JPM Aerospace & Defense 2012 Outlook_2011-01-06

www.morganmarkets.com

North America Corporate Research06 January 2012

Aerospace and DefenseAll About Aerospace/Defense - 2012

Aerospace/Defense

Joseph B. Nadol III AC

(1-212) 622-6548

[email protected]

J.P. Morgan Securities LLC

Seth M. Seifman, CFA

(1-212) 622-5597

[email protected]


Christopher Sands

(1-212) 622-9224

[email protected]


Shailendra K Jain

(91-22) 6157-3325

[email protected]

J.P. Morgan India Private Limited

See page 142 for analyst certification and important disclosures, including non-US analyst disclosures.J.P. Morgan does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision.

We still prefer commercial aerospace stocks over defense. Our baseline expectation for commercial aerospace stocks this year is mid-teens returns on average, driven by that level of earnings growth with flat multiples. Our expectation for defense stocks is modestly negative returns, driven by anaverage 8-10% decline in organic EBIT, mostly offset by share repurchase and dividends.

Commercial aerospace fundamentals are sound despite the weak global economy. We expect airline traffic to grow in the mid single digits even in a ~2% global GDP growth environment, and this should support scheduled ~8% annual production rate growth over the next 3-4 years. We expect aftermarket sales growth to remain in the high single digits in 2012, driven by mid single digit ASM growth, a few percentage points of pricing, and some additional catching up from the recession.

Our top commercial aerospace stock picks going into 2012 are Boeing and Embraer. BA had a good year in 2011, and while the 787 ramp-up continues to drag out longer than one might hope, we believe that another good year is on the way. We see a substantial improvement in cash flow this year and more on the way, with a substantial reduction in inventory build for the 787 program, and ultimately a decline, the key driver. We see the stock reaching $100-120 in the next two years, based on 10-12x a $10 FCF number once the 787 production rate has stabilized at 10/month. ERJ also looks particularly attractive at current levels, and while there is higher risk due to a far smaller backlog, we see upside of well over 50%.

Defense fundamentals look tough, and fiscal reform is the key. We are approaching 2012 with the expectation that defense stocks will be flattish to slightly down this year on average. We think about the prototypical defense stock as generating an organic EBIT decline in the 8-10% range, driven by a 4-5% sales decline and perhaps 50 bps of margin erosion. Share repurchase can reduce the decline in EPS (ex pension) to the mid-single digit range, and after including a 4% dividend and assuming a flat multiple, we anticipate total returns in the low negative single digits. Longer term, we believe that the next major money to be made in the group as a whole will be done so as a result of multiple expansion when major fiscal reform reduces a major overhang, which could take place as soon as after the 2012 election but also could take years.

Our top large cap defense stock picks are Raytheon and General Dynamics.We believe that both RTN and GD have a multiple expansion opportunity relative to the rest of the group. However, a surprise dividend announcement from another company or a surprise strategic move such as a major split or spin-off could be the decisive factor driving the group outperformer in 2012, as was the case for NOC in 2010 and LMT in 2011. Our top SMID defense pick heading into 2012 is XLS.

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Joseph B. Nadol III(1-212) [email protected]

Table of ContentsInvestment Thesis ....................................................................5

Commercial Aerospace ...........................................................................................5

Defense...................................................................................................................6

Key Investment Points .............................................................7

Commercial Aerospace ...........................................................................................7

Defense.................................................................................................................10

Sector-wide...........................................................................................................13

Potential Disruptive Events ...................................................14

Commercial Aero Outlook .....................................................19

Aero Stock Framework..........................................................................................19

Commercial OE ....................................................................................................21

Aftermarket...........................................................................................................42

The Emerging Narrowbody Landscape................................46

Boeing 737 MAX..................................................................................................46

Airbus A320neo....................................................................................................49

Embraer to Re-Engine E-Jets.................................................................................51

2012 Is a Critical Year for CSeries Development ...................................................51

China Determined to Establish Narrowbody Presence ............................................53

MS-21 in the Mix As Well ....................................................................................54

GTF vs LEAP X....................................................................................................54

The Emerging Widebody Landscape....................................57

A350 Execution Is Critical for Airbus....................................................................57

A350 Risk Supporting 777 Demand.......................................................................58

Competitive Dynamics among Other Widebodies ..................................................59

787 Cash Flow Should Improve Decisively in 2012 ...............................................60

Regional Aircraft: New Entrants Coming but Underlying Demand Remains an Issue ....................................................63

Business Jets: Robust Recovery Elusive ............................69

New Jet Demand...................................................................................................71

Used Market Indicators .........................................................................................74

New Jets Coming to Market ..................................................................................76

China: A Critical Market .........................................................78

Middle East: Key Widebody Market ......................................83

Defense Outlook.....................................................................86

Budget Uncertainty Remains Focal Point in 2012 ..................................................86

Declining Addressable Market Forecast Shapes Organic Growth Outlook ..............89

Margin Contraction Likely in Addition to Decreasing Sales ...................................95

Defense Stocks Are Defensive First and Foremost .................................................97

Sector Performance in 2011...................................................................................98

What to Expect from Defense in 2012 ...................................................................98

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Defense Beyond 2012 .........................................................................................101

New Year, New Ratings ......................................................................................103

2012 Large Cap Pecking Order............................................................................109

2012 Small and Mid Cap Pecking Order ..............................................................110

Aerospace/Defense Capital Deployment............................112

Cash Return to Shareholders Continues ...............................................................113

Mergers and Acquisitions....................................................................................118

Company Data ......................................................................121

Alliant Techsystems (ATK).................................................................................121

Boeing (BA) .......................................................................................................122

Bombardier (BBD/B TO) ....................................................................................123

CACI International Inc. (CACI) ..........................................................................124

Comtech Telecommunications (CMTL)...............................................................125

Embraer (ERJ) ....................................................................................................126

Exelis (XLS) .......................................................................................................127

General Dynamics (GD)......................................................................................128

Goodrich (GR) ....................................................................................................129

Harris Corporation (HRS)....................................................................................130

L-3 Communications (LLL) ................................................................................131

Lockheed Martin (LMT) .....................................................................................132

Northrop Grumman (NOC) .................................................................................133

Precision Castparts (PCP)....................................................................................134

Raytheon (RTN)..................................................................................................135

Rockwell Collins (COL)......................................................................................136

SAIC (SAI).........................................................................................................137

Spirit Aerosystems (SPR) ....................................................................................138

TransDigm (TDG)...............................................................................................139

United Technologies (UTX) ................................................................................140

Wesco Aircraft Holdings (WAIR) .......................................................................141

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J.P. Morgan Aerospace/Defense Coverage Universe

Prices as of Jan 5, 2012.

Market P/FCF Price Implied

Company Price Symbol Rating Cap (bln) 2011E 2012E 2013E 2012E 2013E 2012E 2013E 2012E 2013E 2012E 2013E 2012E 2013E Target Upside

Alliant Techsystemsb

$58.26 ATK N 1.9 6.7x 7.8x 8.7x 7.4x 8.2x 4.6x 4.8x 4.5x 4.6x 0.65x 0.64x 9.6x 9.4x $64.00 10%

Boeing $73.53 BA OW 55.3 16.4x 15.2x 13.0x 15.2x 13.0x 7.5x 6.3x 7.5x 6.3x 0.74x 0.65x 17.0x 8.5x $85.00 16%

Bombardier $4.16 BBD/B CT OW 7.3 8.7x 8.1x 6.3x 8.1x 6.3x 5.5x 4.3x 5.5x 4.3x 0.50x 0.44x 11.9x 6.5x $7.50 80%

CACIb

$56.00 CACI UW 1.7 10.6x 10.2x 10.1x 10.2x 10.1x 5.8x 5.4x 5.8x 5.4x 0.49x 0.45x 8.5x 7.4x $54.00 -4%

Comtechc

$29.25 CMTL N 0.7 18.7x 23.6x 21.0x 23.6x NM 5.3x 5.2x 5.3x 5.2x 0.91x 0.93x NM 15.0x $27.00 -8%

Embraer $26.06 ERJ OW 4.7 13.1x 8.7x 7.4x 8.7x 7.4x 5.6x 4.7x 5.6x 4.7x 0.69x 0.61x 11.7x 7.4x $42.00 61%

Exelis $9.26 XLS OW 1.7 4.6x 5.8x 6.2x 5.4x 6.0x 3.4x 3.3x 3.2x 3.3x 0.41x 0.42x 9.4x 8.7x $11.00 19%

General Dynamics $67.40 GD OW 24.7 9.2x 9.2x 9.0x 9.2x 9.0x 5.7x 5.4x 5.7x 5.4x 0.76x 0.72x 8.7x 8.5x $75.00 11%

Goodrich $123.40 GR RS 15.6 20.9x 17.9x 16.1x 17.9x 16.1x 9.5x 8.5x 9.5x 8.5x 1.94x 1.79x 19.3x 17.5x RS NA

Harris Corporationb

$36.68 HRS N 4.4 8.6x 8.3x 9.0x 8.3x 9.0x 5.1x 5.1x 5.1x 5.1x 0.98x 0.92x 7.0x 9.3x $37.00 1%

L-3 Communications $67.43 LLL N 7.1 7.7x 8.2x 8.4x 8.2x 8.4x 5.7x 5.6x 5.7x 5.6x 0.68x 0.68x 5.8x 5.7x $72.00 7%

Lockheed Martin $80.07 LMT N 27.0 10.5x 11.0x 10.7x 8.5x 9.0x 6.1x 6.1x 5.1x 5.4x 0.62x 0.64x 9.5x 9.7x $80.00 0%

Northrop Grumman $58.15 NOC N 16.4 8.3x 8.8x 9.1x 9.6x 10.0x 4.7x 4.9x 5.1x 5.2x 0.61x 0.61x 8.2x 9.0x $53.00 -9%

Precision Castpartsb

$168.92 PCP OW 24.6 20.9x 16.9x 15.3x 16.9x 15.3x 10.2x 8.8x 10.2x 8.8x 2.83x 2.50x 17.7x 16.0x $165.00 -2%

Raytheon $48.05 RTN OW 17.0 9.5x 9.2x 8.2x 8.1x 7.8x 5.2x 4.7x 4.7x 4.5x 0.66x 0.64x 8.3x 7.8x $55.00 14%

Rockwell Collinsb

$56.42 COL OW 8.8 14.3x 12.0x 10.6x 12.0x 10.6x 7.5x 6.6x 7.5x 6.6x 1.73x 1.58x 16.4x 11.1x $70.00 24%

SAICc

$12.55 SAI N 4.2 16.1x 8.7x 8.3x 8.7x 8.3x 4.4x 4.1x 4.4x 4.1x 0.40x 0.37x 8.9x 7.2x $14.00 12%

Spirit AeroSystems $22.15 SPR N 3.2 15.3x 9.6x 8.4x 9.6x 8.4x 6.7x 5.7x 6.7x 5.7x 0.94x 0.79x NM 17.9x $24.00 8%

TransDigmb

$95.19 TDG N 5.1 21.3x 15.8x 13.4x 15.8x 13.4x 10.4x 9.1x 10.4x 9.1x 5.04x 4.50x 15.4x 13.1x $106.00 11%

United Technologies $74.33 UTX RS 67.5 13.5x 12.9x 10.6x 12.9x 10.6x 7.5x 6.6x 7.5x 6.6x 1.21x 1.12x 12.7x 10.3x RS NA

Wesco Aircraft Holdings $13.43 WAIR OW 1.3 16.8x 12.7x 11.0x 12.7x 11.0x 8.9x 7.7x 8.9x 7.7x 2.21x 1.92x 18.8x 14.1x $15.00 12%

Average/Total: $300.2 12.9x 11.5x 10.5x 11.3x 9.9x 6.4x 5.8x 6.4x 5.8x 1.19x 1.09x 11.8x 10.5x

S&P 500 (Consensus) $1,281.06 SPX 12.2x 10.9x

A & D discount/(premium) 6% 5%

EPS PAEPS FCF (per share) Sales (bln) Dividend Dividend / Book Capitalization (bln)

Company 2011E 2012E 2013E 2012E 2013E 2012E 2013E 2011E 2012E 2013E 2011E 2012E 2013E Yield 12E PAEPS Equity Net Debt Total % Debt

Alliant Techsystemsb

$8.71 $7.49 $6.66 $7.89 $7.12 $6.10 $6.19 4.6 4.3 4.1 11.8% 10.9% 10.2% 1.4% 10.1% 1.2 1.0 2.3 45.5%

Boeing 4.50 4.85 5.65 4.85 5.65 4.33 8.65 68.9 77.6 83.3 8.0% 7.7% 8.1% 2.3% 34.6% 6.0 3.1 9.1 34.5%

Bombardier 0.47 0.51 0.65 0.51 0.65 0.34 0.63 18.8 19.3 20.5 6.5% 7.1% 8.1% 2.4% 19.6% 1.3 1.6 2.9 54.3%

CACIb

5.29 5.50 5.52 5.50 5.52 6.59 7.62 3.7 3.9 4.0 7.5% 7.2% 7.2% 0.0% 0.0% 1.1 0.5 1.6 30.8%

Comtechc

1.56 1.24 1.40 1.24 1.40 1.33 1.95 0.5 0.4 0.4 14.0% 12.1% 13.2% 3.8% 88.7% 0.6 -0.3 0.3 NM

Embraer 2.00 3.00 3.50 3.00 3.50 2.23 3.54 5.8 6.4 6.9 9.3% 10.2% 10.8% 3.1% 26.7% 3.1 -0.4 2.7 NM

Exelis 2.00 1.60 1.50 1.71 1.53 0.98 1.06 5.8 5.3 4.9 10.0% 9.4% 9.7% 4.5% 24.2% 1.7 0.5 2.2 21.8%

General Dynamics 7.30 7.30 7.50 7.30 7.50 7.77 7.96 32.8 33.3 32.6 12.2% 11.6% 11.6% 2.8% 25.8% 13.6 2.6 16.2 16.0%

Goodrich 5.89 6.90 7.66 6.90 7.66 6.40 7.06 8.0 8.8 9.3 15.8% 16.8% 17.4% 0.9% 16.8% 3.8 1.9 5.7 33.3%

Harris Corporationb

4.26 4.44 4.08 4.44 4.08 5.21 3.95 6.0 6.1 6.1 14.6% 14.4% 13.3% 3.1% 25.2% 2.2 2.1 4.3 49.7%

L-3 Communications 8.75 8.20 8.05 8.20 8.05 11.68 11.84 15.3 14.5 13.6 10.7% 10.2% 10.1% 2.7% 22.0% 6.7 3.6 10.3 34.9%

Lockheed Martin 7.65 7.30 7.50 9.40 8.92 8.41 8.26 46.7 45.1 43.1 8.3% 8.1% 8.4% 5.0% 42.6% 2.9 2.5 5.4 45.7%

Northrop Grumman 7.05 6.60 6.40 6.04 5.84 7.06 6.43 26.6 25.5 24.2 12.1% 10.8% 10.3% 3.4% 33.1% 12.0 1.0 13.0 7.9%

Precision Castpartsb

8.10 9.98 11.06 9.98 11.06 9.53 10.57 7.1 8.4 9.0 24.5% 25.7% 26.5% 0.1% 1.2% 7.5 -1.1 6.4 NM

Raytheon 5.05 5.25 5.85 5.95 6.15 5.78 6.20 25.2 24.9 24.1 10.8% 10.8% 11.5% 3.6% 28.9% 10.4 1.2 11.6 10.4%

Rockwell Collinsb

3.96 4.68 5.33 4.68 5.33 3.44 5.08 4.8 5.0 5.3 18.3% 20.1% 20.8% 1.7% 20.5% 1.7 0.3 2.0 15.9%

SAICc

0.78 1.44 1.52 1.44 1.52 1.41 1.74 10.8 10.7 10.5 5.9% 8.0% 8.0% 0.0% 0.0% 2.3 0.4 2.7 14.3%

Spirit AeroSystems 1.45 2.30 2.65 2.30 2.65 0.38 1.24 4.8 5.1 5.9 7.9% 10.9% 10.8% 0.0% 0.0% 1.9 1.7 3.6 47.9%

TransDigmb

4.46 6.01 7.08 6.01 7.08 6.18 7.24 1.3 1.5 1.7 40.3% 44.6% 46.0% 0.0% 0.0% 0.8 2.8 3.6 77.3%

United Technologies 5.50 5.75 7.00 5.75 7.00 5.84 7.20 58.2 65.4 75.9 14.4% 14.0% 15.1% 2.6% 33.4% 22.6 5.4 28.0 19.3%

Wesco Aircraft Holdings 0.80 1.06 1.22 1.06 1.22 0.71 0.95 0.7 0.8 0.9 22.5% 23.8% 24.1% 0.0% 0.0% 0.6 0.5 1.1 44.0%

Average/Total: 356.0 372.0 386.0 13.6% 14.1% 14.4% 2.0% 18.2% 23.2%

S&P 500 105.36 117.75

Note: J.P. Morgan ratings: OW = Overweight; N = Neutral; UW = Underweight; RS = Restricted. Price targets are for Dec 31 '12. a. PAEPS excludes net pension expense for LMT, NOC, RTN and ATK.

b. ATK, CACI, COL, HRS, PCP, TDG, and WAIR estimates are calendar year; c. CMTL and SAI years are from Feb. to Jan. Estimates are in U.S. Dollars; BBD stock price converted from Canadian Dollars for multiple calculations based on current exchange rates.

Source: Bloomberg, Company reports, and J.P. Morgan estimates.

Operating Margin

Valuation Metrics

Other Financial Metrics

P/PAEP/E EV/EBITDA EV/SalesEV/EBITDAP

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Investment Thesis

Commercial Aerospace

We continue to see opportunity in commercial aerospace stocks in the coming years and expect average returns in line with earnings growth. This was essentially our thesis last year as well, and an index of US commercial stocks under coverage generated a 16% return last year versus a flat overall market. Our EPS growth forecasts for US commercial aerospace companies are 27% for CY12 and 14% for CY13, on average, and therefore mid-teens returns are a reasonable expectation if fundamentals play out as we expect them to. A bull case could include some modest incremental multiple expansion, but there may not be much of this left now thatvaluations have returned to their historical average from depressed levels in the 2009 timeframe.

We see large commercial aircraft deliveries increasing from 1,047 in 2010 to ~1,540by 2015, which represents an annual growth rate of over 8% in terms of units and seats. We believe that the upturn is supported by global economic and traffic growth, particularly in the emerging markets, which represent more than half of total demand, but increasingly aggressive rate hikes along with the entry of new aircraft into service present the risk of a pullback in the event of a disruption to the global economic recovery. An important profit driver for Boeing and the supply chain is the certification and production ramp up of the 787, and while there are major challenges ahead on this front, we believe the market is, if anything, underestimating the risk retirement that took place in 2011.

We expect aftermarket sales growth to remain in the high single digits in 2012, driven by mid single digit ASM growth, a few percentage points of pricing, and some additional catching up from the recession. The regional aircraft outlook remains more precarious, and production should be roughly flattish in 2012, but only due to growth from new players that are ramping up production on new platforms at the expense of existing manufacturers. Business jet production was roughly flat in 2011, but the outlook for a recovery or at least the magnitude of it has been pushed out from where we anticipated a year ago. We are forecasting 9% delivery growth in 2012 and 15% in 2013, but large cabin aircraft are seeing much stronger demand than small cabin.

Our top two commercial aerospace picks going into 2012 are Boeing and Embraer. BA had a good year in 2011, and while the 787 ramp-up continues to drag out longer than one might hope, we believe that another good year is on the way. We see a substantial improvement in cash flow this year and more on the way, with the key driver as a substantial reduction in inventory build for the 787 program, and ultimately a decline. We see the stock reaching $100-120 in the next two years, based on 10-12x a $10 FCF number once the 787 production rate has stabilized at 10/month. ERJ also looks particularly attractive at current levels, and while there is higher risk due to a far smaller backlog, we see upside of well over 50%. We see even more upside for Bombardier (BBD/B CN), which presents probably both the highest reward and the highest risk in our universe, with the key issue beingsuccessful execution on the CSeries development program. Other commercial aero stocks we are recommending include Precision Castparts (PCP), Wesco Aircraft (WAIR), and Rockwell Collins (COL).

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Defense

We are approaching 2012 with the expectation that defense stocks will be flattish to slightly down this year on average and act defensively in the context of the broader market. We think about the prototypical defense stock as generating an organic EBIT decline in the 8-10% range, driven by a 4-5% sales decline and perhaps 50 bps of margin erosion. Share repurchase can reduce the decline in EPS (ex pension) to the mid-single digit range, and after including a 4% dividend and assuming a flat multiple, we anticipate total returns in the low negative single digits.

We foresee a 4-5% average revenue decline for the industry in each of the next three years. We assume for now that the outcome of the sequestration issue will result in $180 bn of additional cuts to the defense budget over the next nine years, far less than the $500 bn now encoded into law as a result of the failure of the congressional super committee to reach a deal last fall, but incrementally painful nonetheless. Bigger picture, even if sequestration is fully maintained, the US fiscal deficit remains at a $1.1 tn run rate. Until serious fiscal reform reduces that number to a more manageable level below $500 bn, we believe the defense budget will remain under pressure.

In each of the last two years, there has been a clear-cut best performing large cap defense stock, and in both cases there was a single factor that drove much of the performance. In 2010, the winner was NOC, due primarily to the July announcement that it was exploring strategic alternatives for its shipbuilding business, while in 2011, LMT was the major outperformer on the back of its September announcement of a 33% increase in its dividend. Looking to 2012, our Overweight rated large cap selections are RTN and GD, both of which we feel have a multiple expansion opportunity relative to the rest of the group. However, a surprise dividend announcement from another company or a surprise strategic move such as a major split or spin-off could be the decisive news in 2012.

Our framework for rating SMID cap stocks in 2012 includes both our traditional fundamentals-based analysis and, increasingly, our view of a company’s strategic attractiveness. This methodology is based on our view that the challenging operating environment created by budget cuts will increasingly drive consolidation within the industry over the next several years. Our top SMID defense pick heading into 2012 is XLS.

Longer term, we believe the next major money to be made in the group as a whole will be as a result of multiple expansion rather than earnings surprising to the upside. We believe the major trigger for an upward rerating of the multiples will be a visible path toward fiscal reform, even if it includes further cuts to the defense budget since they would likely be the final cuts of the cycle. We do not expect a fiscal deal to be reached before the election, but it is possible, depending on how the political cards are reshuffled, that in the aftermath of the election a framework for reform emerges. It is also possible that it could take many more years to get there. When the market does become convinced that this overhang is lifting, we could envision multiple expansion from the current ~9x range into the 12-15x range on trough earnings. We also believe that this lifting of an overhang will present an all-clear signal of sorts for defense CEOs to look more aggressively at M&A, which should also help stock performance.

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Key Investment Points

Commercial Aerospace

Earnings growth can drive commercial aero stocks higher

Commercial aero stocks have been consistently strong performers off the March 2009 market bottom, and an index of our US aero stocks appreciated 170% through 2011, roughly double the S&P 500’s 86%. The performance in 2011 was no exception, as the index increased by 16% in a flat market. We expect further appreciation based on relatively high visibility earnings growth the next three years that should stem from increasing large aircraft deliveries, higher aftermarket sales, and eventually a bizjet recovery. Our US commercial EPS growth forecasts are 27% for CY12 and 14% for CY13, on average. We would not count on much multiple expansion or compression, with the stocks trading just under their long term average of ~14x next year’s EPS. Earnings growth should help support multiples, and there could be some upside as we move through the cycle, a dynamic consistent with past experience if not the contents of a finance text book. On the other hand, the average multiple has not moved much beyond 15x as the trajectory of the current up cycle has taken shape, so we do not see much upside either. The valuation anomalies in commercial aero are our two non-US stocks under coverage, Embraer and Bombardier. Each now trades in the 6-8x range on our 2013E EPS—steep discounts to historical averages and other aerospace companies—and we believe each presents a compelling risk/reward. This is particularly true for Embraer, where we expect continued execution and a weaker real to drive margins and therefore earnings above expectations this year. Bombardier carries higher risk due to the critical stage of the CSeries development it is entering into amid indications that the schedule is starting to slip, but the 2-3 year potential upside is perhaps unique in our coverage universe.

We are still in the early stages of a commercial aero up cycle

We estimate that large aircraft deliveries will increase ~40% over the next four years, helping to drive earnings growth at OEMs and suppliers. This forecast is more or less consistent with the rate plans Boeing and Airbus have laid out, and while we see downside risks, this level of increased deliveries seems reasonable, given our expectations for continued air traffic growth, rising demand from US carriers replacing older narrowbodies, robust backlogs at Boeing and Airbus, a dearth of parked aircraft young enough to return to service, oil prices that should remain high enough to make new aircraft compelling, and our belief that airlines will retain access to capital at relatively attractive rates to purchase new aircraft. The 737 and A320 account for just over 40% of the increase in our forecast, with 787 contributing an incremental ~25%.The major risks to rising aircraft deliveries are a global recession that cuts into traffic growth, particularly in China and other emerging markets, the evaporation of credit for aircraft customers, and delayed ramp ups for new programs, including 787, CSeries and A350.

EMs should help traffic growth hold despite moderate 2012 deceleration

Global traffic has grown at ~1.5x GDP historically, but this multiple has expanded since 2004, averaging 2.0x since then. It is early to declare a new relationship, but we do see it as significant that this relative strength has persisted for eight years. Traffic has been particularly resilient amid recent economic turmoil, including in 2011, which saw growth approach 6%. Surprisingly, Europe led the way, and deceleration there should provide a headwind for 2012. Japan’s earthquake recovery should

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provide a partial offset, and we see Chinese traffic growth remaining in the low double digits. Overall, we forecast traffic growth of 4.5% this year. This is slightly below the 5% annual growth we estimate is consistent with the seats coming to market over the next five years, but faster growth beyond 2012 could easily make up the difference. 2011 notwithstanding, emerging markets should be the primary drivers of growth, and emerging market carriers now account for half the combined Boeing/Airbus backlog. We estimate that traffic growth drives 60% of new aircraft demand with emerging markets accounting for ~60% of traffic growth. We expect emerging markets to continue driving growth in the coming years thanks to higher economic growth and an expanding consumer class; however, a severe emerging markets slowdown, including a hard landing in China, is a risk for traffic growth and therefore aircraft demand.

Boeing orders should remain elevated

Boeing should turn in another strong order year, thanks mainly to the 737 MAX, which is poised for a wave of commitment conversions and new orders. BCA chief Jim Albaugh expects 1,400-1,500 firm commitments for the 737 MAX by year end, up from 150 today, implying ~1,300 orders this year. The 787-10, a further stretch of the 787 that Boeing could launch this year, might be another source of order strength. We believe customers are already interested in the aircraft and the economics should be appealing. Boeing generated a record 200 777 net orders in 2011, and we envision continued demand due in part to delays and uncertainty on the A350. Boeing booked 805 net orders in 2011for a book-to-bill of ~1.7x, and management believes that book-to-bill will exceed 1.0x in both 2012 and 2013, though next year’s target looks more up in the air to us. Strong order performance could be a positive signal for the stock, since the correlation between the share price and last 12 months average orders has been 0.70 since 1989.

787 cash turnaround should begin with decisive move in 2012

We expect Boeing’s free cash flow to increase by over $2 bn in 2012 as 787 cash flow takes the first step—which should be a large one—on a path of multi-year improvement. Our estimate for 2012 FCF of $3+ bn would represent ~90%conversion, whereas 2011 should be only ~30%. Last year, 787 inventory grew by $1.6-1.7 bn/quarter, generating a massive drag on cash. Inventory should grow again materially in 2012, but 787 does not have to become a source of cash for Boeing cash flow to improve, it just has to become a smaller use of cash. 787 cash flow iscomplex and our estimates depend on assumptions for production, deliveries, unit costs, and rework where visibility is low. We assume, for example, that Boeing delivers 40 787s this year. The key point for 2012 is that rather than accumulate 787s on its balance sheet, as it did in 2010 and 2011, Boeing should deliver them as well. This mitigating factor on inventory growth should cut 787 inventory growth in half, driving sharply improved company cash flow. Ultimately, we could see FCF approaching $10/share, and while BA has traded on GAAP earnings historically, we expect the market to take some account of the company’s strong cash generation. Assuming FCF of $10/share in 2014, we could see the stock trading at 10-12x next year’s FCF in 2013, or somewhere in the $100-120 range. Potentially large pension contributions beyond 2012 remain a question mark for Boeing's cash flow outlook.

Aftermarket sales should grow nicely in 2012, likely approaching 10%

We expect aerospace aftermarket sales growth to remain robust in 2012. Growth rates may decline from the solidly double-digit range posted last year, but we see

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them remaining close to double digits, or in some cases better, on mid single digit ASM growth, a few percentage points of pricing, and some additional catching up from the recession. We estimate that aftermarket sales grew ~17% y/y on average between 4Q10 and 3Q11, 10 percentage points ahead of ASMs, indicating that aftermarket sales have recovered some ground from 2009/2010, when destocking and deferred maintenance resulted in growth well below that of ASMs. Cumulatively, however, aftermarket sales have just surpassed 2008 peak levels (+5% in 3Q11 vs 3Q08), whereas ASMs are up 14% over the same period. This suggests that aftermarket sales could see some more excess growth ahead. It also implies that despite a year of robust growth, aftermarket sales are not running particularly hot relative to underlying demand. This makes the commercial aero aftermarket somewhat defensive, in our view, in that another global recession is unlikely to trigger another severe round of destocking and deferrals that would cause sales to fall well short of ASMs.

Critical year for CSeries and A350 development programs

Both programs face challenges, though the CSeries should affect Bombardier’s stock more than the A350 does EADS’ or Boeing’s. While Bombardier is maintaining its late 2013 delivery target, it has acknowledged schedule pressure, and first flight later this year will be critical. We believe the stock is already discounting a delay, though the magnitude is unclear. CSeries execution is now Bombardier’s most important goal, as we do not believe it has the financial strength to weather a sustained, 787-like delay, though we do not expect one at this time either. For Airbus, the challenge is getting A350 development back on track after delaying all three variants last year. This is a highly complex program, and Airbus still appears to be struggling with several issues, including managing the supply chain and working with composites, so further delays appear likely. Boeing should continue to benefit from the long wait for A350-1000 EIS in 2017 and questions about its final configuration in the form of higher 777-300ER demand and we believe Airbus must make progress on these fronts to start changing the market dynamic between these two aircraft. Ultimately, we still expect the A350—or the -900 variant, at least—to be successful in the marketplace. Getting there could be extremely difficult for Airbus, but EADS should be able to absorb the pain. In Bombardier’s case, we believe that management has essentially bet the company on the CSeries.

Large bizjets should continue to outperform modest recovery for smaller jets

We expect the divergence in demand between larger and smaller business jets to persist in 2012. Emerging market customers, particularly in China, should continue ordering larger, well-established business jets, while smaller jets, which are more dependent on developed world businesses, should see demand improve more modestly. This has resulted in a two tiered industry, with a better near term outlook for those selling larger jets. For example, Bombardier’s TTM book-to-bill is 1.4x, driven mainly by Globals, and Global deliveries are increasing this year. Gulfstream book-to-bill ratios have consistently exceeded 1.0x as well. On the other hand, Cessna’s TTM book-to-bill is only 0.4x, Embraer has continued to see Phenom cancellations, and Hawker recently put the brakes on development of its new light bizjet amid weak demand. The reduced prospects for global growth in 2H affected bizjet indicators, with used inventories crawling higher (though pricing may be bottoming) and flight ops flat to down. One good piece of news for bizjets is that the lack of a real recovery in this segment leaves little apparent room to fall in the event of another macro shock, at least in the case of small cabin aircraft, though a China

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hard landing looks like a risk for large cabin demand. We also believe that expectations remain low, meaning that any upside surprises with regard to demand—particularly for smaller jets, where it turns quickly—could yield big rewards. The stocks we cover with the most exposure to smaller bizjet demand are Embraer, Rockwell Collins, and Bombardier.

Defense

Defense looks defensive in 2012, for better or for worse

We expect defense stocks to face modest pressure in 2012, as earnings come under pressure from declining sales and margins and the long-term fiscal overhang prevents multiples from expanding. In this context, we look for the defense primes to act defensively this year, lagging if the market performs well and outperforming if the market performs poorly. We think about the prototypical defense stock as generating an organic EBIT decline in the 8-10% range, driven by a 4-5% sales decline and perhaps 50 bps of margin erosion. Share repurchase can reduce the decline in EPS (ex pension) to the mid-single digit range, and after including a 4% dividend andassuming a flat multiple, we anticipate total returns in the low negative single digits. This can either look very good or very bad depending on what happens in the market more broadly. Our framework for rating SMID cap stocks in 2012 includes both our traditional fundamentals-based analysis and, increasingly, our view of a company’s strategic attractiveness. This methodology is based on our view that the challenging operating environment created by budget cuts will increasingly drive consolidation within the industry over the next several years.

There is usually one key driver of large cap relative performance

In each of the last two years, there has been a clear-cut best performing large-cap defense stock, and in both cases there was a single factor that drove much of the performance. In 2010, NOC generated a total return of 20% versus -3% for an index of its peers, and the bulk of the outperformance came after the July announcement that it planned to consider strategic alternatives for its shipbuilding business. In 2011, LMT generated a total return of 21% versus 1% for the peer index, and essentially all of the outperformance took place in the weeks leading up to and immediately following its September announcement of a 33% increase in its dividend. We believe that the announcement was well anticipated and drove much of the outperformance that took place before it. Looking to 2012, our Overweight rated selections are RTNand GD, both of which we feel have multiple expansion opportunity relative to the rest of the group. However, a surprise dividend announcement from another company or a surprise strategic move such as a major split or spin-off could be the decisive news in 2012.

Long-term fiscal uncertainty is weighing on defense multiples

Despite the deficit reduction achieved by last year’s Budget Control Act of 2011 (BCA), the long-term fiscal outlook in the US remains deeply challenged. The US is in the midst of a spending binge that saw the annual federal deficit as a percentage of GDP increase by 700 bps in FY09 to 10%, and this metric has remained at 9% for the last two years. We view the current run-rate deficit as $1.1 tn, or 7% of FY11 GDP, which is equivalent to the $1.3 tn deficits in each of the last two years less the $0.2 tn of annual savings mandated by the BCA. In order for the US to reduce its deficits from this unsustainable level and improve its long-term fiscal outlook, significant structural changes are necessary. Entitlement spending and/or taxes will have to be a major part of the solution, but as the largest component of discretionary

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spending, defense is likely to play a role, as well. Our view is that as long as the US long-term fiscal situation remains unresolved, and consequently the role of defense in the solution is unknown, defense valuations will stagnate at current levels. We believe multiple expansion will ultimately drive improved defense valuations, but only expect this to occur once a long-term fiscal resolution is reached and there is more clarity into the trough level of the defense budget.

Sequestration overhang should be resolved this year

The Budget Control Act cut $450 bn from the defense budget through FY21, but the larger implication for defense was the creation of the congressional “super committee” tasked with finding a minimum of $1.2 tn of additional deficit reduction through FY21. When the super committee failed to reach an agreement by its deadline last year, sequestration, and with it an additional $500 bn of defense cuts from FY13-FY21, became law. Despite this, industry and market participants are generally operating as if defense will be spared from the full $500 bn of additional cuts, and while it is likely that defense will be subjected to additional cuts, the magnitude and nature of such cuts remain unknown. Sequestration is set to take effect at the beginning of FY13, and therefore the fate of defense spending as it pertains to the BCA will be finalized this year, although given Washington’s track record we don’t expect a final resolution without a lot of debate and brinksmanship. In the meantime, we are factoring $180 bn of additional defense cuts as part of the sequestration process into all of our company earnings estimates.

Budget cuts drive poor revenue outlook

Our revenue outlook for the defense primes is shaped by our view of the addressable market for defense products, which consists of base and supplemental investment account outlays and international sales, as well as our view on defense services. Under the FY12 defense budget, the base investment account budget is flat y/y while the supplemental investment account budget is down 46% y/y. Supplementals represent a relatively small component of the overall investment account budget, and as a result, the total investment account budget is declining 6% y/y in FY12. We assume outlays lag budget authority and therefore, we expect total investment account outlays to decline 3% y/y in FY12. We forecast flat international sales in FY12 which given their relatively small contribution to the total addressable market, results in a 3% y/y decline in the addressable market in FY12. In this context, we forecast an average y/y organic sales decline of 5% for the defense primes in 2012. The 200 bps discrepancy between our estimated organic sales decline and forecastfor the addressable market is largely attributable to the defense services businesses of the primes, which we expect will face even more pressure than products in 2012. Beyond 2012, we forecast an average y/y organic sales decline of 5% for the defense primes in 2013 as cuts under the sequestration phase of the BCA ($180 bn over 9 years based on our assumption) kick in, causing the y/y decline in the addressable market to reach 4%, and defense services pressures persist.

Defense services headwinds expected to intensify

We believe defense services will face increased pressure this year given their large exposure to supplemental funding. We view the O&M budget account as the best proxy for the market for defense services, and while we expect it will fare relativelywell in the intermediate term as it relates to base budget cuts given our view that it is “sticky”, we believe its significant exposure to supplemental funding will drive meaningful declines in total O&M account funding over the next few years as US

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troop levels in the Middle East decline. The base O&M account budget in FY12 is flat y/y; however, the supplemental O&M account budget is down 19% y/y, and as a result, total O&M funding is declining 7% y/y in FY12. We see less of a lag in O&M outlays than we do in investment account outlays, and accordingly we forecast a 6% y/y decline in O&M outlays in FY12. In this context, we forecast an average y/y organic sales decline of 5% in 2012 for defense services providers, including the services businesses of the defense primes. We believe the pressure on defense services will continue, and most likely increase, beyond 2012 as we expect the decline in supplemental funding to accelerate. We forecast a 13% y/y decline in O&M outlays in 2013.

Weak fundamentals pressure margins

Defense companies continued to deliver strong margin performance in 2011 despite the difficult environment, and we estimate the average full-year operating margin for the defense primes exceeded 10% for the fifth consecutive year. This performance came in spite of a challenging operating environment in which we expect full-year average organic growth for the defense primes will be negative for the first time in over a decade. We believe that margins in 2011 benefited from favorable mix and risk retirement under contract accounting, both of which we believe are unsustainable in 2012. With less flexibility to support margins, we expect strong top line headwinds and DoD austerity measures will drive operating margins down starting in 2012. We forecast an average operating margin for the defense primes of 9.8% in 2012, which represents a 60 bps y/y decrease from our 2011 estimate of 10.4%. We see average operating margin decreasing another 30 bps in 2013 to 9.5%.

A major pick-up in M&A activity looks like a question of when

As the defense industry enters a downturn, we expect to see a continued increase in strategic transactions and M&A activity. The cresting of the cycle has been marked by several spin-offs, including completed transactions by NOC and ITT and a pending one by LLL, as well as sales of businesses to private equity. We see this as the early stages of a reshuffling of the industry. We expect to see more of these transactions, and ultimately we also expect to see a pick-up in merger activity. While the group of small and mid cap defense companies may continue to grow over the next year or two, ultimately we expect it to shrink as larger companies turn increasingly to acquisitions. The Pentagon has publicly stated it does not wish to see consolidation among the “top five or six” players, but that still leaves room for a deal or two among the top seven (LMT, BA, NOC, BA.L, GD, RTN, and LLL), and we believe the DoD’s attitude may change if the budget continues to face pressure. We believe a key catalyst for consolidation will be broader US fiscal reform, which may take a further chunk out of the budget but at least should put a floor on how low the defense budget might go in the coming years. We believe acquisitions and divestitures will be important catalysts for stock selection in the group, and we are increasingly taking potential activity into account when considering our ratings, particularly among the small and mid cap companies.

The election should not be a positive driver unless a fiscal deal emerges

We view the November presidential election as an interesting catalyst because defense may perform in a counter intuitive manner. The conventional wisdom is that defense could rally if Republicans win the White House in November. While this may occur, we think a Republican victory would have a more profoundly positive impact on the broader market, in which case we would look for defense to rally, but

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lag the increase in the overall market, in line with our thesis that defense will behave defensively in 2012. Conversely, we believe that the re-election of President Obama could cause the market to decline and defense to outperform, despite the possibility that a Democratic victory could have more negative long-term implications for defense than a Republican victory.

