2009-12-09 16:57:36 -

Credit quality in the U.S. commercial aerospace industry will remain under pressure in 2010, while the U.S. defense sector is likely to experience more stability, according to Fitch Ratings. Fitch expects deliveries in all commercial aerospace original equipment (OE) segments to decline in 2010, but aftermarket sales should begin to improve modestly. Defense spending will continue to grow in the low single digits.

'Beyond 2010 the industry faces some key issues: likely additional production cuts at Boeing and Airbus, and possible declines in U.S.

Department of Defense (DoD) modernization spending,' said Craig Fraser, Managing Director at Fitch. 'Rating upgrades are unlikely in 2010, and downgrades remain a risk for some commercial aerospace companies.'


Credit metrics for many A&D companies deteriorated in

2009, but they are likely to be steady in 2010. Profits and cash flows could be helped by improvement in the high-margin aftermarket, the full-year impact of 2009 cost reductions, and defense growth, but they will be held back by higher pension expense and weak commercial OE markets. Fitch says liquidity remains strong after improving in 2009 because of lower share repurchases and some opportunistic debt issuance, but the company expects cash deployment will increase during 2010, particularly for acquisitions and pension contributions.

Key risks for the sector include the weak global economic recovery, exogenous shocks (terrorism, disease pandemic, etc.), large U.S.

government deficits, and execution on new programs. The 787 program remains a continuing source of risk for Boeing and its suppliers. Flight hours and airline traffic have moved off of cyclical lows, but they remain at depressed levels. A general risk is that some production rates have not been revised downward materially despite the weak economy.

Fitch does not expect that financing availability will be a limit on aircraft deliveries in 2010, although some concerns remain in the aircraft finance business. Longer-term, Fitch considers the commercial outlook solid because of large backlogs and the need to build aerospace infrastructure in developing regions.

Commercial Aerospace.

The following expectations for key commercial aerospace segments are incorporated into Fitch's forecasts.

--Large Commercial Aircraft (LCA): Fitch expects LCA deliveries from Boeing and Airbus will decline approximately 5% in 2010 to 920 aircraft, with revenues down 5%-10%. These estimates incorporate the announced production cuts for the A320 family (down two aircraft per month) and B777 (down almost 30%), but they exclude possible 787 deliveries (discussed below). Fitch believes there is a strong chance of additional production cuts, but these are more likely to take place in 2011. Long manufacturing lead times, advance payment requirements, and indications of sold-out 2010 production schedules support the argument against additional cuts next year, unless they are announced in the next few months to take effect at the end of 2010.

Fitch's forecasts will include additional 5%-15% cuts beginning in 2011.
Fitch forecasts the additional LCA production reductions in 2011 because of a moderate global economic recovery, airline capacity reductions in 2008 and 2009, substantial airline losses, and deliveries that are exceeding typical aircraft retirements. However, the eventual production declines should be moderate relative to prior LCA cycles as a result of large backlogs, production restraint since the last downturn, some remaining overbooking in the delivery plans, and the geographic diversity of the customer base. In addition, the long-term nature of aircraft assets, as well as operating cost savings, provide incentive for customers to continue taking delivery of aircraft despite cyclically weak airline traffic. If the projected production cuts are managed with sufficient lead time, both the manufacturers and the supply base should be able to adjust their cost structures in time to prevent deterioration of their credit profiles.

Fitch expects LCA orders to be low in 2010 and 2011, a continuation of the trend in 2009, in which there have been only 287 net orders through November compared to 867 deliveries during the same period. There were 142 cancellations through November, and Boeing has indicated that it had approximately 215 deferrals in the first three quarters. Low orders are not a credit concern given that Boeing and Airbus had a combined backlog of 6,849 aircraft at the end of November, equal to more than seven years of production at estimated 2010 rates. Excluding 787 and A350 backlogs, the industry still has almost six years worth of orders.

Boeing's 787 program will continue to be a key concern for the LCA sector and its supply base in 2010. If Boeing meets its current schedule, Fitch estimates the company could deliver 10-15 787s in late 2010, but there is considerable risk to the schedule, including an aggressive flight testing program, certification, and the production ramp-up. Boeing will be building 787s through the flight testing program, exposing the company to the risk of reworking some aircraft if problems are discovered during the flight tests. Uncertainty over customer penalties and supplier claims add to the 787s risks. Through November, the 787 accounted for the bulk of Boeing's order cancellations (83 out of 111), although the company still has 840 firm orders for the aircraft.

--Commercial Aftermarket/Services: The commercial aftermarket will likely be the first part of the aerospace industry to recover from the downturn. Fitch forecasts aftermarket spending will be flat to up 5% in 2010, with a weak first half offset by an improved second half. The expected economic rebound should drive airline traffic growth and eventually will lead to rising flight hours and capacity, which are the primary drivers of aftermarket spending. Some inventory rebuilding and completion of deferred maintenance should also help the aftermarket recover in 2010. Business jet utilization has also been improving off of a low base, which will aid aftermarket spending in that sector.

