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Aerospace and Defense Defense Slowing in 2007; Commercial Orders Are Likely Peaking Global Sector Coordinator Joseph B Nadol III (1-212) 622-6548 joseph.b.nadol@@jpmorgan.com J.P. Morgan Securities Inc. Full sector coverage details on page 118 Key Drivers US defense spending growth is slowing. President Bush s 2006 Future Years Defense Plan calls for a 4% investment account CAGR through 2011. However, this excludes supplemental runoff and cuts recently reported in the media that could amount to US$35+ billion. We expect outlay growth to slow from 8% in 2005 to 0% in 2007. Defense budgets outside the US provide a mixed picture. Despite some large recent contracts, European governments outside the UK still have not shown a commitment to increase defense budgets. However, the outlook for orders from Asia is still strong, and the high price of oil is helping Middle Eastern customers. Orders can be volatile, as illustrated by Pakistan s cancellation of an F-16 order due to the earthquake. Deliveries of large commercial aircraft should continue to grow, reaching 910 by 2007 from 586 in 2003. Demand from Asia and the Middle East and from low cost carriers is driving recovery. Sizeable risks remain, including struggling US network carriers, high oil prices, and the overhang of terrorism. We see 2006 as a mid-cycle year, with single aisle output peaking in 2008, and widebodies in the 2009-10 timeframe. Supplier constraints are beginning to emerge in commercial aerospace. Aerospace grade metals, including aluminum and titanium, seem to be in tight supply. We believe these constraints may pose a risk to the increasing delivery schedule projected through 2008. Our Non-Consensus Views Slowing US defense outlay growth should shift the focus to margin performance. We believe that slowing investment account outlay growth over the next two years will benefit those companies with 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. Premium electronics/it valuations based on sustained growth appear unwarranted. As we believe defense growth will slow to near zero in 2007, we do not believe many defense electronics/it companies will sustain the double-digit top-line growth that their managements and investors are targeting. This could result in substantial multiple compression. We are mainly constructive on the long-term defense outlook despite near-term pressures. We see four key drivers to future growth: geopolitical threat, federal budget, replacement, and technology. We believe US defense spending will continue to grow in the long term due to the global environment and a strong replacement cycle, but investment accounts could see near-term pressure from operational costs and increasing non-discretionary costs. Low-cost manufacturing and solutions should be important discriminators in aerospace/defense markets. The low-cost 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. 115
Aerospace and Defense: Top Picks Company Key Financials Rationale and Catalysts Embraer SA Recommendation: Overweight Fiscal EPS (Local): Year-end December Ticker: ERJ US/ ERJ.N 2004 2005E 2006E 2.17 2.59 2.50 Price (Local): US$36.61 2005E 2006E Mkt Cap (US$): 4.3 bn 14.1 14.7 We believe Embraer could have the most significant upside potential in our universe due to its 170/190 product family, its long-term low-cost labor advantage, and an attractive valuation. We forecast a robust 2006 for new orders, especially for the 170/190 family. New orders remain a key potential driver for the stock. While Boeing and Airbus have generated strong demand for their products in Asia and the Middle East, Embraer s products are targeted more at the North American and European markets, which remain depressed. When airline finances in these regions improve, we expect order volume to pick up. We believe that Embraer s VLJ and LJ platforms will be successful due to its significant cost advantage. Valuation is a substantial discount to Boeing and EADS on many metrics, including 2006E P/E and EV/EBITDA. Email: joseph.b.nadol@jpmorgan.com 9.4 9.2 Northrop Grumman Recommendation: Overweight Fiscal EPS (Local): Year-end December Northrop s operating margins are among the lowest in the industry, offering substantial potential for expansion. We Ticker: NOC US/ NOC.N 2004 2005E 2006E expect operating margins to expand 90bps from 2005 to 2006 and to continue expanding thereafter through program Ticker ADR: 2.96 3.70 4.35 maturity and integration of past acquisitions. Northrop has evolved from being a major acquirer to a cash generator, and is now more shareholder-friendly. Price (Local): US$56.91 2005E 2006E Mkt Cap (US$): 20.6 bn 15.4 13.1 Email: joseph.b.nadol@jpmorgan.com 8.4 7.2 United Technologies Corp. Recommendation: Overweight Fiscal EPS (Local): Year-end December Ticker: UTX US/ UTX. N 2004 2005E 2006E Ticker ADR: 2.65 3.10 3.50 Price (Local): US$54.37 2005E 2006E Mkt Cap (US$): 55.4 bn 17.5 15.5 Email: joseph.b.nadol@jpmorgan.com 9.3 8.6 Source: Company data, Datastream, JPMorgan estimates, JPMorgan SaVanT. Prices as of November 22, 2005. Share repurchases are accelerating. The company recently authorized US$1.5 billion of share repurchases after completing its prior authorization. The company s ship business continues to pose several risks, including the fixed price CVN-77 contract and uncertainty surrounding DD(X). However, we believe we are at or near the trough for the SCN budget, ship margins, and investor sentiment for the sector. 