Sector-wide

Pension remains a focus area

Most major aerospace/defense companies still have large, defined benefit pension plans, and as a result, interest rates and asset returns have a material effect on GAAP earnings. There is an additional dynamic for defense companies because they are typically reimbursed by the government for most of their pension expense, although not necessarily at the time it is accrued on GAAP income statements. For these reasons, we believe it is important to consider pension adjusted earnings for thosecompanies that report FAS pension expense and CAS reimbursements, most notably LMT, NOC and RTN. Interest rates, as measured by the Moody’s Corporate AA Index, were down ~125 bps in 2011, which will likely create pension headwinds for 2012 earnings, although interest rates were down a more modest ~25 bps between when companies gave guidance last October and the end of the year and therefore, we believe most of the headwinds associated with the decline in interest rates in 2011 are already factored into estimates. With the late-year rally in equity markets driving a positive return from the S&P 500 and fixed income likely generating healthy returns given the interest rate environment, we expect that asset returns in 2011 will not create significant incremental headwinds for 2012 earnings. Funded status remains a concern, but all major aerospace/defense companies have the balance sheet strength and cash generation capability to meet their funding obligations, and many have opportunistically made contributions as RTN did late last year, raising debt in a low interest rate environment to fund its pension. Late Q4 contributions could positively impact the 2012 earnings outlook, and we believe this has been part of the driver behind RTN’s strong late-year stock performance.

The dollar is a major swing factor for non-US aircraft manufacturers

Non-US aircraft manufacturers Airbus, Bombardier, and Embraer sell their products in US dollars, while a significant portion of their costs, primarily for labor and overhead, is denominated in their respective local currencies. This makes currency a meaningful driver of earnings. In the mid 2000s, profits for all three companies, particularly Airbus, came under pressure as the dollar steadily declined. More recently, currency volatility has meant that the value of the dollar has had a more varied impact, but to the extent that the dollar weakens from here, these companies would see stronger headwinds, while dollar appreciation would bolster earnings. For Bombardier’s Transportation segment and UTX’s commercial units, revenues and costs both tend to be foreign currency-denominated, so these businesses see a translation impact from changing currency values. In both cases, a weaker dollar is neutral for margins but a boost for sales and earnings and vice versa.

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Potential Disruptive Events

The A350 program suffers a severe setback

We believe further A350 delays are probable, while a more significant setback of more than a year is less likely but still a possibility. Another potential setback is an engineering issue preventing the A350 from delivering promised performance. Finally, there could be a raft of order cancellations, particularly for the -1000. This variant is least well defined – final assembly begins in 2015 – and Emirates and Qatar, which comprise over half of the backlog of 75 aircraft, each expressed dissatisfaction regarding the overhaul Airbus announced last year, including the upgraded engine. Emirates went on to order 50 more 777-300ERs, the direct competitor to the -1000. Some consequences of a major A350 setback would be similar to those of another months-long delay, only of greater magnitude, including more demand for the 777-300ER, which would have the ~350 seat market to itself for longer, and perhaps more 787-10 demand as well if Boeing launches this program. It would also extend the period for Boeing to move forward with a 777 refresh. Among the suppliers we cover, we see Spirit AeroSystems as most exposed to a major A350 setback. Spirit is a top A350 supplier, providing composite fuselage panels and the wing leading edge, and problems with this program could be a material cash flow headwind.

Pension rules change for the worse due to emerging populist pressure

Defense companies are generally compensated for pension expense through Pentagon contracts, as it is considered an allowable cost under the Federal Acquisition Regulation. Given the poor market returns in recent years and low interest rates, these recoveries have grown substantially. While recoveries by BA and GD are not clearly disclosed, we estimate that the other three top defense contractors (LMT, NOC, and RTN) recovered $2.3 billion from the government in 2011, which amounts to 25% of our estimate of their combined pretax income. While this has not yet been a popular subject in the press, we could envision a populist effort to change this policy given current economic and fiscal conditions and the pressure that other pension funds, both public and private, are facing. A proponent could argue that defense companies are returning most of their profits to shareholders, so cutting a quarter of those disbursements and putting them, as opposed to taxpayer money, into the pension funds could be construed as “fair”. Defense companies could reasonably argue that the reimbursement is a major condition of the contracts they agree to, and they would probably demand to be made whole through higher pricing. Additionally, a reasonable bystander might say that the numbers involved are a drop in the bucket compared to a ~$1.1 tn deficit and a $647 bn defense budget, and there are many better ways to take waste out of the procurement system. Nonetheless, as the corporate jet tax break issue from mid-2011 demonstrated, populist policies can overrun other factors in this type of environment. If this were to become a possibility in 2012, we believe it would have a material impact on the performance of the stocks.

Boeing and/or Airbus are unable to ramp production as planned

Boeing and Airbus’ plans to increase deliveries by ~40% over the next four years seem certain to stress the supply chain and OEMs’ own production capabilities. A major aircraft supply disruption would have significant earnings and cash flow implications for the industry. A worst case scenario could look like 1997, when

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Boeing halted the 747 line and stopped 737s from entering final assembly as it grappled with parts shortages and other challenges associated with trying to raise production by ~120% over 18 months. The planned Boeing production ramp ahead is smaller at ~60% over three years, so risk should be lower. Boeing also claims to have learned its lessons and is monitoring suppliers aggressively to help them keep up. 787 looks like the platform most at risk for Boeing, in part because the company will deliver some aircraft from a new final assembly plant in South Carolina; however, Boeing maintains that the first 787 is on track for delivery from Charleston in the first half of this year. One other issue on this front is credit availability, with Airbus noting that the inability of smaller suppliers to obtain credit amid the European debt crisis is resulting in a scarcity of A350 parts.

A hard landing for emerging market economies, particularly China

Emerging markets are a key source of new aircraft demand, and we see a downturn in these countries as the primary risk to the cycle. We estimate that emerging markets account for ~60% of air traffic growth, and as traffic growth accounts for 60% of aircraft demand, emerging market traffic growth is responsible for ~35% of total demand. The US and Europe are expected to grow slowly near-term, so emerging markets should be an essential traffic growth driver. In addition, emerging market carriers account for about half of Boeing and Airbus’ combined backlog. Boeing and Airbus plans to increase deliveries by ~40% over the next four years and are therefore highly dependent on delivering new planes to emerging markets to accommodate growing demand for air travel. J.P. Morgan forecasts that emerging market growth will decelerate to 4.7% this year, dragging global GDP growth down to 2.1%, which we still believe could support 4-5% global traffic growth based on recent traffic/GDP multiples. The risk is that a severe recession impacts emerging economies much more substantially, such that traffic growth slows dramatically or turns negative. China is the leading emerging market customer for aircraft, accounting for roughly 15% of global deliveries, and there are well known concerns it could suffer a hard landing. J.P. Morgan still forecasts 8.2% economic growth in China this year, however, and Chinese traffic has typically grown at ~1.5x GDP, implying traffic growth could remain in the low double digit range this year. A more precipitous decline could have significant implications for global aircraft demand.

Aircraft finance falls victim to the rolling credit crunch

New aircraft financing has held up well in recent years. We saw widespread fear of a multi-billion dollar funding gap in 2008/2009, for example, but the issue faded away. The Europe crisis has prompted these fears to re-emerge, and there is no question that European players, a major presence amid the ~25% of new aircraft financing that came from banks last year, are pulling back. By itself, this obstacle should be surmountable, with higher contributions from other banks (including Chinese, Japanese, and Middle Eastern institutions) and more reliance on capital markets and government export credit. However, a more substantial financial conflagration in Europe would have severe consequences for global credit markets, potentially preventing carriers from financing deliveries. Beyond this immediate risk, Basel III could make bank financing more expensive in 2013. In addition, we may be exiting the “golden age” of government export credit financing, which accounts for ~30% of total financing. An OECD agreement taking effect in 2013 will raise the cost of these loans and guarantees, and US airlines are now fighting back hard against government financing. Ultimately, we see customers obtaining financing for planned deliveries in most macro scenarios, but it is worth noting that the easy access to capital of recent

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years is not guaranteed, particularly with rising deliveries resulting in a higher funding requirement each year.

Bombardier announces a major problem or delay on the CSeries program

We believe Bombardier has virtually “bet the company” on the CSeries program, meaning that any major setback, such as a multi-year delay, failure to deliver promised performance, or inability to generate orders, could send the stock sliding sharply. With final assembly gearing up now and first flight slated for later this year, we see 2012 as the make or break year for the program. We believe the market is already discounting at least a modest delay (maybe ~6 months or so), so it would take something larger and more disruptive than that to truly pressure the stock. We have seen no evidence of such a problem, but given the complexity of the program, including the prevalence of composites, the adoption of fly-by-wire controls, a revolutionary new engine, and the need to integrate systems developed by suppliers around the world, there is no shortage of potential problem areas. In addition, Bombardier does not have the financial strength for the incremental development costs and a multi-year delay on par with Boeing’s 787 experience, so the disclosure of major problems could prompt discussion about the future of the company. No other company we follow is so dependent on the CSeries that this would have a material impact, though Embraer would probably benefit at the margin as prospects for E-Jet demand beyond 2013 would improve.

China pursues a Western acquisition or partnership in commercial aerospace

It is clear that China intends to be a leading player in the commercial aerospace industry over the long term, and one strategy for accomplishing this would be through acquiring or partnering more closely with a Western aerospace company. China took a step in this direction last year through the announcement of a strategic partnership with Bombardier. It is taking some time to iron out the specifics of this agreement, but Bombardier has indicated there should be more news to come this year. We believe that this agreement should suit both parties quite well. The Chinese stand to accelerate their entrance into the global aerospace market through access to Bombardier’s aerospace know-how, while Bombardier could generate increased Chinese demand for its aircraft, including most critically the CSeries, and gain a deep-pocketed backer to help make CSeries development risk more tolerable. The path along which this partnership will develop this year is not clear. An outright acquisition of Bombardier’s commercial aerospace business does not appear imminent, though that could become more likely if the CSeries program runs into significant obstacles. For other players, such as Boeing, Airbus, and Embraer, the acceleration of China’s competitiveness in aerospace would be a long-term negative.

A major political deal changes the fiscal game

We believe that defense stock multiples are essentially capped until the market starts to gain confidence that Washington is successfully moving toward reinstating the long-term fiscal health of the US. The difficult cuts to discretionary spending,including defense, under the sequestration portion of the BCA, even if upheld this year, only reduce the run-rate annual deficit to ~$1.1 tn in FY13. We see a realistic sustainable annual deficit as 2-3% of GDP, which equates to $300-450 bn annually and represents a level at which debt would grow in line with GDP growth. While the BCA last year was a start, it fell far short of what is necessary to plug the gap. We do not believe that a political deal that credibly solves this issue is likely before the election this November. However, depending on how the political cards are shuffled,

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there could at least be movement toward a solution in the lame duck period post election. Ultimately, we believe that the next time defense stocks as a group generate real positive alpha return will be driven by multiple expansion, and the trigger will bea resolution of the massive fiscal overhang that threatens to drive more cuts in the future regardless of how material the cuts have already been. Even if earnings continue to miss expectations for 2-3 years after such a deal, we could envision P/E multiples rising from 8-9x to the 12-15x level on credible estimates for trough earnings.

Europe finally gives in to a breakup of the euro

The future of the eurozone is a major question on the mind of everyone in the financial community going into 2012. While there could of course be major implications for the global economy and geopolitics if there is a "bad ending" to the drama unfolding seemingly in slow motion in Europe, there is also a nuance that is more specific to the aerospace industry than most. German exporters have significantly benefited from a currency that has likely been far weaker than the Deutschemark would have been if not for the introduction of the euro, and this has helped Airbus’ competitiveness versus Boeing. If the euro breaks up, looking beyond the significant economic displacement that would be likely for some time, labor in Germany (and perhaps to some degree in France as well) would over the long run probably cost more than it does today. We could envision this helping Boeing competitively as Airbus would need to compensate with its pricing strategy.

There is a surprise “big bang” merger in defense

We discuss above the potential for M&A activity in defense to heat up in the coming years as management teams try to find other ways to create value in a challenging fundamental environment. We believe it is taken for granted, however, that there will not be a blockbuster defense deal, such as merger between two defense primes. We acknowledge that antitrust concerns would likely scuttle such a deal, but the government could look at consolidation differently in a new budget environment for defense. We anticipate that defense company CEOs will be more willing to consider M&A, both on a small and large scale, when the government’s fiscal health is on a clear path toward restoration. If such a merger were to occur, or even be proposed, we would expect it to light a fire under the defense space as the market contemplates the potential for more big deals. BA still looks to us like the most likely candidate to attempt a major transaction, though we would not expect any movement on this front until a lot more 787 risk is retired and the program begins to generate some cash. Our assessment of a big deal undertaken by BA or any other company would depend on the price paid and the strategic fit.

A geopolitical crisis alters US defense spending policy

The US withdrew from Iraq at the end of last year, marking an official end to the decade long conflict, and it is scheduled to withdraw from Afghanistan by the end of 2014, concluding an even longer effort. The current framework for US defense spending is based on the assumption that there are no major military efforts, similar to those in Iraq and Afghanistan over the last ten years, in the foreseeable future. However, the geopolitical landscape is far from stable, and any event that would require a substantial deployment of US troops would also likely require more spending, somehow, some way. There are plenty of potential issues out there in the current geopolitical environment, such as increased volatility in North Korea as leadership transitions to the inexperienced Kim Jong Un, the continued nuclear

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ambitions of Iran, increased hostility in Pakistan, and even the potential need to regroup in Iraq or Afghanistan. Additionally, a massive terror or cyber attack or a significant disruption to the supply of key world resources, such as oil, could all prompt a US military response. It would take a significant event or issue to drive a major US military presence somewhere, but that is why we classify this as a potential disruptive event, and it cannot be ruled out. Any geopolitical crisis that materially increases US defense spending would improve the outlook for defense contractors.

The US economy recovers sooner and more sharply than expected

The outlook for the US economy remains challenged; however, if it were to improve sooner than anticipated, we would expect the fundamental outlooks for both commercial aerospace and defense to improve, the former due to more airline traffic and the latter due to an improved fiscal situation. However, while we believe the improved outlook would drive improved performance for both commercial aerospace and defense stocks, we also believe both could lag the overall improvement in themarket. Boeing and Airbus already have enormous backlogs, and we see limited upside to planned production rates in the coming years due to supply constraints, minimizing the potential for increased earnings. The defense budget is expected to decline in coming years as the BCA takes effect and supplemental spending winds down. As such, any diminished fiscal pressure would only serve to reduce anticipated cuts and defense spending would likely remain below current levels. In addition, in a surging economy we would expect defense to act defensively and therefore underperform the overall market.

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Commercial Aero Outlook

Aero Stock Framework

We expect earnings growth to driving additional strong performance for our US aerospace stocks, with multiples, which are around historical levels on average, remaining flattish. Aero stocks have been especially strong performers out of the downturn, with a market cap weighted index of our six US commercial aero stocks (BA, COL, GR, PCP, SPR, and TDG) showing appreciation of 170% from the March 2009 bottom versus 86% for the S&P 500. This performance has been consistent, as our aero index has easily outperformed the S&P 500 in each of the past three years.

Figure 1: US Aerospace Index and S&P 500 Price Performance, Mar 2009 - Dec 20011

Source: Bloomberg.

Note: US Aerospace index is a market cap weighted index including BA, COL, GR, PCP, SPR,

and TDG. Performance of the index and the S&P 500 measures price appreciation, not total

return.

Figure 2: US Aerospace Index and S&P 500 Price Performance, 2009 2011

Source: Bloomberg.

Note: US Aerospace index is a market cap weighted index including BA, COL, GR, PCP, SPR,

and TDG. Performance of the index and the S&P 500 measures price appreciation, not total

return.

We expect earnings growth to drive stock prices

Looking ahead, we are forecasting 27% EPS growth in 2012 on average for these six companies plus Wesco Aircraft which came public last July and is therefore not included in our index. This is followed by 14% average growth in 2013. We believe there is fairly high visibility on aerospace earnings growth due to rising aircraft delivery rates, aftermarket growth as traffic and capacity increase, and eventually, a business jet recovery. We see solid growth stretching into 2014 as well.

We are not looking for multiples to expand or contract much

In our view, aerospace stocks can continue to perform well based on this sustained, high visibility earnings growth. We do not expect changes in valuation to be major driver of stock prices, however. On average, our aerospace stocks (BA, COL, GR, PCP, SPR, TDG, and WAIR) are trading at 13.7x on consensus EPS for the next fiscal year. This is just below the long-term average of 14x and our base case assumption is that the average multiple will not change significantly.

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Figure 3: Aerospace Index Price to Next FY Earnings, Dec 2000 - Dec 2011

Source: Factset, Bloomberg, and J.P. Morgan estimates.

Note: Aerospace Index multiple is a simple average including BA, COL, GR, PCP, SPR, TDG, and WAIR.

The sustained earnings growth we expect should provide some support for valuation at this level, but we are not counting on much expansion either. During the last cycle(2004-2007, inclusive) the multiple was fairly high, averaging 17.4x over those four years. The multiple remained above average far into the up cycle, averaging 16.7x in 2007. Although we see another earnings ramp, we are not expecting much in the way of multiple of expansion. The basic outlines of the current cycle has been unfolding for two years and over that time, the average multiple has not exceeded 15x, indicating we are unlikely to see the valuations of the mid 2000s return soon. In addition, multiples dipped below 13x in each of 2010 and 2011 during periods of heightened macro concerns and some downside risk for multiples should remain for as long as financial markets are unsettled.

Non-US stocks Embraer and Bombardier stand out on valuation

The valuation anomalies in commercial aero are our two non-US stocks under coverage, Embraer and Bombardier. Each now trades in the 6-8x range on our 2013EEPS—steep discounts to historical averages and other aerospace companies.

Table 1: Aerospace P/E Ratios

CY13 P/EBoeing 13.1xBombardier 6.2xEmbraer 7.4x

Goodrich 16.1x

Precision Castparts 15.1xRockwell Collins 10.4x

Spirit AeroSystems 8.0xTransDigm 13.3xWesco Aircraft Holdings 10.8xAverage 11.2x

Source: Bloomberg and J.P. Morgan Estimates.

Note: Prices as of Jan 4.

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They were also the two worst performing stocks among our aero companies last year,though we believe each presents a compelling risk/reward.

Figure 4: Aero Stock Price Performance in 2011

Source: Bloomberg.

Note: WAIR performance calculated since its July 27, 2011 IPO.

We are particularly intrigued with Embraer, as we expect continued execution and a weaker real to drive margins and therefore earnings above expectations this year.Bombardier carries higher risk due to the critical stage of the CSeries development it is entering into amid indications that the schedule is starting to slip, but the 2-3 year potential upside is perhaps unique in our coverage universe.

Commercial OE

Commercial aircraft production growth is just beginning

We estimate that mainline aircraft deliveries totaled 1,109 in 2011, up 6% from 2010,but this should be just the start of a period of multi-year growth. We estimate thatdeliveries will rise another 15% this year, with 787 acting as a leading driver, followed by 7-9% in each of 2013 and 2014. Overall, the five year increase in production rates from 2010-2015 could approach 50%.

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Table 2: Large Commercial Aircraft Delivery Estimates

2005 2006 2007 2008 2009 2010 2011E 2012E 2013E 2014E 2015E 2016EBoeing717 13 5 0 0 0 0 0 0 0 0 0 0 737 212 302 330 290 372 376 372 420 438 492 504 504 747 13 14 16 14 8 0 9 20 20 18 18 18 757 2 0 0 0 0 0 0 0 0 0 0 0 767 10 12 12 10 13 12 20 24 24 24 24 24 777 40 65 83 61 88 74 73 84 100 100 100 100 787 0 0 0 0 0 0 3 40 79 109 120 120 Subtotal 290 398 441 375 481 462 477 588 661 743 766 766

Airbus300/310 9 9 6 0 0 0 0 0 0 0 0 0 A320 Family 289 339 367 386 402 401 425 460 483 483 483 483 330/340 80 86 79 85 86 91 90 100 105 105 90 60 350 0 0 0 0 0 0 0 0 0 1 20 50 380 0 0 1 12 10 18 23 29 35 35 35 35 Subtotal 378 434 453 483 498 510 538 589 623 624 628 628

OtherE190/5 12 43 78 92 82 75 94 96 100 90 85 85CSeries 0 0 0 0 0 0 0 0 1 30 60 100 Subtotal 12 43 78 92 82 75 94 96 101 120 145 185

Total 680 875 972 950 1,061 1,047 1,109 1,273 1,385 1,487 1,539 1,579

Source: Company Reports, J P Morgan estimates.

Narrowbodies account for roughly 40% of the expected increase in deliveries from 2012-2015, though new platforms—particularly 787 (~25% of projected delivery growth)—are pushing rates higher as well. Boeing and Airbus announced most rate hikes for legacy platforms in 2010, though there were incremental increases announced in 2011, with Boeing saying it would increase 737 production to 42/month in 1H 2014 and Airbus disclosing plans for 42 A320s starting late this year.

Table 3: Monthly Build Rate Projections

Model 2010 2011E 2012E 2013E 2014E

737 31.5 31.5 35 38 (2Q) 42 (1H)A320 family 34, 36 (Dec) 36, 38 (Aug) 40 (1Q), 42 (4Q) 42 42777 6 6 7 8.3 (1Q13) 8.3A330/340 8 8 9 10 (2Q) 10

Source: Company reports and J.P. Morgan estimates.

Delivery ramp appears consistent with expected demand

For the market to absorb the steep increases in production that Boeing and Airbus have planned, air traffic growth must hold up in the coming years, and we have a supply-demand model to evaluate this dynamic. We estimate that there are currently 3.15 million seats in the in-service passenger fleet, and the aircraft in our delivery forecast for 2012 would add just 230k seats this year, with the annual increase expanding to nearly 300k in 2016. We assume that 2.5% of seats are retired annually, which is roughly in line with the 2.4% average over the past ten years, and with US fleet replacement set to picking up, this could prove to be conservative. Theseassumptions yield net annual seat increases in a fairly tight range between 4.8% and 5.4% over each of the next five years, with a 5.2% CAGR. In order for supply and demand to be roughly in balance therefore, traffic must grow ~5% annually, which we view as a reasonable assumption given the resilience of traffic growth amid economic challenges in recent years, a long-term traffic CAGR of 5% over the past 30 years, and the potential for emerging markets to drive growth.

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Table 4: Aircraft Demand - Supply Model, 2012E - 2016E

2012E 2013E 2014E 2015E 2016EInitial Seats (th) 3,147 3,298 3,470 3,658 3,852Additions (th) 230 255 274 286 295Retirements (th) (79) (82) (87) (91) (96)Ending Seats (th) 3,298 3,470 3,658 3,852 4,051Growth 4.8% 5.2% 5.4% 5.3% 5.1%

Seats CAGR, 2012-2016 5.2%Traffic CAGR, 2012-2016 5.0%

Source: Ascend and J.P. Morgan Estimates.

Demand is sensitive to traffic growth

The number of seats required in the fleet is fairly sensitive to changes in traffic growth, so sluggish traffic growth could result in too many seats coming to market, while accelerated growth could result in too few. For example, if OEMs bring to market all the seats we expect over the next five years and traffic grows at a CAGR of only 4%, we estimate that the oversupply of seats globally would be 6%. Conversely, if traffic grows at a 6% CAGR, we believe the supply of seats available will be 4% below the number required. Our downside case implies over 1,200 excess aircraft over five years or ~15% of forecast deliveries over the period. On the upside, a 6% CAGR could result in ~900 fewer aircraft fewer than needed, or 11% of expected deliveries.

Table 5: Required Seat Growth Estimates in Three Scenarios

Downside Case Base Case Upside CaseTraffic Growth CAGR, 2012-2016 4.0% 5.0% 6.0%Seats Required, 2016 3,829 4,016 4,211Seats Available, 2016 4,051 4,051 4,051Difference - Oversupply 6% 1% -4%

Source: Ascend, Seatguru.com, company reports, and J.P. Morgan estimates.

5% traffic growth CAGR is consistent with experience

Traffic is the most important driver of new aircraft demand, accounting for an estimated 60% of the total, and we believe 5% is a reasonable assumption for traffic growth over the next five years. Global traffic has grown at a 5% CAGR over the 30 years from 1981-2011, so our estimate is in line with long term growth. Five year CAGRs over this period have ranged from just under 3% to nearly 8%, though the low end of this range has a combination of both recessions and air travel specific shocks, such as the September 11 terrorist attacks, the first Gulf War, and the SARS epidemic. For the most recent five year period ending in 2011, we estimate that traffic has grown at a 4.6-4.7% CAGR.

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Figure 5: Global RPK Growth, 1981 - 2011E

Source: ICAO, IATA, and J.P. Morgan estimates.

Air traffic growth is in large part a function of GDP, and over the past 30 years, traffic has grown at 1.5x global GDP on average. The implication here is that global GDP would need to grow at a 3.3% CAGR over the next five years to support a traffic CAGR of ~5%, and given the headwinds that global economic growth is facing, this looks like it should be at high risk. However, recent traffic/GDP multiples have been above average, and we expect this to continue in the coming years.

Figure 6: Global Air Traffic Growth as a Multiple of Global GDP Growth

Source: ICAO, IATA, and J.P. Morgan.

Traffic has grown faster relative to GDP in recent years

Looking at a more recent period, 2004-2011E, air traffic has grown well in excess of 1.5x GDP. The simple average multiple for this period is 2.0x but it includes2009, when traffic declined less than GDP and this skews the outcome. Looking at CAGRs is therefore more useful and the traffic CAGR over this period is 6.4%, which compares to a 2.7% CAGR for GDP, for a multiple of 2.4x. The relationship between traffic and GDP CAGRs for the 1981-2011 period is 1.7x. Multiples have been

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consistently strong over the past eight years as well. Excluding 2009, the lowest value over the period was 1.5x in 2006, which is the simple average for the last 30 years.

Figure 7: Traffic and GDP CAGRs, 2004-2011E

Source: J.P. Morgan, ICAO, and IATA.

Traffic growth has held up particularly well amid the macro uncertainty of recent years. For the four year period ending in 2011, we estimate the global traffic CAGR was 3.9% vs 1.4% for GDP, yielding a 2.7x multiple. In the teeth of the recession in 2009, global traffic fell only 1.1%, better than the global economy as a whole (-2.3%), which constitutes outperformance since one would normally have expected it to shrink faster. The bounce back year in 2010 was exceptionally strong for traffic, with an 8% increase vs 4% for GDP. We estimate global traffic grew nearly 6% in 2011, over 2x J.P. Morgan’s global GDP growth forecast of 2.6%. We do not yet believe that the relationship between traffic and GDP has altered permanently, but we do believe that the multiple has expanded due to persistent weakness in the parts of the economy that are less important for airline traffic. Since the global growth rates that we are forecasting looking ahead are subpar for the same reasons that growth has lagged in recent years (global deleveraging), we believe this dynamic will continue. Under this scenario, global GDP growth of only about 2% should be enough to support 5% airline traffic growth on average and our delivery forecast outlined above.

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Figure 8: Global GDP and Global Traffic Growth, 2004-2011E

Source: ICAO, IATA, and J.P. Morgan.

Emerging markets likely to drive traffic growth; but how much?

Emerging markets have been a leading contributor to global traffic growth—and global GDP—in recent years, and we believe emerging markets must continue driving traffic higher if it is to grow sufficiently to accommodate the new aircraft scheduled to enter service over the next 3-4 years. During 2000-2010, we estimate that emerging market traffic grew at a 7-8% CAGR while developed world traffic grew at only ~3%.

Table 6: Estimated Global Airline Passenger Traffic, 2000 and 2010

RPKs, in billions

2000E 2010E CAGREmerging Markets 880 1,838 7.6%Developed Markets 2,138 2,846 2.9%Total 3,018 4,684 4.5%

Source: ICAO, JAL, ANA, and J.P. Morgan estimates.

Note: Developed markets includes, North America, Europe, and Japan.

During this period, emerging markets contributed nearly 60% of global traffic growth, and as a result the emerging market proportion of global traffic increased from ~30% to ~40%. The fact that the faster growing emerging markets now account for a bigger piece of the traffic pie should help support future growth. But while we are confident that emerging market traffic will outgrow developed market traffic, the level of growth in the emerging markets remains a question mark. Lower exports to the US and Europe mean emerging economies should not be immune to anemic growth in the developed world, and there are prominent and well known concernsregarding other imbalances such as China’s property market. J.P. Morgan forecasts that emerging economies will grow 4.7% this year vs only 1.2% for developed economies, and this represents a deceleration from 2010’s 7.3% for emerging markets and 2011’s estimated 5.7%.

Despite the potential for near term deceleration, we remain confident regarding emerging market traffic growth. This is in part because we see the rise of the emerging market consumer and the development of internal economies within

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emerging markets as leading drivers of traffic growth. We view these as among the powerful trends in the global economy and they should persist for years, if not decades. The fact that some of the most prominent emerging economies are both populous and geographically large—such as China (already the world’s number two market for domestic air travel), India, and Brazil—should help the aerospace industry become a leading beneficiary of emerging economies’ internal development.

Emerging markets’ contributions to backlogs at Boeing and Airbus highlight their importance. Emerging market carriers account for 42% of the Boeing backlog, and lessors, which place the bulk of their aircraft in emerging markets, add another 16%, making roughly half in total, with the remainder going to developed market carriers. At Airbus, emerging market carriers now make up 58% of the backlog, with 18% for lessors and 23% for developed market carriers. The increased prominence of emerging market carriers in the Boeing and Airbus backlogs is striking, with this customer group now accounting for about half the total, up from 17% in 1990. This relationship makes sense since emerging market traffic growth is responsible for about 35% of aircraft demand and EM replacement requirements should account for at least another 15% of demand (global replacement is 40% of demand overall).

Figure 9: Commercial Aircraft Backlog Distribution, 1990

Source: Ascend. Note: Backlog includes Airbus and Boeing.

Developed economies include Australia, Austria, Belgium,

Canada, Denmark, Finland, France, Germany, Greece, Iceland,

Ireland, Italy, Japan, Luxembourg, Netherlands, New Zealand,

Norway, Portugal, Spain, Sweden, Switzerland, United Kingdom,

and United States.

Figure 10: Commercial Aircraft Backlog Distribution, 2011

Source: Ascend. Note: Backlog includes Airbus and Boeing.

Developed economies include Australia, Austria, Belgium,

Canada, Denmark, Finland, France, Germany, Greece, Iceland,

Ireland, Italy, Japan, Luxembourg, Netherlands, New Zealand,

Norway, Portugal, Spain, Sweden, Switzerland, United Kingdom,

and United States.

Traffic growth should decelerate in 2012 but perhaps only modestly

Global passenger traffic is up 5.9% through November 2011, and we expect it to settle in the 5.5-6.0% range for 2011. Looking to 2012, we expect traffic growth to decelerate somewhat, with slower growth in Europe, which is the leading contributor to global growth in 2011, acting as the major headwind.

Emerging17%

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Figure 11: Traffic by Region, 2011E

Source: ICAO, IATA, ANA & JAL, and J.P. Morgan estimates.

Figure 12: Traffic Growth Contribution by Region, 2011E

Source: ICAO, IATA, ANA & JAL, and J.P. Morgan estimates.

Note: Africa’s estimated contribution to global growth was < 1%

in 2011.

A rebound in Japan following last year’s earthquake and a continuation of robust growth in emerging markets should limit the damage, however, and we see potential for traffic to grow in the 4-5% range, only modestly below our expected five-year CAGR of 5%. Ultimately, traffic growth could come in well above or below this level, depending on developments in the global economy, including oil price fluctuations, or specific shocks to air travel around the world, such as wars, terrorist attacks, and pandemics. Our visibility really only extends a few months into 2012, and airlines can react fairly quickly to changes in the demand environment.

Table 7: Traffic Growth Rates by Region

2011E 2012E

Africa 1.0% 2.0%Asia/Pacific 5.5% 8.0%Europe 8.5% 2.0%Latam 11.5% 8.0%Middle East 8.5% 10.0%North America 2.0% 2.0%Total Growth 5.7% 4.5%

Source: ICAO, IATA, ANA and JAL, and J.P. Morgan estimates.

European headwind in 2012 should be meaningful

Europe’s contribution of over 40% of global traffic growth in 2011 was a notable surprise and is unlikely to repeat. We forecast that European traffic was up nearly 9% last year despite expected GDP growth of only 1.6% (J.P. Morgan estimate) and the unfolding financial crisis. The region did, however, benefit from a few tailwinds. First, the volcanic ash cloud that formed over Iceland in 2010 and canceled flights across the region made for an easy comp in April, when total traffic jumped 27%. European traffic remained elevated beyond April, however, and we attribute this in part to the fact that the region classified as “Europe” includes airlines in faster growing emerging markets, most notably Turkey, but also Russia and Eastern Europe. In addition, growth reflects market share as well as market size, and we believe European carriers recaptured some share, particularly from Middle Eastern carriers, during 2011. This is likely reflected in the solid growth rates we have seen for major carriers Air France-KLM, British Airways-IBERIA, and Lufthansa, each of which has seen 2011 RPKs grow ~7% through November.

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Figure 13: European Total Traffic Growth, 2011

Source: IATA.

Europe’s strong performance in 2011 contributed ~2.5 percentage points of global growth. For 2012, each 1 percentage point decline in European traffic growth from ~9% should lower global growth by ~30 bps, all else equal. Therefore, a drop to 2% (7 points of decline) would reduce Europe’s contribution to world traffic growth to ~40 bps. Other regions, particularly Asia, may pick up some slack, but this is the primary reason we see traffic growth declining next year.

Japan should drive acceleration in Asia/Pacific growth

Asia/Pacific RPKs were up only 5.4% through November and we expect growth in this region to accelerate in 2012. With 27% of global traffic—only slightly below Europe’s contribution—each 1% change in Asia/Pacific traffic growth should have a similar effect on total traffic growth of approximately 30 bps. Therefore, if Asia/Pacific traffic increases to 8% this year, its contribution to global growth should rise from 1.5% to 2.3%, offsetting some—though not all—of the decline we foresee in Europe.

The primary driver of accelerating traffic in the Asia/Pacific region should be a rebound in Japan, following last year’s earthquake. Through October, ANA and JAL traffic was down 16% for 2011, and we could envision a low double digit bounce back next year using October RPKs as a run rate. Japan accounted for ~11% of Asia/Pacific traffic in 2010.

Figure 14: Japanese Air Traffic (RPKs in mn), Jan 09 - Oct 11

Source: Company data: Note: Includes ANA & JAL.

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Chinese growth could remain low double digit in 2012

China is by far the biggest player in the Asia/Pacific region with over 30% of RPKs (excluding Hong Kong and Macao). It is also the world’s second largest market for air travel, with an estimated 9% of global RPKs (vs ~28% for the US), and Chinese growth will be a key determinant of global growth in the years to come. Chinese passenger traffic growth decelerated in 2011, though it remained double digit. Through November, RPKs were up 12% versus 17% in 2009 and 20% in 2010. The CAGR for Chinese RPKs in the 2000-2011E period is 15%.

Figure 15: Chinese Air Traffic Growth, 2000-2011E

Source: CAAC and J.P. Morgan estimates.

Both international and domestic traffic growth decelerated in China in 2011. The decline in international growth from an outsized 33% in 2010 to 15% in 2011 was steeper than the drop in domestic traffic; however, domestic traffic—which includesHong Kong, Macau, and Taiwan, all of which Chinese authorities classify as domestic—is the more important of the two pieces, accounting for ~80% of total RPKs.

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Figure 16: Chinese Traffic Growth - Domestic and International, 2000-2011E

Source: CAAC and J.P. Morgan estimates.

Note: Hong Kong, Macau, and Taiwan routes included in domestic.

Chinese traffic growth this year will be dependent on GDP growth of course, and heightened macro uncertainty is a source of concern. However, J.P. Morgan forecasts only a modest deceleration in GDP growth this year to 8.2%, down from 9.0% for 2011. Over the past 12 years, we estimate that Chinese passenger traffic has grown at ~1.5x GDP on average, and if we exclude unique events affecting Chinese air travel, such as the SARS epidemic of 2003, the subsequent bounce back in 2004, and the Beijing Olympics in 2008, the multiple has been fairly consistent within a range of 1.2-1.8x.

Figure 17: Chinese Traffic Growth/GDP Growth, 2000-2011E

Source: IMF, CAAC, and J.P. Morgan estimates.

If we assume 8% GDP growth, then a reasonable traffic growth outlook is in the 10-15% range based on the historical relationship. At the midpoint, this implies flattish

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growth relative to 2011. Chinese traffic in this range would provide about one percentage point of global traffic growth this year, roughly in line with 2011.

The remainder of Asia remains a key driver

China and Japan are sizable markets, but they account for less than half of Asia/Pacific traffic, and even excluding these two countries, Asia/Pacific would still be the world’s third largest air travel market after the US and Europe. We estimate that traffic in Asia ex China and Japan grew by ~6% in 2011. Some parts of this region grew faster, such as India, while other portions, such as Australia, Singapore, Taiwan, and Thailand (where flooding has curbed traffic) grew more slowly. With so many countries making up this piece of global traffic, visibility is limited. We see potential for traffic growth to remain in the 5-6% range, though there are potential headwinds, including slower global growth for those places most integrated into the world economy (Hong Kong, Singapore, South Korea, and Taiwan) as well as country-specific headwinds for India.

Table 8: Traffic for Airlines ex China and Japan

RPKs in mn

2010 YTD 2011 YTD Y/Y ThroughQantas 84,269 85,631 1.6% OctoberCathay Pacific 80,309 84,121 4.7% OctoberIndia (total country) 73,550 81,746 11.1% SeptemberSingapore Airlines 69,978 71,511 2.2% OctoberKorean Air 45,544 48,380 6.2% SeptemberThai Airways 45,929 46,757 1.8% OctoberMalaysia Airlines 31,101 33,404 7.4% OctoberChina Airlines 27,068 26,810 -1.0% OctoberAir Asia 21,234 25,926 22.1% OctoberVirgin Blue 21,262 22,497 5.8% SeptemberGaruda Indonesia 15,154 20,210 33.4% OctoberEVA Airways 20,092 20,036 -0.3% OctoberTiger Airways 5,773 6,449 11.7% SeptemberTotal 541,264 573,479 6.0%

Source: Company Data and DGCA.

Middle East growth slowing but should stabilize at above-average level

We estimate that the Middle East accounts for 8% of global traffic, but it has been a fast-growing region in recent years as network carriers Emirates, Qatar, and Etihad establish themselves as leading global players. The prominence of these carriers and their Persian Gulf hubs means that over 90% of Middle East air traffic is international and average international traffic growth has been 15% since 2003. International traffic growth has slowed to 8.7% in 2011 through November vs 17.8% for 2010.

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Figure 18: Middle East - Trailing 12 Month International Traffic Growth, Dec 2003 - Nov 2011

Source: IATA.

Political unrest has played a role, and the lowest growth reading of 2011 thus far was in March, shortly after Egyptian President Hosni Mubarak stepped down. However, we do not believe unrest explains all of the deceleration, and stronger than expected traffic growth among major European airlines suggests that they have at least temporarily won back some share from the Middle East network carriers that have been increasingly siphoning off their customers. At Dubai International airport, where activity is dependent on both regional and global and trends, we have seen passenger growth decelerate from 16% for all of 2010 to 8% for the first eleven months of 2011. This is fairly consistent with the decline in international traffic growth throughout the region.

Figure 19: Dubai International Airport - TTM Avg Passengers (Left) and TTM Avg Passenger Growth (Right), Dec 2009 - Nov 2011

Source: Dubai International Airport, Bloomberg.

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While Middle East traffic growth has decelerated, it continues to grow in the high single digits, and with the network carriers adding capacity we expect this to continue. The political unrest of 2011 could make for some easier comps this year, though the political situation in Egypt is far from settled and further unrest across the region is a risk. Therefore, we believe a reasonable assumption for Middle East traffic growth is that it remains fairly consistent with 2011, perhaps accelerating a bit to ~10% as network carriers shore up market share. With their low costs and generally profitable business plans, we do not believe the network carriers will continue to lose share back to the European carriers, and in fact we anticipate a reversal. Each 100 bp change in Middle East traffic growth results in a 10 bp move in global traffic growth, so for the Middle East to move the needle next year, growth would have to accelerate or decelerate materially.

Latam’s contribution could decline moderately

We estimate that Latin America accounts for ~5% of global traffic so it is unlikely to be a needle mover this year. 2011 traffic was up 12% through November thanks in part to a strong showing in Brazil, where domestic traffic rose 15% despite significant deceleration in GDP growth to 2.8% from 7.5%, according to J.P. Morgan estimates. Brazilian GDP growth is expected to stabilize at ~3% in 2012, though we could see a lag effect, with some deceleration in air traffic this year. For the region as a whole, J.P. Morgan forecasts that GDP growth will decline to 3.2% this year from 4.1% in 2011. This reinforces the notion that there could be some deceleration in store, but GDP growth should remain above the global average and an expanding middle class in Brazil and elsewhere should support traffic growth. As a result, we could see traffic growth falling to the high single digits, which would only subtract ~10 bps from global GDP.