Fitch's general concern for the aftermarket is that current conditions are still very weak, with many companies reporting double digit declines year-over-year in the third quarter. Some capacity metrics are still negative despite indications of increased airline traffic. Fitch will have more conviction on the outlook for this sector once capacity starts to increase. Companies with healthy exposures to this high-margin segment include Goodrich, Honeywell, Rockwell Collins, Transdigm, and United Technologies.

--The business jet market was the worst commercial aerospace sector in 2009, suffering a rapid and severe downturn. Industry deliveries fell 38% through September, and Fitch expects a 35%-40% unit decline for the year, with revenues likely down 25%-30%. An eventual peak-to-trough unit decline of 50% or more for the industry is not out of the question, and Fitch expects aircraft deliveries to fall another 5%-10% in 2010 from 2009 levels. The large unit declines result from hundreds of order cancellations and the failure of light jet manufacturer Eclipse Aviation.

Although utilization rates have started to rise and corporate profits have turned up, Fitch expects continued weakness in the sector because utilization rates are still well below peak levels and the corporate profit improvement is largely due to cost cutting. This sector will continue to be volatile because of the discretionary nature of the product, the availability of numerous substitute forms of travel, and the relationship to corporate profits. A key development in the sector in the past five years has been strong orders from outside North America, and these international orders could be the catalyst for an upturn beyond 2010. Manufacturers in this sector include Bombardier, Dassault Aviation, Embraer, General Dynamics, Hawker Beechcraft, and Textron, as well as key suppliers such as Honeywell.

--The regional aircraft market (regional jets and turboprops) has many of the same drivers as the LCA market, but it has lower backlogs. Orders so far in 2009 have been weak, and the outlook for this sector is negative for 2010. Regional jets deliveries from Bombardier and Embraer will probably fall about 15% in 2009 and at least 15% in 2010, excluding possible deliveries from new entrants in the market. Fitch estimates that turboprop deliveries from Bombardier and ATR (a joint venture between EADS and Finmeccanica) will rise modestly in 2009, but they will likely decline 5% in 2010. New entrants into the regional jet market remain an important part of the sector's outlook, and in 2010 the market will likely see the initial deliveries of Sukhoi's Superjet 100 and China's ARJ21.

Defense.

High U.S. DoD spending levels continue to support defense sector credit quality, and the outlook is still favorable in the near term because spending in fiscal year 2010 will continue to rise. The core DoD budget should grow approximately 4% in FY2010, and modernization spending (procurement plus R&D), the most relevant part of the budget for defense contractors, should be up 2%-3%. Fitch believes that FY2010 is probably the peak in modernization spending, and there are several risks to monitor in FY2011 and beyond. These include the Obama Administration's first full budget in FY2011, the Quadrennial Defense Review (QDR), and the large projected federal budget deficits in FY2009-FY2011. In addition to spending levels, some other changes proposed by the new administration could have a detrimental impact on defense contractors, including acquisition reform and the 'insourcing' of services previously contracted out by the DoD.

Fitch believes core modernization spending could decline 1%-2% in FY2011, although the overall core budget could rise. The FY2011 budget and QDR will likely continue the changes the Obama administration introduced in the current year's budget, and Fitch is not anticipating any dramatic shifts. Fitch expects supplemental spending that supports operations in Iraq and Afghanistan will fall over the next several years, but for several reasons the decline will be gradual, and the supplemental spending will not disappear. Spending related to Iraq will be down, but spending in Afghanistan will increase. Some security spending by the U.S. in Iraq will likely be replaced by Iraqi government spending, which could continue to be a source of revenues to U.S.
contractors. Finally, the DoD will need to refurbish or replace some equipment and material that is in poor condition or left in Iraq.

Given the strong credit metrics and liquidity at most of the leading defense contractors, ratings in the sector are unlikely to be pressured by modest declines in modernization spending. Program execution and cash deployment probably present greater risks. Defense company backlogs fell in the first three quarters of 2009 due to some program cancellations, although orders in the fourth quarter could reverse some of the decline.

Liquidity and Cash Deployment.

Strong liquidity and financial flexibility helped the North American A&D industry withstand the difficult economy in 2009, and the industry even improved its liquidity position in the past 12 months, although at the expense of increasing total debt to $60 billion from $55 billion. At the end of the third quarter the top 15 A&D companies rated by Fitch in North America had $35 billion in cash compared to approximately $5 billion in current debt maturities and short-term debt. The only material credit facilities set to expire in 2010 (GD, L-3, and RTN) have already been replaced.

Many companies in the sector pulled back on discretionary expenditures in 2009 (share repurchases fell $10 billion, for example) in the interests of building liquidity. With stabilization appearing in some parts of the A&D sector, Fitch expects greater cash deployment in 2010.

Acquisition activity began to increase in the past quarter, and Fitch expects this will continue in 2010. Share repurchases and dividend increases will likely rise as well.

Higher pension contributions will be another use of cash in 2010. The A&D sector has seven of the largest 25 pension plans in corporate America, and some are significantly underfunded. The situation is mitigated for defense contractors, which get some recovery of pension costs in government contracts. Harmonization of Cost Accounting Standards and the Pension Protection Act is something to watch during 2010.

