great company it is today. But anyway, adding regional jets to the mix allowed people to go further. So it wasn't just say Burlington to New York, it would be Dayton or further out, 800, 900, a thousand nautical miles. So thinner routes that allowed you to feed into a hub. And of course, from the standpoint of airline operations, it's hugely important. you're not going to five people to Paris from Wichita, probably not.

11:27So you're going to want to bring them to say Chicago or Washington or whatever, and then fly them. So you need this big hub and spoke operation to feed your primary hubs. And how has the consolidation of the airline industry, we could focus on the US, had an impact on the regional market, and maybe relative to the longer range market? It's been really damaging. That's an important question because of course you've gone to three majors in four if you count Southwest, but they don't really have that hub and spoke operations. So they don't use regionals. A lot of those hubs were deemed superfluous.

12:08You look back 20 years. Pittsburgh, Charlotte, why not? These are major hubs. Well, no longer, sadly. St. Louis wants the hub for TWA. My goodness. And TWA had regional feeders. The joke at the time was how many airlines will there be? In the year 2025, there'll be three to globally merged mega carriers and financially troubled TWA, somehow they eventually died. All of this was devastating for regional aircraft producers. There used to be about 10 of them. And now there is, let me count, let me think, one. I should say two, because ATR still builds regional turbo props, which no one uses in North America.

12:48But the only regional jet producer is Ember Air. And it's surprising to me in some sense where as civilization moves forward, you would think that something like this, you would have more opportunities, more access. So just from your point of view, obviously the airlines had all types of issues in terms of balance sheets and unions and competition, but it does just run counter to what I would think is common sense would say that we'd continue to have more opportunities. So when you think about the outlook for regional in the future, do you have any sense that there will be a rebound or recovery, a rebirth of more of these hubs?

13:28Not the hubs, but the fleets. There's a greater focus on point to point travel. In other words, people don't like being boxed up and shunted through Charles de Gaulle or JFK or Nareeta. They really don't like it at all. They'd rather fly direct, say, from Boston to Dublin. one, whatever. So you're getting more cities with international service, you're getting more direct. You're getting a lot more of the Southwest effect suburban airlines. Southwest doesn't use regionals. Neither does JetBlue. A lot of the new folks in town, recently a legend in Frontier and now more recently breeze or what have you.

14:03They just do point to point between secondary cities, Dubuque to Las Vegas. So there's less need for regionals. However, there's this big mystery. There are thousands of 50 -seat planes still flying. Embraer has long since ceased production of the 145. Pretty much everyone has ceased production of 50 -seat aircraft, almost everyone. Water places them. The default answer is you bump up to Embraer's smallest aircraft, which is the E -175, 75 seats or so. They're starting to do pretty well with that. It's not an ideal solution, but it's the only game in town. When you say it's not an ideal solution, I assume it's because the 50 seat planes are made for aircrafts that are lucky to get 50 people on them for those flights.

14:51Is that basically categorize it? Yeah, that's right. People do like frequency and regional operations. Having said that, there's a seat mile cost production the more you go up, and that's always been the problem with regional aircraft. Now, Embraer saw all of this coming. They've got really good planning capabilities, and that's why they diversified. The 175 is a true regional. The 195 really are not. No one's going to use it to feed a hub. There may be a point to point to aircraft. The problem is it's also neither here nor there. It's not a regional, but it's not really a true major. It's doing well enough.

15:29You're talking 30, 40 planes a year. So that raises the question of what they do next. Of course, part of the diversification strategy was also business jets, and that's done very well for them. But from their regional origins, they have done a really good job of expanding it. In those early days, you mentioned it was a breakthrough to be able to fly on a jet, to do one of those shorter routes or less dense routes. I'm just curious when it comes to the players like Boeing and Airbus, was that just not an attractive opportunity was it actually a technological breakthrough for Embraer or was it something that the larger players may be just ignoring because of the profit opportunity?

16:11Yeah, for Airbus and Boeing, these were margin destroyers. The regional jet marketplace was regarded as this how to put it gently just distorted fantasy land of Alice and Wonderland economics where you had companies willing to lose money on each plane they sold but make up for it somehow and volume. See you had companies like British Airspace or SAUB or Falker or whoever else just losing their absolute shirts on these programs. And of course Airbus and Boeing were standing by watching Giggling Embraer made a go of it because they transitioned away from it and because they were a low cost operation back in a time when companies like say SAUB or British share space for PICOS, but to get into reiterate, regionals have historically been the land of value destruction.