North American growth likely to remain sluggish

At ~30% of global traffic, North America is the largest regional air traffic market. Growth has been sluggish in recent years, with US traffic according to ATA up only 7% from the 2000 level, given the steep reversals of the September 11 terrorist attacks, the subsequent recession, and the 2008/2009 financial crisis and recession. IATA reports North American growth of 2.4% through November, implying an 80 bps contribution to global growth of 5.9% over the same period.

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Figure 20: US Air Traffic (Left) and Traffic Growth, (Right) billions of RPMs

Source: ATA and J.P. Morgan estimates.

2012 could see some acceleration relative to 2011 if a US recovery gathers steam in the second half, but we are probably looking at another year of modest growth. US GDP is expected to rise only 2.5%, and most major US carriers are forecasting flat to down capacity this year. There is the potential for American’s bankruptcy to weigh on capacity growth as well. With load factors solidly above 80% in North America, there is not much slack in the system, so plans to remove capacity are likely a reflection of expectations for modest traffic growth at best. Each one percentage point change in North American traffic growth results in a 30 bp change in the region’s contribution to global growth.

But replacement is the key source of aircraft demand in North America

Traffic growth is the primary driver of demand for new aircraft—we estimate it accounts for ~60% globally—but replacement is an important component as well, accounting for the remaining 40%. This proportion is even higher in the US, a mature market with a sizable and aging installed base, particularly with regard to narrowbodies. We saw moves toward re-fleeting in 2011 and expect more to come.

Among leading US carriers, 62% of the narrowbody fleet is over 10 years old and 35% is over 15 years old. The inclusion of JetBlue and Southwest in that group brings down the age of the fleet, however, and the four remaining legacy carriers—American, Delta, United, and US Airways—operate narrowbody fleets in which 70% of the aircraft are over 10 years old and 40% are over 15 years old.

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Table 9: US Narrowbody Fleets of Leading Airlines by Carrier and Age

<=10 years 11-15 years 16-20 years 21-25 years > 25 yearsAmerican 36% 23% 19% 20% 2%Delta 22% 28% 18% 21% 12%JetBlue 94% 6% 0% 0% 0%Southwest/AirTran 55% 23% 11% 9% 2%United/Continental 30% 38% 25% 7% 0%US Airways 34% 34% 11% 20% 1%Total 38% 28% 17% 14% 4%

Source: Ascend.

Out of production aircraft like MD-80/90s, DC-9s, and 757s are among the older aircraft in the US narrowbody fleet, and American and Delta are the carriers with the highest concentration of these aircraft. Combined, these two airlines have nearly 700 of these aircraft in service. United also has nearly 160 757s in service with an average age of 18 years.

Table 10: Leading US Airlines' Fleets of Older Narrowbody AircraftCarrier 717 757 DC-9 MD-80 MD-90 Total

American 120 209 329Delta 170 25 117 29 341Southwest +AirTran 88 88United 157 157US Airways 24 24Total 88 471 25 326 29 939

Source: Ascend.

Table 11: Avg. Age of Older Narrowbody Aircraft at Leading AirlinesCarrier 717 757 DC-9 MD-80 MD-90 Total

American 13 21 18Delta 18 34 22 16 21Southwest +AirTran 11 11United 18 18US Airways 19 19Avg Age 11 17 34 21 16 18

Source: Ascend.

Several US carriers moved toward fleet replacement in 2011. American committed to 460 narrowbody aircraft in July, becoming an A320 customer for the first time (130 standard models and 130 neos) and adding more 737s as well (100 NGs and 100 MAXs). While American entered bankruptcy late last year, management remains committed to taking these aircraft as a foundation for the future of the airline, and we still expect this to occur. In addition, Southwest became the launch customer for the 737 MAX with a 150 aircraft firm order plus 58 more 737 NGs. The carrier noted that replacement was the driving rationale behind the order. Finally, Delta ordered 100 737-900ERs last year to replace older jets, primarily 757s. We anticipate more orders for narrowbodies coming from US carriers, including United and potentially more from Delta as well. The six major US airlines in the table currently have 2,715 narrowbodies in service.

Table 12: Major US Airlines’ Orders in Boeing and Airbus Narrowbody Backlogs

737 NG 737 MAX A320 Family A320 NEO TotalAmerican Airlines 139 100* 130* 130 499 Delta Air Lines 100 7 107 JetBlue Airways 51 40 91 Southwest Airlines 148 150 298United Airlines 57 42 99 US Airways 59 59 Total 444 250 289 170 1,153

Source: Ascend and Company news. Note: * represents commitments.

Load factors remain high

Traffic growth and replacement are the key parameters for evaluating Boeing and Airbus’ production plans. However, an evaluation of spare capacity is also important since filling up excess capacity can also satisfy rising demand for seats, though we do not expect either of this to play a significant role in the current cycle.

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Spare capacity is an unlikely source of new seats since there is not much of it. The 2010 global load factor of nearly 78% for 2010 was a record and this seems unlikely to have declined much in 2011. IATA has reported similar increases in traffic and capacity through November 2011 (5.9% for traffic and 6.3% for capacity) along with a YTD load factor of 78.2%. The most recent IATA reading has come off the peak a bit, but load factors remain quite high in historical terms, and we believe thissupports the addition of new aircraft to meet rising demand.

Figure 21: Global Load Factor, 1970 - 2011E

Source: ICAO, IATA, and J.P. Morgan estimates.

Parked aircraft unlikely to drive capacity growth

Bringing aircraft back from storage is another way for airlines to add capacity. However, we do not see the parked fleet as a major threat to Boeing and Airbus’ plans to increase production rates. In part, this reflects the age of the parked fleet. Of the ~1,800 western-built passenger jets currently in storage, nearly 70% are more than 15 years old, making them less appealing as sources of incremental capacity. Additionally, of the ~550 aircraft that are fifteen years old or younger, Embraer and Bombardier’s 50-seaters account for 35-40%. This does not leave many young or middle-aged narrowbody or widebody aircraft for carriers to press into service.

Figure 22: Parked Fleet by Age

Source: Ascend. Note: As of Dec 14, 2011.

Market dynamics like high oil prices and the availability of export credit have been more favorable for purchasing new relative to used aircraft in recent years and this seems unlikely to change near term. A significant decline in oil prices seems most

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likely to occur as a result of a recession that depresses traffic growth and therefore demand for all aircraft, not just new ones. Similarly, a spike in interest rates would drive up the cost of financing for all aircraft. Changes to the government export credit regime could inhibit new jet demand, however. New rules should be raising the cost of export financing for new aircraft, and US carriers are fighting to limit export credit that they believe puts them at a competitive disadvantage. Nevertheless, we see the fundamentals of the export credit system remaining in place.

Backlogs have continued growing, supporting plans for higher rates

Bulging backlogs at Boeing and Airbus should support plans to increase rates, and the two OEMs continued to expand their order books in 2011. Boeing’s backlog of 3,771 aircraft (excluding ~800 737 MAX commitments) represents ~8 years ofproduction at the 2011 delivery rate versus an average of ~3.5 years from 1965-2010, and burning this backlog down to open delivery slots within a reasonable timeframe is one reason management has advanced for increasing rates. Turning to Airbus, the backlog of 4,461 aircraft, which grew faster than Boeing’s in 2011 because the neo was available all year, represents 8.3 years of production at estimated 2011 rates, compared to a historical average of 4.6 years. While we would never expect lawyers to be able to enforce a cycle—that is, we expect there would be substantial contractual changes and lower production if demand declined substantially—the large and growing backlogs do support the notion that demand even in the challenging macro economic environment is strong.

Figure 23: Boeing and Airbus Backlog to Deliveries Ratio, 1975 – 2011E

Source: Company reports.

2011 major orders illustrate underlying demand trends

Boeing posted a strong order year in 2011, with an estimated gross order total of 921 aircraft (805 net). This includes only one 737 MAX order (the 150 aircraft launch commitment from Southwest) and excludes another ~800 commitments for the aircraft. Boeing picked up high profile orders and commitments last year that we believe illustrate three of the company’s leading demand drivers. The first is emerging market growth as a source of aircraft demand, which we see in Indonesian carrier Lion Air’s commitment for 230 737s (including 201 MAXs). The second is uncertainty about the delivery timing and specifications of the A350-1000, which we see in Emirates’ order for 50 777s. And the third is US replacement demand, which we see in Southwest’s order for 208 737s (including 150 MAXs). These three record commitments—the Emirates’ order was a record at list prices ($18 billion) until Southwest bested it (nearly $19 billion) and Lion Air would become a record upon

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conversion (nearly $22 bn)—were all announced within a month of each other in November and December.

Table 13: Boeing and Airbus Backlog by Model

Boeing AirbusModel Backlog Model Backlog

737 NG 2,215 A320 Family 2,080737 MAX 150 A320neo Family 1,276

747 97 A330 356767 72 A340 2777 380 A350 567 787 857 A380 180

Total 3,771 Total 4,461

Source: Company reports. Note: Airbus backlog through November only, while includes Transaero' order for 8 A320neo.

We see room for further order strength at Boeing

Boeing saw solid demand for both narrowbodies and widebodies in 2011. For 737, we estimate that net orders for the in-service NG model totaled 401, for an estimated book-to-bill of just over 1.0x despite the introduction of the 737 MAX in July. The NG backlog now amounts to 4.4 years of production at the 42/month production rate that Boeing plans to reach in 2014. Deliveries of the 737 MAX are expected to begin in 2017.

Among widebodies, net 777 orders reached a record 200 for an estimated 2.7x book-to-bill as Boeing capitalized on Airbus troubles with the A350. 2011’s strong order performance has resulted in a backlog that equates to 3.8 years of production at the expected 2013 rate of 8.3/month.

Looking forward, the conversion of 737 MAX commitments should be a leading source of orders. In addition, we believe Boeing could launch the 787-10 this year, which could drive additional strength. We see further room for substantial 777 orders as long as the A350 slides to the right, and given the high and possibly improving profitability of this platform for Boeing, this is a major item to watch going into 2012. Management expects commercial airplane book-to-bill to surpass 1.0x in 2012 as well as 2013, and MAX conversions as well as a 787-10 could help support this, though we still believe visibility is limited two years out given the macro uncertainties.

Table 14: Boeing and Airbus Net Orders, 2011

Boeing AirbusModel Net Orders Model Net Orders

737 NG 401 A320 Family 69737 MAX 150 A320neo 1,246

747 (1) A330 83 767 42 A340 (2)777 200 A350 (19)787 13 A380 9

Total 805 Total 1,386

Source: Company reports and Ascend. Note: Airbus orders through November, plus Transaero's order for 8 A320neos.

Airbus booked far more firm orders than Boeing in 2011—1,386 versus 805 on a net basis—but most of these were for the re-engined A320neo, which will not be available until late 2015 at the earliest. While Airbus took neo orders all year, Boeing did not announce it would re-engined the 737 until July and even then it was not available for firm orders until December. As a result, Airbus booked 1,246 neo

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orders in 2011 versus only 150 MAX orders for Boeing. If we include the 800 MAX commitments, however, the picture appears more even.

Airbus order performance was weaker on other platforms. There were only 138 orders for standard A320s, for a book to bill of only 0.5x; however, Airbus still maintains a strong standard A320 backlog that should carry it much of the way to entry into service of the neo. Where Airbus did lose ground to Boeing was widebodies. A330 orders totaled 83, more or less in line with deliveries, while the A350 continued to struggle with 19 net cancellations, a fact we attribute to uncertainty about schedule and specifications. 787 net orders remained low, though they reached positive territory just before year end. Meanwhile, Boeing generated a record 200 777 orders, and we view the A350 issues as a major driver of this.

The cargo market looks weak

Cargo traffic has been far weaker than passenger traffic recently, with freight ton kilometers (FTKs) down nearly 1% through November 2011 vs 5.9% growth in passenger RPKs. Expectations for decelerating global growth are likely the key factor driving down air cargo traffic, as manufacturers hold back from replenishing inventories or turn to less expensive shipping alternatives, such as boats. 2011 also represented a challenging comp, as restocking in 2010 led to outsized cargo growth that took the level of traffic solidly above the 2007 peak. We believe it has been difficult to sustain cargo traffic growth following the restock amid a less than robust global economic recovery, and with global GDP growth expected to decelerate to 2.1% this year, the immediate future does not look especially promising.

Figure 24: Global Cargo Traffic - FTKs (Left) and FTK Growth (Right), 2003 - 2011E

Source: ICAO and IATA.

With regard to the relationship between traffic and capacity, October’s freight load factor was down over five percentage points relative to its 2010 peak, though the decline relative to the pre-recession level of ~46% is probably in the one percentage point range. One issue to be aware of with regard to freight traffic and capacity is that far more freight traffic currently travels in the bellies of passenger aircraft than in dedicated freighters. In fact, we estimate that passenger aircraft have accounted for 5-6 times more freight traffic this year than freighters, though freighter traffic has

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help up relatively well and is back to the 2010 peak, whereas belly-hold volumes are down more than 4% from that level according to IATA.

But we see a minimal impact on aircraft demand

Weak cargo traffic should have little impact on overall aircraft demand, with freighters representing only 5% of Boeing’s firm order backlog and 1% of Airbus’. Cargo aircraft form a greater portion of the backlog for certain key platforms, however, and this is where we are focusing our attention.

For example, we are watching carefully Boeing’s plans to increase 777 production from the current rate of 7/month to 8.3/month early next year but we expect production plans to hold up. Freighters currently make up 18% of the 777 backlog, down only slightly from 21% at March 31, 2009 on the eve of Boeing’s decision to reduce the 777 production rate to 5/month from 7/month. The difference between then and now is that overall 777 demand is now on the upswing, whereas in early 2009, it was falling dramatically. Net 777 orders reached a record 200 in 2011, and while freighters accounted for ~20% of the total—roughly the same proportion as the backlog—we see demand for the passenger variant remaining robust for some time, given uncertainty about the A350-1000 schedule and performance, which should leave the entire market for this size aircraft to Boeing. Also, as indicated in the table below, the customer set for the 777F is looks solid, and while some leading freight carriers could potentially seek deferrals, as Cathay Pacific recently did for 747-8 freighters, we do not expect cancellations and we believe the backlog is flexible enough for Boeing to substitute in passenger 777s for deferred freighters if necessary.

Table 15: 777 Backlog by Operator and Expected Delivery Year

2012E 2013E 2014E 2015E 2016E Other Total

Cathay Pacific 0 0 2 3 3 0 8

Emirates Airline 2 3 3 2 0 0 10

Ethiopian Airlines 2 0 1 2 1 0 6

Etihad Airways 0 0 2 0 0 0 2

FedEx 2 2 0 0 0 11 15

Korean Air 2 1 1 1 0 0 5

LAN Cargo 2 0 0 0 0 0 2

Lufthansa Cargo 0 2 0 3 0 0 5

Qatar Airways 3 0 0 0 0 0 3

Southern Air 2 0 0 0 0 0 2

Unannounced 0 2 3 4 2 1 12

Total 15 10 12 15 6 12 70

Source: Ascend.

Note: As of Dec 23, 2011.

747-8 more vulnerable to weak cargo market

With freighters accounting for over 60% of the backlog for the 747-8, the platform is far more vulnerable to developments in the cargo market. Boeing began delivering 747s in October, with 9 going out in Q4, leaving a backlog of 97 at the start of this year. Boeing is currently building 1.5 747s per month and plans to increase the rate to 2.0 per month around the middle of the year.

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Table 16: 747-8 Freighter - Backlog by Customer and Expected Delivery Year

2012E 2013E 2014E 2015E 2016E 2017E Total

AirBridgeCargo 3 2 0 0 0 0 5

Atlas Air 4 2 0 0 0 0 6

Cargolux 4 2 4 0 0 0 10

Cathay Pacific 4 2 0 0 0 0 6

DAE Capital 0 0 0 0 2 3 5

Emirates Airline 0 2 3 0 0 0 5

GECAS 0 0 2 0 0 0 2

Global Supply Systems 0 0 0 0 0 0 0

Korean Air 3 1 2 1 0 0 7

Nippon Cargo Airlines 3 4 4 3 0 0 14

Total 21 15 15 4 2 3 60

Source: Ascend.

Freighter deferrals are clearly a risk for the 747-8, as we have already seen Cathay Pacific defer two 747-8s from 2012 to 2013. Freight traffic has been weakest in Asia, and with Cathay, Korean, and Nippon Cargo expected to account for nearly half of 747-8 freighter deliveries over the next two years, some other shifts in the schedule are possible. Boeing appears to have a small cushion, however, which could limit the impact of freighter deferrals on production rates. Ascend shows that Boeing is scheduled to deliver 28 total 747s in 2012, more than the level implied by the production rate of ~21 (for half a year at 1.5/month and half at 2.0/month) and this overbooking could create some flexibility in the schedule.

Aftermarket

We expect aerospace aftermarket sales growth to remain robust in 2012. Growth rates may decline somewhat from the solidly double-digit range we witnessed during the rebound year of 2011, but we could see growth remaining in the high single to low double digit range on a combination of mid single digit ASM growth, a few percentage points of pricing, and some additional catching up from the recession.

Flight hours, which are dependent on GDP, are the main demand driver in the commercial aerospace aftermarket. Aftermarket sales will therefore rise and fall with the economy to a substantial degree, and J.P. Morgan’s forecast for only 2.1% global GDP growth in 2012 seems likely to weigh on aftermarket sales at the margin. Nevertheless, traffic should grow faster than GDP in 2012 and with load factors running at high levels, we could see traffic growth of 4-5% resulting in similar increase in ASMs and flight hours.

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Figure 25: Average Organic Aftermarket Sales Growth and ASM Growth, 1Q08 - 3Q11

Source: Company reports, OAG, and J.P. Morgan estimates.

Note: Average AM growth includes COL, UTX (Hamilton and Pratt), TDG, HON, and GR.

Aftermarket sales have recovered nicely but still lag ASMs

While flight hours should be the leading driver of aftermarket sales over time, there are others, including inventory dynamics, which took over during the recession when inventory destocking and maintenance deferral caused aftermarket sales to decline far more significantly than ASMs. Aftermarket sales have since recovered nicely, particularly in 2011 but they continue to lag ASMs since the last peak. This indicates there is room for the gap to narrow further, though it may not disappear entirely.

Q3 results in each of the past three years provide an example of this dynamic. We estimate that average aftermarket sales fell 16% y/y in 3Q09, whereas ASMs were down only 1%. A year later, aftermarket sales had barely budged, while ASMs were already 7% above the 3Q08 peak. Aftermarket sales have bounced strongly over the past 3-4 quarters, but they have only just in 3Q11 recovered to the 2008 level, surpassing 3Q08 by 5%, despite the fact that ASMs are now up 14% over the same period.

Figure 26: 3Q Aftermarket Sales and ASMs, Indexed from 2008

Source: OAG and company reports.

Note: AM sales include organic commercial aftermarket sales for COL, GR, Hamilton Sundstrand (UTX), HON, Pratt & Whitney (UTX),

and TDG.

As aftermarket players are generally able to command annual price increases of a few percentage points, the change in volume relative to airline capacity is even more substantial. If there is another downturn, we could expect to see a slowdown in aftermarket sales, but we do not expect the type of declines we saw in 2009 given

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how far below capacity growth aftermarket sales growth has been running. This is because we see far less room for airlines and distributors to cut back on inventory this time around, and we would also expect that they will be unable to put off some of the work deferred during the downturn any longer.

Figure 27: Organic Aftermarket Sales Growth by Company, 1Q11 - 3Q11


Aftermarket sales recovered sharply last year with 15-16% average organic sales growth through Q3 compared to 6-7% ASM growth. All six companies in our aftermarket index posted double-digit growth in each quarter with the exception of COL and Pratt in Q3. Among the individual businesses, TransDigm and UTX’s Hamilton and Pratt units have surpassed the 2008 level, while Goodrich, Honeywell, and Rockwell Collins are still below the 2008 peak, though they are approaching it.

Figure 28: 3Q Aftermarket Sales by Company, Indexed from 2008


Note: Reflects organic sales growth.

TransDigm sales growth has been the outlier, with 3Q11 aftermarket sales 24% above the 3Q08 peak and y/y aftermarket sales growth of at least 18% in each of the past five quarters. A relatively small portion of TDG’s aftermarket content is discretionary, and this could be supporting sales growth, but the decisive factor is likely TDG’s more aggressive and successful implementation of price increases. TransDigm has forecast ~10% aftermarket sales growth for 2012, though this seems a bit conservative to us given the company’s apparent success in pushing through price increases and we are therefore looking for ~15% growth. TDG’s guidance is fairly consistent with what other aftermarket players have said at this point in the year, and we view these targets as reasonable, for the most part.

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Table 17: Commercial Aero Aftermarket FY12 Sales Guidance and J.P. Morgan Estimates

Guidance JPM Estimate

Honeywell* up 7-12% +7%

Rockwell Collins up low dd +14%

TransDigm up ~10% +15%

Goodrich (organic) na +10%

Pratt & Whitney up mid sd +7%

Hamilton Sundstrand (organic) up ~10% +10%


Note: J.P. Morgan Electrical Equipment/Multi-Industry analyst Steve Tusa covers Honeywell and his team provided the estimate

above. Also, our 10% estimate for Goodrich is based on our estimate prior to the announcement of United Technologies’ planned

acquisition of the company.

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The Emerging Narrowbody Landscape

We enter 2012 with far greater certainty on what the narrowbody market will look like relative to last year, at least from a product standpoint. Boeing and Embraer have joined Airbus on the path toward re-engining, decisions that we believe make sense from a business standpoint, leaving Bombardier (CSeries) and COMAC (C919) as the two key players developing new aircraft for the narrowbody market. Below, we outline what we view as the key dynamics in this market now that product strategies are set.

The business case for re-engining is compelling

We have a positive view toward Boeing and Embraer’s decisions last year to re-engine existing narrowbodies rather than replace current models with all-new aircraft. These moves followed Airbus’ launch of the re-engined A320neo in late 2010, and taken together, we believe re-engining is a good strategic outcome for the industry, as it should result in far lower R&D expenses and lower cost, schedule, and performance risk. Bombardier is still proceeding with the CSeries, an all new narrowbody that will pit the company against the small end of the 737/A320 market, at least initially. This approach is higher risk to be sure, but we believe Bombardier is far better off as the only established player with a clean sheet narrowbody rather than as one of four. For Boeing and Airbus, strong initial demand for the 737 MAX and A320neo underscores that carriers are hungry for narrowbodies with 10-15% better fuel burn that are available sooner rather than later. The narrowbody market should grow more competitive over time with Bombardier moving up market and China entering with the C919, but we believe it makes sense for Boeing and Airbus to use their advantage of incumbency and the prospect of guaranteed incremental improvement to satisfy the current high level of demand with a fairly low level of incremental investment.

Boeing 737 MAX

Boeing’s primary narrowbody development effort is now the 737 MAX, which the company announced it would offer with a commitment from American last July, followed by a formal launch the following month. The upgraded 737 family will consist of three variants, the -7, -8, and -9, which correspond in size to the -700, -800, and -900 variants of the 737 NG family.

Boeing plans first delivery of the 737 MAX in 2017—Southwest is the launch customer—and minimizing changes to the current airframe is one way the company plans to remain on schedule and to minimize cost. The new LEAP-1B engine on the 737 MAX will have a 68-inch fan diameter, 7 inches larger than the CFM56 currently on the 737 NG, and this will require extending the landing gear to make room for the fan as well as some structural strengthening to accommodate the larger engine. In addition, Boeing intends to make some changes to the structure of the tail and introduce a fly by wire control surface. Recent experience suggests Boeing will have to work hard to prevent the 737 MAX project from growing more ambitious, but management is focused on minimizing risk. Boeing’s ability to begin taking firm orders late last year suggests it is making progress toward configuring the aircraft and management is targeting firm configuration in 2013, with first flight in 2016.

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BCA R&D falling, though 2012 should be close to a bottom

We see falling R&D as an important earnings driver for Boeing, and the decision to re-engine is consistent with this outlook. Re-engining should result in far lower R&D spending over time than a clean sheet narrowbody would have driven—perhaps $1-2 bn vs ~$10 bn—but the outlook for the 2012-2013 period is not that much different than it would have been in any other narrowbody development scenario. Declining R&D for 787 and to a lesser extent 747-8 should be the decisive driver of R&D over the next two years, whereas it will take some time for narrowbody R&D spending to ramp. BCA R&D ran ~$3 bn from 2007-2010, and we estimate that 787 accounted for about half of that. BCA development expenses should have fallen to $2.7-2.8 bn in 2011 based on the first three quarters, and management has guided to a company-wide decline of $300-500 million in 2012. R&D could come down a bit further beyond that, but we expect it to remain above $2 billion and it could very well flatten out after this year. Each $100 mm decline in Boeing R&D increases EPS by 9 cents.

Figure 29: Boeing Commercial Aerospace R&D Expenses, 2002 - 2013E

$ in mn

Source: Company data, J.P. Morgan estimates. Note: 2009 R&D excludes a $2.5 bn charge for the first three 787s.

737 MAX starting off as a commercial success

The 737 MAX has come out of the blocks nicely with regard to orders. Boeing just began taking firm orders for the aircraft and has 150 so far, all from Southwest. Nevertheless, the company has captured 948 total commitments from 13 customers (including Southwest). Converting these commitments into orders should support Boeing’s book-to-bill over the next two years, and BCA chief Jim Albaugh has said he expects to exit the year with 1,400-1,500 firm commitments, implying that Boeing will book ~1,300 737 MAX orders alone. From a headline standpoint, the warm reception for the 737 MAX has helped Boeing recapture some momentum from its competitor, after the first half of the year saw Airbus rack up over 1,000 A320neo commitments amid concerns that it would steal longstanding Boeing narrowbody customers.

We view the LEAP-X engine as the most significant technical risk

While we believe Boeing’s decision to re-engine the 737 was a good one, we see two main risks associated with this path. The first, which is a technical issue, is that CFM’s LEAP-1B engine cannot meet specifications. This is the only engine for the 737 MAX, and any issues would be a direct hit to the rationale for re-engining that could drive customers to Airbus’ A320neo, which offers Pratt’s GTF, a more

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established engine, as a choice alongside LEAP-X. Our concern with the engine is that unlike Pratt, CFM does not appear to have a substantial leap-ahead enabling technology for its new engine, but rather it believes it can drive significant fuel efficiency through lots of small incremental improvements such as more advanced materials, minor engineering improvements, etc. Also, we believe it is possible that CFM could achieve the fuel burn spec but at the expense of other unanticipated performance compromises, such as higher maintenance expense. Airline customers had substantial concerns about LEAP-X performance earlier in 2011, though they appear to have been resolved for now. CFM still has a great deal of work ahead on LEAP-1B, however, and delays and performance issues remain a risk for the 737 MAX. If the engine ultimately does not meet its specification, we believe that CFM would be on the hook to the customer rather than Boeing, but Boeing is risking the competitiveness of its platform and its sales on CFM's ability to deliver.

And pricing looks like the primary business risk

The second major risk we see is pricing and therefore Boeing’s margins. Boeing claims the 737 NG enjoys an 8% cash operating cost advantage over today’s standard A320. While the relative claims of aircraft manufacturers are difficult to verify, we do believe the 737 NG offers lower cash operating costs than the A320 and that Boeing is therefore able to command a premium price for this platform, which supports margin performance in its commercial airplane business. As for the 737 MAX, Boeing says the cash operating cost advantage will be 7% relative to the A320neo. However, at this early stage of the development process, we believe there is little visibility regarding where the operating performance of the two aircraft will shake out. While the results are ultimately unlikely to vary wildly from expectations, we could see small changes in relative operating efficiency having a significant impact on pricing.

Figure 30: Estimated Breakdown of Cash Operating Costs and Ownership Costs For a Sample of Major Global Airlines


Note: Cash operating costs exclude G&A and selling expenses where possible. Ownership costs include depreciation and lease

payments.

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The reason is that the cost of buying the airplane is relatively small compared to the cost of operating it. Based on a diverse sample of major airlines, we estimate that ownership costs, which we define as depreciation and leasing expenses, account for only 10-20% of direct operating costs, which are the sum of cash operating costs and ownership costs. So if the 737’s cash operating cost advantage over the A320 deteriorates, Boeing must theoretically reduce its price premium to maintain direct operating cost equilibrium. And because cash operating costs are such a high proportion of direct operating costs, there is a high degree of leverage on ownership costs. This means that small percentage changes in cash operating costs can result in much larger percentage changes in price, which will affect margins.

Of course, this analysis assumes a perfectly efficient market, and the actual aircraft market is far from that in large part due to the advantage of incumbency. Therefore, the actual impact on pricing from a declining operating cost advantage is difficult to quantify. However, the aggressive and partially successful move that Airbus made to win over American Airlines may have set the stage for pricing erosion. For what its worth, which may not be much since actual prices are heavily discounted from list, Boeing is actually asking for a higher list price premium than Airbus ($10 million versus $6 million) for the re-engined aircraft. The key takeaway is that the current equilibrium between the 737 and A320 is advantageous to Boeing from a pricing and margin standpoint. Re-engining will likely reset that equilibrium, and deterioration of Boeing’s relative operating cost advantage could have a materially negative impact on margins. With its launch order last month, Boeing has begun signing the contracts that will determine how this plays out, but the fact that pricing data is so closely held means we may not know the impact for years.

Airbus A320neo

A320neo selling well, though Boeing/Airbus dynamic little changed

Airbus launched its re-engined narrowbody family ahead of Boeing in December 2010, and Airbus’s success in garnering orders for this aircraft was a major factor driving Boeing to re-engine when it had been leaning toward a clean sheet narrowbody. In fact, the Bombardier CSeries was the major driver behind the introduction of the neo itself, so both aircraft manufacturers were ultimately proded to innovate and improve their products by an upstart. Neo orders dominated the first half of 2011, particularly the Paris Air Show. By late June, Airbus had over 1,000 orders and commitments for the neo in the seven months since the launch of the aircraft, two thirds of which it announced in Paris. Boeing subsequently met with similar success, gathering nearly 950 commitments for the 737 MAX after announcing its intention to build the aircraft in July.

Most of the neo orders came from carriers already operating A320s, such as AirAsia and Indigo, or leasing companies, so the deluge of A320neo orders did little to change the competitive dynamic between Boeing and Airbus. However, Airbus did make inroads with American, previously a Boeing-only customer, convincing the carrier to undertake a split buy. American’s major fleet renewal announcement in July included 260 A320s (130 standard and 130 neos) vs 200 737s (100 NGs and 100 MAXs). American may have been eager to diversify its fleet, so Boeing’s prospects for maintaining exclusivity may have low at the outset, but the prospect of losing even more share at American was a factor pushing Boeing toward re-engining. Now that Boeing and Airbus are each offering re-engined versions of their popular narrowbodies, any major shift between these two dominant players seems unlikely,

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with A320 customers likely to buy neos, 737 customers likely to buy MAXs, and those with split fleets likely to buy both.

Table 18: Airbus A320neo and Boeing 737 MAX Orders/Commitments

Airbus BoeingCustomer Orders/Commitments Current Fleet of A320s Customer Orders/Commitments Current Fleet of 737sAirAsia 200 72 AnnouncedIndigo 150 47 Southwest 300 458 American Airlines 130 New Customer American Airlines 100 167 ILFC 100 290 Lion Air 201 64 Republic 80 New Customer Aviation Capital Group 35 44 Qantas (JetStar) 78 64 Subtotal 636Go Air 72 11GECAS 60 210 ReportedALAFCO 80* 21 COPA Unknown 47CIT 50 77 GOL Unknown 102Qatar 50 39 Norwegian Air Shuttle Unknown 61JetBlue 40 120 GECAS Unknown 181ALC 36 11 3 unnamed lessors Unknown NAAvianca TACA 33 2 2 other customers Unknown NALufthansa 30 128 Subtotal 312SAS 30 12Virgin America 30 46 Total 948Aviation Capital Group 30 34Cebu 30 29TAM 22 126LAN Airlines 20 76Garuda (Citilink) 10 3TransAero 8 New CustomerTransAsia 6 8Spirit Airlines 45 37Volaris 30 34Total 1,450

Source: Boeing, Airbus, Ascend, and Leeham News and Comment. Note: * ALAFCO has 50 firm order and 30 MoUs.

CSeries and C919 have yet to broadly catch on

Newcomers such as the CSeries and C919 could shake things up, but this will take time. Airbus has unquestionably reduced CSeries demand, but if the CSeries proves itself with regard to schedule and performance in the coming years, we expect demand to improve. The C919 has captured 215 orders (including 55 commitments) thus far and with the exception of GECAS, which is part of a major supplier, all of the customers are Chinese. In our view, demand for the aircraft thus far has been in large part a reflection of the Chinese government’s efforts to establish an aircraft production capability, and we believe demand outside China is unlikely to be robust.

Table 19: C919 Backlog

Customers Operator Area Firm Orders CommitmentsAir China China 5 15BoCom Leasing China 30CDB Leasing China 10China Eastern China 5 15China Southern China 5 15China Aircraft Leasing (HK) China 20GECAS USA 10Hainan Airlines China 20ICBC Leasing China 45Sichuan Airlines China 20Total 160 55

Source: Company data.

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A350 issues could divert resources from the A320neo

As with the 737 MAX, the A320neo is intended to be a low risk development program, with minimal changes to the aircraft beyond the engine. This would seem plausible in a vacuum, but we now view the A350 as the greatest risk to the A320neo with regard to execution. If the problems with this program that prompted Airbus to announce two delays last year grow so acute that it pulls engineering resources away from the A320neo, we could see Airbus having trouble delivering the first plane before the end of 2015 as planned. Boeing encountered a similar situation in recent years, when 787 problems diverted attention from the 747-8, though Boeing’s upgraded to its jumbo jet was a far more ambitious project than the neo.

Embraer to Re-Engine E-Jets

Embraer is the third OEM to hang new engines on an existing platform, with a re-engined E-Jet likely to be known as the E-Jet EV. There has been no formal launch yet and no specifications have been announced for the upgraded E-Jet, though management has decided to pursue the project rather than develop a clean sheet aircraft in the 130-150 seat range to compete more directly with Boeing and Airbus narrowbodies as well as Bombardier’s CSeries. While management gave serious consideration to a clean sheet aircraft, the decisive factors appeared to be Boeing’s decision to re-engine the 737, including the -700, rather than develop a new, larger narrowbody, and the lack of market traction for the CSeries, which would have been a very close competitor for Embraer’s new plane.

Re-engined E-Jet still coming together

Embraer is still determining whether it will re-engine two, three, or all four E-Jet models, with the 190 and 195 sure to go ahead. A stretched 195 is a possibility as well. This aircraft would likely be just over 130 seats and would fall between the CS100 and CS300. The basic CSeries would have longer range, but Embraer believes that most customers will not need the extra range. Embraer expects re-engining the E-Jet to cost ~$2 billion, including supplier and other contributions—compared to ~$3.4 billion all-in for the CSeries—and the target EIS for the E-Jet EV is 2018.

GE is the incumbent engine provider for the E-Jet and in our view is the favorite for the E-Jet EV. It is developing an engine known as the Passport in the same power class as the CF34. Embraer, however, has yet to commit to an engine and is assessing other options as well. The ground clearance required for the E-Jet EV’s larger fan diameter will require Embraer to lengthen the landing gear. We expect a formal launch of the E-Jet EV in early 2012 with the key selection of an engine and more detailed specifications.

2012 Is a Critical Year for CSeries Development

Execution has always been a key risk for the CSeries, and 2012 should deliver a clearer picture of management’s ability to deliver the aircraft more or less on time and on spec. While management maintains it is still on track for an on time delivery in late 2013, a modest delay seems likely at a minimum. With just under two years to go until its first delivery target Bombardier has noted that it has eaten through nearly all the contingency in the schedule, with Aerospace chief Guy Hachey stating the company is “against a wall” on timing. CEO Pierre Beaudoin has also said that a 3-6

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month delay would be acceptable, indicating to us that we are likely to see one of at least this magnitude.

Bombardier was the worst performing aerospace stock in our group in 2011, falling 20% vs a flat S&P 500, and we believe concerns about CSeries execution are a major reason for the underperformance. This means some delay is likely priced in already, and we believe the market and customers would likely accept the 3-6 months Beaudoin put forward. One issue for the stock, however, is that once Bombardier announces one delay, expectations for others might grow. While we believe Bombardier can sustain a moderate delay, it does not have the financial resources to deal with a 787 type situation and a multiyear delay would likely have severe consequences for the company and the stock.

Costs do not appear to be surging too far beyond expectations at this point, though management has not updated its estimates for development costs recently. Total development costs for the CSeries are expected to be $2.7 billion, with Bombardier contributing $1.3 billion and suppliers and governments each contributing ~$700 million. In addition, Bombardier’s capex is expected to be $700 for a total Bombardier investment of $2 billion. Bombardier reports the program tooling balance each quarter, which should correspond to gross development costs (including supplier and government contributions but excluding capex). As of October 31, this balance was $1.2 billion, or 45% of the way through expected development costs with about two years to go until the target delivery date.

Figure 31: CSeries Cumulative Gross Development Costs at 10/31 and Remaining Costs to Stay on Budget $ in millions


The CSeries is approaching important milestones in 2012, most notably first flight, currently slated for 2H. Before that, however, Bombardier must establish the maturity of the aircraft’s various systems in integrated testing and this should be a focus in 1H. We believe the fuselage, built by China’s Shenyang Aircraft, ate up much of the contingency, but Bombardier has reportedly moved beyond this issue. The company is watching about five other areas, however, and we believe flight

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$200

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$1,600

31-Oct-11 Remaining

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control software is among these. With regard to the engine, Pratt completed the first flight test program for the 1524G and a second test campaign was to have begun recently.

If you build it, they will come; demand ultimately depends on execution

The market has been disappointed by the 153 orders and commitments Bombardier has gathered for the CSeries thus far, particularly since the largest order—40 aircraft from Republic—is at risk of cancellation. We agree that customers have not rushed to embrace the aircraft, but we also see potential for demand to sort itself out if Bombardier can deliver an aircraft reasonably close to on time that fulfills its performance commitments. Excluding Republic, Bombardier still has 113 commitments, and as deliveries will start very in late 2013 at the earliest and it will take time to ramp up the production rate, most if not virtually all slots are gone before 2016. Even in that year, we believe most of the deliveries are spoken for. If Bombardier is delivering CSeries aircraft in 2014 and 2015 that bring promised performance benefits, we believe the company will have more success overcoming pressure from Airbus and convincing airlines to adopt the aircraft, particularly since Airbus and Boeing do not have many slots available until later in the decade. Building the backlog after it has retired development risk should enable Bombardier to take a firmer line on pricing.

Table 20: CSeries Backlog

Customer Orders/CommitmentsAtlas Air 10*Braathens Leasing 10Ilyushin 10*Korean Air 10Lease Corp. Int'l 20Lufthansa 30Republic Airways 40Undisclosed 23Total 153

Source: Ascend, company data. Note: * represents LoI.

China Determined to Establish Narrowbody Presence

China’s Comac continues to develop the C919, which is to be the country’s first entry into the market for large commercial aircraft, following up on the ARJ-21 regional jet. Planned seating for the standard model is 156-168 depending on the configuration, though COMAC is planning other variants as well, including smaller and larger aircraft, a freighter, and a business jet. Range for the standard model is expected to be 2,200 nm, with an extended range version planned for 3,000 nm. Comac selected CFM’s LEAP-X as the engine for the C919, and many Western suppliers have content on the aircraft. First flight of the C919 is scheduled for 2014, with first delivery in 2016.

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Table 21: C919 Specifications

C919Passengers 156-168Cruise Speed 0.79 MRange 2,200-3,000 nmWing Span 35.8 mLength 38.9 mHeight 11.95 mEngines 2x CFM LEAP X1C

Source: Aviationweek, Air Transport Intelligence, Flightblogger, J.P. Morgan estimates.

Comac will target the domestic market with the C919—at least initially–which should give it ample opportunity to establish the aircraft since China is the world’s largest market for new aircraft—particularly narrowbodies—and should continue to grow in the coming years. COMAC continued garnering orders for the C919 in 2011 and total orders and commitments currently stand at 215. All of these are from Chinese customers, with the exception of lessor GECAS. We attribute the GECAS commitment to GE’s role as a major supplier on the program, including as a partner in the CFM consortium that will provide the engine, and GECAS might ultimately place its C919s with Chinese operators. While the C919 will probably garner some international orders, we do not expect it to compete with Airbus and Boeing globally. We do expect, however, that the aircraft will be a major step for China toward building a global aerospace industry that ultimately should compete across the full product spectrum, but this will take 10-20 more years.

