Embraer SA (NYSE:ERJ)
Q4 2010 Earnings Call
March 25, 2011 9:30 am ET
Frederico Curado - President and CEO
Cynthia Benedetto - EVP and CFO
Andre Gaia - Director, IR
Rodrigo Rosa - Tax and Accounting Director
Stephen Trent - Citigroup
Caio Dias - Santander
Good morning, ladies and gentlemen, and welcome to the audio conference call that will review Embraer's fourth quarter 2010 results. (Operator Instructions)
This conference call includes forward-looking statements or statements about events or circumstances which have not occurred. Embraer has based these forward-looking statements largely on its current expectations and projections about future events and financial trends affecting the business and its future financial performance. These forward-looking statements are subject to risks, uncertainties and assumptions, including among other things general economic, political and business conditions in Brazil and in other markets where the company is present.
The words, believes, may, will, estimates, continues, anticipates, intends, expects and similar words are intended to identify forward-looking statements. Embraer undertakes no obligations to update publicly or revise any forward-looking statements because of new information, future events or other factors. In light of these risks and uncertainties, the forward-looking events and circumstances discussed on the conference call might not occur. The company's actual results could differ substantially from those anticipated in any forward-looking statements.
Participants on today's conference call are Mr. Frederico Curado, President and CEO; Ms. Cynthia Benedetto, Executive Vice President and CFO; Mr. Andre Gaia, Director of Investor Relations; and Mr. Rodrigo Rosa, Tax and Accounting Director.
I would now like to turn the conference over to Mr. Curado.
Good morning and thank you for participating in our conference call, here present and also through the internet. While we discuss a little bit of our 2010 results, we will provide an outlook for 2011, and then of course we open the floor for questions.
Some highlights about 2010, important fact that we did deliver all of our guidance projections either achieved or surpassed. We are going to go through them. We registered earnings per share of almost BRL0.80 and earnings per ADS of US$1.8. And as far as commercial aviation, we had after two years of slow sales, we were able to get almost at one to one book-to-bill and with 97 new orders and 101 deliveries.
Our customer base very importantly was expanded further. We had E-jets now flying in 39 countries and 58 customers. So this is quite an improvement taken the previous programs of Embraer. This obviously creates a very positive environment and not on operating lease prospects for 44 E-jets, but also for the accreted during the end of finance ability of those assets. We have delivered the 700 E-jets last year, the customer was British Airways. And we also improved our market share in the business direct market.
As far as deliveries we reached 19% of market share last with of course the ramp up of the Phenom 300. 145 jets, 19 large cabin and 126 small cabins, large cabins are Legacies and Lineages, small cabins are Phenoms. I think a landmark order from NetJet, not only the size of the order by the importance being NetJet the largest corporate jet operator in the world, very sophisticated customer, a very demanding customer, so 50 Phenom 300 for that customer.
And one more program that Embraer certified on time, the Legacy 650, which takes the range of the Legacy closer to 4,000 miles and of new avionics and new interior features. A true North Atlantic business jet was certified on time in all three aeronautical authorities last year, in Brazil and Europe and earlier this year in United States. Besides also I think it was an important year for the solidness and the sustainability of this business. We do see as one of the potential growth avenues for Embraer in the mutual long-term.
We had successful outcome of the discussions, country-to-country, which in Brazil, and Portugal, Czech Republic, Argentina, Chili and Columbia for their participation in the program, both industrially and also of course as an operator, as acquiring the aircraft. Those LOIs obviously they have to be succeeded by specific agreements on both industry and commercial sides in the next couple of years. But intention is there and it's a very good start for the program.
We also had our first successful penetration in the Asian market as far as defense products with eight Super Tucanos for Indonesia and have in minds our long-term vision for this business. We created and separated a corporate unit to handle the defense business and expand it not only in terms of size, but also in terms of broadness of our activities. The range we're active not only the air force, but also start looking into opportunities with the army, with navy, with Homeland Security with types of application C4I, the two major events that come into Brazil. So we see that there is growth there, and we want to address that growth in a very dedicated and specific manner.
We celebrated 10-year anniversary last year as far as sites we had Gavião Peixoto site, which in 10 years grew from Greenfield to of 1,600-1,700 people. And all of our test flights, the fabrication of our 190 wings, and all the military programs there. We also celebrated 10 years of our presence in China and in Singapore, and 10 years of our leasing in New York stock exchange as well. We were honored with closing the bell last October, marking the 10 years of our shares floating in New York.
As far as revenues and as far as the people, which is our number one value, for the second year in a row, we were included by two distinguished magazines in Brazil, dedicated with specific and of total independent assessments. One of them including, working with great place to work institutes as one of the best Brazilian companies to work for. So this is a great pride for us, taken the size of Embraer and the size of our blue collar workforce.
