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Insight: Embraer's Herculean task: Brazilian jet takes on Lockheed

Private jets are seen at the Embraer headquarters in Sao Jose dos Campos, 100 km (62 miles) from Sao Paulo May 14, 2013. REUTERS/Nacho Doce
Private jets are seen at the Embraer headquarters in Sao Jose dos Campos, 100 km (62 miles) from Sao Paulo May 14, 2013. REUTERS/Nacho Doce

By Brad Haynes

SAO JOSE DOS CAMPOS, Brazil (Reuters) - For decades Brazilian planemaker Embraer SA has kept its head down, shying away from larger aircraft in competition with industry giants that its executives called the "big dogs."

A military cargo plane trundling down the runway is about to change that.

In a direct challenge to Lockheed Martin Corp's storied Hercules airlifter, Embraer is promising a jet that flies higher, fuller and faster - at a lower price.

The bold move is part of Brazil's campaign for credibility as a player on the world stage. After years sprucing up second-hand military gear, the South American powerhouse is bulking up its homegrown defense industry and looking to export into a shrinking global market.

If Embraer's KC-390 is airborne by the end of next year as planned, Brazil will succeed in a segment where peers stumbled, leapfrogging programs launched by Russia, India and China over the past decade. It will be the largest plane ever made in Latin America, with a belly big enough to fit a Blackhawk helicopter.

"I don't think the Hercules has ever faced such serious competition - and it's the oldest aircraft in production," said Richard Aboulafia, an aviation consultant with the Teal Group.

Embraer is betting it can not only match the gold-standard Hercules but outperform it on many fronts by using jet engines instead of the sturdy turboprops that have powered Lockheed's workhorse since the 1950s.

Upsetting the common wisdom on tactical transport, Embraer is hitching its hopes to the same family of engines powering the Airbus A320 airliner, and promising an edge when it comes to maximum payload, cruising speed and altitude. Lockheed argues nothing can match the durability of the turboprop.

"The props give us a tremendous advantage going into dirt, gravel and unprepared strips," said Larry Gallogly, a former C130J pilot for the United States Air Force now working for Lockheed. "If you go into those strips with a jet engine, that engine is liable to get destroyed."

Executives at Embraer, which is designing its cargo jet for the Brazilian Air Force to land on rugged airstrips from the Amazon to Antarctica, say the fear of fragile jet engines is based on old assumptions they are overturning with this plane.

"If you'd asked me 30 years ago, I would have told you a turboprop is better on rough terrain. Today I'm certain it's not," said Paulo Gastão, head of Embraer's KC-390 program.

The evolution of high bypass turbofans means the turbines at their core are better protected from flying debris, said Gastão, a former test flight engineer with Brazil's Air Force.

Still, analysts say that will be a hard sell for the handful of nations that regularly deploy special operations units in hostile territory.

By opting for an engine that has already flown a million hours, Embraer is avoiding the risks associated with the latest turboprop technologies. Huge propellers made of cutting-edge composite materials added to costly delays on the massive Airbus A400M cargo plane, for example.

Still, the move away from turboprops means sacrificing fuel efficiency and range - two points on which the Hercules will hold an edge.

PENT-UP DEMAND

The jet engine may help set the KC-390 apart in a market that has shown signs of stagnating under Lockheed's dominance.

The U.S. planemaker sold more than 2,000 Hercules planes in its first four decades, but sales of the upgraded C130J Super Hercules have barely topped 300 since the turn of the century.

Early demand for the Super Hercules was tepid, but sales have picked up in the past five years and Lockheed expects to close deals for about 300 more in coming years. A huge user base and global support infrastructure will help sales campaigns.

The Brazilians are promising to shake up the market by undercutting the Super Hercules on price.

A competitive price tag will be key for Embraer, which can't rely on a huge domestic market as many military contractors do.

Instead, Brazil has rounded up partner nations expressing early interest in the new aircraft in exchange for a role in its industrial development - a largely Latin American version of the coalitions that back big European defense products.

Brazil, Argentina, Colombia, Chile, Portugal and the Czech Republic have together requested 60 of the new cargo jets. Over the next 10 years, Embraer sees a market for more than 700 planes worth over $50 billion in the segment.

"We're looking for a reasonable share of that," Gastão said, adding that 15 percent of the market would be a healthy slice. "It doesn't need to be so much to be very interesting."

