EMBJ

Business Context and Reporting Period

Company: EMBRAER S.A. (Brazilian Aviation Company Inc.)
Filing Type: Form 20-F (Annual Report)
Reporting Period: Fiscal year ended December 31, 2006
Corporate Structure: Following a March 31, 2006 reorganization, the company simplified its capital structure, merging former Embraer into the current entity. The Brazilian government holds a "golden share" with veto rights over specific corporate actions, including changes to defense programs and control of the company.

Key Financial Metrics (2006)

Material Changes vs. Prior Period (2005)

• Revenue: Net sales decreased 0.6% to $3.807 billion. Commercial aviation sales dropped 9.3% due to fewer deliveries (98 vs. 120 in 2005), while executive aviation sales surged 109.4% driven by Legacy 600 deliveries.
• Profitability: Net income declined 12.5% to $390.1 million. Operating income fell significantly to $307.7 million (from $507.8 million in 2005) due to increased operating expenses and lower gross margins.
• Margins: Gross margin compressed from 30.2% to 28.1%, primarily due to the 8.7% appreciation of the Brazilian Real against the U.S. dollar (impacting real-denominated costs) and production learning curve costs for the EMBRAER 190/195.
• Backlog: Firm order backlog increased to $14.806 billion (930 aircraft) at year-end, up from $10.383 billion in 2005. As of March 31, 2007, backlog reached $15.0 billion.
• Debt: Total debt decreased from $1.553 billion in 2005 to $1.349 billion in 2006, largely due to loan repayments.

Guidance, Outlook, and Risks

Outlook and Guidance

• 2007 Deliveries: Forecasted at 165-170 aircraft, with 40% expected in the first half of the year.
• R&D Costs: Expected to total approximately $237.0 million in 2007, driven by the development of new executive jets (Phenom 100/300 and Lineage 1000).
• Capital Expenditures: Projected at $194.0 million for 2007 and $117.0 million for 2008 to support production ramp-ups.
• Market Trends: Management anticipates continued growth in the executive jet market and increasing demand for mid-capacity jets (70-120 seats) globally, particularly in China and the Middle East.

Key Risks and Contingencies

• Off-Balance Sheet Guarantees: Maximum exposure under financial and residual value guarantees was $2.122 billion as of December 31, 2006. The company holds $272.7 million in escrow to secure these obligations.
• Customer Concentration: Significant reliance on a few key customers (e.g., JetBlue, US Airways, HNA Group) and suppliers. 100% of ERJ 145 backlog was attributable to Chinese customers as of March 2007.
• Currency Fluctuation: While sales are primarily in U.S. dollars, a significant portion of costs (labor, R&D) is in Brazilian Reais. Appreciation of the Real negatively impacts margins.
• Government Financing: Reliance on Brazilian government export financing programs (ProEx, BNDES-Exim). Reductions in these programs could impact cost-competitiveness.
• Tax Disputes: The company has challenged certain Brazilian taxes and payroll charges, with preliminary injunctions allowing non-payment of approximately $523.6 million (including interest) as of year-end.

Investor Verification Checklist

• Backlog Quality: Verify the stability of the $15 billion backlog, specifically the concentration of orders with Chinese customers and the potential for cancellations or delays.
• Currency Impact: Monitor the exchange rate between the Brazilian Real and U.S. Dollar, as appreciation directly erodes gross margins on real-denominated costs.
• Guarantee Exposure: Assess the adequacy of the $272.7 million escrow against the $2.122 billion maximum exposure on financial and residual value guarantees.
• Production Ramp-up: Confirm the resolution of supply chain and wing assembly issues affecting the EMBRAER 190/195 to ensure 2007 delivery targets are met.
• Tax Litigation: Track the status of the $523.6 million tax dispute, as an adverse ruling could result in significant cash outflows.