IN FOCUS: Brazil defence growth opens new doors for Embraer

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Two years can seem like a long time in the revitalised Brazilian defence market. While the lengthy delay to the air force's FX-2 fighter contract award receives most of the attention, the Brazilian military and the national defence industry have moved forward aggressively in key areas, revealing a new appreciation for taking national and regional security obligations more seriously.

brazilian air force hermes 450 uav brazilian air force

 Brazilian air force

The Hermes 450 is being adapted for local requirements

Perhaps the most telling example of this trend is the rapidly diversifying portfolio of Embraer Defense Systems. In 2012 alone, Embraer won a landmark border surveillance contract from the Brazilian army, formed a joint venture to manage satellite construction projects, publicly began contemplating a surprise entry into the shipbuilding industry, and - not least - posted a 24% increase in annual revenues, topping $1 billion in defence and security sales for the first time in the company's history.

The wide scope of those interests point in the direction of Embraer's evolution into Brazil's main prime contractor for a rapidly growing set of defence and security needs. It is a strategy likely to reshape the company's portfolio of products in the defence sector in less than a decade.

HEALTHY POTENTIAL

At the beginning of 2012, Embraer expected 75% of its defence revenues to come from four major programmes: development of the KC-390 transport and tanker; modernisation of AMX/A-1 and Douglas A-4 combat aircraft for the Brazilian air force and navy; the A-29/EMB-314 Super Tucano; and EMB-145-based P-99 and R-99 surveillance and command and control aircraft. It was a list with a healthy potential backlog and well within Embraer's comfort zone as an aircraft manufacturer.

By 2020, Embraer expects the fighter modernisation programmes and the P-99 and R-99 production lines to be gone, with the KC-390 and light attack aircraft to account for 43% of the defence company's overall revenues. Meanwhile, revenues generated by several new business product lines, featuring Embraer as a border surveillance integrator, satellite construction manager, unmanned aerial vehicle maker and possibly even a shipbuilder, will contribute 42% of sales by the same point, according to its projections.

To be fair, Embraer had dabbled in the systems integration business in the past. It created an air operations centre for Mexico, which connected to the nation's EMB-145-based airborne early warning and control system aircraft. It had also participated in the creation of the Brazilian air force's system for the surveillance of the Amazon (SIVAM), but as a subcontractor to Raytheon.

There were no system integrators in Brazil when the SIVAM programme was awarded in the mid-1990s, as the country was in the midst of a near two-decade reduction in defence spending.

National priorities have shifted in the past decade, however, as Brazil has embraced a larger role on the regional and world stages and discovered a new wealth of oil and natural gas deposits within its maritime borders in the South Atlantic.

NEW LAW AIMED AT SOURCING WITHIN BORDERS 

Foreign defence companies have been doing well in Brazil. With rising security needs and a small defence industrial base, the nation has been forced to go beyond its borders to buy military hardware.

That is why Brazil's new submarines come from France, its newest ocean patrol vessels come from the UK and its new fighter will be acquired from France, Sweden or the USA; the latter in a competition between the Rafale, Gripen E and Lockheed Marting F/A-18E/F Super Hornet.

But a new law passed in 2012 seeks to change Brazil's reliance on foreign companies for major weapons systems. Public law 12.598 establishes a new category for a "strategic defence company", of which at least 60% of the shares are owned by Brazilians.

It is not the first time a government has leveraged its defence budget to incentivise or protect a domestic industry. The US defence industry is shielded from some foreign competitors by the Buy American Act and the Berry Amendment.

Brazil's new law does not prohibit foreign companies from competing on military hardware or services bids, but it does make it harder for them to win. Instead, the law exempts strategic defence companies from Brazil's tax on industrial goods, and frees them from obligations to contribute to unemployment insurance and social security programmes.

The move appears partly aimed at countering the foreign defence companies that have been buying ownership stakes in Brazilian defence companies.

"There is no prohibition for someone who is a multinational company, but they are not to be eligible for the benefits of being a strategic defence company," says Luiz Carlos Aguiar, chief executive of Embraer Defence Systems.

The programme has already caused a minor restructuring within the defence industrial base. Two years ago, Embraer formed the Harpia Systems joint venture with Elbit Systems subsidiary AEL Sistemas, with equal ownership by both companies. As a result of the new law, former Embraer rival Avibras agreed to buy 10% of Elbit's stake in the joint venture, increasing the number of shares owned by the Brazilian firms to 60%.

Defence spending remains at a modest 1.6% of gross domestic product, but the country's rising economic output means spending has risen proportionately. Overall spending peaked in 2012 at $36 billion, of which about $5.16 billion was set aside for investments split between the three armed services.

"That's above what we had last year," says Luiz Carlos Aguiar, chief executive of Embraer Defense Systems. "There are some important programmes they have been reducing because they are finalising, and they are being replaced by others. That's why I believe we have space to grow in Brazil. Out of this $5 billion, Embraer, as a group, have 27%."

If that level of spending is sustained Brazil will be buying much more than new fighters and KC-390s during the next decade. The military is seeking to modernise its inventories of combat and support equipment, while introducing a wide-ranging surveillance network over the country's porous south-eastern border and territorial waters.

