EMBJ

Business Context and Reporting Period

Company: EMBRAER S.A. (Embraer)

Filing Type: Form 20-F (Annual Report)

Reporting Period: Fiscal year ended December 31, 2007

Business Overview: Embraer is a leading global manufacturer of commercial, executive, and defense aircraft. The company operates in four primary segments: Commercial Aviation (64.4% of 2007 sales), Executive Aviation (16.0%), Defense and Government (6.6%), and Aviation Services (10.1%). The company's functional currency is the U.S. dollar, as over 90% of its production is exported.

Key Financial Metrics (Year Ended Dec 31, 2007)

Note: Operating cash flow turned negative in 2007 primarily due to increased inventory build-up to support higher production rates.

Material Changes vs. Prior Period

• Revenue Growth: Net sales increased 39.5% to $5.25 billion, driven by a 43.5% increase in Commercial Aviation sales (130 aircraft delivered vs. 98 in 2006) and a 44.0% increase in Executive Aviation sales (35 Legacy 600 jets delivered).
• Margin Compression: Gross margin declined from 25.3% to 22.0%. This was attributed to the 17.2% appreciation of the Brazilian Real against the U.S. dollar (increasing labor costs), costs associated with hiring and training approximately 4,500 new employees, and overtime costs to meet delivery schedules.
• Operating Expenses: Total operating expenses rose 27.5% to $777.5 million. Research and Development (R&D) expenses more than doubled to $259.7 million due to the development of new executive jets (Phenom 100/300, Lineage 1000). Selling expenses increased 63.8% due to marketing campaigns and variable costs tied to higher deliveries.
• Non-Operating Items: Net income was significantly boosted by a $104.8 million reversal of a tax provision (PIS/COFINS) following a favorable Supreme Court decision, and an $89.4 million reversal of interest on tax contingencies.
• Debt Structure: Total debt increased to $1.75 billion, with a shift toward short-term debt (53.2% of total) compared to 2006 (37.3% short-term).

Guidance, Outlook, and Risks

Outlook and Guidance

• 2008 Deliveries: Management estimates delivering between 195 and 200 commercial jets, plus 10 to 15 Phenom 100 executive jets.
• Backlog: As of March 31, 2008, the firm order backlog reached a record $20.3 billion (up from $18.8 billion at year-end 2007).
• Capital Expenditures: Expected to be approximately $330 million in 2008 and $270 million in 2009, focused on facility construction and production line improvements.
• R&D Costs: Expected to total approximately $243 million in 2008.

Key Risks and Contingencies

• Off-Balance Sheet Guarantees: Maximum exposure under financial and residual value guarantees was $2.21 billion as of December 31, 2007. The company holds $287.5 million in escrow to secure these guarantees.
• Tax Litigation: The company has obtained preliminary injunctions allowing it not to pay certain taxes totaling $565.0 million (including interest). A final adverse decision could require significant payments.
• Currency Fluctuation: Approximately 13% of production costs are denominated in Brazilian Reais. Appreciation of the Real against the U.S. dollar negatively impacts margins.
• Customer Concentration: Significant reliance on key customers (e.g., JetBlue, US Airways, HNA Group) and key suppliers (risk-sharing partners for engines, wings, avionics).
• Government Financing: Dependence on Brazilian government-sponsored export financing (ProEx/BNDES) to maintain cost competitiveness.

Investor Verification Checklist

• Margin Sustainability: Verify if the 2007 margin compression due to Real appreciation and hiring costs is a temporary ramp-up issue or a structural shift.
• Tax Provision Reversal: Confirm the permanence of the $104.8 million tax provision reversal and the status of the $565 million tax liability injunctions.
• Cash Flow Conversion: Analyze the divergence between strong Net Income ($489M) and negative Operating Cash Flow ($52M used) to understand working capital requirements.
• Guarantee Exposure: Review the adequacy of the $287.5 million escrow against the $2.21 billion maximum guarantee exposure in a potential economic downturn.
• Production Ramp-up: Monitor the ability to meet the 2008 delivery guidance of ~200 jets without further margin erosion from overtime or supply chain bottlenecks.