CORPORATE INDUSTRY CREDIT RESEARCH December 9, 215 Industry Top Trends 216 Aerospace & Defense Credit Analysts Christopher DeNicolo Washington, D.C. +1 22 383 2398 christopher.denicolo@ standardandpoors.com Lucy Huynh London +44 2 7176 7631 lucy.huynh @ standardandpoors.com Chris Mooney New York +1 212 438 1449 chris.mooney@ standardandpoors.com STRONG COMMERCIAL AEROSPACE MARKET AND IMPROVING DEFENSE DEMAND LEAD TO STABLE CREDIT QUALITY Ratings Outlook. Rating trends across aerospace and defense remain mostly stable supported by stabilizing defense spending in the U.S. and Europe and somewhat weaker (but still solid) demand for most commercial aerospace suppliers. Forecasts. Credit ratios are likely to deteriorate modestly in 216 as the large U.S. defense contractors use excess cash to reward shareholders. Revenue growth will be modest (less than 5%) and margins flat to improving slightly. Assumptions. Commercial aircraft orders are likely to be lower in 216 and production increases at Boeing and Airbus will slow. Defense spending in the U.S. is expected to grow modestly after being flat the past few years. European defense budgets are likely to be mostly flat to rising modestly. Risks. For commercial aerospace the largest risk is supply chain disruption, but also the uneven global economy, low oil prices, and strong U.S. dollar. For U.S. defense, the largest risks are financial policy and the upcoming U.S. elections. For European defense firms it s weak domestic spending. Industry Trends. The commercial aerospace market is softening somewhat but is still relatively strong. Defense demand has now flattened out in the U.S. and Europe and could start to see modest increases in 216, especially in light of the recent ISIS-related terrorist attacks. Under Standard & Poor's policies, only a Rating Committee can determine a Credit Rating Action (including a Credit Rating change, affirmation or withdrawal, Rating Outlook change, or CreditWatch action). This commentary and its subject matter have not been the subject of Rating Committee action and should not be interpreted as a change to, or affirmation of, a Credit Rating or Rating Outlook. 1 STANDARD & POOR'S RATINGS SERVICES
Industry Top Trends 216: Aerospace & Defense December 9, 215 RATINGS TRENDS AND OUTLOOK GLOBAL AEROSPACE & DEFENSE RATINGS DISTRIBUTION AND OUTLOOK CHART 1 RATINGS DISTRIBUTION CHART 2 RATINGS DISTRIBUTION BY REGION 15 1 5 Aerospace & Defense AAA AA+ AA AA- A+ A A- BBB+ BBB BBB- BB+ BB BB- B+ B B- CCC+ CCC CCC- CC C SD D 14 12 1 8 6 4 2 North America W.Europe Asia-Pacific Latin America AAA AA+ AA AA- A+ A A- BBB+ BBB BBB- BB+ BB BB- B+ B B- CCC+ CCC CCC- CC C SD D CHART 3 RATINGS OUTLOOKS WatchPos 3% Positive 4% Negative 11% WatchNeg 3% CHART 4 RATINGS OUTLOOK BY REGION Negative WatchNeg Stable WatchPos Positive 1% 8% 6% 4% Stable 79% 2% % N.America W.Eur CHART 5 RATINGS OUTLOOK NET BIAS Net Outlook Aerospace & Defense Bias (%) -2-4 -6-8 -1-12 -14 13 14 15 CHART 6 RATINGS NET OUTLOOK BIAS BY REGION Net Outlook Bias (%) 2 1-1 -2-3 -4 N.America 13 14 15 W.Europe Source: S&P Ratings With almost 8% of outlooks stable we do not expect many rating changes in the next 12 months. However, for non-stable ratings there is a pronounced negative bias so any rating changes would likely be downgrades. Most of the negative outlooks reflect financial policy decisions, largely acquisitions, and are not a result of industry conditions. 2 STANDARD & POOR'S RATINGS SERVICES
Industry Top Trends 216: Aerospace & Defense December 9, 215 FORECASTS KEY INDUSTRY FORECASTS CHART 7 REVENUE GROWTH (ADJUSTED) CHART 8 EBITDA MARGIN (ADJUSTED) 1% N.America W.Europe Global Forecast 16% N.America W.Europe Global Forecast 5% 14% 12% % -5% 1% 8% 6% -1% 4% 2% -15% 212 213 214 215 216 217 % 212 213 214 215 216 217 CHART 9 DEBT / EBITDA (MEDIAN, ADJUSTED) CHART 1 FFO / DEBT (MEDIAN, ADJUSTED) 5.x 4.5x 4.x 3.5x 3.x 2.5x 2.x 1.5x 1.x.5x.x N.America W.Europe Global Forecast 212 213 214 215 216 217 3% 25% 2% 15% 1% 5% % N.America W.Europe Global Forecast 212 213 214 215 216 217 Source: S&P Ratings. All figures are converted into U.S. Dollars using historic exchange rates. Forecasts are converted at the last financial year end spot rate. 3 STANDARD & POOR'S RATINGS SERVICES
