Fitch: North America Aerospace & Defense Supported By Strong Global Demand, Spending Trends in 2008
(Source: Fitch Ratings; issued Dec. 5, 2007)
NEW YORK --- Fitch Ratings has a positive outlook for credit quality in the North American commercial aerospace industry in 2008, and a stable outlook for credit quality in the North American defense sector.
The favorable outlook for commercial aerospace is based on demand outside of North America, which has resulted in large order books and strength in all commercial product segments. Concerns about economic weakness have increased in recent months, but Fitch estimates that only a global recession would change the positive outlook for commercial aerospace.
The defense credit outlook continues to be supported by high Department of Defense (DoD) spending levels, although spending growth in the core budget should slow. Supplemental defense spending to support operations in Iraq and Afghanistan will likely continue through 2008, and any impact from lower supplemental spending would not be significant for several years due to the need to reset and modernize equipment. The outcome of the U.S. presidential elections is not likely to affect core defense spending until FY2011.
Global Exposure Limits Impact of U.S. Economic Slowdown
U.S. economic weakness could test the strength of the current commercial aerospace upturn, but Fitch believes the industry would pass that test because of the global diversity of commercial aerospace demand. For example, at least 75% of the current large commercial aircraft (LCA, Airbus and Boeing) backlog is from customers outside North America. In Fitch's view, there would need to be a substantial amount of contagion leading to a global economic downturn for the commercial aerospace outlook to become negative. The sector is not exhibiting signs of weakness at this time, as illustrated by the strong orders for LCA and business jets in the past two-three months. The most significant concern would be that high fuel prices and higher interest rates combine to compress already thin airline profit margins.
Fitch will continue to monitor several key items for signs of a change in commercial aerospace trends. The business jet market would likely be the first segment to show weakness, in Fitch's opinion, because of substitute forms of travel and higher exposure to North America demand. Other data that will be watched include global passenger traffic, global cargo traffic, global airline profitability, delivery deferrals, and order cancellations. Fitch does not believe lower orders in 2008 would be a warning sign of commercial aerospace weakness because of the high orders in the past three years and the large backlogs in the industry.
There has been no noticeable impact on the aircraft finance market from the 'credit crunch' at this point, but it is an area to watch in 2008. Given the large backlog in the commercial aerospace industry (more than 6,000 LCA), there will be several hundred billion dollars of new aircraft to be financed and insured over the next several years. Commercial aircraft have been a strong asset class over the past few years, attracting a significant amount of capital. There were several capital market aircraft transactions in 2007, but the market still mainly consists of leasing companies and banks. Fitch expects this to continue in 2008. The healthy aircraft finance market has benefited some manufacturers with finance subsidiaries (Boeing and Bombardier are examples) which have been able to reduce financing assets, raising free cash flow.
Fitch expects all segments of the commercial aerospace industry to deliver solid growth in 2008, and this growth should continue into 2009. Orders have exceeded expectations again in 2007, and Fitch now projects that most parts of the commercial aerospace industry will not reach a delivery peak until 2009 or 2010. Substantial order backlogs provide a cushion to delivery estimates, particularly in the LCA segment. Markets outside of North America continue to drive the strong demand for commercial aerospace products, and the current demand is a mix of both a cyclical upturn in some markets and secular growth in other markets. Risks to the outlook include exogenous shocks (terrorism, disease pandemic, etc.), changes in global economic activity, supply chain pressures, execution on new programs, production increases, and labor negotiations.
The following expectations for some key commercial segments are incorporated into Fitch's credit ratings:
--Large Commercial Aircraft (LCA):
Fitch expects LCA deliveries from Boeing and Airbus to rise to approximately 980-1000 aircraft (up 11%) in 2008 from approximately 890 aircraft in 2007, which is up about 7% from 2006 deliveries. Fitch expects deliveries to rise to more than 1100 aircraft in 2009, with further increases in 2010. Deliveries in 2008 should be split nearly equally between the two manufacturers (with a slight edge possible to Airbus), and the mix between wide-body and narrow-body aircraft should be about the same in 2008 as in 2007, before shifting in favor of wide-body deliveries in 2009 as 787 production increases. Orders have exceeded expectations for the third consecutive year, totaling more than 2,100 aircraft year-to-date. Fitch expects orders to decline in 2008, but the book-to-bill ratio could still approach 1:1 in 2008 given some pending aircraft campaigns.
The order backlog at the end of 2007 should exceed 6,100 aircraft, or more than six years worth of production at expected 2008 production rates. The large backlog supports the rising delivery outlook, as does the production restraint exhibited by Boeing and Airbus so far in this upturn. Orders from U.S. legacy airlines in the next several years could add further support to the upturn, although the likelihood of U.S. orders could be reduced by a U.S. recession or airline consolidation. Substantial order backlogs provide a cushion to the upturn, and Fitch estimates that cancellation of even 15-20% of existing orders would still leave the industry with enough backlog to support modest delivery increases for several years. Risks to Fitch's outlook include supply chain constraints, execution of production increases and new aircraft programs (787 and A380), exogenous shocks such as terrorist attacks and disease pandemic, economic weakness, and labor issues (Boeing contract renewals and potential further cuts at Airbus with Power8). Key events in 2008 will include 787 first flight (late first quarter), 787 first delivery (November/December), and the potential expansion of Airbus' Power8 restructuring program.
