Aerospace and Defense chapter. Global Gambits The Right Moves for Right Now. See jpmorgansavant.com for global sector valuation tools

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1 e 28, 20 Global Gambits The Right Moves for Right Now Aerospace and Defense chapter The following is a chapter from, dated e 28, 20. This chapter is presented for convenience, and should be read in conjunction with the full report and its analyst certifications and important disclosures. The full report is available on Morgankets.

2 e 28, 20 Aerospace and Defense Defense Slowing in 08; Commercial Orders are Likely Peaking Global Sector Coordinator Joseph B. Nadol III (1-212) J.P. Morgan Securities Inc. Full sector coverage details on page 6 Key Drivers US defense spending growth should slow over the next two years after six years of 10% average growth. President George Bush s FY07 Future Years Defense Plan calls for a 5% investment account CAGR through Supplemental spending has kept growth rates strong, but we expect outlay growth to slow from 10% in 20 to 6% in 2007 and 2% in Defense budgets outside the US provide a mixed picture. High oil prices are pushing Middle Eastern countries to reexamine defense requirements, although large orders have not yet started to flow. The outlook for orders from Asia is still fairly strong, but European governments outside the UK still have not shown a commitment to increase defense budgets. Deliveries of large commercial aircraft should grow to 965 by 2008 from 586 in 20. Demand from Asia and the Middle East and from low-cost carriers is driving the cyclical upturn. Risks to the cycle are a late-cycle global economy, struggling US network carriers, high oil prices, and the overhang of terrorism. We see 20 as a mid-cycle year, with single aisle output peaking in 2008, and widebodies in the 2009/10 time frame. Business jet cycle is roaring ahead with the corporate earnings cycle, while demand for regional jets has suffered. We expect business jet deliveries to grow by 18% in 20 and 17% in 2007 to nearly 1,000 units. A feature of this cycle that differentiates it from past cycles is the larger number of international deliveries, which are about 40% of the total for some manufacturers, up from less than 20% historically. While the 50-seat regional jet deliveries have dwindled to almost zero due to market saturation and high fuel costs, 70- to 110-seat jets are selling better and demand has picked up for turboprops. Our Non-Consensus Views Slowing US defense outlay growth should shift investor focus to margin performance. We believe slowing investment account outlay growth over the next two years should reward those companies with ways other than top-line growth to generate earnings growth. We favor defense stocks that can generate growth through margin expansion and with managements that can allocate capital well. Defense stocks are driven by funds flows as much as fundamentals. Defense stocks (as measured by an index of LMT, NOC, and RTN) have outpaced the S&P 500 since the beginning of ember by 21% through May. We believe this has been driven by an increasingly defensive posture by investors rather than a change in the defense industry outlook. We believe that stock performance over the rest of the year hinges more on the outlook for the stock market than anything else; if the broader market rebounds, we believe defense stocks could decline on an absolute basis, while they will likely continue to outperform if the recent pullback continues. We believe some commercial aerospace stocks are priced as if there will not be a cyclical downturn, while we see opportunities in others with higher long-term growth prospects. While the valuation variance among defense stocks is now low, it is rather high among commercial aerospace stocks. We see more opportunities among the commercial stocks to make relative calls within the group as explained below. Low-cost manufacturing and solutions should be important discriminators in the aerospace/defense markets. The lowcost revolution is finally reaching aerospace/defense, as very light jets, aircraft labor costs, aircraft spare parts, and even defense platforms are all affected. We see ERJ on the commercial aerospace side and LMT on the defense side as potential beneficiaries. 2