16:59And want to pull in some of the other business segments as well, the defense and military side of things, how big of a percentage or just how important and relevant is that to the Embraer business today? Yeah, it's pretty important to depend and sell you measure it, but typically 20%, 30 % roughly goes back and forth depending on the years and the programs, but what amazes you is just how ridiculously absurdly efficient they are. There's the stuff they get to do as part of LL, where Brazil's national defense champion Brazil's buying Greek and fighters from Sweden. We get to co -produce them in country who array.

17:38That's not really what they do best. They just have to do it or they just want to do it whatever. But for example, they produce a series of maritime patrol and airborne early warning special mission surveillance aircraft using the 1 .45 and even the 120 at some point. These were really good. These were very impressive. And then most amazingly, there's the KC -390 story. This is a tactical military transport developed in conjunction with the Brazilian Air Force. No one can quite figure out how they did this. I mean, it is an amazing achievement for both the development cost and for the unit price.

18:19It's got a wing box that's similar to a 767 wide body, really good for tactical military operations. And the only bad thing I can say about it is that it doesn't have the US military stamp of approval. They're working on that. If it did, this would be a killer product. As it is, it's a good product that's finding a niche in the world. But the fact that they did this, It's just a testament to really amazing and really efficient engineering given the cost constraints. Is there something that continues to drive that? Again, it's such a standout in a country that is certainly an economy that's often associated with the largest emerging market players, but I wouldn't say that they're necessarily categorized or stereotyped in this way of having this engineering prowess, manufacturing prowess, anything along those lines.

19:09So, Is there something that continues to drive that cost and technological advanced? You know, two things. One is they've always been good at a vertical integration with engineering education. You look at operations like ITA, I forget the acronym, but basically they were created in parallel with an engineering academy down in Brazil. Really good at producing skilled talent. So they basically become a talent farm, if you will. The other factor, frankly, is that corporate culture. It's been engineering driven engineering focused very aware of Cosskin's trains. You look at what's going on with Boeing right now, the decapitation that very badly needed to take place this week and did I'm happy to say it was the exact opposite.

19:53It was run by people who were excellent at Microsoft Excel with some skills at Microsoft PowerPoint and very little knowledge of engineering or aircraft design and manufacturing. Embraer is the exact opposite. It's really been good at retaining that aircraft focused engineering and design culture. Yeah, it's fascinating to learn about. On the military and defense side, again, you mentioned it doesn't have the US stamp of approval. I wonder about that business, how much of what their building is being exported to other nations. And it seems like it would be a very unique business line if you're building something that could be used eventually against you potentially.

20:36So how does that trend over time? And is there anything unique about managing that business segment that you would point to? Well, just that shift away from domestic requirements to global opportunities. You look at it start, they were building very light planes, liaison planes like the Jean -Guy, Embrero 110, and then the Tukano, which was a very light trainer for the Brazilian market. but they began to get some nice export orders and then they developed the Super Tukano, otherwise known as the ALX, and the ratio for that export -versed domestic has been roughly two to one in favor of exports.

21:13KC390, they've started to get some export traction so far. It's roughly one to one domestic exports, so they've become far more export -oriented with the big caveat that their US market breakthroughs have been pretty limited so far, just some props sold for US special forces, a few other things. But in general, their mindset is a lot more global than it used to be. Is there an opportunity with what's happening with Boeing for Embraer to fill in that gap a bit more? Yeah, absolutely. They're not going to be building the Air Force's next generation Superfighter anytime soon. But most promisingly they have allied with, I guess what you might call a couple of US second -tier defense primes, Sierra Nevada respected company, L3 Harris respected company on marketing into the US.

22:05Again, breakthroughs have been pretty darn limited partly because of the nature of what Embrayer produces. It's not really what you call perfect for a superpower, but it's really good for second -tier countries. could they get a breakthrough with the KC -390? That's something that I'm sure Lockheed Martin is watching very closely. They build the C -130 Hercules transport, which is a pretty direct competitor, and that's continued to keep the entirety of the U .S. military transport franchise. But this is something that people have to watch if they're in the business of being a U .S. military prime.

