2009 AeroDefense Outlook
SECTOR REVIEW
Favor Defense Over Comm'l Aero to Start '09
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Presenting Our Early 2009 Thesis, with a Shorter-Term Horizon: Heading
into 2009, we are resetting our thesis for comm’l aerospace and defense,
emphasizing execution and visibility over valuation, at least through H1. We also
adjust to a shorter-term view for our ratings given the market’s exceptionally low
level of confidence, particularly with respect to comm’l aerospace.
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Defense – Execution over Valuation: Defense generally offers better visibility
than comm’l aero, and despite the election of a Democrat to the White House,
early signs from the Obama Administration suggest modest stability in defense
outweighs poor visibility elsewhere amid still-declining global GDP growth. While
valuation dominated our ‘08 ratings, we begin ‘09 expecting the market to favor
execution and CF. This yields upgrades to L-3 (LLL) and Raytheon (RTN) from
Neutral to OP. Although NOC’s execution improved in late 2008, investor
confidence still wanes, and we expect this and heavy pension cost to continue to
stall its shares. Hence, we downgrade Northrop Grumman (NOC) from OP to
Neutral. While we like Lockheed Martin (LMT), we maintain our Neutral rating on
continued expectation for headline risk on F-22 and F-35 in the short-term. We
now expect GWOT spending to remain solid well into the Obama presidency,
diminishing the war overhang for RTN and LLL in our view. GD should benefit as
well, but our extremely negative view of biz jet (worst part of comm’l aero) offsets
our enthusiasm for Combat Systems and Ships. Similarly, our favorable view of
COL is mollified by biz jet/GA exposure (~25% of sales). We remain Neutral on
GD and COL. ATK stays OP on program capture and execution.
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Comm’l Aero - Prefer Aftermarket over OE: We are reversing the OE theme
we held for much of ‘08, switching to focus on aftermarket, which could be an
early cycle recovery play. In contrast, OE is late cycle and still waiting to take the
earnings hit from lower delivery rates. The velocity in late ‘08 of declining fuel
prices, coupled with the deterioration in credit availability, has clearly undermined
the demand case for new a/c. Instead, with their newly found lower cost
structures, airlines may rely more heavily on the existing fleet, and continue to
lower prices to stimulate traffic demand. Consequently, we downgrade Boeing
(BA), Spirit (SPR) and Precision Castparts (PCP) to Neutral from OP. Our focus
stock is Goodrich (GR), which we believe benefits from unique positioning away
from the thornier parts of aerospace. Limited OE exposure coupled with
favorable platform positions on aircraft less likely to be retired gives GR a better
position relative to other suppliers. Beyond economic recovery (CS targets Q2
‘09 as global and U.S. GDP growth rate trough), the bull case for the three
downgraded names also relies heavily on 787, for which positive news on first
flight may begin to surface in the spring. Before then, newsflow should continue
to be negative as these companies have yet to reduce delivery rates and lower
earnings expectations for ‘09. Plus, the expected euphoria from 787’s eventual
first flight may be brief as certification and production ramp remain a challenge.
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Q4 Preview & Higher Pension Cost in 2009: Our Q4 preview is included
on pg. 26 with a quick recap grid for Q3. Also, we reduce ests. for several
names as Dec’s rapid discount rate decline boosts 2009 pension expense.

Commercial Aerospace
Focusing on Aftermarket as OE Weakens
We are reversing the original equipment (OE) theme we held for much of 2008, refocusing
on aftermarket, typically an early cycle recovery play. In contrast, OE is late cycle
and still waiting to take the earnings hit from lower delivery rates. The velocity in late ‘08 of
declining fuel prices, coupled with the deterioration in credit availability, has clearly
undermined the demand case for new aircraft. Instead, with their newly found lower cost
structures, airlines may rely more heavily on the existing fleet, and continue to lower prices
to stimulate traffic demand.
After analyzing historical trading and operating data (orders, deliveries, etc) we are shifting
from a 12-18 month view that commercial aerospace shares have more than fully
discounted the entire down-cycle and will bounce back at least partially to a shorter-term
view that OE stocks such as BA and SPR are likely to be range bound for the next three to
nine months. We do not see tremendous downside risk to SPR or BA unless 787
completely falls apart which we do not believe is likely. Going into 2009 we find it difficult
to make a buy argument for commercial OE as we think the relief on oil prices makes a
case for specific stocks that benefit from fleet activity such as GR, and possibly BEAV if
airline capex holds up on the retrofit side. However, with so much uncertainty in the
economy we think selective defense names (particularly those with lower platform
exposures) can offer the most stable earnings profile and visibility within our coverage
universe. Platform exposure will define which suppliers withstand capacity cuts best. For
example, with most of its aftermarket on A320, A330, and 777, GR seems fairly well
insulated from reductions to the MD-80 and DC-9 fleets. In addition to favorable platform
exposure, a non-discretionary spares portfolio and more limited OE exposure at the EBIT
level will provide relative strength at GR.
OE and Aftermarket Have Different Cycles, And the Latter May Recover First
The below charts illustrate the lower cyclicality in the aftermarket, which tends to reflect
traffic levels (ASMs) at the airlines, compared to the more significant cycle highs and lows
in the new build market where Boeing and Airbus live. Exhibit 1 compares growth rates
between these two markets, while Exhibit 2 shows a comparison of absolute data.
Further, we note that Exhibit 2 shows how aftermarket continued to rise globally between
1994 and 1995 while OE deliveries declined. In the current cycle, with fuel prices now at
quite manageable levels, we would expect ASM growth to likely resume in 2010, although
OE may continue to trend down that year, and even in 2011. Under this scenario,
aftermarket-based companies such as GR appear most attractive. TDG shares this
benefit, although at its current multiple, we find it too expensive to recommend.

