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The slowdown in global economic growth will test the North American A&D industry in 2009, particularly on the commercial side, but Fitch Ratings considers the industry to be well-positioned to weather the downturn from a credit perspective. Large backlogs, strong credit metrics and healthy liquidity support the industry's credit profile.
Commercial aerospace markets are mixed, with the business jet and aftermarket segments most at risk, but Fitch's downside scenarios assume production rates could be weak even in the large commercial aircraft (LCA) and regional aircraft markets in the second half of 2009.
Department of Defense (DOD) spending levels are high after nearly ten years of substantial growth, but Fitch believes the spending upcycle has ended and, going forward, there will be modest core budget growth and gradually declining supplemental spending. Any impact from the 2008 elections will likely be delayed due to the timing of the budget process and other federal priorities such as the economy.
Fitch has rated the sector conservatively during the upturn over the past several years, taking into account the sector's cyclicality, and many of the companies possess very strong credit metrics for their current ratings. For example, Fitch estimates that most companies could withstand temporary EBITDA declines of 25% and still have credit metrics in line with the current ratings, assuming flat debt levels.
Liquidity and Cash Deployment
Most of the large A&D companies rated at Fitch have strong liquidity positions and financial flexibility, both of which will help the industry stand up to the weaker global economy in 2009. At the end of the third quarter, the top 15 North American A&D companies rated by Fitch had cash and equivalents totaling $27.5 billion, and another important player in the global industry, Europe-based EADS (BBB+, Outlook Stable), had cash and investments of Euro 12.9 billion.
Short-term debt and debt maturities for the top 15 North American companies totaled approximately $9 billion at the end of the third quarter, and total debt outstanding was about $55 billion. Most of the companies have committed, long-term credit lines, with only General Dynamics, L-3 and Raytheon having credit lines expiring in the next 18 months.
Given the difficult conditions in the credit markets, Fitch expects A&D companies to follow conservative cash deployment strategies in 2009 in order to build liquidity. Share repurchases, which totaled approximately $14 billion in the U.S. A&D industry in the first nine months of 2008, should decline, and Fitch expects constrained M&A activity beyond bolt-on acquisitions. Fitch expects debt levels to stay flat in the industry, although there is a large backlog of long-term debt issuance building up that will be used primarily to term out short-term debt. If the economy continues to weaken, restructuring actions may become a noticeable use of cash in 2009.
Pension contributions will also increase in 2009 because of the decline in financial markets in 2008, partially offset by higher discount rates. The pension situation in the defense sector is mitigated by the deferred implementation of certain elements of the Pension Protection Act of 2006 for some defense contractors and by the ability of defense contractors to include pension costs as allowable costs in defense contracts.
With industry conditions weakening, Fitch will increase its surveillance in 2009 of off-balance sheet (OBS) obligations. In addition to the pension situation mentioned above, these OBS items include backstop financing commitments, financial subsidiary support agreements, residual value guarantees, trade-in obligations and legal disputes.
Aircraft finance remains a concern in light of the uncertain credit markets. Fitch calculates that financing required for 2009 deliveries of LCA and regional aircraft could total $65 to 70 billion. Fitch estimates that financing is firm through the first six to nine months of 2009, and will likely be firm through the end of 2009 if there is no worsening in the credit markets. The main risk is additional losses in the financial sector, leading to reduced credit availability in the second half, which could be a catalyst for additional delivery deferrals in late 2009 and 2010.
The outlook at commercial banks is very unclear at this time in Fitch's opinion, and the uncertainty at some large aircraft lessors adds risk. Furthermore, the tightening of credit terms adds risks to the financing situation. A final modest concern is the amount of existing airline debt that is maturing in 2009 and 2010, which Fitch estimates is approximately $10 billion over the two years in the U.S. alone.
Fitch expects manufacturers to increase customer financing in 2009 and 2010. Fitch estimates that Boeing and EADS have the financial strength to finance up to 10% of their deliveries over an 18 month period without affecting credit ratings, although other factors could combine with increased customer financing to cause a review of Rating Outlooks or ratings. Fitch will also focus on the terms of the loans in assessing the impact on Boeing's and EADS' credit quality. Fitch also believes the three large engine manufacturers have the ability to extend additional customer financing. Export credit agencies (ECA) will also increase their aircraft finance activity in 2009. Other mitigants to the aircraft financing risks are the small size of the market in relation to the global credit markets, and the relative attractiveness of new aircraft as collateral.
Fitch's near-term outlook is mixed in the commercial aerospace industry because of the deteriorating economic environment and concerns about financing. The aftermarket is likely already declining, business jets are most at risk of delivery reductions, and the LCA and regional segments are the most difficult to forecast, with pressure on production rates possible in the second half of 2009. Longer-term, Fitch considers the commercial outlook solid because of large backlogs and the need to build out aerospace infrastructure in developing regions. Key risks for the sector include the global economy, aircraft finance, exogenous shocks (terrorism, disease pandemic, etc.) and execution on new programs. A general risk is that production rates have not been revised downward materially despite the weakening economy and several segments are at or near historical delivery peaks.