We were again selected to be part of the ISE, the index of the BOVESPA Sao Paulo stock exchange sustainability index. Actually we have been part of that index since the index was created several years ago. And we were back to be included in Dow Jones Sustainability Index with a gold class. So that was a particular rewarding achievement for all of us, for our financial area, but also for the whole company, as far as the initiatives also that we have on the social and environmental fronts.
And preparing for the vision that we have that Embraer can expand beyond just the current scope is, we have dropped the whole description of the economy in Embraer, but is Brasileira de Aeronautica, and shortened it to Embraer late last year. So with that we also open the scope of the company, the business scope, that as I said on the defense area, we also addressed other areas than aeronautics specifically. But also gives us an opportunity to investigate a potential participation on the energy business. So those two elements are now part of our social objectives.
As we had indicated, we saw a stable 2010. Our guidance was $5 billion in the quarter, we surpassed that a little bit. So fundamentally the same level revenues, same level of activities that you had in 2009, which given the circumstances was I think a positive result for us. As far as deliveries, that achievement and that surpassing of the revenues came because of course we have a few more deliveries and forecasted. As you can see in blue you have the commercial jets, in yellow the large cabin business jets, and in green the small cabin business jets.
By the way, more and more it would be less meaningful to talk about deliveries and it will be more meaningful if we talk about revenues, because now we really have such a broad range of product that our Phenom 100, the $3.8 million aircraft vis-à-vis Lineage 1000, $50 million-plus aircraft, and 190, $30 million-plus aircraft, really creates I think a tough modeling for delivery versus revenue and we are giving guidance for revenue annually by business area.
Our backlog had a little decrease, vis-à-vis 2009, but if we breakdown 2010 in two quarters you'll see that the second half of last year we have rather stabilized our backlog in the $15.5 billion. So this is roughly worth of three years of production. Obviously, this is not solid and we have some programs that go way beyond years. But again, I think the worse is behind us and we have and we were able to flatten out and now hopefully to increase our backlog again to higher levels. But half of that backlog is commercial aircraft about 20% is defense, and 30% business jets.
If you take the breakdown of our revenues in the last three years, in all the directions of diversification, I think they show up there. So we have been able to grow the business jet and defense businesses in the mix of Embraer total revenues. And also maybe even more importantly the geographical diversification, Brazil from a simple 4% three years ago, it is now 13%.
Obviously there is a reduction in total revenue that helps that calculation, but it is growing. So our presence in Brazil, our presence in Latin America, it resembles Brazil and Latin America 28%. It is the second largest market for Embraer last year, second largest destination of our products and services.
As far as financial results, we had a strong quarter. So that took us to again to achieve our guidance as far as revenue, so its $5.36 billion stable gross margin. And I have to make a remark that that gross margin of course also had some strong headwinds as far as the Brazilian currency, which was offsets by productivity and a lot of investments that we have been doing and continue to do in our quality productivity, motivation of our labor, to face those challenges.
We pretty much got the G&A flat, again despite the strong valuation of the real. Commercial expenses, selling expenses they were up due to several factors. But fundamentally to increasing the infrastructure to support our new programs in the market and most importantly on the business jet side.
So as we deliver 100 to 100 plus aircraft per year, we have of course to invest in spare part, have to invest in the certification of repair stations, as far as people, and obviously guarantee. So this is a fundamental origin of those selling expenses. And in U.S. GAAP and IFRS, the numbers are very, very similar and they are reflected there.
As you know, from this call forward, we will concentrate only on IFRS, which is the legal system in Brazil and there is also the one accepted in the United States. That's how we are trying to give you that comparison, so that you can take that reference forward and have a seamless transition hopefully.
As far as the operating margin, we basically achieved our guidance, which was 7% in the quarter and we reached 7.3%, a little bit 0.05% higher, again a strong quarter, last quarter of last year. And as I said, despite all the challenges coming from the currency and the increasing cost of the Brazilian labor, which has been growing above inflation, above just the real appreciation.
So we have the combination of strong real and real increases in reais. So that has been the challenge, not only in Embraer, but all Brazilian exporters. Besides EBITD there is a reasonable difference between U.S. GAAP and IFRS, but we achieved our guidance, we have surpassed it. And I think it was a direct consequence of our operating result.
Net income, if we take IFRS that decrease has to do with the fact that Brazil is to have a separate legislation for income tax calculation, which makes all of our lives difficult as far as forecasting net results, even for us it's difficult. Actually it's also the influence that it might have on the 6404. So apples-to-apples, we had an increase in our bottomline this year 6.5%, I think was a positive result for us.
The earning per share and the payouts as far as dividends, historically have been distributing 50% of our profit as dividends or interest on capital. During the crisis in 2009, deliberately we distributed the minimum that the Brazilian law requires, which is 25%, to preserve cash. And as we feel comfortable now, we are going back and around 35% is what we have distributed last year. And this is roughly, let's say, a number that we consider a good average. We have no policy for dividend distributions this season or by quarter-by-quarter by the Board of Directors. But that increase reflects higher comforts as far as our cash position vis-à-vis the future demands.