3 e 28, 20 Aerospace and Defense: Top Picks Company Key Financials Rationale and Catalysts Embraer Rating: Overweight Fiscal EPS (Local) Year-end. Embraer is a pre-eminent play on low-cost labor in the global aerospace industry, in our view. We believe the Ticker: ERJ US / ERJ 20 20E 2007E demand for seat aircraft, an expanded share of the corporate jet market, and ultimately an expansion into the larger aircraft market (likely as a supplier/partner) could enable the company to generate sustainable doubledigit average top-line growth. Exchange: NYSE P/E (Calendar) Price (Local): US$ E 2007E Mkt Cap (US$): 6.3 bn Analyst: Joseph B. Nadol III EV/EBITDA (Calendar) Phone: (1-212) E 2007E joseph.b.nadol@jpmorgan.com Northrop Grumman Rating: Overweight Fiscal EPS (Local) Year-end. Ticker: NOC US / NOC 20 20E 2007E Exchange: NYSE P/E (Calendar) Price (Local): US$ E 2007E Mkt Cap (US$): 21.7 bn Analyst: Joseph B. Nadol III EV/EBITDA (Calendar) Phone: (1-212) E 2007E joseph.b.nadol@jpmorgan.com Source: Company data, Bloomberg, JPMorgan estimates, JPMorgan SaVanT. Prices as of e 15, 20. The company s low-cost labor force provides it with a sustainable competitive advantage. We estimate that Embraer s labor costs are 20-25% of those of its major competitors in North America and Europe. We expect E-Jet orders to build in 20 and 2007 as North American carriers recover financially and continue to obtain scope clause relief from the bankruptcy process, two historical precursors of demand. Northwest has indicated that it plans to place an order, and we believe Embraer could be a likely candidate to receive the order. Embraer s increasing commitment to the business jet market should bear fruit from 2008 when Phenom s 100 deliveries commence. The Lineage 1000 (2008) and Phenom 300 (2009) will also boost share, and the company is working on at least two additional models to follow. Valuation is at a substantial discount to global peers on metrics including 2007E P/E and EV/EBITDA. NOC s operating margins are among the lowest in the industry, offering substantial potential for expansion. We expect its operating margins to expand 130 basis points from 20 to 2007 and should continue to expand thereafter through shipbuilding recovery, program maturity, and integration of past acquisitions. Management has returned cash to shareholders via growing dividends and the repurchase of shares. We believe NOC has more effectively reduced its share count through repurchase than most peers. The company has also avoided value-destroying acquisitions, and we believe it is likely to continue to do so. Shipbuilding provides a substantial profit growth opportunity due to margin upside potential and emerging budget growth. We estimate that Ship Systems will produce operating profits of US$700 million by 2010E, up from US$249 million in 20, including a hurricane-related charge, and US$3.78 in 20E. EPS contribution should grow from US$0.47 in 20 to US$1.38 in 2010E, which would provide a 4% annual boost to EPS growth. 3

4 e 28, 20 Aerospace and Defense: Top Picks (cont d) Company Key Financials Rationale and Catalysts United Technologies Rating: Overweight Fiscal EPS (Local) Year-end. Ticker: UTX US / UTX 20 20E 2007E Exchange: NYSE P/E (Calendar) Price (Local): US$ E 2007E Mkt Cap (US$): 61.5 bn Analyst: Joseph B. Nadol III EV/EBITDA (Calendar) Phone: (1-212) E 2007E joseph.b.nadol@jpmorgan.com Source: Company data, Bloomberg, JPMorgan estimates, JPMorgan SaVanT. Prices as of e 15, 20. UTX has a balanced mix of businesses that have performed well in a variety of economic and geopolitical situations. The sales mix is well balanced, in our view, between aerospace and building infrastructure businesses, as well as between domestic and international customers. This business diversification provides a natural hedge against a cyclical downturn in individual businesses. Management has successfully deployed capital over time, balancing acquisitions and the return of cash to shareholders. A strategic focus on service-related acquisitions has contributed to the consistency of earnings and high returns on capital. We believe the perception that P&W s business is decaying because of a loss of commercial OE share could change. While we dispute the premise, as P&W s commercial OE business is only about US$1 billion of UTX s US$46 billion of sales, we believe that a possible reopening of the A350 opportunity due to a pending program restructuring could favorably impact the stock s multiple. In the longer term, P&W is well positioned to take back share when Boeing and Airbus refresh their narrowbody offerings, likely in the next 2-3 years. 4

5 e 28, 20 Aerospace and Defense: Stocks to Underweight Company Key Financials Rationale and Catalysts Boeing Rating: Underweight Fiscal EPS (Local) Year-end. The outlook for IDS is not strong against the backdrop of slowing budget growth, and the C-17 is the most substantial Ticker: BA US / BA 20 20E 2007E near-term program run-off risk. Technical problems plaguing the JTRS program have reduced funding on FCS, and have necessitated the transfer of FIA work to LMT. Exchange: NYSE P/E (Calendar) Price (Local): US$ E 2007E Mkt Cap (US$): 67.8 bn Analyst: Joseph B. Nadol III EV/EBITDA (Calendar) Phone: (1-212) E 2007E joseph.b.nadol@jpmorgan.com L-3 Communications Rating: Underweight Fiscal EPS (Local) Year-end. Ticker: LLL US / LLL 20 20E 2007E Exchange: NYSE Price (Local): US$75.70 P/E (Calendar) Mkt Cap (US$): 9.2 bn 20E 2007E Analyst: Joseph B. Nadol III EV/EBITDA (Calendar) Phone: (1-212) E 2007E joseph.b.nadol@jpmorgan.com Source: Company data, Bloomberg, JPMorgan estimates, JPMorgan SaVanT. Prices as of e 15, 20. Conversely, the long-term competitive outlook for BCA seems to be improving, and the 787 continues to generate strong demand relative to the A350. However, we estimate a cyclical peak in 2008 and expect the market to begin discounting this more heavily. We believe Boeing is significantly overvalued, as we believe the market is valuing BA as a growth stock rather than a cyclical. This could be sustainable for some time, but we believe it will change when the peak of the cycle becomes visible, and we believe this will result in substantial multiple erosion. Using a sum-of-the-parts valuation, we estimate a value for the stock in the 50s if we assume an average long-term commercial operating margin of 9%, and in the 70s if we assume 12%, which the company has never reached in its modern history, even at peak (however, we note that this SOP valuation is a scenario and not an expected outcome). Management s long-term target of 10% organic growth appears to us to be unrealistic amid declining industry growth. Slowing outlay growth could impact L-3 more than other companies, as investors typically focus on internal growth more for L-3 than peers due to its aggressive acquisition strategy and growth-oriented shareholder base. While L-3 s 2007 growth could approach the 10% target, we do not believe the company can generate 10% organic growth in 2008 when investment account outlays are 0%. Contribution to growth from acquisitions should slow due to both a leveraged balance sheet and L-3 s enlarged revenue base. Increasing complexity of the business makes management difficult. L-3 makes everything from supplying tank engines and electro-optical sensors to modifying aircraft and training foreign militaries. It operates over 65 subsidiaries, making corporate oversight difficult. L-3 s valuation remains at premiums to defense company averages, particularly on an unleveraged basis. On a 2007E EV/EBITDA basis, L-3 s stock trades at a 16% premium to LMT, NOC, GD, and RTN. We expect the company s multiple to contract as growth slows. 5

