merrill lynch combat fighter aircraft outlook

8/3/2019 Merrill Lynch Combat Fighter Aircraft Outlook

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Global

Aerospace

23 February 2000

Byron K. Callan Global Coordinator(1) 212 449-1394

Andrew Clifton: (44) 171 772-2539

David Ainsworth: (1) 212 449-1312Suzanne Kecmer: (1) 212 449-6725

Pete Deighton Marketing Analyst(44) 171 772-1890

Com bat Fight er A i rc ra f t Out look

Replacement Needs, Exports Drive Upturn

Highlights: Fighter aircraft production to increaseFor now, a balance between U.S. and Europe

Global Securities Research & Economics GroupGlobal Fundamental Equity Research Department

Copyright 2000 Merrill Lynch, Pierce, Fenner & Smith Inc.

#5434

RC#60205505


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Combat Fighter Aircraft Outlook 23 February 2000

2

Executive Summary:

Fundamentally IntactCompared to our 1999 review of the outlook for combatfighter aircraft, our 2000 review shows some slippage indeliveries of major types in 2000-02 because of the timingof recent awards. Furthermore, we stopped projectingdeliveries for the Boeing F-15, subsequent to unsuccessfulcompetitions for Greece and Israel in 1999.

However, our core view on this sector of the aerospace anddefense market is fundamentally intact:

Replacement of older aircraft purchased in the 1970sand 1980s underpins production rate increases from2001 through 2005, and probably through 2010.

The current generation of multi-role combat fighteraircraft is much more capable than ones they replace.Introduction of these new aircraft could prompt

additional purchases in regions where military tensionsremain high.

Military aircraft programs are important to firms wefollow, with BAE SYSTEMS, Boeing and NorthropGrumman deriving the highest percentage of salesfrom this activity. For 2000, we estimate that none ofthe companies we follow will derive more than 25% ofits sales from advanced fighter aircraft production.

What Was New in 1999

Last years report looked at the motif of transition andcontinuity. In hindsight, there was more transition than

there was continuity:

Production of the Boeing F-15 will probably end in2000.

The outlook for the Lockheed Martin F-16 wasenhanced with wins in Greece and Israel.

Aerospatiale Matra and Daimler Chrysler announced amerger, to form EADS.

The U.S. Congress moved to cut funding for theLockheed Martin/Boeing F-22 fighter. For manyinvestors, this raised a debate that has been underwayfor quite some time in Washington over the

affordability of tactical fighter aircraft programs.

An air war that NATO fought against Yugoslavia wasinitially heralded as the triumph of air power.However, more recent assessments suggest that airpower still has a way to go in delivering its ownmilitary victories.

What to Watch for in 2000

For 2000, the most important issues in the tactical combataircraft market include the integration of EADS and of BAESYSTEMS, the status of the Joint Strike Fighter program

and the outcome of several international campaigns.

The integration of the two major European defensesuppliers will be closely watched because of issues thatbedeviled U.S. majors in 1998 (Boeing) and 1999(Raytheon and Lockheed Martin). A related issue is howmilitary aircraft production is sorted out, particularly

Eurofighter. EADS brings Mirage 2000, Rafale andEurofighter under one corporations control.

Prototypes of the Joint Strike Fighter should be flying thisyear and a decision on the program is expected in March2001. This is the largest military aircraft program ever andan important issue for investors is whether the DoD stickswith its original plan for a winner-take-all contract awardor if the DoD modifies its acquisition strategy. Theacquisition strategy could be altered to ensure that the loserin JSF survives and so that there is more competition in themilitary aircraft market.

Key campaigns to watch include a contract from the UAE

for F-16 fighters and a small, but politically important,campaign in Norway that pits the F-16 against theEurofighter. The UAE contract is important to get theBlock 60 version of the F-16 underway.

Finally, the outcome of the U.K. BVRAAM/Meteor missileshould be watched because of its implications forEurofighter. One advantage the U.S. has had ininternational campaigns has been the ability to offerfighters with AMRAAM (Advanced Medium Range Air-to-Air Missile). Equipping Eurofighter with an improvedmedium range air-to-air missile could make it a morepotent competitor in the 2008 and beyond time periodwhen the missile is in production.

A Better Balance

For the next five years, Europes combat aircraft offeringsshould be fairly balanced with those of the U.S. The U.S. F-22 is too expensive for many nations, although it couldeventually be bought by the handful of countries thatpurchased the F-15 (Israel, Japan, and Saudi Arabia). Wehave not seen the F/A-18E/F come up in many major exportcampaigns. This leaves that F-16 as the major contender ofU.S. aircraft designs that are now in production.

In contrast to prior decades, Europe has a broader array of

offerings. An agreement reached in 1995 for BAESYSTEMS to market the Gripen opens this aircraft to awider set of customers. Europe is also offering the Mirage2000, Rafale and Eurofighter.

Joint Strike Fighter could have a very powerful impact onthe market, beginning in 2003-05. But this will depend onits costs and whether it is adhering to a schedule for designand production. Europe now has no direct answer to JSF,although BAE SYSTEMS is a partner on the LockheedMartin team.


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3

Forecast Shows TroughDeliveries in 2000-01

We estimate that total deliveries of U.S.-built multi-rolecombat aircraft could trough in 2001 at 64 aircraft. Thistrough occurs because of our assumption that F-15

production ends and because of a further decline in F-16production. However, we estimate that deliveries rise backto 160-170 aircraft in 2004-05 on F-16 exports and ramp-ups on domestic purchases of F-22s and F/A-18E/Fs.

For Europe, we estimate that deliveries will hover atapproximately 30 aircraft in 2000-01, but that they shouldclimb to over 100 aircraft by 2004, mainly because ofproduction of the Eurofighter.

Investment Implications

The conclusions of this report are in accord with ourinvestment stances and earnings estimates for firms wefollow. The need to replace aging military equipmentshould result in fairly steady growth for the sector in the

2000s. Slips in the timing of contract awards do notdetract from this thesis.

Global Team

Byro n K. Callan ..................................................................Global [email protected]

(1) 212 449-1394

Canada

Ihor Danyliuk........................................................................Ihor_Danyliuk@ca.ml.com

(416) 369-2818

Singapore

Chey Hoon Sim....................................................................CheyHoon_Sim@ml.com

(65) 330-7205

UK & Continental Europe

Andrew Clifton......................................................................Andrew_Clifton@ml.com (44) 171 772-2539

United States

David M. Ainsworth..............................................................David_Ainsworth@ml.com

(1) 212 449-1312

Suzanne E. Kecmer.............................................................Suzanne_Kecmer@ml.com

(1) 212 449-6725

Marketing An alyst

Pete Deighton......................................................................Pete_Deighton@ml.com

(44) 171 772-1890


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4

CONTENTS

nn Section Page

Executive Summary 2

Forecast and Investment Issues 1. 5

Status of the Worlds Inventory:

Who Owns What

2. 11

1999 Campaigns and Wars:

What Changed?

3. 17

2000 Focus on Funding Debates,

Competitions and EADS

4. 20

Competitions A Better Balance

Between Europe and the U.S.

5. 22

Appendix: Aircraft Data 6. 26


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5

1. Forecast and Investment IssuesWe have believed that the replacement of older fighter aircraft would be a

principal driver of new combat aircraft demand in the future. 1999 saw

several campaigns decided that underscored this contention. We expect U.S.

fighter aircraft units produced to increase from a low of 64 units in 2001 to

160-170 units by 2005. European production could increase from 30 units to

approximately 110 units over the same period. There is no pure play on

military aircraft, but many firms we follow benefit.

The Direct and Indirect Importance of FighterAircraft to Defense/Aerospace Stocks

Fighter and bomber aircraft programs account for significant sales and operatingprofits of many of the companies we follow. Companies are directly impacted bynew production of fighters. They are also indirectly impacted by sales of electronics,weapons and services that equip and sustain fighter and bomber inventories. Table 1shows the estimated contribution of combat aircraft-related programs to the 2000sales estimates for some of the companies we follow. Table 1 includes ourestimate of:

Sales from aircraft prime and major subcontractor positions

Sales of airborne electronic warfare, avionics and radar

Sales of air-to-air and air-to-ground missiles and munitions

Note that the BAE figure in Table 1 excludes any of the estimated revenues fromthe Al Yamamah programs with Saudi Arabia. This is now primarily a supportand services operations, although it is heavily centered upon military aircraft. Ifthe whole contract value were to be included, then the figure for BAE would be40%. We have not included companies that derive less than an estimated 10% ofsales from combat aircraft programs.

