|
|
|
|
|
|
|
|
|
|
Fitch U.S. Aerospace/Defense Outlook: Commercial Strength Continues, But Moderates |
|
|
|
(Source: Fitch Ratings; issued Dec. 5, 2006)
|
|
|
|
NEW YORK --- Fitch Ratings expects credit quality in the North American aerospace & defense industry to be stable or improving in 2007, supported by solid end-market demand, rising backlogs, and substantial liquidity. Most commercial aerospace segments remain in a strong upturn, and better-than-expected orders in 2006 suggest that peak deliveries in the current cycle for most segments lies beyond 2007.
The changes in control in the United States Congress and the Pentagon have added some uncertainty to the U.S. defense credit outlook, but Fitch does not expect these changes will materially affect defense spending in the next several years. These end-market outlooks are incorporated into Fitch's ratings for the North American A&D companies, and Fitch expects any rating actions to be driven primarily by company-specific factors such as cash deployment decisions or business plan execution.
Key risks to Fitch's A&D outlook include exogenous shocks (terrorism, etc.), execution on new programs, and the supply chain.
Fitch believes that cash deployment decisions will continue to be a key determinant of A&D rating actions in 2007. Fitch calculates that the top 15 North American A&D companies had approximately $21 billion of cash on hand at the end of the third quarter. This should be augmented by typically strong fourth quarter cash generation, possible divestitures, and solid free cash flow in 2007, which Fitch conservatively estimates will be approximately $13 billion (after dividends).
Over the past several years, most large A&D companies have strengthened their balance sheets by reducing debt, while also following generally balanced cash deployment strategies that included increased share repurchases, dividends, and discretionary pension contributions. With most of the large A&D companies at or near their rating objectives, Fitch expects less debt reduction in 2007 than in previous years. Fitch does not expect large acquisitions in 2007, but there should be moderately sized transactions (less than $1.5 billion) as the large A&D players look to round out portfolios and diversify into service businesses.
A general concern in the debt markets in 2006 has been the impact of event risk (leveraged buyouts (LBO), takeovers, etc.) on creditors. Fitch believes this risk is modest for the large North American A&D companies, but it is a valid concern for small and mid-size A&D companies.
Event risk for the large A&D companies is mitigated by strong equity performance in 2006, reasonable equity valuations, the size of some of the companies, likely government resistance to an LBO of a large defense supplier, and Fitch's opinion that large commercial aerospace companies need strong balance sheets due to the nature of the commercial aerospace business (large investment requirements, cyclical markets, financially weak customers, financial subsidiaries, etc.). However, Fitch notes that most large A&D companies have debt covenants that provide minimal protection to creditors from event risk. Small and mid-size A&D companies have historically been frequent targets of LBO's, and Fitch expects this to continue. However, the event risk for small and mid-size companies in the high-yield sector is partially mitigated by restrictive covenants that provide some protection to creditors.
Commercial Aerospace:
As expected, most segments of the commercial aerospace industry were strong in 2006, and this strength should continue in 2007, although Fitch expects that growth rates will likely moderate. Orders in 2006 were stronger than expected, and Fitch now projects that most parts of the commercial aerospace industry will not reach a delivery peak until 2008 at the earliest. Given the level of backlogs, deliveries could remain flat after the peak is reached.
The strength in demand continues to be driven by markets outside of North America, particularly large developing economies. This suggests that current demand is the result of both a cyclical upturn in some markets and secular growth in other markets. Risks to the outlook include supply chain constraints and event risk (terrorism, disease, etc.).
Fitch does not expect an economic downturn in 2007, but the commercial aerospace industry would be negatively affected by economic weakness, particularly in some overseas markets that are currently key drivers of some segments in the industry.
The following expectations for some key segments are incorporated into Fitch's A&D credit ratings:
- Large Commercial Aircraft: Fitch expects large commercial aircraft deliveries from Boeing and Airbus to rise to approximately 900 aircraft (up 9%) in 2007 from approximately 825 aircraft in 2006, which is up about 23% from 2005 deliveries. Deliveries in 2007 should be split nearly equally between the two manufacturers, and there is some upside to the delivery estimate depending on production rate decisions.