Among the OE stocks, SPR looks less expensive than BA, but in this market we believe
SPR will continue to be penalized for having even greater exposure to Boeing Commercial
Airplanes (BCA) than Boeing itself, which derives around half of its earnings from its
defense business, not to mention SPR greater fixed cost base, and more limited cash flow.
We also place PCP in the OE basket, as it garners higher OE margins than other suppliers,
and has become more heavily dependant on the endlessly delayed B787, which will be a
huge boon once it goes to rate in a couple of years. PCP had benefited in our 2008 thesis
from its secondary exposure to capex in the energy segment, but that viewpoint is less
relevant given the new realities in the energy market.
The Bull Case on Commercial Aerospace
To remain bullish, we would have to believe one of two things is going to happen soon,
and in force. The first is a sustained signal that the economy is rebounding and global
GDP growth rates are about to inflect upward. Exhibit 10 shows that Credit Suisse’s
economists do not expect this to happen until Q3 at the earliest, so we have difficulty
adopting this first point. Point 2 hinges on positive B787 news. While we believe each
new day brings us closer to first flight and eventual first delivery, we do not expect the
market to believe first flight is real until just before it happens (current cautious expectation
is late April). Even then, we think the flight must then be followed by a relatively smooth
certification process and production ramp for the shares to hold any gains. We are not
hanging our hat on this. We suspect that any near-term gain in BA, SPR and PCP
Castparts are likely to be in line with a broad market (read: bear market) rally, and as such
we see these names are market performers for the short-term. As alluded to earlier, we
may enjoy modest traction ahead of a legitimate first flight date, but it could be short-lived,
depending on macro circumstances at that time. We would point to Exhibit 19 to note that
Boeing shares did not rally following the upward improvement in global GDP growth, as it
is a late and long-cycle business, which did not see BCA deliveries and earnings trough
until 1995.

Comm’l Fundamentals Still Deteriorating
Demand for commercial aircraft depends on the appetite for air travel. Air travel demand is
measured in RPMs or RPKs (revenue passenger miles or kilometers), while airline supply
is measured in ASMs or ASKs (available seat miles or kilometers). The primary driver of
air traffic, in our view, is global GDP growth and we analyze the correlation in the next
section below (see Exhibit 11 for chart of Global Air Traffic Growth vs. GDP Growth).
The International Air Transport Association (IATA) forecasts a 3.0% global decline in air
traffic in 2009 on low global GDP growth of 0.9%. Yet, the severe rapid reversal (and
tough H1 comps) thus far in international air traffic and freight suggests the 2009 decline
may exceed IATA’s forecast (see Exhibit 4 and Exhibit 5)
Our previous thesis held that expensive oil and easy money would support aircraft
demand, even if the economy weakened a bit. But, the global decoupling never
materialized, and with credit taking longer than we expected to thaw, and the simultaneous
plunge in oil prices, the case for needing new aircraft is dramatically different than before.

We would also note that the rapid reversal in international air traffic is accelerating much
faster than the global airline industry can remove capacity. The most recent IATA results
for November worsened considerably from prior months. The November international
passenger decline was 4.6%, showing further demand contraction from the 1.3% decline
in October and the 2.9% fall in September. International cargo dropped by 13.5%, the
largest drop since 2001. Meanwhile, capacity in international passenger markets was only
cut by 1.0% in November, far short of the demand decline.
Lower traffic, combined with the absence of high fuel prices as a new equipment driver
and constrained credit, will likely continue the trend of declining orders illustrated in
Exhibit 6 (trailing twelve month order activity at both Boeing and Airbus), which may yield
production rate decreases for Boeing and Airbus as backlog is drawn down. The backlog
erosion may be further accelerated by deferrals and or cancellations of existing orders.

Boeing released its 2009 production schedule when it provided 2009 financial guidance in
July of 2008 during 2Q’08 earnings. The schedule called for delivery of 500 – 505 planes
(including 25 787s). The ’09 guidance and production schedule was suspended after the
IAM machinists struck for two months and no updated delivery schedule or guidance has
been provided (now expected with Q4 EPS on January 28, 2009). Still, Boeing has
recently stated it does not plan to reduce production rates. But, with yet another 787 delay
and first flight scheduled for 2Q of this year, it is reasonable to assume the first 787 will not
deliver until 2010. This would imply a revised delivery schedule of 475 – 480 aircraft. We
are not convinced that rates are sustainable due to the aforementioned structural issues
such as a tougher aircraft financing environment and weakening demand.
Indeed, Boeing just announced on January 9, that it would eliminate roughly 4,500
commercial aerospace positions (mostly in Washington state), which essentially reverses
the job growth in 2008, when BCA employment rose to 68k from around 63k. BA
specifically noted that the job reductions are generally in overhead, and not directly in
aircraft production. But, we see this effort as some level of acknowledgement of the tough
environment, which we do believe will ultimately lead to formal production decreases,
which are already in our model, as per below.
Following our annual aerospace and defense conference (see note dated 11/20/2008), we
revised our projected production schedule for Boeing based on macro headwinds
(demand weakness and financing challenges) and continued internal production (IAM
strike) and development issues (787/747-8). We expect demand to impact production
rates late next year, and lack of credit availability to pressure rates further in 2010. Taking
these various challenges together, we made sizeable downward adjustments to our 2009
and 2010 estimates (Exhibit 7).