Table 1: Estimated 2000 Sales Contri bution of Fighter Airc raft-Related

Products and ServicesCompany Percent of sales

BAE SYSTEMS 25%

Northrop Grumman 19%

Boeing 17%

Lockheed Martin 12%

EADS 10%

Source: MLPF&S

We have excluded surface-to-air missile sales from programs such as RaytheonsPatriot and national air defense systems. These programs also play a role inballistic missile defense. Arguably, we could have included Newport News inTable 1 because aircraft carriers would be ineffective without aircraft.

An Aging Inventory Needs To Be Replaced

Each year we aggregate data on the combat aircraft holdings of countries, aspresented by the IISS (International Institute for Strategic Studies). In October,the IISS releases a publication called The Military Balance which has a wealthof information on the defense budgets, military force structure and individualequipment holdings of countries. We review the data in order to examine broaderinvestment themes.

The total number of combat aircraft in inventory is declining. For 1995, based onIISS data, we estimated that there were 26,800 fighter aircraft in the inventories ofmilitaries and for 1999, we estimate the total declined to 22,700. This has resulted

Fighter and bomber aircraft

programs contribute 10%-25%

of sales for select companies

we follow

World inventory of fighters

declined in1999


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6

mostly from the retirement of aircraft by countries that comprise the former SovietUnion and China. Year-over-year changes are imprecise. Numbers have jumpedaround, in part, due to changes in estimates made by IISS. China does not disclosethe size of its armed forces, so IISS relies on a number of sources. U.S. data mayhave been incorrect for 1998. Official U.S. data does not show a drop from 1997to 1998.

Table 2: How Inventories of Figh ters Have Changed1995 1996 1997 1998 1999

United States 4,554 4,090 4,073 3,743 4,076

China 4,747 4,988 3,589 3,427 3,355

Russia 2,700 2,239 2,525 2,478 1,744

Source: IISS, MLPF&S

Demand for new combat aircraft is driven mainly by the need to replace olderaircraft purchased in the 1970s and 1980s.

We estimate that approximately 10% of the worlds inventory of fighters arein the hands of countries that could not afford to replace them. Countries withannual defense expenditures of less than $1 billion are not in a position to buy

Western-built multi-role fighter aircraft. There have been instances ofRussian sales of advanced MiG-29s to Bangladesh and of Su-27s to Eritreaand Ethiopia; however, we think that these cases probably involve whitetails or aircraft sold out of Russian air force inventory.


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7

Forecast U.S. Delivery Trough in 2001,Then Sharp Rebound

Table 3 shows our forecast of deliveries of U.S. fighters for 2000-05. There havebeen several changes from the forecast we published in February 1999, when welast reviewed the outlook for U.S. fighter deliveries:

We show production of the Boeing F-15 ending in 2000.

Compared to our year-ago forecast, we show lower Lockheed Martin F-16deliveries in 2000 and 2001. This is due to delays in contracts, particularlyfor a UAE buy.

We assume that Taiwan and Turkey will place follow-on orders for F-16s.Currently, there is nothing in Lockheed Martins backlog to suggest this.

We no longer have an Other line item for F-16s

Table 3: U.S. Deliveries Trough in 2001

1998 1999 2000E 2001E 2002E 2003E 2004E 2005E

Lockheed Martin F-16

Bahrain - - 10 - - - - -Egypt - 10 10 20 4 - - -

Greece 20 - - 15 30 15 -

Israel - - - - - 12 18 25

Singapore 18 5 7 - - - - -

South Korea 30 35 8 - - - - -

Taiwan 55 36 - - - 20 20 20

Turkey 22 20 - - - - 25 25

U.S. 1 5 5 5 10 10 10 10

UAE - - - - - 25 25 25

Subtotal, F-16 145 111 40 25 29 97 113 105

Lockheed Martin F-22 1 - 5 3 7 12 22 22

Boeing F-15

U.S. 7 7 7 - - - - -

Israel 15 15 5 - - - - -

Saudi Arabia 18 18 12 - - - - -

Other - - - - - - - -

Subtotal, F-15 40 40 24 - - - - -

Boeing F/A-18C/D

U.S. 6 6 - - - - - -

Finland 10 17 18 - - - - -

Switzerland 13 - - - - - - -

Subtotal, F/A-18C/D 29 23 18 - - - - -

Boeing F/A-18E/F

U.S. - 12 24 36 36 36 36 36

Total U.S. fighters 215 186 111 64 72 145 171 163

Source: MLPF&S


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8

Deliveries of European-Built Fighters Should ClimbSharply from 2000 to 2005

Table 4 shows our forecast of deliveries of European fighters for 2000-05. A saleof 15 Aerospatiale-Dassault Mirage 2000s to Greece that was announced in 1999should enable the company to avoid a production line break in the program.Compared to last years forecast, we have:

Reduced annual deliveries of Gripens. Sweden should take approximately 17per annum. South African deliveries will not start until 2007, compared to ourprior estimate of 2003.

There are slight variations in the data for Dassault.

We added Greece to the Eurofighter/Typhoon delivery schedule based on itsorder last year.

Table 4: European Produc tion Rate Ramp Up Driven by Euro fighter

1998 1999 2000E 2001E 2002E 2003E 2004E 2005E

Eurofighter/Typhoon

Germany - - - 1 5 12 15 15

Greece - - - - - - 10 10Italy - - - 1 6 9 10 10

Spain - - - - 5 6 7 7

U.K. - - - 1 6 15 20 20

Other - - - - - - 10 10

Subtotal, Eurofighter - - - 3 22 42 72 72

Saab JAS Gripen (BAe)

Sweden 16 16 17 17 17 17 17 17

South Africa - - - - - - - -

Subtotal, Gripen 16 16 17 17 17 17 17 17

Dassault Mirage 2000France 10 10 10 - - - - -

Greece 5 5 5 - -

Qatar 6 3 - - - - - -

UAE - - - - 5 15 10 -

Subtotal, Mirage 2000 16 13 10 5 10 20 10 -

Dassault Rafale

France - - 4 5 1 9 15 14

Other

Subtotal, Rafale - - 4 5 1 9 15 14

Total European production 32 29 31 30 50 88 114 103

Source: MLPF&S

Investment Recommendations

We think it is important for investors to recognize that defense is a business thattends to operate on very long cycles. The life span of a fighter aircraft, fromdesign to retirement of the last production unit, can be 30 years or more. Theinvestment conclusions we have noted in this report do not differ all that muchfrom prior years reports we have published on this subject:

An upturn in military aircraft production is emerging and production rates may


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not peak until late this decade.

This upturn provides visibility to the earnings and cash flow streams ofcompanies that build fighter aircraft or that supply weapons, systems and partsthat are used on aircraft.

We have mixed investment opinions on companies with direct and indirectexposure to fighter aircraft and bomber markets. Our forecast suggests that growthin aircraft deliveries probably will not begin to be evidenced by the financial

results of companies we follow until 2001. Here are investment opinionsummaries of major military aircraft and electronic suppliers we cover:

nn Aerospatiale Matra/EADS

Our opinion on Aerospatiale Matra is currently Accumulate. This companys mainexposure to military aircraft is its 46% ownership of Dassault Aviation, themanufacturer of the Mirage and Rafale. The Group is scheduled to merge withDaimlerChrysler Aerospace (Dasa) and Spains Casa to form the EuropeanAeronautic, Defense and Space company (EADS) by the end of June. This willintroduce the additional exposure of those two companies stakes in Eurofighter,which are 30% and 13% respectively. It remains to be seen how the new companywill address the issue of these two competing products in the business portfolio.

Additional exposure to the combat aircraft space is gained from AerospatialeMatras 37.5% interest in the enlarged missiles business, Matra BAe Dynamics.

We await more detailed news on the financial structure, strategy and prospects ofthe new Group. These are expected to be forthcoming over the next few months asit prepares for its stock offerings, which are expected to occur in the May/Juneperiod. We believe there is considerable potential arising from the new Groups80% ownership of Airbus and the scope for restructuring the entity. A successfulimplementation of this cross-border merger should also allow further benefits inthe areas of missiles, space and helicopters.

nn Boeing

Boeings valuation is currently driven mainly by expectations for its commercialaircraft deliveries and operating performance. However, Boeing is the leadingmilitary aircraft supplier in the U.S. and is the prime contractor on the C-17transport (which is not dealt with in this report), the F/A-18E/F fighter and hasone-third of the value of the F-22. Production of the F/A-18C/D and F-15 iswinding down. Boeing is also competing for the Joint Strike Fighter program.Our projections for Boeings military aircraft business show a stable sales outlook.