Fitch has developed both base cases and downside cases for the A&D industry in 2009, with the downside cases used to provide a test of the sector's ratings. The following expectations for some key commercial segments are incorporated into Fitch's credit ratings:
- Large Commercial Aircraft (LCA): Fitch's base case for LCA deliveries from Boeing and Airbus in 2009 is based on the manufacturers' current production rate plans, which would suggest 980-990 deliveries, up slightly from 2008 rates adjusted for the Boeing machinists strike. Fitch's downside case is for production rate cuts of 10% from the base case in the second half of 2009 and continuing into 2010, or 935 deliveries in 2009 and 885 in 2010. Fitch's downside case assumes air traffic continues to weaken and aircraft finance becomes more difficult. If the downside case were to materialize, Fitch expects it would be short-lived because the large backlog would drive production increases once the global economy recovers. The key variables in the LCA market for 2009 are aircraft finance (discussed above) and the backlogs as BA and Airbus. The LCA backlog at the end of November reached nearly 7,500 aircraft, or more than 7.5 years of production at current rates. Excluding aircraft models not yet being delivered (787, A350, etc.) the backlogs covered about 6 years of production. While delivery deferrals have picked up and will probably continue to rise in 2009, Fitch assumes BA and Airbus still have some overbooking for the 2009 order book, providing some cushion before production rates would be reduced. The international nature of the backlog (about 85% outside North America) provides some comfort compared to the last downturn, when BA's backlog, for example, was more than 50% exposed to U.S. airlines. 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.
- The business jet market has been very strong for several years, and it is delivering record numbers of jets. The strength continued in the first nine months of 2008, with deliveries up 30%. However, there are signs that the market is slowing with the economy, and Fitch considers this segment to be the most at risk in commercial aerospace in 2009. Signs of weakness include lower utilization and higher inventories of used aircraft. Manufacturers have begun to respond, with Cessna, Embraer, General Dynamics, and Hawker announcing production adjustments for smaller jets. Despite these adjustments, the industry is still planning to deliver more jets in 2009, up in the low to mid single digits to about 1,300 aircraft, which is Fitch's base case for the sector. Fitch considers the downside case of 10-15% production cuts in the second half and into 2010 as equally likely as the base case. Fitch considers this segment at risk due to the discretionary nature of the product, the availability of numerous substitute forms of travel, relationship to corporate profits, and a relatively high exposure to North America, despite the significant increase in international orders over the past few years.
- Aftermarket/Services: This segment should be the first to weaken given that it is driven primarily by air traffic, which has turned negative. Fitch's base case is for a decline of 1-2% in 2009, and the downside case is down 2-4%. This high-margin segment still has a favorable long-term outlook given the aging of the regional jet and Airbus fleets, long-term global air traffic growth, the growth of low cost carriers and outsourcing by airlines and governments.
- The regional aircraft market outlook is similar to the LCA outlook, although this segment has a smaller backlog. Fitch's base case for 2009 is for deliveries to be flat to modestly down from the approximately 400 aircraft in 2008, more than half of which should be regional jets (RJ) from Bombardier and Embraer, and the rest turboprops from Bombardier and ATR. Fitch's downside case is for a 10% cut in production in the second half of 2009 continuing into 2010. New entrants continue to be a development to watch in this segment, with continued development of the Sukhoi Superjet 100, the Mitsubishi MRJ and China's ARJ-21.
The U.S. defense sector has a solid credit outlook due to the high spending levels and the strong credit profiles of the industry's main players, but there is some uncertainty because of the political changes in Washington and increased government spending related to the credit crisis. DOD spending levels are high after nearly ten years of substantial growth, but Fitch believes the spending upcycle has ended and going forward there will be modest core budget growth and gradually declining supplemental spending. Although Fitch does not expect declining core budgets, most of the leading DOD contractors could maintain their current ratings in the case of declining revenues, an indication of the sector's credit strength. Any impact from the 2008 elections will likely be delayed due to the timing of the budget process and other federal priorities such as the economy. Because of the timing and complexity of the DOD budget, the new President will not have a full impact on the budget process until the FY11 budget, although there could be a modest impact on the FY2010 budget which will be considered in calendar 2009. The FY09 budget was already enacted.
Fitch breaks down its analysis of defense spending into two parts: core budgets and supplemental budgets (used for the War on Terror). Modernization spending (procurement and RDT&E) is the most relevant part of the core budget for defense contractors. Fitch expects core modernization spending to be flat to up in the low single digits for the next several years. Inflation-adjusted spending could be negative. Despite the possibility of trillion dollar deficits, Fitch believes large cuts to the core budget are unlikely for several reasons: a high threat environment, the expense of cutting large programs in some cases (termination fees, etc.), and the impact on defense employment in an economic downturn. The DOD is more likely to see programs reduced in size or capability or pushed out rather than completely eliminated. Procurement reform is likely whatever happens to spending.
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 likely rise. 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.
Credit concerns for the defense sector include acquisition reform, program risks within the budget, program execution, and shareholder focused cash deployment.
Impact of the Economic Downturn
Fitch's A&D outlook is based on the firm's global GDP forecast of 0.9% growth in 2009, with GDP contractions in the euro zone, the United Kingdom, and the United States. Growth in the BRIC countries should slow, but will still likely grow at approximately 5.7%.
A&D market indicators show that the global economic environment has started to have an impact on the industry, although the impact has not yet been severe and strong backlogs could limit its depth. International passenger traffic as measured by the International Air Transport Association (IATA) turned negative in September and October, and cargo traffic has fallen for five consecutive months. LCA order deferrals and cancellations (127 aircraft) have increased through November, although net orders (1,396 aircraft) remain strongly positive for the year and backlogs have continued to rise. There have been numerous airline bankruptcies in 2008, but all of them have been small carriers. Airline profits have been pressured so far in 2008, but the recent plunge in oil prices could offset much of the negative impact from falling traffic. Finally, some business jet production forecasts for smaller jets, which Fitch considers to be a leading indicator of other commercial segments, have started to be adjusted downward.
Fitch considers the U.S. A&D industry to be in a stronger condition entering the current downturn that it was at the start of the last downturn in 2001. The industry is larger, more liquid, supported by larger backlogs, and more geographically diverse. International markets continue to support the industry's credit quality, but the benefits have been lessened by increasingly slow economies outside the U.S. One other important difference between the current and prior downturns is that the commercial weakness will not be offset by substantial defense spending growth.