--The business jet market should continue to show strong growth in 2008, with expected deliveries up 14%-15%, excluding some VLJ (Very Light Jet) deliveries which would bring growth rates up further. Aircraft delivered in 2008 should exceed 1,200 units, up from more than 1,000 units in 2007, which is up 18-20% over 2006. The key development in this segment continues to be the increasing percentage of orders from outside North America, with most manufacturers reporting that 50% or more of orders are coming from overseas. Other drivers of the strong market include healthy corporate profits and liquidity, as well as replacement demand. It now appears that the peak of the business jet cycle is in 2009 at the earliest. Risks to the outlook include supply chain constraints, new entrants, and economic growth. Fitch believes that the business jet market would be the first commercial aerospace segment to exhibit weakness in the face of an economic slowdown because there are substitute forms of travel and the segment has a higher exposure to North America than some other aerospace segments.
--The regional aircraft market rebounded in 2007 from a trough in 2006, and growth should continue in 2008. It is useful to divide this segment into regional jets (RJ) and turboprops. RJ deliveries by Bombardier and Embraer will likely rise 18-20% in 2008 to 220-225 units after rising an estimated 9-10% in 2007, when Embraer's higher deliveries offset Bombardier's production decline. There continues to be a shift to larger RJ's, while the 50-seat market has disappeared. RJ orders have been strong in 2007, and a key development has been the turnaround in Bombardier's orders, which more than doubled. Turboprops from Bombardier and ATR are benefiting from high fuel prices, and deliveries should rise 45-50% in 2007 to approximately 110 aircraft and around 20% in 2008.
New entrants are a key development to watch in this segment. The first flight of the Sukhoi Superjet 100 could occur in late 2007 or early 2008, and Mitsubishi's launch decision for the MRJ is expected in the first half of 2008. Bombardier's decision on whether to launch its CSeries airplane in the lower part of the LCA market will be an important event in 2008.
--Aftermarket/Services growth should be in the mid-to-high single digits in 2008, slightly above projected growth in global air traffic. This high-margin segment is an attractive business, and it could be the focus of some M&A activity. Drivers of longer-term growth in this segment include the aging of the regional jet and Airbus fleets, global air traffic growth, the growth of low cost carriers, and outsourcing by airlines and governments. Risks to the outlook include lower air traffic caused by economic weakness or shocks, leading to the parking of older aircraft. A longer-term issue to watch is the growth of Parts Manufacture Approval (PMA) material, which could cut into revenues and margins of original equipment aftermarket providers.
High DoD spending levels continue to be the foundation of solid credit quality in the defense sector. DOD spending levels are very high after strong growth in the past 10 years. The recently enacted FY2008 DoD appropriations budget and expected supplemental funds for the War on Terror could bring DoD spending in FY2008 to more than $670 billion, including about $176 billion for modernization (procurement and RDT&E, the most relevant parts of the budget for defense contractors) spending in the core budget. Fitch's assumption for modernization spending growth over the next few years is in the low to mid single digits, excluding supplemental funding for the War on Terror. Spending in other addressable markets such as Intelligence and NASA, as well as good orders and rising backlogs in the first three quarters of 2007, also support the outlook for 2008. Concerns for the defense sector include shareholder focused cash deployment, program performance, program risks within the budget, and Congressional pressure.
However, the spending environment is less favorable than it has been in the past several years. In addition to flatter growth, the defense industry is getting more scrutiny from Congress, which has begun to challenge spending growth on large programs. The lead systems integrator trend is also being questioned.
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 they are increasingly including some modernization funds that benefit the prime defense contractors. An important question is what impact the end of operations in Iraq and Afghanistan would have on defense spending. The most likely scenario is that spending would continue for several years to 'reset' the military to full operational status.
Some important events for the defense industry in 2008 include the submission of the FY2009 defense budget request (early February), the award of the USAF tanker contract (early 2008), and the elections in November. The outcome of the presidential election could have an impact on supplemental spending in 2009, but it is not likely to have an impact on core defense spending for several years. Due to the timing and complexity of the DoD budgeting process, the new President will not have a full impact on the budget process until the FY2011 budget, although there could be a modest impact on the FY2010 budget.
Cash Deployment, Debt Levels, M&A
Cash deployment will continue to be a key factor in North American aerospace & defense (A&D) rating trends. Fitch calculates that the top 15 North American A&D companies had approximately $30 billion of cash on hand at the end of the third quarter, which should be augmented by typically strong fourth quarter cash generation and solid free cash flow in 2008. Most investment grade companies in the sector are at or near their rating targets, and they generally have strong credit metrics for their ratings.
As a result, Fitch expects that debt reduction will not be a cash deployment priority for most investment grade A&D companies in 2008. Fitch expects significant spending on share repurchases and pension contributions, as well as for acquisitions and dividend increases. Fitch also expects that this spending will be executed using free cash flow and existing cash balances. Non-investment grade companies in the sector will focus on debt reduction and acquisitions.
Overall (investment grade and non-investment grade), Fitch expects the amount of outstanding debt in the A&D sector will decline in 2008, barring any large, debt-funded acquisitions. M&A activity in the A&D sector could increase in 2008 because of lower valuations and less competition from private equity firms.
Fitch expects the size of most transactions will be less than several billion dollars.