We rate Boeing Accumulate/Buy, mainly because we expect improvement incommercial aircraft margin which should more than offset a decline in deliveriesof large civil aircraft. Capital structure remains conservative and completion ofthe Hughes Satellite buy in mid-2000 could again enable the company to buy backits shares.

nn BAE SYSTEMS

The Group is the leading European company in the combat aircraft industry. Itsmain product is now the Eurofighter (it owns 37.5% of the consortium), with theHarrier and Tornado platforms in operation. In addition, it manufactures the Hawk,which can be used as a trainer aircraft and/or a light attack vehicle. The Group hasrecently completed the acquisition of Marconi Electronic Systems, which has somestrong market positions in military aircraft avionics, radar and electronic warfare.It also has a 37.5% stake in Matra BAe Dynamics, which manufactures a range ofair-to-air and air-to-ground missiles.

Key fighter programs are

Mirage 2000, Rafale and

Eurofighter

Fighters important, but

commercial aerospace is keyinvestment theme

We recently upgradedour opinion


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We have recently upgraded our recommendation from Neutral to Buy on accountof the poor performance of the shares over the last 12-15 months. The company isnow being valued at an average 20% discount to global peer companies, and wefeel that the market is now being overly cautious in its assessment of theintegration of Marconi over the next year.

nn Lockheed Martin

Our opinion of Lockheed Martin is Neutral/Buy. Key Lockheed Martin militaryfighter programs include the F-16 and F-22. We expect growth in sales from bothprograms in the 2001-04 timeframe. Additionally, Lockheed Martin supports theF-117 stealth strike aircraft and is competing for the Joint Strike Fighter program.

Lockheed Martin had a difficult 1998-99 for reasons that had little to do fighteraircraft programs. Sales and profit margin expectations for the C-130J airlifterproved to be too optimistic and there were several issues that arose in Space and inSpace diversification programs.

Our opinion is Neutral/Buy mainly because we would like to see several near-termissues resolved at the company and because 2000 earnings are heavily skewed tothe fourth quarter. Issues include the timing of a contract award from the UAE forF-16 fighters, timing of the COMSAT acquisition and space activities.

nn Northrop Grumman

We rate Northrop Grumman Buy mainly because of growth prospects inelectronics. The decline in B-2 bomber activity is bottoming out in 2000 andbacklog growth this year should herald an upturn in electronics sales for 2001-03.Northrop Grumman provides the APG-68 radar for the F-16 and the APG-7x radarfor the F-22. It also is a leading provider of electronic warfare systems. NorthropGrumman is responsible for approximately one-half the value of the F/A-18E/Faircraft and supports older Grumman and Northrop models.

Resolution of near-term issuescould uncover earnings power

Driven by electronics growth


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2. Status of Worlds Inventory:Who Owns WhatBased on data gathered by IISS, we estimate that in mid-1999, the worlds

militaries had 22,700 fighters and 997 bombers. This compared to 23,700

fighters and 863 bombers in mid-1998. By far, the U.S. has the most modern

inventory of military aircraft. Russias aircraft holdings continue to decline

and Chinas holdings remain overwhelmingly obsolete. Europe is beginningto modernize aircraft holdings procured in the 1960s and 1970s.

Stage Setting

Our definition of the combat aircraft market encompasses supersonic and subsonicadvanced fighter, fighter/bomber, and interceptor combat aircraft. This year, wehave included medium and strategic bombers because these aircraft are now usedmainly for conventional (non-nuclear) missions.

We have not considered the market for specialized support aircraft, such astransports, surveillance, and maritime patrol aircraft.

We have also excluded trainers from consideration, such as the Raytheon

JPATS (now called the T-4 Texan) program, MiG-AT, as well as light attackaircraft/trainers, such as the British Aerospace Hawk. These aircraft typesgenerally do not compete against multi-role aircraft, although they are a factorwhen discussing replacement demand. In particular, the British AerospaceHawk can be used as a trainer or light attack/air defense aircraft and isreplacing aging supersonic fighters.

The data in this report on aircraft holdings of states is from the 1999-2000Military Balance, which is produced annually by the London-based InternationalInstitute for Strategic Studies (IISS). For our analysis, we have used a typology thatRand Corporation used in a 1995 report entitled Trends in Global Airpower. Randclassified aircraft into three categories; front-line, useful and old. We havemodified front-line and instead refer to aircraft in this category as modern.

nn Modern

This categoryincludes multi-role aircraft (aircraft that can attack ground targetsand dogfight with other fighters) built in the 1980s and 1990s, in addition to someolder designs that are still quite capable. Fighters, in this category, include theU.S. Grumman F-14, Boeing F-15 and F/A-18 and Lockheed Martin F-16 andF-117. European-built aircraft are the Panavia Tornado, Eurofighter, Saab JASGripen and French Dassault-built Mirage 2000 and Rafale. Russian designs arethe Sukhoi Su-27/-30 and Su-24 and the Mikoyan MiG-29 and MiG-31. Versionsof these aircraft built in the late 1980s and 1990s can operate in all types ofweather conditions and with the exception of the F-14, Tornado, F-117, andSu-24, all are still in production. Bombers included as modern are the U.S. B-1and B-2 and the Russian Tupolev Tu-22.

nn Useful

Useful includes fighters and specialized strike aircraft that tend to be of 1960s and1970s vintage although, in some instances, designs were conceived in the late1950s. The exceptions to this age cohort are the British Aerospace Harrier/BoeingAV-8B and the Sukhoi Su-25. U.S. built types include the A-6, A-7, A-10, F-111and F-4. European-built aircraft include the Saab Viggen and the Sepcat Jaguar.Russian designs include the MiG-23/-27 and the MiG-25. We have included theB-52 bomber in this category, even though it is an ancient aircraft. However, itselectronic self-defense system and ability to carry large quantities of stand-offsmart weapons make it very useful, as evidenced by its deployment to threaten Iraqin 1997 and 1998. The Russian Tu-95 is considered "useful" as well.

Focus is on advanced

combat aircraft

Most modern designs stem

from 1970s

Useful aircraft designed

in 1960s


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nn Old/Obsolescent

Oldincludes aircraft designs from the 1940s and 1950s. In terms of the quantitiesin service, the largest single type is the Chinese J-6. This is a copy of the MiG-19,which first entered production in 1955. Other types include the MiG-21 and aChinese copy called the J-7/F-7 (J if it flies within China or F if it wasexported), the Lockheed-built F-104, Dassault Mirage III/-5 and the Sukhoi-7/17/20/22. We have included the Northrop F-5, in this category, because the

basic design stems from the 1950s. However, the aircraft could be included inUseful, because of its capabilities, particularly when upgraded with moremodern avionics and air-to-air missiles. Chinese H-5 and H-6 are included in"Old". The H-5 is the Chinese version of the Russian Illyushin Il-28, a tacticalbomber that first flew in 1948 and the H-6 is the Chinese version of the TupolevTu-16. The Tu-16 first flew in 1952.

Where we believe appropriate, we have made some adjustments to IISSsestimates of aircraft holdings. These mainly involve the holdings of developingcountries and/or in situations where there is more recent data available. Theseinstances include estimates for Afghanistan, Cuba, Iran and Iraq, none of which arelikely to be markets for Western aircraft in the coming years.

Total Inventory of Aircraft Fell From 1998The total inventory of combat aircraft fell in 1999, compared to 1998. IISS canchange inventory totals, based on new information, but our counting of data in the1999/2000 Military Balance shows the total number of fighters declined byapproximately 1,000 to 22,737 from 23,694 in 1998. The biggest single cause ofthe decline was in the inventory of J-6 aircraft in China (from 2,195 in 1998 to1,795 in 1999) and a decline in Russias inventory of fighters from 2,756 in 1998to 2,055 in 1999.

We suspect that the decline in J-6 figures may have to do with a reassessment ofthe fighter inventory in China. Figures for Russias fleet of MiG-31s and Su-24sprobably have to do with reductions in the size its holdings.

U.S. Has Largest, Most Modern Force

Exhibit 1 shows that the U.S. has, by far, the most modern force of tactical combataircraft in the world. As of mid-1999, IISS data we counted shows a totalinventory of 4,254 aircraft, 3,666 of which could be considered modern.

