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Commercial Aviation Aerospace & Defence, Airlines, Multi- Industry a Renewed Lease of Life *See Page 2 for All Contributors to This Report 1 Morgan Stanley & Co

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Commercial Aviation Aerospace & Defence, Airlines, Multi- Industry a Renewed Lease of Life *See Page 2 for All Contributors to This Report 1 Morgan Stanley & Co July 22, 2013 MORGAN STANLEY BLUE PAPER MORGAN STANLEY RESEARCH Global Rupinder Vig1 +44 20 7425 2687 [email protected] Penny Butcher1 +44 20 7425 6698 [email protected] John Godyn2 +1 212 761 6605 [email protected] Nigel Coe2 +1 212 761 5574 [email protected] Commercial Aviation Aerospace & Defence, Airlines, Multi- Industry A Renewed Lease of Life *See page 2 for all contributors to this report 1 Morgan Stanley & Co. International plc+ 2 Morgan Stanley & Co. LLC Aircraft manufacturers can expect to enjoy several years of strong demand, as order flows remain healthy, financing is getting easier and growth in aircraft lessors smooths the cycle. Three factors give us confidence this cycle will be stronger for longer: Backlog confidence is rising. Backlogs for aircraft OEMS (original equipment manufacturers) are at all-time highs and now come from a more diversified customer base. High oil prices are driving demand for fuel-efficient aircraft, airlines in developed markets need to replace older fleets, and growth is still robust in emerging markets. Our bottom-up analysis of Boeing and Airbus backlogs suggest a low risk of cancellations. Financing hurdles are easing. EM banks and export credit agencies have allowed DM airlines to focus on return-enhancing replacements and EM airlines on expansion. We look at new financing opportunities available as the EETC market opens beyond the US, which should help airlines with attractive fleet orders to finance in the high-yield market. Leasing companies are playing a crucial role. Often overlooked, the proliferation of aircraft lessors plays a vital role in stabilising the commercial OEM cycle, enhancing the capital base, diversifying the customer base and bringing liquidity to the market. Who will benefit? EADS, Boeing and B/E Aerospace are clear beneficiaries of the strong cycle. Suppliers may see lower aftermarket revenues, but we like Rolls and Safran for Morgan Stanley Blue Papers focus on critical investment themes that require coordinated their young fleet exposure. Leasing company Air Lease looks attractive for its young fleet. perspectives across industry sectors, regions, Airlines IAG and Turkish should gain the most from EETCs. We also like Pratt, via United or asset classes. Technologies, for its backlog. Morgan Stanley does and seeks to do business with companies covered in Morgan Stanley Research. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of Morgan Stanley Research. Investors should consider Morgan Stanley Research as only a single factor in making their investment decision. For analyst certification and other important disclosures, refer to the Disclosure Section, located at the end of this report. * = This Research Report has been partially prepared by analysts employed by non-U.S. affiliates of the member. Please see page 2 for the name of each non-U.S. affiliate contributing to this Research Report and the names of the analysts employed by each contributing affiliate. += Analysts employed by non-U.S. affiliates are not registered with FINRA, may not be associated persons of the member and may not be subject to NASD/NYSE restrictions on communications with a subject company, public appearances and trading securities held by a research analyst account. MORGAN STANLEY RESEARCH July 22, 2013 Commercial Aviation — A Renewed Lease of Life Contributors to this Report European Aerospace & Defence Rupinder Vig1 + 44 20 7425 2687 [email protected] Jonathan Ackerley1 + 44 20 7425 8754 [email protected] European Airlines Penelope Butcher1 + 44 20 7425 6698 [email protected] Suzanne Todd1 + 44 20 7425 8316 [email protected] Jaime Rowbotham1 + 44 20 7425 5409 [email protected] Daniel Ruivo1 + 44 20 7425 5816 [email protected] US Aerospace & Defense / US Airlines John Godyn2 +1 212 761 6605 [email protected] Nathan Hong2 +1 212 761 3212 [email protected] Christopher Phifer +1 212 761-1736 [email protected] US Multi Industry Nigel Coe2 +1 212 761 5574 [email protected] Michael Sang2 +1 212 761 7092 [email protected] Jiayan Zhou2 +1 212 761 5766 [email protected] EEMEA Turkey Airlines Nida Iqbal3 +971 4 709 710 [email protected] Asia Pacific Airlines Edward Xu4 +852 2239 1521 [email protected] Li Mao4 +852 2239 1523 [email protected] Japan Airlines Takuya Osaka5 +81 3 5424 5915 [email protected] Haruka Yamada5 +81 3 5424 5323 [email protected] Australia Airlines Scott Kelly6 +61 2 9770 1583 [email protected] Julia Weng6 +61 2 9770 1197 [email protected] Latin America Airlines Eduardo Couto7 +55 11 3048 6133 [email protected] Augusto Ensiki2 +1 212 761 7134 [email protected] 1 Morgan Stanley & Co. International plc+ 4 Morgan Stanley Asia Limited+ 6 Morgan Stanley Australia Limited+ 2 Morgan Stanley & Co. LLC 5 Morgan Stanley MUFG Securities Co., Ltd.