6 e 28, 20 JPMorgan Global Aerospace and Defense Team Research Equity Research Credit Research Americas Americas Joseph B Nadol III Global Sector Coordinator Joseph B Nadol III Adam Epstein United States Khatija A. Ladhani (HG-Aerospace/Defense) Yilma Abebe (HY- Aerospace/Defense) EMEA EMEA Pan Europe Harry Breach Pan Europe Joseph B Nadol III Brian Chen (HY-Aerospace/Defense) Julien Dumas-Pilhou (HG/HY) Asia Pacific India Gautam Chhaochharia Singapore Winnifred Heap 6

7 e 28, 20 Companies Recommended in This Report (prices as of COB 16 e 20) Boeing (BA/$85.54/Underweight), Embraer SA (ERJ/$35.07/Overweight), L-3 Communications (LLL/$75.01/Underweight), Northrop Grumman (NOC/$63.01/Overweight), United Technologies (UTX/$61.75/Overweight) Analyst Certification: The research analyst who is primarily responsible for this research and whose name is listed first on the front cover certifies (or in a case where multiple research analysts are primarily responsible for this research, the research analyst named first in each group on the front cover or named within the document individually certifies, with respect to each security or issuer that the research analyst covered in this research) that: (1) all of the views expressed in this research accurately reflect his or her personal views about any and all of the subject securities or issuers; and (2) no part of any of the research analyst s compensation was, is, or will be directly or indirectly related to the specific recommendations or views expressed by the research analyst in this research. Important Disclosures Lead or Co-manager: JPMSI or its affiliates acted as lead or co-manager in a public offering of equity and/or debt securities for Boeing, Embraer SA, Northrop Grumman, United Technologies within the past 12 months. Director: A senior employee, executive officer or director of JPMSI or its affiliates is a director of Boeing. Client of the Firm: Boeing is or was in the past 12 months a client of JPMSI; during the past 12 months, JPMSI provided to the company investment banking services, non-investment banking securities-related service and non-securities-related services. Embraer SA is or was in the past 12 months a client of JPMSI; during the past 12 months, JPMSI provided to the company investment banking services, non-investment banking securities-related service and non-securities-related services. L-3 Communications is or was in the past 12 months a client of JPMSI. Northrop Grumman is or was in the past 12 months a client of JPMSI; during the past 12 months, JPMSI provided to the company investment banking services, non-investment banking securities-related service and non-securities-related services. United Technologies is or was in the past 12 months a client of JPMSI; during the past 12 months, JPMSI provided to the company investment banking services, non-investment banking securities-related service and non-securities-related services. Investment Banking (past 12 months): JPMSI or its affiliates received in the past 12 months compensation for investment banking services from Boeing, Embraer SA, Northrop Grumman, United Technologies. Investment Banking (next 3 months): JPMSI or its affiliates expect to receive, or intend to seek, compensation for investment banking services in the next three months from Boeing, Embraer SA, Northrop Grumman, United Technologies. Non-Investment Banking Compensation: JPMSI has received compensation in the past 12 months for products or services other than investment banking from Boeing, Embraer SA, Northrop Grumman, United Technologies. An affiliate of JPMSI has received compensation in the past 12 months for products or services other than investment banking from Boeing, Embraer SA, Northrop Grumman, United Technologies. 7