Some designs can be traced

back to late 1940s

China and Russia continue to

retire aircraft


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Exhibit 1: U.S. Has Largest Fleet of Modern Combat Aircraft

0

500

1,000

1,500

2,000

2,500

3,000

3,500

4,000

United

Sta

tes

Russ

ia

Germ

any

Taiw

anIs

rael

Ukrain

e

Saudi

Arabi

a

United

King

dom

Fran

ce

Turk

ey

Japa

n

Neth

erla

nds

Egyp

t

Cana

da Italy

Gree

ceIn

dia

Belg

ium

Korea

,Sou

th

Spai

n

Bela

rus

Swed

en

Uzbe

kist

an

Aust

ralia

Denm

ark

Numberofmodernai

rcraft

Source: MLPF&S, IISS

In addition to a modern fleet of fighters and bombers, the U.S. also has:

A dedicated fleet of specialized support aircraft, including AWACS andairborne early warning, signal intelligence gathering and electronic warfareaircraft.

A fleet of tankers. The Air Force has 547 KC-135 tankers (this is a militaryaircraft that was the basis for the Boeing 707). No other country comesremotely close to this size inventory.

Made extensive investments in the modernization of the munitions that arecarried by its aircraft.

Some of the highest pilot training time in the world.

Investors may conclude that because of the magnitude of the U.S. inventory, it canbe easily cut back, in light of the holdings of other countries. We think that thisjudgement is incorrect for several reasons:

It does not account for the limitations imposed by geography. The U.S.cannot bring its entire inventory of aircraft to bear on a single country.Distance and availability of air bases will limit the number of aircraft that canbe deployed.

Air defense systems must be considered. Russian-supplied air defenseequipment has become much more sophisticated and the risks posed by man-portable and by systems carried on light armored vehicles has made operationsbelow 15,000 feet risky.

Within this context, it is interesting to note that the U.S. Air Force deployedapproximately 15% of its tactical fighter force to deal with Yugoslavia in 1999.This was a country that had 75-80 supersonic fighters at the start of the conflict, ofwhich all but 17 were MiG-21s. The +1,000 aircraft that were deployed againstYugoslavia ultimately contributed to the withdrawal of the Yugoslav Army fromKosovo, but the magnitude of the forces needed to accomplish this was surprising.

U.S. has the most modern

Air Force

Size alone is not a

pre-condition for success


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14

Exhibit 2 shows the 25 largest combat aircraft fleets in the world. Total figureshave been broken down by holdings of modern, useful or old aircraft. China has alarge air force, but its almost entirely comprised of old designs. Russia still onpaper has the third largest air force in the world.

Exhibit 2. The Top 25 Largest Combat A ircraft Fleets

0

500

1,000

1,500

2,000

2,500

3,000

3,500

4,000

4,500

United

States

Russia Taiwan Ukraine Syria Egypt Israel Greece Libya Poland Japan Sweden Iran

Numberofaircraft

Useful

Old

Modern

Source: IISS, MLPF&S

Large Quantities of 1950s-Designed Aircraft Remainin Service

Exhibit 3 shows that a surprising feature of the worlds inventory of tactical

combat aircraft is the high percentage of aircraft designs from the 1950s that arestill in service.

Exhibit 3: Old Aircraft Are Still Big Part of World Inventory

Modern

38%

Useful

26%

Old

36%



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15

The MiG-21 and Chinese version of this aircraft, the J-7, represent the largestsingle aircraft type in service.

Exhibit 4: Aircr aft Types of Which More Than 800 Are In Use

0

500

1,000

1,500

2,000

2,500

3,000

3,500

MiG-21/F-7/J-

7

F-16 J-6 F-5 F-15 F/A-18 MiG-29 MiG-23/-27 Su-24 F-4 Tornado


Whats The Available Market?

Just because there are more than 22,000 aircraft in use around the world does notmean that there will be sales over the next 20 years of aircraft to replace all thesethat are now in service. Some countries simply will not be able to afford newmulti-role combat aircraft and others will not be buying from Western countries,either because the West will not sell or because they want to foster their ownaerospace industries and will instead rely on indigenous designs.

Furthermore, there are other options available to countries, other than just buyingnew aircraft:

Ballistic missiles, such as SCUD, have offered greater assurance of striking at

threats at a fraction of the cost of maintaining a squadron or two of multi-rolefighters. The military utility of these missiles is limited because of theiraccuracy and size of the warhead they carry.

Another option is to buy attack helicopters to replace fighters. Slovakia statedits plans to do this in 1999. Finally, there are light, subsonic fighters, such asthe BAE SYSTEMSs Hawk, which appeals to many countries.

The sophistication and capability of attack helicopters also entails that theyare contenders in fighter aircraft replacement schemes. This is particularlytrue of countries that face internal insurgencies and/or expect that any majormilitary contingency they find themselves in will be in an alliance with otheradvanced military powers.

It is unlikely that Western-built aircraft will be sold to Russia, China, Ukraine,Belarus and a number of smaller states, including North Korea, Iraq, Yugoslaviaand Iran. Additionally, countries with annual defense budgets of less than $1billion are unlikely to be able to afford new Western-built multi-role combataircraft. Exhibit 5 shows that, in terms of long-term replacement, excluding off-limits states and countries with minimal levels of defense spending, leaves 60% ofthe market available to Western suppliers.

Countries considering new

aircraft have many options


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16

Exhibit 5. 60% of the Market, By Units, Is Open to t he West

Available to West

60%

Cannot Afford

10%

Unavailable to West

30%

Source: MLPF&S


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17

3. 1999 Campaigns and Wars:What Changed?Military conflicts again highlighted the value of advance aerospace systems in

1999. The Boeing F-15 did not score any export victories in 1999 and hence,

its production will likely end in 2000-01. In the U.S., a funding cut to the F-22

program underscored tension over tactical fighter modernization.

Yugoslavia Highlighted Airpower

One of the key events that has impacted the outlook for military aircraft in 1999was the 78-day air war between NATO and Yugoslavia. NATO flew 37,000sorties (one-aircraft mission), while Yugoslavia flew 10 air intercept missionsduring the war. The lessons learned from the conflict were somewhatcontradictory and so far, have not lived up to initial investor expectations. Theselessons included:

The very wide disparity between U.S. and European aerospace militarycapabilities. The U.S. flew in eighty percent of the strike missions. The airforces of most European countries were of limited use because of the lack ofall-weather day/night target designators, smart weapons and electronic warfaresystems.

The utility of strategic bombers. B-2 bombers were used for strikes onheavily defended portions of Yugoslavia.

The inability of NATO forces to locate stationary or dispersed tactical militarytargets.

Reluctance to engage low-level air defense systems.

Importance of GPS-guided weapons.

Utility of UAVs. Unmanned aerial vehicles were used for targeting andreconnaissance.

The need for numbers. The number of aircraft committed to the campaignwas initially small, but the need for continuous pressure resulted in a fargreater commitment than was originally envisioned.

One of the great ironies of the conflict was that Rep. Jerry Lewis (R-CA) used theexperience as a justification to block procurement funding of the F-22. NATO lostjust two aircraft during the entire campaign (an F-117 and an F-16) and otherwisedominated airspace over Yugoslavia. The success of NATO air power raised theissue of whether more modern fighters were needed.

The other irony is that there has only been limited movement within Europe tonarrow the gap between the defense capabilities of its armed forces and those ofthe U.S. There has been a move to create an independent military force in Europethat would be separate it from NATO. However, there have not beencommensurate moves to step up spending on tankers, munitions, electronic warfare

and support measures aircraft and space-based assets that could make this forceindependent of the U.S.

F-16 and Eurofighter Score Big Wins

As we discussed in our forecast above, the big winners of 1999 were the F-16 andthe Eurofighter. The Mirage 2000 also had a decent year and a selection byGreece enabled Dassault to bridge a potential line break in 2001.

Greek decisions in 1999 on the modernization of its air force were significant.In early 1999, it announced its intention to buy 60-90 Eurofighters, with initialdeliveries beginning in 2005. Greece will be an industrial partner on theprogram as a result of this. Greece also announced in April, its decision to

Yugoslavia v. NATO has mixed

implications for airpower

F-16 sweeps Greece, Israel

Eurofighter gets first export


18/32


18

buy more than 50 Block 50 F-16s. The F-15 looked like it had a good chancein this competition, but the cost of introducing a new aircraft was a factor inthe final decision. Greece operates 40 F-16C/Ds. Greece also announced thatit would buy 15 Mirage 2000-5s.

Israel selected the F-16 for its fighter modernization program. A contract wassigned on January 14 for 50 F-16s, with a value of $1.34 billion. Israel hasoptions for another 60 F-16s. These aircraft will replace A-4s and Kfirs that

Israel now operates. Deliveries will begin in early 2003.

A contract was concluded with Egypt in August 1999 for 24 F-16C/Ds, valuedat $324 million to Lockheed Martin. Deliveries begin in 2001 and should lastabout 15 months.