MS-21 in the Mix As Well

Though it receives less attention than some of the other aircraft in development, Russia is working on a new narrowbody as well. Irkut’s MS-21 is a family of three aircraft expected to seat 150-230. The first MS-21 is scheduled for first flight in 2014 and first delivery in 2016. Irkut is targeting operating costs 15% below those of comparable Boeing and Airbus models. The company selected Pratt’s GTF to power the MS-21. Sukhoi’s Superjet regional jet, which entered service last year, has had difficulty winning orders outside the former Soviet Union, and we believe this is likely to be an issue for the MS-21 as well. However, the selection of a Western engine for the MS-21, compared to the more aggressive use of Russian technology for the Superjet, should enhance its prospects in the global marketplace.

Table 22: Specifications of MS-21 Models

MS21-200 MS21-300 MS21-400

Passengers 150-162 181-198 212-230Cruise Speed 0.8 M 0.8 M 0.8 MRange 2,700 nm 2,700 nm 2,970 mmMTOW 148,720 lbs 168,000 lbs 191,900 lbsWing Span 35.9 m 35.9 m 36.8 mLength 35.9 m 41.5 m 46.7 mHeight 11.4 m 11.5 m 12.7 mEngines 2x P&W PW1000G 2x P&W PW1000G 2x P&W PW1000G

Source: Company Reports, J.P. Morgan estimates.

GTF vs LEAP X

A new generation of engines for narrowbody aircraft will enter service in the coming years, with Pratt & Whitney and CFM (a 50-50 JV between GE and Safran’s Snecma) each developing a new engine family that will power several platforms, offering lower fuel burn, emissions, and noise. Pratt’s PurePower 1000G (also

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known as the Geared Turbofan, or GTF) is further along in the development process. The presence of a gear system permits the GTF’s fan to operate more slowly than the compressor and the turbine, thus enhancing efficiency, and we believe this makes the GTF the more revolutionary of the two engines. Efficiency improvements in CFM’s LEAP X depend on a higher bypass ratio and a higher pressure ratio in the compressor, both of which are enabled by more extensive use of composite materials. Each engine manufacturer is ultimately promising about a 16% improvement in fuel burn relative to current models, though incremental improvements are likely over time. While we understand that CFM faced some technical challenges on LEAP X in the first half of last year, the development effort appears to have moved beyond these. In terms of aircraft platforms, the Bombardier CSeries, Mitsubishi Regional Jet (MRJ), and Irkut MS-21 will be powered exclusively by PW1000G engines, while the LEAP X will power the Boeing 737 MAX and COMAC C919.

Table 23: Current Engine Share for A320neo Orders

CFM Leap X Airlines Pratt & Whitney PW1000G200 Air Asia

ALAFCO 5015 CIT 3010 Garuda (Citilink)60 GECAS40 ILFC 60

Indigo 150JetBlue 40

Lufthansa 3080 Republic30 SAS

Qatar 5030 Virgin America

465 Total 410

Source: Company data. Note: Numbers represent aircraft, not engines; there are 2 engines per aircraft.

The competition heats up at Airbus, which launched its A320neo aircraft with both engine options in late 2010. Thus far, orders have been split fairly evenly, with the PW1000G out of the gate strong before being overtaken by LEAP X at the Paris Air Show. The PW1000G surged again late in the year with orders from ALAFCO and Qatar at the Dubai Air Show. The A320neo has gathered 1,450 orders/commitments to date, with customers choosing engines for 60% of those aircraft thus far. Among those that have chosen engines, the split is 55/45 in favor of LEAP X.

Figure 32: Historical Market Share (CFM56 and V2500)

Source: Ascend.

43% 40% 42% 42% 42% 42%

57% 60% 58% 58% 58% 58%

0%10%20%30%40%50%60%70%80%90%

100%

2006 2007 2008 2009 2010 2011

V2500 CFM56

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Most A320neo customers currently operate standard A320s, and the incumbent engine provider generally has an advantage, even though it is IAE, a consortium in which Pratt is a member that manufactures the V2500, rather than Pratt & Whitney. In this context, LEAP X’s market share is consistent with though slightly below the 56-60% we have seen for CFM in recent years. GE’s role in financing aircraft through GECAS supports demand for CFM products, and this should remain the case. Among A320neo customers yet to choose an engine, there are both CFM and IAE customers, so both engines should see additional orders. American is the one major new A320 customer to order the neo that has yet to select an engine, making this a closely watched competition. With American in bankruptcy, however, we doubt a decision is imminent.

Table 24: A320neo Orders/Commitments with Engines Unannounced

Airlines Neo Orders/Commitments Current choice of A320 family enginesALAFCO 30 Already ordered 50 P&WAmerican Airlines 130 New customer; yet to decided on engineAviation Capital Group 30 57% IAE, 43% CFMALC 36 53% IAE, 47% CFMAvianca TACA 33 CFMCebu 30 CFMCIT 5 Already ordered 30 PW, 15 CFMGo Air 72 CFMQantas (JetStar) 78 IAELAN Airlines 20 65% CFM, 35% IAESpirit Airlines 45 IAETAM 22 75% IAE, 25% CFMTransAero 8 New customer; yet to decided on engineTransAsia 6 IAEVolaris 30 IAETotal 575

Source: Ascend, Company data.

One other major development on the engine front last year was Pratt’s announcement that it would purchase Rolls-Royce’s 33% stake in IAE. As part of the deal, Pratt and Rolls agreed to form a new JV to develop engines for the next generation of 120-230 seat aircraft that will incorporate Pratt’s GTF technology. Rolls will not be a partner on the GTF for the A320neo but it will make a small development contribution. We view this deal as further validation of the GTF and a positive strategic development for Pratt that moves it one step closer insuring its place as a leading narrowbody engine provider over the long term.

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The Emerging Widebody Landscape

There are several important issues in the widebody market, but in this section, we will focus on three critical ones with potential stock implications this year. The first is A350 development, where Airbus stumbled in 2011. The company announced two delays last year and we see potential for more. The second, which is related to the first, is the future of Boeing’s widebody programs. Uncertainty about A350 schedule and performance, particularly for the -1000 variant, was a leading driver of Boeing’s record 777 order performance in 2011, and to the extent that uncertainty persists, the 777 should benefit further. In addition, the longer it takes Airbus to bring an A350-1000 to market that satisfies customers, the longer Boeing can wait to upgrade the 777. Boeing’s 787-10, which we expect the company to launch this year, will also compete against the A350 and could start contributing to orders this year. In short,Boeing dominated widebody demand in 2011, and further issues with the A350 could sustain this dynamic. Finally, we expect to see the beginning of a sustained improvement in Boeing’s cash flow this year as the company delivers some of the 787s that have been accumulating at its Everett, WA facility over the past two years.

A350 Execution Is Critical for Airbus

Airbus announced two delays to the A350 program last year. First, in June, the company delayed the -1000 variant by two years to 2017 and the -800 variant by two years to 2016. Then, in November, Airbus acknowledged there would be a six month delay for the -900 variant into 1H 2014 from the end of 2013. The 2011 delays came on the heels of a 2010 announcement that -900 delivery would be delayed from summer 2013 to 2H 2013 and were therefore not especially surprising. Given the complexity of the program and continuing challenges in the supply chain, we could see the schedule move further to the right.

Several supply chain problems contributed to the A350-900 delay, with the center fuselage panels among the more notable issues. Spirit said in early November that it had begun shipping these composite panels from North Carolina to its facility in St-Nazaire, France, but the process of getting the panels to Airbus’ final assembly facility in Toulouse has taken longer than expected. Airbus has identified rear wing spar manufacturing challenges working with composites (potentially including the fuselage panels cited above), and missing frames, clips, and brackets as drivers of the delay. Another issue to be aware of is the European debt crisis, with EADS CFO Hans Peter Ring noting that limited access to capital among suppliers is leading to parts shortages.

Looking ahead, Airbus now expects final assembly of the first A350-900 to begin early this year. The company made progress last month with delivery of the first A350 forward fuselage to the final assembly plant in Toulouse. Airbus will first assemble a static test aircraft, with final assembly of the first flight test aircraft scheduled to begin in 2Q. First flight is scheduled for early next year, with flight testing continuing into 2014, and delivery expected in 1H.

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Table 25: A350 Schedule

A350-800 A350-900 A350-1000Begin Final Assembly Late 2014 Early 2012 2015First Flight 2015 1Q2013 2016Entry Into Service 2016 1H2014 2017

Source: EADS.

A350-1000 to get engine overhaul

The A350-1000 delay is longer and involves more significant changes to the aircraft. The two year push out of first delivery to mid 2017 should enable development of a new version of Rolls-Royce’s Trent XWB engine that will offer greater thrust and range, and is intended make the -1000 compete more effectively against the 777-300ER. Upgrading the engine comes with challenges of its own however, particularly with regard to weight. We believe the A350-1000 may already be overweight, with the upgraded engine contributing further to this problem. Final assembly of the A350-1000 is now slated for mid 2015, followed by first flight a year later and first delivery a year beyond that. For the A350-800, final assembly is scheduled for late 2014, with first flight in late 2015 and entry into service in mid 2016.

A350 Risk Supporting 777 Demand

The most striking development in the widebody market during 2011 was the strong performance of the 777-300ER, which took in a record 152 gross orders vs zero for the A350-1000, its primary competitor. This lopsided performance is not especially surprising since Airbus delayed the A350-1000 to 2017. This means that even if the aircraft is on time, any customer that wants a ~350 seat plane before 2020 or so—the 75 A350-1000s already in backlog should constitute at least 2 years of deliveries—must order the 777. Concerns that the schedule could slip further or that performance could fall short of expectations are likely cutting into A350-1000 demand as well. The entire 777 backlog of 380 aircraft represents ~4 years of production, so Boeing still has plenty of slots to fill before Airbus can deliver the A350-1000 in quantity and this should support further 777 demand. Ongoing uncertainty about A350-1000 schedule and performance could help 777-300ER demand as well.

We saw evidence of customer dissatisfaction with the A350-1000 schedule and specifications in Dubai last year, when Emirates, which has 20 A350-1000s on order, or 27% of the backlog, placed a record order for 50 777-300ERs, with options for 20 more. Emirates President Tim Clark was candid about how A350-1000 delays were cutting into Emirates’ ability to grow, thus increasing the urgency of adding capacity with 777s. He also noted his dissatisfaction with Airbus’ decision to alter the specs of the aircraft when it announced the delay and new engine last June, a judgment echoed by Akbar Al Baker, CEO of Qatar Airways, which has another 20 A350-1000s on order and is also the launch customer for the -900.

A350-1000 issues take pressure off Boeing to upgrade 777

A350-1000 delays also extend Boeing’s window for determining how to upgrade the 777. Boeing has been considering such a move for some time but the lack of a strong competitor should reduce the urgency somewhat. Still, Boeing is working toward an upgraded 777 and last year brought news about plans to develop the 777-8X/9X, an upgraded family of aircraft in the 300-415 seat range. Among the biggest changes under consideration is the adoption of composite wings. Boeing would also look to power the aircraft with upgraded GE-90 engines providing better fuel burn. The 777-

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8X would be smaller than the 777-300ER, while the -9X would be larger. The new -9X could seat 390 vs 365 for the -300ER. Emirates has been a vocal proponent of upgrading the 777, and we believe the 20 options for 777-300ERs that Emirates took at the Dubai Air Show last year may include rights to convert to upgraded 777s. Deliveries of the 777-300ERs Emirates currently has on order stretch through 2019, which is around the time a 777-8X/9X could enter service in theory. Boeing will continue to watch the A350's progress before launching any derivative of the 777, because it has little incentive to invest heavily to replace a successful product until the competitive challenge is clear.

Competitive Dynamics among Other Widebodies

While market dynamics are fairly straightforward between the 777-300ER and the A350-1000 right now, the picture is less clear cut among widebodies below this size. Demand for these aircraft has not been particularly strong, with a total of 156 net 787cancellations the past three years along with 41 for the A350 (all -800s and -900s). Competitively, the A350 stacks up against parts of both the 787 and 777 families, with the A350-800 currently lined up most closely against the 787-9 and the A350-900 lined up against the 777-200ER/LR. Later this year, the launch of the 787-10 could alter the mix.

Table 26: 787 vs. A350 vs. 777

787-8 787-9 A350-800 777-200ER/LR A350-900 777-300ER A350-1000Passengers 210-250 250-290 270 301 314 365 350Cruise Speed .85 M .85 M .85 M .84 M .85 M .84M .85 MRange 8,200 nm 8,500 nm 8,300 nm 7,725 nm 8,100 nm 7,930 km 8,000 nmMTOW 484,000 lbs 540,000 lbs 540,100 lbs 656,000 lbs 584,200 lbs 775,000 lbs 650,400 lbsWing Span 60 m 63 m 64 m 60.9 m 64 m 64.8 m 64 mLength 57 m 63 m 60.6 m 63.7 m 66.9 m 73.9 m 73.9 mHeight 17 m 17 m 16.9 m 18.5 m 16.9 m 18.7 m 16.9 mDiameter 5.74 m 5.74 m 5.96 m 6.19 m 5.96 m 6.19 m 5.96 mEngines 2x GEnx or RR Trent

10002x GEnx or RR

Trent 1000RR Trent XWB 2x GE-90 RR Trent XWB 2x GE 90 RR Trent XWB


In the smallest category among these three, the 787-9, a stretched 787, should stack up well against the A350-800, a shrunken A350. In terms of demand, the 787-9 backlog is growing and is now at 266 aircraft (up from 234 a year ago) as Boeing pushes customers to convert orders for the -8 to the more profitable -9. For the A350-800, the backlog is down to 119 aircraft from a peak of 182, due in part to customer conversions to the -900. Air New Zealand is the launch customer for the 787-9 and the aircraft is slated to enter service in early 2014, a slip from the prior target of late 2013 that Boeing disclosed last year. As noted above, A350-800 EIS slipped two years to mid 2016 last year. Given the low level of recent demand, conversions to the -900, and the scarcity of engineering resources at Airbus for the other two A350 variants and the less ambitious but critical A320neo, we continue to believe that the A350-800 is at risk of cancellation.

Airbus’ A350-900 has the strongest level of demand among the three variants, with 373 aircraft in backlog as of Nov 30. Demand has not been particularly strong recently, with 80 gross orders over the past three years, but its Boeing competitor the 777-200ER/LR is fading, with only 17 gross orders. Boeing may decide to launch the 787-10 this year, which would complete in this category. We estimate that the 787-10 could carry close to 300 passengers, roughly on par with the A350-900. Boeing has indicated, however that the range on a 787-10 could be ~7,000 nm, or about

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1,000 nm below the A350-900. Nevertheless, we expect the 787-10 to offer highly attractive economics and help to support orders at Boeing, if is launched. Boeing’s plans for a 777 refresh include a 777-8X, which would likely be a bit larger than the 787-10. Assuming Airbus can remain close to on schedule, however, the A350-900 could have a head start of about 5 years on the 777-8X, assuming -900 entry into service in 2014.

787 Cash Flow Should Improve Decisively in 2012

Boeing’s 787 inventory has been growing by $1.6-1.7 billion per quarter since mid 2010, and this has been a significant drag on the company’s overall cash flow. For 2011, our free cash flow estimate of just under $1 billion equates to a conversion ratio under 30% and a nearly 90% decline from the 2007 peak. We attribute last year’s poor cash flow to the 787, as we estimate inventory growth alone accounted for a nearly $7 billion use of cash (not to mention capex and R&D). The dynamics of 787 cash flow are complex and our estimates depend on depend numerous assumptions regarding issues where visibility is low. The key point for 2012 with regard to cash flow, however, is that rather than just accumulate 787s on its balance sheet, as it did in 2010 and 2011, Boeing will deliver them as well and hopefully reduce its inventory of completed aircraft. This mitigating factor on inventory growth should cause cash flow to improve sharply.

787 does not have to generate cash; it just has to burn less

Now that Boeing has disclosed the 787 block size and deferred production balance, we have seen much attention on when 787 cash flow will turn positive on a unit basis and what the likelihood is that Boeing will take a forward loss on the program. These are important questions, but from a cash flow improvement perspective, neither is critical, in our view. 787 inventory grew by $7.50/share in 2010 and should grow by ~$9/share in 2011 (before any impact on taxes). For 787 cash flow—and therefore Boeing cash flow—to improve, this cash burn must simply decline, not disappear altogether. The level of cash burn on 787 in 2011 is so high that cash burn could remain elevated in 2012—in fact, it should—and still show dramatic improvement. Given strong cash generation in the business ex 787, we believe lower 787 cash burn should be the leading driver of a $2+ billion jump in FCF to over $3 billion, which represents ~90% of our 2012 net income estimate.

Deliveries should drive the 2012 inventory turnaround

787 WIP inventory increased by $1.6-1.7 billion/quarter through 9M 2011. One driver was the fact that Boeing was building 787s and not delivering them. We estimate that Boeing will build 20-25 787s in 2011 while delivering only three, withthe difference sitting in inventory. This wide discrepancy between production and deliveries should narrow and turn in favor of deliveries as Boeing unloads aircraft that have piled up in Everett the past two years. The fact that planes will be going out the door rather than remaining on the balance sheet is the key favorable change in 787 cash flow. As Boeing delivers each of the 40+ aircraft in inventory, WIP will decline by the unit cost of the aircraft across the accounting block, which we peg at just under $120 mn. Building such a high inventory of completed aircraft prior to first delivery is unusual, and is one element that distinguishes the 787 cash flow trajectory from that of other programs, such as 777.

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We estimate 40 787 deliveries in 2012

2012 deliveries will come from two sources: straight off the assembly line and out of inventory. The number off the line depends on the production rate and each aircraft’s readiness for delivery off the line. Based on Boeing’s own schedule—an increase from 2.5/month to 3.5/month in late winter/early spring and a jump to 5/month in the fall—the company can build 43-44 787s next year. However, management does not expect aircraft to be ready for delivery off the line until 2H. In addition, we are baking in a moderate delay in line rate increases relative to Boeing’s schedule. Deliveries out of inventory are a wild card. Boeing has indicated that clearing out these aircraft will take 2-3 years, though the pace is unclear and we expect a slow start. In total, therefore we are looking for 40 deliveries, which we expect will be weighted toward the back half of the year.

Two main drivers of inventory growth: one is building new planes

While 787 cash flow should improve, we expect it to be negative through at least 2013 and we still see nearly $3 bn of 787 inventory growth next year followed by over $200 mn in 2013. The difference between the actual cost of the latest 787 coming off the line and the average cost assumed in the initial accounting block of 1,100 aircraft is one source of growth. We believe the unit cost in the accounting block is just under $120 mn and that it still costs significantly more than this to build a 787. While the cost assumed in the block is run through the income statement at delivery, the excess over that amount is added to the deferred production balance in inventory. On a unit basis, excess cost should decline and eventually turn negative as Boeing comes down the learning curve, though the amount added to the deferred production balance also depends on the number of aircraft built, which should rise.

And the other is fixing older planes

We estimate that Boeing closed out 2011 with over 40 completed 787s yet to be delivered, and completing these aircraft will generate additional costs, or “rework”. We believe the unit cost of each of these aircraft is already above the ~$120 mn average cost we assume for the block, so all rework will increase the deferred production balance. Estimating rework is difficult, but we believe the total deferred production balance rose by ~$1 bn/quarter in Q2 and Q3. We believe the bulk of this was for new aircraft, but if we assume a 60/40 split, then rework is running ~$400 mn/quarter. While the level of rework required varies by aircraft, costs should remain fairly steady once Boeing finishes setting up a parallel production line for rework.

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Figure 33: Estimated Change in 787 WIP Inventory, 2011E - 2015E$ in millions


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Regional Aircraft: New Entrants Coming but Underlying Demand Remains an Issue

Regional jet demand has not rebounded in the way that demand for large commercial aircraft has. We estimate regional jet deliveries fell an estimated 17% in 2011 to 55, representing a 57% decline from the 2008 peak. 2011 deliveries of both Bombardier CRJs and Embraer E-170/175s fell. (We classify Embraer’s E-190/195 as a smaller mainline aircraft rather than a regional jet, and demand for this platform has been far stronger.) New entrants such as Sukhoi’s Superjet, COMAC’s ARJ-21 and Mitsubishi’s MRJ should put deliveries back on an upward trajectory, but none of these has seen particularly strong demand outside its home market. The outlook for existing Bombardier and Embraer platforms remains depressed as demand at the small end of the commercial aircraft market continues migrating toward larger aircraft. Turboprops fared much better, with a nearly 1.7x book to bill ratio, though the ATR 72 accounted for the bulk of the orders, with Bombardier looking at production cuts for the Q400. Amid rising oil prices, tuboprops’ superior fuel efficiency is supporting demand, at least for ATR.

Demand remained weak in 2011

2011 was a fairly weak year for regional jet demand. Combined orders totaled 106 aircraft (passenger only), though Bombardier and Embraer, the two established players competing to sell regional jets globally, accounted for only 29 of these. The remaining 77 were for the Superjet (65) and the ARJ21 (12), both of which are primarily players in their home markets of Russia and China, respectively. (Sukhoi did, however, win Superjet orders from small airlines in Indonesia and Mexico, broadening its customer base.) Meanwhile, Mitsubishi has yet to find a third customer for the MRJ. While the regional jet book-to-bill was nearly 2.0x industry-wide, only Bombardier and Embraer were delivering aircraft for the entire year.

Table 27: Regional Jet Orders, 2011

Customer OrdersBombardier CRJ Family 10Chinese Airlines 6*Petroleum Air Services 1Pluna Lineas Aereas 3Embraer E-170/175 19Air North 1ALC 7Alitalia 10Fuji Dream Airlines 1Sukhoi Superjet 100 65Blue Panorama Airlines 4Gazpromavia 10VEB-Leasing JSC 24Sky Aviation 12Interjet 15COMAC ARJ21 12China ShangFei 10Myanmar Airways 2Total 106

Source: Company reports, Ascend. Note: * represents conditional orders.

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Following last year’s weak order performance, backlog for Bombardier and Embraer regional jets is dwindling. According to Ascend, the E-170/175 backlog is now 54 aircraft (as of Dec 27, 2011), with more than half destined for Flybe. Also, 2011 deliveries of the E-170/175 accounted for only ~10% of E-Jet deliveries. One factor mitigating the impact of falling E-170/175 demand for Embraer is that it builds these aircraft on the same line as the E-190/195, which has seen far stronger demand. We estimate that total E-Jet orders for 2011 reached 111. This means that as long as E190/195 demand holds up, Embraer should be able to stave off overall rate cuts. We see E-Jet production as safe in the 100+ range though 2013, though we have concerns about the years beyond due to the entry into service of new competitors from Bombardier (CSeries) and Mitsubishi (MRJ).

Table 28: ERJ 170/175 and Bombardier CRJ Family Backlog by Customer

Customer BacklogEmbraer E-170/175 54FlyBe 31Alitalia 8Air Lease 7ETA Star Group 5Oman Air 2Air North 1Bombardier CRJ Family 54Air Nostrum 26Undisclosed Chinese Airlines 6*Felix Airways 6Iraqi Government 4Nur-Avia Company 4Brit Air 3Undisclosed 2Adria Airways 1Ibex Airlines 1Petroleum Air Services 1Total 108

Source: Ascend. Note: * represents conditional orders.

The situation at Bombardier is a bit more precarious. We estimate that the current CRJ backlog is only 54 aircraft (including 6 conditional orders), which compares to an estimated 38 deliveries for 2011 (Feb-Dec). Management has said it plans to lower the rate production rate in 2012 but has yet to give guidance and we see potential for a significant decline. Regional jets are not a major source earnings for Bombardier’s Aerospace business—Globals and Challengers account for the bulk of profits—but overhead absorption could become an issue, particularly if Q400 rates fall significantly as well (see below). Management has expressed confidence that it will win some upcoming campaigns with its CRJ1000, though it remains unclear to us when and whether orders will be forthcoming. In addition, Bombardier is investing in a beefed up presence in emerging markets, where it believes its relative absence has helped Embraer to take the lion’s share of orders recently, at a time when demand has been more muted in Bombardier’s traditional US and European markets. This could be somewhat helpful but we believe an at least equally important objective here is to sell more CSeries aircraft to emerging market customers. We estimate that CRJ deliveries will drop to 28 in CY12, followed by 21 in CY13.

There is almost certainly a cyclical component behind the weak demand we have observed for regional jets in recent years, given the slow global recovery and the fact that the smaller airlines that buy regional jets tend to be in worse shape financially than their larger counterparts. We believe there is a structural element as well,

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however, with demand moving toward larger aircraft. 50-seaters dominated the regional market in the early 2000s, but demand disappeared long ago due to changes to pilot contracts and scope clauses. Now, demand for 70-90 seaters is fading as well. The direction of resources for new aircraft development is one indicator of where this market is going, with Bombardier focused on the small end of the narrowbody market with the CSeries. While Embraer will not follow Bombardier into this territory with an all new larger aircraft, it is not yet clear whether its re-engining program will include the E-170/175 and a stretched E-195 is on the table.

In terms of demand, we saw Delta turn away from plans to purchase Embraer or Bombardier aircraft to replace older narrowbodies and opt to upgrade the larger side of its narrowbody fleet first instead, with an order for 737-900ERs. On the other hand, American's bankruptcy could result in additional orders for CRJs as the carrier looks for larger aircraft with better economics to replace the 50-seaters that currently serve as the spokes of its regional system. Ultimately, we do see an economically viable role for regional jets at some level as their economics are generally attractive on a per trip basis and they play a key role in the hub and spoke system that is the cornerstone of the US airline industry. At the present time, however, we still see an overabundance of regional capacity available, and demand should remain relatively soft for as long as this is the case.

Table 29: Regional Aircraft Deliveries and J.P. Morgan Estimates, 2003-2016E

2003 2004 2005 2006 2007 2008 2009 2010 2011E 2012E 2013E 2014E 2015E 2016EBombardierCRJ 100/200 152 100 44 1 0 0 0 0 0 0 0 0 0 0 CRJ 700 50 64 63 14 7 4 27 18 13 7 3 5 7 7CRJ 900 12 14 14 50 55 52 33 14 12 8 4 8 8 8CRJ 1000 0 0 0 0 0 0 0 9 13 13 14 18 25 25Subtotal: 214 178 121 65 62 56 60 41 38 28 21 31 40 40EmbraerERJ 135 14 1 2 0 0 0 0 0 0 0 0 0 0 0ERJ 140 16 0 0 0 0 0 0 0 0 0 0 0 0 0ERJ 145 57 87 46 12 7 6 7 6 2 0 0 0 0 0Embraer 170 0 46 46 32 11 9 22 11 1 3 0 0 0 0Embraer 175 0 0 14 11 34 56 11 8 8 16 10 5 5 5Subtotal: 87 134 108 55 52 71 40 25 11 19 10 5 5 5Fairchild-Dornier328JET 0 0 0 0 0 0 0 0 0 0 0 0 0 0SukhoiSuperjet 100 0 0 0 0 0 0 0 0 6 20 25 30 30 30CAICARJ21 0 0 0 0 0 0 0 0 0 2 25 30 30 30MitsubishiMRJ 0 0 0 0 0 0 0 0 0 0 0 5 15 25Total Jets 301 312 229 120 114 127 100 66 55 69 81 101 120 130 Growth -6% 4% -27% -48% -5% 11% -21% -34% -17% 25% 17% 25% 19% 8%Turboprops:ATR 9 13 15 24 42 55 54 49 51 60 65 65 65 65Bombardier 18 22 28 45 66 54 61 56 49 22 18 22 25 30 Others 5 9 4 8 8 0 0 0 0 0 0 0 0 0Subtotal 32 44 47 77 116 109 115 105 100 82 83 87 90 95 Growth -55% 38% 7% 64% 51% -6% 6% -9% -5% -18% 1% 5% 3% 6%Total 333 356 276 197 230 236 215 171 155 151 164 188 210 225 Growth -15% 7% -22% -29% 17% 3% -9% -20% -9% -3% 9% 15% 12% 7%

Source: Ascend, Company reports and J.P. Morgan estimates. Note: BBD deliveries correspond to next fiscal year. (i.e., 2010 deliveries correspond to the fiscal year that ended Jan 31, 2011),

while 2011 consist of only 11 months till Dec 31, 2011 and from 2012 onwards fiscal year is same as calendar year.

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ATR had its best ever year

Passengers typically prefer jets to turboprops, but the latter’s better fuel efficiency, particularly on short routes, led to a surge of orders and a strong pickup in deliveries starting in 2006. Turboprop deliveries have held up better than regional jets recently, declining by only 9% in 2010, followed by 5% in 2011. In contrast, regional jet deliveries fell 34% in 2010 and another 17% in 2011.

Figure 34: Turboprop Orders vs. Deliveries, 2006 - 2011E

Source: Ascend, Company Data, and J.P. Morgan estimates.

Turboprop order activity was fairly strong in aggregate last year, though there was a sharp divide between Bombardier’s Q400 and ATR’s turboprops. ATR had its best ever year with 158 new orders compared to orders for only 8 Bombardier’s Q400s. The Q400 backlog has dropped to an estimated 23 aircraft, under half the 49 deliveries we have estimated for 2011 (Feb-Dec). Bombardier attributes its weak Q400 order performance to the fact its offering is more sophisticated than the ATR 72 and that the airlines buying aircraft in 2011 were interested in simpler aircraft. In addition, the installed base for Dash 8 aircraft skews more toward North America, where there was minimal order activity in 2011

We expect Q400 deliveries to fall sharply next year to 22 from 49 before bottoming just below 20 in 2013. With a larger backlog, we expect ATR annual deliveries to be in the 60-65 aircraft range going forward, making for a Q400 driven 18% overall decline in 2012 deliveries. We see deliveries coming in flat to modestly higher thereafter.

Table 30: List of Turboprop Orders and Backlog

Model 2011 Orders Backlog

ATR 42 16 19ATR 72 142 238Bombardier Q 400 8 23Total 166 280

Source: Source: Ascend. Note: As of Dec 28, 2011.

New competitors entering the market

Three new competitors are entering the regional jet market. Sukhoi is farthest along, having delivered the first Superjet 100-95 in April 2011. We estimate that Sukoi delivered six aircraft in 2011, all to customers in the former Soviet Union, with 20 to come in 2012. The current backlog is 165 aircraft, most of which are headed to Russia, but the Superjet has racked up some orders outside the former Soviet Union

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as well, including Mexico and Indonesia last year. Although it looks competitive on paper, the Superjet faced several delays and questions about its SaM 146 engine. While Russian authorities have certified the Superjet, we do not yet believe the aircraft has been certified by either EASA or the FAA. Last year, Sukoi launched a business jet version of the Superjet, for which Comlux became the initial customer.

COMAC’s ARJ21-700 is a large regional jet optimized for the hot and high conditions in China’s west. The jet is in flight testing now and is scheduled for entry into service late this year, but it has already seen several delays and further schedule slips are possible. There are currently 132 aircraft in backlog. As the aircraft’s specifications have been developed with the unique geography of western China in mind, the ARJ21-700 is unlikely to be a significant player on the international market. However, the stretched ARJ21-900 could in theory be more exportable down the road. In addition, the ARJ21 will have the home field advantage in the world’s fastest growing market for air travel and one where regional jets are underrepresented, factors that could generate demand.

Table 31: New RJ Competitors Backlog by Customer

ARJ 21 OrdersOperator

Area Superjet OrdersOperator

Area MRJ OrdersOperator

Area

Henan Airlines 50 China Kartika Airlines 30 Indonesia Trans States Holdings 50 USAChengdu Airlines 30 China Pearl Aircraft Corp. 30 Bermuda ANA-All Nippon Airways 15 JapanCDB Leasing Company 20 China VEB-Leasing JSC 30 RussiaHebei Airlines 10 China Aeroflat Russian Airlines 20 RussiaShandog Airlines 10 China Interjet 15 MexicoGECAS 5 USA Sky Aviation 12 IndonesiaShanghai Airlines 5 China Gazpromavia 10 RussiaMyanmar Airways 2 Myanmar Wills Lease Finance Corp. 6 USA

Blue Panorama 4 ItalyLao Central Airlines 3 Loas

Finance Leasing Company 2 RussiaArmavia 1 Armenia

Total 132 Total 163 Total 65

Source: Ascend.

In our view, the most serious potential competitor to Bombardier and Embraer jets in the long run is the Mitsubishi Regional Jet (MRJ). The MRJ will use Pratt & Whitney’s fuel efficient PW1000G geared turbofan engine, which should deliver ~15% fuel burn savings relative to rivals. Although the Japanese have little history integrating jet aircraft, the Mitsubishi-led consortium building the plane has developed expertise on recent Boeing programs. The MRJ was launched in early 2008 with an order from ANA, and the only other customer thus far is US regional operator Trans States. We believe Mitsubishi is willing to be aggressive on price to attract more orders. Both Trans States and ANA are seeking the 90-seat version of the MRJ, though there is a 70-seat variant as well. The MRJ is not expected to enter service until 2014, though the program has seen some schedule slippage and this remains a risk.

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Table 32: New RJ Competitors

Sukhoi Superjet 100-75 Sukhoi Superjet 100-95 ARJ21-700 MRJ 70 MRJ90Passengers 68-78 86-98 78-90 70-80 86-96Max. Cruise Speed .78M .81M .82M .78M .78MRange 1,566-2,450 nm 1,645-2,457 nm 1,200-2,000 nm 860-1860 nm 920-1,820 nmMTOW 85,585-93,210 lbs 93,740-10,1150 lbs 89,000-96,000 lbs 81,240-88,626 lbs 87,303-94,358 lbsWing Span 27.8 m 27.8 m 27.28 m 29.7 m 29.7 mLength 26.44 m 29.94 m 33.46 m 33.4 m 35.8 mHeight 10.28 m 10.28 m 8.44 m 10.4 m 10.4 mCabin Width 3.24 m 3.24 m 3.14 m 2.96 m 2.96 mEngines 2 x SaM 146 2 x SaM 146 2 x GE CF34-10A 2 x Pratt & Whitney GTF 2 x Pratt & Whitney GTF

Source: Company data.

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Business Jets: Robust Recovery Elusive

We expect the divergence in demand for larger and smaller business jets to persist in 2012. Emerging market customers, particularly in China, should continue ordering larger, well-established business jet models, including Gulfstream’s large cabin platforms and Bombardier’s Globals. Meanwhile, smaller jets, which are more dependent on developed world businesses as customers, should see demand improve more modestly. A darkening global macro environment and persistently weak demand for smaller jets meant overall 2011 order activity was disappointing relative to early expectations. Nevertheless, 2012 should represent a formal turning point in this cycle, with overall deliveries growing again (ex VLJs), following a flat 2011 and a 45% cumulative decline over the prior two years from the 2008 peak level of 1,033 jets. The 9% delivery growth we expect, to 620 aircraft from 567 in 2011, hardly qualifies as a sharp rebound, however. We see delivery growth accelerating to 15% in 2013 as a recovery gathers steam. One good piece of news for business jets is that the lack of a real recovery in this segment probably leaves it little room to fall in the event of another macro shock, at least at the low end, though a China hard landing looks like a risk for large jet demand. In addition, we see expectations as relatively low, meaning that any upside surprises—particularly for smaller jets, where demand turns quickly—could yield big rewards. In addition to the OEMs, avionics provider Rockwell Collins has a fairly high degree of exposure to small and medium business jets.

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Table 33: Aircraft Deliveries, 1997-2013E

1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011E 2012E 2013E

BombardierChallenger 600 34 36 42 38 41 31 24 29 36 29 35 44 36 38 37 33 38Challenger 300 – – – – – – 1 28 51 55 51 60 33 29 36 34 40Challenger 800 – – – – – – – – 4 18 12 17 7 6 4 11 15Global Express – 3 32 35 30 17 14 20 14 22 25 27 25 24 24 29 30Global 5000 – – – – – – – 4 17 18 23 25 26 25 26 29 30Learjet 40 – – – – – – – 17 21 26 23 21 14 6 4 10 13Learjet 45 / 45X – 7 43 71 63 27 17 22 30 30 34 27 19 10 7 11 15Learjet 60/60XR 32 32 35 29 17 12 9 18 15 23 23 26 13 12 17 12 12Learjet 85 – – – – – – – – – – – – – – – – 6Discontinued Models 21 22 24 28 17 9 2 – – – – – – – – – –Total 79 100 173 207 180 101 70 129 188 213 226 247 173 150 155 169 199

Cessna (Textron)Citation Mustang – – – – – – – – – 1 45 101 125 73 45 45 50Citation Jet/CJ1 63 64 59 56 61 30 22 20 18 25 34 20 14 3 2 - -Citation Jet/CJ2 – – – 8 41 86 56 27 23 37 44 56 21 17 15 18 26Citation Jet/CJ3 – – – – – – – 6 48 72 78 88 40 20 25 25 26Citation Jet/CJ4 – – – – – – – – – – – – – 19 37 37 33Citation Encore – – – 6 37 36 21 24 17 14 23 28 5 5 5 5 -Citation Excel – 15 39 79 85 81 48 55 62 73 82 80 44 22 25 25 30Citation Sovereign – – – – – – – 9 46 57 65 77 33 16 18 18 21Citation X 28 30 36 37 34 31 18 15 14 12 17 16 7 3 7 7 9Discontinued Models 90 91 82 66 48 41 31 25 21 18 – – – – – – –Total 181 200 216 252 306 305 196 181 249 309 388 466 289 178 179 180 195

DassaultFalcon 50/EX 10 13 11 18 13 10 8 5 5 5 2 1 – – – – –Falcon 900/B/C 7 5 8 6 6 4 3 3 1 – – – – – – – –Falcon 900DX – – – – – – – – 2 4 10 4 1 3 – – –Falcon 900EX 16 15 16 23 21 17 10 15 16 16 18 19 17 21 18 20 21Falcon 2000 18 14 34 26 35 35 12 11 6 6 1 3 1 – – – –Falcon 2000EX – – – – – – 16 29 21 30 33 18 3 – – – –Falcon 2000LX – – – – – – – – – – – 6 23 30 20 23 26Falcon 7X – – – – – – – – – – 6 21 32 41 27 30 33Total 51 47 69 73 75 66 49 63 51 61 70 72 77 95 65 73 80

EmbraerPhenom 100 – – – – – – – – – – – 2 97 100 45 50 65Phenom 300 – – – – – – – – – – – – 1 26 35 40 40Legacy 450/500 – – – – – – – – – – – – – – – – –Legacy 600/shuffle – – – – – 8 13 13 14 27 35 36 18 10 13 13 17Lineage 1000 – – – – – – – – – – – – 5 8 3 4 6Discontinued Models – – – 2 5 – – – – – – – – – – – –Total – – – 2 5 8 13 13 14 27 35 38 121 144 96 107 128

GulfstreamG100/ G150 6 14 9 11 5 9 5 9 12 20 32 39 11 13 14 16 25G200/ 280 – – 1 6 25 15 19 13 14 22 27 30 8 11 4 15 20G300/ 350 – – – – – – 8 5 12 12 13 12 – – – – –G400/ 450/ IV/ IVSP 22 32 39 37 36 29 13 19 14 16 20 20 30 31 36 32 28G500/ 550/ V/ VSP 29 29 31 34 35 32 29 32 37 43 46 55 45 44 44 44 42G650 – – – – – – – – – – – – – – 10 20 33Total 57 75 80 88 101 85 74 78 89 113 138 156 94 99 108 127 148

Hawker BeechcraftPremier IA/Hwkr 200 – – – – 18 29 29 37 30 23 54 31 16 11 9 6 10Hawker 400XP 43 43 45 51 25 19 24 28 53 53 41 35 11 12 – – 5Hawker 800 series 33 48 55 67 55 46 47 50 58 64 67 88 51 34 34 38 45Hawker 4000 – – – – – – – – – – – 6 20 16 11 15 18Discontinued Models 2 – – – – – – – – – – – – – – – –Total 78 91 100 118 98 94 100 115 141 140 162 160 98 73 54 59 78

HondaJet – – – – – – – – – – – – – – – – 20

Total w/o VLJs 446 513 638 740 765 659 502 579 732 862 974 1,033 628 566 567 620 713% change 37% 15% 24% 16% 3% -14% -24% 15% 26% 18% 13% 6% -39% -10% 0% 9% 15%

Total w/ VLJs 446 513 638 740 765 659 502 579 732 863 1,019 1,136 846 739 657 715 848

% change 37% 15% 24% 16% 3% -14% -24% 15% 26% 18% 18% 11% -26% -13% -11% 9% 19%

VLJs include: Cessna Mustang, Embraer Phenom 100, and HondaJet.

Source: GAMA, Company reports and J.P. Morgan estimates.