Positive cash flow or free cash flow was $287 million last year. We had a challenge in the first quarter and the third as well, but the two strong quarters second and fourth that gave us a positive figure at yearend.
With that said, that's a nice story that Cynthia can tell about. We have a strong cash position and now indebtedness has a long-term maturity, so it's a very comfortable place to be as far as indebtedness and cash position. So we know the importance of having a strong balance sheet in a cyclical business as such as ours.
The debt conservativeness will always be present in our minds, either because I have to face investments forward or because I have to be prepared to face any unknowns from if there is attack in 2011 from a volcano in Iceland, from now the situation in Middle East. So companies that leverage their balance sheets in our business, they are really taking a risk, which we are not prepared to take. That's why keep a conservative position as far as cash.
And the closing comment, talking about our outlook for 2011. A bit of growth as far as revenues about 5%, not a brilliant growth, but that is a reflect that both businesses, defense and business jets, are relatively flat and the commercial jets do see a bit of upsight. Although, again not stellar. So obviously a 5% growth in our revenues next year, that revenue in spite of the continuous appreciation of the real, as you know the real had appreciated in 2011 already. We expect to translate that growth also into margins. So we are raising 7% in our EBIT and the margins roughly the same a little bit better 7.5%, EBITDA stable at $610 million. These are outlook for 2011.
Investments I think it's important and we have separated research and development, because in U.S. GAAP they are expensed and IFRS they are not. The research which is a precompetitive expenditure they are expensed. The development which is basically related to new program developments, they are deferred and then amortized in the COGs. So I think to help you out to model, the way you follow the company's fundamental that from now on we have to separate that so we can have a clear picture.
Obviously from now on you must look at our cash flow also to evaluate our expenses or R&D. In U.S. GAAP, we could pretty much look at the financial statements. But now we have to be careful because those $210 million they will not be expensed, they will be differed for future amortization.
CapEx as certainly many of you'll recall, for the last two years we have been postponing what we could postpone without jeopardizing our programs. It is now time to really pick up and catch up as far as those investments. We have Melbourne, which will deliver the first jet before yearend. We have the two factories in Portugal, which will produce the first ships in the first half of next year. And we have tolling and other equipment for Legacy 450 and 500, so the CapEx will go up this year. Two levels which are compatible to what we have had in the past, as you can see in that figure. So it's a significant year for investment for us, overall about $500 million of investment next year.
With that, I will close the presentation, and open the floor and also the people who are in the call for questions. And we'd be very pleased to answer them. Thank you.
(Operator Instructions) Our first question comes from Mr. Joe Nadol with JPMorgan.
It's actually (inaudible) for Joe this morning. A couple of questions. First of all the guidance for EBIT at $420 million, I was wondering, Rosa, if you could talk about the inventory adjustment charges that you took in the fourth quarter. And then if you add that charge back, you're actually forecasting that EBIT is going to be coming down in 2011? And I wondered if maybe you could quantify a little bit what's causing that decline? How much of that result is from the appreciation the real from the increase their legal cost from maybe from any changes and mix with the defense coming down?
You are coming across quite tough to understand, maybe the natives, they could understand you better. Joe, if I got your question right, when we gave the guidance of 7.25%, we had expectation that we could have to make some sort of write-off or provision in this quarter.
So we did not know this was asked during the last quarter actually. We had no idea of having a higher operating margin in 2011, which was reduced because this impact was earlier than forecasted, no. This is not the case. It was the other way around actually.
So when we thought about 7.25%, we kind of thought that among the potential impacts to some non-recurring events to our results could happen, if it happen it would happen in 2010 as they did actually. So I am not sure I answered your question, but that's what I understood from what you asked.
If I could ask one follow-up. It is just about business jets and if you comment on the demand environment, you mentioned book-to-bill remaining below one and the forecast decline in the Phenom deliveries for this year. And I think that I know the environment is so difficult, but I think maybe the sentiment had been about maybe some order activity across the industry improving in 2011, maybe eventually into higher deliveries in 2012. It looks like you're not really expecting to see all that much strength in the way of orders and maybe if you comment on that.
If we look backwards and see the profile of our growth in the business jets markets, we had some step functions. And those step functions, there were direct results of the certification and entrance of service of new products. So in the last few years, we have had a new certified programs, the certified product coming to the market every year. That has really given us this very aggressive compounded average growth rate in the last few years.
In 2011, we do not have debt basically all the airplanes are certified. As you see despite the fact that we have less airplanes to be delivered in 2011, the revenues are pretty much at the same level, because the product mix will be richer than it was last year. Translating what I am saying, last Phenom 100s and more Phenom 300s and Legacies.