The End of F-15 ProductionOr Just a Line Break?

Boeings loss of competitions in Greece and Israel in 1999 entailed a decision bythe company to write-off $270 million pretax in inventory of parts that wereprocured for 24 F-15s the company anticipated selling in 2000. We believe thatthe Boeing F-15 has reached the end of the line and we do not forecast future sales.There is the potential for sales to South Korea, Egypt and Saudi Arabia, but theseprobably will not occur for another 2-3 years. The cost of restarting the F-15 line

and the availability of other fighter aircraft should limit the F-15s prospects.

EADS and Implications for Fighter Market

On October 15, Frances Aerospatiale Matra and Germanys Dasa announced theirintention to merge to create EADS. Subsequently, agreement has been reached toinclude Spains Casa. The combination is expected to complete by the middle ofthis year. It will result in EADS holding a large, if minority, stake in the 2 majorEuropean military aircraft manufacturers. Aerospatiale Matra owns 46% ofDassault Aviation (manufacturer of the Mirage and Rafale), with Dasa and Casaholding stakes in the Eurofighter consortium of 30% and 13% respectively. Notethat there are currently discussions underway investigating the inclusion ofFinmeccanica (which owns 19.5% of Eurofighter) in a shared military aircraft

venture, which would then own 62.5% of the program. The Italian company is alsoin discussions with BAE SYSTEMS regarding this issue.

We are unsure as to how integrated the 2 competing platforms can be within thenew corporate structure. In view of the advance development and production stageof each product, manufacturing efficiencies would not appear to be achievable,even theoretically. It is possible that some arrangement could be arrived atregarding sales and marketing in export markets, although several barriers can beenvisaged. These include the nature of the ownership of each product, theperceived respective strengths in export markets and the existing commitment foreach type. The formation of EADS does not alter our view that there will only beone European next generation product. Perhaps the issue that it does most raise iswhether the two parties are brought together through the existing BAE

SYSTEMS/Dassault relationship, or through EADS. In the meantime, we expectEurofighter and Rafale to co-exist for at least the next decade.

The F-22 Funding Debate

One of the surprising developments of 1999 was that the Lockheed Martin/BoeingF-22 fighter came under attack in Congress. Tactical combat aircraftmodernization programs in the U.S. have been very controversial because of thebudget resources they consume and because of questions about the wisdom ofsustaining a large inventory of relatively short-range fighter aircraft, givenchanging military threats.

EADS needs to sort

out offerings

F-22 should be procured

despite 1999 controversy


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19

In July, Rep. Jerry Lewis (R-CA), who heads the defense procurementsubcommittee of the House Appropriations Committee proposed zeroing a $1.8billion procurement request for the F-22. This set off all sorts of alarm bells thatrang even louder when the House passed an appropriations bill that included thesubcommittee recommendation. A compromise was worked out between theHouse and Senate, but the issue highlighted the extent of debate over nextgeneration fighter aircraft.

Russian Sales: VPK Sukhoi Shines

It is important for investors to keep an eye on how Russias aircraft manufacturersare doing. Their sales efforts have created competition from time to time(Malaysia is one example) for European and U.S. firms. Russian aircraft are ascapable as current generation fighters and introduction of these aircraft can spurregional modernization of air forces and air defense systems.

There are two major Russian military suppliersVPK Sukhoi and MIG MilitaryAircraft. Of the two, VPK Sukhoi has a stronger export program underway. In1999 it delivered Sukhoi 30s to India and concluded a contract with China for asale of 50 Su-30s. These aircraft are comparable to the F-15. Sukhoi is alsodelivering aircraft Su-27s to Vietnam and is providing kits for license assembly of

200 Su-27s for China.

Russia exports highly

advanced fighters


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20

4. 2000 Focus On Funding Debates,Competitions and EADSThe debate over tactical aircraft modernization funding should continue in

2000 in the U.S. Russias use of airpower in Chechnya suggests that other

nations are adopting NATO war-fighting models. In Europe, the focus

remains on restructuring and how EADS could impact fighter programs.

U.S. Outlook: Funding Debate Continues

Modernization of U.S. tactical combat aircraft assets has been a much debatedtopic. Investors finally saw this debate spill over the Beltway (a highway thatencircles Washington, DC and parts of northern Virginia and Maryland) this pastsummer when F-22 funding was cut. The debate is likely to continue in 2000 andbeyond for a number of reasons:

The Congressional Budget Office testified in March 1999 that over the next27 years, the U.S. planned to purchase 3,700 new tactical fighters at a totalcost of $340 billion. The size of the investment will attract attention.

The changing geography of military threats, advances in stand-off weapons,

(such as cruise missiles), and the vulnerability of large air bases and aircraftcarriers to missile attacks have raised questions about the wisdom of investingin relatively short-range combat aircraft inventories.

Other branches of the military have competing modernization needs.

There are conflicting views on the efficiency of air power. The war withYugoslavia was hailed by some as a demonstration of the ability of airpoweralone to affect the behavior of an adversary. However, others have questionedthis and pointed out that air power was incapable of preventing ethniccleansing.

The fulcrum of the debate is apt to be the F-22 in 2000, although we do not believethat this aircraft program will again take the kind of flak thrown at it in 1999.Supporters have mustered a number of arguments for the F-22, including:

It needs 50% fewer tankers to operate than an F-15.

It is far more capable of engaging hostile aircraft and operating over hostileterritory than current generation fighters.

Unit costs should decline as aircraft production matures.

Attention is likely to shift in 2000-2001 to the Joint Strike Fighter program. Theperformance of the F/A-18E/F implies to us that its procurement is not likely to bea major debate in the coming year.

Joint Strike Fighter Developments

Boeing and Lockheed Martin are proceeding with development of their designs for

the JSF (Joint Strike Fighter). Boeings entrant is designated the X-32 andLockheed Martins is designated the X-35. Both companies should be flyingprototypes this summer and a March 2001 down-select is anticipated.

Joint Strike Fighter remains the biggest potential fighter program ever, in terms ofits total value. Current plans call for three different versions of the JSFone thatwill be used for conventional take-off and landings, another that can land on anaircraft carrier and another with vertical take-off capability. The Air Force intendsto buy 1,763 JSFs; the Navy, 480; the Marines Corps, 609 and the U.K. RoyalNavy, 60. Initial operating deployment is now planned for 2008.

The debate on U.S. fighter

modernization will continue

in 2000

Eyes on JSF in 2000


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21

The most interesting development to watch in 2000 regarding the Joint StrikeFighter is whether the DoD adheres to a plan to award a contract to build theaircraft to a single prime contractor. It has dawned on the DoD that the contractorthat loses the JSF contract may exit from the fighter aircraft market and therebycreate a monopoly supplier. The DoD has created a Joint Strike Fighter ReviewGroup that is assessing how the two major competitors could behave if the existingacquisition strategy is maintained, or if other acquisition strategies should bepursued, including Split Award, Leader/Follower or Alternative Teaming at thePrime Level.

Our view on Joint Strike Fighter is that there will probably be delays in theprogram due to funding and technical concerns. This could entail that there aremore purchases of F-16s and F/A-18E/Fs and it could also impact the MarineCorps, forcing it to consider other ways to deliver close air support to its troops.We also doubt that JSF will be purchased in the numbers envisioned because ofvulnerability of large airbases and/or aircraft carriers that could emerge in the post2015 time period.

EADS

The new management of EADS have publicly stated that it is aiming for

completion of the new entity by the end of June. Pre-offering presentations in theSpring will provide an opportunity for the new Group to specify its strategy andoutlook in the sphere of military aircraft. As we have mentioned above, EADS willhave a significant stake in the 2 competing European fighter programs, Eurofighterand Rafale. We do not envisage any significant changes being made to theoperating and sales structures of each platform in the current year. Perhaps themost realistic scope for synergies lies between the Dasa and Casa Eurofighteractivities, although the advanced stage of the program will limit the scope forsavings.

The other main issue to be addressed is whether Finmeccanica chooses to combineits 19.5% interest in Eurofighter with one of the other two parties, EADS (43%) orBAE SYSTEMS (37.5%). Discussions are understood to be currently underwaywith both parties, and are believed to encompass combinations possibly involving

related activities such as avionics, maintenance and commercial aircraft.

Other International Developments

Investors should watch for the ramifications of the heavy use of airpower byRussia in its campaign against Chechen rebel forces. This is likely to bolsterinternal calls for modernization of the air force in Russia.

Asian markets are perking up again. Thailand may acquire second-handF-16s, as could New Zealand (although there is a political controversy overthis). Malaysia is looking to buy Su-27s/-30s.