Industry Top Trends 216: Aerospace & Defense December 9, 215 ASSUMPTIONS KEY INDUSTRY ASSUMPTIONS COMMERCIAL AEROSPACE 1 Orders Declining 2 Revenue Growing As Production Increases 3 Margins And Cash Flow Improvements Orders for large commercial aircraft are likely to decline from record levels in 212-214 as most near-term demand is already in backlog and the wait for popular aircraft models stretches 7-8 years. In addition, there is a dearth of new models to boost sales. The impact of the uneven global economy, low oil prices, strong U.S. dollar, and other macro factors may start hitting new orders, although air traffic growth remains strong. U.S. DEFENSE Most suppliers are likely to see higher revenue growth in their commercial business as Boeing and Airbus continue to increase production, albeit at a slower pace than in recent years. Revenues related to business and regional jets are likely to decline as these markets remain weak overall. As production increases slow and most of the new aircraft introduced in the past few years are now in production, margins and cash flow should start improving for most suppliers. However, some firms are still having trouble profitably increasing production. 1 U.S. Revenue Growth To Resume 2 Margins Moderating 3 Shareholder Returns Increasing For Large Firms The recent two-year budget agreement provides for about a 7% increase in base defense spending in fiscal 216 and a more modest increase in 217. Although though there is a lag between when money is appropriated and when it gets spent and previous cuts are still working through the procurement system, we still expect most defense contractors to return to revenue growth in 216. EUROPEAN DEFENSE The U.S. government continues to look for the best technology at the most affordable price, especially considering the huge federal budget deficit. Therefore, we expect pricing pressure in the industry to persist. Most companies have rationalized their cost structure to bid more competitively though much of the savings are passed on to the customer, thus limiting margin improvement. Most large U.S. defense contractors are still generating solid cash flow and have sizable cash balances. This has led many of these contractors to increase their share repurchases and dividends. We do not believe this trend will lead to a general decline in credit quality for these companies unless the shareholder rewards exceed their cash flow--which would materially reduce their cash balances or increase debt--or if they increase acquisition activity without reducing share repurchases, like Lockheed Martin. 1 Stabilizing Demand 2 Continued Restructuring 3 Strong Liquidity Although European defense budgets remain strained, overall defense procurement spending is showing some signs of stability following years of cuts. European governments are facing the challenge of balancing fiscal pressures while closing the gap in their defense spending to meet NATO's defense spending target of 2% of GDP as the geopolitical tensions in their surrounding regions have increased. Their need to maintain, modernize, and expand their military capabilities and forces should continue to support the European defense contractors that we rate over the medium term. We expect European defense contractors to maintain their focus on operating efficiency improvements to manage profitability while demand is subdued. Operating margins across the sector are expected to remain either stable or show slight improvements, benefiting from restructuring as well as the divestment of underperforming segments. We expect the sector s liquidity to remain strong, supported by significant customer advances and low capital expenditure requirements. 4 STANDARD & POOR'S RATINGS SERVICES
Industry Top Trends 216: Aerospace & Defense December 9, 215 RISKS AND OPPORTUNITIES KEY INDUSTRY RISKS AND OPPORTUNITIES COMMERCIAL AEROSPACE 1 Supply Chain Risks 2 Macro Impacts 3 Delivering On A Huge Backlog Although production rate increases have slowed, the supply chain has barely kept up. Aircraft like the 737 and A32 are already at record production rates and the original equipment manufacturers (OEMs) have plans to increase rates even further in the next few years, putting further strain on the system. U.S. DEFENSE Low oil prices are having a mixed impact on the industry as they have increased airline profitability, which makes it easier for airlines to pay for the aircraft they have on order, but at the same time may make some airlines hold onto older, less fuel-efficient aircraft longer, especially if they think low prices will persist. Global air traffic growth has remained strong despite slowing economic growth in some parts of the world, but aircraft orders could suffer if economic growth weakens further. The strong U.S. currency may also hamper aircraft sales as all aircraft are priced in U.S. dollars. Both Boeing and Airbus have huge order backlogs, with some models stretching out 7-8 years. This represents a large amount of potential earnings and cash flow if the OEMs and their suppliers are able to increase production efficiently. 