And we see ahead organic growth, but not various cheap growth, but some organic growth in the market in next year in 2012. But again in 2013, 2014, as we introduce the Legacy 450 and Legacy 500 into the market, we'll have another step function in our revenues, in our market share, because you'd be addressing two new segments in which we have no product today. So between today and the entry to serve those two new jets, basically we'll follow organic growth, and this is roughly the helicopter view of the business.
Our next question comes from Mr. Stephen Trent for Citigroup.
Stephen Trent - Citigroup
I know you're somewhat deemphasizing jet deliveries now versus the past. Just curious in terms of the commercial jet guidance for 2011 versus what you did in 2010, have you recently adjusted your thinking given the turmoil that we're seeing in world markets and geopolitical events, the stuff in Libya, a terrible tragedy in Japan? Have you recently adjusted your thinking in terms of putting up this guidance?
First of all, let's talk about Japan. We have just few orders outstanding in our backlog for Japan. Our preliminary analysis is that there will no impact to that, and actually we just delivered one 170 for Japan Airlines.
And on the supply chain side, maybe our most relevant supply in Japan is Kawasaki. They were not hit directly by the tragedy of either the earthquake or the Tsunami. So the question is to understand, and I think nobody at this stage really knows that, not even them, what is the duration and what is the extent of the impact to the Japan as a whole economy.
So first analysis is there is no direct impact, and actual rates maybe published in few more weeks to fully understand if maybe we have some indirect impact in our major supplier and there fore to ourselves, and there is obviously no particular position of Embraer to the whole industry. For example, Boeing is much more exposed to Japan than we are. So I think it's an industry concern, not only ours.
Now to your question about the guidance and if it's more or less conservative vis-à-vis Libya? No. We did take into account that the oil prices will potentially reduce the profitability of the airlines. IATA number calls from some 40%-plus reduction from the $16 billion forecasted this year to something like $9 billion or so next year. So that of course gives us a bit of a conservatism as far as global demand.
We have 100% of our production in 2011 already sold and are in a very comfortable position as far as sales, finance for that amount of airplanes as well already taken care of or at least in a very good perspective. So I'd say there is no specific impact from Libya and from Japan. There is an overall caution vis-à-vis the commercial traffic coming from higher oil prices, which potentially will impact profitability and demand on the airline side.
Stephen Trent - Citigroup
Just wanted to get your thoughts on the competitive environment. Airbus is doing a deal. Your Canadian rival seems to continue advancing on the CSeries. Boeing is telegraphing that they're going to clean-sheet. Any update on whether you're going to clean-sheet? And then on the business jet side, there is at least some indication that Cessna is looking to retrench. And I just wanted to get your thoughts on that.
Let's first address the commercial side. (Denel) has already captured the orders. At least for me, it's clear that the renewal will actually pick up from the existing 320s. So it's really a continuation of its return to heritage, very successful program, and that view in my perspective increases the longevity of the 320 family years down the road.
I see a direct impact to the CSeries in renewal. Some of the successes that have been announced by Airbus, somehow customers who are being at work to address by Bombardier CSeries. So I think (Denel) does not have the CSeries.
Boeing, I think more and more it talks openly about a brand new design, which in my humble perspective makes a lot of sense as the engineering is probably going to be less and less loaded with the 787 and the 47-8s, you have that amount of resources available. So clearly our clean-sheet design makes sense. As far as Embraer, we are waiting exactly to understand where Boeing is going to define whether or not we engage in the development of a new larger aircraft. When I say larger, typically a fiber-based aircraft or if we keep our sales focused in the existing segments by revamping the E-Jets at this stage.
The revamp of E-Jets at this stage is something which I think is premature, because our plan is to choose state-of-the-art sales are a testimony to what I am saying. So we have come back and we had a good start this year. We got an Italian order that we have had already. And so I do not feel pressed at all about reengineering or redesigning of the E-Jets. They are very competitive aircraft.
So what we really should focus is, is there an opportunity for Embraer to increase its participation in the market by coming to the next segment in let's say 130 seats or so segment with a fiber-based aircraft. I think the final piece of this moving puzzle, which I have been talking about for the last three, four, five years, looks like it's going to be fixed within the next few months by Boeing. And then we'll have a decision. So yes, I do anticipate, and we are making a decision on that investment before yearend as a result of the competitors' landscape.
So, so far what have we done this year? Not only we have a reasonably comfortable product and the backlog competitive product, we have a solid cash position, a solid economic position, and we have also four to five years invested significantly in technological development.
So if we decide to go ahead, we'll be ready as far as technology, we'll be ready as far investor capability, we'll be ready as far as the ability to fund the program and with the correct productivity and labor skills to address that.
Now on the business jet side, the market is clearly lagging behind the airline market. I did read Cessna's intention to develop a brand new aircraft. Pragmatically, what I see is I think Embraer seized a very nice opportunity of bringing to the business jet markets in the last five years something new, which was something like having an airline-designed aircraft type to a market where reliability was not as important as it is in the airline side and bringing some revolutionary products with Phenom 100, Phenom 300, the new Legacy.