Central Europe remains a potentially large market, with Poland, the CzechRepublic, Hungary all looking for new aircraft to replace aging Soviet-

supplied models. Austria is also looking to replace older Saab-built aircraft.Purchases are most likely to be made with initial lease of aircraft.

The UAE F-16 buy remains an important issue to watch for 2000. The UAEhad announced in 1998 that it wanted to buy up to 80 Block 60 versions of theF-16. This aircraft type has an agile beam radar, internal navigation/targetingsystems and other enhanced electronics.

European consolidation needs

to be completed

Military and sales campaigns

bear on outlook


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22

5. Competitions A Better BalanceBetween Europe and the U.S.There are a number of new aircraft campaigns in 2000-05 and there could be

follow-on buys by current customers. In contrast to prior decades, the

product offerings of Europe and the U.S. may be more balanced in the 2000s.

New Threats and Old Aircraft Drive Demand

The defense business is unique because there is not supply and demand of the sortthat generates cycles in other businesses. Demand for military products typicallyrises and falls based on national security considerations, the ability of countries topay for military equipment and on changes in technology. Different countries facedifferent security threats. One whose primary security threat is drug traffic, bordersecurity and internal insurrection may need only light, subsonic attack aircraft, orhelicopters. Another, whose threat is considered a possible attack by a highlydeveloped adversary fielding bombers, multi-role aircraft and all supportingequipment will have a very different type of purchase in mind.

We see demand for military aircraft being driven by several factors over the nextfive years:

nn Need to replace older aircraft

The life of an aircraft is typically measured in hours of flight. For early versions ofthe F-16, 4,000 hours of flight was expected before major airframe overhaul had tobe done. Current generation F-16s have 8,000 flight hour life-spans. One reasonthat older aircraft remain in service is that they are probably not used that much.For example, the U.S. still operates B-52 bombers that were built in the early1960s. For the much of their lives, these aircraft sat on runway alert.

The stresses of combat flight entail metal fatigue. Salt water, sand and otherenvironmental factors contribute to age. It is quite possible to rebuild an airframe,but it may not be at all economical, particularly given the costs to do so.Additionally, an older aircraft is very likely to be less capable than current and

future generation systems because of its lack of stealth and avionics.

The end of the Cold War entailed a procurement holiday in Europe and the U.S.and countries in the former Soviet Union simply could not afford to replacemilitary equipment. Exhibit 6 shows how sharply U.S. buys of tactical combataircraft had fallen since the 1980s.

Replacement of older aircraft is

key driver of demand


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23

Exhibit 6. U.S. Fighter Buys Have Dropped Sharply

0

50

100

150

200

250

300

350

400

450

500

1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000

Numberoftacticalcombataircraft

perFYbudget

Source: MLPF&S, Congressional Budget Office

nn New military threats from modernization of other air forces

Replacing older aircraft with newer ones often entails stepped up capability.Taiwan and China are examples of countries that began modernizing antiquated airforces with far more capable equipment. In Chinas case, the modernization isbased on the Su-27/-30 procurement and development of the J-10. In Taiwan, ithas centered on procurement of the F-16s and Mirage 2000s. In this instance themodernization plans of each have fed off one another. Similar patterns can beobserved in the Middle East and Latin America.

nn Advances, proliferation of air defense systems

Yugoslav air defense kept NATO forces from operating below 15,000 feet and anunwillingness to risk casualties meant that attack helicopters were not deployed.

Russia has been selling the S-300 air defense system and Raytheon andAerospatiale Matra are offering advanced surface to air missile systems. This willimpact aircraft demand because aircraft that are incapable of operating in a morestrenuous air defense environment will need to be replaced.

nn Harmonization with allies, political consideration

A final consideration in military aircraft demand is that purchases can be made inorder to better align a defense force with that of a larger power and/or in order todiversify supply sources. South Africa, for example, chose not to include U.S.fighters when it evaluated replacement of older Mirage aircraft. Similarly, CentralEuropean campaigns are unlikely to see Russian built aircraft chosen because theyare not easily integrated into NATO.

Replacement can heighten

regional tensions

Air defenses make replacement

necessary


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24

Upcoming Campaigns

Table 5 shows upcoming campaigns for tactical combat aircraft.

Table 5: Potential Fighter Buys

Country Requirement Decision Contenders

Austria 30 2000 F-16, Gripen

Brazil 72-149 2003-5 Mirage, Gripen, New design

Chile 20 2000 likely to buy second-hand aircraft

China 500 on-going Su-27, J-10, FC-1

Czech Republic 20-30 2000-01 F-16, Gripen, F/A-18

Norway 20 2000-01 F-16, Eurofighter

Poland 60 or more 2001-02 F-16, Gripen, Mirage 2000

Saudi Arabia 75 2001 F-16, Gripen, Eurofighter

South Korea 120 2002 F-15, Su-30, Eurofighter, Rafale

Syria 50 2000 Su-27, MiG-29

Vietnam 50 on-going Su-27

Source: MLPF&S

An Emerging Balance Between the U.S. and Europe

Table 6 captures a change that we believe is important to consider in the comingdecade namely that there is a balance between the offerings of the U.S. andEurope. For the next 2-3 years, most campaigns are apt to see the F-16 pitchedagainst the Gripen, Mirage 2000 and the Eurofighter. We are not aware ofcampaigns where the F/A-18E/F is under serious consideration and the F-22 couldbe purchased by only a small number of countries acceptable to the U.S. and whocould afford the aircraft. Rafale is also not prominent in upcoming campaigns,although Dassault continues to market the aircraft.

The competitive landscape thus differs somewhat, compared to prior decades. Inthe 1980s and 1990s, the U.S. was able to offer lightweight fighters (the F-20,

briefly) and medium multi-role aircraft (the F/A-18 and F-16). Finally, the F-15was available as well. Key points in several competitions was the ability of theU.S. to offer AMRAAM missiles that allowed aircraft to engage others at fargreater ranges than aircraft equipped with European-built missiles. In the 1980sand early-mid 1990s, Europe offered the Mirage 2000 and Tornado. Rafale hasbeen offered, but it did not score any export successes.

The 2000s represent a change in the competitive landscape:

The F-16 is now the major aircraft type being offered by the U.S. The F/A-18C/D is winding down production and F-15 production is ending.

The Saab/BAE SYSTEMS agreement to jointly market Gripen has expandedthe market reach of this aircraft. Gripen is similar to the F-16.

Go-ahead on the Eurofighter program has made this a more viable offering and the winin Greece underscores this. Eurofighter does not have a radar that is as capable as the F-16 Block 60 aircraft (it is mechanically steered, not an agile beam radar), but theBVRAAM/Meteor missile program should result in the aircraft being equipped with amedium range air-to-air missile that is more capable than AMRAAM.

Europe is able to offer the Mirage 2000, the Gripen, Rafale and Eurofighter.European aircraft are largely equipped with European electronics and avionics.The Mirage 2000 was first introduced in 1985 and most of the buying seemslimited to countries that already own the aircraft and are buying it because ofattrition in their fleets. Gripen is a lightweight multi-role fighter in service withSweden and ordered by South Africa while Eurofighter is being procured by theU.K., Italy, Germany, Spain and Greece. France is procuring Rafale.

Europes offerings are more

evenly matched with U.S.

in 2000


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25

The point here is that Europe is offering a wider range of fighters than it has in priordecades. This is shown in Table 6. In the 1960s and early 1970s, most European airforces were equipped with U.S.-built F-104s and the U.K. operated some F-4s.

Table 6: A Comparison of European and U.S. Combat Air craft Offerings

1970 1970 1980 1980 1990 1990 2000 2000 2010 2010

U.S. Europe U.S. Europe U.S. Europe U.S. Europe U.S. Europe

Light fighter/bombers F-5 Jaguar A-10 Hawk Hawk Hawk KTX-2? Mako?

A-7 Mirage 5 A-7 Harrier Harrier

F-5/-20 Jaguar

Medium/multi-role F-4 Buccaneer F-16 Mirage 2000 F-16 Mirage 2000 F-16 Gripen JSF Eurofighter

A-6 F/A-18 Viggin F/A-18 Gripen F/A-18E/F Eurofighter F/A-18E/F Rafale

A-6 Rafale Gripen(?)

Mirage 2000

Heavy/multi-role F-14 F-15 Tornado F-15 Tornado F-22

F-111

Source: MLPF&S

There are several issues to watch:

The Gripen and F-16 are the only two advanced multi-role aircraft thataddress the low-end of the global fighter market. There are still severalhundred Northrop F-5s, Dassault Mirage IIIs, 5s and F1s, and Mikoyen MiG-21s in service around the world. It remains to be seen how the Gripen and F-16 do against one another. Additionally, we wonder if there is not room for acheaper supersonic fighter to meet this long-term market need.

