Aerospace and Defense: An S&P Ratings Report Card

The global recession is weighing heavily on commercial aerospace manufacturers and their suppliers. Air travel has declined significantly in the U.S., Europe, Japan, and elsewhere, resulting in a sharp drop in aircraft orders and a cloudy outlook for deliveries, reversing a strong market upturn that occurred in recent years. The defense sector, however, is bucking the trend for the most part. It is still benefiting from large government spending, although shifting military priorities and budget pressures are creating uncertainties for the long term. Economists at Standard & Poor's Ratings Services forecast that real U.S. gross domestic product will contract by 2.2% in second-quarter 2009 and 1.0% in the third, and that it won't turn positive until the fourth quarter. For 2010, they expect a tepid 1.2% gain. This means difficult conditions will continue for the commercial aerospace industry, with the defense market less affected because it receives aid from sizable budgets.

Tough times for commercial aerospace

Business prospects have worsened considerably in recent months for commercial aerospace manufacturers and their suppliers. The sector is contending with the deepening global recession, declining air traffic, capacity cuts by airlines, and reduced availability of financing for aircraft purchases. In this climate, demand for jetliners has dropped significantly and orders in 2009 will be much lower than they were from 2005 through most of 2008. While industry fundamentals have deteriorated, we believe 2009 will not be so bad for the two largest aircraft manufacturers, Boeing (BA) and Airbus SAS, a unit of European Aeronautic Defence and Space (EADS). These companies still have robust backlogs, which should lead to higher combined deliveries this year. Beyond that, however, we believe prospects for deliveries are uncertain because air travel has slowed considerably worldwide and some airlines have deferred or cancelled orders. Others may follow suit. Before the turmoil in the financial markets and the ensuing economic weakness, we expected the strong cyclical commercial aerospace upturn to last until 2011. In addition to commercial airplane manufacturers and producers of other original equipment, we rate a number of companies that provide replacement parts and services. The recession has also hurt this important and generally higher-margin business because many airlines are cutting capacity (or slowing capacity growth) in response to lower demand for air travel. Thus, aircraft manufacturing and the aftermarket are currently in a downturn. Another segment of commercial aviation, the business jet market, has weakened sharply since late 2008 because of the global recession, lower corporate profits, the upheaval in the capital markets, reduced availability of financing, and the increased proportion of attractively priced used planes on the market. In addition, some people view the use of corporate aircraft unfavorably in the current economic climate.

A "stable outlook" for most issuers

Because of these conditions, we expect the commercial aerospace sector's credit quality to face some pressure in 2009, but we do not anticipate widespread rating actions. 65% to 70% of the issuers still have a stable outlook (compared with about 85% in December 2008), partly because of the fairly steady defense operations of many companies that we rate. Many issuers achieved meaningful credit-quality improvements in recent years, but these started to reverse in the last three months of 2008, which several negative rating actions indicate. This trend continued in the first half of 2009, with moderate rating activity in April to July. On July 7, 2009, we placed our corporate credit rating on Vought Aircraft Industries on CreditWatch with positive implications, reflecting our expectations of a meaningful improvement in the company's liquidity and leverage following the completion of the sale of its 787 aircraft manufacturing business and operations at its South Carolina facility to Boeing for $580 million in cash. On June 29, 2009, we lowered our corporate credit rating on Sequa by one notch and assigned a negative outlook based on lower-than-expected sales, earnings, and cash generation stemming from the downturn in all of the company's business segments, which resulted in further deterioration in already very weak credit protection measures. On June 26, 2009, we placed our ratings on BE Aerospace (BEAV) on CreditWatch with negative implications because difficult conditions in the airline industry, combined with higher debt, have pressured credit metrics. On June 24, 2009, we lowered our ratings on Moog (MOGA) by one notch and removed the ratings from CreditWatch, where we had placed them with negative implications in April 2009. The CreditWatch placement reflected expectations of weaker credit protection measures due to higher debt levels to fund acquisitions and to weakness in key markets, especially industrial and commercial aerospace. The outlook is now stable. On June 9, 2009, we raised our long-term corporate credit rating on Hawker Beechcraft to CCC+ from SD (selective default), reflecting our view of the company's risk of payment default and potential for further distressed redemptions post-tender offer, following the company's recent tender offer to buy a portion of its unsecured notes at values substantially below par. On April 29, 2009, we revised our outlook on Textron (TXT) to negative from developing, reflecting reduced earnings guidance for 2009, due mostly to lower profits at the Cessna business jet unit and increased losses at Textron Financial.