I do expect reaction. I don't think that a company like Cessna with almost nine years of experience and a tremendous brand and capabilities will just see idle. So I think this market will be more competitive. The superiority of our products today over time will be challenged by the competent people like Cessna. And this is clear for us and we're prepared to that new scenario.
So we never thought we would have the ability to bring products to the market which was way superior to the existing ones. This gap tends to close in the next several years. But again, we'll keep investing and be prepared to try to keep the leadership in the segments.
Caio Dias - Santander
What is the FX assumption you use when defining the operating margin guidance for this year, the 7.5%? The second one is related to the off-balance sheet exposure you have deriving from the residual value and financial guarantees. Now that they are going through a scenario where we have high oil price, there might be some pressure for the 50-seater operators to ground their smaller aircraft. Do you believe this could increase the risk of Embraer being exercising one of these guarantees or do you believe that this is a scenario that you're comfortable with or you don't see any risk on this front?
The average rate we assumed was 170.
Yes, the oil prices tends to affect 50-seater operation, not on the jet, but also turboprops. I can't see a situation today worst than it was maybe three years ago and the oil was picking to $120 or so. And the large fleets of our 50-seater jets are with companies such as American Airlines and now Continental United and Delta. So unless we have a scenario where there have been (inaudible), again which I don't think is on the radar today, I do not see a particular risk for the airlines going down as a consequence of the debt not being serviced and eventually Embraer being called on warranties.
Now, we keep investing in the active market of the 145. The 145 is retaining a high residual value than its competitors. Recently we announced we're moving forward to engage one of the most senior executives in the industry exactly to integrate the whole sales, finance, asset management as far as our use of the aircraft and also the interface of delivering companies to make it even more solid. So we never took the eye off the ball, the 145, although there are no new aircraft. Actually on the business jet side, we just sold a few Charter 145s which will be produced in 2011.
Despite of the very slow new sales, we never took the eye off the ball. The 145 is an important asset for us, for the people who are financing the assets and for the airlines. So I do not want to sound too optimistic, but realistically I think we're well covered.
Caio Dias - Santander
I remember a couple year ago, Mesa, which is one major operator of the ERJ-145, they were facing some liquidity problems. What is Mesa's current situation nowadays?
Mesa is bankrupt, and because of that we created in 2009 a provision in our balance sheet of $100 million. A part of this provision has been materialized. We have gotten it out, part of this provision, and we still have remaining $60 million as a provision for that situation in our balance sheet.
The situation is evolving. We do not have the close of all the aircraft involved, and we're following the situation as we'd be required.
Some of their partners, they are no longer operating under Embraer aircraft.
The 145 you said is holding up better in value than its competitors. And did you say it is because there is a larger market share and you are backing it up financially? Is that why the value is holding up?
No, the market share is actually a little bit less, and we're not backing it financially. We're investing in the secondary markets, not throwing money away. We're investing in making sure that we have a portfolio of maybe 30, 40 or so, but customer support, spare parts, supporting in airline resource or moving airplanes from one continent to the other with (inaudible), trying to make documentation as easy as we can. But also, what I have not mentioned is the actual airplane is edgy, better.
I thought I heard you earlier say that new businesses you're looking at maybe getting into the energy business? Did I hear that right or is that something that you're seriously considering?
You did. When we opened our social objectives to a broader scope on the defense area, Embraer was only aerospace and also we were confined to the aerospace. We opened that to defense and security with no boundaries, and also we add energy. So why have we added? Because of course we're thinking about it.
We do not have a business case yet for investments and we'll be very, very cautious to make an investment on that. We're not trying to shy away or stay away from the aerospace sector. This is our main business. Our main business is commercial jets. We'll remain in commercial jets certainly in my professional lifetime.
So it's not that. The question is how to find new avenues for growth and also to add some neutrality to the driving parameters of the cyclical behavior of the business jets and commercial jets, how to bring some stability to our operations, leveraging out our core competencies.
So this is what we're doing. Of course I have people full time investigating opportunities. Brazil has the means to grow as far as infrastructure strongly in the next 10 years. There will be opportunities on the energy sector for sure, especially renewable energy sources.
So can we participate there? Can't be sure now, but we're working hard to find a way to participate. So beyond that, it would be speculation. But we have dedicated resources, small ones, but senior people and resources to investigate that.
Bombardier has had this strategic framework announcement with the Chinese. Two days ago, they announced where they're talking about possibly selling CSeries and the C919 together. They would give I guess jointly 110 to 180-seat offering. What impact do you think that will have on Embraer; and maybe more broadly, what impact do you think they could have on the industry? What I'm thinking is could you see Boeing and Mitsubishi joining together and then what that would mean for Embraer.
