Defense & Aerospace: Woes Not Even War Will Ease

-- The commercial airline industry's painful restructuring will have two more years to go

-- A military buildup will mean significant purchases of defense software, not just hardware

Buoyed by big budgets to transform the military for the war on terrorism and rogue nations like Iraq, the defense industry has been one of the few bright spots in the economy. But the terrorism dividend won't be enough to offset the ongoing crisis in commercial aviation, so 2003 offers no prospect of net gains for aircraft builders and their myriad suppliers.

When the Aerospace Industries Assn. totes up total sales expected in 2003 from both military and civilian spending, it foresees a 6.8% decline, to $138 billion. That's double the size of last year's 3.2% drop, to $148 billion. The outlook is actually bleaker for commercial aviation than the numbers suggest, because AIA projects sales to the Pentagon will buck the downward trend and climb $5 billion higher.

However, that modest boost on the defense side is no portent of a long-term trend. Given the massive swing in federal finances, from a $236 billion annual surplus two years ago to a deficit of more than $150 billion now, the proposed fiscal-year 2004 defense budget due early this year will probably call for only a small increase in spending--to about $379 billion. And after fiscal 2004, Defense Dept. officials don't envision any real increases for the rest of this decade. Pentagon buying power could even diminish, says Loren B. Thompson, chief operating officer of Lexington Institute, a defense think tank. As the 2004 election looms, he predicts, defense money will get "leeched away" by Congress.

Short term, aerospace and defense-industry execs cheered the 18% jump, to $130 billion, for defense modernization in the current fiscal '03 budget. That opens the door to some major new warfighting systems. More money could flow to the White House's mini-Star Wars missile shield. But America's defense heavyweights are not sanguine about a war with Iraq. They fear it will merely shift spending from the development of new, big-ticket items to the replenishment of munitions and fuel. If investors think that a war in Iraq would lift the outlook for Boeing (BA ), Lockheed Martin (LMT ), and Northrop Grumman (NOC ), they need to think again, says Boeing Co. CEO Philip M. Condit. "That is not the case."

So defense companies remain cautious. Last summer, as war clouds were gathering, wary execs did not raise earnings projections for either 2002 or 2003. That sent shares in major defense contractors tumbling roughly 25%. The drop "may be just the start of water reaching its true level," warns Robert Friedman, an analyst at Standard & Poor's.

Still, the uncertainties in defense pale beside the woes of commercial aerospace. Nearly all airlines are bleeding money, tens of thousands of workers have lost their jobs, and the crisis shows no sign of letting up in 2003. Most U.S. airlines won't be profitable again until 2005, predicts Edmund Greenslet, publisher of Airline Monitor, a newsletter. "It takes that long to recover from cataclysmic adversity," he notes.

One casualty of the airlines' struggle will be orders for new planes. Already, surplus aircraft account for 13% of the world's jetliner fleet, the highest percentage ever, according to Airline Monitor. And more are apt to get yanked from service. Says Teal Group analyst Richard Aboulafia: "I definitely think you'll see an uptick in the desert air force"--the planes mothballed in the deserts of Arizona and California.

For Boeing and Airbus, the gloom heralds further output declines. AIA expects Boeing to cut production to about 280 airliners this year, down from 380 in 2002. And Rainer Hertrich, co-CEO of Airbus parent European Aeronautic Defense & Space Co., says that Airbus also may be forced to trim production from last year's 300 planes. Blame that in part on sagging demand in the U.S. In fact, imports of Airbus jets fell in 2002 for the first time in seven years. Nor will exports help relieve Boeing's anguish. While overseas sales of military planes remain healthy, total aerospace exports dipped 5% last year and seem destined to shrink 10% this year. When everything is tallied, AIA sees world sales of commercial jetliners dropping by 33% this year, to about $18 billion.

Ask about profits, and AIA winces. Its forecast falls far short of last year's earnings of $9 billion, which was a mere 3.5% gain from 2001 for makers of both commercial and military hardware. So the grief in this sector is far from being over--regardless of what happens in Iraq.

By Stanley Holmes in Seattle, with Stan Crock in Washington

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