One of the advantages that the U.S. has played in the late 1980s and 1990s isthat its aircraft offerings have included the AMRAAM (Advanced MediumRange Air-to-Air Missile). A key issue over the next ten years is whetherEurope develops an advanced medium range air-to-air missile independentlyof the U.S. The U.K. BVRAAM (Beyond Visual Range Air-to-Air Missile)

program will be very important to watch because if the European Meteormissile is selected and if its development is not marred by cost or technicalissues, then Europe could be in a position by the 2005-10 timeframe to offerEurofighter with armaments that are independent of the U.S. Industry sourcesindicate that Europe lags the U.S. in radar, but BVRAAM/Meteor could makeEurofighter even more attractive.

Europe now appears to have no answer to the Joint Strike Fighter or F-22. Ifthe Joint Strike Fighter is developed within the price range ($28-$35 millioneach) that is expected for the aircraft, if could emerge as the logicalreplacement for a number of aircraft types in the 2010 period.

The balance that now exists in the fighter market could again tilt to the U.S. by theend of this decade, depending on how Joint Strike Fighter fares. If this aircraft

lives up to its advertised promise as an affordable replacement for F-16s, Mirages,Harriers and other aircraft types, then it could sweep competitions at the end of thedecade when it is available and in production. This, however, is beyond mostinvestors horizons.

AMRAAM advantage offset by

METEOR/BVRAAM

JSF could tilt market back

to U.S. favor


26/32


26

6. Appendix: Aircraft Data

Major Aircraft Types

Table 7 summarizes key data for multi-role fighters now in production ordevelopment. We have used estimates of fly-away costs--not total cost of eachaircraft type. Total cost includes the research and development costs of designing

and providing tooling for the building of the aircraft. Costs vary with theproduction run and the complexity of the aircraft. A J-7 is not even remotelycomparable to more advanced designs.

Table 7: Fly Away Prices for Diff erent Aircraft Types

Country Aircraft Type Manufacturer Unit Price

China J-7 Chengdu Aircraft Industrial Corp. $2-$3

France Mirage 2000 Dassault 35

Rafale " " 55

Japan F/S-X Mitsubishi 60

Russia Su-27/-30 Sukhoi 30-45

MiG-29 Mikoyan 25

Sweden Gripen Saab/British Aerospace 30

Taiwan Ching Kuo Aero Industry Dev. Center 30

U.K/Germany/ Eurofighter Brit. Aerospace/Daimler/ 70

Italy/Spain Alenia/CASA

U.K. Harrier British Aerospace 40

Tornado 40

U.S.A F-15E Boeing 55-80F-16C Lockheed Martin 25-35

F/A-18C Boeing 25

F/A-18E Boeing 55

F-22 Lockheed Martin 80-100

Source: MLPF&S. All $$ figures in U.S. millions

nn Boeing F/A-18

The F/A-18 is a multi-role fighter/bomber that now comprises the backbone of theU.S. Navy's carrier aviation fleet. The aircraft was designed in the early 1970s and in1976, the Navy chose this Northrop-designed, McDonnell Douglas built aircraft toreplace A-4s and A-7s then in service. The Navy now has 195 F/A-18As and Bs and

330 F/A-18C/Ds and the Marine Corps flies 300 F/A-18s. International customersfor the aircraft include Spain, Canada, Australia, Finland and Switzerland, Kuwaitand Malaysia. These countries all operate the aircraft in land-based modes.

An improved version of the F/A-18, called the E/F is now being procured and firstflight occurred in December 1995. This aircraft will be used to modernize U.S.Navy carrier aviation (notably as a replacement for 1960s-vintage A-6 strikeaircraft) and it incorporates several improvements over the C/D. The program hasbeen managed differently than others, with more emphasis on integrated productdevelopment, low rate expandable tooling concepts and design for manufactureand assembly. The E/F is about 25% bigger in volume than the C/D. It isstealthier and has a greater payload and longer range.

The U.S. currently plans to buy at least 548 F/A-18E/Fs. We believe that this will

Costs and capabilities

vary widely

F/A-I18 C/D phases out of

production replaced by

E/F Version


27/32


27

depend on how the Joint Strike Fighter program progresses. If JSF is a success,then this number, or fewer, could be bought. If, as we expect, JSF slips, then moreF/A-18E/Fs could be bought that 548.

nn Boeing F-15

The U.S. Air Force selected McDonnell Douglas in 1969 to build a replacementaircraft for the F-4 Phantom and F-106 interceptors then in service. The principal

mission of the F-15 was, and remains air superiority. The aircraft has been inproduction since the early 1970s and there are 440 F-15s in service with the U.S.Air Force in the air superiority role.

In 1984, the Air Force selected a modified version of the F-15 over a modifiedversion of the F-16 to fulfill a requirement for a long-range "strike" aircraft thatcould be used to attack ground targets. This selection resulted in the "E" versionof the aircraft and the "E" version can carry a payload of up to 12 tons of bombs ofbombs over a distance of 750 miles. There are 204 F-15Es in service.

Production for the U.S. Air Force has been completed. The production lineremains open today because of orders from Israel and Saudi Arabia. Saudi Arabiaordered 72 of a modified version of the F-15 called the "S" version in 1992 andIsrael has ordered 25 of the so-called "I" version. Deliveries from these two orders

should be completed by 2000.There are several potential international customers for the F-15 and it is possiblethat this aircraft resumes in production. A follow-on buy is possible from SaudiArabia. New operators could include Egypt, South Korea, and Turkey.

nn Lockheed Martin/Boeing F-22

The F-22 remains the highest priority program in the Air Force and is intended toreplace the F-15 in air superiority missions. The current goal of the U.S. Air Forceis to buy 442 F-22s. First production delivery is scheduled for 2001 and theprogram is split between Lockheed Martin and Boeing. Lockheed Martin has 2/3of the share of the program and Boeing the remaining 1/3.

The F-22 will be a radical improvement over existing U.S. fighter aircraft. The

aircraft is stealthy and its modern avionics offers a pilot unprecedented situationalawareness. For example, the F-22 can identify a threat aircraft through radar or anelectro-optic sensor and then can prioritize threats and the distance at which theycould launch air-to-air missiles. The aircraft engine can "super cruise" whichmeans it can fly at supersonic speed without resorting to a fuel-gulping afterburner.

The Air Force currently plans to buy 339 F-22s. We believe a smaller buy isprobable.

nn Lockheed Martin F-16

Lockheed acquired the General Dynamics Fort Worth division in 1993 and therebyadded the F-16 program and one third of the F-22 (it already had one third) to itsportfolio. The U.S. Air Force selected the F-16 in 1975 as a lightweightalternative to the F-15. In 1976, this aircraft received a major international boostwhen it was chosen by Belgium, Norway, Netherlands and Denmark in the so-called "deal of the century." There are more F-16s in use than any other westernbuilt aircraft in the world.

The F-16 has evolved from a lightweight air superiority fighter to a multi-rolefighter bomber. The aircraft is still production for the U.S. Air Force from ordersplaced in FY98. The backlog of undelivered F-16s stands at approximately 150and international customers who are, or who should receive F-16s over the nextfive years include Taiwan, Turkey, Egypt and Israel. F-16s are licensed producedin Turkey and in South Korea. The Japanese FS-X is a modified version of the F-16 and is not included in the backlog. However, Lockheed Martin should benefitfrom technology transferred from this project and will produce certain major

End of the line in 2000

F-22 enters production

Exports drive prospects


28/32


28

components.

One other aspect of the F-16 that is important is the Mid-Life Update, or MLU.The MLU upgrades F-16A/B (so-called Block 10/15 aircraft) with a new missioncomputer, an improved version of the APG-66 radar, an improved cockpit layoutand other enhancements to the airplane's avionics. The Netherlands (136 aircraft),Belgium (48), Denmark (61), Norway (56) are the major participants in thisprogram and other operators of the A/B versions could also join.

nn Eurofighter/Typhoon

This air superiority fighter has been developed by a consortium of Europeanenterprises and the program is managed by Eurofighter Jagdflugzeng in Munich.Eurofighter was conceived in the early 1980s to counter next generation Russianfighters and was to replace F-4 Phantoms, F-104 Starfighters, Tornado ADVs, aswell as some ground attack aircraft in service with NATO air forces.

