by Christopher Mecray

In perhaps one of the best examples of corporate health schizophrenia in recent years, the aerospace/defense industry is enjoying some of the best of times and enduring perhaps some of the worst of times within its own vertical markets. A dichotomous picture emerges of a healthy, even booming defense sector, offset in part by an ongoing crisis in several commercial markets, including commercial aircraft and space products and services. In some sense, this picture confirms the logic of strategic diversification moves taken by Boeing, for example. In total, however, the ongoing defense upcycle, coupled with spots of weakness in key commercial verticals, indicates the sector may be running with a six- cylinder engine, but only five cylinders are firing at present.

The numbers tell the tale. For commercial primes, sales and earnings performance is down heavily this year. For Boeing, commercial jet sales are off 23 percent, with Earnings Before Interest and Taxes (EBIT) plummeting an expected 62 percent. Meanwhile, sales are down 16 percent and EBIT off an estimated 57 percent at General Dynamics. Others with more margin resistance are holding up better on the profit side, but Raytheon aircraft sales have been flat to down for several years (with zero profit), while United Technologies’ commercial aerospace businesses are down solidly in 2002 and 2003, driven by aftermarket slowing. The relative importance of these lines to each company differ, but the common point here is that commercial has been a drag on profit growth and cash flow in 2003 after a tough year as well. No question, commercial aerospace is suffering with only slim hopes for a strong 2004 comeback.

A different picture emerges when we look at the 2003 defense performance. Among the primes, defense sales are up a staggering 23 percent on average, while core EBIT margins (before non-cash pension impacts) have risen, translating to more than 30 percent EBIT growth in defense businesses. Of course, this includes some benefit from ongoing consolidation moves, but organic sales growth remains impressive at around seven to 10 percent for the group. This is not Cisco circa 1999, mind you, but these numbers are not too bad for a flat economy producing widely stagnant revenue in 2003.

Interestingly, when examining the primes on an aggregate basis, the net picture is not negative. Boeing, for its massive slide in sales this year and super-sized charges in space, remains solidly cash flow positive (to the tune of $2.5 billion), clearly benefiting from a healthy defense core, now half of its sales. General Dynamics and Raytheon have done an admirable job of stemming cash drain as production has waned. Both companies look on track to meet cash flow guidance, with General Dynamics actually tracking net income with free cash (a sound goal for any company) in spite of its Gulfstream woes. The same is true for United Technologies, even with the loss of high margin spares volumes this year. All this speaks directly to the robustness of defense cash, which is spouting like a Texas geyser on the back of record government outlays. Iraq spending has been a contributor, but paling in comparison with robust core procurement budgets after the FY03 Bush step-up in funding for a host of Defense Department priorities.

The outlook for 2004, interestingly, is somewhat better for both sides of the sector, with defense projected to continue to create growth and performance, while commercial markets should at least stabilize as aftermarket-driven demand begins to rebound. Even space products will play a more positive role, with expected satellite and launch demand now more than a year past the bottom seen in 2002. Overall, we believe the group will remain under pressure from tepid commercial demand at least through 2004, but stable production rates and improved overall cash flow will mitigate the financial effects of the downturn. As balance sheets are repaired or strengthened, smaller add-on deals for the primes will increase dividends, ongoing share repurchases and limited acquisitions. Of particular interest is the government IT services sector in this regard.

So, while a mixed bag, we have seen solid evidence that end market diversification for aerospace players is proving its case, while pure-play defense businesses are relying on generally healthy defense outlays to continue for some years. We surmise that once defense funding moves beyond its peak, these players may shift eventually back to searching for commercial derivative work (scary as that sounds), perhaps in the IT services arena, given the growth trends and consolidation in the government side today.

Christopher Mecray is a research analyst with Deutsche Bank Securities Inc. The following comments should not be considered a recommendation concerning the purchase or sale of any security mentioned herein.