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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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.

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

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. as we thought that the need to replace old aircraft with new, coupled with replacement demand out of developed markets and growth in emerging markets, would keep The OEM backlog is at record levels. According to the demand up. This has indeed been the case, with 2012 International Civil Aviation Organisation, revenue passenger seeing a total of 2,314 orders (for a book-to-bill ratio of kilometres (RPK) have risen by 6.7% on average since 1962, 1.95 times) and 2013 to date also seeing positive trends expanding at a rate of 1.65 times global GDP, driven by with 1,326 orders so far (for a book-to-bill of 2.21 times). improvements in technology and production costs, rising OEM strength has also been underpinned by a shift away consumer and corporate wealth, and deregulation. This traffic from traditional financing sources (such as European growth has seen OEM backlogs rise to record levels as banks) towards export credit agencies and emerging developed markets order planes for replacement and emerging market and Japanese banks. markets order planes for growth. EADS and Boeing have a total combined gross backlog of just over 14,000 aircraft (close

MORGAN STANLEY RESEARCH

July 22, 2013 Commercial Aviation — A Renewed Lease of Life

Our bottom-up analysis of the entire backlog gives us under-appreciated role in enhancing the stability of the confidence the OEM cycle is well placed to continue to commercial OE cycle, for a number of reasons. (1) Lessors show strength. In this Blue Paper one of the focus topics is take on the residual risk associated with aircraft, reducing the our belief in the ongoing strength of the OEM cycle, something risk of new aircraft orders for airlines. (2) Lessors enhance that many investors have questioned given the positive trends liquidity across all aircraft, but primarily across younger aircraft seen in the last few years. To this end we have carried out a full in demand, which encourages airlines toward the market analysis of every order currently in the Airbus and Boeing segment to which OEMs are most closely tied. (3) The backlog, customer by customer. With the help of our global presence of lessors further diversifies an OEM’s customer airlines teams we have analysed each order on the basis of i) base and can ‘introduce’ an OEM to new customers. (4) their financial health and ii) their likely fulfilment, of the backlog. Lessors enhance the capital base available for financing Our results reveal that ~10% of the Airbus backlog and ~8% of aircraft, thereby increasing access to capital for an OEM’s the Boeing backlog could be at risk as a result of poor financial customers and reducing airlines cost of debt, regardless of the health of the airlines. When assessing likely order fulfilment interest rate environment. (5) Lessors increasingly represent a (due, for example, to low traffic in the region or infrastructure source of orders in themselves for the OEMs. constraints), we estimate an additional ~8% is put at risk for Airbus and ~6% for Boeing. Given that both OEMs have a Progress has been made in easing infrastructure backlog of over 14,000 aircraft, the risk outlined above would constraints. Markets remain concerned that long-term traffic still leave both companies with considerable visibility (more growth could be constrained by infrastructure. In this Blue than the average global industrial player). Geographically, our Paper, we examine the recent progress seen at Rome and analysis suggests that airlines in India are most vulnerable. Istanbul airports. Both cities had several bidders for the work, showing that private capital is available so airport capacity The need for more efficient aircraft and demand from investment need not be a burden for governments – it can emerging markets are strong growth drivers. Over the past actually be a source of revenue. In other places (such as decade, fuel costs have more than doubled as a percentage of Munich and London), lack of political support – as opposed to revenues. This has led to significant demand for new, more capital – has seen little progress made. fuel-efficient aircraft (such as the A320neo, B737MAX, B787 and A350XWB). This has been coupled with continuing  Airlines: the internationalisation of the EETC market demand from emerging markets (EM), which now make up offers a new financing avenue for non-US airlines that 47% of the backlog versus just 15% in 1990, and replacement may have faced financing challenges in the past, as it demand out of developed markets (DM), where ageing fleet is centres on aircraft collateral value rather than airline a concern. This adds to our view that the OEM cycle can creditworthiness. As long as a high oil price environment continue to show strength and the depth of diversity of the persists, we would expect credit investors to be most backlog should instil confidence. attracted to airline debt backed by the most fuel-efficient assets, suggesting those airlines with large order books for The introduction of EETCs could be a real game new aircraft types could attract more favourable financing changer… EETCs are a form of aircraft financing often used in terms and potentially could lower their average cost of the US but extremely rarely in Europe, and are a focus topic in debt. We expect that well capitalised airlines will continue this Blue Paper. They are capital market instruments largely to have ready access to financing. In this Blue Paper we issued and rated on the value of the aircraft secured, rather take a detailed look at the EETC market including recent than the creditworthiness of the airline borrower. Only four transactions by IAG. EETCs have been issued so far in Europe, by the financing vehicles of Air France and Iberia, between 1999 and 2004. Our  Aerospace: the opening of the EETC market should in-depth analysis of the EETC market and its implications have a beneficial knock-on effect. Airlines aside, the indicates that the appeal of EETCs (especially in Europe) will EETC market may help those companies that have placed be very high and adds a further avenue for airlines to finance orders for delivery a few years out and still need to put their new aircraft demands (particularly those whose financing in place. Our key stocks to play this theme are creditworthiness would otherwise restrict severely their ability EADS, Boeing and B/E Aerospace. On the flipside, a to obtain financing). strong OEM cycle with greater retirement of younger aircraft could see earnings risk at aftermarket names that …and leasing companies will play an important, rely on servicing for profit. For those wanting to play the under-appreciated role in underpinning the backlog. The aftermarket, we prefer stocks with younger fleet proliferation of aircraft lessors plays a crucial yet exposures, such as Rolls-Royce and Safran.

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July 22, 2013 Commercial Aviation — A Renewed Lease of Life

Exhibit 1 Exhibit 2 Developed markets had a major share of backlog in …but emerging markets have now caught up 1990… 60.0% 100.0% 1990 2013 1990 2013

80.0% 40.0%

60.0%

20.0% 40.0%

0.0% 20.0% Asia East Africa Pacific Middle North area Europe 0.0% America Unknown

Caribbean Developed Region Emerging Market LatAmand Source: Ascend, Morgan Stanley Research Source: Ascend, Morgan Stanley Research

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July 22, 2013 Commercial Aviation — A Renewed Lease of Life

Our order of preference for likely beneficiaries and most challenged

Availability & Cost of Finance Backlog, Traffic & EM Fuel Volatility – Rising Trends Infrastructure Exposure Constraints

Key Well capitalised, incumbent EM based/partnered Well capitalised, low-cost Hub airports in major Beneficiaries airlines with attractive airlines, OEMs with high and young fleet airlines. population centres () backlogs, increased use of backlog exposure EM, and and airlines with high lessors. suppliers with younger fleet slot shares at hubs. exposure. Most OEMs and their supply Airlines only focused on Balance sheet constrained New entrant, growing Challenged () chain, balance sheet Western markets. airlines and old generation EM airlines unable to constrained airlines. exposed supply access DM population chain/MRO. centres. Neutral (~) Acceleration of replacement OEMs and lessors: cycle likely for OEMs, but boost in wide-body traffic volumes likely demand, but traffic constrained. volumes constrained.

EU AEROSPACE

EADS    ~ Rolls-Royce ~  ~  Safran ~  ~  MTU ~   ~ US AEROSPACE

Boeing    ~

B/E Aerospace    

Spirit AeroSystems    ~ EU AIRLINES

IAG    

Turkish Airlines    ~ EU AIRPORTS Vienna Airport ~ ~ ~  Zurich Airport ~ ~ ~  ADP ~ ~ ~  US MULTI-INDUSTRIAL General Electric ~  ~  Honeywell ~ ~ ~ ~ United ~  ~ ~ Technologies US LESSORS Air Lease    ~

Source: Morgan Stanley Research

MORGAN STANLEY RESEARCH

July 22, 2013 Commercial Aviation — A Renewed Lease of Life

Sub-sector Stock Picks

EU Aerospace (Rupinder Vig): demand – a segment to which the OEMs and supply chain are Top Pick – EADS historically more leveraged.

We believe EADS is best placed to benefit from a stronger As always with macro-cyclicals, our views assume no macro OE cycle... Within our European coverage universe, EADS shock – but, importantly, we would argue that the current OE looks best placed to benefit from a longer, stronger cycle. cycle should be more resilient even if one did occur. Further, the record level of backlog and its diversity should give Although we are not believers in the ‘there is no cycle anymore’ visibility on EADS’s earnings into the medium term, and the view of the OE cycle, we do believe that the cycle is far more need for new, more efficient aircraft should support demand. stable and resilient to macro shocks than in the past. The depth of current backlog is unprecedented, at an all-time high in …and the international opening of EETCs. A common terms of years of production. The breadth of the backlog has investor concern is how airlines will finance the very large also improved considerably, lending diversification to what was backlog in place. With the EETC market opening up, aircraft once a concentrated portfolio of customers. In addition, the financing should become less of a headwind. This market proliferation of aircraft lessors plays an important, should also make a notable difference to airlines that have under-appreciated role in enhancing the stability of the cycle. lower creditworthiness, as EETCs are largely issued and rated on the value of the aircraft secured (as opposed to the airline’s Stock implications: We are bullish on Boeing (Overweight), creditworthiness). This is good news for OEMs, and we regard the OE cycle bellwether, as evidence mounts that the company EADS as a clear play on this theme in Europe. We should also is executing well on rate increases, which should ultimately set see a positive impact on suppliers such as Rolls-Royce, Safran the stage for margin expansion. We also believe B/E and MTU, which have sizeable exposure to the Airbus and Aerospace (Overweight) is well suited to benefit from the Boeing backlog. themes we have outlined above, in spite of its recent run – particularly if there is a renewed interest in product across the However, the benefits for commercial OEMs come at the customer base. Although we are less excited about the expense of aftermarket growth. A stronger OEM cycle is aftermarket segment, companies with strong market positions, clearly good news for new aircraft deliveries, and a less the ability to offset volume weakness with price, and restrictive financing environment should also help. Although acquisition-led growth prospects look attractive; we favour this should have a positive impact on the supply chain, it is a TransDigm Group (Overweight). double-edged sword, as the stronger OEM cycle and the availability of new, more efficient aircraft could also increase EU Airlines (Penelope Butcher): aircraft retirements, which would hurt aftermarket revenues. Top Picks – IAG, THY US Aerospace (John Godyn): We see International Consolidated Airlines Group (IAG), the Top Picks – Boeing, B/E Aerospace parent of British Airways, as a key beneficiary of the international opening of the EETC debt financing market. Of Our findings support our bullish view on the commercial the developed European airlines under our coverage, we OE cycle. First, structural EM-driven traffic growth is estimate that IAG’s 2013-15 gross capital expenditure supportive of original equipment (OE) demand, as nascent, obligation is the largest versus its 2013 cash balance, at a ratio under-penetrated aviation markets are traditionally stimulated of 2.56 times versus a sector median of 1.34. IAG also has the through price, which requires aircraft with the lowest operating highest aggregate 2013-15 gross capital expenditure to costs capable of high utilisation. Second, even with relatively operating cash flow, on our numbers, at a ratio of 1.11 versus a sluggish traffic growth in developed markets, there is a strong sector median of 0.86. This suggests that IAG may prefer to case for replacement demand amid continued high fuel prices, finance its capital expenditure through external financing rather which have effectively eliminated the supply overhang of than internal cash flows. Its ability to tap external financing is parked aircraft. Third, easy access to aircraft financing at therefore critical to IAG’s fleet management plan. The group’s attractive rates is a major factor driving a preference for new success in tapping the EETC market in June gives us aircraft across airlines. Fourth, robust EM-driven demand and confidence that it now has a much better chance of obtaining continued globalisation are particularly supportive of wide-body such financing. This is important, because IAG recently

