September 21, 2010 Strategic Challenges and Opportunities in the Global Aerospace and Defense Sectors Prepared for SpeedNews 11 th Annual Aviation Industry Suppliers Conference in Toulouse 1 1300 Wilson Boulevard, Suite 320 Arlington, VA 22209 703-504-9300 pchao@rsadvisors.com
Today s Presentation We would like to introduce five key questions to help you think about the issues and bellwethers that we see in the next one to two years 1. How has the global recession affected the aerospace and defense market? 2. Where are defense budget headed? 3. What kind of commercial recovery are we really in? 4. Are the defense & commercial markets counter cyclical or complementary? 5. How can industry respond? Source: RSAdvisors analysis 2
Today s Presentation We would like to introduce five key questions to help you think about the issues and bellwethers that we see in the next one to two years How has the global recession affected the aerospace and defense market? Source: RSAdvisors analysis 3
How has the recession hit A&D? Changes in the market were accelerated by the recession, however not all of them were surprises GDP ($B) $13,500 $13,000 $12,500 Quarterly US GDP (in billions, 2005-2010) 4.0% 3.0% 2.0% 1.0% 0.0% -1.0% -2.0% Annual % Rate Impact on A&D Industry Commercial Triggered the last down cycle in commercial aerospace Reminded everyone that the business jet industry is cyclical $12,000-3.0% -4.0% -5.0% Forced a reduction in airline seating and heavy manufacturing capacity 1,600 1,500 1,400 1,300 1,200 1,100 1,000 900 800 700 600 2005 Q3 2005 Q4 2006 Q1 2006 Q2 2006 Q3 2006 Q4 2007 Q1 2007 Q2 2007 Q3 2007 Q4 2008 Q1 2008 Q2 2008 Q3 2008 Q4 2009 Q1 2009 Q2 2009 Q3 2009 Q4 2010 Q1 2010 Q2 S&P 500 (2005-2010) -57% Sep-05 Dec-05 Mar-06 Jun-06 Sep-06 Dec-06 Mar-07 Jun-07 Aug-07 Nov-07 Feb-08 May-08 Aug-08 Nov-08 Feb-09 May-09 Aug-09 Nov-09 Feb-10 May-10 Aug-10 Government Highlighted the role governmental debt will play in steeper defense spending Complicated national security challenges with whole of government solutions Introduced a more benign view of near peer threats Mergers & Acquisitions Shifted the balance of power between strategic buyers and private equity firms Source: CapitalIQ, RSAdvisors analysis 4
How has the recession hit A&D? We classify these and other changes into three categories: cyclical trends vs. long term trends vs. discontinuities Recent Changes to the Status Quo Change Commercial aircraft s recovery China overtakes Japan as the 2 nd largest economy For profit space exploration takes off Indicator Global Commercial Jet Deliveries 1,000 800 600 400 200 0 1958 1962 1966 1970 1974 1978 1982 1986 1990 1994 1998 2002 2006 12,000 10,000 8,000 6,000 4,000 2,000 0 China s Quarterly GDP 1987 2009 SpaceX launches Falcon 9 Cause Economic cycle Aircraft age & cost Demographics Public policy (NOT technology) Type of Change Cyclical Trend Long Term Trend Discontinuity Other Examples Defense budgets Acquisition reform Aging federal workforce Increasing integration of economies Technology revolutions Source: CapitalIQ, SpaceX, RSAdvisors analysis 5
Today s Presentation We would like to introduce five key questions to help you think about the issues and bellwethers that we see in the next one to two years Where are defense budgets headed? Source: RSAdvisors analysis 6
Where are defense budgets headed? Budget crises are putting pressures on European defense spending, while the Middle East, Asia and Latin America are seeing growth Aggregated Percent of GDP Spent on Defense Defense Spending as a % of GDP by Region Canada: 1.3% United States: 4.3% Caribbean and Latin America: 1.8% NATO Europe: 1.67% Non-NATO Europe: 2.05% Middle East and North Africa: 6.38% Sub-Saharan Africa: 3.10% Russia: 2.78% Central and South Asia: 2.79% East Asia and Australia: 3.01% Source: World Bank, SIPRI Historically nations that spend less than 3% of GDP on defense tend to face necessary tradeoffs 7
Where is the US defense budget headed? US defense spending has oscillated within three spending bands over US history Historical US Defense Spending Current and FY11 Constant $ Defense Spending, 1794-2015 1000 1 Defend the Nation Ex-war, spend 0.9% of GDP on defense (flat trend as % of GDP) Constant FY11 $ Defend the West Ex-war, spend 5.4% of GDP on defense (declining trend as % of GDP) Defend the Hemisphere Ex-war, spend 1.1% of GDP on defense Current $ (flat trend as % of GDP) 0.001 1794 1804 1814 1824 1834 1844 1854 1864 1874 1884 1894 1904 1914 1924 1934 1944 1954 1964 1974 1984 1994 2004 2014 Source: US Department of Commerce, US Department of Defense, RSAdvisors analysis 8
