Fitch Ratings expects continued improvement in the North American aerospace and defense industry's credit quality in 2005, building on the industry's improved financial performance in 2004. After several years during which defense revenue growth offset declining or stagnant commercial aerospace revenues, both defense and commercial aerospace volumes should rise in 2005.

With overall top line performance less of a concern than in previous years, the main drivers of credit quality changes will likely be company-specific factors such as cash deployment, operating margins, competitive position and strategy, litigation, and acquisitions. Cash deployment will remain a key credit issue in 2005 given the industry's substantial liquidity. Fitch estimates that operating margins should rise despite higher material costs. Acquisition risk should be relatively low for the industry's larger players, but it is a more significant concern for lower tier companies. For the larger players, divestitures could be a significant source of cash as noncore assets are sold. Risks to watch include exogenous shocks to the commercial aerospace sector and program cuts in the U.S. Department of Defense (DoD) budget.

It appears that late 2003 was the trough of the global commercial aerospace downturn, and parts of the commercial aerospace industry recovered in 2004 (i.e. the aftermarket) while other parts stabilized (i.e. commercial aircraft deliveries). Fitch expects the recovery to continue in 2005, driven by global economic growth, primarily outside North America. Fitch revised the Rating Outlooks of several commercial aerospace companies during 2004 to Stable from Negative, in line with the improving state of the industry. While credit quality in the industry should improve in 2005, Fitch does not believe that the improvement will be substantial enough to warrant rating upgrades. Operating margin performance or cash deployment could alter this opinion.

Although the commercial aerospace environment has improved, the recovery rests on a fragile foundation, given the industry's vulnerability to event risk (i.e. terrorist attacks, the Middle East situation, fuel prices, and economic growth, among others). In addition, many mainline carriers remain weak, including United Airlines, US Airways, and Delta Air Lines. Fitch's estimates for the commercial aerospace industry do not assume a liquidation of a major carrier in 2005, but the probability of a liquidation is too high to ignore. Liquidations or the other issues listed above could alter Fitch's outlook for some parts of the commercial aerospace industry in 2005.

On a segment basis, Fitch expects the commercial aerospace recovery to broaden to all segments of the industry except the regional aircraft segment, as detailed in the following paragraphs:

-- Based on current production plans, large commercial aircraft (LCA) deliveries from Boeing and Airbus should rise 10%-12% in 2005 from approximately 600 aircraft in 2004, which is up slightly compared with 2003. The growth will come primarily from narrow-body deliveries, and there should not be the negative delivery mix that was seen in 2004, although the pricing environment remains unclear.

-- Fitch believes the business jet segment could be the strongest segment in the commercial aerospace industry in 2005, with deliveries up 15%-20%, firmer pricing, and an improved used aircraft situation. Business jet delivery growth is being driven by healthy corporate profitability, the jet card market, and the extension of the bonus depreciation tax law in the U.S.

-- The high margin commercial aftermarket should continue to grow in 2005 as global airline traffic increases at mid-single digit rates. However, Fitch expects the aftermarket growth to be more moderate than in 2004, when the industry faced easy comparisons with 2003 (SARS and Iraq, among others) and benefited from mandatory upgrades.

-- The regional aircraft segment will be the industry's weakest segment in 2005, and it also has the most uncertain outlook given the troubles at the mainline carriers in the U.S. and weak order visibility. Overall regional aircraft deliveries should be down 10% in 2005 as a substantial decline in small regional jets offsets a mix shift to larger regional jets (more than 70 seats) and higher turboprop deliveries. Fitch believes that additional downward adjustments in regional jet production rates are possible in 2005.

U.S. defense spending has risen substantially in the past several years, boosting the credit quality of defense contractors. Although Fitch believes that the strongest growth is in the past, absolute spending levels are high and are not expected to decline in the next several years. Fitch believes that the DoD budget will continue to rise in the next few years but at a decelerating rate. Fitch revised the Rating Outlooks of several major defense contractors to Positive in 2004, and upgrades are possible in 2005 depending on financial performance and cash deployment.

While Fitch considers the size of the U.S. defense budget to be a positive for defense industry credit quality, there are program risks within the budget as the DoD evaluates spending priorities in the context of 'transformation,' the Comanche cancellation being the most recent example. In addition, the fiscal 2006 budget process will likely include a more detailed review of programs and priorities due to the new two-year budget cycle and as a result of the Quadrennial Defense Review, which should be in progress next year. All of these factors increase the risk of DoD program modifications, with reductions or delays probably more likely than cancellations. If program changes occur, defense contractors with diversified program portfolios should be able to survive without a material impact on credit ratings, but smaller, less diversified companies could see negative rating actions.

Cash deployment will be a key factor in aerospace and defense credit quality developments in 2005 because of the industry's substantial liquidity. Fitch estimates that the top dozen aerospace and defense companies in North America (excluding finance subsidiaries) could have approximately $13 billion of cash on hand at the end of 2004 and could generate an equivalent amount of free cash flow in 2005. Cash resources could be augmented by divestitures. Cash deployment has clearly shifted toward shareholders in the past two years, but debt reduction has still been substantial. Fitch expects that companies in the industry will continue to pursue balanced cash deployment strategies that include debt reduction but at a slower pace than in the past several years. Fitch estimates that debt was reduced in the industry by more than $4 billion in 2004, and about $2 billion more could be reduced in 2005. Discretionary pension contributions will likely continue to be a significant use of cash in 2005, and share repurchases and dividends will rise in 2005.

Aerospace and defense margins should improve in 2005 because of higher commercial volumes, particularly in relatively high margin segments like the aftermarket and business jets. Productivity improvement efforts in the past several years (headcount reductions, facility closures, the transfer of operations to low cost countries, and Six Sigma, among others) should also help margins. In the defense industry, some large programs are transitioning from development to production, which should lead to higher margins as long as the companies control costs. These factors should overcome higher material costs, pricing pressures in a few commercial segments, and higher development costs related to several new commercial programs.

A more detailed report on the 2005 aerospace and defense industry outlook will be available on the Fitch Ratings web site in mid-December.