Aerospace: Preparing For A Descent

Aerospace executives undoubtedly wished that 2004 would go on forever. Total industry sales stretched 8% over the previous year, to a record $161 billion. Even better, profits soared to $10 billion -- the best in five years. And for the first time in two years, commercial jet deliveries inched higher.

Most industry analysts see a modest spurt in orders for commercial jets this year as well. Still, a number of conflicts or financial crises could disrupt aerospace fortunes. Rising fuel prices and record government deficits are the most pressing concerns. Less likely, but still a threat, is a full-blown recession or another terrorist strike on U.S. shores.

Prospects for the military market are mixed. In the long term, analysts expect sales to soften. "The defense marketplace will become even more competitive as budgets are reduced and nontraditional competitors enter this business," says James F. Albaugh, Boeing Co. (BA ) chief executive for Integrated Defense Systems. And some Pentagon programs, he admits, "could be on the list to cut."

Beginning this year, arms merchants will start to feel the effects of smaller increases in defense dollars. How much less money is anybody's guess, but part of the Pentagon's budget of nearly $500 billion will shift from research and development and procurement to military pay, health care, and other basic needs. Big-ticket items, such as the F-22 Raptor jet fighter, aren't in danger of getting axed, but annual support will dwindle. "It's hard to conceive that defense spending will continue to rise after five years of dramatic increases, at the same time that Social Security spending and domestic spending are being cut," says Steven M. Kosiak, budget-studies director at the Center for Strategic & Budgetary Assessments, a Washington think tank.

The message to defense contractors is clear: Start tightening your belts. But neither the Bush Administration nor Congress is going to smack them this year with shock-and-awe cutbacks. In fact, the Aerospace Industries Assn. predicts another round of growth in 2005, with total sales up by 7.5%, just a smidgen below last year's 8%, to $173 billion. Military aircraft and missile sales, which rose 10% in 2004, will again drive the growth. So big names such as Lockheed Martin (LMT ), Raytheon (RTN ), and Northrop Grumman (NOC ) will collect most of the gains. Still, "it will be a transitional year, psychologically," says Lehman Brothers (LEH ) aerospace analyst Joseph Campbell. "Defense companies and the Pentagon will realize that the better growth days are behind them."


In contrast, the civil outlook is brightening further. Analysts estimated that Airbus and Boeing would deliver 324 and 287 jetliners, respectively, in 2004, and higher numbers are forecast for this year: 340 jets for Airbus, vs. 324 for Boeing. Both are upbeat about new midsize planes that may appeal to low-cost carriers. In December, Airbus announced the A350, an upgrade of its popular A330 midrange jetliner, to compete with Boeing's new fuel-sipping 7E7 Dreamliner. Airbus CEO Noel Forgeard says he hopes for 50 orders of the A350 by June. Boeing Commercial Airplanes Chief Executive Alan Mulally confidently asserts the 7E7 will reach 200 orders faster than any jet ever has.

Any pickup in big-jet sales depends on how fast traditional U.S. airlines recover. Only one of the top 10 U.S. carriers, Southwest Airlines (LUV ), made a profit last year. But with worldwide passenger traffic up 10% last year and expected to rise 7% in 2005, analysts say, U.S. airlines could be on the mend by 2006.

Even then, new plane orders could lag by another year or two. That's why Merrill Lynch & Co. (MER ) analyst Byron Callan urges caution. The airline industry is changing for many reasons, including gains by low-cost carriers, the popularity of 70- to 110-seat regional jets, and higher fuel prices. As a result, Callan suggests, deliveries to legacy airlines may just "muddle through" to 2008 or 2010. At that point, a takeoff in demand will hinge on the airlines sorting out their cost problems.

The bottom line for aerospace folks: Strap on your seatbelts, we'll be experiencing a little turbulence.

By Stanley Holmes in Seattle, with Stan Crock in Washington

    Before it's here, it's on the Bloomberg Terminal.