I think it's a very important development for the industry, what happened. I could not understand some of the statements. The CSeries is way down the road as far as development and the C919 is starting now. They are into the design phase. I read this morning everything I could read about this news. So it is not clear for me how they will achieve the level of commonality integration they are talking about. So either the CSeries has to be redesigned and probably zeroed-down down to wait for the C919 to catch up and then somehow adapt to the C919 or the other way around, or the Chinese will basically adopt the architecture and the fundamental systems' design and supply charters that the CSeries has already formalized.
So this is a bit further for me. But on a longer-term perspective, I think this is a very important development, shows or suggests that Bombardier is looking for some more solidness to its commercial aircraft business. So that's maybe a way for Bombardier to stay in the business or stay in a stronger way. And certainly you catalyze the Chinese learning curves. That's for sure.
So I think this is really materializing to a marriage. It's pretty open. I see a clear upside for the Chinese as far as accelerating their learning curve. And for Bombardier's, it's hard to say. It's a fiscal year for them, because it's a call where you're basically leaving the (inaudible) with a partner in the long run.
I think that has the potential impact, again not tomorrow, but mid-term and long-term to Boeing, to Airbus, to Embraer.
Is that going to trigger something else? It's to say this stage. It's like 24 hours only. I don't see Boeing reacting going after Mitsubishi because of that. I think Boeing has sufficient power and brains and all to define their own destinies. But I think there is certainly an element which will be more highlighted in their scenario, certainly in our scenario for sure. So the impact on Embraer is hard to tell at this stage.
The thing I can probably be a bit assertive about today is that we do not contemplate any architecture where Embraer will be a sub-supplier or sub-tier or tier-0.5 or a major risk-sharing partner. We see ourselves as independent and fighting for the leadership in these segments where we are.
So we may decide not to engage in new segments. But to where we are acting, we want to stay independent with our own capability. We do not want to relinquish our ability to address the customer. This is clearly our strategy today.
When you look at the U.S. fleet of regional jet, the 145, for example at ExpressJet there is a lot of aircraft that are going to come off lease in 2016, 2017 and 2018. What do you expect to happen to those aircraft and what do you expect to happen to the U.S. regional fleet?
I think it's inevitable. That will happen and those assets will be significantly depreciated. So I think that will depend on oil prices. If oil is high, even with a very low asset value, I see many of those airplanes leaving United States and going to secondary markets. If you ask for today, believe it or not, there is no like a variable 145s for the secondary market. There is demand of 2s and 3s in places like Africa, Eastern Europe and Brazil and other secondary markets.
But the volume I think will be significant. So if oil is very high, we may have kind of obviously a glitch, all of a sudden in three to four years time 100s of airplanes standing simultaneously, both CRJs and ERJs, which may create some difficulty to replace them in an orderly way, which we have been able to do so far.
If oil stays where it is now, I think there is two-some case. CNJ in United States, if the asset value is really low or zero or close to zero, fully depreciated, then that may be a case for some utilization, yet the cost per trip is still advantageous vis-à-vis larger aircraft.
Just want to try the business jet question again, recognizing your comments that revenue is becoming more important than units. The large unit decline in Phenoms is still surprising to us, particularly the market is getting a little better, you are taking share of very large backlog. We were surprised to see that.
How much of it is just the market is slower than some had been thinking? Cessna is saying Mustang will be down significantly as well in '11. Is that very low into the market just fully saturated at this point and the lifecycle of that program? Is that really the explanation?
Yes, I think it is a very fair point. Well, it's no secret to anybody that the business jet market has been much more heat-pressing on the lower end than the upper end. It's quantitative. Just mentioned the Mustang the Phenom 100 is the same thing.
And then your question about the backlog, I think it's a very correct question. Our backlog was built in the good years. So that backlog stretches out many years down the road. We have challenges. We have few Phenom 100s to be sold for this year yet. And we do not know the cancellation until it's 18 months before delivery. That's when they have to put another pre-delivery payment.
So far, we have been very successful in bringing airports, in bringing people who have orders down the road to take airplanes earlier. But this is a daily challenge as you come with cancellation. So the Phenom backlog stretches out another three to four years down the road significantly. Clearly we are not able to keep high production rates just bringing that customer which have deliveries down the road.
So in the current environment, many people say, "Well, I'm not in a position to take the airplane today, but I do not want to relinquish my order. I want to wait the year-and-a-half to two years that I do have in my contract." So we see that today.
So I think it's a combination of lower demands on the small ends of the market and also the profile of our backlog which has this characteristic. So we prefer to reduce the production rate of the Phenom 100 to reflect that and have less pressure in making crazy deals just to bring people up and try to keep it more stable and always keeping in mind that the value of Phenom 100 is significantly less, less than half of Phenom 300 and is a fraction of our Legacy.