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New Jet Demand

Heavy jet dominance should persist in 2012

The gap between demand for larger and smaller jets widened considerably in 2011. International customers helped fuel demand for larger jets, as this submarket moved decisively toward recovery. For smaller jets, however, we have yet to see evidence ofa genuine recovery, and demand skipped along the bottom. We saw stronger large jet demand in the book-to-bill ratios of the OEMs that produce them, with Bombardier and Gulfstream both at 1.3x for the first nine months of 2011. Bombardier is raising its production rate for Globals. The other OEMs were all below 1.0x, with Cessna coming in lowest at 0.3x. While Embraer and Hawker fared better than Cessna, neither has seen demand pick up appreciably. Embraer experienced a wave of Phenom cancellations in Q3 and lowered its bizjet delivery guidance for the year, while Hawker put development of the Hawker 200, a new smaller jet, on hiatus citing economic uncertainty, and management expects the market to remain challenging.

Figure 35: 2011 Estimated Bizjet Book-to-Bill (Through 3Q 2011)

Source: Company data Ascend, and J.P. Morgan estimates.

International demand continues to grow in prominence

While the US accounts for ~60% of the global business jet installed base, its proportion of annual deliveries has slid consistently, reaching just under 40% in 2010 vs 67% in the early 2000s. International demand was a key driver again in 2011, and most OEMs stressed the importance of demand outside the US, with Hakwer’s CEO disclosing that 70-75% of the company’s backlog is international.

Figure 36: Proportion of Business Jet Deliveries Outside the United States, 2000-2010

Source: JetNet.

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Emerging markets have been leading contributors to growth, with deliveries to China, Brazil, Russia, and the Middle East each rising substantially between 2000 and 2010. These increases were typically off of very small numbers, which helped to yield large percentage gains, but their weightings are increasing and emerging markets, particularly China, are becoming increasingly important drivers of global growth. While J.P. Morgan expects emerging market GDP growth to decelerate by 100 bps this year to 4.7%, it should remain well above expected developed market growth of 1.4%, and deceleration last year (from 7.3% in 2010 to an estimated 5.7% in 2011) did not stand in the way of robust business jet demand. Business jets are relatively new, increasingly popular products in most emerging markets, so we believe there is pent up demand after years of robust economic growth have expanded the ranks of the very wealthy and red tape has been reduced. Finally, the wealthy individuals who we believe make up a relatively high proportion of emerging market customers are typically less dependent on financing, which may not be readily available for smaller jet customers, who tend to rely on it more.

Stronger emerging market demand is tied to the demand disparity we’ve witnessed between larger and smaller jets, as the customer base in emerging markets tends to prefer larger aircraft. To generalize, we believe this reflects, in part, a focus on premium brands and products among emerging market customers broadly, many of whom are entering the business jet market for the first time. In addition, emerging market customers are interested in the increased range that Gulfstreams and Bombardier Globals can provide.

Figure 37: Gulfstream Proportion of Installed Base

Source: JetNet.

Chinese market now a center of attention

We view 2011 as a turning point for China’s bizjet market. Industry players and investors have long recognized the potential inherent there, given China’s large population and land area, growing wealth, and increasing integration into the global economy. Nevertheless, China became a center of attention in the bizjet industry last year amid a growing perception that this market is moving faster toward realizing its potential. This is in part a reflection of rising demand. Chinese business jet deliveries

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have grown steadily over the past decade and were a key source of support for global business jet demand last year as well. Looking ahead, Bombardier expects China to take ~10% of the deliveries it expects over the next 20 years, or nearly 2,400 aircraft.

Figure 38: China - Business Jet Deliveries

Source: JetNet.

The sources of business jet demand in China are easy to see and have been building for years as the country’s economy has grown. Economic growth has expanded the number of wealthy individuals capable of traveling via business jet and social norms have changed, making such travel more acceptable. Forbes now shows 146 billionaires on its list of the 400 wealthiest people in mainland China in 2011, up 14% in 2010.

It has also become easier to operate a business jet in China. Restrictions on the use of airspace, which is controlled by the military, requirements for early flight plan filing, taxes and other regulations have historically impeded business jet operations in China. The government has begun gradually relaxing these rules in recent years, however, and we believe there could be more to come. Also, it is worth noting that fleet operators, like Hainan Airlines’ Deer Jet, and lessors, like Minshing, have been leading players in the expansion of China’s business jet market. A more managed expansion in which these players continue to figure prominently may suit the government if it prefers to relax aviation rules gradually because it results in a smaller, more familiar customer base.

The installation of infrastructure to support a growing bizjet fleet, including airports, fixed bases, service centers, pilots, etc is also a pacing factor for the growth of China’s business jet fleet. We believe there is a lot to do on infrastructure development but that infrastructure can accommodate the current level of demand growth.

China’s increasing role as a business jet customer has given it more leverage to attract OEMs and expand its role as a producer. For example, Embraer will transition the Harbin facility at which it had been building ERJ-145s as part of a JV to the production of Legacy 650s. In addition, Hawker and Dassault have each explored working with Chinese partners.

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Used Market Indicators

Mixed signals in the used market

The used market can be an indicator of new market demand, with a large number of used aircraft available for sale at attractive prices likely to divert demand from new jets. Signals here have been mixed, however, offering no clear indication of a recovery or a renewed slump.

The proportion of the in-production fleet available for sale, or used inventory, closed out 2011 at 10.8%. This is still fairly high in historical terms and more or less on par with the 11% peak observed during the 2001-2003 recession. On the other hand, used inventory is down 350 bps from the mid 2009 peak, though only 50 bps of this decline occurred in 2011. The year started out with a continuation of the march downward in used inventory, with a 100 bp decline through July, but inventory then increased for four consecutive months and ended up giving back half the initial gain.

Table 34: Used Jets Inventories and Pricing by Category, 2011

Current Inventory Level

Change in Inventories (y/y)

Current Avg Asking Price (in mn)

Change in Avg. Asking Prices

(y/y)Heavy 9.7% 0.8% $21.8 -3.0%Medium 11.2% -2.1% $9.1 -3.1%Light 11.5% -0.5% $3.8 -4.0%Total 10.8% -0.5% $12.5 -3.2%

Source: Jetnet.

The fact that used inventories began rising again amidst a darkening outlook for the global economy is not encouraging, but we do not necessarily view it as a signal that new demand is poised for another substantial drop off. We believe the more important development is that used inventories have moved decisively off their peak over two plus years. Inventories tend to be a leading indicator of new demand, so we view the longer term trend as more informative than the recent uptick. We have seen this dynamic play out in the Heavy jet market. Heavy jets, where we know new demand is strongest, are down 300 bps from their peak level to 9.7%, but this includes an 80 bp inventory increase during 2011. The positive signal for Heavy jets was the prolonged inventory decline through 2009 and 2010, since demand remains strong following a move in the wrong direction in 2011.

As for the historically high level of used inventory, it is possible that the new normal level of used inventory will be higher in the next up cycle than it was in the prior one. This could reflect a higher proportion of older aircraft available for sale that are less attractive to customers or a desire among the emerging market customers driving demand who are just entering this market to own a new jet.

Pricing, where improvement should coincide more closely with a pickup in new demand, remains weak but showed signs of firming in 2011. The average asking price for all in-production models available for sale was $12.5 million in December. This represents a 23% decline from the 2008 peak but only a 3% decline from the prior December and a 1% decline over six months. Earlier last year, we saw signs of firming, with a 2% increase from between January and March, but this trend reversed and we will need a few more data points before we can determine whether pricing is bottoming now. As with used inventories, a “new normal” level consistent with an up cycle might be weaker than it was last cycle.

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Figure 39: Average Asking Price and Percent of Active Fleet for Sale

Source: JetNet and J.P. Morgan estimates.

Used inventory declines for individual OEMs varied considerably throughout the year. Gulfstream has the lowest inventory among all six major OEMs at 8.2%, though it increased 90 bps last year after declining 350 bps in 2010. Embraer’s Legacy 600/650 saw inventories increase 230 bps to end the year at 15.0%. Dassault inventories hovered in the 9-10% range, ending the year at 9.9%, or 70 bps above2010. Cessna inventories declined 60 bps, with all Citation platforms except Cit. CJ2/CJ2+ experiencing lower inventories. Hawker Beechcraft and Bombardier saw70 bps and 50 bps of decline, ending 2011 at 13.3% and 11.6%, respectively.

Figure 40: Used Inventory by Manufacturer, Jan 10 - Dec 11

Source: JetNet and J.P. Morgan estimates.

Note: Excludes VLJs.

US flight ops up 3.4% through Nov, as recovery slowed

Business jet utilization can also be helpful as a signal for future demand, and this data weakened through the year .According to the FAA, flight ops are up 3.4% for the first 11 months of 2011, but growth was far stronger in 1H at 6.0% before it dropped to flat over the next five months. This drop off is not encouraging since flight ops remain ~20% off the 2007 peak, though they are up ~25% off the 2009 bottom, and it coincided with a slower US macro outlook. We would point out that FAA flight data is not capturing the full global utilization picture since it includes only flights into, out of, or within the US, but not those within or between other countries. Therefore the data captures only a portion of the activity driving non-US demand, which accounts for the majority of overall demand. Still, with ~60% of the business jet installed base in the US, some recovery in US will likely be necessary to

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propel a more robust recovery. Additionally, the flight ops data is a cautious signal for the bizjet aftermarket.

Figure 41: Monthly Flight Operations – Business Jets, Jan 02 - Nov 11

Takeoffs and Landings

Source: FAA.

New Jets Coming to Market

Development activity ramped down somewhat during the recession, but there are currently a number of efforts under way, including some about to come to market and some just launched this year.

Ongoing development efforts

Most immediately, Gulfstream is wrapping up two development efforts, with both the G650 and G280 scheduled to go out to customers this year. We view these initial deliveries as important milestones for Gulfstream and believe G650 milestones in particular could be catalysts for the stock. The G650 is a flagship Gulfstream product that will offer more speed and range than any other business jet currently available. Demand has been strong, with a backlog around 200 aircraft. The mid-size G280 is entering a segment of the market where demand is less robust, and this aircraft has been far less successful in building its backlog.

Other development efforts underway prior to 2011 include Bombardier’s Lear 85, which is scheduled to enter service in 2013, and the Global 7000 and 8000 models, with planned EIS in 2016 and 2017, respectively. The new Globals will compete with Gulfstream’s G650. Embraer is developing two new aircraft as well, the mid size Legacy 500 and mid-light Legacy 450. These two programs experienced a substantial EIS delay this year, in part due to challenges with flight control software. The Legacy 500 recently rolled out of the hangar for the first time to prepare for ground testing ahead of its planned first flight by year end. We expect first delivery in late 2013 or early 2014, about one year later than the previous target. The Legacy 450 should enter service about a year behind the Legacy 500.

The Hawker 200 light jet is another new product, and Hawker Beechcraft announced it would slow development, citing a weak economy. We view this as a reflection of the fact that the demand environment for light jets remains highly challenging. The Hawker 200 had begun flight testing, with entry into service expected later this year or in 2013.

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2011 launches

The two highest profile product launches in 2011 both came from Cessna: the Citation M2 and the Citation Latitude. The M2 is a light jet scheduled for EIS in 2013. It is in large part a revamped CJ1, with a new cabin and cockpit as well as a low price of $4.2 mn. Cessna hopes this aircraft will make it more competitive against Embraer’s Phenom 100, which has made impressive inroads against the CJ1 and Mustang. The Latitude is a midsize jet intended to bridge the gap between the super-light Citation XLS+ and mid size Citation Sovereign. It carries a price of $14.9 mn and should compete with Bombardier’s older Learjets, Hawker’s 900 XP and the Embraer Legacy 450. We view Cessna’s selection of Garmin to provide the avionics for both these new aircraft as significant, since Rockwell Collins has traditionally provided avionics for Citation jets. If we also consider the Citation Ten, Garmin has now won the avionics on the three most recent platforms Cessna has launched. There is considerable industry skepticism surrounding the outlook for the new Cessna aircraft.

Table 35: Model Specifications

Falcon 2000S Cessna M2 Cessna Latitude

Capacity 6 4 8Maximum Range 3,350 nm 1,300 nm 2,000 nmMax Cruise Speed 496 ktas 400 ktas 445 ktasEngine Pratt & Whitney 2XPW308C William Int’l FJ44 twinjet Pratt & Whitney PW306D turbofanAvionics Honeywell Flight Deck Garmin 3000 Garmin 5000Price $25 mn $4.2 mn $14.9 mnEIS Early 2013 3Q13 2015

Source: Company Data, Aviation Week, Aircraft Compare. Note: All specifications vary with different configurations and operational conditions.

In the derivatives category, Dassault launched an upgraded Falcon 2000S to replace the Falcon 2000DX. The aircraft is intended to help Dassault remain competitive in a mid size category that includes the Challenger 300, Gulfstream G280, and Hawker 4000.

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China: A Critical Market

As the world’s second largest national market for air travel, China should remain a leading source of demand for new aircraft, and we estimate that it will continue to take ~15% of global passenger deliveries, roughly in line with 2011. Traffic growth should be the leading driver of Chinese aircraft demand, and we are cautiously optimistic on this front despite concerns about a decelerating Chinese economy. Traffic has grown at a fairly consistent 1.5x GDP the past decade, so if the economy can expand at J.P. Morgan’s forecast rate of 8%, then traffic should grow ~12%, in line with last year. China is also making strides on the supply side and last year overtook Boeing for the second largest share of the country’s backlog in unit terms with the C919 and ARJ21. Airbus is still the clear number one. China still faces many challenges on the C919 and on building its aerospace capabilities more generally, but authorities are clearly committed to this cause, and the pace and manner in which they progress should have implications across the industry for years.

The Chinese fleet at a glance

The Chinese passenger aircraft installed base is 1,834 aircraft, with Boeing and Airbus each accounting for ~45%, Embraer another 5%, and the remainder split among others. With domestic traffic far exceeding international, the Chinese fleet is heavily weighted towards narrowbodies (78% of the total), and Boeing’s 737 and Airbus’ A320 family constitute 39% and 37% of total fleet, respectively. In the widebody space, Airbus has the edge thanks to the A330, which constitutes roughly half of all widebodies and 8% of the total fleet. China Southern introduced its first Airbus A380 this year and now has two A380s in service, while China is scheduled to receive its first Boeing 787 in 2H12. Embraer’s E-190 makes up 3% of the fleet, while some other airlines operate ERJ-145s, CRJs, and other aircraft.

Table 36: Current Chinese Fleet

Narrowbody Widebody Others TotalAirbus 670 176 0 846 % 37% 10% 0% 46%Boeing 713 105 0 818 % 39% 6% 0% 45%Embraer 47 0 46 93 % 3% 0% 3% 5%Others 0 0 77 77 % 0% 0% 4% 4%Total 1,430 281 123 1,834

Source: Ascend. Note: As of Dec 31,2011.

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Table 37: Chinese Airlines' Current Fleets

AIRBUS BOEING Others TotalOperator A300 A320

FamilyA330 A340 A380 737 747 757 767 777

China Southern Airlines 178 21 2 114 15 10 13 353China Eastern Airlines 7 149 22 9 79 3 15 284Air China 85 28 6 123 4 9 5 14 274Cathay Pacific 33 11 21 41 106Shenzhen Airlines 50 54 104Hainan Airlines 10 3 80 3 96Xiamen Airlines 68 6 74Tianjin Airlines 2 66 68Sichuan Airlines 60 3 63Shanghai Airlines 44 10 4 2 60Shandong Airlines 47 7 54Others 146 21 64 67 298Total 7 670 138 29 2 673 25 40 15 65 170 1,834

Source: Ascend and J.P. Morgan estimates. Note: As of Dec 31, 2011.

Commercial aircraft deliveries to China have increased from 44 in 1985 to an estimated 206 in 2011, more than 3x the increase in global deliveries over the same period. Chinese operators took 17% of an estimated 1,239 global deliveries in 2011, making it the world’s largest market for commercial aircraft. Demand for new airplanes should continue to grow in China, and we see China as a leading driver of rising production rates, with deliveries forecast to remain in the ~15% range of global production.

Figure 42: Aircraft Deliveries to Chinese Operators (Left) and Proportion of Global Deliveries (Right), 1985-2011E

Source: Ascend.

COMAC overtakes Boeing in China backlog

The passenger aircraft backlog for Chinese operators increased from 947 at the end of 2010 to 1,035 in 2011. Airbus is the dominant player within the backlog, accounting for 43% of the total, and its Tianjin assembly line for A320s accounts for a portion of its success. In addition, we believe Airbus’ strategy of negotiating orders with the government has paid of better than Boeing’s historical tendency to negotiate deals with individual airlines.

C919 orders have propelled COMAC ahead of Boeing within the Chinese backlog in an early sign of how local competition will change the Chinese market. COMAC’s ARJ21, a regional jet that has faced several delays, is part of the reason it has taken a

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larger share of the China backlog than Boeing, but C919 orders now exceed those for 737. The lessors in the ARJ21 and C919 backlogs are all Chinese, and we believe these aircraft will be placed with Chinese carriers, so we have included them in the China backlog even if operator has yet to be identified.

Table 38: Chinese Backlog

Narrowbody Widebody Others TotalAirbus 313 130 0 443 % 30% 13% 0% 43%Boeing 141 100 0 241 % 14% 10% 0% 23%Comac 160 0 125 285 % 15% 0% 12% 28%Embraer 22 0 0 22 % 2% 0% 0% 2%Others 0 0 44 44 % 0% 0% 4% 4%Total 476 230 44 1,035


In the widebody category, Airbus’ share of the backlog exceeds Boeing’s thanks to the A330, which has proven more popular than the 777 and comprises 30% of the total widebody backlog, while the A350 and A380 add 25% and 1%, respectively. While China now operates only 2 A380s with 3 more in backlog for China Southern, we believe orders will pick up for this platform over time as the Chinese market matures, with increasingly crowded routes and demand for outbound tourism. Following China Eastern’s decision to replace its order for 15 Boeing 787s with 737s, the platform accounts for 26% of the widebody backlog, while 777 accounts for the remaining 18%.

Orders keep coming for COMAC

COMAC, the Chinese national aircraft company, accounts for 28% of the backlog, again of 7% market share in the last year, and we believe this number should grow over time. COMAC is developing two aircraft, the ARJ regional jet, which accounts for 125 of its 285 orders, and the C919 narrowbody, for which backlog has increased to 160 from 45 at the end of 2010. After facing repeated delays, the ARJ21 is now scheduled for entry into service in 2012. As it is the first major development effort from COMAC, the ARJ21 is a significant achievement for China’s aerospace industry, though we do not see much demand outside the domestic market.

Table 39: C919 Orders and Commitments

Customers Firm Orders Commitments

Air China 5 15BoCom Leasing 30CDB Leasing 10China Aircraft Leasing (HK) 20China Eastern 5 15China Southern 5 15GECAS 10Hainan Airlines 20ICBC Leasing 45Sichuan Airlines 20Total 160 55

Source: Ascend and company reports. Note: As of Dec 31, 2011.

The C919 is China’s first narrowbody effort and competes directly with Boeing and Airbus. COMAC booked nearly 115 new orders last year, increasing backlog to 160

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orders from customers including Sichuan Airlines and three leasing companies—ICBC, BoCom, and China Aircraft Leasing (HK). The Big 3 airlines—Air China, China Southern, and China Eastern—each have 5 firm orders and 15 commitments, while China’s CDB Leasing ordered 10 aircraft in 2010. GECAS, a leasing arm of GE and the only non-Chinese customer to commit to the aircraft, also signed an LoI for 10 C919s. (GE has significant content on the C919, including the LEAP-X engine, which GE’s CFM JV is developing.)

If COMAC can produce a viable product in a reasonable amount of time—EIS is slated for 2016, though the schedule could face pressure—the C919 should grab a meaningful portion of the Chinese market. In addition, this platform has started gaining traction from some foreign customers, most notably Ryanair, which has disclosed it is considering an order for up to 300 planes. Ryanair is known as a tough negotiator and it operates an all-737 fleet, so its interest in the C919 may be primarily as a lever to push Boeing on pricing.

Table 40: Delivery Schedule for China

2012 2013 2014 2015 2016 2017 2018 2019 2020 TBD TotalA320 Family 92 101 61 38 9 7 0 0 5 0 313 A330 30 29 11 70 A350 2 7 9 23 11 5 57 A380 2 1 3 737 43 39 27 28 4 141 777 12 7 12 9 1 41 787 1 5 4 11 3 5 6 24 59 C919 14 35 46 31 17 17 160 ARJ21 2 31 31 30 30 1 125 ERJ190 11 4 5 2 22 Others 22 11 6 5 44 Total 215 228 157 123 63 55 61 54 33 46 1,035


Local manufacturing is an important factor for generating Chinese demand

An aircraft order in China must be approved by both the government and the airline that wants the plane. With this in mind, Boeing and Airbus strategies in China began to diverge noticeably in 2007: Boeing signed several large orders with individual carriers (Xiamen and China Southern) before obtaining approval through official state channels, while Airbus largely maintained its focus on the top-down official state allocation mechanism coordinated by the General Administration of Civil Aviation of China (CAAC) and the China Aviation Supplies Import and Export Group Corporation (CASCG). Airbus’ continuously increasing share of the backlog indicates that its strategy is working well for now. We believe that Boeing is now changing its strategy to better accommodate the government officials responsible for permission to import aircraft, and we will be looking for a market share recovery vis a vis Airbus, although it will likely take some time, and overall market share will be pressured by the loss of share to the C919.

Airbus remains well positioned in China because it has moved more work there. Airbus delivered the first A320 from its final assembly line in Tianjin to Air China in June 2009. Airbus has also sourced 5% of the A350 aircraft in China, and Airbus and China’s state-owned aerospace company set up a JV in 2008 to build composite parts for the A350 in Harbin.

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Chinese manufacturing operations are growing increasingly important to commercial aircraft OEMs, not only for the labor cost advantage they confer but also as the price of admission to the aircraft market. Embraer received approval for assembling Legacy 600/650 business jets at the Harbin Embraer factory where it had been producing ERJ-145s, though its proposal to assemble E-190s at Harbin was rejected by the Chinese government, probably to protect the indigenous ARJ 21 platform. In addition, Shenyang Aircraft Corporation (SAC) is manufacturing the fuselage for the Bombardier CSeries, and COMAC signed an accord with Bombardier last year to establish long-term strategic cooperation on commercial aircraft. The agreement remains ill-defined, but we could see more specifics this year, and close cooperation between the two companies could represent a major step forward for the development of China’s aerospace capabilities. We expect more Western firms to seek out opportunities to cooperate with China, in part to gain market access, and both Dassault and Hawker have spoken about exploring partnerships.

Other steps Chinese manufacturers have take to further their capabilities through cooperation with western aerospace companies include Shenyang’s collaboration with Cessna on the Sky Catcher, China Aviation Industry General Aircraft’s (CAIGA) acquisition of Cirrus Aircraft, and AVIC's acquisition of Teledyne Continental Motors, which makes piston engines for general aviation.

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Middle East: Key Widebody Market

The Middle East is an important driver of new aircraft demand, accounting for nearly 10% of the global passenger backlog. Emirates, Etihad, and Qatar as well as the leaders of Dubai, Abu Dhabi, and Qatar are committed to increasing these carriers’ market share and making aviation a core industry for the Persian Gulf region. These goals should support demand, even amid some ups and downs in traffic growth. The network carriers’ strategy of connecting Europe, Asia, and Africa through their Gulf hubs means that Middle East demand is skewed toward widebody aircraft. This makes the region a more significant buyer of aircraft when measured by value rather than unit volume, and Middle East demand is the largest pillar supporting backlogs for A380, A350, and 777. Middle East traffic growth has held up well in recent years and while it decelerated somewhat in 2011, we expect it to remain well above the global average.

Figure 43: Middle East in Service Passenger Fleet Trend


The Middle East fleet at a glance

Middle East carriers operate 966 passenger aircraft, or 4% of the global passenger fleet. 47% of the fleet is made up of Airbus planes, while Boeing makes up 36%. Embraer contributes 4%, while others account for the remaining 13%. The Middle East region has a geographical advantage in that it that works well as a hub in international travel between Asia, Europe, and Africa; hence widebody aircraft account for 48% of the total fleet compared to 36% for narrowbodies. Boeing’s 777 and Airbus’ A330 account for 16% and 12% of the total fleet, respectively while Emirates Airlines operates 19 Airbus A380s. In the narrowbody segment, Airbus has the edge with 65% of the narrowbody fleet, while Boeing and Embraer account for the remainder.

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Table 41: Current Fleet Share

Narrowbody Widebody Others TotalAirbus 207 245 0 452 % 21% 25% 0% 47%Boeing 96 214 42 352 % 10% 22% 4% 36%Embraer 14 0 23 37 % 1% 0% 2% 4%Others 0 0 125 125 % 0% 0% 13% 13%Total 317 459 190 966


Table 42: Middle East Fleet by Operators

AIRBUS BOEING TotalOperator A300 A310 A320

FamilyA330 A340 A380 737 747 757 767 777 Others Embraer Others

Emirates Airline 27 18 19 91 155Saudi Arabian 6 40 14 21 3 5 23 6 15 133Qatar Airways 38 29 4 25 96Etihad Airways 15 22 11 8 56Iran Air 11 3 5 8 2 13 42El Al 14 6 4 8 6 38Gulf Air 16 10 4 4 34Royal Jordanian 2 15 3 4 8 32Mahan Air 18 7 2 3 30Oman Air 7 15 2 2 26Iran Aseman 4 21 25Others 7 9 78 6 4 51 3 3 6 2 36 8 86 299Total 42 21 207 118 45 19 80 40 10 19 155 48 37 125 966


A few operators dominate the region

A few operators including Emirates, Saudi Arabian Airlines, Qatar, and Etihad accounted for nearly 60% of total growth over the past decade. Emirates and Qatar were fairly small airlines 10 years ago and are now the number one and number three airlines in the region, respectively. Saudi Arabian Airlines’ fleet has increased 50% since 2000, while Etihad did not even exist 10 years ago.

Table 43: Delivery Schedule for Major Middle East Operators

Operator 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 TBD TotalEmirates Airline 12 23 26 36 40 29 25 30 7 0 0 228Qatar Airways 13 21 20 14 6 10 13 28 28 34 1 188Etihad Airways 9 10 13 9 11 7 5 10 11 10 0 95Republic of Iraq 2 2 0 5 0 0 0 0 0 0 35 44Gulf Air 1 12 7 1 0 0 0 0 8 8 0 37Air Arabia 6 9 12 9 0 0 0 0 0 0 0 36Saudi Arabian Airlines 14 7 4 2 3 3 0 0 0 0 0 33FlyDubai 7 7 7 5 3 0 0 0 0 0 0 29nasair 7 0 8 9 0 0 0 0 0 0 0 24Others 24 12 11 5 4 3 3 6 3 0 0 71Total 95 103 108 95 67 52 46 74 57 52 36 785


Middle East carriers have ~800 planes on order with ~50% of deliveries expected before the end of 2015. The Middle East carriers have 68% of their backlog weighted toward widebody aircraft, mainly to accommodate increasing international traffic and expand their market share worldwide. The big three gulf airlines – Emirates, Qatar, and Etihad – account for 29%, 24%, and 12% of total backlog, respectively.

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Table 44: Current Backlog Share

Category Total %Narrowbody 233 30%Widebody 534 68%Others 18 2%Total 785 100%


Airbus is the leading player in the Middle East backlog with a 58% share. The region is critical for Airbus widebody platforms going forward, particularly the A350 and the A380, for which it comprises 35% and 51%, respectively, of the global backlog. While Boeing has a smaller share, the region is a critical destination for 777s, particularly after Emirates record order for 50 aircraft last November. This carrier alone now accounts for 28% of the 777 backlog.

Table 45: Backlog Share by OEM

OEM Total %

Airbus 459 58%Boeing 304 39%Embraer 6 1%Others 16 2%Total 785 100%


Geography plays a key role in Gulf carriers’ growth

The major Middle East carriers work on a similar model in which they link Asian and European cities via the Persian Gulf and act as a hub for international travel. An unofficial “Sixth Freedom” of the air allows any airline to carry passengers or cargo from a second country to a third country via a scheduled stop in its home country. This has enabled the Gulf carriers to take advantage of their central location to expand their share of traffic between Asia and Europe. The region’s proximity to India, which is home to 1.2 billion people and lacks a leading international airline, is another key driver. Emirates has taken this model furthest and ranked first globally in 2010 in terms of international RPKs. In addition, Dubai’s rise as a business and leisure center has propelled Emirates’ origin and destination traffic.

The Middle East should remain a key source of demand

The Middle East region has been an important driver for the aerospace industry in recent years, particularly when travel continued growing during the recession. While traffic has slowed somewhat, it remains above the global average.

Both Boeing and Airbus take a similar view of the outlook for new aircraft demand from the region in their 20-year market forecasts in which they expect the MiddleEast region to experience above-average traffic growth—6.6% average annual growth from Boeing—and drive demand for new aircraft. Boeing expects the region to take deliveries of more than 2,500 new passenger aircraft through 2030, which would account for ~ 8% of total global deliveries. The region should pack a greater punch by value, however, due to its preference for widebodies.

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Defense Outlook

Budget Uncertainty Remains Focal Point in 2012

The US defense budget grew steadily in the decade following 9/11, driven by prolonged engagements in Iraq and Afghanistan and a low starting point created by the post-Cold War peace dividend. The overall defense budget grew at a 9% CAGR during the nine year period beginning in 2001, peaking in FY10 at $691 bn. During this period, the base budget grew at a 7% CAGR, while supplemental funding expanded from nearly immaterial levels to $163 bn, or 24% of the total budget. The FY11 budget was relatively flat y/y, with the base and supplemental components changing negligibly. However, the FY12 budget is down 6%, and we see this as the true beginning of a downturn that should last for several years. While the FY12 base budget was relatively flat y/y, supplemental funding decreased by 27%, driving the 6% y/y decrease in the total budget.

We expect supplemental funding to continue to decline, which when coupled with base budget pressure as a result of the Budget Control Act of 2011 (BCA), suggests that defense budgets will remain well below FY10 and FY11’s peaks for several years, and at this point, barring an extraordinary change of events, we have visibility into three years of overall budget declines through FY14. Beyond FY14, the budget will be a function of 1) how the long-term fiscal scenario plays out – we believe that material entitlement cuts will be required to create a sound fiscal footing, but the political consensus necessary to bring this about has not yet fully formed, and 2) the geopolitical outlook, which does not appear as if it is moving toward a period like the 1991-2001 peace. We do not subscribe to the theory that we have seen articulated in many other places that defense has a natural long-cycle and therefore the budget will come under pressure for much of the remainder of the decade. However, we do see additional material fiscal reform as a necessary precursor to the bottom of this “cycle”.

Figure 44: DoD Base and Total Budget Authority and Outlays

Source: DoD, Congress, J.P. Morgan estimates.

BCA overhang will likely be present for the majority of 2012

Despite the passage of the FY12 budget late last year, there is substantial intermediate-term and long-term uncertainty around the US budget picture. The

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foremost intermediate-term issues are 1) the ultimate level of the cuts mandated by the BCA passed in August of last year as part of negotiations to increase the federal debt ceiling, and 2) how the DoD will adapt not only to the first stage of the cuts (which will be unveiled in early February in the form of the FY13 budget proposal) but also to whatever level of cuts from the second sequestration stage that are ultimately upheld. The BCA legislation cut ~$900 bn from the federal deficit, including $450 bn from defense, through FY21 and capped security funding in FY12 and FY13, but its more notable implication for defense was the creation of the congressional “super committee” tasked with finding a minimum of $1.2 tn of additional deficit reduction through FY21. When the super committee failed to reach an agreement by its November 23, 2011 deadline, sequestration, and with it an additional $500 bn of defense cuts from FY13-FY21, became law. There has been little visibility into whether any efforts to avoid sequestration in whole, or at least in part, might be successful and in the mean time the DoD and industry are operating as if the full level of sequestration mandated cuts will be avoided. The market seems to be supporting this notion, as defense performed almost perfectly in line with the broader market from the time the BCA was passed through the time sequestration became law.

Figure 45: Indexed Price Performance During Super Committee Deliberations

Source: Bloomberg.

Note: Defense includes LMT, NOC, GD, RTN and LLL.

Defense Secretary Panetta has been extremely vocal about the potentially devastating implications of sequestration level cuts, and many in Congress support the secretary's position, with some already working on legislation to spare defense from the full level of sequestration mandated cuts. The additional cuts are not set to take effect until FY13, leaving Congress the better part of 2012 to try devise an alternative solution. Given the super committee’s failure and Congress’ general disposition, we don't expect a final resolution to the long-term defense budget debate in the first half of the year and look for the budget overhang to weigh on the stocks until there is more clarity on the long-term budget landscape.

We expect additional defense cuts, although less than sequestration level

While sequestration is the current law, Congress holds the power to modify the law thereby creating an opportunity for additional scenarios. There is a fairly wide spectrum of potential outcomes, but we are modeling a middling case under which

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defense is exposed to $180 bn of additional cuts over the nine year period from FY13-FY21, which would be painful but far less so than the ~$500 bn currently called for under sequestration. This estimate equates to a 4% reduction in the base budget in FY13, a level that is much more manageable than the 12% y/y reduction implied by sequestration level cuts.

Table 46: Base Budget Authority Scenarios ($ bn)

FY08 FY09 FY10 FY11 FY12 FY13E FY14E FY15E

Current Scenario (Sequestration) $487 $511 $528 $530 $532 $471 $480 $490

Growth 5% 3% 0% 0% -12% 2% 2%

Most Likely Scenario ($180 bn Incremental) $487 $511 $528 $530 $532 $512 $522 $532

Growth 5% 3% 0% 0% -4% 2% 2%

Least Likely Scenario (No Incremental) $487 $511 $528 $530 $532 $532 $542 $552

Growth 5% 3% 0% 0% 0% 2% 2%


In the years beyond FY13, the current assumption (as is almost always the case) embedded in the numbers is that the base budget expands at a low single digit rate. Our view is that regardless of the outcome on sequestration, these budget totals will remain under pressure until a sustainable fiscal course has been set.

Supplemental funding should continue to decline

Supplemental funding has provided a boon to defense budgets over the last decade as the US has spent more than $1.2 tn on its efforts in Iraq and Afghanistan. Troop levels are a good barometer of supplemental funding as demonstrated by the number of deployed troops peaking (196,000 in Oct 2007) at the beginning of fiscal year in which supplemental funding also peaked ($187 bn in FY08). Supplemental funding declined at a 6% CAGR from FY08’s high through FY11, and the decline is accelerating as FY12’s $115 bn of supplemental funding represents a 27% y/y decline from FY11’s $158 bn.

Figure 46: Estimated Historical and Projected Troop Levels

Source: Brookings Institute, J.P. Morgan estimates.

Since the war in Iraq officially concluded last December, future supplemental funding will be primarily for US activities in Afghanistan. The current troop level in Afghanistan is ~90,000, and the president has called for that level to reach ~70,000

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by this summer. Additionally, the president is targeting a full withdraw of US forces from Afghanistan by the end of 2014, although based on comments from military leaders and other authorities, this goal seems ambitious and increasingly unlikely. However, even if the US isn’t able to achieve a complete exit by the end of 2014, we expect a material decline in the troop level, and consequently supplemental funding, over the next few years.

Table 2: Historical and Projected Supplemental Budget Authority ($ bn)


Supplemental Budget $187 $153 $163 $158 $115 $75 $40 $15

Growth -18% 6% -3% -27% -35% -47% -63%


Declining Addressable Market Forecast Shapes Organic Growth Outlook

We analyze the growth prospects of the industry by examining the addressable market for industry participants. For products businesses, our addressable market is comprised of DoD base and supplemental investment account outlays, which include procurement and RDT&E (research, development, test and evaluation) spending, and international sales. For the services businesses and services segments of the primes, we view base and supplemental O&M (operations and maintenance) outlays as the best proxy for the addressable market.

Base investment account and O&M budgets set to decline in FY13

Consistent with our view of the total base budget declining 4% in FY13, we see both the investment account and O&M base budgets decreasing in FY13 as the investment account and O&M account represent the largest components of the base budget, averaging 70% in aggregate over the last ten years. While we expect both accounts to decline, we expect the magnitude of the declines to vary from the decline in the overall budget given the differences in the two accounts.

Figure 47: FY12 Base Budget by Account

Source: Congress, J.P. Morgan estimates.

The investment account has historically been the most volatile component of the base defense budget given the relative ease of curtailing weapons procurement as opposed to reducing personnel or closing military bases. As such, given the sharp decline in funding expected in FY13, we believe lawmakers will look to the investment account

Personnel25%

O&M36%

Inv. Accts.34%

Other5%

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to absorb a disproportionate burden of overall y/y decline. In the context of our 4% forecast decline in the overall base budget in FY13, we are expecting an 8% decline in the base investment account in FY13 from FY12's $179 bn to $164 bn. While we are forecasting modest 2% annual growth in the total base budget in FY14 and FY15, we expect the investment account to remain flat in both years at FY13's $164 bn, and as mentioned above, we have a downward bias to our estimates at this time.

Table 47: Historical and Projected Total, Investment Account and O&M Base Budget Authority ($ bn)


Total Base Budget $487 $511 $528 $530 $532 $512 $522 $532

Growth 5% 3% 0% 0% -4% 2% 2%

Base Investment Account $177 $180 $182 $179 $179 $164 $164 $164

Growth 2% 1% -2% 0% -8% 0% 0%

Base O&M $163 $180 $185 $196 $195 $191 $195 $199

Growth 11% 3% 6% -1% -2% 2% 2%


Compared to the investment accounts, the O&M account is generally more “sticky” and therefore less vulnerable in a given year to large reductions. In the context of our 4% forecast decline in the total base budget in FY13, we are expecting just a 2% decline in the O&M account. We are forecasting 2% annual growth in the account in FY14 and FY15, consistent with our view of the total budget. Importantly, however, these estimates are just for the base budget, and do not include the supplemental budget.

Declining supplemental budget exacerbates declines

The investment account and O&M account have been the biggest beneficiaries of supplemental funding, averaging 18% and 67% of total supplemental funding, respectively, since FY01. Not only do these two budget categories comprise the vast majority of supplemental funding, but over the last several years they have derived a significant amount of their total funding from the supplemental budget, as well. This is particularly true for the O&M account which has received an average of 30% of its total funding from supplemental funding since FY01. In comparison, an average of 12% of investment account funding has been from the supplemental budget since FY01. In FY12, the O&M category is still deriving 32% of its funding from supplemental budgets, while the investment account is deriving just 7% from supplementals.

Figure 48: Base vs. Supplemental Funding Contribution


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As a result of the O&M account’s significant exposure to the supplemental budget, we expect the sharp falloff in such funding over the next few years to drive a meaningful reduction in both supplemental and total O&M funding. We forecast a 49% average annual decrease in supplemental O&M funding from FY12-FY14, which when coupled with flattish average annual base growth during that period results in an average annual decline in total O&M funding over that three year period of 10%.

Table 48: Historical and Projected O&M Budget Authority ($ bn)


Base O&M $163 $180 $185 $196 $195 $191 $195 $199

Growth 11% 3% 6% -1% -2% 2% 2%

Supplemental O&M $93 $92 $109 $112 $90 $56 $30 $11

Growth -2% 19% 2% -19% -38% -47% -63%

Total O&M $256 $272 $294 $308 $285 $247 $225 $210

Growth 6% 8% 5% -7% -13% -9% -7%


We forecast a 40% average annual decline for the supplemental investment accounts from FY12-FY14. However, given the relatively smaller contribution of supplementals to the total investment accounts, the large average annual decrease has a much smaller impact on total investment account funding. We forecast an average annual decline in total investment account funding of 5% from FY12-FY14, which reflects our forecast of a 3% average annual decline in base investment account funding as well as our forecast for the significant average annual decline in supplemental investment account funding.

Table 49: Historical and Projected Investment Account Budget Authority ($ bn)


Base Investment Account $177 $180 $182 $179 $179 $164 $164 $164

Growth 2% 1% -2% 0% -8% 0% 0%

Supplemental Investment Account $67 $35 $34 $26 $14 $10 $5 $3

Growth -48% -4% -22% -46% -29% -50% -40%

Total Investment Account $245 $215 $216 $205 $193 $174 $169 $167

Growth -12% 0% -5% -6% -10% -3% -1%


It is clear from troop level and supplemental funding projections that the industry is in the process of losing a substantial source of revenue. However, it is much harder to quantify the impact of that loss at the corporate level due to the lack of quality disclosure by individual companies of their exposure to the wars in Iraq and Afghanistan. Additionally, while the supplemental budget is a large and distinct line item within the budget, not all funding driven by the US efforts in Iraq and Afghanistan is defined as supplemental. A substantial amount of funds in the base budget support the wars, while some funding is shifted from the base budget to the supplemental budget creating funding for projects that otherwise would not have been possible. As a result of these complexities, it is hard to measure the true impact of the US withdrawal from Iraq and Afghanistan on the defense industry, although it is likely that the impact is greater than what is suggested by the decline in the supplemental budget.