1 International Sales 2 216 Elections 3 Mergers And Acquisitions Many U.S. allies are increasing defense spending, particularly in the Middle East, which has somewhat offset lower U.S. spending in recent years. Low oil prices may affect some sales to the Middle East if they persist for an extended period. International sales typically carry higher margins but tend to be more difficult to predict, and defense budgets around the world are much smaller than that of the U.S. EUROPEAN DEFENSE The Democratic front-runner, Hilary Clinton, is more pro-defense spending than Bernie Sanders (and many Tea Party Republicans, for that matter). On the Republican side, there is a sharp divide between traditional defense hawks and those who want to reduce all government spending, including defense. The recent ISIS attacks in Paris and other geopolitical crises around the world could make defense spending a bigger issue in the election and limit calls for further cuts. The pace of M&A has accelerated in 215 and we believe it could continue to accelerate in 216. There is significant consolidation underway in the government services space due to less available work and intense price competition that favors greater scale, and we expect that to continue. We expect larger prime contractors to buy small- to mid-size companies to acquire new technologies or gain access to certain markets. However, we do not expect any of the large primes to merge because the government has expressed concerns about competition in the industrial base. 1 Supportive Export Markets 2 Increasing Geopolitical Tensions 3 Cyber Security While the economies of key export markets beyond the U.S. are now also experiencing similar budgetary challenges, we continue to expect that geographically diverse defense contractors will benefit overall. Accessible export markets remain particularly important for European defense contractors as they seek to counterbalance the flat or reduced defense spending in most European countries. While low oil prices are pressuring the budgets of many countries in the Middle East, a key export market for European defense contractors, defense spending remains a priority in light of the ongoing threats to the region's security. Although the timing of orders may be an issue over the near term, we expect that the overall level will remain solid. The profitable and growing commercial cybersecurity market has been identified as an attractive opportunity by European defense contractors, as evidenced by recent M&A activity focused on the segment. We expect this trend to continue, particularly in light of increasing regulatory requirements for organizations to protect against data and information leaks. 5 STANDARD & POOR'S RATINGS SERVICES
Industry Top Trends 216: Aerospace & Defense December 9, 215 INDUSTRY DEVELOPMENTS COMMERCIAL AIRCRAFT ORDERS SLOWING, BUT PRODUCTION STILL INCREASING CHART 11 LARGE COMMERCIAL AIRCRAFT ORDERS CHART 12 LARGE COMMERCIAL AIRCRAFT DELIVERIES Gross Orders 35 3 25 2 15 1 5 Boeing Airbus *Thru 11/1/15 for Boeing, 1/31/15 for Airbus 2 4 6 8 1 12 YTD* 14 12 1 8 6 4 2 Boeing Airbus 2 4 6 8 1 12 14 Source: Boeing, Airbus via manufacturers websites US DEFENSE BUDGETS RESUMING GROWTH CHART 13 U.S. DEFENSE SPENDING 21-216 CHART 14 U.S. SUPPLEMENTAL WAR FUNDING Billions $6 $5 $4 $3 $2 $1 $- 1 Base 3 *Agreed to in recent budget deal but still to be approved by Congress 5 7 9 11 13 16* 17* Billions $2 $18 $16 $14 $12 $1 $8 $6 $4 $2 $- Supplemental War Funding 1 3 5 7 9 *Agreed to in recent budget deal but still to be approved by Congress 11 13 16* 17* Source: U.S. Department of Defense 6 STANDARD & POOR'S RATINGS SERVICES
Industry Top Trends 216: Aerospace & Defense December 9, 215 FINANCIAL POLICY GLOBAL AEROSPACE & DEFENSE: CASH, DEBT AND RETURNS CHART 15 CASH & EQUIVALENTS / TOTAL ASSETS Global Aerospace & Defense - Cash & Equivalents/Total Assets (%) CHART 16 TOTAL DEBT / TOTAL ASSETS Global Aerospace & Defense - Total Debt / Total Assets (%) 25 14 12 2 1 8 6 15 1 4 2 5 25 27 29 211 213 LTM 25 27 29 211 213 LTM CHART 17 FIXED VS VARIABLE RATE EXPOSURE CHART 18 LONG TERM DEBT TERM-STRUCTURE 1% 9% 8% 7% 6% 5% 4% 3% 2% 1% % Variable Rate Debt (% of Identifiable Total) Fixed Rate Debt (% of Identifiable Total) 25 27 29 211 213 LTM 12 1 8 6 4 2 LT Debt Due 1 Yr LT Debt Due 3 Yr LT Debt Due 5 Yr Nominal Due In 1 Yr $ Bn LT Debt Due 2 Yr LT Debt Due 4 Yr LT Debt Due 5+ Yr 25 27 29 211 213 14 12 1 8 6 4 2 CHART 19 CASH FLOW AND PRIMARY USES CHART 2 RETURN ON CAPITAL EMPLOYED $ Bn 6 5 4 Capex Net Acquisitions Operating CF Dividends Share Buybacks 14 12 1 Global Aerospace & Defense - Return On Capital (%) 3 8 2 6 1 4 2-1 25 27 29 211 213 215 25 27 29 211 213 215 Source: S&P Capital IQ, S&P Ratings calculations 7 STANDARD & POOR'S RATINGS SERVICES