MORGAN STANLEY RESEARCH

July 22, 2013 Commercial Aviation — A Renewed Lease of Life

committed to significant new capital expenditure obligations for particular headwinds in funding aircraft, be it by internal means 24 additional B787 aircraft and 50 A350s beyond our 2013-15 (both Ryanair and easyJet now operate on-balance-sheet net forecast period. Our estimates suggest that gross capital cash positions) or eternal (leasing, bank loans or bonds). The expenditure for these deliveries could be around €5 billion, EETC is merely one more in a range of available options. The equivalent to the requirement for 2013-15. We also believe the opening of the EETC market is unlikely to be a game changer EETC market may allow IAG to reduce its average cost of debt, for legacy carrier Lufthansa, either, as the attraction of the which stands at 4.7% today. As our calculations show later in EETC lies in allowing less creditworthy airlines to issue this Blue Paper, a 40% mix of EETC at a 4% coupon in IAG’s investment-grade debt, whereas Lufthansa already enjoys current debt structure could lower the average cost of debt by corporate investment grade status. 110bps and bring down the group’s annual interest expense by €53 million (-23%). EU Airports (Jaime Rowbotham): Top Picks – ADP, Vienna Airport, Zurich We also believe emerging market airline Turkish Airlines Airport (THY) will benefit from the EETC opening. The company has launched an ambitious expansion plan to double its fleet Despite the low traffic growth we are seeing today, medium- to from 202 aircraft in 2012 to 423 by 2021, primarily adding long-term growth expectations remain good. This, coupled with narrow-body B737-8MAX and A320 neo aircraft. THY does not potential infrastructure capacity constraints, bodes well for provide capex guidance, but we estimate that gross capex in volumes and pricing at the main European airports. We find the 2013-15 equates to 21.4% of revenues in the period, versus airports space attractive, and our preferred names are ADP, 5.4-8.8% at the European legacy carriers. The company is Vienna Airport and Zurich Airport. We expect traffic to pick up committed to 8.6 times its 2013 cash balance, which is far again in 2H13, after declining so far this year, and this should above the developed European range of 0.55-2.56, suggesting help trading multiples expand. We estimate that the airports it is likely to require external financing. The company has trade on average on c.8 times EBITDA in 2013, compared to historically financed aircraft purchases 85% via support from their recent historical range of 7-10 and the significantly higher export credit agencies. It has highlighted EETCs, JOLCOs multiples in recent private transactions (Vinci Airports paid 15 (Japanese operating leases with call option) and bond times EBITDA for ANA in Portugal, Manchester Airports Group issuances as potential sources of financing for its current fleet paid 16 times EBITDA for Stansted in the UK and PSP expansion plan. Investments acquired Hochtief’s airports for 10 times EBITDA). Moreover, capital expenditure for these airports is falling, which We see no major benefit from the introduction of EETCs for our should allow companies to lower their leverage over the next other Overweight-rated airlines – easyJet, Ryanair and few years, increasing the scope for larger shareholder returns Lufthansa. We do not expect the low-cost carriers to face or acquisitions. Exhibit 3 EU airlines: capital expenditure analysis – legacy and EM growth airlines see relatively high capex burdens, but financing availability reduces risk of cash flow shortfalls while re-fleeting takes place Aggregate gross capex forecast as proportion of Aggregate gross capex Revenue Gross Cash Operating CF 13-15e Market Cap 13-15e (YE13e) 13-15e AF-KLM 4,404 2.24x 5.4% 1.04x 0.78x IAG 5,000 0.86x 8.8% 2.56x 1.11x Lufthansa 8,279 1.16x 8.6% 2.14x 0.86x easyJet 1,040 0.19x 7.6% 0.91x 0.56x Ryanair 2,098 0.21x 12.3% 0.55x 0.50x Air Arabia 3,232 0.53x 27.7% 1.34x 1.11x Turkish 14,061 1.26x 21.4% 8.60x 1.52x MEDIAN 0.86x 8.8% 1.34x 0.86x

Note: Market cap as of 16 July 2013 close. Source: Thomson Reuters, Morgan Stanley Research estimates

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July 22, 2013 Commercial Aviation — A Renewed Lease of Life

US Leasing (John Godyn): thus growth in the backlog. Honeywell participates primarily as Top Picks – Air Lease an OEM and aftermarket supplier of aircraft electronics.

Our work reinforces our view that aircraft leasing Pratt, through United Technologies, is our favoured way fundamentals are poised to improve. Among the lessors, we to play the strong backlog. The company has the highest prefer Air Lease (AL) as we believe it benefits from a number of aerospace mix in our coverage universe, and is well positioned advantages over peers, including a well articulated earnings to benefit from the 12,000 plane backlog. Management growth strategy; the largest order book among public lessors; recently reiterated plans to double revenue at Pratt from $12.2 the youngest fleet of high-quality assets; a conservative billion to over $24 billion by 2020, which implies attractive balance sheet with more debt capacity; and opportunity for annual revenue growth of over 7% (CAGR), outpacing the higher returns on equity. mid-single-digit growth we have seen in long-term aircraft deliveries and worldwide traffic growth. We think some lessors can be valued as part of the aerospace supply chain. As the parallel goes, many The GTF will be the main driver of Pratt’s revenue upside. aerospace suppliers have a close relationship with an OEM Management expects the GTF engine, also known as the that affords the supplier a preferential position on a programme PW1000G, to generate upwards of $400 billion over the life of and earn revenue on a certain percentage of the units that the the programme. Pratt’s recent acquisition of the IAE joint OEM sells. This allows the supplier to share in the demand venture from Rolls-Royce brings with it significant high-margin curve that an OEM faces and benefit from the visibility aftermarket content, which we think will provide a margin associated with record backlogs. In many ways, AL shares bridge to offset dilution from the initial GTF deliveries, starting these characteristics. Many in the industry feel that the in 2014 with the CSeries. company has cultivated relationships with the manufacturers that are second-to-none among public lessors. The GE Aviation is also attractive, but a much smaller part of management team also has a long history of being on new the overall business. We estimate that GE has just 14% of aircraft design committees, and launch customers for those the backlog, but the company retains a 50% share of the CFM aircraft. As a result, the company is on a very short list of engine economics through a joint venture with Snecma. That lessors (only GE Capital Aviation Services (GECAS) and AL of said, GE’s engine business (including military) represented just late) that are positioned to benefit from launch customer pricing 15% of consolidated revenues in 2012, so a much smaller and/or relationships. Moreover, on subsequent aircraft orders, driver of share price performance than at United Technologies. AL can get incremental discounts by introducing new customers to a particular manufacturer’s aircraft type. AL sells Numbers can be deceptive, as GE and Rolls-Royce’s its OE-purchased inventory forward (and is nearly sold out of strength lies in wide-bodies. The cost of the engine and inventory to 2015), effectively simulating the ‘revenue backlog’ eventual maintenance are proportional to the size of the that many aerospace suppliers benefit from through their aircraft. Put another way, bigger planes require bigger (or association with the OEMs. All of these points parallel the more) engines, which in turn require more expensive characteristics that define aerospace suppliers. Importantly, maintenance, repair and operations. As such, having we believe trading like an aerospace supplier should drive an wide-body content is important. We note that 100% of increased focus on price/earnings multiples and enhance Rolls-Royce engines are for wide-body aircraft, driven largely multiple stability – points in direct contrast to the bear case on by their positions on the 787 and A350. Similarly, 70% of GE’s the stock, which is that its multiple converges to much cheaper backlog is on wide-bodies, a number that will likely drift aircraft leasing peers over time. upwards once the 777-x takes orders. In stark contrast, 95% of Pratt’s backlog is for narrow-body content. US Multi-Industrial (Nigel Coe): Top Picks – United Technologies Commercial aviation is a meaningful end-market for United Technologies, Honeywell and GE. The two largest players by revenues are United Technologies and GE through their respective engine segments, Pratt & Whitney and GE Aviation. We think improvements in engine technology have been, and will remain, the key driver of aircraft efficiency and

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July 22, 2013 Commercial Aviation — A Renewed Lease of Life

Exhibit 4 Exhibit 5 EE/MI aerospace and defence exposure by stock Pratt has a solid share on a number of key aircraft 36% platforms Engine OEM 30% Plane CFM GE Pratt RR In production 24% V2500, Airbus A320 Family CFM56 PW6000 18% Airbus A330 CF6 PW4000 Trent 700 Airbus A380 GP7000 GP7000 12% Trent 900 Boeing 737NG CFM56 6% 747-8 GEnx 767 CF6 0% JT9D ITW DOV ETN EE/MI AME GE HON UTX PW4000 ITW = Illinois Tool Works, DOV = Dover, ETN = Eaton Corp, EE = electrical equipment, MI = multi-industrial, AME = Ametek, GE = General Electric, HON = Honeywell International, UTX = RB211 United Technologies. Source: Company data (2012), Morgan Stanley Research 777 GE90 PW4000 Trent 800 787 GEnx Trent 1000 Embraer E-Jet CF34 Bombardier C-jet CF34

In development Airbus A320 PW1000G Leap Airbus A350 Trent XWB Boeing 737Max Leap Boeing 777-x Unnamed Bombardier CSeries PW1000G Embraer G2 Unnamed Comac C919 Leap Mitsubishi MRJ PW1000G Source: Company Data, Morgan Stanley Research

MORGAN STANLEY RESEARCH

July 22, 2013 Commercial Aviation — A Renewed Lease of Life

Part 1: Why this cycle could continue to positively surprise

for growth, fleet growth is still almost double passenger growth Expect a stronger OEM cycle fuelled by replacement demand in trends in the past decade. developed markets, growth in emerging markets and the need for more efficient aircraft EM growth remains important for global traffic trends – Over the past decade, fuel costs have more than doubled as a favourable for new aircraft demand. Ultimately, global traffic percentage of revenues, driving demand for new, more fuel-efficient growth is the best overall indicator of demand for aircraft, as aircraft (such as the A320neo, B737MAX, B787 and A350XWB). This traffic strength drives the need for capacity growth and has been coupled with continuing demand from emerging markets healthier margins across airlines, which stimulates capital (which now make up almost half of the backlog versus just over 15% expenditure and aircraft replacement decisions. In contrast, in 1990) and replacement demand in developed markets. All of this without the benefit of a rising global demand environment, we should see the OEM cycle continue to surprise positively, and the believe global airline operating margins are likely to suffer and level and depth of diversity of the backlog should instil confidence. a lack of profitability across customers will lead to less demand for aircraft. Consistent with prior rebounds, as the global

economy rebounded from the financial crisis, year-on-year Macro and political issues have not traffic (measured in RPKs) recovered as well, even exceeding growth rates seen during most of the pre-financial crisis cycle. constrained demand for new aircraft However, since this initial burst, global traffic growth has been Since the birth of the jet age (c.1960), growth in the on a positive but decelerating trend, underperforming the last commercial aviation sector has consistently exceeded cycle and historical average growth rates – a fact that has GDP across the globe. According to the International Civil weighed on aftermarket but not OE trends. Aviation Organisation, RPKs have risen by 6.7% on average since 1962, expanding at a rate of 1.65 times global GDP, Air travel remains labour- and driven by improvements in technology and production costs, capital-intensive rising consumer and corporate wealth, and deregulation. High fixed costs mean that any drop in revenue has a In recent years, however, growth rates have contracted disproportionate impact on earnings. The airline industry (by 3% on average in 2007-11) as the global financial crisis has a high level of fixed obligations, which limits the ability to and sovereign woes in Europe have taken their toll. 2009 obtain additional financing; restricts the ability to respond saw an unprecedented contraction in global GDP growth, nimbly to the competitive environment; and increases which was reflected in a similar volume and yield contraction vulnerability to economic conditions. Fixed obligations include among the global airlines. This was particularly pronounced in debt, aircraft leases and financing, aircraft purchase the US and Europe, which, together, still represent around 60% commitments, airport development and other facilities. As a of global traffic volumes. While year-to-date traffic trends were result of the substantial fixed costs, a decline in revenue results tracking close to 4.3% in May, IATA expects this will moderate in a disproportionately high percentage decline in earnings. towards ~4.5% growth over the whole of 2013, suggesting another year of below-average traffic growth for the industry. Airlines are far more capital-intensive than other service industries. Air transportation is a service and, by nature, Traffic growth rates may be slowing, but the same cannot labour-intensive. In 2011, labour costs amounted to 16% of be said of aircraft fleet growth. In fact, we believe there is a total expenses, with fuel at 30%, together accounting for disconnect between volume trends, financing availability and almost 50% of the cost base. However, unlike most service the aircraft backlog at key manufacturers Boeing and Airbus. providers, airlines are also highly capital-intensive. The backlog of deliveries and options stands at ~14,000 Depreciation, maintenance and aircraft rental account for aircraft (~10,000 firm orders – Boeing and Airbus only). If we 22-23% of expenses. The need for substantial amounts of assume that all of these deliveries are incremental to the capital has a significant impact on the balance sheet and cash installed fleet base today, this would see the installed fleet grow flow because, over time, the industry has only been able to by 86% (CAGR of 8% through 2020, 5.5% on firm orders only). generate around 50% (usually less) of its capital requirements If we conservatively assume that ~30% of the installed base is from internally generated cash flow. The debt-to-equity ratio for ‘old generation’ and therefore only 70% of the backlog is slated the European airlines we cover averages 2-3 times, but ranges