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Foreign sales provide a revenue source independent of US fiscal concerns

While the DoD is the primary customer for the US defense industry, a smaller portion of the total market for defenses primes is comprised of international sales through Foreign Military Sales (FMS) and direct commercial sales (DCS). Limited data is reported for the DCS component, making it difficult to quantify the size and growth of this portion of the international market; however, FMS transactions are facilitated, tracked and reported through the Defense Security Cooperation Agency (DSCA) and we view the annually reported FMS figures as the best proxy for the international market. FMS sales in FY11 were $28 bn and the DSCA indicated it expects FY12 FMS sales to “hover around $30 bn”, although the agency is still refining its projections. We are assuming flat y/y FMS sales in FY12 based on current global economic conditions. However, beyond FY12, we see a moderate pickup in annual growth to 2%, as fiscal pressure in regions such as Europe is more than offset by a meaningful ramp in sales to customers in the Middle East.

Figure 49: Historical and Projected FMS Sales ($ bn)

Source: DSCA, J.P. Morgan estimates.

Softness in the addressable market should drive organic sales declines

Our addressable market forecast represents our view of the revenue for which defense companies are competing and is measured by base and supplemental investment account outlays and FMS sales. Our assumptions for the base andsupplemental investment accounts represent our estimates for budgeted amounts, and therefore must be adjusted to reflect the lag of actual outlays to the budget. We have developed outlay assumptions for our investment account estimates based on recently enacted budgets and actual outlays in order to help size the addressable market in the coming years. Our outlay assumptions are applied to our investment account estimates over four (base) and two (supplemental) years and help to dampen the impact of the budget cuts in the early years as they are absorbed over a multi-year period.

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Table 50: Addressable Market ($ bn)

FY08 FY09 FY10 FY11 FY12E FY13E FY14E FY15E

Total Investment Account Outlays $193 $209 $211 $203 $196 $186 $174 $168

Growth 9% 1% -4% -3% -5% -7% -3%

FMS Sales $29 $31 $25 $28 $28 $29 $29 $30

Growth 7% -18% 12% 0% 2% 2% 2%

Total Addressable Market $221 $240 $236 $231 $225 $215 $203 $198

Growth 8% -2% -2% -3% -4% -6% -2%

Source: DoD, Congress, DSCA, J.P. Morgan estimates.

We believe our addressable market forecast accurately reflects the global demand for domestic defense products. However, defense services have become an increasingly important part of the total defense market, as evident from each of the defense primes having dedicated services segments and some of the smaller defense firms focusing exclusively on providing services. When assessing the outlook for the services businesses, we feel it is most appropriate to analyze O&M outlays. While O&M outlays are not a perfect measure of the addressable market for defense services, we do see them as the best measure available. We assume base O&M outlays will follow a similar growth trajectory as base O&M budget projections and to estimate supplemental O&M outlays we apply similar assumptions to our supplemental O&M budget forecasts as we do to our supplemental investment account budget forecasts to estimate our supplemental investment account outlays.

Table 51: Historical and Projected O&M Outlays ($ bn)

FY08 FY09 FY10 FY11 FY12E FY13E FY14E FY15E

Base O&M Outlays $152 $167 $170 $180 $179 $175 $179 $182

Growth 10% 2% 6% -1% -2% 2% 2%

Supplemental O&M Outlays $93 $92 $105 $111 $95 $63 $35 $15

Growth -1% 15% 5% -15% -33% -44% -57%

Total O&M Outlays $245 $259 $276 $291 $273 $238 $214 $197

Growth 6% 6% 5% -6% -13% -10% -8%


Defense primes

Although we don’t have the benefit of full financial results for 2011 yet, based on the first three quarters of the year it appears that average organic growth for the defense primes will be negative for the first time in over a decade. We expect organic revenue to continue to decline in each of the next three years in the context of a declining addressable market and declining O&M outlays. We forecast an average organic sales decline of 5% for the defense primes in 2012. This decline is ~200 bps more than our forecast decline in the addressable market for products, but given our forecast for a 6% decline in O&M outlays, we believe our organic sales estimates reflect the challenging conditions across the entire defense industry, including both products and services. Beyond 2012, we expect organic sales for defense primes to decline by 5% again in 2013.

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Table 52: Defense Primes Estimated Organic Growth

2002E 2003E 2004E 2005E 2006E 2007E 2008E 2009E 2010E 2011E 2012E 2013E

Boeing BDS 9% 10% 11% 2% 5% 1% 0% 5% -6% -1% -7% -4%

GD (ex Gulfstream) 13% 13% 11% 8% 7% 8% 6% 10% 1% -2% -7% -6%

L-3 Communications 15% 5% 15% 12% 9% 10% 5% 4% -1% -3% -5% -6%

Lockheed Martin 10% 20% 10% 4% 5% 6% 2% 2% 4% 2% -4% -4%

Northrop Grumman -2% 11% 14% 3% 0% 5% 7% 5% 2% -3% -4% -5%

Raytheon 7% 9% 11% 6% 7% 8% 9% 7% 2% -2% -1% -3%

Average 9% 11% 12% 6% 6% 6% 5% 6% 0% -2% -5% -5%

Investment Account Outlays 14% 12% 14% 5% 12% 5% 16% 2% 6% -4% -3% -5%

Relative Performance -6% -1% -1% 1% -6% 2% -12% 4% -5% 2% -2% 0%

Source: J.P. Morgan estimates, Company data.

Note: Historical investment account outlay growth is calendar year, projections are government fiscal year.

Embedded in our estimates is our assumption of $180 bn of further cuts from the sequestration process. If the impact of sequestration were fully flushed through our estimates, our addressable market assumptions would worsen to a decline of 6% in 2013 and 10% in 2014. Additionally, as noted above, our estimates include the fairly benign assumption that the base investments account flattens out beginning in FY14, while given our concerns about the long-term fiscal situation, our bias is to the downside. We expect to gain substantial visibility into the likelihood of major long-term fiscal reform after the election in November.

SMID defense companies

We also expect organic sales to decline at small and mid (SMID) cap defense companies. The growth profiles of SMID cap players are much more volatile than those of the larger primes as their revenue bases are significantly smaller and typically less diversified, resulting in an increased vulnerability to individual programs. Comtech’s growth profile exemplifies this concept. The large MTS and BFT-1 contracts and subsequent re-compete loss have driven an extremely volatile growth profile that has featured several years of double digit swings in growth. This type of volatility makes it less meaningful to compare average SMID cap organic growth to growth in the addressable market or specific outlays in the same manner in which we do for the defense primes, but nonetheless, we think those metrics offer valuable insight into trends. We forecast average organic sales declines of 6% in 2012 and 2% in 2013 for our SMID cap universe.

Table 53: SMID Cap Defense Estimated Organic Growth

2003E 2004E 2005E 2006E 2007E 2008E 2009E 2010E 2011E 2012E 2013E

ATK 7% 9% 11% 12% 14% 8% 7% -2% -5% -6% -4%

CACI 16% 20% 5% 3% 10% 14% 10% 12% 9% 4% 2%

Comtech 33% 33% 40% 5% 26% 7% -22% 47% -42% -20% 2%

Exelis 18% 25% 21% 14% 13% 8% 0% -3% -2% -8% -8%

Harris 29% 28% 12% 17% 18% 15% -3% 6% 0% -4% -3%

SAIC 17% 18% 3% 4% 7% 11% 7% 0% -2% -1% -2%

Average 20% 22% 15% 9% 15% 10% 0% 10% -7% -6% -2%


Note: All growth rates represent calendar year. HRS represents only RF Communications and Government Communications businesses.

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Margin Contraction Likely in Addition to Decreasing Sales

In addition to the pressure from revenue headwinds, we expect defense earnings in 2012 to be impacted by thinning operating margins. Operating margins remained surprisingly strong through the first nine months of 2011, and we believe that they will eventually start to run out of gas, primarily driven by austerity measures at the DoD. We expect operating margins to begin a multiyear decline in 2012 as the DoD grapples with a smaller than expected budget this year and begins to make tough funding decisions for the years ahead.

Challenging operating environment to drive operating margins down in 2012

Including our estimate for 2011, average operating margin at the defense primes has exceeded 10% for the last five years, peaking at 10.7% in 2008. Profitability in the latter half of the last decade benefited from record spending levels and generally contractor-friendly policies. However, as the DoD adjusts to life in a more difficult budget environment, we expect profitability to decline.

The impact of reduced DoD funding on operating margins should be twofold. First, decreased defense spending will drive lower sales which will put downward pressure on operating margins as companies’ fixed costs are spread over less revenue. Additionally, and perhaps more importantly, as the DoD tries to get the most out of its reduced funding, it is likely to look to contractors to share the burden in the formof reduced profitability. As the primary customer to defense primes, the DoD acts as a monopsonist in the market giving it the ability to dictate terms to its suppliers. As such, operating margins in the industry generally reflect levels deemed to be “fair” by the DoD. With less funding and the prospect of making incremental procurement cuts as the alternative, the DoD has already begun to take actions that we believe will drive a lower level of “fair” operating margins, and we expect these actions will continue.

In the context of declining organic revenue and less favorable sales terms, we expect the defense primes to experience a 60 bps decline in average operating margin this year from an estimated 10.4% in 2011 to 9.8% in 2012. Beyond 2012, we see the decline continuing, albeit at a slower pace. In 2013, we see average operating margin deceasing an additional 30 bps to 9.5%. Our sharply lower estimate in 2012 may be aggressive, perhaps overly so, but if anything we could see further pressure manifesting itself in 2013 and the years beyond as backlogs continue to turn over and contracts signed in the first few years of the austerity era increasingly supplant older, higher margin contracts.

Table 54: Defense Primes Operating Margins

2002 2003 2004 2005 2006 2007 2008 2009 2010 2011E 2012E 2013E

BA BDS 7.7% 8.3% 9.0% 11.7% 6.5% 8.9% 9.6% 8.9% 7.9% 7.7% 6.5% 6.5%GD (ex-Gulfstream) 9.9% 9.1% 9.6% 9.6% 10.1% 10.3% 11.1% 11.1% 11.4% 11.4% 10.6% 9.9%LLL 11.3% 11.5% 10.9% 10.6% 10.3% 10.4% 10.5% 10.6% 11.2% 10.7% 10.2% 10.1%LMT 6.2% 7.5% 7.7% 9.3% 10.2% 11.0% 11.7% 11.1% 10.3% 10.3% 10.2% 9.8%NOC 6.6% 7.5% 7.0% 7.8% 8.5% 9.0% 9.5% 9.4% 9.8% 10.6% 9.9% 9.4%RTN 10.9% 9.4% 10.8% 11.6% 11.7% 12.1% 11.8% 12.1% 12.6% 12.4% 12.1% 12.1%Weighted Average 8.0% 8.3% 8.7% 10.0% 9.3% 10.2% 10.7% 10.5% 10.4% 10.4% 9.8% 9.5%


We expect to see the same operating margin trends in the SMID cap space that we believe we will see at the defense primes. We forecast a 50 bp decline in average

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SMID cap operating margin this year from an estimated 11.0% in 2011 to 10.5% in 2012. We see the average operating margin decline for SMID cap defense players in 2013 slowing to 30 bps, resulting in an average operating margin in 2013 of 10.2%

Table 55: SMID Cap Operating Margins

2002 2003 2004 2005 2006 2007 2008 2009 2010 2011E 2012E 2013E

ATK 12.8% 12.4% 10.6% 11.1% 10.9% 6.8% 9.9% 10.3% 10.3% 11.3% 11.0% 10.7%CACI 7.9% 8.8% 8.9% 8.7% 8.1% 6.8% 6.7% 6.5% 6.4% 7.5% 7.2% 7.2%Comtech 16.6% 16.8% 20.0% 17.9% 11.6% 15.6% 14.0% 12.1% 13.2%Exelis 8.2% 10.5% 10.5% 11.3% 11.1% 12.0% 10.7% 11.6% 11.7% 10.3% 10.1% 9.9%HRS 12.4% 15.7% 17.4% 18.1% 13.4% 19.8% 24.9% 22.0% 20.4% 18.8%SAIC 6.4% 6.8% 6.8% 6.4% 7.1% 7.5% 7.7% 8.0% 8.6% 8.2% 8.0% 8.0%Weighted Average 8.4% 9.1% 9.0% 9.7% 10.1% 10.0% 9.6% 10.5% 11.6% 11.0% 10.5% 10.2%


Contract accounting provides flexibility, but how much remains?

Operating margins in 2011 surprised on the upside more often than not and frequently in conjunction with disappointing sales. We see a few potential reasons for this. First, the sales that missed were probably weighted toward lower margin sales, as many cancelled and/or delayed programs were likely in lower-margin stages of development, such as R&D. We view this mix derived benefit as not sustainable in 2012.

An additional explanation of the strong margin performance is contract risk retirement. The nature of defense contact accounting generally gives companies significant discretion over the recognition of profits, including points at which risk is perceived to be retired and margin recognition can therefore be increased. Given the pressure and incentives to meet earnings expectations, we believe companies are inclined to take advantage of the flexibility afforded by contract accounting, particularly in challenging operating environments such as 2011. Last year, we saw a surprisingly large number of “margin beat, sales miss” quarters from the defense segments of the primes. As the chart below demonstrates, an inordinate amount (52%) of quarterly results in Q2 & Q3 of 2011 for the defense segments of the primes fell in the bottom right quadrant.

Figure 50: Defense Primes Segment Performance vs. JPM Expectations (Q2 & Q3 2011)


Note: Scatter chart includes reportable segments for LMT, NOC, RTN, GD (ex Aerospace), LLL and BA's BDS segments. The Y axis

represents sales relative to JPM estimate; the X axis represents margins relative JPM estimate.

Given their long-term nature, most contracts in the defense space are accounted for on a percentage-of-completion basis. Under this method, at the outset of the agreement a contract price is set and total costs are estimated resulting in a

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predetermined profit. As work under the contract is completed, profit is recognized on a pro rata basis in each period based on the percentage of total costs incurred during each period. The percentage-of-completion method of contract accounting provides an inherent flexibility because as estimates of total costs change, contractors are required to recognize the entire difference in the period that the estimate is changed. Contractors are generally conservative in their initial cost estimates in order to protect themselves from unforeseen risks, and this often allows them to realize greater profits at a later date. Changing cost estimates is a very subjective exercise and as a result, contractors have a great deal of discretion on the timing of such adjustments.

While it is impossible to say for certain, we believe the prevalence of “margin beat, sales miss” results we saw in 2011 indicates that the risk buffer now embedded in margin accrual rates is lower than it was a year ago, and we expect the underlying pricing pressure to manifest itself beginning in 2012.

Defense Stocks Are Defensive First and Foremost

Defense stocks tend to perform defensively, outperforming in strong bear markets and underperforming in strong bull markets. While industry-specific factors such as budget activity or political/geopolitical events may cause defense performance to deviate from this trend in any given year, defense stocks are defensive first and foremost. Since 1988 the S&P 500 has had three years in which it returned -10% or less and defense (as measured by an index of the primes) outperformed in each of those three years by an average margin of 2,400 bps. Conversely, over the same time period the S&P 500 has had 14 years in which it returned 10% or greater. Defense underperformed in 10 of those 14 years, or 71% of the time, and the average performance over all 14 years was underperformance of 1,100 bps.

Figure 51: S&P 500 and Defense Performance

Source: Bloomberg.

Note: Defense performance measured by a market cap weighted index including LMT, NOC, GD, RTN and LLL.

In years in which the market performs moderately, such as 2011, the defensive posture of defense stocks is less pronounced than it is in years in which market movements are more extreme (+/-10%). Notably the small and mid (SMID) cap

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defense players tend to be much more volatile than their larger counterparts and as a result, generally don’t demonstrate the same defensive tendencies.

Sector Performance in 2011

The S&P 500 generated a slim 2% total return in 2011, as stocks recovered during the latter part of the year from a significant selloff during the summer. Defense primes performed relatively well, returning 6% for the year for outperformance of 4%. This strong performance was a bit surprising considering the stocks overcame a considerable amount of bad news on the budget outlook during the second half of the year. Despite the threat and ultimate reality of sequestration, defense primes showed no real signs of weakness in the back half of the year. Instead, the stocks performed in line with the broader market, demonstrating a strong correlation with the overall market that was not present in the first half of the year. Since sequestration was a relative non-factor in the performance of defense primes in 2011, it appears as if the market believes defense will be spared from the full extent of cuts mandated by sequestration, which is consistent with our view.

Figure 52: 2011 Defense Price Performance vs. S&P 500

Source: J.P. Morgan estimates, Bloomberg.

Note: Defense primes include LMT, NOC, GD, RTN and LLL.

Note: SMID cap defense includes ATK, CMTL, HRS, CACI and SAI.

While defense primes performed surprisingly well in 2011, their small and mid (SMID) cap peers fared much worse. An index of SMID cap defense companies in our coverage universe returned -17% in 2011, underperforming the market by 19%. SMID cap defense stocks are generally more volatile, and in 2011 they had a tough start to the year and were never able to recover.

What to Expect from Defense in 2012

We expect defense stocks to face pressure in 2012, as earnings come under pressure from modestly declining sales and margins and the long-term fiscal overhang prevents multiples from expanding. In this context, we look for the defense primes to act defensively this year, lagging if the market performs well and outperforming if the market performs poorly. Our framework for rating SMID cap stocks in 2012 includes both our traditional fundamentals-based analysis and, increasingly, our view of a company’s strategic attractiveness. This methodology is based on our view that

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the challenging operating environment created by budget cuts will increasingly drive consolidation within the industry over the next several years.

Declining fundamentals pressure defense prime valuations

We believe declining DoD budgets and general US fiscal uncertainty will continue to weigh on defense earnings and valuations in 2012. Our estimates for the defense primes reflect our view of a challenging operating environment in which declining revenues and deteriorating margins will put pressure on earnings over the next few years. However, we believe that consensus expectations do not yet reflect the outlook for the industry. Our earnings estimates for the primes are 3% lower than consensus on average for 2012 and 6% lower for 2013, and we expect consensus estimates to decline after each quarter this year. Despite the deficit reduction achieved by the Budget Control Act of 2011, we believe the continued US fiscal overhang will keep defense multiples at current levels. As such, our base case expectation for the stocks is that they will decline modestly in line with the reduction in earnings expectations as multiples remain flat.

Figure 53: JPM Earnings Estimates vs. Consensus

Source: J.P. Morgan estimates, Bloomberg.

While we expect the challenging environment in 2012 to drive relatively weak operating results at the primes, we also expect companies will return capital in the form of share repurchases and dividends to help support valuations. Share repurchases have been a popular method of supporting EPS over the last several years, and our estimates reflect continued strong repurchase activity in 2012. We would not be surprised to see greater than anticipated repurchase activity if operating results fall short of expectations or the stocks begin to lag materially. Additionally, companies may opt to increase their dividend more materially than they have in the past. LMT increased its dividend by 33% last year, raising its yield to ~5%, and in doing so, we believe the company created a strong support level for its stock. We expect others may follow suit this year, seeking similar support in a challenging operating environment. In general, we see dividends as a more prudent way to return capital to shareholders than share repurchases, as the depth of the defense downturn remains unknown at this time which may lead to companies overpaying for their stock. Also, we see no benefit to shareholders from share repurchases as compared to dividends, as shareholders who prefer to do so can mimic the impact of a share repurchase by utilizing their dividend proceeds to purchase more stock. Furthermore, dividends return cash to shareholders without taking the risk that the defense budget

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and industry profitability might decline more than management expects or that the market is discounting its stock valuations.

Figure 54: Share Repurchase Dollar Volume


Defense looks like a market call in 2012, but other catalysts could play a role

While we expect defensiveness to ultimately be the overriding theme for defense stocks in 2012, there are plenty of industry specific issues at play. The two largest visible catalysts this year are the resolution of sequestration and November’s presidential election. While both have clear implications for defense, we believe the former is largely already priced in and the latter’s influence on defense performance will be more a function of its impact on the broader market than the defense industry itself given our stance that defense stocks will act defensively in 2012.

Despite sequestration becoming law upon the congressional super commitee’s failure to reach an agreement, the market appears to expect that the defense primes will be subjected to fewer cuts than those mandated by sequestration, as the performance of the stocks has been almost in lockstep with the market since the BCA passed. A resolution of this issue is coming in 2012 since sequestration is scheduled to take effect at the beginning of 2013, and as noted above, we expect the ultimate level of cuts will fall below those mandated by sequestration. However, we believe this resolution will not provide a major boost to the stocks since it would only confirm current market expectations.

We view the November presidential election as a more interesting catalyst because defense may perform in a counter intuitive manner. The conventional wisdom is that defense could rally if Republicans win the White House in November. While this may occur, we think a Republican victory would have a more profoundly positive impact on the broader market, in which case we would look for defense to rally, but lag the increase in the overall market, in line with our thesis that defense will behave defensively in 2012. Conversely, we believe that the re-election of President Obama could cause the market to decline and defense to outperform, despite the possibility that a Democratic victory could have more negative long-term implications for defense than a Republican victory.

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Our SMID ratings framework increasingly factors in industry M&A

As declining defense fundamentals weigh on earnings, we expect industry consolidation to pick up in the coming years. While we believe a merger or two among the top seven players in the industry could take place in the coming years, we view acquisitions of some of the SMID cap stocks as a more likely trend. We believe that the industry is in the very early stages of this consolidation, and that this is marked not by a reduction in the number of companies, but rather an increase. Companies such as NOC and ITT spun-off defense businesses in 2011 and LLL intends to complete a spin-off in 2012. In addition, there have also been a number of small defense businesses sold to private equity.

We see this spin-off activity as a precursor to consolidation as it creates a greater number of smaller businesses that may ultimately fit back together in a more rational way than would have been possible without the spin-offs. While we think that the unsettled nature of the long-term budget environment will prevent M&A activity from picking up immediately, we believe the beginnings of a fiscal resolution could serve as a catalyst to both defense stocks and M&A activity, as potential acquirers become more comfortable with the trough earnings potential of assets. It appears very unlikely that this will occur prior to the election, but the reshuffling of the political deck in Washington in November could serve as a catalyst for this resolution. In this context, our framework for rating SMID cap stocks in 2012 includes both our traditional fundamentals-based analysis and, increasingly, our view of a company’s strategic attractiveness.

Defense Beyond 2012

We view 2012 as a rather pedestrian year for the stocks of defense primes which begs two very fundamental questions: what will cause the stocks to perform again and when might it occur? While we believe we have some insight into the former, the latter is much harder to predict. We believe that the multiples of the defense primes will not materially rerate until the long-term fiscal situation in the US improves due to meaningful entitlement and/or tax reform. Given the political challenges inherent in effecting entitlement and tax reform, the timing of any such reform is difficult to predict, although we do the believe that the stalemate in Washington is highly likely to persist for the majority of this year. As we expect that sales and margins will both remain under pressure for several years to come, our view is that the next big upward movement in large cap defense stocks will likely come from multiple expansion as opposed to earnings improvement, and we see the driver of this as a light at the end of the tunnel for the US’s fiscal woes.

US fiscal picture must improve in order for defense stocks to perform

While the Budget Control Act of 2011 (BCA) was a step in the right direction, the long-term US fiscal outlook remains challenged and as long as this is the case, we believe defense valuations will be pressured. It is clear that entitlement and/or tax reform are going to have to play a major role in correcting the US fiscal imbalance. As the largest component of discretionary spending, defense will also remain an important part of the conversation, but it will be impossible for defense alone to provide a solution given the magnitude of the deficit.

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Figure 55: 2013 Projected Federal Outlays

Source: OMB.

We believe the uncertainty regarding the role defense will play in any future fiscal resolutions is responsible for depressing current defense multiples, and consequently valuations, and we expect valuations will only improve when a long-term fiscal solution is reached and the role of defense in the solution is well understood. This clarity should provide insight into the long-term prospects for the defense industry which, in turn should drive multiple expansion as well as M&A activity.

The annual federal deficit as a percentage of GDP averaged 2% from FY70 through FY08, which is a sustainable level because it leads to debt levels that grow at about the same rate as GDP. The deficit jumped to 10% of GDP in FY09, and this metric has remained at 9% for the last two years. Beginning in FY12, the OMB expects the deficit as a percentage of GDP to start declining from recent highs. However, the OMB uses a number of assumptions that we view as unrealistic, including aggressive GDP growth expectations (the OMB expects 3.6% growth in 2012 and a 4.2% CAGR over the next three years through 2015), the expiration of Bush era tax cuts at the end of 2012 and the absence of other common changes to the budget such as the payroll tax cut extension and Medicare “doc fix” laws that passed last December. Our view is that the current deficit run-rate is $1.1 tn, or 7% of FY11 GDP, which is equivalent to the $1.3 tn deficits in each of the last two years less the $0.2 tn of annual savings mandated by the BCA. Additionally, we expect the long-term fiscal outlook beyond FY15 to deteriorate significantly as a result of rapid growth in entitlement programs.

Figure 56: Federal Outlays and Deficits ($ bn)

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Once consolidation begins, we expect one or two of the top seven players to disappear

We believe that the challenging operating environment created by reduced funding levels will drive consolidation in the defense industry over the next few years. While it may take some time before acquirers gain enough confidence in the level of trough spending to make major moves, we believe that defense primes will begin to acquire smaller competitors in the early stages of consolidation and that any transactions this year will fit that mold. Beyond 2012, as the long-term fiscal picture becomes clearer and the overhang is lifted, we would not be surprised to see one or two larger-scale transactions among the top seven players in the industry: LMT, BA, NOC, BA.L, GD, RTN, and LLL. Anti-trust issues could be a major impediment to any such transaction and the DoD has publicly ruled out the idea of any two of the top “five or six” companies merging as recently as early 2011. However, one of the DoD’s major premises given its other public comments has been that its base budget will not decline, and this will no longer be valid if any of the funds eliminated under sequestration remain sequestered. Ultimately, we expect that the DoD will relent as the reduction in its budget and the difficult decisions it will face will change its perspective. The last major round of consolidation was in the 1990s and ended in 1998 when the LMT/NOC merger was rejected after a long review. At that time there were only three major prime contractors and our stance is that the DoD does not need seven major contractors as it currently has and that a group that is perhaps one or two companies smaller, but more organized, might result in a more efficient industry base.

New Year, New Ratings

With the New Year upon us, we adjusted our ratings to reflect our frameworks for 2012. The following descriptions describe the rationales for each of our ratings changes.

General Dynamics: upgraded to OW

As with its peers, we expect GD to experience weakness in its defense businesses in 2012. However, unlike its peers, GD has Gulfstream and its attractive growth prospects to help it offset poor performance in its defense businesses. We believe this dynamic makes GD one of the best positioned defense primes and warrants a premium valuation relative to pure-play defense primes. While GD has historically benefited from a premium valuation, poor performance in 2011 eroded the company’s relative premium and the stock currently trades in line with its peers. Given its attractive relative valuation and more promising business prospects, we expect GD to outperform its peer group in 2012 and, consequently, we upgraded the stock from N to OW.

GD was the worst performer in its peer group in 2011, returning -4%, or 1,100 bps lower than the average of its peers. GD lost 1.2 multiple points in 2011 as it declined from 10.1x 2012E EPS at the beginning of the year to 8.9x 2013E EPS at the end of the year. We attribute GD’s underperformance in 2011 to three key issues: 1) increasing concerns that its defense businesses, particularly Combat Systems, might underperform peers; 2) increased uncertainty surrounding Gulfstream after the crash of the G650 in testing and more generally in light of the unsettled global economy; and 3) investor disappointment in the $1 bn acquisition of healthcare IT provider Vangent.

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Looking forward to 2012, we expect GD to recoup some of its valuation lost in 2011. We believe that the overhang on the defense business, at least relative to peers, is now mostly priced in, even if it is not captured in consensus earnings estimates. We look for Gulfstream to have a strong year as the G650 successfully enters service, and the final milestones on this front should serve as catalysts for the stock. Finally, while this might be categorized more as a hope than an expectation, we trust that the company will not make an acquisition similar to Vangent this year.

Sales outlook – Defense down 7% organically, more than offset by Aerospace and acquisitionsOverall, we are forecasting sales growth of 1.4% in 2012, and our assumptions include a 7% organic sales decline in defense (81% of 2011E sales), 13% sales growth in Aerospace (19% of 2011E sales), and a 5% lift from the full year benefit of acquisitions made in 2011. Our estimate of a 7% organic sales decline for GD's defense businesses is ~225 bps worse than our average forecast for its peers. Much of the estimated organic sales decline is attributable to a 12% organic sales decline in the Combat Systems segment, which we believe is particularly vulnerable given the rapidly decreasing demand and funding for its products, particularly Stryker and Abrams vehicles, in conjunction with the decline in supplemental spending. The organic sales decline in the Combat Systems segment in 2012 should be partially offset by an estimated $700 mn of revenue contribution from the late-2011 acquisition of Force Protection, and our overall forecast for segment sales is a 5% decline. While Force Protection faces the same fundamental challenges as the rest of the segment, GD acquired the company at an attractive multiple and we expect it will realize substantial cost synergies given GD’s expertise in the combat vehicle industry. We are penciling in a 5% organic revenue decline in the IS&T business in 2012, which should be offset by a full year of Vangent sales resulting in flat sales for the segment in 2012. Finally, we expect the Marine segment to be down 2% organically in 2012, offset by contribution from the acquisition of Metro Machine.

Our relatively poor fundamental outlook for GD’s defense businesses contrasts sharply with our more optimistic view of the company’s Aerospace segment, which we expect to generate 13% sales growth this year. Our forecast is driven largely by delivery increases in Gulfstream’s new G650 and G280 aircraft, partially offset by a slight reduction in the legacy models. Overall, we are looking for a 17% increase in deliveries, including a 7% increase in the important large cabin category. While delays are always a possibility and any significant setbacks to these two planes would have a material impact on the growth outlook for the segment in 2012, the company continues to indicate both aircraft are on schedule with little time left before customer deliveries, and we are not forecasting any delays.

We updated our Combat Systems estimatesWe updated our 2012 and 2013 estimates for GD to reflect a refined view on the Combat Systems segment which includes both the impact of the Force Protection acquisition as well as an updated view on the legacy business (see the table below).

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Table 56: Estimated Breakdown of Combat Sales ($ mn)

2006E 2007E 2008E 2009E 2010E 2011E 2012E 2013E 2014E

US Military VehiclesStryker $1,300 $1,400 $1,300 $1,900 $1,900 $1,900 $1,615 $1,292 $646Abrams 1,116 1,352 1,478 1,580 1,480 1,480 1,184 888 533Other US Military Vehicles 614 1,217 1,847 1,918 1,418 1,268 1,205 1,145 1,087

Total $3,030 $3,969 $4,624 $5,398 $4,798 $4,648 $4,004 $3,325 $2,266Weapon Systems & MunitionsUS Weapon Systems & Munitions $1,560 $1,907 $1,800 $2,190 $2,339 $2,503 $1,967 $1,716 $1,516Intl Weapon Systems & Munitions 358 576 543 685 542 447 466 481 502 Total $1,918 $2,483 $2,343 $2,875 $2,881 $2,950 $2,432 $2,198 $2,018European Military Vehicles Total $1,034 $1,345 $1,227 $1,372 $1,199 $1,341 $1,394 $1,450 $1,508Force Protection Total $0 $0 $0 $0 $0 $0 $700 $500 $500

GD Combat Total $5,983 $7,797 $8,194 $9,645 $8,878 $8,939 $8,531 $7,473 $6,292


Our 2012 sales forecast is increased from $8.0 to $8.5 bn on the $700 mn contribution by Force Protection, partially offset by our estimate for organic revenue growth declining from -10% to -12%. We also adjusted our estimate for organic revenue decline from -10% to -12% for 2013, but because of the addition of Force Protection in the previous year, our sales estimate for the Combat Systems segment in 2013 increased from $7.2 bn to $7.5 bn. Force Protection's operating margin has averaged 4% over the last three years, well below Combat Systems’ 14%. We believe GD will be able to substantially improve Force Protection’s margin, ultimately reaching double digits, but we expect it will take a few years. In 2012, we are assuming an 8% operating margin from Force Protection’s operations which resulted in 40 bps of dilution to our previous estimate for the segment and as a result, our 2012 operating margin assumption for the Combat Systems segment decreased from 13.0% to 12.6%.

At the corporate level, our 2012 and 2013 sales forecasts both increased by 1% to $33.3 bn and $32.6 bn, respectively. Our operating margin forecast in 2012 declined 10 bps to 11.6% on the 40 bps of margin dilution in the Combat Systems segment related to the acquisition. The net impact of our revised forecasts for the Combat Systems segment was five cent increases to our EPS estimates in 2012 and 2013 to $7.30 and $7.50, respectively.

The Aerospace bull thesis is only partially factored into our estimatesOur forecast for Aerospace EBIT calls for growth to $1.10 bn in 2012, $1.32 bn in 2013, and $1.43 bn in 2014 from our estimate of $940 mn in 2011. While there are naturally multiple risks to our forecast, including macro demand issues, final certification and ramp-up on the G650 and G280, and potential cannibalization of legacy platforms, we are accounting for them by factoring conservatism into our estimates, both for sales and margins. For example, we assume that legacy large cabin deliveries decline from 80 in 2011 to 60 by 2014 due in part to the effect of cannibalization. Additionally, we assume that margin expands from 15.4% this year to 18.0% by 2014, but it could be higher as the G650 increases as part of the mix and if it achieves its potential margin in the mid-high 30% range. Overall, if we assume that the legacy business is flat from 2011 and that G650 margin achieves its potential, we could envision Aerospace EBIT of $1.66 billion in 2014, which equates to an increase of about 50 cents in EPS that year relative to our current EBIT estimate.

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Valuation now looks more attractiveAt 9.0x 2013E EPS, GD trades slightly higher than the 8.7x 2013E PAEPS average valuation of its peers. We believe GD’s Gulfstream business should trade at a much higher multiple than defense businesses based on our outlook for multi-year growth beyond 2012, and therefore we think GD warrants a premium relative to its peer group. Our target price is $75, based on a 10.0x multiple of 2013E EPS of $7.50. Using our estimates for GD’s 2013 EBIT breakdown as a guide, we assign a 1.0 multiple point premium to GD relative to defense peers based on a 9.0x multiple for its defense businesses and a 12.0x multiple for its Aerospace segment.

Lockheed Martin: downgraded from OW to N

LMT had a banner year in 2011, returning 21% compared to only 1% for the other defense primes on average. LMT looked cheap going into 2011, but after deliveringorganic growth in a year in which its peers could not and raising its dividend by 33% to produce a ~5% yield, LMT's multiple grew 1.5 points from 7.6x 2012E PAEPS at the beginning of the year to 9.1x 2013E PAEPS at the end of the year. While we hate to “punish” good performance in terms of both fundamental operating performance and cash deployment decisions, we now see less relative upside in the stock. In addition, we see continued overhang from the JSF program this year. We expect the combination of these factors to limit LMT’s ability to outperform its peers in 2012 and as a result, we downgraded the stock from OW to N.

Operating performance was best among peers in 2011With a total return of 21% in 2011, LMT substantially outperformed both the S&P 500 (2%) and its entire peer group consisting of NOC (3%), GD (-4%), RTN (9%) and LLL (-3%). We believe LMT’s performance last year was justified given its delivery of superior operating results and commitment to an industry leading dividend. LMT reported organic growth of 3%, 2% and 7% in the first three quarters of 2011, respectively, making it the only company in its peer group to deliver positive organic growth in the first three quarters of last year. While 4Q11 results have not yet been reported, we expect LMT will be the only company in its peer group to deliver full year organic growth in 2011. We estimate LMT will generate 2% organic growth in 2011, more than 425 bps better than the average organic growth rate we are forecasting for its peers.

Dividend increase leads to an industry leading payoutLMT increased its quarterly dividend by 33% last September from 75 cents per share to $1 per share. The increase raised LMT’s annualized yield by ~140 bps to 5.5%, catapulting the company from 59th to 19th among the best yielding companies in the S&P 500 and providing a substantial source of price support for the stock. LMT is now paying out 43% of 2012E PAEPS, over 50% more than the 27% average of its peers.

F-35 faces budget challenges aheadLMT faces increased budgetary risk on the F-35 program in 2012. The program has a long history of both setbacks and successes, and while 2011 was no exception, we believe the challenges facing the program this year could be more daunting than they were in 2011. Last year saw groundings, public debates over concurrency costs, and other headline risks. This year is sure to have its fair share of those as well, but we view the resolution of the ongoing budget debate as a much more important risk given its potential long-term implications for the program. We still do not know how the DoD plans to get under the budget cap for FY13, but its plans will be disclosed at

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least in short via a press conference held by Defense Secretary Panetta this Thursday and in full detail when the FY13 budget proposal is submitted in early February. A haircut to previously allocated funding for the F-35 program would not be a major surprise. Additionally, while the DoD is not yet planning for sequestration, it is now the law of the land until, if and when, it is changed. Getting under the far lower cap level implied by sequestration or some compromise level between the coming FY13 proposal and the sequestered level could take another bite out of the program. In the case of full sequestration, we believe that the loss of one of the aircraft's three variants (most likely the US Marine’s STOVL variant but also possibly the US Navy’s CV variant) is a possibility.

Valuation now looks fairAt 9.0x 2013E PAEPS, we feel LMT is fairly valued. We believe the improvement in the company’s valuation over the last year was well justified, but see less upside at the current level, especially in light of the macro defense environment. While the dividend yield should continue to support the stock in 2012, we believe LMT will be a middle-of-the-pack performer this year.

Exelis: upgraded to OW from N

XLS was spun-off from ITT Corp. on October 31st of last year and we initiated coverage shortly thereafter with a N rating. The stock has significantly lagged since the spin-off, and while we expect earnings to be down sharply this year, we believe the worst will be behind the company after 2012. We believe that the stock already heavily discounts the difficult outlook and a substantial pension overhang and as a result, we upgraded XLS from N to OW.

Core product franchise sales are down 80+% and are probably bottomingWe believe that most of the revenue downside in XLS’s three key product areas –electronic jammers, radios, and night vision goggles – is behind the company. Sales in these areas were $1.7 bn in 2008, declined to about $600 mn in 2011, and management has provided guidance that they will decline to about $300 mn in 2012. We view this as a cyclical bottom, and while we do not anticipate that an upturn is going to take place anytime soon, we do see value in these franchises that is not really captured by a depressed earnings stream that the market is valuing at a single digit earnings multiple. We would not want to overstate the case given the potential for program kills in this environment, but we do in fact see opportunities in these areas in the coming years. For example, XLS is the sole source developer for the next generation counter-IED program, JCREW 3.3, and has teamed with NOC to compete for the US Army’s Mid-Tier Networking Vehicular Radio which is replacing the cancelled GMR variant of the JRTS program. While demand for these next generation products surely won’t reach the wartime peaks of their predecessor programs anytime soon, they do offer upside to XLS’s current sustainment-levelrevenue in these product areas and, perhaps more importantly, they support XLS’s position as a leading player in key product areas for which we expect there to be enduring demand.

Stock has been weak since the spin-offSince it began trading as an independent entity on November 1, XLS has generated a total return of -20%, versus a 1% average total return for our other SMID cap stocks under coverage during the same time frame.

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Valuation is at the bottom of peer range even after adjusting for pensionAt 7.6x 2013E PAEPS (after adjusting for an estimated $2.35 per share of unrecoverable, non-defense related pension liability), XLS carries the lowest multiple in our defense coverage universe, including both large and SMID cap names, and its valuation represents a 15% discount to its SMID cap defense peers. In addition to its attractive valuation, XLS offers a 4.5% dividend yield which is the highest among its SMID cap defense peers and second only to LMT in our defense coverage universe.

It is time to start considering the strategic attractiveness of SMID franchises

We see long-term strategic value in XLS’s core franchises in electronic jammers, radios and night vision goggles. However, we expect the potential of a substantial tax liability to prevent the company from participating in any industry consolidation over the next two years. Additionally, there are other parts of the business we consider much lower quality than the core electronics franchises noted above, and there could be more downside to our estimates. Despite these issues, we upgraded XLS to OW and it is at the top of our SMID cap pecking order to begin 2012 as we believe it has the most potential in a difficult group.

