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A&D Industry Credit Risks Seen Shifting to Defense

NEW YORK & LONDON --- As part of its recent European aerospace and defense investor seminars, Fitch Ratings discussed the improved outlook for parts of the commercial aerospace industry, the potential for increased M&A activity among European companies, the likely effect of the pressure on defense budgets in Europe, concerns about U.S. defense spending after fiscal 2011, the threat posed by new entrants in the large commercial aircraft (LCA) market to Airbus and Boeing, and the likely drivers of future rating actions. In general, the industry's main credit risks are likely to shift to defense from commercial in the next year.

The improved outlook for commercial aerospace since the start of 2010 is attributed to the strong rise in airline traffic, improved prospects for airline profitability for this year, alleviated concerns about aircraft finance and fewer cancellations and deferrals to date, particularly in the LCA market.

Backlogs at Airbus and Boeing remain high by historical levels. While Fitch anticipates LCA deliveries to be slightly lower in 2010 than in 2009, from 2011 onwards, percentage production increases of close to double digits are likely.

Other segments of the commercial aerospace sector, such as business and regional jets, have yet to show signs of recovery and may not do so until 2011. The aftermarket should improve in the second half.

In the LCA market, the duopoly that Airbus and Boeing have enjoyed is likely to be challenged in the next five to 10 years. The single aisle aircraft market will see a number of new competitors from Canada, China, and Russia that will challenge the Airbus A320 and Boeing 737 families of aircraft, but Fitch believes these new entrants are unlikely initially to pose a serious threat to the incumbents. This is because of the competitive advantages Airbus and Boeing have owing to their technological capabilities, existing comprehensive service and maintenance network and greater experience in aircraft program execution. Also, Airbus and Boeing will respond to the new competition with improved or new single aisle aircraft.

With overall defense budgets in Western Europe under pressure from the general high budget deficits of most countries, the companies most exposed to European defense spending may see their traditional revenue base shrinking in real terms. These companies may choose to pursue growth in many emerging markets, although export opportunities are becoming increasingly competitive and politicised as more and more developed markets-based defense companies chase a limited number of sizeable contracts in countries such as India and Brazil.

Fitch believes the potential for a pick-up in M&A in the coming 12 months is high, especially involving European companies, given the stabilization in commercial markets, significant cash piles at most companies and an increased appetite for inorganic growth owing to the stagnant home markets. Many European companies remain interested in defense acquisitions in the U.S. to gain access to that country's large defense budget and Fitch believes some acquisition activity involving European companies in the U.S. to be likely in the coming year.

Cash deployment strategies at large European A&D companies in the coming 12 months are likely to center on acquisition activities, with share buybacks or other forms of shareholder returns unlikely to feature prominently. U.S.-based players are likely to focus on share repurchases and pension contributions.

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Fitch: Global Aerospace and Defense Sector Credit Risks Likely to Shift from Commercial to Defense