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July 22, 2013 Commercial Aviation — A Renewed Lease of Life

from net cash at the healthiest end to 4-5 times at the consistent with the average age worldwide but find themselves financially weaker end of the sector. older than the average in Latin America, the Middle East and Rest of World (RoW), where the average age profile has An airline’s profitability record has often affected access changed. This lends support to the outer years for Boeing and to traditional financing sources, but other sources (such Airbus backlogs as the US carriers replace their ageing fleets. as export credit) have filled the gap. Over the past 20 years Unsurprisingly, rising fuel prices have been a key catalyst in (half of the jet aircraft era), the net profit margin for the global driving average aircraft ages lower, so are highly correlated industry has averaged 1.8%. Excluding years of extreme with replacement demand. exogenous shock (1990-93, 2001, 2008-09), the average is still only 2.8%. In the same period, capital expenditure has totalled Exhibit 6 $1,075 billion, of which 46.6% came from internal cash flow, The fuel efficiency of new aircraft has improved leaving $574 billion to be tapped from the capital markets. sharply … According to industry forecaster Airline Monitor, this funding requirement could reach $650-700 billion in the next 10 years.

High fixed costs exist at the individual aircraft level. The average cost per ASK has been decreasing as the average size of aircraft has increased. This has been driven in part by technology, helping fuel and labour productivity, and making better use of infrastructure such as expensive monopolistic airports. For airlines, marginal costs for additional passengers transported are very low, which reinforces price discounting. Variable costs per aircraft, however, are significant and have increased as jet fuel prices have risen in the last few years. The fall in operating costs with aircraft size drives the importance of Source: Lee, IATA route density. Exhibit 7 … but fuel costs as a percentage of revenues have This feature also leads to network effects: adding a connection more than doubled in the past decade not only creates additional revenues and costs on the new route but also enables additional traffic/revenue to be 40% generated for existing connections. The combination of these two dynamics drives the business model of network airlines, 30% where feeder flights to hubs provide the customers that make larger planes economical to fly on higher-density, longer-haul 20% connections. Hubs are also a key driver of code-sharing, which brings in additional feeder flights operated by other airlines. 10%

Need for more fuel-efficient aircraft 0% 2000 2002 2004 2006 2008 2010 2012 Elevated fuel prices have stimulated replacement demand. The cost of fuel is a major component of the cost of Source: Company data, Morgan Stanley Research operating an aircraft. As such, fuel efficiency has a material impact on the operating cost curve. High fuel prices are therefore an important catalyst for replacement demand. Over the 20 years between 1982 and 2002, fuel prices remained low as a percentage of airline operating expense. This contributed in many ways to the situation in which airlines find themselves today, where high fuel costs exacerbate the problem of operating older aircraft. Low fuel costs invited a multi-decade hiatus for regular aircraft replacement, which is now overdue. Notably, the US carriers operate with a fleet age largely

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July 22, 2013 Commercial Aviation — A Renewed Lease of Life

Exhibit 8 The order upswing of recent years has bred investor Fuel costs have replaced labour as the largest concern about the economics of buying new aircraft. With component of airline cost structures EADS’s backlog now exceeding seven years of production, the 40% focus is shifting onto management’s ability successfully to deliver on this backlog. This in turn hinges on economic benefit to an airline of purchasing a new aircraft. This has become 30% particularly important in the current climate where funding costs have risen sharply, making the purchase of new aircraft in an 20% environment of higher funding costs.

To assess this, we have carried out an in-depth analysis of the 10% efficiency advantage of a number of new aircraft. To ascertain whether the economic benefit of purchasing a new aircraft Fuel as % of Total Op. Expenses Op. Total of % as Fuel 0% outweighs the capital cost, we have compared a number of new aircraft to their predecessors. For single-aisle aircraft, we 1Q72 1Q75 1Q78 1Q81 1Q84 1Q87 1Q90 1Q93 1Q96 1Q99 1Q02 1Q05 1Q08 1Q11 have compared the A320neo to the current A320 and the B737 Source: US A4A Cost Index, Morgan Stanley Research MAX to the B737-700. For wide-bodies, we have compared the Exhibit 9 A350-900 to the B777-200 as well the B787-9 to the B777-200. Unsurprisingly, rising fuel prices have been highly We compare the fuel cost of these aircraft to gauge the correlated with replacement demand potential saving that the successor aircraft provides. While this 900 Fuel price Replacement aircraft $3.50 approach has its limitations, in that running costs and flight

800 usage will be different for each airline, we believe the analysis $3.00 provides a good indication of the potential economic benefit to 700 $2.50 an airline. 600 FuelPrice 500 $2.00 Another limitation is that running costs and flight usage will be different for each type of aircraft. We think accuracy on the 400 $1.50 single-aisle planes is relatively high, as the next generation of 300 Number of Aircraft of Number $1.00 planes in this class should not differ much at all in terms of 200 operational deployment, weight or capacity. For the wide-body $0.50 100 aircraft, however, the comparison is more complex so we have included seat capacity information to reflect these differences. 0 $0.00 Exhibit 10 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 Fuel makes up over 50% of an airline’s running costs Source: US A4A Cost Index, Ascend: Western Jets as of 31/12/12, Morgan Stanley Research Maintenance To be fair, high fuel prices can be a double-edged sword, , 15% but today they are very much a tailwind for the OE cycle. Rising fuel prices can be a negative for new aircraft demand if Depreciation, fuel prices rise so quickly that they put a number of airlines at 6% risk of a liquidity squeeze. It is therefore unsurprising that airline stocks have a long history of being negative correlation Rent, 3% with the oil price. However, persistently high, or even slowly rising, fuel prices are positive for new aircraft demand as they Fuel raise the premium that airlines place on young, fuel-efficient Expense, 58% aircraft. Unless fuel prices rise or a major demand shock Flight Crew occurs without a commensurate fall in fuel prices, we expect Expense, high fuel prices to continue to put pressure on airlines to 18% replace older, less efficient aircraft.

Source: Airline Monitor, Morgan Stanley Research (based on a B737-700)

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July 22, 2013 Commercial Aviation — A Renewed Lease of Life

Exhibit 11 For the B737 MAX and the A320neo, we estimate a saving What are the potential savings from a new, more of 17% in fuel costs over their current equivalents. Given efficient aircraft? that fuel costs make up over half of an airline’s running costs, a Aircraft Comparison Potential fuel cost saving 17% saving here is attractive. If we assume an 8% saving on A320 NEO vs. A320 17% the running costs for each new plane, this would more than B737 MAX vs. B737-700 17% cover the financing cost that could be seen as a potential A350-900 vs. B777-700 14% downside to renewing the fleet. B787-9 vs. B777-700 23% Source: Airline Monitor, Morgan Stanley Research For wide-body aircraft, similar savings look possible. The The results suggest airlines can make significant savings A350-900 can be seen as a direct replacement for the replacing old aircraft with new, more efficient aircraft. Our B777-200 for airlines, with almost identical seating and the analysis shows that there are significant savings to be made same wide-body domestic or long-haul capabilities. Our from replacing older aircraft with new, more efficient ones. analysis indicates a potential saving of 14%; for the B787-9 the Clearly the oil price is an important input into this analysis and, saving is higher, at 23%. at a fuel price significantly lower than current levels, the economic benefits of a new aircraft would fall to a level that might make airlines reconsider their purchasing requirements.

Exhibit 12

The efficiency gain from a new aircraft is very significant and clearly justifies the capital cost involved Single-Aisle Airbus Boeing (A320 NEO vs. A320) (B737 MAX vs. B737-700) A320 A320 NEO % Savings B737-700 B737 MAX % Savings Seat Capacity 150 - 220 150 - 220 Seat Capacity 130 - 150 126 - 180 Block Hours 1,651,733 1,651,733 Block Hours 1,940,918 1,940,918 Gallons of Fuel 1,298,618 1,106,661 Gallons of Fuel 1,341,919 1,145,142

Fuel Expense 3,884,440 3,310,257 Fuel Expense 4,172,387 3,560,553 Fuel Cost Per Gallon 2.99 2.99 Fuel Cost Per Gallon 3.11 3.11

Gallons of Fuel Per Block Hour 786 670 Gallons of Fuel Per Block Hour 691 590 Fuel Cost Per Block Hour 2,352 2,004 17% Fuel Cost Per Block Hour 2,150 1,834 17% Wide-Body Airbus Boeing (A350-900 vs. B777-200) (B787-9 vs. B777-200) B777-200 A350-900 % Savings B777-200 B787-9 % Savings Seat Capacity 314 - 440 314 - 475 Seat Capacity 314 - 440 250 - 290 Block Hours 646,250 646,250 Block Hours 646,250 646,250 Gallons of Fuel 1,430,657 1,260,188 Gallons of Fuel 1,430,657 1,163,250

Fuel Expense 4,405,008 3,880,131 Fuel Expense 4,405,008 3,581,659 Fuel Cost Per Gallon 3.08 3.08 Fuel Cost Per Gallon 3.08 3.08

Gallons of Fuel Per Block Hour 2,214 1,950 Gallons of Fuel Per Block Hour 2,214 1,800 Fuel Cost Per Block Hour 6,816 6,004 14% Fuel Cost Per Block Hour 6,816 5,542 23%

Source: Airline Monitor, Morgan Stanley Research

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July 22, 2013 Commercial Aviation — A Renewed Lease of Life

The average age of the global commercial Exhibit 13 Average age of the global commercial fleet 15 fleet is declining Average age of installed base In 1990, the average age of the global fleet was just over 14 12 years. The trend towards a younger global fleet is nothing new. With our data sampling only the in-service, commercially 13 operated fleets of Boeing, McDonald Douglas and Airbus, this average age looks relatively low in the context of the previous 12 two decades.

11 There will always be a skew towards the younger planes. As global traffic continues to double every 15 years or so, the 10

need for new planes just to cover the increasing demand has 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 seen delivery rates at Airbus and Boeing continue to grow, and Source: Ascend, Morgan Stanley Research many older planes are kept in service as there is a genuine need to fill a capacity gap. Exhibit 14 Global fleet age progression 11% 11% 10% 12% 11% By 1997 the average age had risen to almost 13.5 years. 18% 16% 15% This change over just seven years was the result of production 33% rates at the OEMs failing to match the rapid a rapid increase in 27% 29% 38% 35% 36% 36% passenger air traffic. While the proportion of ‘young’ aircraft (up 31% to 10 years old) in the fleet increased, the fact that older aircraft had to remain in service skewed the average age upwards.

57% 56% 57% As of the end of 2012, the average age of the global fleet 51% 52% 54% 53% 52% was back at 12 years (in line with the average age in 1990). Increasing production rates at the OEMs have been better able to replace older aircraft, even as traffic has continued to grow. 1990 1995 2000 2005 2009 2010 2011 2012 0-10 Years 11-20 Years >20 Years Source: Ascend, Morgan Stanley Research Retirements averaged 88 per year between 1990 and 2000 – largely B727s and later B747s … The average age for Exhibit 15 retirement of Boeing 727s has been just under 30 years, and As the capacity gap narrows, will deliveries and Boeing saw a steady stream of retirements at the end of their retirements as a % of the installed base converge? Deliveries as a % of IB Retirements s a % of IB economic life until the beginning of this decade. Similarly, the 12% Boeing 747 has an average retirement age of over 26 years. As a result, these retirements can be seen as ‘natural’, rather than 10% driven by any particular need or advantage to retiring a plane 8% earlier.

