Aerospace & Defence
Airmageddon?
Revising all forecasts for stronger dollar but lower – possibly much lower –
civil volumes – Defence should continue to perform relatively well
Civil Aerospace
Stocks have bounced – but this is a later-cycle industry (especially OE – new aircraft)
so companies have yet to suffer much financial impact. Stock prices, however, tend to
follow the book-to-bill (orders:deliveries), which has already plummeted and could
drop much further still.
The weak orders echo (1) a sharp decline in airline traffic in 4Q08 and (2) overordering
from the “bubble” years.
The big difference from previous recessions is the credit crunch – aircraft deliveries
are almost all financed, but there is little finance in place from mid-2009 onwards.
This could threaten an earlier, steeper decline in deliveries than is customary.
There is a special cashflow risk to EADS as aircraft build rates and orders fall, causing
an outflow of customer advances even while EADS struggles to fund the cash cost of
its very large contract provisions.
The stronger US$ helps mitigate some of the airline traffic weakness and will
eventually boost earnings – but that impact is limited in the next 2-3 years as the
companies are heavily hedged. The dollar has a negative effect on debt levels, as
much of that debt is dollar-denominated.
Defence
Defence stocks have had less of a recent bounce than the cyclicals, but have been
appropriately defensive over a longer period.
The outlook is for continued strong organic earnings growth, greatly bolstered by the
benefit of recent acquisitions and the immediate benefit of the strong dollar to
earnings translation from the half of sector earnings which are US-based – an effect
which is not reduced by hedging.
Key Changes
BAE Systems BAES.L 390p – reduced target from 605p to 430p (peer derating),
retain Buy.
Rolls-Royce RR.L 361p – reduced target from 260p to 220p (peer derating, some
forecast cuts), retain Sell.
Qinetiq QQ.L 156p – raised target from 160p to 190p and upgrade from Reduce to
Add (moved basis on one year to 2010E, stock has fallen).

Valuations and recommendations
Civil
􀁘 Late-cycle sector, so limited adverse impact to earnings so far – OE deliveries still
rising and aftermarket has only just started to suffer
􀁘 Share price decline so far has largely been a derating - we think this has further to
go
􀁘 So - combined with somewhat weaker earnings and weaker cash, we see
substantial further downside for civil stocks
􀁘 Recent bounce in Rolls-Royce and Meggitt make those stocks look particularly
vulnerable - we still see substantial further downside for EADS, too
􀁘 EBIT collapse looks unlikely in most cases, though restructuring and exceptional
charges could make 2009E a poor year overall and EADS is vulnerable to a highly
uncertain Airbus outlook through 2012E
􀁘 Timing of trough and subsequent recovery in civil aerospace stock prices generally
follows civil aerospace book-to-bill on the way down and (probably) airline
profitability on the way up –book-to-bill has fallen steeply, but has much further
to go
􀁘 Lack of available finance for aircraft deliveries after mid-2009 is a major and novel
risk – this could lead to an earlier, unusually steep fall in aircraft deliveries
􀁘 Specific risk for EADS (and to a much lesser degree for Rolls-Royce) is adverse
cash impact of outflow of customer advances and deposits as orders and deliveries
fall off, as well as demand for vendor financing – for EADS, this compounds
potential outflows from cash cost of