Fitch: U.S. Budget Request Positive for Defense, Mixed for Commercial Aerospace
(Source: Fitch Ratings; issued Feb. 6, 2007)
NEW YORK --- The president's fiscal year (FY) 2008 budget request reinforces the strong defense spending environment seen in the past several years, but is mixed for the commercial aerospace segment, with large commercial aircraft benefiting at the expense of general aviation.

The core Department of Defense (DOD) FY2008 request (excluding war-related funding) is modestly higher than Fitch expected, both for the overall budget and modernization spending (procurement and RDT&E), the most relevant part of the budget for defense contractors rated by Fitch.

The supplemental budget requests used to fund the war on terror for both FY2007 and FY2008 include substantial modernization funds (approximately 25% of the total), also supporting the financial performance of defense contractors.

The Department of Transportation (DOT) budget request includes a reauthorization proposal for the FAA which would likely increase costs for business jets and general aviation aircraft.

Discretionary Department of Homeland Security spending (which with the DOD accounts for approximately three-quarters of homeland security spending) increases 6.1% in the budget request versus the prior year request to $37.7 billion, and NASA requested spending is up 3.1% from the prior year request to $17.3 billion. The president's budget request is subject to revision by Congress, but Fitch does not expect substantial revisions despite the change in control of Congress in the November elections.

The budget request is generally consistent with the expectations incorporated into Fitch's ratings, and the budget request alone is unlikely to drive changes in ratings or Rating Outlooks. Fitch bases its long-term credit view for the defense sector on the core DOD budget, excluding war-related spending. The supplemental budgets funding the war on terror are currently providing a boost to defense contractor financial performance, but Fitch does not expect this funding to continue in the long-term.

Excluding supplemental budgets, the core DOD FY2008 budget request is $481.4 billion, up 11.3% from the enacted FY2007 budget and 3.7% above the levels projected in last year's request. Nearly half of the overall increase goes to the Army and Marine Corps. Requested modernization spending is $176.8 billion, 13.0% higher than enacted last year, but 1.6% above the prior year's projected levels.

The growth in modernization is driven by procurement spending, which is up 25.1% to $101.7 billion from what was enacted in FY2007 (but only 2.0% above last year's projections). The growth is being aided by previously planned production of a new aircraft carrier and an amphibious transport dock ship, plus increases in production of the F-35 Joint Strike Fighter, F-22 Raptor, EA-18 Growler and the V-22 Osprey, among others.

The high levels of supplemental DOD budgets used to fund operations in the war on terror continue to support sector financial performance. A $141.7 billion supplemental request was submitted for FY2008, and $93.4 billion was requested to support operations in FY2007, adding to the $70 billion FY2007 supplemental enacted last year. With these two additional supplemental requests, $662 billion in supplemental budgets have gone to the DOD and the intelligence community after the events of Sept. 11, 2001.

A key consideration for defense contractor financial performance is the increasing amount of modernization spending included in the supplemental budget requests. Modernization spending accounts for approximately 25% of both of the new supplemental requests. Combining the amounts in the core and supplemental budgets, modernization spending is projected to rise 7.5% in FY2008, and modernization spending in FY2007 and FY2008 will total approximately $409 billion. Of this total, nearly one-fifth of the funds will come from the supplemental budgets, highlighting the impact the war on terror is having on defense spending levels.

The DOT budget request includes proposed changes in the financing structure of the FAA's air traffic control system. Funding would move from an excise tax system to a cost-based user fee system for commercial aircraft. General aviation aircraft, including business jets, would continue to pay fuel taxes, but the level of the fuel taxes would most likely be adjusted upward to better reflect the costs that these users impose on the air traffic control system, potentially shifting a substantial amount of funding burden to general aviation from the commercial airlines. In addition, there would be user fees for all types of aircraft in the nation's most congested airspace.