So we really focus on more the quality of the revenue rather than engaging in exercises to keep the production rate at the footing level, which would require really some aggressive commercial attitude to fill up the gaps.
So you still have a decent amount of product activity and are still having to kind of shuffle positions in the backlog a decent amount at this point?
I also wanted to follow up on the margin question that was asked earlier, which was that if you add back the $62 million charge, I think you guys would have done about 8.5% operating for the year. So you're effectively guiding to 100 basis points of margin compression in the underlying business, excluding that charge, which given you're not getting that much volume and you have FX and you have labor going against you, I guess isn't too surprising.
But for those of us who were with you yesterday, we saw the COO's presentation and all the changes that have been made there, and we saw the factories that looked particularly streamlined and efficient. So once you're getting better volume beyond '11, how do you think about what the ultimate margin expansion capability of this company is given all those changes you've made?
I think I fully understand what you're saying. Just to comment on the 100 basis points, qualitatively you're right, and I agree with you. Quantitatively, you have to take into account that our gross margin has been affected by amortization and previous investments in IFRS, which will not be the case in the U.S. GAAP. So the comparison does not directly subtract that difference.
But yes, we have cost pressure. This cost pressure is not only a double-dip headwind in the sense that we have the real appreciating vis-à-vis the dollar, but also the wages in Brazil are growing in reais.
I will give you the number. We are now in the perspective of having some 10%-plus of higher cost in our labor in Brazil, all of things considered. We have been able and the numbers that we are forecasting here, they show an aggressive response as far as productivity, as far as automation, but it is very hard in an industry like ours with no pricing flexibility to absorb 10% in a year.
So I agree that the outlook in 2011 is not stellar, is not brilliant. I think it actually has challenge behind it. And you have seen how we have responded to those challenges and physically what we are doing. But I remain optimistic about what you just said in the final part of your question. As soon as you can have some markets' perspective, some volume perspective, this thing will have a leveraging factor that will really push Embraer to better results.
The tough thing is only a 5% increase of it is market-driven, is not industrially-driven at all. I mean we have capacity to do much more than that. We did more than that in the past. So we have a mark which is still not fully covered and headwinds like what I just mentioned. 10% in labor in one year is a lot.
But we are not crying, we're not complaining. We are working hard and nominally we'll have better results than 2010. But I fully understand your frustration, if you will. But it does not mean any change in our attitude to improve the capacity of this campaign, the productivity. It's quite the contrary. It's just that the challenge is just higher than it was last year. And of course, we work to beat those numbers.
But I think at this stage, it would not be correct to outlook something higher than that.
On the retail jet side, you're holding deliveries flat for next year. You're sitting on about a two-and-a-half year backlog, not counting year-to-date orders. In the past, this has been kind of the area where you've ramped up production on the commercial side. So given that you're holding it flat for next year, what would be a new healthy amount of backlog? Are you looking at your backlog and saying there is some potential regional jet weakness given fuel cost? Why isn't that going up from 100?
We expect to have a book-to-bill of at least 1 in 2011. So we definitely see 2012 better than 2011. How much better? It's too early to tell. We can ramp up our production in a relatively short time. Embraer has no constraints. I mean our infrastructure is for 15 airplanes a month, 180 airplanes a year. That's what we can do. But of course, the supply chain has to come with that. So we are producing 102 airplanes a year.
A lot of availability seems to be market driven. So far our policy, as I said, is a good start in the year. But it of course will be premature for we to say 2012 is going to be a flat and upwards. Hopefully it is. And of course our sales guys are working hard to that.
If we have the perspective of significantly changing the production rates, we'll do it for sure. And that does not interfere in any of our new programs. So this is not a problem.
Talking about new programs, particularly on the business jet side, can you just give us a quick update on the 450/500, what the orders are looking like and also touch upon the KC-390 on the defense side?
Well, the 450/500 are running on their own time. I don't think (technical difficulty). Yes, we have a lot of work already done way down the road as far as simulating the aircraft to have a full rig. Actually we had a full engineering simulator who can fly 500 in a stimulator, not full motion simulator, but engineering stimulator.
As far as investing in the qualitative design, it's probably a program that will give us smoother entry to service than previous program. So its okay to have the classical challenges of some supply that are a little bit late, things like these, but our other program is going quite well. I don't think we're divulging the sales of the 500, not many orders I can tell you, because of course no plane would come into service in a few years. The market today is not in a mood of committing. And we have a backlog already. So nobody today would commit to an airplane to get it in five, six years ahead of time. There is no reason why you should do that.
Well, Brazil market is overheating and Brazilian inflation is creeping up. So the President of Brazil very correctly so has engaged in an exercise to control the development expenditure. And whether or not we'll a direct impact to our improvements, not clear yet. There are rumors that it will, but we have not received any direct communication or amendment or anything like that.