22:41And I would say I would put the BizJet business in a different category, but for the commercial side of the business and the defense and military side of the business. When it comes to customers and their interest in diversifying fleets, does that play a role in terms of giving them an opportunity or is there more desire to concentrate in a certain aircraft type? Can you just talk about the benefits or negatives that would be associated with customer fleets and how they manage them? Yeah, there's a completely different business with completely different customers. Every so So often you'll get an airline talking about operating a business jet unit and it began with Pan Am and DeSoe Falcon jet.

23:22It didn't work out around 20 years ago. You had United with its operation called Avalar. It didn't work out. You're getting people talking about it now. It's not going to work out. Business jets go to high net worth individuals, corporations and fractional and charter providers who are generally not affiliated with airlines. It's just a completely different customer base completely different set of operating specs. So this was a real I don't want to say gamble, but it was a really shall we say different move when they went into the space It was okay. This is out of our comfort zone. We're gonna meet some new people We're gonna do some new things with completely new airframes.

24:01This is about 20 years ago And they created the phenom 100 and 300. Later the legacy, 455, 100 now the pre -tour. I don't know why they renamed it the pre -tour, but they renamed it the pre -tour. They based the business in Florida. A lot of the manufacturing isn't in Brazil, it's in Florida. And they have done incredibly well. A kind of arbitrage. They basically said regional jet margins suck. Business jet margins, they're pretty darn good. Why, if we better margins than regionals, but not as good as what say Gulf Streamer Sessner are getting. And sure enough, that worked brilliantly. For example, the Phenom 300, which sells for roughly 12 million or so, has become the product of reference for a lot of fractional charter providers.

24:47They've been building about five per month of those things. That's a really good business. And you mentioned that customers completely different. Do you have a separate sales team that are interacting like is there a brokerage that really controls a lot of this? You go to events like National Business Aircraft Association Convention, either in Vegas or Orlando depending on the year. You see how hand -to -hand it is. A lot of it comes down and it's like Mark Wahlberg, what can I do to get you in, etc. It's not the same as talking with people looking at spreadsheets in airline fleet departments.

25:20It's not that at all. It's not economics. A lot of it is sentiment -based. A lot of it is the rich Corinthian leather They're coupled with our gorgeous executive dining option facilities. On this jet are just going to be so much better. And I know you're probably not dumb enough to believe that because all business jet primes are pretty darn nice. But come on, we golf together, we're friends. Don't you like our jet? It's just a completely different set of selling stuff. Yeah, I can only imagine. It's a fascinating addition to other businesses which seem very traditional in terms of the sales cycle and what would go into them, going back to commercial.

26:00I think of this as a backlog type business where you have orders, you place those orders in. What does the typical cycle look like just in terms of when they're announcing that there's an order book, when those actually come into service or when they recognize the revenues and then we'll get into the lifecycle they call the planes as well. Typical to build a jet takes a year, depending on the jet, wide body is longer, but they don't build wide bodies. However, the one funny thing about this business is that orders are placed many years out, depending upon airline requirements. The old joke is if an airline makes money, it orders planes.

26:39If it keeps making money, it takes delivery of those planes. There isn't always a connection here. You could see an order appear and it won't be delivered till 2028. in the case of some air bus jets that are usually popular, 20, 30s aren't uncommon. But in terms of manufacturing time by the year, in terms of payments, your revenue question, typically there is some tiny amount up front. It could be one gricle, it could be 1%, or 2%. Then you make progress payments as manufacturing begins, and then at handover, typically it's about 50 % roughly. So delivery is a big event from a revenue standpoint, but there are milestones on the way that do give you money.

27:16And when I see the list price for some of these new plans, I know that's not what is being paid. Is there a rule of thumb in terms of what discount airlines might get relative to list price? Yeah, on the business, you had front list prices are pretty normal, as a matter of fact, they're typically inflated by options, rust proofing and air hockey table and whatever else. But gen liners list price is a great work of fiction. Typically, you get 50 % off for showing up and wearing a tie. Obviously a lot depends on the equipment, the timing, the circumstances. And this represents one of Embrayers' few vulnerabilities years ago they were going head -to -head with Bumbardi A on what was the Bumbardi A C -Series against the 195, 195, 195.