These changes would not take effect until 2009, but they are a concern for the general aviation segment. Mitigating the potential negative impact on the business jet segment is the strong order activity in the past two years and the increasing percentage of orders coming from outside North America. The proposed changes could be a positive for airline profitability, adding further to the likelihood that domestic airlines will begin to order to new aircraft in the next several years.

The president's budget request is the beginning of the budget process, and Congress may make revisions. Compared to the past several years, there is more concern about revisions given that the opposition party now controls the U.S. Congress. However, Fitch does not expect substantial revisions by Congress for several reasons.

First, the Democrats have a slim majority in both houses, and on a straight party vote they cannot 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 than old line Democrats and some are pro-Defense. Finally, with the 2008 elections just over the horizon, Fitch believes 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.

Fitch's rating definitions and the terms of use of such ratings are available on the agency's public site, Published ratings, criteria and methodologies are available from this site, at all times. (ends)

The 2008 Budget: A Peak, or a New Pattern?
(Source: The Lexington Institute; issued Feb. 7, 2007)
(© The Lexington Institute; reproduced by permission)
By Loren B. Thompson, Ph.D.

On Monday, the Bush Administration released details of its proposed military budget for 2008. According to Steven Kosiak of the Center for Strategic and Budgetary Assessments, it is the biggest military spending request since 1946 -- the last year of budgeting for World War Two.

You'd think that would warrant splashy coverage in the national media, but in fact all of the major papers -- the Times, the Post, the Journal -- consigned the story to the bottom of an inside page. Many of the key details about the budget were reported last week by Bloomberg Business News reporter Tony Capaccio, and the big papers seemed to treat the formal release of budget documents on Monday as a ho-hum affair. Page One was reserved for more important news, like the fact that it is cold outside.

Which raises an interesting question. Is higher defense spending now so wired into popular expectations that the biggest defense budget in two generations isn't news?

As Capaccio pointed out on February 3, the proposed defense budget would represent the tenth consecutive year of real increases in military outlays since a post-cold-war lull in spending. During most of the intervening period, commentators have argued that defense spending was surging temporarily -- in response to the Balkan war, the 9-11 attacks, the conflict in Iraq and so on.

But the Congressional Budget Office reports that in fiscal 2006 military outlays totaled $500 billion, which means the further increases expected in 2007 and 2008 will place defense spending well above its range for the past fifty years, even after removing the effects of inflation. Defense spending has tested the $500 billion limit (in constant 2007 dollars) three times previously since World War Two; each time it peaked and began a multi-year decline. This time could be different.

In the parlance of technical analysts on Wall Street, military spending may be breaking out of its characteristic "trading range" to establish a new pattern for the defense sector. There are plenty of reasons to think this could be true.

First, Democrats have abandoned their aversion to military spending, and look unlikely to significantly trim the President’s request. Second, all of the military services say they are short of funds for modernization despite the high level of spending. Third, costs associated with the all-volunteer force and a "long war" against global terrorism look unlikely to abate. And perhaps most importantly, the economy has grown vigorously during the Bush years to a point where all of the military's pressing needs can be met for about 4% of Gross Domestic Product.

On the other hand, there are also cogent reasons for believing that defense spending is approaching a top. The factors most frequently cited to support this thesis are the aging of baby boomers and the federal budget deficit, which lead some experts to project unsustainable tension in future years between tax receipts and rising entitlement costs.

Beyond that, the current up-cycle in defense spending was spurred mainly by 9-11 and the war in Iraq; the absence of follow-on attacks in America and waning public support for the Iraq campaign could undercut efforts to sustain defense spending at current rates (the Office of Management and Budget projected last year that defense would fall from 4% of GDP in 2006 to 3% in 2011).

Obviously, any repetition of the 9-11 attacks would bring another surge in defense spending. In the absence of such attacks, the key driver of spending levels will be the duration of the U.S. military commitment to Iraq.

Since President Bush shows no desire to withdraw and Democrats lack the legislative majorities necessary to compel retreat, it looks like defense spending will not decline for the remainder of the decade.


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