6% …but rose sharply after 9/11. The number of retirements rose sharply in 2002 post 9/11, and this trend accelerated 4% through the decade in absolute terms and as a percentage of the installed base, indicating a higher turnover of aircraft. 2%

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 Source: Ascend, Morgan Stanley Research

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July 22, 2013 Commercial Aviation — A Renewed Lease of Life

Exhibit 16 Interestingly, Latin America has seen a lot of retirements Retirements as a % of installed base have closely even though its civil aviation markets are relatively tracked the absolute retirement number, even with immature. Unlike growing markets such as the Middle East the much larger installed base where retirements remain low, Latin America has seen 500 5.0% Retirements As a % of insatlled base significant retirements alongside rapidly growing traffic. This is indicative of a market in which growth exists, but with a strong 400 4.0% level of operational competition, so a focus on more efficient

300 3.0% aircraft becomes important.

200 2.0% While not without risk, EM remains a strong No. of Retirements

As a % of Installed Base %Installed As of a growth driver 100 1.0% Emerging market growth moves the needle. Segmenting

0 0.0% global traffic growth trends shows that developed market growth has been the underperformer, reflecting Eurozone 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

Source: Ascend, Morgan Stanley Research weakness post the financial crisis and capacity rationalisation and consolidation in the US. In contrast, emerging market Exhibit 17 growth has been a clear area of outperformance – a trend we Average retirement age by region (last 20 years) believe can continue for some time. Emerging markets are no 35.00 longer minor contributors to global traffic, representing ~50% of

30.00 traffic. With traffic growth historically correlated to real GDP

25.00 trends, a major driver of the recent emerging versus developed market outperformance has been the higher real GDP trends in 20.00 emerging markets than in developed economies. However, 15.00 relative GDP growth is not the only explanation: deeper, 10.00 potentially longer-lasting secular drivers also support emerging 5.00 market traffic growth.

0.00

Other EM economies have a long way to catch up if they are ever Africa Europe to become as aircraft-loving as DM economies. Though Asia Pacific Asia Multinational Middlen East Latin America Latin North America difficult to quantify precisely due to topological and Source: Ascend, Thomson Reuters, Morgan Stanley Research infrastructure differences, the emerging economies have far fewer aircraft than the developed economies, adjusting for Most replacement demand is from mature differences in population and wealth. Although they are quickly markets (US and Europe) closing the gap, there is still significant upside if the emerging economies can match the number of aircraft per person in The US has accounted for the lion’s share of retirements. developed economies, with Asia having the most upside in This should come as no surprise, as the US is the most mature absolute and relative terms. Even adjusting for lower GDP per market in terms of both traffic growth and its installed base. capita (given affluence drives demand for leisure travel and Until the mid-2000s the US accounted for the vast majority of productivity drives demand for business travel). Asia stands global retirements, and still accounts for around half of global out as an outlier poised for growth. Furthermore, these annual commercial retirements. adjusted data imply that the ratio of aircraft per person is likely to grow more rapidly in emerging economies, as the quality of More recently, Europe and Asia have seen higher levels of life and productivity are likely to grow faster there than in retirement as their fleets have matured. As traffic growth in developed economies given their comparative GDP growth these markets starts to level out, retirements have increased, rates. with new aircraft deliveries beginning to replace older ones more often than adding to capacity.

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July 22, 2013 Commercial Aviation — A Renewed Lease of Life

Exhibit 18 Exhibit 21 Share of system-wide last 12-month RPKs Global fleet growth is likely to be driven by EMs Africa 9 2% North America 8.5 North America Europe 27% Asia 8 29% Asia 7.5 Latin America

7 Middle East Middle East Africa 8% 6.5 Australia 6

Latin America Norm.) (Log Aircraft of Number 5.5 Europe 6% 5 28% 3456789 Million People (Log Normalized) Note: Adjusted for leap year. Source: IATA, Morgan Stanley Research Note: Assumes Western Asia = Middle East. Source: United Nations Statistics Division, Census.gov, Ascend: Western Jets, Company data, Morgan Stanley Research Exhibit 19 Advanced economies’ real GDP growth Exhibit 22 8% Despite strong gains in GDP per capita, Asia lags other regions in population-adjusted fleet size 6% 3.5 North 4% 3 2.5 2% 2 Australa 0% 1.5 Middle East Europe 1 -2% People 0.5 Africa Latin -4% 0 -0.5 Asia

1970 1973 1976 1979 1982 1985 1988 1991 1994 1997 2000 2003 2006 2009 2012 2015 -1 Million_ per AC Normalized Log Source: IMF WEO April 2013, Morgan Stanley Research forecasts from 2013 onwards 6789101112 Log Normalized GDP per Capita Exhibit 20 Note: Assumes Western Asia = Middle East. Source: United Nations Statistics Division, Emerging/developing economies’ real GDP growth Census.gov, Ascend: Western Jets, Morgan Stanley Research 10% Exhibit 23 8% IATA emerging market versus developed market traffic growth spread 6% Emerging Market Less Developed Market 60% YoY Growth Rate Spread 4%

2% 40%

0% 20%

1970 1973 1976 1979 1982 1985 1988 1991 1994 1997 2000 2003 2006 2009 2012 2015 Source: IMF WEO April 2013, Morgan Stanley Research 0%

-20%

-40%

2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 Note: EM = Africa, Asia, Latin America and Middle East, DM = Europe and North America Source: IATA, Company data, Morgan Stanley Research

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July 22, 2013 Commercial Aviation — A Renewed Lease of Life

EM versus DM outperformance likely to continue for some Exhibit 25 time. A useful way to track this theme is the EM versus DM Developing markets tend to need younger aircraft traffic growth spread. Unsurprisingly, the trends above have when stimulating traffic growth resulted in significant outperformance in EM domestic traffic Aircraft Greater Than 15 Yrs Old (LHS) % of Total Fleet (RHS) trends versus DM over the last decade. Moreover, the secular 3,500 50% drivers of this trend mean it is highly resilient across the cycle. 3,000 Boeing’s market outlook for 2012-31 supports the view that the 40% emerging economies will be the primary source of growth in 2,500 30% aircraft demand going forward. Structural EM-driven traffic 2,000 growth strength is supportive of OE demand, as nascent, 1,500 under-penetrated aviation markets are traditionally stimulated 20% through price, which primarily requires aircraft with the lowest 1,000 operating costs capable of the highest utilisation rates – new 10% aircraft. 500 0 0% Exhibit 24 Africa North MidEast LatAm Euro Australia Asia America Boeing market outlook supports EM growth 7% Traffic Growth GDP Growth Fleet Growth Source: Ascend: Western Jets as of 12/31/2012, Morgan Stanley Research

3% CAGR (%) CAGR

0% Latin Asia Middle Africa Europe CIS North World America Pacific East America

CIS = Azerbaijan, Armenia, Belarus, Georgia, Kazakhstan, Kyrgyzstan, Moldova, Russia, Tajikistan, Turkmenistan, Uzbekistan and Ukraine. Source: Boeing Market Outlook 2012-2031, Morgan Stanley Research

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July 22, 2013 Commercial Aviation — A Renewed Lease of Life

Exhibit 26 Annual retirements by region 500 Africa Asia Pacific Europe International / Multi-National Latin America and Caribbean Middle East 400 North America

300

200

100

1 3 4 7 9 3 5 8 1 92 95 98 00 04 06 09 10 12 99 9 99 9 99 9 0 00 0 0 00 0 0 0 1990 1 1 199 1 1 1996 1 1 199 2 2001 2002 2 2 200 2 2007 2 2 2 201 2 YTD

Source: Ascend, Morgan Stanley Research

Exhibit 27 Annual retirements by aircraft 500 707 717 720 727 737 747 757 767 777 A300 A310 A320 A330 A340 DC- Series MD-Series Other 400

300

200

100

0 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

Source: Ascend, Morgan Stanley Research

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July 22, 2013 Commercial Aviation — A Renewed Lease of Life

Older aircraft models have a major share of Exhibit 29 Oil price – $ per barrel since 2000 retirements $160 Brent Crude US$/BBL B727s and B737s account for a high number of retirements. These planes fuelled the growth of US domestic $120 commercial aviation, and have enjoyed long average working lives, with both at just over 26 years. There have also been a lot of retirements for the older DC-Series and MC-Series planes. $80

There has been no revolutionary aircraft to replace these $40 planes. Even on a global scale, planes such as the B727, B737 and A320 have been able to dominate the mid-range $0 sector with no game-changing products introduced. Changes

made by Airbus and Boeing have been a more gradual, Jul/03 Jul/04 Jul/05 Jul/06 Jul/07 Jul/08 Jul/09 Jul/10 Jul/11 Jul/12 Jul/13 evolutionary nature, so there has been little motivation to Source: DataStream, Morgan Stanley Research renew aircraft. The same can be said for the older DC-Series and MC-Series planes. There are a lot of new planes coming to market. With the A380 and B787 both still in the process of ramping up So the B747 continues to be flown for over 25 years on production, they are soon to be joined by the A350 XWB, a new average; but this could change. With the A380 taking the derivative of the B777, and of course the B737MAX and lead in the somewhat niche market for jumbo-jetliners, airlines A320neo. All of these aircraft will offer significant are looking to replace their B747s with significantly more improvements in operational efficiency, and therefore efficient wide-body aircraft, such as the B787 and A350XWB. profitability, to their predecessors, and soaring fuel markets have added to market demand. Backlogs show that many aircraft are set to be replaced in the coming years. As fuel costs have increased as a In addition, more attractive financing rates diminish the proportion of airlines’ operating costs, the focus on having the appeal of keeping older planes. As we discuss in Part 3, the newest, most efficient planes possible has increased. Even cost of financing aircraft has become more attractive in recent factoring in some capacity expansion, many of the orders are years, and the increasing use of EETCs is set to ensure the for replacement. cost of aircraft finance remains low. With fuel cost accounting for such a large part of an airline’s operational costs, the Exhibit 28 prospect of a 15-20% saving in fuel cost will more than cover Average retirement age of aircraft models the cost of finance on a new plane. A320

A310

A300 Average age of aircraft will continue to fall

MD-Series with increased production and launch of 757 more fuel-efficient aircraft 767 The average length of a commercial aircraft’s lifecycle is 747 undoubtedly falling. The average age of the global fleet fell 737 from 13.5 years in 1998 to 11.9 by the end of 2012, and the 727 trend looks set to continue. 707

DC-Series Growing traffic demand and relative inelasticity of supply 0.0 5.0 10.0 15.0 20.0 25.0 30.0 35.0 40.0 have kept average ages high. Production from OEMs has Source: Ascend, Morgan Stanley Research risen gradually over the last two decades, but this has not matched traffic increases, meaning that older aircraft have had

to be kept in service.

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July 22, 2013 Commercial Aviation — A Renewed Lease of Life

Exhibit 30 Retirements as a % of deliveries continue to trend upwards 1200 Retirements Deliveries Retiremnts as a % of Deliveries 45%

40% 1000 35%

800 30%

25% 600 20%

400 15%

10% 200 5%

0 0%

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 Source: Ascend, Morgan Stanley Research

Exhibit 31 Exhibit 32 Oil price versus retirements Global GDP versus retirements 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 500 6.0% 160 500 Retirements (LHS) World GDP (RHS) Retirements Brent Crude 450 5.0% 450 140 400 4.0% 400 120 350 350 3.0% 100 300 300 2.0% 250 80 250 1.0% 200

$ per barrel per $ 200 60 0.0% 150 150 40 -1.0% 100 100 20 50 50 -2.0%

0 0 0 -3.0% 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 Source: Ascend, Thomson Reuters, Morgan Stanley Research Source: Ascend, Thomson Reuters, Morgan Stanley Research As mature markets receive their new planes, and growing During this period of rising deliveries, the markets mature, the average age is set to trend down. We number of parked aircraft has remained presume that mature markets will seek to retire their older, less stable, but the number going into efficient planes as soon as possible, given the new wave of retirement is trending up efficient aircraft that are now on offer. In growing markets such as Asia Pacific and China, there will come a time when airline The last few years have seen largely stable numbers of profitability will need to focus more on cost control, so the need parked aircraft … After the late 1990s when the parked fleet as to retire older planes will increase. a percentage of the installed base approached all-time lows, the period post 2000 has seen this rise closer to 10% of the installed base.

