Big Bet on Small Planes Pays Off for Brazil

How is it that an obscure Brazilian aircraft manufacturer has come from the brink of bankruptcy five years ago to be the toast of this year’s Paris Air Show, recipient of $6.6 billion of new business and leader in the world’s hottest passenger-jet market?

Timing, unflappable investors and the ability to foresee that commercial jets would not automatically become bigger and more powerful in the 1990s.

The shift to regional airlines, changing airline economics, and passengers’ discomfort with the small, turboprop planes that typically fly into places such as Bakersfield and Schenectady, N.Y., have created a booming market for smaller jets--that is, those that seat 30 to 100 passengers and which typically fly routes of no more than 1,000 miles.

Enter Empresa Brasileira de Aeronautica, or Embraer, which was saved by investors who bet $500 million in 1994 that the state-owned concern, then in shambles, could privatize and remake itself as a free-market force in an industry dominated by giants Boeing and Airbus Industrie. The bet hinged on Embraer’s ability to design and sell a 50-seat jet to airlines for whom smaller wasn’t necessarily better.

That bet seems to have paid off. Two years after delivering its first jet, Embraer has grabbed half of the market that this year has accounted for 61% of all new aircraft orders--up from 23% in 1997. That penetration is not expected to continue, but smaller jets during the next decade are projected to account for 25% of all commercial airplanes sold (just 8% in dollar terms because of the steeper price of bigger jets).

Chances are that most American travelers haven’t yet flown the smaller jets because U.S. airlines have been slow to incorporate them. And pilots, who get paid more when they fly bigger planes, have resisted. But that will change in the next decade: More than a quarter of all jets to be delivered from now until 2008 will be “RJs,” or regional jets.

“A special niche has developed. It’s all a result of the enormous press to be competitive,” said Mauricio Botelho, Embraer’s chief executive, interviewed at the company’s sprawling headquarters and factory complex in this hilly city 55 miles north of Sao Paulo.

Botelho was leader of an investment group that revived and redirected the failing company from propeller-driven craft to jets.

Airlines are using the regional jets not just as “feeder” craft to funnel passengers from outlying cities into hubs, but increasingly for direct service between cities that are either too far for turboprops or lacking the passenger load to justify bigger jets. Such routes include Orange County to Salt Lake City; Cincinnati to Nassau, N.Y.; and Columbia, S.C., to New York City.

“They were originally envisioned as replacing the turboprop, but their role is expanding,” said George Hamlin, senior vice president of Global Aviation Associates, a Washington consulting firm. “American Airlines is using Embraer jets between Chicago and Baltimore.”

Regional jets would be more prevalent were it not for the resistance of the airline pilots union, which through “scope clauses” in its labor contracts has been able to restrict use of the smaller jets by airlines and their affiliates, said Paul Nisbet, an aerospace analyst with JSA Research of Newport, R.I. The size of the aircraft that pilots fly has a direct bearing on how much they earn.

For example, American Airlines and its affiliates can fly only 67 regional jets out of a total fleet of 400 planes, Hamlin said. TWA can fly only 30 regionals in its fleet of 214 planes, according to the pilots contract.

But the industry tide is turning. Last year, regional air passenger traffic grew close to 12%, more than double the 5% growth rate of airline traffic overall, said Adam Pilarski, senior vice president at Avitas, a Reston, Va.-based aviation consulting firm.

Despite the growth, the niche has so far gone unchallenged by the industry’s two titans, Boeing and Airbus, which are sticking to mega-models. Boeing spokesman Randy Harrison said his company has no plans to introduce a model smaller than its 106-passenger Boeing 717.

“We are not in that market because at this time our analysis indicates we cannot make money at it,” Harrison said, noting that Boeing gave the smaller jet market a go after acquiring De Havilland of Canada. But it sold the line in 1991 to Bombardier of Canada.

If Boeing or Airbus were to introduce a regional model, it would take years to start deliveries anyway. So for now, regional jets are dominated by Embraer, with its 50% of the market; Bombardier, which has 40%; and Fairchild-Dornier, a U.S.-German joint venture that has the rest.

That’s good news for Embraer--and for Brazil.

Embraer last year provided the nation with $1.2 billion in export sales, a figure that will double in 1999. Manufactured exports are desperately needed to offset Brazil’s dependence on commodities such as sugar, steel and coffee to generate foreign currency, commodities whose prices have sunk in recent years.

Aircraft not only are great for trade but are helping to diversify the Brazilian economy, spinning off dozens of related enterprises, many of them high-tech. Although engines, wings and other parts of Embraer jets are imported ready-made from foreign suppliers, roughly half of each plane’s $16-million average value is manufactured in Brazil.

Embraer has delivered 129 of its 50-seat ERJ-145 models since the first one rolled off the assembly line in April 1997. An additional 166 firm orders have been placed for the planes, and 288 more have been conditionally ordered. And Embraer is looking to expand its market offering, introducing three new configurations ranging from 70 to 108 seats in Paris. Deliveries of Embraer’s new 37-seat model will start this month.