Deliveries are slated to begin in 2016 and it should take about four years to serve the initial demand, he said.

Embraer has also studied civilian versions of the cargo jet, including a stretched version for the Brazilian postal service.

FOCUS ON FRONTIER MARKETS

Embraer picked a tricky moment to launch its biggest military program ever, as budget cuts for the world's largest armed forces are rattling the defense industry.

The fate of the KC-390 will prove whether Embraer's focus on frontier markets in Latin America, Africa, South Asia and the Middle East can shelter its defense division from the broader slump. Nearly 90 percent of the transport plane's estimated market is outside the United States, Europe, China and Russia.

A deal with Boeing for joint sales to the United States, Britain and parts of the Middle East could expand the plane's market by over 400 aircraft, according to an industry source who spoke anonymously given the preliminary nature of the studies.

If the KC-390 had arrived a decade ago it would have been a prime candidate for the U.S. Joint Cargo Aircraft program, but a glut of cargo planes and budget cuts has since dimmed its odds there, according to a source briefed on thinking in Washington.

The biggest opening in the U.S. market may come after 2020, when the Pentagon begins replacing hundreds of its aging C130s.

Regardless of the expanded sales map, the partnership with Boeing SA has brought technical advice on Brazil's first wide-body aircraft, along with an unexpected vote of confidence.

"That is a seal of quality from Boeing that sort of caught us by surprise," said Colonel Sergio Carneiro, who oversees the program for the Brazilian Air Force.

DELICATE DIPLOMACY

Still, the help from Boeing underscores that the KC-390 is a bet on international politics as much as engineering, as Embraer has learned in recent years.

In 2006 the United States withheld technology to block a deal for dozens of Embraer light attack planes negotiated by the late Venezuelan President Hugo Chavez, a fiery American foe.

A Pentagon contract to send the same aircraft to Afghanistan was snagged last year in courts by American rival Beechcraft. The deal became campaign fodder in the U.S. presidential race and faces the threat of Congress axing the program next year.

Ties with Washington have generally warmed since President Dilma Rousseff took office, but recent evidence of U.S. spying on her communications led to her cancelling a state visit to Washington in October. The news undercut a Boeing bid to sell fighter jets to Brasilia, raising doubts about the long-term prospects of its partnership with Embraer.

The shifting political winds add risks to future revenue, wrote Citigroup aviation analyst Stephen Trent in a note to clients earlier this year. He cut his recommendation on Embraer shares to "sell" in April after the stock climbed 20 percent in three months, supported by signs of progress on the KC-390.

Trent said the rally was overdone, pointing out that defense companies usually trade at a discount of up to 20 percent compared to commercial planemakers. Embraer shares remain among the top five performers on Brazil's benchmark Bovespa stock index in 2013, gaining 30 percent so far this year.

For Embraer, a more diverse revenue stream is the clearest way to smooth out the violent swings of commercial aviation cycles. Its strategy has cut business with airlines from two thirds of revenue in 2008 to just over half this year.

The focus on defense is also a return to Embraer's roots - it was born in 1969 out of the Brazilian Air Force.

On the brink of bankruptcy in the 1990s, Embraer was privatized to fund its big bet on regional aviation. The company has grown into the world's third-biggest commercial jet maker, competing with Canadian planemaker Bombardier Inc but below the radar of Boeing and Airbus.

Now Embraer is becoming a cornerstone of the domestic Brazilian defense industry, tapping a surge in government spending on upgraded fighter jets, jungle radars and even a geostationary defense satellite.

The defense ministry is investing heavily in the KC-390 program: $2 billion of development costs, plus a contract for 28 planes, which should be signed within the next six months.

Even with the up-front investment, Colonel Carneiro said Brazil will likely save money on the new planes compared to the lifetime cost of the Super Hercules or ongoing maintenance of its existing Hercules fleet of 22 aircraft, which is 35 years old on average.

"There are people who keep riding around in antique cars - they are very wealthy people," Carneiro said in an interview at Air Force headquarters in Brasilia. "We are not a wealthy country. If only for that reason, we need a more modern plane."

(Additional reporting by Andrea Shalal-Esa in Washington; Editing by Kieran Murray, Ed Tobin and Claudia Parsons)

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