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July 22, 2013 Commercial Aviation — A Renewed Lease of Life

Exhibit 33 … while retirements have slowly been picking up as older The number of parked aircraft remains stable aircraft are replaced by new, more efficient ones. While the Parked Fleet as a % of Installed Base 12% level of parked aircraft has remained relatively stable, 12% 12% 11% 11% retirement numbers have risen steadily on the back of a raft of 10% 11% 10% 10% 10% 9% 9% new, more efficient aircraft coming into service. We expect this 8% 9% 8% 8% trend to continue as new aircraft (such as the B787, A350XWB, 7% 7% 7% A380, C919, A320neo and B737 MAX) come into service and 5% 5% 5% 5% ramp up towards full production. 4% The depth of backlog is unprecedented, with backlogs at an all-time high in terms of years of production 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

2013 YTD 2013 This cycle’s backlogs are much deeper than in past

Source: Company Data, Morgan Stanley Research cycles. Boeing and Airbus both report book-to-bill ratios that are calculated by (as the name implies) comparing the number Exhibit 34 Smaller aircraft dominate Airbus’s parked aircraft of aircraft added to the backlog (booked) to the number of aircraft delivered (billed) in a given period. As such, a A340 A380 A300 book-to-bill ratio above 1 means the net impact of booking and 7% 0% A330 16% delivery activity has expanded the backlog – a dynamic 8% indicative of healthy demand for a supplier’s product. Historically, the ratio has ranged from low points of ~0.50 to A321 high points of ~3. Boeing’s ratio is at mid-cycle levels and, per 7% A310 management commentary, is likely to remain above 1 in 2013. 12% We believe the underlying OE cycle fundamentals argue for an A318 elevated book-to-bill ratio for longer. Similarly, Airbus expects 0% its ratio to remain above 1 throughout 2013. Boeing and Airbus’s huge backlogs in themselves contribute to demand A319 resilience by creating scarcity, requiring airlines to jockey for 13% position into the next economic upturn. An aircraft is purchased A320 not just for the here-and-now, but also for the decades ahead. 37% Airlines recognise that delaying deliveries could put the airline Source: Company data (2012), Morgan Stanley Research at the back of the queue, which could subsequently hamper Exhibit 35 competitiveness if/when the economy improves. Airbus storage period for parked fleet by aircraft age Exhibit 36

49 Backlog visibility remains near record high Years of backlog 49 10 21

98 29 5 5

19 4 24

19 14 5 Total Backlog / Current Year Deliveries < 1yr 1-3yrs >3yrs Total Backlog / Avg. Next 3 Year Deliveries Upto 5 yrs 6-10 yrs 11-20 yrs > 20 yrs 0

Source: Company data (2012), Morgan Stanley Research 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 Note: Represents total Boeing and Airbus backlog and deliveries. Source: Boeing, Airbus, Morgan Stanley Research

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July 22, 2013 Commercial Aviation — A Renewed Lease of Life

Exhibit 37 Last OE cycle wasn’t overheated, adding longevity to this Supplier book-to-bill ratios have been elevated for cycle. In spite of high order rates, build rates never showed some time, contributing to record backlogs their typical volatility across the last cycle. From last cycle’s 6 Boeing Airbus trough year of 2003 to last cycle’s peak in 2007, total Boeing and Airbus deliveries were up 53%. By comparison, the 5 trough-to-peak period of 1995-99 saw a 141% rise in Boeing

4 and Airbus deliveries and the 1984-91 trough-to-peak cycle saw a 210% rise. The discipline of the OEMs in delivering

3 modestly while enjoying strong new order demand not only saved the cycle during the financial crisis but has also laid the

Bookto Bill Ratio 2 foundations for an extended cycle this time around.

1 Healthy mix of growth and replacement in Boeing’s aircraft backlog. Aircraft demand comprises two major 0 components: replacement and growth. Within ‘growth’ there

1958 1961 1964 1967 1970 1973 1976 1979 1982 1985 1988 1991 1994 1997 2000 2003 2006 2009 2012 are two subcomponents. There is what one would characterise

Source: Boeing, Airbus, Ascend, Morgan Stanley Research as ‘normal’ growth (air traffic growth tied to global GDP and population growth) and ‘speculative’ growth, which is typically Exhibit 38 when a young carrier attempts to seize share in existing Moderate production last decade relative to new markets or expand considerably beyond its current fleet with a orders will extend the current cycle stated above-market growth plan. We calculate about 41% of 3000 BA & Airbus Orders & Deliveries Boeing’s backlog is a ‘mature order’ – or one likely to be for replacement of ageing planes. Through an economic 2500 Deliveries Orders downturn, this is the most resilient segment of demand. The

2000 remainder of the backlog appears to be for growth, but of this segment less than half is made up of speculative orders.

1500 Specifically, speculative orders only account for ~22% of Boeing’s entire backlog, on our estimates.

1000 Therefore, ‘backlog bears’ can present a case for

500 haircutting backlogs, but by a little, in our view. In fact, if we adjusted Boeing’s current backlog by around one-fifth, its

0 backlog would be cut from ~7 years at current production to ~5.6 years – still an extremely healthy level by historical 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 Source: Boeing, Airbus, Ascend, Morgan Stanley Research standards. We also think it fair to make the argument that ‘froth’ in an order book – what backlog bears refer to when an order is Exhibit 39 at greater risk of being cancelled – is not a given and is BA speculative orders are a minority of the backlog dependent on the trajectory of the global economic cycle. In other words, if we see economic trends accelerate from here, 22% what previously appeared to be froth may crystallise into much more solid demand. However, if we’re hit by a surprise shock to the business cycle, what we had calculated as solid demand Mature Order 41% may appear frothy. As such, as long as recent airline operating conditions continue, we suspect that what many argue is froth Growth Order will ultimately prove relatively limited. Speculative Order Emerging market demand has played a major role in a prolonged elevated book-to-bill ratio. As a result of the long 37% build in demand worldwide, orders grew considerably faster than deliveries as carriers jockeyed for increasingly rarer slots given OEMs’ reluctance to raise rates. This conservatism was Source: Boeing (as of June 2013), Ascend, Morgan Stanley Research

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July 22, 2013 Commercial Aviation — A Renewed Lease of Life

not misplaced. In fact, during the financial crisis and its Exhibit 40 aftermath, rates were not cut. But with GDP growth still EM demand caused orders to spike elevated across emerging economies and quality of life (GDP 1,750 Large Commercial Aircraft Deliveries (1995-2015E) 2015+ per capita) improving rapidly, we expect EM demand for air 1,500 Peak travel to continue to drive deeper backlogs through elevated Predominant Order Acitivity Regionally: book-to-bill ratios for some time to come. 1,250 European US Asia/ME carriers majors 1,000 demand 2007-09 2009-12 Rising production rates reflect the strength of underlying wave demand as seen by manufacturers. Historically, Boeing and 750 # of Planes Airbus have responded to the ebbs and flows of demand for 500 aircraft across the business cycle by adjusting production rates. Given the market power they wield in what is largely a 250 duopoly, the companies have been able to manage their 0 production levels in an effort to maximise their own profits.

Thus, Boeing/Airbus production rates reflect demand 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013E 2015E conditions as well as both suppliers’ best efforts to maximise Source: Ascend, Morgan Stanley Research estimates (E) profitability by managing supply. As a result, we believe prospective rate increases from both Boeing and Airbus Exhibit 41 suggest the suppliers have confidence that the current cycle Announced production rate increases suggest has legs. To be fair, the suppliers do not have a crystal ball and suppliers have confidence in the future cannot predict when the next macro shock will come, which is 45 2010 2011 2012 2013 why the depth of the backlog is important. But, in our view, rising production rates amid historically high backlogs and book-to-bill ratios above 1 are more likely to be a positive signal 30 than a risk.

The breadth of the backlog has improved 15

considerably over time, lending Number of Aircraft diversification to what used to be a much more concentrated portfolio of customers 0 In the 1970s, the US airline fleet was around three-quarters of 737 747 767 777 787 A320 A330 the global fleet, so the aerospace cycle largely followed the US Note: All figures represent estimated yearend production rates. economic cycle. Today, US aircraft are just one-quarter of the Source: Boeing, Morgan Stanley Research global fleet, lower than during the 1999 aerospace peak. Although European demand was a source of diversification, Exhibit 42 Europe’s advanced economy tended to follow the same cycles Boeing backlog by geography as the US. Therefore, demand for aircraft in the US was coincident with demand for aircraft in Europe. This high correlation among economies, which drove aircraft demand, as North well as the high correlation of each region’s demand for aircraft America and its respective economic cycle, caused the overall 39% aerospace cycle to be more extreme. APAC 30%

Africa 2%

Europe LATAM 7% 16% MidEast 7%

Source: Boeing, Ascend, Morgan Stanley Research

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July 22, 2013 Commercial Aviation — A Renewed Lease of Life

Exhibit 43 still dealing with the extended effects of 9/11 and a recession, Proliferation of airlines = diversity in demand other parts of the world were growing. Petrodollar wealth in the Middle East and growth across Asia, particularly China, led to a Mid East, 8% dramatic increase in aeroplane orders across this third major economic region. As a result, the US was left out of the order LatAm, 12% Europe, 25% cycle for some time. In fact, US carriers accounted for less than ~10% of Boeing’s backlog in 2007 before recovering recently to ~35%. Africa, 13% As a result, despite some large-scale consolidation, the North America, 23% customer base has a longer tail than in the past. Today Asia Pacific, there are ~1,500 airlines around the world, and only two 19% manufacturers of scale in the narrow-body/wide-body segments. Airlines – both passenger and cargo – are confronted with a far more competitive market between Source: Ascend, Morgan Stanley Research themselves in jostling for increasingly rare aircraft slot Exhibit 44 positions. One could argue that, after the first 100 global Top 100 airlines = 65% fleet, but a long tail exists airlines, remaining carriers are too small to matter to an OEM. Global Airlines Number of Aricraft % Total However, for many of these smaller airlines, the timing of a new Top 5 World Carriers 3,354 15% jet delivery may be a make-or-break issue, especially with new Top 10 Carriers 5,072 23% technology playing an even larger role in a world of high fuel Top 100 Carriers 14,073 65% prices. This spike in the number of airlines should in all World Fleet Total 21,764 likelihood moderate to more reasonable levels. But this doesn’t Airlines % Total alter the critical fact that, for now, Boeing and Airbus are in a Airlines with >100 planes 42 3% strong position. with 50-99 planes 44 3% with 20-49 planes 112 7% Diversification through geographic breadth is helpful, but with 10-19 planes 136 9% is less effective during broad-based macro downturns. with <10 planes 1,206 78% Given that aircraft are fungible assets (that can easily be Number of Airlines Worlwide 1,540 100% Source: Ascend, Morgan Stanley Research moved from region to region), a backlog that is geographically more diversified is better positioned in the event of a negative, Exhibit 45 regionally focused shock such as 9/11, SARS or swine flu. Correlation between traffic growth across regions Furthermore, a geographically diverse customer base allows limits the benefits of geographic diversification the manufacturer to dynamically allocate order positions to 20% R2 = 0.6452 regions that are enjoying strong demand for aircraft to the extent that geographies decouple across the business cycle 15% and customers in an underperforming region cancel or defer orders. As a result, diversification certainly plays an important 10% role in reducing backlog volatility. However, given that it is rare for regions to decouple for extended periods (as airline traffic 5% trends across all regions are ultimately highly correlated), we would not overstate this benefit. In particular, during 0% broad-based macro downturns, geographic diversification is Global RPMs YoY ChangeGlobal (%) RPMs YoY unlikely to work as well as it would during periods of greater -5% -10% -5% 0% 5% 10% 15% 20% dispersion in regional economic activity. US A4A System RPMs YoY Change (%)

Source: Airline Monitor, US A4A Monthly Passenger Traffic Report, Morgan Stanley Research

This global rebalancing has produced an enduring change for aerospace. During the last decade, while US airlines were

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July 22, 2013 Commercial Aviation — A Renewed Lease of Life

Growth set to slow in China and India in the We do not think this presents a major risk at this stage. near to mid term, but we do not see EM With over one-third of the combined backlog for Airbus and concerns as an issue for civil aviation Boeing booked for customers in emerging markets, the health of these economies is clearly important. However, we believe The resilience of the OE cycle has been called into traffic growth will remain high, as market penetration in many of question because of macro concerns in emerging these economies is very low compared with developed markets markets. EM growth has been an increasing concern in recent such as the US. Moreover, whereas emerging markets used to months, and while Morgan Stanley’s economists believe there buy second-hand aircraft, many can now finance new aircraft, is better cyclical news on the horizon, they accept there could and are doing so in large numbers, in part to improve their be some headwinds further out. perceived growth status.

