Last month we looked at the steel sector in Brazil, reviewing how prospects for steel companies fared with changes in exchange rates. This month we'll examine Brazil's airline sector, and how a major transformation in the aircraft manufacturing industry bodes for Brazil's largest aircraft manufacturer Empresa Brasileira de Aeronáutica S.A. (Embraer), and GOL Linhas Aéreas Inteligentes S.A. (GOL), one of Brazil's low-fare, low-cost airlines.

Over recent months, the airline sector has been in the limelight worldwide, as investors continue to cite overcapacity, high labor costs, and outsized pension liabilities as several good reasons to dump their shares in the major airline carriers.

In recent years, these factors have led to a few large, legacy carriers seeking bankruptcy protection, such as United, USAIR, and Air Canada, or at least flirting with the idea, as are Delta and Alitalia.

Some weakened carriers have also been taken over by larger rivals, namely Lufthansa's acquisition of SwissAir and Air France's purchase of KLM.

Lately each of these carriers and their competitors have faced a new variable, the price of oil breaking through the US$ 50 mark. In order to deal with the high cost of fuel, many carriers have added fuel cost surcharges to their regular fares, further increasing ticket prices in an era of overcapacity. Others have squeezed costs by cutting back on food service and renegotiating salaries with pilots and attendants.

Last week, one aircraft manufacturer, Airbus, responded with the inaugural voyage of its behemoth A380. Airbus argues that if airlines are going to pay more for a given tank of fuel, they might as well pack as many customers onto the plane as possible. This strategy has always had its technical limitations, but last week Airbus proved it can be done.

With a capacity of 800 passengers, the Airbus A380 is causing a rift in the industry. As the A380 is particularly suited to those long international flights the low-cost airlines avoid, it now seems the airline manufacturers are increasingly focused on either production of large or small aircraft.

Airbus' main rival, Boeing, is concentrating on the production of smaller jets - betting that carriers will demand cheaper, more flexible airplanes for shorter routes. Which manufacturing model will prevail in today's hugely competitive market?

If you believe the future of the industry lies in smaller jets plying shorter routes, and that the Airbus A380 is nothing more than a bloated white elephant designed for the bloated legacy carriers, consider investing in the fourth largest aircraft manufacturer, Embraer.

Embraer is Brazil's second-largest exporter, making mid-sized commercial airplanes, the Legacy corporate jet and military aircraft. The company recently revealed US$ 10.1 billion in firm orders for its planes in 2005, compared with US$ 10.6 billion a year ago.

Embraer's slimmer fleets are in great demand from budget airlines operating shorter routes with smaller craft, like JetBlue, which recently ordered over 100, and Republic Airway Holdings, which ordered 16 and has options on 34 more.

And following the sale of 15 Embraer 170 planes to Saudi Arabian Airlines, Embraer executives are forecasting increased demand from the Middle East, which could reach around 150 planes of up to 120-seat capacity over the next decade.

Last week Embraer placed its bet that airlines will continue to seek smaller, cost-effective planes, inaugurating a new mid-size jet, the 100-seat Embraer 190, which is more than 10 percent cheaper to operate than the larger jets produced by Boeing and Airbus.

JetBlue of the U.S. has an option to buy an additional 100 Embraer 190s and Air Canada, which is restructuring under court protection, is in talks to finalize an agreement in principle announced in December.

Embraer (ERJ, $29), currently trades at 10 times estimated 2005 earnings. Analysts surveyed by Thomson Financial expect Embraer’s earnings to grow at a 12 percent pace over the next year.

Now, despite fuel prices hovering at nosebleed levels and some of the larger airlines struggling under government protection, some of the world's smaller carriers have managed to turn a profit, reputedly by buying more fuel-efficient airplanes and keeping other costs down.

One such is GOL Linhas Aéreas Inteligentes, a "low-cost, low-fare" airline, structured along the lines of other budget carriers like Southwest and JetBlue of the U.S., EasyJet of the UK and Ryanair of Ireland.

GOL operates a simplified, modern fleet with low maintenance, fuel and training costs, which results in higher aircraft utilization and efficiency ratios.

GOL also keeps costs low by encouraging online bookings, outsourcing phone reservations, eliminating paper tickets, and offering only cold sandwiches and soft drinks onboard.

Since 2001, GOL has carried over 23 million passengers and now offers 38 major business and travel destinations in Brazil.

Last December GOL started flying to Buenos Aires, Argentina and plans on commencing flights to Santa Cruz de La Sierra, Bolivia by June.

Following a successful IPO in June 2004, GOL (GOL, $29) shares are trading at a lofty 22 times estimated 2005 earnings.

Despite the relatively high valuation, Merrill Lynch currently rates GOL as a buy, JP Morgan recently upgraded GOL to "overweight", and Morgan Stanley analyst William Greene views GOL as "one of the best long-term investment stories in the airline universe today".

So the argument over who will win the manufacturing war really boils down to a question of demand - will the future of flying involve short distances or shuffling from one hub to hub, or will there always be demand for non-stop, long-haul traffic?

You might do well to ponder this question while seated at the airport waiting for your next flight.

All information and content herein is furnished "as is" without warranty of any kind, express or implied, including but not limited to implied warranties of merchantability, fitness for a particular purpose, or non-infringement of third party rights. In no event will the author or his affiliates be liable for any damages, including without limitation direct or indirect, special, incidental, or consequential damages, losses or expenses arising in connection with this article. The author does not own positions in any of the above-mentioned securities.

Gary Sands is a freelance journalist based in Rio de Janeiro. Gary also publishes a humorous weblog called Everything I Know about Foreign Policy I Learned as a Kid, found on Blogger.com -http://foreignpolicyforum.blogspot.com/atom.xml.

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