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Embraer (NYSE:ERJ), the world’s leading manufacturer of commercial jets up to 120 seats, recorded net sales of US$843.4 million, in the first quarter 2007 (1Q07) and net income of US$26.2 million, equivalent to diluted earnings per ADS of US$0.1412. Analysts had been expecting the company to earn $0.40 on $853 million in sales. As was reported a month ago, the miss resulted from production issues.

Due to difficulties with the supply chain of the EMBRAER 170/190 family, Embraer delivered 25 aircraft during the first quarter of 2007, compared to 27 deliveries during the same quarter in 2006. Furthermore, the Company’s industrial costs increased as a result of longer production lead time and higher man/hour labor costs in its production process, including those related to overtime work, in order to achieve the scheduled deliveries.

Given that the shares rallied when the company reported the initial production levels last month, investors may fairly wonder why the shares are dropping on today’s news. Obviously the report last month was just aircraft - not revenue or earnings. And analysts were able to get fairly close to the right revenue number but still fell way short on earnings. In part it is likely that the estimates didn’t properly reflect operating leverage - it is something all too frequently underestimated. However, a good part of it was related to the efforts made to stem the production issues. As the company reported:

In order to be better prepared for the expected production ramp-up in the coming quarters, Embraer has hired approximately 2,000 employees, since January 2007 all of which engaged in a training program. Since the costs related thereto are accounted for as “industrial costs,” the Company’s gross margin for the quarter was adversely affected. Most of the new employees will be working a third shift, to be fully implemented during the third quarter of 2007. The training program can last up to 90 days, and all employees are coached by experienced professionals.

It sounds expensive, and clearly it was. It is also highly unlikely that they caught Embraer management entirely by surprise. It would have been a good idea for the company to give a heads-up regarding the extra costs when they reported the production levels in April.

ERJ 1-yr chart:

ERJ 1-yr chart

Source: Embraer Leaves Investors Out of the Loop