Slower growth in China has been well publicised... Our China and India only make up 9% of the backlog. Growth in economists believe the Chinese economy will remain in these two key economies is widely expected to slow down transition for some time, so we would expect to see the volatility sharply, with a knock-on effect on global growth. However, they and downside risks to growth that are associated with account for a very small proportion of the combined economies in transition. Airbus/Boeing backlog. With the level of over-booking in place, a slowdown in deliveries to either of these economies should ...and a similar picture is emerging more widely across be absorbed by OEMs, we believe. Asia. Recent data show a slight deceleration in growth across the region, with external demand slowing in line with weaker Exhibit 47 Global split of Airbus and Boeing backlog data from the US and domestic demand held back by a tighter fiscal policy stance. Africa Others 1% 4% Asia Pacific India’s economy is of particular concern, but again there 23% is a more positive outlook in the mid to long term. After a North America difficult period during which investment activity slowed down 28% sharply, the government has introduced structural reforms on a regular basis. These have been very well directed, and should China benefit investment and growth over time. 5%

Exhibit 46 Middle East 8% Global trips per capita, 2011 Europe LatAm & Carribean 21% 6% India 4%

Source: Ascend, Morgan Stanley Research

Source: Airbus 2012 Global Markey Forecast

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July 22, 2013 Commercial Aviation — A Renewed Lease of Life

Part 2: Backlog analysis – more resilient than you might think

Exhibit 48 Key findings from our bottom-up analysis of the current Airbus The aircraft backlog is at record levels and Boeing backlog Airbus Boeing Total Financial health of airlines 2001 1575 1397 2972 • Airbus: ~10% of the total backlog could be at risk due to poor 2002 1523 1235 2758 financial health of the airlines. 2003 1647 1177 2824 2004 1685 1147 2832 • Boeing: ~8% of the total backlog could be at risk due to poor 2005 2372 1846 4218 financial health of the airlines. 2006 2724 2486 5210 Likely order fulfilment by airlines 2007 3612 3452 7064 • Airbus: ~10% of the backlog could be at risk of not being 2008 3907 3727 7634 delivered, due to a variety of reasons (for example, excess order 2009 3672 3387 7059 placement, lower traffic growth than expected, lack of 2010 3732 3456 7188 infrastructure or regional operational issues). 2011 4614 3776 8390 2012 4857 4425 9282 • Boeing: ~6% of the backlog could be at risk due of not being Current 5102 4338 9767 delivered, due to a variety of reasons (for example, excess order Note: Data represent firm orders only. Source: Ascend, Morgan Stanley Research placement, lower traffic growth than expected, lack of infrastructure or regional operational issues). Exhibit 49 Both Airbus and Boeing have firm backlogs Regional analysis approaching 8 years of production • Airlines in India appear most likely to cancel orders due to their Total Backlog Firm Orders 7,212 poor financial health. We estimate that ~46% of total Indian 6,900 backlog for Airbus could be at risk • Areas with lowest cancellation risk are the Middle East, the rest of 5,102 Asia and China. 4,338 • 15% of the backlog in Europe could be at risk versus 4% in North America.

The backlog at OEMs is at record levels… The backlog at Airbus and Boeing has risen steadily over past 10 years

(barring the decline in 2008/09) due to the increase in aircraft Source: Ascend, Morgan Stanley Research demand globally. The current backlog is at record levels: at Airbus 5,102 aircraft, at Boeing 4,338). Exhibit 50 Airbus and Boeing: historical & estimated deliveries …providing strong earnings visibility at OEMs and 1,600 suppliers. Our analysis of the backlog at Airbus and Boeing Narrow-body Wide-body suggests the total backlog provides earnings visibility for the 1,200 next 10 years (at 2012 production levels, Airbus 588, and Boeing 601). Even when considering only firm orders, the backlog provides visibility for the next eight years, which is high 800 compared with historical levels. 400

- 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013E 2014E 2015E 2016E Source: Boeing, Airbus, Morgan Stanley Research estimates (E)

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July 22, 2013 Commercial Aviation — A Renewed Lease of Life

Backlog in comparison to EU industrials Exhibit 51 Backlog visibility remains near record high Among industrials, A&D has the highest levels of backlog. Years of backlog 10 The backlog for A&D is not only at record levels, but also highest among the EU Industrials. Most EU A&D companies have a backlog of more than three years, whereas EADS backlog stands at €567 billion (which represents around 10 years of revenues at 2012 sales level). EU machinery and electricals have an average backlog of six months to one year, 5 and there is no backlog for EU Autos.

BA Backlog / Current Year Deliveries BA Backlog / Avg. Next 3 Year Deliveries 0

1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 Note: Represents total Boeing and Airbus backlog and deliveries. Source: Company data, Morgan Stanley Research

Exhibit 52 Most EU A&D companies have a backlog of more than three years (at current level of earnings) (in local currency bn) Backlog (Dec 2012) 2012 Revenue Backlog in no of years EU A&D EADS 567 55 10 Rolls-Royce 60 12 5 Safran 49 13 4 Finmeccanica 45 17 3 BAE Systems 42 19 2 Thales 30 14 2 MTU 11 3 3 Cobham 2 2 1 EU Machinery Alfa Laval 14 30 0.5 Metso 5 8 0.6 Outotec 2 2 0.9 EU Electricals Siemens 101 78 1.3 Alstom 53 20 2.6 ABB 30 39 0.8 Invensys 1 2 0.6 Kuka 1 2 0.5 Rotork 0.2 1 0.4 Source: Company Data, Morgan Stanley Research

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July 22, 2013 Commercial Aviation — A Renewed Lease of Life

Europe, and it has higher exposure to developing economies Methodology such as the Middle East and Asia, together representing 55%. We asked our global airlines analysts to rank the global backlogs of Airbus has a total firm order backlog of 5,102 aircraft from Airbus and Boeing on two parameters: global airlines.

1. “Ranking the backlog on financial health of airline”. This Our analysis suggests North American airlines are in parameter looked primarily at the financial health of the airline, and good financial health and are least likely to cancel their ranked the airlines on a scale of 1-5 based on each airline’s ability orders for Airbus. When considering the average ranks of all to fulfil the order placed. A score of 5 indicates that the airline has the airlines across the regions, we see that the financial health good financial strength and is unlikely to cancel orders, and a score of the North American airlines is very strong; these companies of 1 indicates that it may cancel its orders due to poor financial are least likely to cancel their Airbus orders for financing health. reasons. The average rank of the financial health of airlines in 2. “Ranking the backlog on likely fulfilment of order”. This North America is 4.2, whereas in India it is 2.0. Airlines in India parameter focuses on whether orders already placed (and appear most vulnerable to potential order cancellations due to therefore in the backlog) may not be fulfilled for a variety of poor financial health of the airlines. reasons, such as: Exhibit 53 o low traffic; Breakdown of Airbus backlog by region o incorrect demand forecasts; China 4% Latin America o lack of infrastructure; 7% Rest of Asia o operational issues; or India 30% 8% o switch in aircraft order.

Our global airlines team ranked the airlines from 1 to 5, with 5 Middle East indicating the lowest probability of cancellations and 1 indicating the 13% highest.

Focus of our analysis: Using this methodology and the data North America 21% Europe that we collated, we have tried to answer questions falling into 17% two broad categories: Source: Ascend, Morgan Stanley Research. Note: Only Firm Order Backlog  Financing risks. How strong is the current backlog for Exhibit 54 Airbus and Boeing based on the financial health of the Backlog from airlines in India is most vulnerable to airline? How many cancellations could the two companies cancellations (poor financial health of airlines) see due to poor financial health of the airline industry? Backlog rank on financial health of airline Backlog rank on likely fulfilment of order (Answered by our Parameter 1 in the analysis) 5.0

 Forecast / capacity risk. Is there a need for such a huge 4.0 backlog to increase the capacity of airlines to meet traffic

demand? How many cancellations could Airbus and 3.0 Boeing see due to over-bookings? Will a lack of

infrastructure play a role in cancellations of aircraft? Will 2.0 lower increase in traffic lead to aircraft cancellations?

Could incorrect demand forecasts by airlines be a reason 1.0 for cancellations?

0.0 Airbus backlog analysis North Middle China Rest of Latin Europe India America East Asia America

~55% of Airbus’s backlog is from developing regions. Only Source: Morgan Stanley Research 38% of Airbus’ total backlog comes from North America and

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July 22, 2013 Commercial Aviation — A Renewed Lease of Life

Exhibit 55 We estimate ~10% of Airbus’s backlog is at risk of Breakdown of Airbus backlog by rank cancellation due to poor financial health of airlines… % of Backlog on financial Looking at the backlog for airlines that ranked 1 or 2 on the health of airline 38% 37% 36% financial health metric, we found that just ~10% of Airbus’s % of Backlog on likely 35% fulfilment of order backlog is at risk and could see cancellations. We believe that, with ~€10 billion of cash available as a buffer, Airbus could cover any loss arising from cancellations by these airlines 21% (which have a ranking of 1 or 2), with a minimal impact on the 18% business. In contrast, we estimate that ~55% of the backlog is very strong and unlikely to see cancellations. Our analysis demonstrates the strength of the backlog and consequently

5% earnings visibility at EADS, and gives us comfort on aircraft 3% 3% 4% financing issues.

12345 …whereas it could see cancellations of up to 10% due to

Source: Ascend, Morgan Stanley Research over-bookings. Analysing the backlog rank for likely order fulfilment, we estimate that Airbus could see ~10% of its There is strong demand for new aircraft from the Rest of backlog cancelled or deferred to future years. Within this, most Asia and North America, which look least likely to see of the cancellations due to over-booking are expected to come cancellations due to over-booking. Airlines in the Rest of from Latin America. ~70% of the Latin American backlog is Asia and North America appear least likely to cancel orders. expected to be cancelled due to over-bookings. Rest of Asia is They are not over-booked and are expected to see significant expected to see only 2% of cancellations for the same reason. capacity expansion in the coming years. This is followed by the Middle East, where very few airlines are over-booked in terms of order placement. The average rank for airlines in Asia and North America for likely fulfilment of orders is 3.8 versus 3.4 for the Middle East, with the lowest being for India at 2.3.