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 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 consistency of earnings and high returns on capital. Continued operational improvements have boosted margins and returns. Restructuring actions over the past five years have contributed more than 200bps of margin expansion. We believe there is room for improvement, particularly in several acquired companies with low margins. We believe that UTX will generate long-term revenue and earnings growth in excess of the aerospace/defense industry average, which warrants a premium to the industry valuation, in our view. 116
Aerospace and Defense: Stocks to Underweight Company Key Financials Rationale and Catalysts Boeing Recommendation: Underweight Fiscal EPS (Local): Year-end December The outlook for IDS is not strong, with the backdrop of slowing budget growth potentially impacting the C-17 in Ticker: BA US/ BA. N 2004 2005E 2006E particular, and technical problems on net-centric programs. JTRS execution problems may reduce the scope of 2.30 3.05 3.80 Boeing s work on the contract, and FCS is coming under increased scrutiny. Price (Local): US$69.10 2005E 2006E Mkt Cap (US$): 53.1 bn 22.6 20.9 Email: joseph.b.nadol@jpmorgan.com 14.0 9.2 L-3 Communications Recommendation: Underweight Fiscal EPS (Local): Year-end December Ticker: LLL US/ LLL.N 2004 2005E 2006E 3.33 4.15 4.70 Price (Local): US$74.50 2005E 2006E Mkt Cap (US$): 8.9 bn 18.0 15.8 Email: joseph.b.nadol@jpmorgan.com 10.5 9.8 Rockwell Collins Recommendation: Underweight Fiscal EPS (Local): Year-end September Ticker: COL US / COL.N 2004 2005 2006E 1.67 2.20 2.55 Price (Local): US$45.4 2005E 2006E Mkt Cap (US$): 7.8 bn 20.2 17.4 Email: joseph.b.nadol@jpmorgan.com 11.9 10.1 Source: Company data, Datastream, JPMorgan estimates, JPMorgan SaVanT. Prices as of November 22, 2005. Conversely, the long-term competitive outlook for BCA is improving, and the 787 continues to generate strong demand relative to the A350. However, we forecast a cyclical peak in 2008 and expect the market to begin discounting this more heavily. We believe Boeing is significantly overvalued. Boeing should generate about 60% of earnings from defense and 40% from commercial aircraft in 2006. Since defense comps trade at 13-14x earnings, and we believe that next year is midcycle for commercial aircraft, we estimate that Boeing s current multiple of 20.9x 2006E EPS is at a substantial premium to fair value. Management s long-term target of 10% organic growth appears unrealistic amid declining industry growth, in our view. 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 2006 growth could approach the 10% target, we do not believe L-3 can generate 10% organic growth in 2007, when we estimate investment account outlays are 0%. The contribution to growth from acquisitions should slow due to both a leveraged balance sheet and L-3's enlarged revenue base. L-3 lowered its acquisition growth target from 10-12% to 6-8% at its 3Q05 investor conference. Increasing complexity of business makes management more difficult. L-3 Communications makes everything from supplying tank engines and electro-optical sensors to modifying aircraft and training foreign militaries. It operates over 65 subsidiaries, making corporate supervision difficult. L-3 s valuation remains at premiums to defense company averages. On a 2006E P/E basis, LLL trades at a 12% premium to the average of LMT, NOC, GD, and RTN. We expect the company s multiple to contract as growth slows. We expect Collins defense revenue growth to slow to 4.5% in 2007 from 18% in 2005 and 15% in 2006 as industry growth trends toward zero. Collins generates industry-leading defense margins of 18%, which could come under pressure should its 55% revenue contribution from commercial-type contracts decline due to increased Congressional scrutiny of alternative contract structures. Rockwell Collins has considerable exposure to Boeing and Bombardier at the expense of Airbus and Embraer, while we believe the latter two will take market share over the next two years. Collins valuation remains rich relative to our universe. Collins currently trades at 17.4x calendar 2006E EPS. It also trades at by far the highest EV/sales multiple in our coverage universe (1.94x, an 83% premium to the average). 117
JPMorgan Global Aerospace and Defense Research Equity Research Credit Research Americas Americas Joseph B Nadol III Global Sector Coordinator Joseph B. Nadol III Neal Rosenberg Adam Epstein United States EMEA EMEA Pan Europe Joseph B. Nadol III Pan Europe Neal Rosenberg Adam Epstein Harry Breach See page 193 for team member contact details. Khatija A. Ladhani (HG-Aerospace/Defense) Akasha Redrick (HY- Aerospace/Defense) Julien Dumas-Pilhou (HG/HY) 118
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