CACI: downgraded to UW from N

Other than CMTL, CACI was the only SMID cap defense stock in our universe to deliver a positive return in 2011, and its 5% total return was 1,900 bps higher thanthe average of its peer group. This performance was driven by strong operating fundamentals in a very difficult environment as well as a large $200 mn share repurchase executed in Q1 of FY12 that supported the stock and reduced shares outstanding by about 13%. As with LMT, we find it difficult in some ways to "punish" success by lowering our rating, but we believe that difficult industry fundamentals, particularly for government services, will eventually snuff out revenue growth. Additionally, we believe that the bar is higher for CACI than it is for the rest of the industry due to its strong performance over the past couple of years, and this is manifested in both its valuation and the consensus expectations for continued revenue growth. As a result, CACI is last in our SMID cap pecking order to start 2012, and we downgraded the stock from N to UW.

Organic growth has been superb, but can it last?CACI has demonstrated an uncanny ability to deliver organic growth on a consistent basis despite severe macro headwinds, including in its most recent quarter when it delivered 8% y/y organic revenue growth in a period in which its service peers averaged y/y organic revenue declines of 7%. While this has been impressive, the 8% y/y organic revenue growth marked the first time in nine quarters that organic revenue growth fell below double digits, perhaps signaling that growth is beginning to slow. TTM book/bill has also registered 1.00x and 1.02x in the past two quarters, respectively, and this points toward a flattening organic growth profile ahead.

Expectations are higher than they are for peersWhile we would not characterize expectations for CACI as extraordinarily high, we do think that the company’s recent success has set a higher bar for CACI than for much of the rest of the industry. CACI trades at the high end of the SMID group range of 7.6-10.1x on 2013E P/E, although admittedly a 10.0x P/E is not high-flying. Additionally, consensus expectations call for 6% revenue growth in FY13, easily the highest expectations in the SMID cap group. If top line growth disappoints, we could envision the loss of a multiple point or two.

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2012 Large Cap Pecking Order

We expect the group as a whole will perform defensively this year, but we anticipate relative performance differential as there is every year. The main considerations driving our pecking order within the defense primes group are our views of relative sales and margin outlooks, relative valuations, and exposure to non-DoD revenue sources. Our large cap defense pecking order at the beginning of 2012 is as follows: RTN, GD, LMT, LLL and NOC.

Raytheon: attractive valuation and strong international prospects should drive outperformance

RTN ended 2011 with the lowest valuation among our large cap defense coverage universe despite a strong year-end rally. At 7.8x 2013E PAEPS, RTN trades at a 14% discount to the average of the other large cap defense names. Despite decent stock performance in 2011 (9% total return, second best among the peer group behind LMT), RTN has been the cheapest stock among its peers for an extended period. It remains our top pick and we expect the valuation gap to narrow this year.

RTN’s international prospects provide the company with a revenue stream that is independent of domestic fiscal concerns and positions the company well relative to peers with less international exposure. With an estimated 25% of 2011E sales derived from international customers, RTN has the largest international sales mix of its peer group. Overall, we forecast a 1% organic revenue decline for RTN in 2012 verses an average 5% decline for its peers and a 3% decline in investment account outlays. This relative top line strength drives a more attractive earnings profile and RTN is the only defense prime for which we expect EPS to grow in 2012. RTN’s recent large debt offering and plans to contribute a substantial portion of the proceeds to its pension fund could provide upside to our numbers, and we believe this is in part responsible for the late-year rally of the stock.

General Dynamics

Please see “New Year, New Ratings” section for details.

Lockheed Martin


L-3 Communications: service weakness drives challenging outlook

LLL has the second most attractive valuation behind RTN at 8.4x 2013E PAEPS. However, in the context of the company’s weak guidance at the end of 2011, we do not see any major catalysts for the stock this year. At its annual analyst meeting in December, management guided to a 6% y/y decline in sales, including a staggering 19% y/y decline in its Government Services segment, and a 60 bps y/y decline in operating margin. The mid-year spin-off of Engility (consisting of the SETA and training and operational support businesses) will only modestly reduce the pressure in the Government Services segment, as the remaining services business is expected to decline by 16% in 2012. LLL’s other segments are expected to be flat-to-down in 2012. The company’s most attractive attribute continues to be its strong, consistent cash flow generation, and the stock currently trades at only 5.6x its 2012 FCF/share guidance. Nonetheless, we expect earnings and cash flow to decline in future years, and while LLL’s cash flow is tempting, it is not quite enough to propel the stock further up our pecking order.

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Northrop Grumman: looks expensive relative to peer group

NOC is trading at 9.9x 2013E PAEPS, which remains the richest valuation in our large cap defense coverage universe by a wide margin and represents a 16% premium to the average valuation of its large cap defense peers. NOC’s premium valuation is the primary reason we rank the stock last in our large cap pecking order, although we also have concerns that NOC could experience more margin pressure than its peers. We believe the primary driver of the stock’s premium valuation is NOC’s unique position among its peers as a generator of pension income. We believe this attribute leads some investors to pay for NOC’s GAAP EPS and, on that basis, NOC looks much more fairly valued. On 2013E EPS, NOC trades at 9.0x, in line with the 9.0x average of its peers. However, we believe pension-adjusted EPS is a better valuation metric, especially considering we do not believe investors should pay for pension income. In this context, NOC continues to look expensive relative to its peer group and as a result, the company ranks below all of its peers in our large cap pecking order.

2012 Small and Mid Cap Pecking Order

Our framework for rating SMID cap stocks in 2012 includes both our traditional fundamentals-based analysis and, increasingly, our view of a company’s strategic attractiveness. Our SMID cap defense pecking order at the start of 2012 is as follows: XLS, SAI, HRS, ATK, CMTL and CACI.

Exelis


SAIC: management turmoil and weak service fundamentals drive difficult outlook, but valuation is getting interesting

SAI trades at 8.3x 2013E PAEPS, which is at the low end of its SMID cap defense peers and represents a 5% discount to the average of the other SMID cap defense names. The stock has been a laggard for the last three years, generating average returns of -14% over the past three years versus 15% average returns for the S&P 500, and the valuation is now beginning to look compelling. Despite the intriguing valuation, we expect SAI to face challenges on several fronts in 2012 as it navigates a difficult operating environment amidst significant management uncertainty.

We are forecasting a 6% decline in O&M outlays in 2012, which we expect will equate to softness in the market for defensive services, and while SAI's last reported quarter was better than most with -2% organic growth, we have seen other service businesses begin to show weakness that we think that will continue throughout 2012. In addition to a challenging external operating environment, SAI is undergoing major management turnover as CEO Walt Havenstein announced his retirement last year, and the company dismissed several executives in response to the CityTime incident. Our poor outlook for defense services and the substantial management uncertainty surrounding the company are keeping our rating at N, but if the company is able to maintain its earnings in this tough environment, we could see a bit of multiple recovery as the management uncertainty is resolved.

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Harris: 2012 looks like the year tactical radios might finally roll over, but its assets are among the best in the SMID cap group

At a projected 67% of operating income in FY12 versus just 26% of FY12 sales, tactical radios are the key earnings driver for HRS. The company has found ways to sustain growth in this key product line over the last several years despite a deteriorating market, most notably through a large and hugely profitable award to produce vehicular radios for the M-ATVs that were utilized in surge in Afghanistan. While the company’s new CEO, Bill Brown, has not yet spoken publicly about his outlook for the company, we believe calendar 2012 could finally be the year in which the company concedes that its tactical radio product line will face a downturn.

We expect EPS to decline to the $4/share range and perhaps lower in the next 2-3 years, while consensus still reflects earnings power of nearly $6/share. However, we believe the market already substantially, but not fully, discounts our earnings outlook. We foresee some potential weakness as the earnings bar is reset, and this may take a number of quarters. Beyond that, we believe HRS could be one of the most attractive SMID cap defense companies for a strategic suitor given its positioning, and we rank it third in our SMID cap pecking order to start 2012.

Alliant Techsystems: challenging outlook due to weak end-markets

ATK’s valuation is the second lowest in our SMID cap defense universe at 8.2x 2013E PAEPS, which represents a 6% discount to the average of the other SMID cap defense names. However, we have a poor outlook for earnings, as weakness in the company’s Armament Systems segment is pressuring revenues, while last quarter’s crack in operating margin in the company’s Security and Sporting segment suggests profitability will also be challenged going forward. Our FY14 EPS estimate of $6.60 is 21% below consensus, and even (as with HRS) if the stock is already discounting an earnings outlook closer to our view than the consensus view, we believe it will be difficult for the stock to perform if our outlook proves to be correct and consensus estimates have to decline materially. We do not expect the fundamental outlook for ATK to improve in 2012, and therefore we have modest expectations for its performance this year, despite the discounted valuation on our well below consensus estimates.

Comtech Telecommunications: a challenging road ahead, and strategy remains up in the air

CMTL was the best performer in the SMID cap defense space last year, posting a total return of 7%, 2,100 bps better than the average of its peer group. The stock benefited from both a proxy fight by activist investor MMI Investments that was ultimately abandoned and a large share repurchase program. Meanwhile, CMTL’s core businesses remain under pressure as evident by management’s tone toward the remainder of FY12 on its last quarterly call and in its related filing. The company is already suffering significant revenue declines as a result of the loss of the MTS and BFT-1 contracts, and management now believes it will not be able to achieve revenue growth ex-MTS and BFT-1 in FY12 as previously hoped. The deteriorating revenue picture is accompanied by a weakening margin outlook which, coupled with last year’s strong performance and continued strategic uncertainty as managementseeks acquisitions, lead us to rank CMTL next-to-last in our SMID cap pecking order to begin 2012.

CACI


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Aerospace/Defense Capital Deployment

We believe the creation and destruction of value via capital deployment is among the most important stock price drivers in aerospace/defense, and in this section we examine capital deployment trends among six of the longer-established large cap stocks we follow: Boeing, General Dynamics, Lockheed Martin, Northrop Grumman, Raytheon, and United Technologies.

Companies returning cash to shareholders

The dominant theme in capital deployment among these companies in recent years has been returning to shareholders, mainly in the form of repurchases, though dividends have been important too. Through 9M 2011, for example, net share repurchases and dividends for these six companies totaled ~$12 bn, or over 140% of FCF. In absolute terms, this should approach the 2008 record and it will likely set a new record in percentage terms. While we applaud management’s willingness to return cash, we question whether an approach that focuses more heavily on dividends, rather than repurchases, might not create more value. Lockheed’s decision to raise its dividend 33% last year looks like a step in this direction and we believe this explains part of the stock’s 19% outperformance relative to the S&P 500 in 2011 on a total return basis.

Table 57: Aerospace/Defense Capital Deployment

2001 2002 2003 2004 2005 2006 2007 2008 2009 20102011 (Q3)

Cumulative

CAGR 1999-2010

FCF 6,862 9,722 9,285 12,055 16,920 17,967 20,709 13,076 17,536 15,501 8,494 166,867 5%

Cash for ACQ 4,721 666 5,201 1,855 6,262 6,316 3,572 5,818 2,955 1,465 2,401 52,922 -11%% FCF 69% 7% 56% 15% 37% 35% 17% 44% 17% 9% 28% 32%

Shares for ACQ 2,405 7,752 0 0 0 0 0 0 0 0 0 18,433Acquired Debt 1,986 4,865 1,200 220 537 450 323 13 0 0 0 10,666Total ACQ Value 9,112 13,283 6,401 2,075 6,799 6,766 3,895 5,831 2,955 1,465 2,401 82,020 -17%

Dividends 1,855 1,994 2,251 2,662 3,174 3,631 4,180 4,657 5,073 5,416 4,252 42,558 10%% FCF 27% 21% 24% 22% 19% 20% 20% 36% 29% 35% 50% 26%

Repurchases 3,129 850 1,383 3,302 7,274 7,143 10,225 13,805 5,510 8,307 8,476 76,529Cash from options 853 1,379 774 1,542 1,394 2,196 1,820 987 616 700 589 14,144Net Repurchases 2,276 -529 609 1,760 5,880 4,947 8,405 12,818 4,894 7,607 7,887 62,385 8%

% FCF 33% -5% 7% 15% 35% 28% 41% 98% 28% 49% 93% 37%Capital returned as % of FCF 60% 15% 31% 37% 54% 48% 61% 134% 57% 84% 143% 63%

Net Debt 35,177 35,929 33,279 23,858 17,969 12,427 5,406 16,584 10,934 12,548 15,343 -7%Net Debt/EV 22% 22% 18% 12% 8% 5% 2% 9% 5% 6% 8%

Source: Company reports. Note: Includes BA, GD, LMT, NOC, RTN, and UTX.

Given their strong balance sheets, ample cash generation capabilities, and shareholder oriented management teams, we expect cash return to remain a leading element of capital deployment strategies near term, though there are potential changes on the horizon. United Technologies’ pending acquisition of Goodrich, which carries an $18.4 bn transaction value, and the resulting ramp down in repurchases that UTX management has announced, should swing the pendulum toward M&A in 2012. In addition, as noted in the defense section of this report, webelieve M&A will likely play a more prominent role in defense companies’ capital deployment strategy as the industry reconfigures in response to a shrinking budget. A

113



merger between two defense primes remains unlikely for the time being, but acquisitions and divestitures could lead to a reshuffling that has already started to unfold with Northrop’s Huntington Ingalls divestiture, ITT’s breakup, and L-3 Communications’ planned spin of Engility.

Boeing should have more cash to deploy

One other change to note among these companies is that Boeing should have more cash deploy now that the company is delivering 787s, which should make this program a diminishing drag on cash. In terms of priorities, Boeing announced its first dividend increase since 2008 late last year, and we believe management will seek to continue delivering annual increases. In addition, Boeing’s pension expense is rising rapidly though required contributions remain low. The company has been making discretionary contributions and this should remain the case in 2012, though we still expect required contributions to spike, making pension an important component of cash deployment. Boeing stopped buying back stock in 2008 to preserve cash to fund the 787 and 747-8 development efforts, and while repurchases should resume eventually, we do not view this as a top near-term priority. On the M&A front, we view Boeing as a buyer rather than a seller if the wave of defense transactions we anticipate in the coming years rolls in, due in part to an effort to preserve the company’s commercial/defense balance, although we do not see this transpiring in a significant way until at least late 2013 if not 2014 or 2015.

PCP, TDG, LLL should affect industry capital deployment as well

Finally, while our analysis focuses on the six companies mentioned above, which have long track records as leading industry players, other companies’ capital deployment strategies will be important as well. For example, the most active acquirers in our coverage universe are Precision Castparts and TransDigm. Acquisitions remain part of both companies’ growth plans, and both management teams have solid track records integrating their targets, meaning that the market tends to receive acquisition announcements well. While preferring to continue deploying cash toward acquisitions, TransDigm has shown a commitment to using its balance sheet to generate shareholder value, even when management has not seen attractive M&A opportunities. In 2009 for example, TDG borrowed to fund a $375 mn special dividend. We would also highlight L-3 Communications, which is active on both the acquisition and divestiture fronts. L-3 has also returned cash to shareholders consistently in recent years through both buybacks and dividends.

Cash Return to Shareholders Continues

As a percentage of free cash flow, 2011 seems likely to set a record for the amount of cash these companies will return to shareholders. Through 9M, dividends and net repurchases comprised 143% of FCF. The 2008 peak was 134%, before it dropped to 57% as companies preserved cash amid the recession in 2009 and then recovered to 84% in 2010. In dollar terms, the $12 bn 9M total seems likely to approach the 2008 peak of $17.5 bn.

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Figure 57: Aerospace Defense - Dividends and Repurchases, 1999-9M 2011$ in millions


Note: Includes BA, GD, LMT, NOC, RTN, and UTX.

Stock repurchases should be up substantially in 2011

Repurchases have been the primary vehicle for aerospace/defense companies to return cash, and this remained the case in 2011. Net repurchases for 9M 2011 are already $7.9 bn, just above the full year level for 2010 and higher than the full year total for any prior year, with the exception of 2008 ($12.8 bn) and 2007 (8.4 bn). This is not especially surprising since repurchases have become a higher priority in recent years. In 2005, net repurchases for these six companies spiked to nearly $6 bn, and since then ~$5 bn has represented a floor. Repurchases have also represented at least half of cash returned to shareholders since 2005, reaching 65% in 9M 2011, which is the higher end of the range.

Options dilution looks flattish in 2011

Typically, a moderate level of repurchases has been necessary just to offset the exercise of options from compensation plans. This was barely necessary in 2009, with most options under water following the market crash, but option dilution picked up in 2010. For 2011 cash from option exercises should remain flat, with thecompanies receiving $563 mn for the 9 month period vs $700 mn in all of 2010. Future option exercises will depend on stock prices, but options granted with low strike prices in 2008 and 2009 could provide a basis for some dilution of gross repurchases.

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Figure 58: Large Cap Aero/Defense Cos: Share Repurchases and Option Exercises, 1999-9M 2011

$ in mn



Defense companies drove the increase in repurchases last year, and Northrop Grumman was among those leading the way as it deployed the proceeds of the Huntington Ingalls spin. Through 9M, NOC's net repurchases were up nearly $500 mn on full year 2010. General Dynamics’ 9M repurchases also exceeded the 2010 total, while Lockheed was in striking distance after 9 months. Raytheon repurchases should be down modestly, in part due to the Applied Signal acquisition, but the company continues buying back stock at a fairly steady clip of ~$300 mn per quarter and has the capacity to do more. Boeing barely bought back stock again in 2011 as the 787 consumed most of the company’s cash, though repurchases should start up again eventually. United Technologies was on track for a big year but repurchases should come in flattish after company suspended buybacks in 2H following its announcement of plans to buy Goodrich for $16.5 bn in cash and stock. Management has said UTX will not buy back stock this year and that it plans to limit repurchases to ~$1 bn annually for 2013 and 2014 vs ~$2 bn on average the past five years.

Figure 59: Aerospace/Defense Net Share Repurchases, 2005-9M 2011$ in millions


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Dividends continue steady rise with Lockheed Martin standing out

With ample cash to deploy and a more or less consistent record of dividend increases behind them, these six companies increased their dividends again in 2011, though some were more aggressive than others. Lockheed took the lead, raising its annual dividend to by 33% to $4, which gives the stock a yield of nearly 5%, above that of the Philadelphia Utility Index (UTY). Lockheed outperformed the S&P 500 by 19% on a total return basis last year, and we believe the dividend increase was a key driver. Defense companies face a challenging operating environment but have significant amounts of cash to deploy, and we believe investors would applaud similarly aggressive dividend increases by other companies. Yields for the othercompanies range from mid 2% to mid 3%, and LMT pays 43% of its 2012E PAEPS, more than 50% higher than the average of the other defense stocks.

Figure 60: Dividend Yield for Aerospace/Defense Companies, the S&P 500, and the Philadelphia Utility Index

Source: Bloomberg.

Note: UTY is the ticker for the Philadelphia Utility Index. Yields as of Dec 30, 2011.

Dividends likely a better use of cash than repurchases

While we applaud cash return to shareholders, through both repurchases and dividends, a greater emphasis on dividends among these companies may have generated more value in recent years, in our view, and we see the case for dividends on a go-forward basis as well.

We believe the numbers bear out the idea that repurchases have been a suboptimal use of cash, as the stocks of the five leading defense large caps (ex Boeing, which has not bought back stock in recent years) now trade 20% below the average price at which they have repurchased stock over the past five years.

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Figure 61: Defense Company Avg Repurchase Price, 3Q06 - 3Q11 and Current Price

Source: Company reports and Bloomberg.

In general, we see dividends as a wiser way to return capital to shareholders than share repurchase, as the depth of the defense downturn is unknown at this time given the fiscal situation. We also see no upside for shareholders from share repurchase as compared to dividends, as shareholders that prefer to reinvest dividends by purchasing more stock with them can mimic the impact of a share repurchase. At the same time, dividends return earnings to the shareholder without taking the risk that the defense budget and industry profitability might decline more than management thinks or the market is discounting in stock valuations.

We are not expecting a wholesale shift to dividends in the near term, however. While Lockheed’s strong performance last year may prompt some management teams to revisit their dividends, we believe the preference for repurchases has been driven in part by the fact that they bring more flexibility. Once a company has raised its dividend, there is a real aversion to lowering it, while management teams have far more latitude to ramp repurchases up and down. In addition, repurchases are an important source of earnings growth for some companies.

Leverage edged higher but remains low

Aggregate net debt for these companies increased 22% during the first nine months of 2011 to $15.3 billion. Net debt now seems likely to be up for three of last four years, reversing a trend in which it fell for five consecutive years. However, we still view the sector as underleveraged, with net debt-to-enterprise value of only 8% as of September 30. Low leverage of major aerospace/defense companies stands out even more amid the ultra low interest rate environment that has prevailed for much of the past three years, and in our view, companies could have been taking greater advantage of their strong balance sheets, ample cash generation capabilities, and investment grade ratings to take on more debt and increase returns to shareholders. With more leverage, for example, the large cap aerospace and defense companies could be paying out more in dividends.

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Figure 62: Large-Cap Debt (Right) and Net Debt to EV (Left)

$ in bn



From an individual company perspective, leverage is clustered around 7-8% for nearly all the companies, with General Dynamics showing up as something of an outlier at 11%. GD also contributed $2 bn to the $2.8 bn aggregate increase in net debt over the first nine months of 2011, with Boeing and Raytheon each adding $1.2 bn. GD and Raytheon each closed acquisitions last year, while Boeing’s 787 cash burn diminished Boeing’s cash balance. Net debt declines of $800 mn each at Lockheed and United Technologies offset growth elsewhere, while Northrop net debt was flattish. While GD is the most levered company in this peer group, we view the current degree of leverage as very manageable.

Mergers and Acquisitions

2011 was a notable year for aerospace/defense M&A, due mainly to the announcement of United Technologies’ plans to purchase Goodrich, with an estimated transaction value of $18.4 bn. If consummated, this would be the largest deal ever with an aerospace/defense target, eclipsing 1997’s $16.3 bn Boeing-McDonnell Douglas transaction. United Technologies is involved in another pending deal that captured headlines last year due to its plans to buy Rolls-Royce’s 33% stake in the International Aero Engines (IAE) consortium that makes the V2500 engine for Airbus’ A320. Though far smaller than the Goodrich deal—UTX plans to pay $1.5 bn to double its IAE stake—the deal is notable in part because it provides further validation for Pratt & Whitney’s Geared Turbofan engine (GTF), with Pratt and Rolls agreeing to collaborate on the development of an engine for next generation narrowbodies (the aircraft beyond the neo and the MAX) based on GTF technology.

In terms of the deals that closed worth over $100 mn, 2011 saw a modest pickup relative to 2010, with 46 deals globally, up from 42, and an average value of $500 mn, that was up 9%. This resulted in an 18% increase in total deal value to $23 bn. Daimler and Rolls-Royce’s acquisition of Tognum was the largest deal of the year ($4.5 bn), however, and while Tognum does have a defense component (diesel and gas turbine engines for tanks and armored vehicles) a considerable portion of its sales come from outside aerospace/defense as well. Excluding this transaction, average deal value declines to just over $400 mn, down 10% from 2010. Average deal value

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continued to tick up from a low of ~$400 mn in 2009, and at $500 mn is moderately below the ~$580 mn average for 2003-2008, which covers the period from the end of major US defense industry consolidation through the financial crisis. The United Technologies-Goodrich transaction could boost average deal value in 2012, if it is approved, and looking longer term, we see potential for more deal activity in defense if, as we expect, the industry reconfigures itself in reaction to tighter budgets.

Figure 63: Aerospace & Defense, Global M&A Deals Greater Than $100 MM, 1999-2011

Source: DM&A, J.P. Morgan.

US M&A little changed in 2011

US acquirers closed 32 deals with a value greater than $100 million, little changed from 31 in 2010 and the average transaction size remained ~$400 mn. The top dealwas Providence Equity Partners’ acquisition of SRA ($1.9 bn transaction value), continuing a trend in recent years of private equity players paying healthy multiples for defense assets, particularly in services. General Dynamics was a strategic buyer active in services, with its acquisition of Vangent ($960 mn). Commercial aero deals rounded out the top five, including Precision Castpart’s acquisition of Primus ($900 mn), Allegheny Technologies’ acquisition of Ladish ($778 mn), and Esterline’s acquisition of France’s Souriau ($715 mn). In terms of average deal size, activity among US acquirers has recovered somewhat following the financial crisis but remains below the ~$530 mn average for the 2003-2008 period.

Figure 64: Aerospace & Defense, M&A Deals Greater Than $100 MM with US Acquirer, 1999-2011

Source: DM&A and J.P. Morgan.

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Tognum deal supported international activity

There were 14 deals involving a foreign acquirer, up from 11 in 2010, and with a total value of $10 bn, average deal value increased 10% to just over $700 mn. Rolls-Royce and Daimler's acquisition of Tognum for $4.5 bn dominated deals among foreign acquirers, and absent this transaction, average value would have fallen 34% to $425 mn, the lowest level since 2004. The European financial crisis could impact European acquirers’ ability to continue making acquisitions, though we could also see a series of smaller acquisitions as bigger players, including EADS, acquire smaller companies, particularly suppliers, that lack access to capital. One deal with a foreign acquirer worth noting is AVIC’s acquisition of Teledyne Continental Motors. Though small ($186 mn), we see this as an indication of the Chinese becoming more active in international aerospace M&A.

Figure 65: Aerospace and Defense: M&A Activity with Foreign Acquirer, 1999-2011

Source: DM&A and J.P. Morgan.

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Company Data

Alliant Techsystems (ATK)

Company Description

Alliant Techsystems consists of four operating segments: Aerospace Systems, Armament Systems, Security and Sporting, and Missile

Products. Aerospace Systems includes Space Systems and Aerospace Structures. Armament Systems is comprised of military and

precision weapons programs. Security and Sporting includes ammunition, accessories and individual equipment for sporting, military

personal security and law enforcement applications. The Missile Products group includes missile design, engineering and manufacturing.

FY2012E Revenue Breakdown by Segment

Source: J.P. Morgan estimates.

Financial Model $ in thousands, except per share data; FY ending in March

2011 2012E 2013ENet SalesAerospace Systems 1,432,677 1,354,966 1,300,768Armament Systems 1,806,339 1,468,066 1,321,260Missile Products 673,694 683,947 683,947Security and Sporting 929,554 966,863 937,857Net sales 4,842,264 4,473,843 4,243,832Cost of sales 3,840,699 3,461,726 3,364,233Gross Profit 1,001,565 1,012,117 879,599

Research and development 64,960 57,317 57,021Selling 164,062 162,044 152,056General and administrative 246,818 240,931 228,084Operating expenses 475,840 460,292 437,160

Operating income 525,725 551,825 442,439

Interest expense (87,612) (95,956) (91,612)Interest and dividend income 560 728 1,457Income before taxes 438,673 456,597 352,283

Income taxes 124,963 156,909 120,129Minority interest 536 593 600Non-recurring loss (gain) 0 0 0

Net income 313,174 299,095 231,555

Average basic shares 33,240 33,024 32,757Average diluted shares 33,553 33,235 33,057

Basic EPS: $9.42 $9.06 $7.07Diluted EPS: $9.33 $9.00 $7.00

Balance Sheet and Cash Flow ItemsAssets 4,443,845 4,344,997 4,500,105Liabilities 3,277,723 2,957,732 2,957,732Shareholder's Equity 1,156,758 1,377,607 1,532,715

Cash from Operations 421,070 392,400 338,555Capex (130,201) (133,879) (121,000)Free Cash Flow 290,869 258,521 217,555

Net Debt 907,435 724,683 583,575

2012 Quarterly Data: Sales EBIT EPS1Q (June) 1,075,255 130,540 2.132Q (September) 1,109,418 147,406 2.433QE (December) 1,071,333 127,994 2.054QE (March) 1,217,837 145,885 2.392012E 4,473,843 551,825 9.00


Fundamental Positives Space issues are well appreciated.

Composites business holds promise for growth.

Fundamental Risks We expect margin pressure, particularly in S&S.

Uncertainty surrounding the A350 program.

10-Year Stock Price Performance

Source: Bloomberg.

Aerospace Systems

30%

Armament Systems

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Missile Products15%

Security and Sporting

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Boeing (BA)

Company Description

Boeing is the largest aerospace and defense company in the world and the largest exporter in the United States. Is one of the world’s two

leading producers of commercial airplanes and it is the second largest contractor to the US Dept of Defense.

2011E Revenue Breakdown by Segment


Financial Model

$ in millions, except per share data; FY ending in December

2011E 2012E 2013E

Revenues Commercial Aircraft $36,699 $49,239 $54,833 Boeing Military Aircraft 14,988 13,705 13,320 Network and Space Systems 8,702 8,218 7,576 Global Services and Support 8,157 7,664 7,371 Boeing Defense Systems 31,847 29,587 28,267 Customer and Commercial Financing 581 581 581 Other 138 138 138 Accounting differences/eliminations (408) (394) (419)Total Revenues 68,857 79,151 83,400Operating costs and expenses 56,347 65,769 69,254Gross Profit 12,511 13,382 14,146 Equity in income (loss) from JVs 277 300 300 General and administrative expense 3,472 4,407 4,616 Research and development expense 3,834 3,276 3,058 Special charges (20) 0 0 Share-based plans 0 0 0Earnings (loss) from operations 5,502 5,998 6,773 Other income, principally interest 86 72 139 Interest and debt expense (500) (444) (368)Earnings (loss) before income taxes 5,088 5,625 6,544 Income taxes (benefit) 1,707 1,969 2,277Net earnings (loss) 3,381 3,657 4,267 Add charges (gains) 0 0 0Net earnings -- Before charges 3,381 3,657 4,267Diluted earnings (loss) per common share: $4.50 $4.85 $5.65Summary Balance Sheet and Cash Flow ItemsAssets 75,307 79,831 83,101Liabilities 68,846 71,146 72,421Shareholder's Equity 6,461 8,685 10,680Cash from Operations 2,662 8,062 8,352Capex (1,708) (1,700) (1,700)Free Cash Flow 954 6,362 6,652Net Debt 1,402 (3,311) (7,476)2011E Quarterly Data Sales EBIT EPS1Q 14,910 1,000 $0.782Q 16,543 1,534 $1.253Q 17,727 1,714 $1.464QE 19,677 1,254 $1.01


Fundamental Positives Successfully delivered first 787 after 3 years of delays.

Potential cash flow turnaround approaching as 787 cash burn

abates.

Production rates on the way up for 737, 777.

737 MAX should spur order pickup.

Fundamental Risks 787 faces a challenging production ramp.

Further 787 execution problems would reduce cash flows.

Global macro downturn could imperil plans to increase rates.

The defense business faces several headwinds for both sales

and margins.


Source: Bloomberg

Commercial Aircraft61%Defense,

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Capital and Other14%

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Bombardier (BBD/B TO)

Company Description

Bombardier Aerospace is the world’s third-largest manufacturer of aircraft, offering a broad portfolio of business jets, regional jets, and

turboprop aircraft. Its Transportation division is the global leader in the rail equipment manufacturing and servicing industry, offering

passenger railcars, complete rail transportation systems, locomotives, freight cars, airport people movers, propulsion and controls and

provides rail control solutions.

CY2011E (ex. Jan) Revenue Breakdown by Segment


Financial Model

$ in millions, except per share data.

CY11E (ex Jan) CY12 CY13

Revenues:Aerospace $8,629 $8,863 $9,445 Transportation $10,156 $10,443 $11,017 Other 0 0 0 Total Revenues $18,785 $19,306 $20,462 Cost of sales and services (15,854) (16,144) (16,922)SG&A (1,464) (1,525) (1,598)Depreciation and amortization 0 0 0 Research and development (263) (269) (282)Other income/(expenses) 17 0 0 Special items/Other 0 0 0 Total operating expenses (1,710) (1,794) (1,880)Income from operations 1,221 1,368 1,659 Financing income 556 553 571 Financing expense (717) (712) (712)Non-operating income (expense) 1,060 1,209 1,518 Income before income taxes 1,060 1,209 1,518 Provision for income taxes (213) (302) (364)Discontinued operations 0 0 0 Net income $847 $907 $1,154 Diluted earnings per share $0.47 $0.51 $0.65

Summary Balance Sheet and Cash Flow ItemsAssets $24,445 $25,157 $26,116 Liabilities 23,240 23,240 23,240 Shareholder's Equity 1,205 1,917 2,876

Cash from Operations $462 $1,950 $2,141 Capex (1,593) (1,350) (1,050)Free Cash Flow (1,131) 600 1,091

Net Debt $1,521 $1,116 $220

CY11E (ex Jan) Quarterly Data Sales EBIT EPSQ1 $4,661 $312 $0.12 Q2 4,747 296 $0.12 Q3 4,623 301 $0.11 Q4E 4,754 312 $0.12


Fundamental Positives Leading play on bizjet recovery, in our view.

Strong Transportation backlog provides foundation for growth.

CSeries could reinvigorate commercial aircraft franchise.

Fundamental Risks CSeries faces both demand and execution risk.

Falling commercial aircraft production could impede margin expansion.

European debt crisis could ultimately impact train demand.


Source: Bloomberg

Business Jets31%

Regional Jets15%

Transportation54%

02468

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124



CACI International Inc. (CACI)

Company Description

CACI was founded in 1962 as a computer simulation technology company and is now a leading provider of IT and network solutions to the

US government. Its core lines of business include systems integration, intelligence solutions, managed network services, knowledge

management and engineering & logistics.

FY2011 Revenue Breakdown by Segment


Financial Model

$ in millions, except per share data; FY ending in June

2011 2012E 2013E

Revenue $3,578 $3,894 $3,988Costs and Expenses: Direct costs 2,529 2,727 2,795 Indirect costs and selling expenses 742 825 864 Depreciation and amortization 56 52 44 Operating income 251 290 286 Interest expense and other, net 23 28 29 Earnings before income taxes 228 263 257 Income taxes 83 105 101 Income from continuing operations 145 158 155 Average basic shares 30 27 27 Average diluted shares 31 28 28 Basic earnings (loss) per common share: $4.79 $5.77 $5.74 Diluted earnings (loss) per common share: $4.64 $5.60 $5.50 EPS Ex Amortization $5.43 $6.26 $6.01 Summary Balance Sheet & Cash Flow ItemsAssets 2,320 2,448 2,597 Liabilities 1,011 1,168 1,178 Shareholder's Equity 1,310 1,279 1,418 Cash from continuing operations 226 242 232 Capex (14) (15) (16)Free Cash Flow 212 227 216 Net Debt 245 333 164 2012 Quarterly Data: Sales EBIT EPSQ1 924 76 1.41 Q2E 928 66 1.28 Q3E 994 71 1.38 Q4E 1,047 78 1.53 2012E 3,894 290 5.60


Fundamental Positives Free cash flow should exceed net income consistently.

Margin on the upswing after several years of decline.

Fundamental Risks History of superior growth relative to peers has resulted in

outsized expectations

Strong growth looks unsustainable as defense services face

pressure from lower base and supplemental funding.


Source: Bloomberg

DoD

80%

Federal Civilian

Agencies15%

Commercial5%

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125



Comtech Telecommunications (CMTL)

Company Description

Comtech Telecommunications designs, develops and manufactures products, systems and services for communications solutions.

CMTL’s communications products are used for voice, data, facsimile and video transmissions at microwave frequencies in satellite, over-

the-horizon microwave, terrestrial line-of-sight and wireless telecommunications. Comtech operates in three business segments:

Telecommunications Transmission, Mobile Data Communications and Radio Frequency (RF) Microwave Amplifiers.



Financial Model

$ in millions, except per share data; FY ending in July

2011 2012E 2013E

RevenuesTelecom Transmission 231,957 224,036 242,710 Mobile Data Communication 288,449 88,069 49,340 RF Microwave Amplifiers 91,973 87,650 92,033 Corporate Eliminations 0 0 0 Total Revenues 612,379 399,755 384,083 Cost of Sales 371,333 219,225 203,295 Gross Profit 241,046 180,530 180,789 Operating ExpensesSelling, general and Administrative 94,141 89,072 84,689 Research and Development 43,516 38,674 40,038 Amortization of Intangibles 8,091 6,697 6,327 Operating Income 107,798 46,087 49,734 Interest expense 8,415 8,896 9,000 Interest Income and Others (2,421) (1,457) (1,028)Income from Continuing Ops. before Taxes 101,804 38,648 41,763 Income taxes 33,909 10,097 14,617 Net Income before Discontinued Operations 67,895 28,551 27,146 Income (Loss) from Discontinued Operations 0 0 0 Net Income (Loss) 67,895 28,551 27,146

Basic Shares Outstanding 26,840 20,324 17,376 Diluted Shares Outstanding 27,055 20,524 17,576 Diluted Shares Outstanding including convertibles 32,608 26,222 23,276 Earnings (Loss) per common share:Basic 2.53 1.40 1.56 Diluted 2.51 1.39 1.54 Diluted including Convertibles 2.22 1.26 1.36

Summary Balance Sheet & Cash Flow ItemsAssets 937,509 707,562 717,594 Liabilities 308,329 296,611 296,611 Shareholder's Equity 629,180 410,951 420,983

Cash from Operations 97,360 30,806 52,473 Capex (7,138) (8,043) (8,000)Free Cash Flow 90,222 22,763 44,473

Net Debt (358,804) (137,539) (164,897)

FY12 Quarterly Data: Sales EBIT EPSQ1 113,361 15,759 0.47 Q2E 90,673 8,395 0.20 Q3E 98,842 10,796 0.27 Q4E 96,879 11,137 0.30 2012E 399,755 46,087 1.26


Fundamental Positives Strong balance sheet with large cash balance provides

flexibility.

Leading market position and commercial exposure in the satellite modem market should provide support in a weak

defense environment.

Fundamental Risks Loss of key Army programs has resulted in a significant revenue

decline.

Large cash balance is used to pursue an expensive M&A transaction.


Source: Bloomberg

Telecom Transmission

56%

Mobile Data Communication

22%

RF Microwave Amplifiers

22%

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126



Embraer (ERJ)

Company Description

Embraer was formed in 1969 by the Brazilian government and became public in 1994. The company has traditionally been focused on the

production of regional aircraft but it has branched out into corporate aircraft and defense systems as well.



Financial Model

$ in millions, except per share data; FY ending in December.

2011E 2012E 2013E

Net SalesRegional $3,358 $3,704 $3,762Defense 653 780 896 Corporate 996 1,121 1,432 Services 648 693 742 Other 95 100 105 Net Sales 5,751 6,398 6,937 Cost of sales and services (4,468) (4,925) (5,326)Gross profit 1,283 1,473 1,611 Selling expense (429) (468) (496)Research and development (87) (90) (90)General and administrative (262) (264) (275)Employee profit sharing 0 0 0 Other operating expense, net 29 0 0 Equity on income (loss) from affiliates 0 0 0 Total operating expenses (749) (822) (860)Operating Income 534 651 750 Interest income (expense) 31 43 56 Financial transaction loss, net 27 0 0 Non-operating income (expense), net 0 0 0 Total non-operating income (expense) 58 43 56 Income before income taxes 592 694 806 Provision for income taxes (222) (139) (161)Minority interest (9) (12) (12)Net income $361 $543 $633 Diluated earnings per ADS $2.00 $3.00 $3.50 Summary Balance Sheet & Cash Flow ItemsAsset $9,463 $9,882 $10,369Liabilities 6,003 6,003 6,003Shareholder's Equity 3,460 3,879 4,366Cash from Operations 956 723 841 Capex (374) (319) (200)Free Cash Flow 583 404 641 Net Debt (477) (570) (863)2011E Quarterly Data Sales EBIT EPSQ1 $1,056 $94 $0.58 Q2 $1,359 106 $0.53 Q3 $1,364 124 $0.01 Q4E $1,973 210 $0.87


Fundamental Positives We expect margins to surpass expectations.

The defense business should grow significantly over time.

Bizjet segment positioned for growth through share gains and cyclical recovery.

Fundamental Risks Overhangs from exposure American Airlines bankruptcy and a

Foreign Corrupt Practices Act investigation.

Commercial aircraft demand could fall off around mid decade as

new competitors enter the market.

Rising wages in Brazil could cut into profitability.


Source: Bloomberg

Regional59%Defense

11%

Corporate17%

Services11%

Other2%

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127



Exelis (XLS)

Company Description

Exelis provides C4ISR related products and systems and information and technical services. Exelis’ key operating areas include integrated

electronic warfare, sensing and surveillance, air traffic management, information and cyber-security, networked communications,

composite aerostructures, logistics and technical services.



Financial Model

$ in thousands, except per share data; FY ending in December.