Defense: high spending, Slower Growth

Standard & Poor's still views the outlook for the U.S. defense sector as fairly stable over the next year, given high levels of government spending under the current fiscal 2009 and proposed 2010 defense budgets. In addition, supplemental appropriations bills will fund the wars in Iraq and Afghanistan for the rest of 2009 and 2010. Although the defense budget's growth rate is slowing, we expect spending to remain high for at least the next year, resulting in a favorable credit environment for U.S. defense contractors. European governments' modest spending growth and good prospects in export markets have kept the region's defense contractors' credit quality fairly steady. Top-tier companies have been actively seeking alliances with their U.S. counterparts to diversify and gain greater access to the U.S. defense market—the world's biggest—and to improve their foreign currency exposure.

The outlook

We expect the deteriorating economy and commercial aviation environment to put some pressure on the commercial aerospace sector's credit quality. However, we do not anticipate taking extensive rating actions at this time, and we have stable outlooks on 65% to 70% of issuers. This is partly because many commercial aerospace manufacturers and suppliers also benefit from stable defense operations. Also, we believe that U.S. defense companies, which the general economy does not affect directly, should maintain their credit quality and stable outlooks over the next year. Our assessment takes into consideration likely continued high government spending, including supplemental funding. European defense contractors' credit quality should stay fairly steady, given European governments' modest spending growth and potential exports. However, over the longer term, U.S. and European government efforts to address the financial crisis could—or will likely—hamper defense spending, resulting in less funding for existing programs or delaying the start of new ones.
  Rated Aerospace/Defense Companies
Issuer Rating/Outlook*
AAR Corp. BB/Stable
Alliant Techsystems Inc. BB/Stable
ARINC Inc. B/Stable
AmeriQual Group LLC B-/Stable
Atlantic Marine Holding Co. B+/Positive
BAE Systems PLC BBB+/Stable
BE Aerospace Inc. BBB-/Watch Neg
Boeing Capital Corp. A+/Watch Neg
Boeing Co. A+/Watch Neg
Bombardier Inc. BB+/Stable
Colt Defense LLC B+/Stable
Communications & Power Industries Inc. B+/Stable
DAE Aviation Holdings Inc. B+/Watch Neg
DeCrane Aerospace Inc. B-/Developing
DynCorp International LLC BB/Stable
Embraer BBB-/Stable
Esterline Technologies Corp. BB/Stable
European Aeronautic Defence and Space Co. N.V. BBB+/Stable
Finmeccanica SpA BBB/Stable
GenCorp Inc. CCC+/Developing
General Dynamics Corp. A/Stable
Goodrich Corp. BBB+/Stable
Hawker Beechcraft Inc. CCC+/Negative
Heckler & Koch GmbH B-/Stable
Hexcel Corp. BB/Stable
Hunter Defense Technologies Inc. B+/Stable
Israel Aerospace Industries Ltd. BBB/Negative
Kaman Corp. BBB-/Stable
L-3 Communications Corp. BBB-/Stable
Lockheed Martin Corp. A-/Stable
Moog Inc. BB/Stable
MTU Aero Engines Holding AG BB+/Stable
Northrop Grumman Corp. BBB+/Stable
Orbital Sciences Corp. BB+/Stable
Precision Castparts Corp. BBB+/Stable
Raytheon Co. A-/Stable
Rockwell Collins Inc. A/Stable
Rolls-Royce PLC A-/Stable
Sequa Corp. B-/Negative
Spirit AeroSystems Inc. BB/Stable
Textron Inc. BBB-/Negative
Thales S.A. A-/Stable
TransDigm Inc. B+/Stable
Vought Aircraft Industries Inc. B-/Watch Pos
Wesco Holdings Inc. B+/Stable

*Ratings are as of July 9, 2009.
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