8 e 28, 20 Boeing (BA) Price Chart Price Source: Reuters and JPMorgan; price data adjusted for stock splits and dividends. This chart shows JPMorgan's continuing coverage of this stock; the current analyst may or may not have covered it over the entire period. As of Aug. 30, 2002, the firm discontinued price targets in all markets where they were used. They were reinstated at JPMSI as of May 19th, 20, for Focus List (FL) and selected Latin stocks. For non-jpmsi covered stocks, price targets are required for regional FL stocks and may be set for other stocks at analysts' discretion. JPMorgan ratings: OW = Overweight, N = Neutral, UW = Underweight. Embraer SA (ERJ) Price Chart Date Rating Share Price 18-- OW Price Target Price 30 OW OW $ Source: Reuters and JPMorgan; price data adjusted for stock splits and dividends. Initiated coverage 18, 20. This chart shows JPMorgan's continuing coverage of this stock; the current analyst may or may not have covered it over the entire period. As of Aug. 30, 2002, the firm discontinued price targets in all markets where they were used. They were reinstated at JPMSI as of May 19th, 20, for Focus List (FL) and selected Latin stocks. For non-jpmsi covered stocks, price targets are required for regional FL stocks and may be set for other stocks at analysts' discretion. JPMorgan ratings: OW = Overweight, N = Neutral, UW = Underweight. 8

9 e 28, 20 L-3 Communications (LLL) Price Chart Date Rating Share Price 07-Jul- UW Price Target 100 Price 80 UW Source: Reuters and JPMorgan; price data adjusted for stock splits and dividends. This chart shows JPMorgan's continuing coverage of this stock; the current analyst may or may not have covered it over the entire period. As of Aug. 30, 2002, the firm discontinued price targets in all markets where they were used. They were reinstated at JPMSI as of May 19th, 20, for Focus List (FL) and selected Latin stocks. For non-jpmsi covered stocks, price targets are required for regional FL stocks and may be set for other stocks at analysts' discretion. JPMorgan ratings: OW = Overweight, N = Neutral, UW = Underweight. Northrop Grumman (NOC) Price Chart Price OW $120 OW $60 Date Rating Share Price Price Target 29-- OW Source: Reuters and JPMorgan; price data adjusted for stock splits and dividends. This chart shows JPMorgan's continuing coverage of this stock; the current analyst may or may not have covered it over the entire period. As of Aug. 30, 2002, the firm discontinued price targets in all markets where they were used. They were reinstated at JPMSI as of May 19th, 20, for Focus List (FL) and selected Latin stocks. For non-jpmsi covered stocks, price targets are required for regional FL stocks and may be set for other stocks at analysts' discretion. JPMorgan ratings: OW = Overweight, N = Neutral, UW = Underweight. 9

10 e 28, 20 United Technologies (UTX) Price Chart 1 Date Rating Share Price Price Target N OW 22-- N OW Price Source: Reuters and JPMorgan; price data adjusted for stock splits and dividends. This chart shows JPMorgan's continuing coverage of this stock; the current analyst may or may not have covered it over the entire period. As of Aug. 30, 2002, the firm discontinued price targets in all markets where they were used. They were reinstated at JPMSI as of May 19th, 20, for Focus List (FL) and selected Latin stocks. For non-jpmsi covered stocks, price targets are required for regional FL stocks and may be set for other stocks at analysts' discretion. JPMorgan ratings: OW = Overweight, N = Neutral, UW = Underweight. Explanation of Equity Research Ratings and Analyst(s) Coverage Universe: JPMorgan uses the following rating system: Overweight [Over the next six to twelve months, we expect this stock will outperform the average total return of the stocks in the analyst s (or the analyst s team s) coverage universe.] Neutral [Over the next six to twelve months, we expect this stock will perform in line with the average total return of the stocks in the analyst s (or the analyst s team s) coverage universe.] Underweight [Over the next six to twelve months, we expect this stock will underperform the average total return of the stocks in the analyst s (or the analyst s team s) coverage universe.] The analyst or analyst s team s coverage universe is the sector and/or country shown on the cover of each publication. See below for the specific stocks in the certifying analyst(s) coverage universe. Coverage Universe: Michael F. Gambardella: AK Steel (AKS), Alcan Inc (AL), Alcoa (AA), Allegheny Technologies (ATI), Carpenter Technology (CRS), Century Aluminum Company (CENX), Commercial Metals (CMC), Dynamic Materials (BOOM), Falconbridge (FAL), Freeport-McMoran Copper & Gold (FCX), GrafTech International (GTI), Inco Ltd (N), Mittal Steel (MT), Novelis (NVL), Nucor (NUE), Phelps Dodge Corp. (PD), Ryerson Inc (RYI), Steel Dynamics (STLD), Teck Cominco Ltd. (TEKb.TO), U.S. Steel Corp (X), Worthington Industries (WOR) 10

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