Historically, every year we have budgets approved, and there is mechanism in Brazil which sounds silly but it's true that the budget is approved by Congress, but then the Secretary of Treasury will say, "Okay, this is approved, but I am holding part of that as a safety margin." This is not new. It's been happening all these years. And this safety margin gets released along the year.
So I don't see 2011 in a relatively different way that I saw the last few years. And I kind of believe the KC-390, because it had its own accounts, it's not like procurement to the Air Force. It has a specific line in the budget. I at this stage don't expect to have a major (inaudible). So as far as we do not receive any amendment, we'll keep going.
Could you just provide us with an idea of where do you see the biggest upside and downside risks to either revenue or margin guidance? You made a comment on the balance sheet and the finance of the potential new commercial program. If I understood correctly, you mean that even in a new program you wouldn't need more equity to finance that program. Am I correct?
Well, as far as downsides to 2011 guidance, there is no major downside identified today. We're already working to mitigate that risk. I would just call the attention that we would pursue it. (Technical difficulty)
So I don't see much of a downside rather than we have to perform. As I mentioned, we have a few challenges for sales in the business jet area. But talking about unit value aircraft, we are pretty committed and engaged to deliver that.
I think the fundamental upside would be exchange rate. If the exchange rate gets better, it's pure tailwinds. Do I think that's going to happen? No, I don't think so. So as Cynthia mentioned, we're planning about 1.70. So we're actually below that and we are committing to get that difference, 1.66, 1.67, 1.68. We're going to do that anyway. We're going to find ways to compensate for that. But if the exchange rate really is 1.75, 1.80, that's going to help our numbers and potentially we'll get better numbers.
Today, as far as new program, it's too early to talk about raising equity. It is not in our primary to-do list, to raise new equity. If we launch a new program, we'll probably do that in steps. So it's too early to really define how we're going to finance that.
One of the sources will be certainly our cash flow generation, but that obviously would not be sufficient. We have a lot of room in that business. So it's too early to tell. I'm not sure Cynthia wants to complement anything on that.
Is there any update on the potential order from the U.S. Air Force with Super Tucanos? And also is there anything going on with your China plans?
The U.S., no, there is no news on that. Optimistically, I should mention to you that I was directly involved in the visit of President Obama to Brazil. And I was gratefully impressed by how well the Brazilian government received the U.S. visit and how much closer to dialogue it is now. So I really praised that this movement continues and Brazil and U.S. get closer, because we have really the potential to together build a strong continent.
You are talking about between the two countries, over 0.5 billion people, important markets, two large democracies, about same age, 500 years each country, principles of the society, institutions. I think the U.S. institutions are well developed. Brazil is probably the closest developing country to the United State as far as institutions than anybody else. And friendship between the two people.
Why I'm saying to all that? Serving the Department of Defense in United States is not an easy exercise. I think the more comfortable the two countries are, the more close they are, if they really engage and get more profound ties in the military, that improves our chances to participate.
The airplane is perfect to what they need, no question about it. Super Tucano is their ideal aircraft and is ready today. Competing aircraft, first of all they are not ready today and they need a few years for development and most likely not as perfectly adjusted to the IFB as ours. But this is not the product only of course. Geopolitical counts a great deal in those aspects.
Next month, President Dilma Rousseff of Brazil will visit China. She has a state visit and also she'll participate in two later events. There is a BRIC conference or whatever arrangement they have. And also, there is Boao, which is equivalent to the World Economic Forum in Asia, both in the Island of Hainan. So it's going to be a long visit, and our expectation is that an outcome for our industrial presence in China is defined during that visit.
So all the actions, all the discussions, they point towards a final outcome, hopefully positive, by the time of her visit, which is going to be mid-April, so about a month from today.
Positive outcome that you are hoping for is to be able to produce E-Jets at that facility?
Either that or the Legacy 650 there. It's related to the product. It's more related to our presence in China with an important industrial operation with a partnership with AVIC. Institutionally and at a company level, it is more important to reach, specific product will be produced there. So either the 190 or the Legacy, which has an interesting case as far as the tooling is actually more adaptable, the tools are more adaptable to the Legacy if the 145 deliver it than the 190 actually. So the investment is less actually to produce the Legacy aircraft.
It's a promising market. And as far as we are able to export 190s from Brazil to China, it's okay. I think our presence helps that case.
So with that, one more time we thank you very much for taking the time to be with us today. Wish you all a great 2011. Thank you very much. Have a nice day.
That does concludes Embraer's audio conference for today. Thank you very much for your participation and have a good day. Thank you.
Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.
THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S CONFERENCE CALL, CONFERENCE PRESENTATION OR OTHER AUDIO PRESENTATION, AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE AUDIO PRESENTATIONS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY'S AUDIO PRESENTATION ITSELF AND THE APPLICABLE COMPANY'S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.
If you have any additional questions about our online transcripts, please contact us at: email@example.com. Thank you!