Where is the US defense budget headed? post-wwii, we have stayed within a $350B-$550B bounded range ; current wars have us above the range and begs the question are we in a new band? Modern US Defense Spending, 1948-2015 Planned Budget Authority in Constant $B Including Supplementals and FY11 FYDP (does not forecast additional supplementals) $800 $700? $600 Average High in Budget Cycle =~$550B in FY11$ $500 $400 $300 Constant FY11 $ Average Low in Budget Cycle =~$350B in FY11$ $200 $100 $0 Current $ 1948 1952 1956 1960 1964 1968 1972 1976 1980 1984 1988 1992 1996 2000 2004 2008 2012 FYDP/ Requested Supp Funding Source: US Department of Defense, RSAdvisors analysis 9
Where is the U.S. defense budget headed? And with US DoD facing a wide spectrum of threats, from the fight of today to future, near-peer adversaries, how do you organize to address it? Barbell-Shaped Markets Irregular Warfare Ex: Special Forces 10% of the budget Dual Purpose Ex: Army 40% of the budget Traditional Conflict Ex: Navy 50% of the budget Slice #1 Slice #2 The Long War Rapid acquisition, off-the-shelf/short development, quick response is key, COCOM centric Reset/Retrofit Install black boxes in existing equipment to plug into network, maintenance, repair Deterrence Very long cycle, tech. development, platform-oriented but limited production, services centric Transformation Desire for large, horizontal integrating networks, leverage the IT revolution Slice #3 Operational and Policy Support Oriented Services Logistics, operations, and intelligence support High-skilled Services Technically skilled services Is it one or two industrial bases? Can they be the same suppliers? How does DoD organize? Source: US Department of Defense, RSAdvisors analysis 10
Today s Presentation We would like to introduce five key questions to help you think about the issues and bellwethers that we see in the next one to two years What kind of commercial recovery are we really in? Source: RSAdvisors analysis 11
What kind of commercial recovery? Business jets have been hit hardest by the recession, and should be poised for growth; but we won t see 2008 levels for at least 5 years Global Deliveries Per Year 1990-2010 Global Fleet Compared to Global GDP 1988-2015 1,200 As of 3/1/10, the active fleet is now 17,239, up 203 from the end of 2009 Very Light Jets 500% 1,000 Light Midsize 450% 4% 21,806 800 Heavy 2008 to 2010 400% 350% Fleet GDP 600 400 +109% -49% -59% 300% 250% 200% 150% 4% 6% Forecast 200-19% 100% 1988 to 2009: R 2 = 0.9507 50% 0 1990 1995 2000 2005 2010 0% 1988 1993 1998 2003 2008 2013 Note: Very light jets exclude the Eclipse 500 Source: GAMA, JETNET, Business and Commercial Aviation, RSAdvisors analysis 12
What kind of commercial recovery? Regional transport production has seen strong consolidation, a renewed balance between props and jets, and new interest from Asia 500 450 400 Jets Props Regional Aviation Deliveries & Industrial Base Evolution (1989-2019) 36 417 9 OEMs 350 300 (Shorts) Aircraft Delivered 250 200 (Beech) (de Havilland) 182 165 5 OEMs (ATR & SuperJet) 150 3 OEMs 100 106 125 50 0 Note: ITP/CASA deliveries excluded 1989 2009 2019 Source: Company released information, Teal, RSAdvisors analysis 13
What kind of commercial recovery? Focus on the A380 and 787 have created a window for new commercial entries into the narrow body segment, with regional players moving upstream New Commercial Jet Programs (2005-2020) Airbus Narrow Body Replacement Legacy Commercial OEMs Airbus A380-800 Airbus A350XWB - 900-800F -800-1000 -900 Boeing Narrow Body Replacement Boeing 787-8 -9-3 -10 Freighter Boeing 747-8 Legacy Regional OEMs Embraer 195 Bombardier CRJ 1000 Bombardier CS110/130 Embraer RJ NG New OEMs Sukhoi Superjet 100 COMAC ARJ21-700 -110/125-900 -75 COMAC Narrow Body Mitsubishi MRJ70-90 2005 06 07 08 09 2010 11 12 13 14 2015 16 17 18 19 2020 Current Program Likely Program Program Launch Entry in Service Source: Company released data, RSAdvisors analysis 14