Exhibit 56 Airbus conclusion matrix

Financial Health of Airline Likely Fulfilment of Order % of Backlog at highest risk 10% 10% % of Backlog at lowest risk 55% 52% Highest risk region (% of regional backlog at risk) India (44%) Latin America (69%) Lowest risk region (% of regional backlog NOT at risk) North America (85%) North America (76%) Source: Ascend, Morgan Stanley Research

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July 22, 2013 Commercial Aviation — A Renewed Lease of Life

Exhibit 57 Exhibit 58 Backlog for airlines ranking 1 on financial health Backlog for airlines ranking 1 on likely fulfilment of metric order Airlines Ranked 1 for backlog on financial health of airline Region Airline Backlog Region Airline Backlog India Kingfisher Airlines 92 India Kingfisher Airlines 92 Europe SAS 30 Europe SAS 30 Rest of Asia Jetstar Hong Kong 17 Rest of Asia Jetstar Hong Kong 17 Europe Alitalia 14 Rest of Asia Jetstar Japan 15 Europe airberlin 12 Europe Alitalia 14 Europe TAP Portugal 12 Europe airberlin 12 Europe Virgin Atlantic Airways 6 Europe TAP Portugal 12 Europe Aegean Airlines 5 Europe Virgin Atlantic Airways 6 Latin America Mexicana 4 Europe Aegean Airlines 5 Europe Niki 2 Latin America Mexicana 4 Total 194 Europe Niki 2 Source: Ascend, Morgan Stanley Research Total 209 Source: Ascend, Morgan Stanley Research Exhibit 59 Exhibit 60 Backlog for airlines ranking 5 on financial health Backlog for airlines ranking 5 on likely fulfilment of metric order Region Airline Backlog Region Airline Backlog Europe easyJet 150 Europe easyJet 150 North America American Airlines 130 Middle East Emirates Airline 127 Middle East Emirates Airline 127 North America ILFC 116 North America ILFC 116 Middle East Turkish Airlines (THY) 105 North America Spirit Airlines 98 North America Spirit Airlines 98 North America GECAS 87 North America GECAS 87 North America JetBlue Airways 84 Rest of Asia Philippine Airlines 64 North America CIT Aerospace 76 Europe Lufthansa 59 Europe Lufthansa 59 Rest of Asia Singapore Airlines 58 Rest of Asia Singapore Airlines 58 Rest of Asia BOC Aviation 56 Rest of Asia BOC Aviation 56 Rest of Asia Cebu Pacific Air 52 Latin America AviancaTaca Group 51 Latin America AviancaTaca Group 51 Latin America Volaris 49 Latin America Volaris 49 North America Aviation Capital Group 49 Middle East Etihad Airways 43 Middle East Etihad Airways 43 Rest of Asia AirAsia X 27 Middle East Air Arabia 27 Middle East Air Arabia 27 Rest of Asia Thai Airways International 14 Rest of Asia Garuda Indonesia 19 Europe Germanwings 2 Rest of Asia Tiger Airways 15 Europe Swiss 2 Rest of Asia Thai Airways International 14 Rest of Asia SilkAir 1 Rest of Asia Thai Smile 14 Total 1279 Rest of Asia Indonesia AirAsia 9 Source: Ascend, Morgan Stanley Research Rest of Asia Thai AirAsia 5 Rest of Asia Malaysia Airlines 3 Rest of Asia AirAsia Philippines 3 Europe Germanwings 2 Europe Swiss 2 Rest of Asia SilkAir 1 Total 1256 Source: Ascend, Morgan Stanley Research

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Exhibit 61 Airbus backlog analysis Backlog as % of Region Backlog as % of Total Backlog Rank Parameter 1 Parameter 2 Parameter 1 Parameter 2 Parameter 1 Parameter 2 Rest of Asia 1 32 17 2% 1% 1% 0% 2 46 8 3% 1% 1% 0% 3 317 483 22% 33% 7% 10% 4 948 624 64% 42% 20% 13% 5 129 340 9% 23% 3% 7%

Latin America 1 4 4 1% 1% 0% 0% 2 44 221 14% 68% 1% 5% 3 177 0 54% 0% 4% 0% 4 0 0 0% 0% 0% 0% 5 100 100 31% 31% 2% 2%

Europe 1 81 81 10% 10% 2% 2% 2 43 18 5% 2% 1% 0% 3 491 483 58% 57% 10% 10% 4 14 47 2% 6% 0% 1% 5 213 213 25% 25% 4% 4%

North America 1 0 0 0% 0% 0% 0% 2 40 40 4% 4% 1% 1% 3 112 209 11% 20% 2% 4% 4 244 486 24% 47% 5% 10% 5 640 301 62% 29% 13% 6%

China 1 0 0 0% 0% 0% 0% 2 12 12 7% 7% 0% 0% 3 66 66 39% 39% 1% 1% 4 92 92 54% 54% 2% 2% 5 0 0 0% 0% 0% 0%

India 1 92 92 24% 24% 2% 2% 2 77 5 20% 1% 2% 0% 3 207 279 55% 74% 4% 6% 4 0 0 0% 0% 0% 0% 5 0 0 0% 0% 0% 0%

Middle East 1 0 0 0% 0% 0% 0% 2 0 0 0% 0% 0% 0% 3 312 312 51% 51% 6% 6% 4 105 0 17% 0% 2% 0% 5 197 302 32% 49% 4% 6% Note: The rankings are provided by Morgan Stanley airline analysts globally as per rating methodology described above. Source: Ascend, Morgan Stanley Research

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July 22, 2013 Commercial Aviation — A Renewed Lease of Life

Boeing backlog analysis Exhibit 62 Breakdown of Boeing backlog by region India China Latin Boeing has higher exposure to developed economies than 3% 6% America to developing economies (Asia and Middle East). Boeing’s 7% backlog profile is slightly different to that of Airbus, with higher North exposure to North America and Europe (55%) and lower America Middle East exposure to Middle East and Asia (38%). Boeing has a total 37% 9% firm order backlog of 4,338 from global airlines.

Airlines in North America are in a good financial health and are least likely to cancel orders for Boeing… Airlines in North America scored the highest rank globally on financial Europe 18% health and are least likely to cancel orders, our analysts believe. North American airlines ranked 4.3 on average, Rest of Asia compared with 2.3 for Indian airlines. ~40% of Boeing’s 20% backlog is from North America, which implies greater backlog Source: Ascend, Morgan Stanley Research. Note: Only Firm Order Backlog strength and fewer cancellations. Exhibit 63 Backlog from airlines in India is most vulnerable to … whereas Boeing should see lower cancellations from cancellations (poor financial health of airlines) Latin America and North America due to over-bookings. Backlog rank on financial health of airline Backlog rank on likely fulfilment of order Similar to Airbus, we think Boeing is also less likely to suffer 5.0 cancellations (due to over-bookings) from North America. This is followed by Latin America, where very few airlines appear 4.0 over-booked in terms of order placement. The average rank for airlines in the North America for likely order fulfilment is 3.8, 3.0 compared with 3.5 for Latin America, with the lowest in India at 2.3. 2.0 Of the total Boeing backlog, ~8% could be cancelled due to poor financial health of airlines… Based on the backlog 1.0 for airlines ranking 1 or 2 on financial health, we estimate that

8% of Boeing’s backlog is at risk and could see cancellations. 0.0 However, ~55% of the backlog is very strong and unlikely to North Latin Rest of China Middle Europe India America America Asia East see cancellations for financing reasons. Source: Morgan Stanley Research

… whereas it could see cancellations of up to 6% due to Exhibit 64 over bookings, we estimate. Analysing the backlog rank for Breakdown of Boeing backlog by rank likely order fulfilment, we estimate that Boeing could see ~6% % of Backlog on financial of its backlog cancelled. Within this, the majority of potential health of airline 38% 37% 36% cancellations from over-bookings are estimated to come from % of Backlog on likely 35% fulfilment of order India. We expect the Middle East to see a lower number of cancellations due to over-booking.

21% 18%

5% 3% 3% 4%

12345

Source: Ascend, Morgan Stanley Research

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Exhibit 65 Boeing conclusion matrix Financial Health of Airline Likely Fulfilment of Order % of Backlog at highest risk (Rank 1 & 2) 8% 6% % of Backlog at lowest risk (Rank 4 & 5) 57% 56% Highest risk region (% of regional backlog at risk) India (70%) India (70%) Lowest risk region (% of regional backlog NOT at risk) North America (97%) North America (96%) Source: Ascend, Morgan Stanley Research

Exhibit 66 Exhibit 68 Backlog for airlines ranking 1 on financial health Backlog for airlines ranking 1 on likely fulfilment of metric order Region Airline Backlog Region Airline Backlog Europe airberlin 52 Europe airberlin 52 North America Air Canada 42 North America Air Canada 42 Europe Virgin Atlantic Airways 15 Europe Virgin Atlantic Airways 15 Rest of Asia Nippon Cargo Airlines 12 Europe SAS 3 Europe SAS 3 Rest of Asia Skymark Airlines 1 Total 124 Total 113 Source: Ascend, Morgan Stanley Research Source: Ascend, Morgan Stanley Research

Exhibit 67 Exhibit 69 Backlog for airlines ranking 5 on financial health Backlog for airlines ranking 5 on likely fulfilment of metric order Region Airline Backlog Region Airline Backlog North America Southwest Airlines 312 Europe Ryanair 175 North America American Airlines 255 North America GECAS 110 Europe Ryanair 175 Middle East Turkish Airlines (THY) 95 North America Aviation Capital Group 115 Middle East Emirates Airline 69 North America GECAS 110 North America Alaska Airlines 67 Middle East Emirates Airline 69 North America ILFC 60 North America Alaska Airlines 67 Rest of Asia SilkAir 54 North America ILFC 60 Middle East Etihad Airways 46 North America FedEx 55 Latin America Copa Airlines 29 Rest of Asia SilkAir 54 Rest of Asia Scoot 20 Middle East Etihad Airways 46 Rest of Asia Thai Airways International 18 North America CIT Aerospace 44 Europe Lufthansa 13 Rest of Asia Japan Airlines 39 Rest of Asia Singapore Airlines 8 North America WestJet 32 Rest of Asia Royal Brunei Airlines 5 Latin America Copa Airlines 29 Rest of Asia Malindo Air 5 Rest of Asia Scoot 20 Rest of Asia Malindo Air 5 Rest of Asia Thai Airways International 18 Europe Lufthansa Cargo 5 North America United States Navy 14 North America UPS Airlines 4 Europe Lufthansa 13 Total 788 Rest of Asia Singapore Airlines 8 Source: Ascend, Morgan Stanley Research Rest of Asia Royal Brunei Airlines 5 Europe Lufthansa Cargo 5 North America United States Air Force 4 North America UPS Airlines 4 Total 1553 Source: Ascend, Morgan Stanley Research

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Exhibit 70 Boeing backlog analysis Backlog as % of Region Backlog as % of Total Backlog Rank Parameter 1 Parameter 2 Parameter 1 Parameter 2 Parameter 1 Parameter 2 Rest of Asia 1 12 1 1% 0% 0% 0% 2 67 40 8% 5% 2% 1% 3 499 604 59% 71% 12% 14% 4 127 89 15% 10% 3% 2% 5 144 115 17% 14% 3% 3%

Latin America 1 0 0 0% 0% 0% 0% 2 0 0 0% 0% 0% 0% 3 252 252 85% 85% 6% 6% 4 15 15 5% 5% 0% 0% 5 29 29 10% 10% 1% 1%

Europe 1 70 70 9% 9% 2% 2% 2 45 15 6% 2% 1% 0% 3 460 464 60% 60% 11% 11% 4 0 26 0% 3% 0% 1% 5 193 193 25% 25% 5% 5%

North America 1 42 42 3% 3% 1% 1% 2 0 1 0% 0% 0% 0% 3 2 19 0% 1% 0% 0% 4 484 1297 30% 81% 11% 30% 5 1072 241 67% 15% 25% 6%

China 1 0 0 0% 0% 0% 0% 2 18 18 7% 7% 0% 0% 3 75 75 29% 29% 2% 2% 4 166 166 64% 64% 4% 4% 5 0 0 0% 0% 0% 0%

India 1 0 0 0% 0% 0% 0% 2 76 76 70% 70% 2% 2% 3 33 33 30% 30% 1% 1% 4 0 0 0% 0% 0% 0% 5 0 0 0% 0% 0% 0%

Middle East 1 0 0 0% 0% 0% 0% 2 0 0 0% 0% 0% 0% 3 192 192 48% 48% 4% 4% 4 95 0 24% 0% 2% 0% 5 115 210 29% 52% 3% 5% Note: The rankings are provided by Morgan Stanley airline analysts globally as per rating methodology described above. Source: Ascend, Morgan Stanley Research

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July 22, 2013 Commercial Aviation — A Renewed Lease of Life

