Defense & Aerospace: More Plane Pain, But Help From Uncle Sam

>>Sales of civilian aircraft will be flat, though the worst of the slump may be over
>>High-tech weaponry will be a bright spot for defense contractors

For the battered commercial-aviation industry, the New Year will bring more dreary news. Jetliner sales in 2004 will continue on the downward trend that began with the terrorist attacks of 2001, then worsened as the economy soured. And recent budget hikes to transform the U.S. military for the war on terrorism offer little solace. Many of the Pentagon's pet weapons programs -- those aimed at bolstering America's status as the world's lone superpower -- may face slowdowns and funding delays.

It all adds up to a basically flat outlook for the next 12 months. According to the Aerospace Industries Assn. (AIA), total 2004 sales for military and civilian planes will grow less than 1%, to $148 billion -- with all the gains coming on the military side. Still, that's welcome news. Even 1% is better than the steady declines of recent years. In 2003, the U.S. aerospace industry tallied $147 billion in sales -- down $6 billion from 2002. While the commercial outlook remains bleak, at least its rate of descent is slowing. Sales of jetliners this year will dip less than $2 billion, to $32 billion, compared with the more substantial decline of $7.1 billion in 2003.

So traces of optimism are emerging. "The surprising news is that the slump is not nearly as sharp as predicted a year ago," says AIA President John W. Douglass. He anticipates a recovery in civil aviation by 2006. But other experts remain cautious. They worry that another terrorist attack, a new outbreak of SARS, or slower-than-expected economic growth could further dampen travel demand and disrupt the industry's fragile momentum. "Recovery is in sight, but the downside potential is a lot worse than any upside," says Richard L. Aboulafia, aerospace analyst at Teal Group Corp. consultants.

The two biggest jetmakers -- Airbus and Boeing Co. (BA ) -- are betting on better times, despite posting the lowest profits in eight years. Europe's Airbus is plowing ahead with development of the world's biggest jetliner. The 555-seat A380 is expected to enter service in 2006. To date, Airbus has bagged 129 orders for the superjumbo, and sales chief John Leahy sees more buyers lining up. There's not a single megacarrier "that doesn't want one," Leahy says.

As for Boeing, its 10-year dry spell of innovation is ending. The company won board approval in December to build the 200-seat 7E7 jetliner. It could enter service by 2008. "I think we've got a really exciting plane," says Alan R. Mulally, the CEO of Boeing Commercial Airplanes. "The 7E7 will ensure Boeing will be in commercial aviation for decades to come."

Both rivals expect deliveries to hit bottom in 2004 and then begin to recover. Together, they plan to deliver 570 aircraft in 2004. That's a 37% drop since 2001, when they rolled out 852 planes. But 2005 deliveries should rise 6%, to 605 jetliners. "I would be in a state of shock if 2005 is not better than 2003 and 2004," says Leahy.

A Shared Market

Leahy has reason to be hopeful, with Airbus now producing more airplanes than Boeing. This historic shift began in 2003, when Airbus delivered 300 airplanes to Boeing's 280. Airbus boasts that it will continue to outpace Boeing at least through 2005. But analysts believe that over time, if Boeing gets its new plane up and running, the two giants will split the market roughly 50-50.

Defense contractors, for their part, won't exactly be rolling in dough. They see continued growth, but in single digits rather than the healthy double-digit rises of the past several years. "It's hard to say that it will continue at that kind of growth rate," says Henry J. Driesse, senior vice-president of ITT Industries Inc. (ITT ) and president of its defense unit.

But even a 3% hike in the Pentagon's fiscal 2005 budget for procurement and research and development is a lot of new money. It will pour a total of more than $144 billion into industry coffers. That's down from an 8% increase the year before, though. And defense-industry analysts are warning companies to brace for possible delays or cuts in existing programs, with the Joint Strike Fighter and the F-22 fighter viewed as early candidates.

Industry execs are focusing on future spending growth. Even under the more restrained mood in Congress, defense budgets are expected to grow between 4% and 6% until the end of the decade. Technology and training will give the U.S. the edge, says Ronald D. Sugar, CEO of Northrop Grumman (NOC ) Corp. And the need to amplify high-tech military options will put "continued upward pressure on defense spending."

For Northrop Grumman, Sugar sees strong growth in unmanned aircraft, missile defense, shipbuilding, and homeland security. One reason for the expected boost in shipbuilding is that the current production rate of five boats a year won't sustain a 300-ship fleet with an average expected ship life of 30 years. A rate of 10 a year would be needed. "We're going to start doing things of that nature, or we're going to shrink our navy very considerably," says Paul H. Nisbet, a military analyst at JSA Research Inc. in Newport, R.I.

Northrop Grumman, Boeing, Lockheed-Martin (LMT ), and General Dynamics (GD ) are all shifting resources to the new threats that worry the Pentagon. Most prime contractors have created new business units to compete for the prize: network-centric warfare. It involves integrating computers, satellites, and sensors to provide planes, tanks, ships, and soldiers with precise, real-time information about the battlefield. Nicholas D. Chabraja, CEO of General Dynamics Corp., predicts his company's information systems and technology operations will contribute a third of total revenues and earnings this year. Not bad for a company that builds tanks and ships.

In short, while the aerospace sector seems poised for a slow, modest recovery, it's probably too early to celebrate. As just about every defense company knows, the fickle forces of politics can quickly scuttle contracts.

By Stanley Holmes in Seattle and Stan Crock in Washington, D.C., with Chris Palmeri in Los Angeles

— With assistance by Christopher Palmeri

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