In Fitch's view, Boeing will have the most significant liquidity pressures in 2010. Delays in the 787 and 747-8 programs over the past 18 months have negatively affected Boeing's credit quality because of inventory build-up, delayed advance payments, and higher development expenses. Cash flow pressures will likely persist into 2011 due to continued inventory build-up in support of initial 787 deliveries.
Although free cash flow will probably be positive in 2009, Fitch believes that break-even or negative free cash flow is possible in 2010 depending on the ultimate schedule for 787 deliveries, production rates on other aircraft models, and the company's working capital management, which has been good in 2009 considering the 787 inventory pressures and reduced advances because of lower orders.

Aircraft Finance.

Fitch does not expect that financing availability will be a limit on aircraft deliveries in 2010, although some concerns remain in the aircraft finance business. The aircraft finance market was not as bad as feared in 2009, and Fitch expects this trend to continue because credit markets have improved and lower forecasted aircraft deliveries will mean a lower financing requirement than in 2009. Fitch projects funding requirements will be $60-$65 billion for LCA and regional aircraft in 2010, about $5 billion lower than in 2009. An additional $10-$15 billion could be needed for business jets, also down versus 2009.

Concerns in the aircraft finance market include the damaged business models of some large aircraft lessors, the exit of some banks from the market, and indications that pre-delivery payment financing was difficult for some airlines in 2009. Several factors offset these concerns, including strong support from export credit agencies (ECAs), the emergence of some regional financial players in the market, better capital markets activity in the past few months, and the ability of Boeing and Airbus to provide customer financing. Fitch estimates that ECAs could support approximately 25% of LCA deliveries in 2009, illustrating the benefit the industry has received from indirect government support. It looks like Boeing and Airbus will finance less than $2 billion of new aircraft in 2009, leaving the companies with the capacity to help customers in 2010 if needed. New aircraft serve as attractive lending collateral due to the mobility of the assets, operating efficiency compared to previous aircraft generations, and unique treatment in bankruptcy in some jurisdictions.

The comments above apply to new aircraft financing, not refinancings of existing debt. Fitch estimates that there will be $14 billion of maturing airline debt in the U.S. alone in 2010-2011.

Economic Assumptions.

Underpinning Fitch's A&D outlook is the firm's most recent global economic outlook, which as of October 2009 calls for global GDP to shrink 2.8% in 2009, followed by global growth recovery to 2% in 2010 and 2.7% in 2011. GDP should rise, but from a low base, and expansion will be weak relative to previous recoveries. There is some uncertainty in 2011 due to likely tightening of monetary and fiscal stimulus. Fitch expects GDP to grow 6.5% in the BRIC countries (Brazil, Russia, India, China) in 2010. Although global GDP looks set to return to positive growth, the absolute level of GDP is low and, in the U.S., it is possible that GDP may not return to the 2008 level until 2011.

As discussed above, Fitch's specific A&D assumptions include no recovery in 2010 other than early cycle parts such as aftermarket. Late cycle segments such as original equipment will continue to be weak, showing some volume declines, although nowhere near as dramatic as in 2009 or in the last downturn that began in 2001.

A more detailed report on the global 2010 aerospace & defense industry outlook will be available on the Fitch Ratings web site at ' www.fitchratings.com : ' in January.

The following is a list of Fitch-rated issuers and their current Issuer Default Ratings (IDRs) in the North American aerospace/defense sector.

--Alliant Techsystems Inc. (ATK) ('BB'; Outlook Stable);

--Boeing Company (BA) ('A+'; Outlook Negative);

--Bombardier Inc. (BBD/B) ('BB+'; Outlook Negative);

--General Dynamics Corporation (GD) ('A'; Outlook Stable);

--Goodrich Corporation (GR) ('BBB+'; Outlook Stable);

--Honeywell International Inc. (HON) ('A'; Outlook Negative);

--ITT Corporation (ITT) ('A-'; Outlook Stable)

--L-3 Communications Corporation (LLL) ('BBB-'; Outlook Stable);

--Lockheed Martin Corporation (LMT) ('A-'; Outlook Stable);

--Northrop Grumman Corporation (NOC) ('BBB+'; Outlook Stable);

--Raytheon Company (RTN) ('A-'; Outlook Stable);

--Rockwell Collins, Inc. (COL) ('A'; Outlook Stable);

--Textron Inc. (TXT) ('BB+'; Outlook Negative);

--Transdigm Group (TDG) ('B'; Outlook Stable);

--United Technologies Corporation (UTC) ('A+'; Outlook Stable).

Additional information is available at ' www.fitchratings.com : '.

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Fitch RatingsCraig Fraser, +1-212-908-0310Kathleen Connelly,
+1-212-908-0290 (New York)Eric Ause, +1-312-606-2302 (Chicago)Media
Relations:Cindy Stoller, +1-212-908-0526 (New York) cindy.stoller@fitchratings.com : mailto:cindy.stoller@fitchratings.com