The program's structure is largely dictated by work share requirements that, in turnare dictated by the potential buy and costs borne by different countriesparticipating on the program. Britain will claim a 37.5% share of the work,Germany a 30% share, Italy will have a 19.5% share and Spain, the rest. Britainintends to buy 230 aircraft, Germany around 180. Spain will be 87 and Italy 165.

Major contractors involved on the program include British Aerospace (frontfuselage, part of the wing), DASA (center fuselage and tail), Alenia (rear fuselage,part of the wing) and CASA, (half of the rear fuselage and part of the wing).

nn Saab/BAE SYSTEMS Gripen

The Gripen is a lightweight multi-role fighter that is being developed formodernization of the Swedish Air Force. Saab Scania is the principal contractoron the program. The JAS Industry Group includes Saab and other major partnersare Volvo Flygmotor, Ericsson and FFV. The Gripen was designed in the 1980sand prototypes have been flying since 1988. The aircraft will enter production in1996 and Sweden has planned buy 140 of the aircraft.

The aircraft is lighter, at approximately 7.3 tons empty, than many other aircraftdiscussed in this report (which weigh between 9 to 20 tons) and in some ways, is

comparable to the F-16. Its multi-role capabilities come from pods, weapons andmissiles that can be loaded onto the aircraft, depending on the mission. BecauseSweden relies on conscription for its armed forces, the aircraft was designed withease of maintenance in mind. In June 1995, British Aerospace concluded anagreement with JAS to market the Gripen internationally and access 45% of theproduction on export sales.

nn EADS-Dassault Mirage 2000

The Mirage 2000 is an improved version of the earlier generation of Mirageaircraft. The French Air Force decided to buy the Mirage 2000 in 1975 as aninterceptor/air superiority fighter. Like other air superiority fighters, subsequentmodifications to the aircraft have resulted in multi-role and specialized strike

versions of the aircraft. The French Air Force is now taking delivery of the Mirage2000s under a buy that should be completed by 2000. Mirage 2000 has beenexported to several countries, notably India, Greece, Peru and Abu Dhabi. In1992, Taiwan ordered 60 of the Mirage 2000-5 version and deliveries werecompleted in 1998.

nn EADS-Dassault Rafale

The Rafale is a new design that was first unveiled in the early-1980s andincorporates advanced materials, flight controls and avionics. First flight occurredin 1986. The aircraft is a multi-role one and in 1989, the French governmentordered the aircraft. Initially, it will replace older Mirage and Jaguar strike aircraftin the French Air Force and will be the basis for the French Navy's carrier-based

Pan-European program

Sweden and South Africa

have ordered

Production could extend to

late 2000s


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air fleet, replacing 1960s-vintage Crusaders and Super Entendards France now hasa total requirement for 86 for its Navy (assuming two carriers are built) and 234for its Air Force. First delivery of the aircraft is scheduled for 1998 and the jetshould remain in production through the next decade. The Rafale has not yetreceived any export commitments, however, the aircraft has been offered in acompetition the UAE is holding for advanced fighter procurement.

nn MIG-MAPO MiG-29

The MiG-29 was developed in the early 1970s and it became operational withSoviet forces in 1985. The aircraft was conceived as an air superiority fighter and itsmaneuverability and flight characteristics are as good as anything the West now hasin production. The key features of the aircraft include an innovative short-range air-to-air missile system (the "sight" is mounted in the pilot's helmet and the short-rangemissiles carried by the aircraft is among the most agile in the world). Criticisms ofthe aircraft include its short range and reliability of its avionics and engines.

Production of the aircraft for Russian air forces was completed in 1994 and it hasbeen exported to a number of countries, including Iraq, India, Iran North Korea,East Germany, Hungary, Poland, Yugoslavia and Syria. Based on MilitaryBalance data, we estimate that there are over 1,000 MiG-29s in service around theworld. We continue to hear and read conflicting statements about whether or not

this aircraft is still in production.

nn Sukhoi Su-27/-30

The Su-27 is evolving into a family of multi-role combat aircraft Although theaircraft was conceived in the late 1960s, the first prototypes did not fly until thelate 1970s and the aircraft has been in operation with the Russian Air Force since1984. The aircraft is different from the MiG-29 because it was conceived as along-range interceptor. Its range and size are advantages over this competitor andhave enabled Sukhoi to make significant modifications to the aircraft. It too is ascapable as most of the Western aircraft now in production and one of itsadvantages is the ability to carry up to six beyond-visual-range-type missiles.

There are several different versions of the Su-27 that are now being offered. These

include the Su-27 all weather fighter/bomber, the Su-30, which is a long-rangeversion of the Su-27 equipped with a more powerful radar and able to assigntargets to other aircraft, the Su-30MK, which is a two-seat multi-role fighter andthe Su-34, which is a long-range strike version. Sukhoi is developing an improvedversion of the Su-27 that is referred to as the Su-35. The Su-27's Western equivalent isthe F-15.

The Su-27/-30 exports are picking up. China operates approximately 50 Su-27sand has been negotiating for the license production of the aircraft. India hasordered 40 Su-30MKs and deliveries began in 1997. Vietnam has ordered theaircraft and several are in operation.

Development Costs of Major Aircraft Programs

There is no such thing as a cheap aircraft development program, but then this istrue for most aircraft development programs these days. When developmentprograms for relatively simple 70-90 passenger civil airliners are estimated to beapproximately $1 billion, it should come as no surprise that fighter programs areoften multiples of this level. Table 8 shows estimates of how much recentprograms have cost. Not all have gone into production.

France is only buyer so far

Not clear if new production

is occurring

Mainstay Russian export


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Table 8: Development Costs For Several Major Air craft Prog rams

Country Aircraft Company or Enterprise Development cost Status

U.S. A-12 McDonn. Doug./General Dynamics +$5 billion canceled

F-20 Tigershark Northrop $1.2 billion cancelled in Nov. 1986

F/A-18E/F Boeing $6 billion in production

F-22 Lockheed Martin/Boeing $10-$12 billion development

Joint Strike Fighter Lockheed Martin v. Boeing $26 billion development

India LCA Hindustan Aeronautics +$1.9 billion development

Israel Lavi IAI +$1.5 billion cancelled

Taiwan Ching Kuo AIDC $1.5 billion production

U.K./Germany Eurofighter British Aerospace, DaimlerChrysler $10 billion late-stage development

Italy/Spain CASA, Alenia

Japan FSX Mitsubishi/Lockheed Martin +$3 billion In production

South Korea KTX-2 Samsung Aerospace/Lockheed Martin $2 billion development

Source: MLPF&S

Who Does What

Table 9 shows major suppliers of different components of military aircraft.

Table 9: National Champions Exist In Europe. U.S. Has Multipl e Sources

United States France U.K. Italy Germany Russia Sweden

Airframes Boeing Dassault/Aerospatiale BAE SYSTEMS Finmeccanica Daimler Chrysler Mikoyan SAAB

Lockheed Martin Sukhoi

Northrop Grumman

Engines General Electric SNECMA Rolls Royce Fiat MTU Saturn

Pratt & Whitney Klimov

Garrett

Radar Raytheon Thomson CSF BAE SYSTEMS Finmeccanica Daimler Chrysler Ericsson

Northrop Grumman

Lockheed Martin

Electronic self-protect

Northrop Grumman Dassault Electronique BAE SYSTEMS Finmeccanica Daimler Chrysler Ericsson

Lockheed Martin

Litton

Raytheon

ITT

Avionics, other Litton Thomson CSF BAE SYSTEMS Finmeccanica Daimler Chrysler

Honeywell Smith Industries

Rockwell Collins

BFGoodrich

Lockheed Martin

Source: MLPF&S


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[LLL, BA, LIT] MLPF&S was a manager of the most recent public offering of securities of this company within the last three years.[NOC] An officer, director or employee of MLPF&S or one of its affil iates is an officer or director of this company.Opinion Key [X-a-b-c]: Investment Risk Rating(X): A - Low, B - Average, C - Above Average, D - High. Appreciation Potential Rating (a: Int. Term - 0-12 mo.; b: Long Term - >1 yr.): 1 - Buy, 2 - Accumulate, 3 - Neutral, 4 -

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This research report is prepared for general circulation and is circulated for general information only. It does not have regard to the specific investment objectives, financial situation and the particular needs of any specificperson who may receive this report. Investors should seek financial advice regarding the appropriateness of investing in any securities or investment strategies discussed or recommended in this report and should understand thatstatements regarding future prospects may not be realized. Investors should note that income from such securities, if any, may fluctuate and that each security's price or value may rise or fall. Accordingly, investors may receiveback less than originally invested. Past performance is not necessarily a guide to future performance.

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