The mix between wide-body and narrow-body aircraft should be about the same as in 2006, which takes into account Airbus' plan to deliver 24 fewer A380's in 2007 than originally planned. The key surprise in 2006 has been the strength of orders (nearly 1,300 through October) coming off the record year in 2005 (2,083 net orders). The two companies have five years worth of backlog at expected 2007 production rates, supporting a strong delivery outlook for the next several years.
Fitch anticipates that the current production up-cycle will continue to rise and then plateau within the next three years driven by the sizable backlog, continued restraint in production growth, and the probable return to the market of U.S. legacy airlines within the next few years. A key competitive trend is BA's growing lead in the wide-body segment. Risks to Fitch's outlook include supply chain constraints, execution of production increases and new aircraft programs, exogenous shocks such as terrorist attacks and disease, and economic weakness.
-- Commercial aftermarket growth should moderate in 2007 after a strong 2006 in which some parts of the market were apparently boosted by pent up demand at U.S. legacy carriers. Fitch expects this high-margin segment to grow in line with air traffic, so revenues should rise in the mid-single digits. Longer-term, aftermarket revenues are supported by trends such as the aging of the regional jet and Airbus fleets, global air traffic growth, and the growth of low cost carriers.
-- The regional aircraft market continues to be the commercial aerospace industry's weakest segment in 2006, with deliveries likely to be down about 12%. However, this small segment consisting of regional jets (RJ) and turboprops made by Bombardier, Embraer, and ATR will likely bottom out in 2006 and rebound in 2007 as a result of rising RJ deliveries at Embraer and very healthy turboprop deliveries by Bombardier and ATR. It is useful to divide this segment into RJ's and turboprops.
As a result of production cuts by both Bombardier and Embraer during 2006, RJ deliveries will likely fall 25%-30% in 2006 to about 175 units (excluding RJ's sold into the business jet market), with most of the decline coming at Bombardier. In 2007 RJ deliveries should rise 2%-5% as a result of increased deliveries by Embraer, which should offset continued declines at Bombardier.
These 2007 estimates assume no additional production cuts at Bombardier and a successful ramp up of production of Embraer's EMB-190/195, which has a sizeable backlog of nearly 300 aircraft. There continues to be a shift to larger RJ's, while the 50-seat market has disappeared, the number of parked RJ's continues to rise, and order visibility remains poor for aircraft with fewer than 70 seats. Turboprops are benefiting from high fuel prices, and deliveries should rise more than 80% in 2006 and nearly 40% in 2007 to about 110 aircraft.
-- The business jet market should continue to be strong in 2007, with expected deliveries up 12%-14%. Aircraft delivered in 2007 could reach 1,000 units. This comes off a stronger than expected 2006 in which deliveries should rise 18%-20%. The key development in this segment is the increasing percentage of orders from outside North America.
Some manufacturers are reporting that 50% or more of orders this year have come from overseas, double the historical level. Other drivers of the strong market include healthy corporate profits, increased use of jet cards, and replacement demand. It now appears that the peak of the business jet cycle is in 2008 at the earliest. Risks to the outlook include the potential for higher FAA user fees, supply chain constraints, economic growth, and new entrants.
Defense:
The Democrats' victory in the recent elections and the pending change at the top of the Department of Defense (DoD) have added some uncertainty to the U.S. defense credit outlook, but Fitch does not expect these changes will materially affect defense spending in the next several years, for several reasons.
The fiscal year (FY) 2007 defense budget has already been enacted, and the formulation of the FY2008 budget request is well under way. Also, the threats that have driven the higher defense budgets in the past six years did not change after the elections. Finally, there have been reports that the Democrats could push for an increase in defense spending in January to rebuild the capabilities of U.S. ground forces, which could benefit suppliers to the Army and Marine Corps in the next 12-24 months.
