Fitch Street View: Stable Outlook for Global A&D Despite Defence Cuts & Lower Airline Profits
11-Jul-2011 As part of its recent European aerospace and defence investor seminars, Fitch Ratings discussed the outlook for commercial aerospace, the likely effect of the cuts to defence budgets in Europe, the potential for greater merger and acquisition (M&A) activity involving the large European companies, the long-term threat posed by new entrants in the large commercial aircraft (LCA) market to Airbus and Boeing, as well as the likely drivers of future rating actions.
A copy of the presentation, "Global Aerospace and Defence Seminar: 2011 Midyear Credit Review and Outlook", is available at www.fitchratings.com.
The outlook for commercial aerospace has continued to improve throughout 2011 on the back of a sustained rise in airline traffic in most regions, strong orders, good and diverse availability of aircraft finance, a low level of cancellations and deferrals to date and the high likelihood of positive, albeit lower than in 2010, airline profitability this year. High, good quality backlogs at Airbus and Boeing underpin the optimism of the two manufacturers shown in a number of announced production increases which will take effect over the coming three years. Airbus' huge June gross orders (601 aircraft) further padded the already large backlog.
In 2011, Fitch anticipates LCA deliveries will rise to more than 1,000 aircraft, 6%-7% higher than in 2010. In both 2012 and 2013, the percentage production increase is likely to be in double digits as both Airbus and Boeing look to fulfil the strong demand for aircraft. However, such a rapid increase in production levels does not come without risks and Fitch continues to closely monitor factors such as the ability of the supply chain to cope, programme quality issues associated with such a significant ramp-up as well as broader demand dynamics such as jet fuel prices and the outlook for the global economy.
Other segments of the commercial aerospace sector, such as business and regional jets, have yet to show signs of recovery and may not do so until 2012.
High jet fuel prices remain a risk to the commercial aerospace outlook. Although jet fuel prices dipped below USD3/gallon in late June, they are still up nearly 50% in the past 12 months and up about 17% in 2011. Airbus' successful introduction of the A320 Neo illustrates airlines' strong demand for fuel-efficient aircraft, and Airbus' substantial narrow body bookings in June (580 aircraft) add to the importance of Boeing's pending decision about its narrow body product (re-engine, new aircraft, or both). Fitch continues to expect that Boeing will target a new narrow body aircraft by the end of the decade, combined with incremental improvements to its existing 737 product line in the interim. Key considerations in Boeing's narrow body decision will include the size of the aircraft, materials, engines, and production processes. A decision to target a larger aircraft could benefit some of the new entrants into the narrow body sector such as Bombardier's CSeries, as well as influencing the product development plans of other manufacturers such as Embraer.
While the duopoly that Airbus and Boeing have enjoyed for the past two decades in the LCA market is being challenged, with numerous new competitors from China, Russia and Canada bringing new products in the single aisle segment by the second half of this decade, Fitch believes that these new entrants are unlikely to pose a serious threat to the incumbents until at least 2020. This is because of the competitive advantages Airbus and Boeing have due to their technological superiority, existing comprehensive service and support networks and proven capability in aircraft programme execution.
With cuts to the overall defence budgets in most western European countries already announced in late 2010 and further pressure on defence expenditure existing in some countries like the UK, companies most exposed to European defence spending have already seen their traditional revenue bases shrinking in real terms. A focus on emerging markets will be of increased importance for these companies, although export opportunities continue to be highly competitive and politicised as more and more developed markets-based defence companies chase a limited number of sizeable contracts in countries such as India and Brazil.
Fitch believes the potential for growth in M&A in the coming 12 months is high, especially involving European companies, given the stability in commercial markets, large cash piles at most companies and a strong appetite for inorganic growth owing to the stagnant home markets. Many European companies remain interested in defence acquisitions in the US to gain access to that country's large defence budget and Fitch believes a pick-up in acquisition activity involving European companies in the US is likely in the coming year.
Cash deployment strategies at large A&D companies in the coming 12 months are likely to centre on acquisition activities, although the possibility of share buybacks or other forms of shareholder returns has increased over the course of the year. Nevertheless, Fitch believes that most defence contractors will prioritise growing their businesses inorganically as a form of utilisation of their substantial cash piles.
As most companies have already reached their rating targets and as Fitch has rated the sector conservatively through the cycle, meaning there was ample headroom in the financial profiles coming into the recession, future rating actions are likely to be driven by company-specific events such as acquisitions, programme execution issues or large shareholder returns. Perennial industry risks such as terrorist attacks and global pandemics may also act as a catalyst for rating action, depending on their significance and impact.