Empresa Brasileira de Aeronautica S.A. (NYSE: ERJ), or "Embraer," formed by the Brazilian government in 1960 and privatized in 1994, designs, manufactures and sells aircraft and aviation-related structural parts to the world's commercial aviation and defense markets. Embraer is the fourth largest commercial aircraft manufacturer in the world and focuses primarily on the manufacture of regional aircraft for commercial, military, and corporate aviation. Accordingly, the company operates through four segments Service Aviation, Defense and Government, Corporate Aviation, and Executive Aviation. Embraer comprises a well-established family of regional airliners, including the 30-seat Embraer Brasilia Turboprop, the 37-seat Embraer 135, the new 44-seat Embraer 140, and the 50-seat Embraer 145 jetliners. In addition, the company has launched a new family of jetliners the Embraer 170/175 and the Embraer 190/195.
During the second quarter of 2006, Embraer concluded its capital restructuring, which is considered to be one of the most important events since the company was privatized in 1994. Embraer believes that the restructuring provides the foundation for its growth sustainability and enhances its ability to finance expansion programs through the capital markets. In addition, the new capital structure strengthens management relationship with shareholders and is based on the adoption of the highest level of corporate governance standards.
Embraer's sound product portfolio should support stronger customer orders and deliveries. Specifically, the company's Embraer 170/195 line is currently experiencing strong orders. The Legacy also experienced increasing demand. Embraer reported more than 225 new firm orders during 2006 for the commercial aviation, increasing its customer base with new companies such as AeroRepublica, Royal Jordanian Airline, Mandarin Airline, Egypt Air, Northwest Airlines, Virgin Blue, Kenya Airways, among others. For 2007, the company maintains its delivery forecast between 165 and 170 jets. During the third quarter 2007 Embraer achieved the production of 13 jets per month, almost reaching the goal of producing 14 jets per month by the end of 2007.
The higher degree of commonality in the jets family results in exceptional spare parts and maintenance cost reduction for carriers. Moreover, cross crew qualification (CCQ) allows better utilization of resources without the restrictions normally associated with mixed-fleet flying. Furthermore, all four jets are designed to meet or exceed the demanding noise and emission-related requirements established by the International Civil Aviation Organization (ICAO). During the first quarter 2007 the company's firm order backlog increased 1.4% quarter-over-quarter, reaching US$15 billion. In the second quarter of 2007, the backlog was US$15.6 billion. In the third quarter of 2007, backlog reached all time record of US$17.2 billion.
Even though the short-term outlook remains encouraging, we are highly concerned that low-cost carriers plan have been adding too much capacity, too quickly, to the global air transport system. In this sense, we are worried that the current international economic environment is not very promising. In fact, the current subprime mortgage crisis coupled with all times high prices of oil remains a real threat to the U.S. and world short-term economic growth as a whole and for the airline industry in particular.
On June 20, 2007, Embraer and the Brazilian airline BRA have signed an agreement for 20 firm orders of Embraer 195 jet, plus 20 options. The value of the deals around US$730 million and could reach US$1.46 billion if all options are confirmed. Nevertheless, just few days ago BRA went bankrupt, this was very disappointing news. We still understand that the current situation of the Brazilian airline industry is highly concerning. After some years of strong traffic growth coupled with reduced investments in the airports infrastructure, we have been witnessing the complete failure of the Brazilian airports infrastructure. There have been many delays and flight cancels in the most important Brazilian airports. Even worse, we do not expect this difficult situation to improve in the short-term. We understand this difficult business environment for the airline industry in Brazil will affect the continued growth of the market in the short-term. Since the Brazilian airlines are important clients of Embraer, we believe Embraer's revenues could be affected in the following quarters.
On August 3, 2007, Embraer and Air France/KLM signed an agreement for 20 E-jets (14 Embraer 190 and 6 Embraer 170) and options for more 18 E-jets. Additionally, during the second quarter 2007 Embraer also received some orders: (i) Taiwan based Mandarin Airlines (13 firm orders for Embraer 175), (ii) Republic Airlines (13 firm orders for Embraer 175), (iii) TAME Linea Aerea del Ecuador confirmed two contracted options of Embraer 190. Airlines are attracted to these 70-110 seat jets as they attempt to right-size their individual route capacities. We also believe Embraer 's 70-110 seat jets product line could see surging demand from 2006 levels through 2007 bolstered by continued sales campaigns for the company's newest family of 70-110 seat commercial jets (Embraer -170/190) in the US, Europe, and Asia. ERJ is currently the only manufacturer offering a family of aircraft that spans the 70-110 seat gap, with superior performance, exceptional cabin comfort, and reduced operating costs.
Even though the growing demand for these 70-110 seats jets, Embraer has not been able to translate revenues into profits. First quarter 2007 showed increased industrial costs, including labor cost due to overtime work and increased number of employees. Second quarter 2007 again showed higher-than-expected operating expenses, including a 133% year-over-year increase in research and development expenses, 34.5% year-over-year increase in selling expenses and 26.1% year-over-year growth in general and administrative expenses. Third quarter 2007 results were higher-than-expected. However, it was just a result of a non-recurring item. During the third quarter, Embraer made the reversal of a provision of US$156.6 million, due to a favorable court decision regarding a tax dispute. Without this non-recurring item, net income would have highly disappointing.
The company has been facing a difficult economic environment with the continued appreciation of the Brazilian real. As a result of those problems, the company has posted disappointing operating margin and net income. Since approximately just 15% of ERJ's sales and services are denominated in Brazilian reals and most of the company's fixed costs (as salaries, taxes, etc) are also denominated in Brazilian reals, the continued appreciation of the Brazilian currency against the U.S. dollar has a negative impact on the company's results, reducing Embraer's international competitiveness. We believe the Brazilian real will remain strong in the very short term. It is amazing to find out that Brazilian domestic interest rates went down from more than 19% in September 2005 to 11.25% now and the Brazilian real continued to gain value against the U.S. dollar. Even worse, the Brazilian Central Bank recently decided to leave rates unchanged for the first time in 2 years in its October meeting, at the same time U.S. basic rates are going down, it seems to be the perfect environment for a continued appreciation of the Brazilian real. Moreover, The basic fundamentals behind the strength of the Brazilian real, including the positive trade and current account surplus, remain in place. As a result, we see little chance for Embraer to improve its operating margin in the very short term.
Finally, Embraer's customer base is highly concentrated for some models. Two airlines, JetBlue and US Airways, account for approximately 40% of the firm's backlog. This exposes the company to considerable risks because its earnings growth would be severely impaired if these airlines cancel orders based on poor industry conditions. Many commercial airlines are still facing weak markets and will be cautious on capital spending. During 2005 and 2006, there were many orders canceled or suspended. The current economic environment in U.S. is not helping at all. All considered, we are reducing are 2007 and 2008 earnings estimates, and we are keeping our current Sell recommendation on ERJ.