Indeed, Brazil's ambitions grew so large it appeared to briefly force Embraer on the defensive, as the promise of lucrative systems-integration contracts energised new competitors from the country's construction companies. Salvador-based Odebrecht formed an alliance with European prime contractor and EADS subsidiary Cassidian to compete for the border surveillance contract. Another Brazilian construction firm, Synergy Group, teamed up with Israel Aerospace Industries to pursue the same work.

In the end, the Brazilian army awarded the $400 million contract to Embraer in November 2012 to launch phase one of the system for the surveillance of the frontiers (SISFRON) contract.

The award appeared to deflate the hopes of Embraer's erstwhile competitors. Follow-on awards for SISFRON are still available and the Brazilian navy plans to launch a similar programme next year, but the Odebrecht/Cassidian joint venture has reportedly been dissolved in the aftermath of losing the army contract.

ACHIEVING PRIMACY

Instead, Embraer appears to have secured its new role as the Brazilian military's most important prime contractor, with billions of dollars in new programmes waiting on the books.

With the KC-390 already headed for series production, Embraer Defense Systems looks set to continue on a seven-year growth trend, including the defence unit that existed before the standalone company was formed. Defence sales accounted for only $227 million of Embraer's revenues in 2006, but nearly quintupled to more than $1.05 billion in 2012.

As a percentage of the company's overall revenues, the share claimed by the defence unit has nearly tripled to 17%, even as Embraer has introduced the Phenom 100 and 300 business jets to its product line-up.

The key for Embraer now will be executing on the SISFRON programme. It has only received the phase-one award, but the overall programme is valued at $4 billion during the next decade. The system is going to create a network of border surveillance stations, with ground-based radars, UAV sensors and command and control systems networked together to identify and catch smugglers crossing the open border.

brazilian air force p-3 & f-5 brazilian air force

 Brazilian air force

The fleet of the Brazilian air force includes Lockheed P-3 special-mission aircraft and Northrop F-5 fighters

"Until March we are going to finalise all of the subcontractors on the SISFRON contract," says Aguiar. "We have a deadline by the end of March, and we are in the process right now. We have already implemented our office. We have a physical office separated from Embraer in Campinas. It is a city close by Sao Paulo, close by Orbisat, which is part of the consortium."

Orbisat, which is partially owned by Embraer, is providing the ground-based radar for the phase-one pilot programme. Meanwhile, Atech, another Brazilian contractor partly owned by Embraer, will supply the command and control equipment.

The second phase of the contract is expected to be awarded in 2014, and it is not guaranteed it will be given to Embraer. "It depends on our performance," Aguiar says. "If we do the right thing they will hire us again."

STRATEGIC ACQUISITION

SISFRON's second phase is likely to usher in the use of operational UAVs in regular Brazilian military operations. Embraer anticipated the need and formed a joint venture with Elbit Systems-owned subsidiary AEL Sistemas, which is adapting the Israeli manufacturer's Hermes 450 for Brazilian requirements. In January, Avibras also acquired a 10% stake in the Harpia Systems joint venture, which adds the Falcao UAV to the product mix.

Although the SISFRON phase-two effort will be managed by the army, Harpia is waiting on developments with the Brazilian air force, which is charged with setting overall unmanned air system requirements for all three branches of the military.

"They are designing the requirements for the UAS," Aguiar said in January. "This is going to become public probably two or three months from now, and then we are going to participate and make our proposal to develop this new configuration UAV through Harpia."

Embraer has projected a market in Brazil worth $1 billion during the decade for new UAVs alone. The company has also invested an ownership stake in Santos Labs, which makes small UAVs, and signed a licence agreement with Boeing Insitu.

"It is good not having a UAV in the first phase of SISFRON because it's going to give us a bit of time to develop," Aguiar says.

Another market possibly worth more than $1 billion to Embraer in the next decade is Brazil's nascent satellite industry. In 2012, Embraer formed Visiona, a joint venture with national telecommunications company Telebras, to manage a growing requirement for earth observation and communications relay satellites over Brazil. Visiona is evaluating the selection of manufacturers for the satellites and the command and control systems.

"After that we're going to be responsible for signing the contract with the insurance company and the launching company," Aguiar says. "To integrate those parts, I think we have a chance to learn from this experience in order to add value for the second, the third and the fourth satellites that Brazil, for sure, will need in the future."

KC-390 SET FOR DOMESSTIC VOTE OF CONFIDENCE

The Brazilian air force is likely to announce a firm order for Embraer's KC-390 tactical transport and tanker at the Latin American Aerospace and Defence (LAAD) trade show in Rio de Janeiro in April, analysts say.

The aircraft completed its critical design review on 22 March, which means Embraer can release engineering drawings to the factory floor in preparation for building and flying the first KC-390 in the second half of 2014. If all goes well, series production will start in 2016, with deliveries starting the same year.

Brazil, which is paying more than $2 billion to develop the KC-390, has so far only signed a letter of intent to purchase 28 of the aircraft. Securing a firm order would be a vote of confidence from the KC-390's domestic market, and provide a significant boost to Embraer's sales campaigns to secure further international commitments for the new aircraft.