Today s Presentation We would like to introduce five key questions to help you think about the issues and bellwethers that we see in the next one to two years Are the defense and commercial markets counter cyclical or complementary? Source: RSAdvisors analysis 15
A&D: counter cyclical or complementary? Global commercial transport revenue vs. US defense procurement spending Air Transport Production Value vs. US Defense & Security Procurement, 1978-2015 $200 $80 US DoD Procurement ($B) $180 $160 $140 $120 $100 $80 $60 $40 $20 $70 $60 $50 $40 $30 $20 $10 Air Transport Production Value ($B) $0 1978 1982 1986 1990 1994 1998 2002 2006 2010 $0 US Defense Procurement Spending Complementary Global Commercial Transport Revenue Counter cyclical Source: US Government, Teal, company released data, RSAdvisors analysis 16
A&D: counter cyclical or complementary? The industry is more diverse than you think Top A&D companies, by 2009 revenues 1, share of business by sector $70 $60 $50 $40 $30 Revenues ($B, USD) Commercial / Industrial Commercial Aerospace Defense / Government Commercial / Industrial 32% 47% Defense / Government $20 21% $10 Commercial Aerospace $0 BA EADS UTX LMT NOC BAE GD HON FNC RTN BBD Thales RR L-3 Safran ITT Note: 1) excludes corporate reporting units Source: CapitalIQ, company filings, RSAdvisors analysis 17
Today s Presentation We would like to introduce five key questions to help you think about the issues and bellwethers that we see in the next one to two years How can industry respond? Source: RSAdvisors analysis 18
How can industry respond? Unlike other industries, we have some breathing room $20B of free cash flow a year to deploy in four different options Reinvest through organic growth domestically find the white space i.e. reshape strategy to meet new market threats i.e. develop a new engine Reinvest through organic growth internationally i.e. develop indigenous sales channels i.e. build a local production line Give the money back i.e. dividend cash back to shareholders and investors Grow or diversify through strategic mergers and acquisitions i.e. AlliedSignal s acquisition of Honeywell i.e. Goodrich s acquisition of Rohr, Coltec, Barnes, TRW Aeronautical, etc. i.e. SAFRAN s acquisition of L-1 Source: RSAdvisors analysis 19
How can industry respond? In the last 15 years, M&A has substituted for internal investment 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% Capex - Investment IR&D Defense Industry Cash Outflows (Percent) 1980-2009 Cash Dividends Acquisitions Debt Reduction Net Interest Equity Buybacks Sources: CapitalIQ, FactSet, company filings, RSAdvisors analysis 20
How can industry respond? For some, mergers and acquisitions show that we are in a new period of reshaping the portfolio Recent Major Transactions Acquisitions (Transaction Value in $M) $799M Divestitures (Transaction Value in $M) $1,650M $613M? Shipbuilding $487M? EIG $375M?? $280M Platform Solutions Note: Northrop Grumman has announced plans to separate the Shipbuilding division; Lockheed Martin has announced plans to divest EIG and PAE; BAE has announced plans to sell its engine controls, commercial avionics, and power and energy management business units Source: CapitalIQ, company released data, RSAdvisors analysis 21
Today s Presentation We would like to introduce five key questions to help you think about the issues and bellwethers that we see in the next one to two years How has the global recession affected the aerospace and defense market? Answer: It reminded us we are in a cyclical industry What s happening to the defense and security budget? Answer: It s under pressure, but still robust for the near term and the US will remain the largest market in the world over the long term What kind of commercial recovery are we really in? Answer: One that is segmented with high growth (narrow bodies), no near term growth (regionals, large business jets), and continued uncertainty (commercial jumbos, small business jets) Are the defense and commercial markets counter cyclical or complementary? Answer: Both How can industry respond? Answer: By doing something, not standing still historically companies that adopted a proactive strategy performed better in the recovery Source: RSAdvisors analysis 22
MULTI-DISCIPLINARY FOCUSED EXPERIENCED TRUSTED 23
Pierre Chao Managing Partner 1300 Wilson Boulevard Suite 320 Arlington, VA 22209 703-504-9300 pchao@rsadvisors.com 2010 Private and Confidential