+ 7 Morgan Stanley C.T.V.M. S.A.+ 3 Morgan Stanley & Co. International plc (DIFC Branch)+ See page 65 for recent Blue Paper reports. We are grateful to Manish Ramuka and Chris Phifer for their contribution to this report. 2 MORGAN STANLEY RESEARCH July 22, 2013 Commercial Aviation — A Renewed Lease of Life Table of Contents Executive Summary 4 Part 1: Why this cycle could continue to positively surprise 12 Part 2: Backlog analysis – more resilient than you might think 28 Part 3: The Internationalisation of EETCs Eases Financing Concerns 37 Part 4: Leasing – adding stability to the OEM cycle 48 Part 5: Infrastructure: progress in addressing potential capacity 51 constraint Appendix 1 – Commercial aviation: A 40-year review 53 Appendix 2 – Airbus and Boeing installed fleet analysis 58 Appendix 3 – Airbus and Boeing backlog analysis 60 Appendix 4 – Airbus global market forecasts 62 Appendix 5 – Boeing’s global market forecasts 64 Recently Published Blue Papers 65 3 MORGAN STANLEY RESEARCH July 22, 2013 Commercial Aviation — A Renewed Lease of Life Executive Summary to 10,000 firm orders), equivalent to more than seven years of OEM cycle: stronger for longer. production. There is strong demand for more fuel-efficient aircraft in today’s high oil price environment. We are confident that this, coupled with replacement A more diverse and resilient backlog, easing aircraft financing demand in developed markets and growth demand in emerging markets, headwinds and infrastructure progress could see the OEM cycle will see the current cycle stay stronger for longer. Our conviction is remain stronger for longer. Aerospace OEMs should benefit, as underpinned by three positive trends, which we explore in detail in this should airlines that have large fleet replacement needs and/or are Blue Paper. well capitalised. 1. The OEM backlog is increasingly diverse and resilient. We analyse every aircraft order currently in the backlog to assess i) the financial health Financing this backlog has been tough, but is getting of each airline and ii) the likelihood that it will fulfil each order placed. Our easier. In last year’s Blue Paper, we discussed how we analysis puts at risk 10% of the total backlog at Airbus and 8% at Boeing estimated $300 billion of aircraft financing was required over due to poor financial health of the airline placing the order. As both the next three years, more than half of the $574 billion of the companies have a backlog worth more than seven years of production, we past 20 years combined. We believed that this significant think they still have strong visibility (significantly more than for the average requirement was under-appreciated by the market given that global industrial player). the bulk of it would need to be made up from non-internal 2. The headwinds in aircraft financing are easing. In our Blue Paper of sources such as banks, sovereigns and/or lessors. With the June last year, we showed how the market underestimated the fact that major austerity and regulatory changes that were taking place aircraft financing requirements were rising while traditional sources of in European and US banking markets, we felt the burden of financing were falling. This, we felt, could rein in airlines’ capital responsibility could fall on a much narrower range of expenditure, hamper capacity growth and increase risks to the OEM participants and potentially put order backlogs at risk. back¬log. This thesis has played out. With airlines now more disciplined on capacity decisions, profitability has improved and shares have Airlines: capacity tight, profitability up. We thought last appreciated, in many cases by more than 100%. For aerospace, the year that this issue would improve discipline on capacity impact was limited due to help from export credit agencies and new decisions. In the year since we published that Blue Paper, sources of financing (such as EM banks). Today, we show that financing capacity has remained tight, particularly in the mature issues may be easing with the opening of the international Enhanced markets of the US and Europe. Profitability has improved Equipment Trust Certificate (EETC) market, which offers a new financing and shares have appreciated, in many cases by more than avenue to airlines, particularly those that might otherwise have difficulty in 100%. The continuance of high oil prices curbs the ability obtaining financing. to self-finance significant aircraft purchases and is 3. The importance of leasing companies is overlooked. The market fails to supportive of continuing capacity discipline. appreciate the full potential of leasing companies, in our view. Not only do they take on residual risk associated with aircraft; they also enhance Aerospace: demand still strong. Last year, we did not liquidity across all aircraft. Moreover, they help diversify backlogs and anticipate a material impact on the OEMs from this issue, enhance the capital base available for financing aircraft.
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