2011E 2012E 2013E

Net revenue 5,755 5,306 4,901 Operating Costs (4,514) (4,205) (3,885)G&A (566) (501) (440)Other Income / (Expense) (102) (100) (100)

Earnings from operations 573 500 476 Interest expense, net (8) (32) (31)Other, net 13 0 0

Earnings before income taxes 578 468 445 Income tax expense 206 171 165

Net earnings 372 297 280 Average basic shares 185 185 185 Average diluted shares 186 186 186 Basic earnings (loss) per common share: $2.01 $1.61 $1.51 Diluted earnings (loss) per common share: $2.00 $1.60 $1.50 Summary Balance Sheet & Cash Flow ItemsAssets 4,856 5,077 5,280 Liabilities 2,786 2,786 2,786 Shareholder's Equity 2,070 2,291 2,494 Cash flow from operations 505 283 298 Capex (93) (100) (100)Free Cash Flow 412 183 198 Net Debt 480 373 251 2011E Quarterly Data: Sales EBIT EPSQ1 1,344 114 0.44 Q2 1,485 121 0.42 Q3 1,529 156 0.54 Q4E 1,397 182 0.59 2011E 5,755 573 2.00


Fundamental Positives Strong core franchises in electric jammers, radios and night

vision goggles provide long-term value.

Attractive dividend yield.

Business and size could generate interest from defense primes.

Fundamental Risks Large pension overhang due to contribution from former parent.

Relatively large supplemental exposure.

Stock Price Performance

Source: Bloomberg

C4ISR49%

I&TS51%

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128



General Dynamics (GD)

Company Description

General Dynamics offers a broad portfolio of products and services in business aviation, combat vehicles, weapons systems and

munitions, military and commercial shipbuilding, and communications and information technology. General Dynamics operates in four

segments: Marine Systems, Combat Systems, Information Systems and Technology, and Aerospace.



Financial Model


2011E 2012E 2013E

Net Sales: Marine Systems $6,574 $6,643 $6,443 Combat Systems 8,939 8,531 7,473 IS&T 11,230 11,269 10,931 Aerospace 6,099 6,872 7,777 Other 0 0 0 Net sales 32,843 33,314 32,624 Operating costs and expenses 28,851 29,444 28,848 Operating earnings 3,992 3,870 3,776

Reconciliation to operating earnings Marine Systems 671 658 612 Combat Systems 1,276 1,075 897 Information Systems and Techn. 1,193 1,127 1,038 Aerospace 0 0 0 Other NA NA NA

Interest, net (142) (171) (117) Other income, net 34 0 0 Earnings before income taxes 3,884 3,699 3,660 Provision for income taxes 1,203 1,147 1,133 Net earnings 2,681 2,552 2,527 Adjustment for non-recurring items 0 0 0 Net earnings before non-recurring items 2,681 2,552 2,527

Earnings per share -- basic $7.37 $7.39 $7.60 Basic average shares outstanding 363.7 345.4 332.4

Earnings per share -- diluted $7.30 $7.30 $7.50 Diluted average shares outstanding 367.1 349.8 336.9


Cash from Operations 2,732 3,172 3,157 Capex (432) (455) (475)Free Cash Flow 2,301 2,717 2,682

Net Debt 2,132 1,264 407

2011E Quarterly Data: Sales EBIT EPSQ1 7,798 929 1.64Q2 7,879 949 1.79Q3 7,853 998 1.83Q4E 9,313 1,116 2.052011E 32,843 3,992 7.30


Fundamental Positives Gulfstream growth prospects, particularly the G650, should

offset weakness in the defense businesses.

Weakness in defense businesses appears to be well

appreciated

Fundamental Risks Ill-conceived acquisitions

Navy shipbuilding plan is materially reduced as part of budget

cuts


Source: Bloomberg

Marine Systems

20%

Combat Systems

27%

IS&T34%

Aerospace19%

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129



Goodrich (GR)

Company Description

Goodrich is one of the world’s largest aerospace suppliers. The company operates 3 separate divisions, including Actuation & Landing

Systems, Nacelle & Interior Systems, and Electronic Systems. Goodrich participates in both the original equipment and aftermarket end

markets, and serves customers in the commercial, military, and general aviation areas.

We are restricted on GR due to J.P. Morgan's involvement in the transaction announced on Sept 21, 2011 involving Goodrich Corp (GR)

and United Technologies (UTX).



Financial Model

$ in millions, except per share data; FY ending in December.

2011E 2012E 2013ENet Sales: Actuation & Landing Systems $2,933 $3,290 $3,514 Nacelle & Interior Systems 2,761 3,051 3,271 Electronic Systems 2,345 2,462 2,556 Net sales 8,039 8,803 9,340 Cost of sales 5,511 6,008 6,327 Selling and administrative costs 1,254 1,319 1,389 Merger-related costs 0 0 0 Operating costs and expenses 6,765 7,326 7,716 Operating earnings 1,274 1,477 1,624 Interest expense (140) (140) (140) Interest income 1 5 5 Other income (expense), net (43) (67) (67)Earnings before income taxes 1,092 1,276 1,423 Provision for income taxes (330) (382) (426) Distributions on Trust preferred sec. (8) (9) (10)Net income from continuing op. 754 885 987 Adjustment for non-recurring items 17 0 0 Net earnings before non-recurring 771 885 987 Earnings per share -- diluted $5.89 $6.90 $7.66 Summary Balance Sheet & Cash Flow ItemsAssets 10,330 10,774 11,297 Liabilities 6,414 6,365 6,317 Shareholder's Equity 3,916 4,373 4,945 Cash from Operations 927 1,161 1,242 Capex (298) (352) (346)Free Cash Flow 630 809 896 Net Debt 1,709 1,292 810 2011E Quarterly Data Sales EBIT EPS1Q $1,896 $300 $1.52 2Q $2,001 $303 $1.38 3QE $2,033 $352 $1.57 4QE $2,109 $319 $1.42



Source: Bloomberg

Actuation &

Landing Systems

37%

Nacelle & Interior Systems

34%

Electronic Systems

29%

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130



Harris Corporation (HRS)

Company Description

Harris Corporation is a global communications and information technology company focused on providing assured communications

products, systems and services for government and commercial customers. The company operates three principal segments: RF

Communications, Government Communications Systems, and Broadcast Communications.



Financial Model

$ in thousands, except per share data; FY ending in June

2011 2012E 2013E

RevenuesRF Communications 2,289,200 2,132,740 1,914,494 Government Communication 1,776,500 1,823,148 1,823,148 Microwave Communications 0 0 0 Broadcast Communications 1,985,800 2,292,773 2,407,412 Corporate Eliminations (126,900) (129,773) (122,901)

Total Revenues 5,924,600 6,118,888 6,022,153 Operating Costs and Expenses:

Cost of sales 3,810,500 4,136,492 4,160,704 Engineering & SG&A 1,143,900 1,083,348 1,040,176

Operating Income 970,200 899,048 821,273 Non-operating income (1,900) (200) (1,200)Interest income 2,800 4,054 7,735 Interest expense (90,400) (119,958) (134,871)

Income from Continuing Operations before Taxes 880,700 782,944 692,938 Income taxes 293,600 258,426 226,591 Net Income before Discont. Ops 588,000 525,018 466,347 Discontinued Operations 0 0 0 Net Income (Loss) 588,000 525,018 466,347 Impact of Convertible 0 0 0 Net Income Used in Diluted Share Calculation 588,000 525,018 466,347

Earnings (Loss) per common share:

EPS GAAP 4.60 4.55 4.15 EPS- Recurring 4.89 4.74 4.15

Summary Balance Sheet & Cash Flow ItemsAssets 6,172,800 6,340,974 6,544,062 Liabilities 3,660,800 3,962,000 3,962,000 Shareholder's Equity 2,512,000 2,378,974 2,582,062


Net Debt 1,700,300 1,742,426 1,559,338

2012 Quarterly Data: Sales EBIT EPS GAAPQ1 1,460,300 202,700 1.01Q2E 1,499,858 219,235 1.10Q3E 1,479,420 229,090 1.17Q4E 1,679,309 248,023 1.282012E 6,118,888 899,048 4.55


Fundamental Positives Elimination of GMR variant of JTRS program could create

demand for HRS’ tactical radios as an interim solution.

Impressive portfolio of technologies in government

communications business that can be leveraged into adjacent markets.

Fundamental Risks Sales of tactical radio expected to decline in coming years.

Profitability of Broadcast businesses has consistently

disappointed and should continue to do so, particularly in light of

weak macro environment.


Source: Bloomberg

RF Communications

34%

Government Communication

Systems29%

Broadcast Communications

37%

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131



L-3 Communications (LLL)

Company Description

L-3 provides C3ISR systems, aircraft modernization and maintenance, government services, and a broad range of electronic systems used

on military and commercial platforms. L-3 operates in four segments: C3ISR, Government Services, Aircraft Modernization and

Maintenance, and Electronic Systems.



Financial Model

$ in thousands, except per share data; FY ending in December

2011E 2012E 2013E

RevenuesC3ISR $3,604,792 $3,424,552 $3,219,079 Government Services 3,663,740 3,480,553 3,271,720 Aircraft Modernization & Maintenance 2,453,540 2,355,398 2,214,074 Specialized Products 5,597,260 5,261,424 4,893,125 Total Revenues 15,319,332 14,521,928 13,597,998 Operating costs and expenses 13,685,540 13,035,928 12,222,180 Operating income 1,633,792 1,486,000 1,375,819

Reconciliation to operating income by segmentC3ISR 407,585 369,852 338,003 Government Services 285,663 268,785 252,658 Aircraft Modernization & Maintenance 224,329 200,209 188,196 Specialized Products 716,215 647,155 596,961

Interest income 12,018 14,831 20,403 Interest expense (255,890) (247,560) (255,812) Minority interest (11,700) (10,400) (10,400)Earnings (loss) before income taxes 1,378,221 1,242,872 1,130,009 Income taxes (benefit) 448,361 431,125 396,292 Net earnings (loss) 929,860 811,746 733,717

Basic Shares Out. 104,930 97,740 89,635 Diluted Shares Out. 106,030 99,040 91,135

Earnings (loss) per common share: Basic $8.86 $8.31 $8.19 Fully diluted $8.75 $8.20 $8.05

Summary Balance Sheet & Cash Flow ItemsAssets 15,668,180 15,844,395 15,857,169 Liabilities 8,869,950 9,210,350 9,450,750 Shareholder's Equity 6,798,230 6,634,045 6,406,419

Cash from Operations 1,462,060 1,397,146 1,324,117 Capex (176,000) (240,000) (245,000)Free Cash Flow 1,286,060 1,157,146 1,079,117

Net Debt 3,287,070 3,105,855 2,988,081

2011E Quarterly Data: Sales EBIT EPS1Q 3,601,400 389,600 1.852Q 3,765,200 404,300 2.263Q 3,787,500 406,200 2.244QE 4,165,232 433,692 2.412011E 15,319,332 1,633,792 8.75


Fundamental Positives Engility spin-off a step in the right direction, but initial value-

creation looks fairly modest.

FCF should exceed net income consistently.

Fundamental Risks High exposure to supplementals relative to peers.

Remaining service business (post spin) still appears to face

significant headwinds.


Source: Bloomberg

C3ISR23%

Government Services

24%

Aircraft Modernization & Maintenance

16%

Specialized Products

37%

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132



Lockheed Martin (LMT)

Company Description

Lockheed Martin is the largest US defense contractor by revenue and is engaged in the research, design, development, manufacture,

integration, and sustainment of advanced technology systems and products as well as a provider of management, engineering, technical,

scientific, logistic, and information services. The company has four main operating segments: Electronics Systems, Space Systems,

Aeronautics, and Information Systems and Global Services.



Financial Model


2011E 2012E 2013E

Net Sales

Electronic Systems $14,505 $13,844 $13,039 Space Systems 8,257 7,799 7,267 Aeronautics 14,533 14,533 14,533 IS&GS 9,435 8,910 8,268 Net sales 46,730 45,086 43,107 Cost of sales 41,568 40,244 38,630 Earnings from operations 5,162 4,842 4,477

Reconciliation to earnings from operations by segment:Electronic Systems 1,740 1,634 1,500 Space Systems 988 897 778 Aeronautics 1,571 1,533 1,497 IS&GS 862 778 703 Other/Non-recurring 0 0 (0)

Other income and expenses, net (1,273) (1,180) (869)Earnings before interest and taxes 3,888 3,662 3,607 Interest expense 376 457 457 Earnings before income taxes 3,543 3,232 3,187 Income tax expense 959 968 956 Net earnings 2,584 2,264 2,231

Average basic shares 334.8 306.0 290.8 Average diluted shares 337.8 309.9 297.3

Basic earnings (loss) per share: $7.72 $7.40 $7.67Diluted earnings (loss) per common share: $7.65 $7.30 $7.50PAEPS $9.64 $9.40 $8.92

Summary Balance Sheet & Cash Flow ItemsAssets 35,749 34,789 33,830 Liabilities 33,244 33,244 33,244 Shareholder's Equity 2,504 1,544 586


Net Debt 2,711 3,329 4,063

2011E Quarterly Data: Sales EBIT EPSQ1 10,633 1,159 $1.55 Q2 11,551 1,342 $2.14 Q3 12,119 1,355 $1.99 Q4E 12,427 1,306 $1.98 2011E 46,730 5,162 $7.65


Fundamental Positives F-35 growth should drive long-term earnings growth, regardless

of budget outcome.

Increasing international opportunities should help offset

domestic weakness.

Industry leading dividend yield should provide price support.

Fundamental Risks F-35 program almost certainly faces cuts, and anything large

(e.g. an entire variant) could reduce growth expectations materially.

As the bellwether defense stock, Lockheed may suffer from concerns about overall defense spending.


Source: Bloomberg

Electronic Systems

31%

Space Systems

18%

Aeronautics31%

Information Systems &

Global Services

20%

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133



Northrop Grumman (NOC)

Company Description

Northrop Grumman participates in many defense and commercial technology programs in the US and abroad providing products, services

and solutions in the areas of aerospace, electronics and information and services. Northrop Grumman operates in four segments:

Aerospace Systems, Electronic Systems, Information Systems and Technical Services.



Financial Model


2011E 2012E 2013E

Net SalesInformation Systems $7,992 $7,592 $7,061 Aerospace Systems 10,566 10,038 9,536 Electronic Systems 7,414 7,192 6,904 Technical Services 2,692 2,611 2,533 Intersegment Eliminations (2,053) (1,920) (1,822)Net sales 26,611 25,513 24,211 Operating Costs (21,083) (20,481) (19,552) G&A (2,309) (2,276) (2,172)Earnings from operations 3,219 2,756 2,487

Reconciliation to earnings Information Systems 748 668 600 Aerospace Systems 1,251 1,124 1,001 Electronic Systems 1,072 971 884 Ships 395 379 360 Technical Services 214 196 187

Pension, corporate and other 1,752 1,405 1,243 Interest expense, net (220) (209) (211)Other income and expenses, net (8) 0 0 Earnings before income taxes 2,990 2,547 2,276 Income tax expense 998 866 773 Net earnings 1,992 1,681 1,503

Average basic shares 277.9 249.2 229.9 Average diluted shares 282.6 254.6 234.9

Basic earnings (loss) per share $7.17 $6.74 $6.54 Diluted earnings (loss) per share: $7.05 $6.60 $6.40 PAEPS $6.11 $6.04 $5.84



Net Debt 688 872 1,330

2011E Quarterly Data: Sales EBIT EPSQ1 6,734 811 $1.79Q2 6,560 841 $1.81Q3 6,612 825 $1.86Q4E 6,705 742 $1.712011E 26,611 3,219 $7.05


Fundamental Positives Spin-off of Shipbuilding business demonstrates management's

willingness to generate shareholder value through divestitures.

Relatively low supplemental exposure relative to peers.

Fundamental Risks Valuation suggests the company trades on GAAP EPS, which

implies the company may experience pressure as pension

income rolls off.

May face more margin pressure than peers.

Investor expectations for more aggressive restructuring may not be met.


Source: Bloomberg

Information Systems

23%

Aerospace Systems

31%

Electronic Systems

21%

Technical Services

7%

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Precision Castparts (PCP)

Company Description

Precision Castparts manufactures complex metal components and products for the aerospace, power generation, and general industrial

markets. The company operates three segments: Investment Cast Products, Forged Products, and Fastener Products.



Financial Model

$ in millions, except per share data; FY ending in March

2011 2012E 2013E

Net Sales:Investment Cast Products 2,096 2,370 2,635Forged Products 2,780 3,377 3,806Fastener Products 1,345 1,769 2,181Industrial Products 0 0 0

Net sales 6,220 7,517 8,622COGS 4,327 5,165 5,815SG&A 391 485 560Restructuring and impairment 0 0 0Other expense (income) 0 0 0EBIT 1,503 1,866 2,247Interest expense, net 9 8 (7)Income before taxes and minority interest 1,494 1,858 2,254Income tax expense 500 620 756Minority interest (1) (2) (2)Net income from continuing operations 1,009 1,254 1,525Net income from discontinued operations 4 1 0Net income (loss) 1,014 1,255 1,525

Average basic shares 142.7 144.4 145.8Average diluted shares 144.0 145.8 147.4

Net income per share (basic) $7.07 $8.69 $10.46Net income per share (diluted) $7.01 $8.60 $10.35

Summary Balance Sheet & Cash Flow ItemsAssets 8,956 10,295 11,778Liabilities 1,791 1,838 1,814Shareholder's Equity 7,165 8,457 9,964

Cash from Operations 1,038 1,108 1,633Capex (120) (151) (180)Free Cash Flow 918 956 1,453

Net Debt (922) (592) (2,027)

FY12E Quarterly Data: Sales EBIT EPSQ1 1,675 420 1.97Q2 1,790 437 2.03Q3E 1,978 489 2.23Q4E 2,073 521 2.372012E 7,517 1,866 8.60


Fundamental Positives Aero sales are rebounding and this should intensify in FY12

aided by rate increases, and 787 production.

787 will contribute to earnings growth at PCP right away, unlike

at several other companies.

Move into drill pipe for oil and gas wells is a new earnings

driver.

Acquisition strategy should continue generating value for

shareholders.

Fundamental Risks Margins improved through much of the downturn and remain

high, so long-term expansion potential is likely limited.

Margin dynamics are opaque, especially in Forged Products, though transparency is improving.

Will likely be difficult to exceed expectation without M&A.


Source: Bloomberg

Investment Cast

Products31%

Forged Products

45%

Fastener Products

24%

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Raytheon (RTN)

Company DescriptionRaytheon serves defense, homeland security and other government markets by providing electronics, mission systems integration and other capabilities in the areas of sensing, effects, C3I, and mission support services. Raytheon operates in six segments: Integrated Defense Systems, Intelligence & Information Systems, Missile Systems, Network Centric Systems, Space & Airborne Systems, and Technical Services.



Financial Model $ in millions, except per share data; FY ending in December

2011E 2012E 2013E

Net SalesIntegrated Defense Systems $4,984 $5,083 $5,033 Intelligence & Information Systems 3,115 3,084 2,960 Missile Systems 5,736 5,736 5,621 Network Centric Systems 4,670 4,483 4,259 Space & Airborne Systems 5,200 5,148 4,994 Technical Services 3,412 3,309 3,144 Other 0 0 0 Intercompany sales (1,876) (1,965) (1,899)Net sales 25,240 24,878 24,111 Costs and Expenses: Cost of sales 19,836 19,681 19,085 SGA + R&D 2,349 2,187 2,121 FAS/CAS Income Adjustment 338 330 130 Operating income 2,717 2,681 2,776

Reconciliation to operating income Integrated Defense Systems 808 824 815 Intelligence & Information Systems 155 226 217 Missile Systems 665 631 607 Network Centric Systems 669 605 575 Space & Airborne Systems 683 695 674 Technical Services 296 265 252

Interest expense 171 173 173 Other income, net 20 20 20 Non-operating expense (income), net 171 141 146 Income before taxes 2,546 2,540 2,631 Federal and foreign income taxes 723 770 805 Net income 1,823 1,771 1,826

Average basic shares 351 325 301 Average diluted shares 354 330 305 Basic earnings (loss) per common share: $5.09 $5.33 $5.93 Diluted earnings (loss) per common share: $5.05 $5.25 $5.85 PAEPS $5.74 $5.95 $6.15

Summary Balance Sheet & Cash Flow ItemsAssets 24,054 23,866 23,761 Liabilities 13,713 13,713 13,763 Shareholder's Equity 10,340 10,152 9,997 Cash from Operations 2,234 2,347 2,357 Capex (500) (440) (465)Free Cash Flow 1,734 1,907 1,892 Net Debt 587 638 728

2011 Quarterly Data: Sales EBIT EPSQ1 6,062 591 $1.22 Q2 6,222 681 $1.23 Q3 6,132 725 $1.26 Q4E 6,824 720 $1.35 2011E 25,240 2,717 $5.05


Fundamental Positives Better organic growth outlook than peers as a result of having

the largest proportion of international sales.

Pension contributions could provide upside to earnings estimates.

RTN has a strong track record of M&A success and is likely to continue to make selective acquisitions.

Fundamental Risks International awards hard to predict and can often face delays,

therefore driving more earnings variability.

International sales not enough to fully offset domestic

headwinds.


Source: Bloomberg

Integrated Defense Systems

18%

Intelligence &

Information Systems

12%

Missile Systems

21%

NCS 13%

Space & Airborne Systems

19%

Technical Services

13%

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Rockwell Collins (COL)

Company Description

Rockwell Collins was spun off from its former parent, Rockwell International, in 2001, and is a leading supplier of aviation electronics and

communications equipment to commercial and military customers. The company maintains two operating segments: Commercial and

Government.



. Financial Model

$ in millions, except per share data; FY ending in September

2011 2012E 2013E

Net SalesCommercial Systems $2,006 $2,231 $2,476Government Systems 2,813 2,728 2,717Net sales 4,819 4,959 5,194Cost of sales 3,427 3,453 3,584Gross margin 1,392 1,506 1,609Selling, general and administrative 515 519 539Losses (earnings) from affiliates 0 0 0Other (income) 0 0 0Operating expenses 515 519 539Operating income 877 987 1,071Interest (expense) income (19) (22) (23)Interest and dividend income 0 0 0Income before taxes 858 965 1,048Income taxes 242 288 325Net income 616 677 723Diluted earnings (loss) per common share: $3.94 $4.50 $5.10


Cash from Operations 657 676 849Capex (152) (150) (161)Free Cash Flow 505 526 689

Net Debt (2) 221 324

2012E Quarterly Data Sales EBIT EPS1QE $1,090 $199 $0.842QE 1,178 218 $0.993QE 1,294 274 $1.274QE 1,397 297 $1.40


Fundamental Positives COL’s commercial aero sales should grow faster than peers.

Bizjet OE growth should be relatively strong thanks to new

platforms and an eventual recovery in demand.

High incremental margins in Commercial should enable COL to

lever expected sales growth into even stronger earnings growth.

Fundamental Risks New business jet demand could remain weak near term.

Collins’ Government sales could disappoint in a challenging

defense spending environment.

Collin’s industry-leading defense margins could gradually face

pressure due to mix shift, particularly if congressional scrutiny of defense procurement reduces the use of commercial-type

contracts.


Source: Bloomberg

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SAIC (SAI)

Company Description

SAIC provides scientific, engineering, systems integration and technical services and solutions to the US and foreign governments and

select commercial customers. SAIC’s operations focus on national security, energy and the environment, critical infrastructure and health.

2011 Revenue Breakdown by Segment


Financial Model

$ in millions, except per share data; FY ending in January

2011 2012E 2013E

Net revenue 11,117 10,796 10,693 Cost of sales 9,632 9,467 9,329 SG&A 527 691 508 Goodwill Impairment 0 0 0 Gain on sales of business units, net 0 0 0Earnings from operations 958 638 855Interest income 2 4 8Interest expense (79) (113) (111)Other income, net 2 3 0Minority interest in income of consolidated subsidiaries 0 0 0Earnings before income taxes 883 532 752Income tax expense 314 262 282Net earnings from continuing operations 569 270 470

Average basic shares 364 335 313Average diluted shares 366 336 315

Basic earnings (loss) per common share: $1.56 $0.81 $1.50Diluted earnings (loss) per common share: $1.51 $0.78 $1.44


Cash from continuing operations 737 804 532Capex (74) (70) (88)Free Cash Flow 663 734 444

Net Debt 485 319 291

2012E Quarterly Data: Sales EBIT EPSQ1 2,688 230 0.36Q2 2,596 209 0.32Q3 2,811 (17) (0.27)Q4E 2,701 216 0.362012E 10,796 638 0.78


Fundamental Positives Investing in relatively high growth markets including C4ISR,

logistics, cyber security, energy, and health IT.

High margin cargo detection business could drive earnings

growth over time.

Fundamental Risks Defense services face pressure from declining base and

supplemental funding.

Recent management turnover drives uncertainty.


Source: Bloomberg

Govt97%

Commercial3%

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Spirit Aerosystems (SPR)

Company Description

Spirit AeroSystems produces aerostructures for commercial, business, and military aircraft. The company operates in three main

segments: Fuselage Systems, Propulsion Systems, and Wing Systems. Spirit was created in 2005 through the carveout of Boeing's

Wichita and Tulsa facilities and their sale to Onex, a private equity investment firm.



Financial Model


2011E 2012E 2013E

Net Sales:

Fuselage Systems 2,398 2,490 2,869

Propulsion Systems 1,219 1,418 1,622

Wing Systems 1,156 1,151 1,359

Other 10 0 0

Net sales 4,783 5,060 5,850

Cost of sales 4,213 4,326 5,030

Selling and administrative costs 155 150 156

R&D 35 33 32

Operating costs and expenses 4,403 4,509 5,218

Operating income (loss) 380 550 632

Interest, net (80) (75) (71)

Other income, net 0 0 0

Earnings before income taxes 300 475 561

Income tax expense (93) (145) (176) One-time items 207 330 385

Adjustment for non-recurring items (1) 0 0 Net earnings before non-recurring items 207 330 385

Earnings per share -- diluted 1.45 2.30 2.65

Summary Balance Sheet & Cash Flow Items

Assets 5,065 5,350 5,515

Liabilities 3,036 2,990 2,770

Shareholder's Equity 2,029 2,360 2,745

Cash from Operations (18) 305 430

Capex (250) (250) (250)

Free Cash Flow (268) 55 180

Net Debt 854 966 849

2011E Quaterly Data Sales EBIT EPS

Q1 $1,050 $70 $0.24

Q2 1,466 64 $0.21

Q3 1,130 121 $0.47 Q4E 1,138 126 $0.52

2011E 4,783 380 $1.45


Fundamental Positives Production rates for 737, which provide ~60% of earnings, are

heading significantly upward and may move higher.

Margin performance could be better than expected.

Boeing re-engining decision should help SPR retain its narrowbody positioning.

Fundamental Risks Cash conversion should remain an issue.

Simulations work on several development programs could result

in higher than expected costs.

Smaller aftermarket and defense exposure than other suppliers

increases cyclicality.

10 Year Stock Price Performance

Source: Bloomberg

Fuselage Systems

50%

Propulsion Systems

26%

Wing Systems

24%Other0%

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TransDigm (TDG)

Company Description

Transdigm Group manufactures aircraft components including ignition systems and components, gear pumps,

mechanical/electromechanical actuators and controls, NiCad batteries/chargers, power conditioning devices, hold-open rods and locking

devices, engineered connectors and latches, cockpit security devices, and AC/DC electric motors. The company’s products are found on a

wide range of commercial, military and general aviation platforms and it is active on both the original equipment and aftermarket fronts.



Financial Model

$ in millions, except per share data; FY ending in September

2011 2012E 2013E

Net Revenue 1,219,553 1,504,349 1,627,107 Sales Growth 47.4% 23.4% 8.2% Cost of Sales 557,100 658,434 682,145Gross Profit 662,453 845,915 944,963 Gross Margin 54.3% 56.2% 58.1%Operating Expenses: Selling, general and administrative expenses 134,840 151,190 167,592 Amortization of Intangibles 40,577 40,500 32,000 Other Operating Exp. 72,454 0 0Income from Operations 414,582 654,224 745,371 Operating Margin 34.0% 43.5% 45.8%Interest expense (net) 185,254 186,394 164,902Earnings before income taxes 229,328 467,830 580,469Income tax expense 77,321 163,741 203,164Net earnings 152,007 304,090 377,305Dividend to participating securities (Vested Stock Options) 2,810 3,000 3,200Net earnings for common stockholders 149,197 301,090 374,105

Average basic shares 49,891 50,600 51,144Average diluted shares 53,332 54,000 54,794

Basic earnings (loss) per common share: 3.37 5.95 7.31Diluted earnings (loss) per common share: 3.17 5.58 6.83

Summary Balance Sheet & Cash Flow ItemsAssets 4,513,636 4,533,644 4,574,434 Liabilities 3,702,687 3,397,606 3,038,291 Shareholder's Equity 810,949 1,136,039 1,536,143


Net Debt 2,762,192 2,519,125 2,131,277

FY12E Quarterly Data: Sales EBIT EPSQ1E 350,550 143,460 $1.10Q2E 372,291 155,061 $1.30Q3E 387,984 173,140 $1.53Q4E 393,523 182,563 $1.652012E 1,504,349 654,224 $5.58


Fundamental Positives Management is highly focused on generating returns for

shareholders and has an appealing strategy to advance the achievement of this goal.

TDG offers the most exposure to the commercial aero aftermarket and should benefit from the recovery in this end

market.

Acquisition should help drive earnings growth.

Fundamental Risks It could become more difficult to drive margin expansion over

time.

Supplementing organic growth through acquisitions will become

increasingly difficult as TDG grows larger.

The company’s use of financial leverage to enhance equity

returns should become less viable in a higher interest rate environment.

10 Year Stock Price Performance

Source: Bloomberg

Actuators/Controls

15%

Ignition

14%

Gear Pumps

8%

Pow er

Conditioning

7%

Other

44%

Specialized

Valv es

12%

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United Technologies (UTX)

Company Description

United Technologies is a global provider of high technology products and services to the building systems and aerospace industries. Its

operations are classified into five principal segments: Otis, Climate, Controls & Security, Pratt & Whitney, Sikorsky, and Hamilton

Sundstrand.

We are restricted on UTX due to J.P. Morgan's involvement in the transaction announced on Sept 21, 2011 involving Goodrich Corp (GR)

and United Technologies (UTX).



Financial Model


2011E 2012E 2013ERevenuesOtis $12,507 $12,997 $13,907 Carrier 12,282 13,029 13,941 Fire & Security 6,885 7,231 7,737 Pratt & Whitney 13,258 13,490 16,053 Sikorsky 7,205 7,566 7,868 Hamilton Sundstrand 6,075 11,097 16,429 Flight Systems 0 0 0 Eliminations (2) 0 0 Total Revenues 58,210 65,410 75,935 Cost of goods and services sold 42,058 47,224 53,923 Research and development 2,016 2,260 2,624 Selling, general and administrative 6,362 6,972 8,094 Earnings (loss) before interest and income taxes 7,774 8,953 11,294 Interest 568 848 1,096 Income before income taxes and minority interests 7,805 8,305 10,398 Income taxes 2,404 2,550 3,192 Minority Interests 406 432 541 Net Income 4,995 5,324 6,665

Earnings per share - diluted $5.50 $5.75 $7.00

Summary Balance Sheet and Cash Flow ItemsAssets 62,936 85,448 89,322 Liabilities 39,419 56,450 56,689 Shareholder's Equity 23,517 28,999 32,632

Cash from Operations 6,636 6,776 8,267 Capex (975) (1,372) (1,413)Free Cash Flow 5,661 5,404 6,854

Net Debt 4,124 16,563 12,740

2011E Quarterly Data Sales EBIT EPSQ1 $13,344 $1,779 $1.11 Q2 $15,076 $2,220 $1.45 Q3 $14,804 $2,202 $1.47 Q4E $14,986 $2,173 $1.48 2011E $58,210 $8,374 $5.50



Source: Bloomberg.

Otis22%

Carrier21%

Fire & Security

12%

Pratt & Whitney

23%

Sikorsky12%

Hamilton Sundstrand

10%

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Wesco Aircraft Holdings (WAIR)

Company Description

Wesco Aircraft Holdings, Inc. provides supply chain management services to the global aerospace industry. The company also provides

hardware, bearings, tools, electronics components, and machined parts. Wesco’s services include just-in-time delivery, long-term

agreements, management of supplier relationships, inventory management, quality assurance, and kitting.

2011 Revenue Breakdown by Segment


Financial Model

$ in thousands, except per share data; FY ending in September

2011 2012E 2013E

Total Revenues $710,910 $771,957 $865,666 Cost of goods and services sold 435,491 481,169 539,661 Selling, general and administrative 113,785 109,725 116,865 Earnings (loss) before interest and income taxes 161,634 181,063 209,140 Interest Income (expense), net (34,492) (24,448) (18,983)Other Income (expense), net 1,005 Earnings before income taxes 128,147 156,614 190,157 Income taxes 52,526 61,863 75,112 Income from continuing operations 75,621 94,752 115,045 Discontinued operations 0 0 0Net income 75,621 94,752 115,045

Average basic shares 90,696 92,603 93,843 Average diluted shares 93,168 95,803 97,343

Earnings per share Basic earnings (loss) per common share: 0.83 1.02 1.23 Diluted earnings (loss) per common share: 0.81 0.99 1.18

Earnings per share - adjustedBasic earnings (loss) per common share: 0.98 1.07 1.27 Diluted earnings (loss) per common share: 0.96 1.04 1.23

Summary Balance Sheet and Cash Flow itemsAssets 1,322,445 1,380,915 1,406,430 Liabilities 682,747 640,054 514,703 Shareholder's Equity 627,548 728,712 879,577

Cash from Operations $106,192 $41,719 $104,253 Capex ($5,119) ($6,948) ($5,194)Free Cash Flow $101,073 $34,772 $99,059

Net Debt $493,290 $450,138 $315,760

2012E Quarterly Data Sales EBIT Adj. EPSQ1E $177,009 $40,765 $0.23 Q2E $186,591 $43,345 $0.25 Q3E $198,014 $46,533 $0.27 Q4E $210,343 $50,419 $0.29 2012E $771,957 $181,063 $1.04


Fundamental Positives Commercial aerospace sales poised for high visibility growth on

rising rates.

Sales have grown faster than deliveries due to share gains; this

should continue.

Rising production rates could drive profitable ad hoc sales.

Aftermarket presence is minimal, offering upside potential longer term.

Fundamental Risks Defense budget pressure is a source of top line risk.

Boeing has made efforts to bypass distributors, though we see

WAIR exposure as limited.

Increasing reliance on ad hoc sales generates incremental risk.

Stock Price Performance

Source: Bloomberg

Military 53%

Comm'l 47%

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Analyst Certification: The research analyst(s) denoted by an “AC” on the cover of this report certifies (or, where multiple research analysts are primarily responsible for this report, the research analyst denoted by an “AC” on the cover or within the document individually certifies, with respect to each security or issuer that the research analyst covers in this research) that: (1) all of the views expressed in this report accurately reflect his or her personal views about any and all of the subject securities or issuers; and (2) no part of any of the research analyst's compensation was, is, or will be directly or indirectly related to the specific recommendations or views expressed by the research analyst(s) in this report.

Important Disclosures

Company-Specific Disclosures: Important disclosures, including price charts, are available for compendium reports and all J.P. Morgan–covered companies by visiting https://mm.jpmorgan.com/disclosures/company, calling 1-800-477-0406, or emailing [email protected] with your request.

Explanation of Equity Research Ratings and Analyst(s) Coverage Universe: J.P. Morgan uses the following rating system: Overweight [Over the next six to twelve months, we expect this stock will outperform the average total return of the stocks in the analyst's (or the analyst's team's) coverage universe.] Neutral [Over the next six to twelve months, we expect this stock will perform in line with the average total return of the stocks in the analyst's (or the analyst's team's) coverage universe.] Underweight [Over the next six to twelve months, we expect this stock will underperform the average total return of the stocks in the analyst's (or the analyst's team's) coverage universe.] In our Asia (ex-Australia) and UK small- and mid-cap equity research, each stock’s expected total return is compared to the expected total return of a benchmark country market index, not to those analysts’ coverage universe. If it does not appear in the Important Disclosures section of this report, the certifying analyst’s coverage universe can be found on J.P. Morgan’s research website, www.morganmarkets.com.

Coverage Universe: Nadol, Joseph B: Alliant Techsystems Inc. (ATK), Boeing Company (BA), Bombardier (BBDb.TO), CACI International Inc (CACI), Comtech Telecommunications (CMTL), Embraer SA (ERJ), Exelis Inc. (XLS), General Dynamics Corp. (GD),Goodrich (GR), Harris Corporation (HRS), L-3 Communications (LLL), Lockheed Martin (LMT), Northrop Grumman (NOC), Precision Castparts (PCP), Raytheon (RTN), Rockwell Collins (COL), SAIC (SAI), Spirit AeroSystems (SPR), TransDigm Group Inc (TDG), United Technologies (UTX), Wesco Aircraft Holdings, Inc. (WAIR)

J.P. Morgan Equity Research Ratings Distribution, as of September 30, 2011

Overweight(buy)

Neutral(hold)

Underweight(sell)

J.P. Morgan Global Equity Research Coverage 47% 42% 12%IB clients* 52% 45% 36%

JPMS Equity Research Coverage 45% 47% 8%IB clients* 72% 62% 58%

*Percentage of investment banking clients in each rating category.For purposes only of FINRA/NYSE ratings distribution rules, our Overweight rating falls into a buy rating category; our Neutral rating falls into a hold rating category; and our Underweight rating falls into a sell rating category.

Equity Valuation and Risks: For valuation methodology and risks associated with covered companies or price targets for covered companies, please see the most recent company-specific research report at http://www.morganmarkets.com , contact the primary analyst or your J.P. Morgan representative, or email [email protected].

Equity Analysts' Compensation: The equity research analysts responsible for the preparation of this report receive compensation based upon various factors, including the quality and accuracy of research, client feedback, competitive factors, and overall firm revenues, which include revenues from, among other business units, Institutional Equities and Investment Banking.

Registration of non-US Analysts: Unless otherwise noted, the non-US analysts listed on the front of this report are employees of non-US affiliates of JPMS, are not registered/qualified as research analysts under NASD/NYSE rules, may not be associated persons of JPMS, and may not be subject to FINRA Rule 2711 and NYSE Rule 472 restrictions on communications with covered companies, public appearances, and trading securities held by a research analyst account.

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In the case of share trading, JPMorgan Securities Japan Co., Ltd., will be receiving a brokerage fee and consumption tax (shouhizei) calculated by multiplying the executed price by the commission rate which was individually agreed between JPMorgan Securities Japan Co., Ltd., and the customer in advance. Financial Instruments Firms: JPMorgan Securities Japan Co., Ltd., Kanto Local Finance Bureau (kinsho) No. 82 Participating Association / Japan Securities Dealers Association, The Financial Futures Association of Japan, Type II Financial Instruments Firms Association and Japan Securities Investment Advisers Association. Korea: This report may have been edited or contributed to from time to time by affiliates of J.P. Morgan Securities (Far East) Ltd, Seoul Branch. 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To the extent that the information contained herein references securities of an issuer incorporated, formed or created under the laws of Canada or a province or territory of Canada, any trades in such securities must be conducted through a dealer registered in Canada. No securities commission or similar regulatory authority in Canada has reviewed or in any way passed judgment upon these materials, the information contained herein

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or the merits of the securities described herein, and any representation to the contrary is an offence. Dubai: This report has been issued to persons regarded as professional clients as defined under the DFSA rules.

General: Additional information is available upon request. Information has been obtained from sources believed to be reliable but JPMorgan Chase & Co. or its affiliates and/or subsidiaries (collectively J.P. Morgan) do not warrant its completeness or accuracy except with respect to any disclosures relative to JPMS and/or its affiliates and the analyst's involvement with the issuer that is the subject of the research. All pricing is as of the close of market for the securities discussed, unless otherwise stated. Opinions and estimates constitute our judgment as of the date of this material and are subject to change without notice. Past performance is not indicative of future results. This material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. The opinions and recommendations herein do not take into account individual client circumstances, objectives, or needs and are not intended as recommendations of particular securities, financial instruments or strategies to particular clients. The recipient of this report must make its own independent decisions regarding any securities or financial instruments mentioned herein. JPMS distributes in the U.S. research published by non-U.S. affiliates and accepts responsibility for its contents. Periodic updates may be provided on companies/industries based on company specific developments or announcements, market conditions or any other publicly available information. Clients should contact analysts and execute transactions through a J.P. Morgan subsidiary or affiliate in their home jurisdiction unless governing law permits otherwise.

"Other Disclosures" last revised September 30, 2011.

Copyright 2011 JPMorgan Chase & Co. All rights reserved. This report or any portion hereof may not be reprinted, sold or redistributed without the written consent of J.P. Morgan. #$J&098$#*P

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