Fitch believes there are also several political factors that will mitigate any negative impact from the elections on defense spending. First, the Democrats have a slim majority in both houses, and on a straight party vote they can not override a presidential veto. Second, it is often difficult to get work done in the Senate without 60 votes, and the Democrats have only 51 seats, including two independents who are assumed to vote with the Democrats. Third, many of the new Democratic congress members are more moderate that old line Democrats and some are pro-Defense. Finally, with the 2008 elections just over the horizon, it is unlikely that Democrats will be too tough on defense spending, thereby reinforcing the perception that the Republicans are more focused on national security issues.
However, the defense companies can expect a less friendly environment in Washington as a result of the election. 'Oversight' seems to be the current buzzword in Washington, so it can be expected that the defense contractors will face more pressure due to high program costs and ethics issues. Acquisition reform efforts could be boosted by the new leadership, and the talks about more fixed price development contracts is an issue to watch. Another item to watch is the extension of the R&D tax credit. Finally, consistent with increased oversight, there could be a struggle over the use of supplemental budgets to fund the operations in Iraq and Afghanistan. These funds do not go through the same detailed review as the regular defense budget, and Congress has already required that the president submit future requests with the regular budget. However, it is not clear whether Congress has the authority make that a requirement.
There have been reports that some Democrats will push for a phased pull-out from Iraq. For the reasons listed above, Fitch does not believe it is a safe assumption that the Democrats will succeed. In addition, if there is a pull-out from Iraq, Fitch does not believe it would be a near-term credit issue due to the need to 'reset' equipment to operational status. The Army and the Marines could need at least two years' worth of funding to reset equipment.
Moving beyond the recent political changes, high DoD spending levels continue to be the foundation of solid credit quality in the defense sector. By some estimates defense spending including supplemental funds for the War on Terror is at the highest level since World War II.
The recently enacted FY2007 Defense budget was better than Fitch expected, and it supports Fitch's assumption of modernization spending (procurement plus RDT&E) growth in the low to mid single digits, excluding supplemental funding for the War on Terror. Supplemental budgets have clouded the analysis of defense spending in the past few years, but these supplemental budgets have protected the core DoD budget from cuts and the supplemental budgets are increasingly including some modernization funds that benefit the prime defense contractors. Backlogs at U.S. defense contractors continued to rise in the first three quarters of 2006, supporting the case for continued revenue growth in 2007.
A more detailed report on the 2007 aerospace & defense industry outlook will be available on the Fitch Ratings web site at www.fitchratings.com in January.
Following is a list Fitch-rated issuers and their current Issuer Default Ratings (IDRs) in the U.S. aerospace/defense sector:
- Boeing Company (The) ('A+'; Outlook Stable);
- Bombardier Inc. ('BB-'; Outlook Stable);
- DRS Technologies, Inc. ('B+'; Outlook Stable);
- GenCorp Inc. ('B-'; Outlook Stable);
- General Dynamics Corporation ('A'; Outlook Stable);
- Goodrich Corporation ('BBB'; Outlook Stable);
- Honeywell International Inc. ('A+'; Outlook Stable);
- L-3 Communications Corporation ('BB+'; Outlook Negative);
- Lockheed Martin Corporation ('A-'; Outlook Stable);
- Northrop Grumman Corporation ('BBB+'; Outlook Positive);
- Raytheon Company ('BBB'; Outlook Positive);
- Rockwell Collins, Inc. ('A'; Outlook Stable);
- Sequa Corporation ('B+'; Outlook Stable);
- Textron Inc. ('A-'; Outlook Positive);
- Transdigm Group ('B'; Outlook Stable);
- United Technologies Corporation ('A+'; Outlook Stable).
Fitch's rating definitions and the terms of use of such ratings are available on the agency's public site, www.fitchratings.com. Published ratings, criteria and methodologies are available from this site, at all times.
Fitch's code of conduct, confidentiality, conflicts of interest, affiliate firewall, compliance and other relevant policies and procedures are also available from the 'Code of Conduct' section of this site.
-ends-
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