In many ways, the KC-390 is Brazil's halo product that the rising economic colossus hopes will herald its arrival on to the international defence market.

In addition to its home market, Argentina, Chile, Colombia, the Czech Republic and Portugal have also signed letters of intent for a further 32 KC-390s. Colombia says it will buy 12 aircraft, while Argentina, Chile and Portugal are expected to order six each. The Czech Republic is also expected to buy two jets.

Rebecca Edwards, an analyst at Forecast International, says Embraer hopes to convert these commitments into a total of 60 firm orders by the end of 2013.

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 Brazilian air force

Embraer completed the critical design-review of the tactical transport and tanker on 22 march

Embraer estimates the medium-lift transport market is worth $50 billion during the next 10-15 years, which could mean a total of 700 orders up for grabs. While Lockheed Martin's C-130J Hercules currently dominates that market, Edwards says Embraer could seize a significant portion of those sales. "The KC-390 is going to pursue sales as the C-130 replacement, a market of considerable size and potential," she says. "Granted, the KC-390 will not be the only competition, but it can be expected to win a good portion of the market. Based on this information, Forecast International anticipates unit production to reach 98 aircraft by 2021 and as high as 234 by 2027."

Indeed, Embraer admits the Lockheed-built tactical transport is its chief rival, even though it was not the company's original intent to compete head-to-head.

Richard Aboulafia, an analyst at the Teal Group, says it is certainly possible that Embraer could sell anywhere from 150 to 200 aircraft, but that is assuming the US market remains closed to Embraer. Teal's forecast calls for a more gradual ramp up of the KC-390 line, with 25 aircraft being built by 2021. Aboulafia says Embraer's projection for a potential market of 700 aircraft is roughly on target, but much of that is locked-up by the USA.

Edwards says many of Embraer's sales will come in the Latin American and African markets, where the USA has comparatively less political clout. Political muscle is a huge factor in military aircraft sales, Aboulafia adds, but Embraer could compete by offering a "really good" aircraft at low prices. However, the challenge will be to hold the KC-390's price down at around the $50 million level. "There are all kinds of reasons to prefer a C-130J, but what they're really going for is value for money for a really good cargo box," Aboulafia says. "They're going to find a niche here."

Paulo Gastao Silva, Embraer vice-president for the KC-390 programme, says the aircraft is "on track" to meet its cost targets, projected at between $2.3-2.4 billion. In fact, there has been a slight drop of about $42 million in the projected development cost for the transport, he says.

Gastao Silva's figures do not quite match up with earlier cost projections, originally budgeted at $1.3 billion, according to a Teal Group report. The report projects the aircraft's development costs would increase by $2 billion to $3 billon, which seems to have at least partially borne out.

One factor which could drive up prices is that the Brazilian government has mandated the use of as many local suppliers as possible, depriving programme managers of the ability to choose the best components at the lowest possible cost, Aboulafia says. Local subsystems tend to cost more than their international counterparts because of economies of scale and development costs. "It's not a killer, it's just something that hobbles designers, especially when they're trying to keep costs down," he says.

But the KC-390 does have significant advantages over its Lockheed-built competitor in that it is a much newer design which incorporates new technologies such as fly-by-wire, Edwards says. The Brazilian aircraft carries a 23t payload, which exceeds the roughly 21t carrying capability of the C-130J. Additionally, the KC-390, powered by twin International Aero Engines V2500 turbofans, is also 100kt (185km/h) faster than the Lockheed type, with a cruise speed of 465kt.

Gastao Silva says the KC-390 is being designed specifically to operate from austere semi-prepared airstrips. He adds that the aircraft can make 10 passes on a fully unpaved runway before the landing strip is rendered useless.

But while choosing the V2500 was a good move because it is a proven airliner engine with a huge installed base on the Airbus A320 fleet, turbofan engines may actually hinder the KC-390's appeal as a tactical transport, particularly for special missions, Aboulafia says. "For this size class, that's assuming more of a cargo mission rather than a special operations," he says. "It also assumes more developed airfields rather than improvised or rough ones."

One of the questions that must be answered about Embraer's claims pertaining to the KC-390's improvised airfield capabilities is what kind of payload the jet will be able to carry when operating from unpaved strips, Aboulafia says. There is also the ever-present danger of foreign object damage to the engines, which is less of a problem on turboprop-powered aircraft.

Additionally, some users prefer turboprops for low-altitude missions because they are much more fuel-efficient when operating in those flight regimes, Aboulafia says. "At low altitude there's nothing like a prop but, moreover, the quad-engined C-130 has more redundancy for those kinds of operations, which many potential users prefer. If you're doing more cargo or longer-range, jets are just fine, that's why the [Boeing] C-17 does just fine with turbofans," Aboulafia says.

Time will tell if Brazil and the KC-390 will be able take on Lockheed and the political muscle of the USA, securing a niche for itself. In any case, the KC-390 should prove to be a remarkable achievement once it completes its development cycle and enters into service.