Industry Top Trends 216: Aerospace & Defense December 9, 215 RELATED RESEARCH The Outlook For The Global Aerospace And Defense Sector Remains Stable On Strong Demand For Commercial Aircraft Despite Flat Defense Spending, Oct. 7, 215 No content (including ratings, credit-related analyses and data, valuations, model, software or other application or output therefrom) or any part thereof (Content) may be modified, reverse engineered, reproduced or distributed in any form by any means, or stored in a database or retrieval system, without the prior written permission of Standard & Poor s Financial Services LLC or its affiliates (collectively, S&P). The Content shall not be used for any unlawful or unauthorized purposes. S&P and any third-party providers, as well as their directors, officers, shareholders, employees or agents (collectively S&P Parties) do not guarantee the accuracy, completeness, timeliness or availability of the Content. S&P Parties are not responsible for any errors or omissions (negligent or otherwise), regardless of the cause, for the results obtained from the use of the Content, or for the security or maintenance of any data input by the user. The Content is provided on an as is basis. S&P PARTIES DISCLAIM ANY AND ALL EXPRESS OR IMPLIED WARRANTIES, INCLUDING, BUT NOT LIMITED TO, ANY WARRANTIES OF MERCHANTABILITY OR FITNESS FOR A PARTICULAR PURPOSE OR USE, FREEDOM FROM BUGS, SOFTWARE ERRORS OR DEFECTS, THAT THE CONTENT S FUNCTIONING WILL BE UNINTERRUPTED OR THAT THE CONTENT WILL OPERATE WITH ANY SOFTWARE OR HARDWARE CONFIGURATION. In no event shall S&P Parties be liable to any party for any direct, indirect, incidental, exemplary, compensatory, punitive, special or consequential damages, costs, expenses, legal fees, or losses (including, without limitation, lost income or lost profits and opportunity costs or losses caused by negligence) in connection with any use of the Content even if advised of the possibility of such damages. Credit-related and other analyses, including ratings, and statements in the Content are statements of opinion as of the date they are expressed and not statements of fact. S&P s opinions, analyses and rating acknowledgment decisions (described below) are not recommendations to purchase, hold, or sell any securities or to make any investment decisions, and do not address the suitability of any security. S&P assumes no obligation to update the Content following publication in any form or format. The Content should not be relied on and is not a substitute for the skill, judgment and experience of the user, its management, employees, advisors and/or clients when making investment and other business decisions. S&P does not act as a fiduciary or an investment advisor except where registered as such. While S&P has obtained information from sources it believes to be reliable, S&P does not perform an audit and undertakes no duty of due diligence or independent verification of any information it receives. To the extent that regulatory authorities allow a rating agency to acknowledge in one jurisdiction a rating issued in another jurisdiction for certain regulatory purposes, S&P reserves the right to assign, withdraw or suspend such acknowledgment at any time and in its sole discretion. S&P Parties disclaim any duty whatsoever arising out of the assignment, withdrawal or suspension of an acknowledgment as well as any liability for any damage alleged to have been suffered on account thereof. S&P keeps certain activities of its business units separate from each other in order to preserve the independence and objectivity of their respective activities. As a result, certain business units of S&P may have information that is not available to other S&P business units. S&P has established policies and procedures to maintain the confidentiality of certain non-public information received in connection with each analytical process. S&P may receive compensation for its ratings and certain analyses, normally from issuers or underwriters of securities or from obligors. S&P reserves the right to disseminate its opinions and analyses. S&P's public ratings and analyses are made available on its Web sites, www.standardandpoors.com (free of charge), and www.ratingsdirect.com and www.globalcreditportal.com (subscription), and may be distributed through other means, including via S&P publications and third-party redistributors. Additional information about our ratings fees is available at www.standardandpoors.com/usratingsfees. Australia Standard & Poor's (Australia) Pty. Ltd. holds Australian financial services license number 337565 under the Corporations Act 21. Standard & Poor s credit ratings and related research are not intended for and must not be distributed to any person in Australia other than a wholesale client (as defined in Chapter 7 of the Corporations Act). Copyright 215 by Standard & Poor s Financial Services LLC. All rights reserved. STANDARD & POOR S, S&P and RATINGSDIRECT are registered trademarks of Standard & Poor s Financial Services LLC. www.spratings.com 8 STANDARD & POOR'S RATINGS SERVICES