In fact, it was the new, bigger models that fueled most of the excitement at the Paris show, where Embraer closed the single-largest regional airline sale to date--up to $4.9 billion worth of aircraft to Crossair of Switzerland. Of the 200 planes ordered or optioned by the Swiss carrier, 160 were for the new 70- and 108-seat Embraer models to be delivered starting in 2002.

Of the $14-billion worth of new aircraft sales announced in Paris, Embraer scored nearly half of all deals in dollar value--and more than Boeing and Airbus combined.

“They were the talk of the town because they managed to sell more than anybody else, more than 200 planes,” said Pilarski of Avitas. “Not bad considering this is a high school team playing with the big boys.”

All this has had a predictably catalytic effect on Embraer’s manufacturing facilities here, which stretch over six assembly hangars and fill 2.5 million square feet of plant space, or twice the size of a typical auto assembly plant. Employment has doubled to 7,000 in two years and 3,000 additional jobs will be added in coming years, CEO Botelho said.

Not bad for a company that seemed doomed as recently as 1994. The company was losing $330 million a year as a manufacturer of only propeller-driven planes, notably the 30-seat Brasilia in use by many U.S. airlines. Tired of absorbing the losses, the Brazilian government considered declaring the company bankrupt.

Then the Rio de Janeiro investment firm Bozano Simonsen Group, of which Botelho was a director, stepped in. It organized a $500-million partnership to buy the troubled company, financed by the pension funds of two of Brazil’s largest companies, Banco do Brasil and Telebras, the national telephone company. At the same time, Botelho laid down an audacious plan to convert the product mix from props only and build a small passenger jet.

“We started to see that there was a turboprop avoidance factor imposed by the passengers,” Botelho said. “They didn’t like the noise, the vibration, and rightly or wrongly, there was a perception of less safety. Passengers would take a one-stop jet to avoid a nonstop turboprop flight.”

Botelho and others in the industry also noticed that business travelers were willing to pay more for jet service, especially if the regional carriers could offer better service in the form of more frequent flights.

“Business travelers will pay more for convenience and same-day returns,” said Hamlin of Global Aviation. “And if you, the airline, offer four flights a day of a 50-passenger jet, you obviously need to find a lot fewer passengers to make some money than if you are flying a 150-passenger jet.”

Botelho had seen the success--and growing backlog--at Bombardier, which began delivering the first 50-seat passenger jet to airlines in 1993. That year, Bombardier sold 75 planes to Comair, a regional airline based in Cincinnati affiliated with Delta Air Lines, a deal that served to “validate” smaller jets, said Walt Coleman, president of the Washington-based Regional Airline Assn., a trade group of 62 carriers.

But instead of merely revamping an existing propeller model as did Bombardier, Botelho decided to design a new jet from scratch with the aid of risk-sharing partners, including engine maker Rolls-Royce and wing builder Gamesa of Spain.

It also meant remaking the company.

“When the company was privatized, the picture was awful,” Botelho recalled. “It required a lot of work in changing the culture, raising the philosophy to build up a new entrepreneurial view. It was not a ride in the park.”

The result is a speedy, fuel-efficient jet that has been ordered or optioned in large numbers by Continental Airlines (200 jets) and American Airlines (67). Although Bombardier has three times as many regional jets in operation, Embraer has jumped ahead in orders and options.

“Embraer was late into the game, but they have certainly made incredible strides in matching the leader, which was Bombardier,” said Doug Abbey of AvStat Associates, a Washington market research firm.

Analysts aren’t so sure that the smaller jet market will forever remain the province of Embraer and its two competitors. With orders continuing to grow, Boeing and Airbus might someday decide the business is too rich to ignore.

“It’s hard to say. They change their minds all the time,” said Bob Miers, director of appraisals at Avmark, an Arlington, Va.-based consulting firm.

The burgeoning market has brought about some competitive squabbling, nothing new among airplane builders. Bombardier has complained to the World Trade Organization that the Brazilian government is subsidizing Embraer--similar to Boeing’s gripes about Airbus.

Botelho waves off the accusation, asserting that all governments, including the United States, support their aircraft manufacturers to some extent. He predicts that the WTO will dismiss the complaint shortly.

Meanwhile, says Avitas’ Pilarski, the regional airline market is “hot and sexy. . . . It’s something that a number of years ago people didn’t think would become a reality. But Embraer and others have proved them wrong.”

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Regional Rise

The number of passengers flying regional airlines--those operating planes with fewer than 100 seats on flights of 1,000 miles or less--has more than doubled in the 1990s.

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Passengers

Worldwide regional air passengers, in millions: 191 million

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Market share

Regional carriers’ share of world air passenger

market:; 13.7%

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Source: Avitas