Part 3: The Internationalisation of EETCs Eases Financing Concerns

the substantially higher costs of Air France and Iberia’s EETC EETCs poised to launch in Europe after a decade of absence issues relative to those of the US airlines, despite their Enhanced Equipment Trust Certificates (EETCs) are a form of aircraft generally higher credit ratings, discouraged further EETC financing used frequently in the US but with extreme rarity in Europe. issuance by European airlines. They are capital market instruments largely issued and rated on the value of the aircraft secured, rather than the creditworthiness of the Ratification of the Cape Town Convention is opening the airline borrower. Only four EETCs have been issued so far in Europe, international EETC market by the financing vehicles of Air France and Iberia between 1999 and Insolvency provisions within an international treaty known as 2004. the Cape Town Convention offer the functional equivalent of Section 1110 to ratifying countries. The main achievement of

the Convention is to bring greater certainty to repossession Bank lending remains squeezed, enhancing the drive for timeframes in a contracting state. Ratification of the EETCs Convention, already achieved by 47 signatories, is expected to As we discussed in our Blue Paper of June 2012, Commercial enhance airlines’ access to international capital markets via Aviation: Navigating a New Flight Path, the global financial EETCs. The Doric Fund launched EETCs backed by UAE crisis has reduced banks’ lending capacity and led some banks aircraft in June 2012 and July 2013, and Air Canada debuted that were historically active in the aviation financing space to an EETC in April 2013. Both the UAE and Canada had ratified leave the market. Furthermore, more stringent capital the Convention. Although the UK has yet to do so, English law requirements for banks will likely lead to a higher cost of capital is widely regarded as a stable and benign legal system where in the bank market. In contrast, capital markets are open for difficulties are rarely experienced with UK aircraft and financing business and could provide the deepest source of financing to transactions2, and this enabled IAG to launch its EETC too. the aviation industry. We expect firm appetite for European issued EETCs The EETC market is the first choice for US airlines to Year to date, the combined transacted volume amounts to finance their fleets $4,419 million versus a total 2012 volume of $4,398 million. We Preferential US financing terms are available due to the see potential for appetite for non-US EETCs to be even higher existence and application of lender safeguards in Section than for US certificates, because it should enable traditional 1 1110 of the US Bankruptcy Code. This entitles certain lenders EETC holders, which include pension funds, to diversify to extract the aircraft in bankruptcy proceedings within 60 days geographies as part of their risk management. We believe of an airline filing for bankruptcy. Other jurisdictions tend not to European airlines to be at the centre of this renaissance and provide such explicit insolvency protection. Since 1994, US expect this development to spark into life in 2H13 and 2014. airlines have raised nearly $67.7 billion via 138 EETC issues covering 2,036 aircraft. A recent EETC issue by US Airways in We use British Airways (BA) as a litmus test for EETCs April 2013 set records by pricing below 4% yields. The demand for fixed income investment could lead to a material reduction in borrowing costs for European airlines. Investor protection concerns previously dampened Relative to other sectors, there is capital intensity and high European airline EETC demand leverage within the airline market. See the key findings of our In Europe, unlike the US, there is usually no certainty as to the IAG analysis later in this report. timeframe on insolvency or asset repossession, which makes it more challenging to obtain the desired EETC rating. In the four A note on our currency assumptions: The US dollar is the EETC issues to date (Air France in 2003 and Iberia in 1999, base currency of aviation finance, and we have adopted it for 2000, and 2004), investors required much more protection than most of our analysis here. Where an airline does not report in has been seen at comparable US airline issues. This was dollars, we have converted reported figures at calendarised particularly the case with the liquidity facility duration: 36 average exchange rates, and forecast figures at spot rates. months for Air France and 36-42 months for Iberia versus the See notes to exhibits for details where relevant. standard 18 months in US EETC issues. We think it likely that

2See UK Government Summary of responses to Call for Evidence on the Convention (February 2010). For example, “The majority of respondents said that the UK had a well 1 http://uscode.house.gov/download/pls/11T.txt established system of non-judicial remedies [on adducing evidence of default] which the international financing system was comfortable with” (p8).

MORGAN STANLEY RESEARCH

July 22, 2013 Commercial Aviation — A Renewed Lease of Life

What is driving investor appetite for Exhibit 71 Central bank base rates 7 aircraft-backed debt? US UK Eurozone Japan

In a long-running low interest rate environment, investors 6 are seeking new avenues for yield 5 Never in recent economic history have interest rates been so low across so much of the globe for so long (Exhibit 71). When 4 rates were first cut to their current levels during 2008-09, it 3 appeared a temporary measure; now, such rates look normal. Central bankbase rate (%) In their search for yield, investors are rediscovering appetite for 2 structured debt products. The emergence has been slow – in 1 the aftermath of the 2008 banking collapse (and given its relationship with structured products) investors sought solace 0

in investments that were perceived to be less risky. Five years 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 on, investors appear to be restless for higher returns, Source: Central banks, Morgan Stanley Research particularly as real interest rates (post inflation) are negative. Exhibit 72 North America and Europe corporate issuance: Asset-backed corporate debt is seeing a revival YTD level at 49% of 2012’s $2 trillion total Some $2 trillion worth of North American and European 2.6 corporate bonds was issued in 2012, the highest level since 2.4 2009 (see Exhibits 72 and 73). To date this year, issuance is at 2.2 49% of 2012 levels. April 2013 saw a 4.8% yield on EUR 2.0 high-yielding issuance, the lowest in a decade (Exhibit 73). 1.8 1.6 Asset-backed debt is also seeing a revival, with US issuance 1.4 up 5.0% in the first five months of 2013 to $85.1 billion. Global 1.2 issuance of collateralised loan obligations (CLOs), a form of Trillon USD 1.0 tranched selling of loan portfolios, stood at $44.4 billion at the 0.8 five-month stage versus $15.5 billion at the same stage in 0.6 0.4 2012. 0.2 - Airline asset-backed debt is increasing and diversifying YTD EETCs are the most prevalent type of airline asset-backed debt 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 Source: Dealogic, Morgan Stanley Research in the US. The issuance pool has diversified, with both US (Hawaiian Airlines, May 2013) and non-US entities (Doric Exhibit 73 Fund, 2012 and 2013, and Air Canada, April 2013) debuting on EUR high-yield issuance (non-financials): May 2013 the EETC market recently. There has been heavy over- yield 5.0% versus 8.3% May 2012 Airfinance subscription of recent transactions. According to 22 Journal (on May 30 and April 30, 2013), the recent debuts by 20 Hawaiian Airlines and Air Canada were six and seven times over-subscribed, respectively. Turkish Airlines (26 November 18 2012) and Ryanair (20 May 2013 and 20 June 2013) have 16 expressed an interest in launching debut EETCs to finance 14

fleet deliveries. % Yield 12

8 Median 7.5%

4 2003 2003 2004 2004 2005 2005 2006 2006 2007 2007 2008 2008 2009 2009 2010 2010 2011 2011 2012 2012 2013

Source: Markit IBoxx, Morgan Stanley Research

MORGAN STANLEY RESEARCH

July 22, 2013 Commercial Aviation — A Renewed Lease of Life

Exhibit 74 Exhibit 75 MSCI Europe Airlines Index ~200% in 18 mths: price Consensus has upgraded 2015 EBIT for all names: reaction to restructures has been very favourable sell-side expects 70–90% realisation of targets 230 100 AF-KLM LUFT IAG MSCI EUROPE AIRLINES AF-KLM LUFT IAG 210 90

190 80 170

70 150

130 60

Rebased to2 Jan 2012 110 50 2015consensus EBITas % of target 90 40 70

30 50 2 2 2 2 2 2 3 3 2 2 2 2 3 12 1 1 1 1 13 1 1 13 13 1 12 12 1 12 12 1 12 12 13 13 13 13 n 1 r r y n 12 ul 12 p 1 v 12 c 12 n b r y n r y n p 1 t 12 v c n 1 y a p u J o e ul e o e ar J Feb 12 Ma A J Aug Se Oct N D Ja Fe Ma Apr 13 Ju Jan 12 eb Apr Ju J Oc Ja Apr Jun 13 Ma Ma F Ma Ma Aug S N D Feb M Ma Source: Thomson Reuters, Morgan Stanley Research Note: AF-KLM guidance calculated as mid-point of adjusted 6-8% operating margin range with €300 million of finance cost for operating leases included, based on €28 billion revenue base. All consensus figures provided by Thomson Reuters. Source: Thomson Reuters, Morgan Stanley Research There is appetite for European aviation-related debt boost European airline debt attractiveness as the market Yankee issuance (a foreign issued, dollar-denominated expects them to restore profitability (in the case of IAG and security) from European borrowers represented close to 43% AF-KLM, which posted operating losses in 2012) and to boost of aggregate European volume in 2012, up from 19% in 20113. margins across the group. Airline debt attractiveness is Over 30% of Yankee bond issuance by volume was from the boosted when the financial position of the obligor is expected UK or Germany in 2012. US investors are keen to invest in by debt investors to improve. Share price performance and Yankee securities because they provide attractive yields and consensus estimates suggest that the market is confident that geographic diversification without the currency risk associated these airlines can deliver at least a very significant portion of with investment in debt issued outside the US. Moreover, their 2015 earnings targets (see Exhibit 74 and Exhibit 75). Yankee securities are regulated by the SEC. According to Standard & Poor’s, in 2011 there was one aviation Yankee loan Consolidation is taking place on multiple levels issuer (AWAS Aviation Group, a lessor) and one aviation- The European aviation industry is in the process of related Yankee bond issuer (Swissport International). 2012 consolidating. Key mechanisms include i) anti-trust immune saw two aviation Yankee loan issuers (AWAS Aviation Group operations that enable joint operations that otherwise would be and FLY Leasing) and three aviation-related Yankee bond restricted under competition law; ii) airline exits (for example, issuers (Dufry Shop Finance, Milestone Aviation Group and Malev and Spanair in 2012) prompted by the high oil price Swissport International). We believe a European airline environment and impact of the financial crisis; and iii) hub Yankee issuance would benefit from the long-term familiarity of airport portfolio densification (such as IAG’s Heathrow US investors with the EETC debt structure, and the established dominance via BMI acquisition in 2012 and easyJet’s London record in debt issuance of European airlines, many of which Gatwick dominance via Flybe’s slot divestment in 2013). These are global brands. actions are stimulating a reduction in capacity outlay and expectation for industry margin enhancement in the next three The airline EETC market is boosted by years. industry outlook Restructure, consolidation and new fleet can position past The equity market is pricing for a healthier European airline performance in the rear-view mirror airline industry by 2015 American Airlines offers an extreme example of how European legacy restructuring programmes (‘SCORE’ at restructuring and market consolidation can aid airline debt desirability. On 12 March 2013, it sold investment-graded Lufthansa, ‘Transform 2015’ at AF-KLM, and ‘Transform’ at th IAG focused on the turnaround of Iberia) are likely, we think, to EETCs while in its 15 month of bankruptcy protection (the company sought court protection on 29 November 2011). The

3 Let’s Go Yankees! European Issuers Tap US Market’s Voracious Appetite for Yield, Standard $663 million EETC issuance included a $507 million tranche & Poor’s, 21 March 2013

MORGAN STANLEY RESEARCH

July 22, 2013 Commercial Aviation — A Renewed Lease of Life

priced at 4.0%, matching the then record low coupon achieved Exhibit 76 for similar airline debt by United Continental in September European legacy order books: wide-body orders 2012. The sale of the EETCs was the first by an airline dominated by new technology with double-digit unit operating under Chapter 11 court supervision. EETC buyers fuel burn improvement may have been looking ahead to American Airlines’ upcoming Aircraft AF-KLM IAG Lufthansa merger with US Airways, which will create the world’s largest A320 3 19 165 1 8 carrier by passenger traffic, and thus have been willing to A330 3 invest in this new airline entity. A350 25 18 A380 4 12 4

Attractive aircraft additions can boost EETC appetite B737 4 A compelling attraction of EETCs is that the collateral can be B747-8i 15 B777 5 611 resold worldwide, unlike almost any other collateral. In time, a B787 25 42 new, fuel-efficient aircraft is likely to be sold on more easily E190 than existing fleet stalwarts such as the B747 or A340, in our E195 4 view. European legacy airlines are adding more efficient Bombardier C 1 30 aircraft, including new-generation models such as the A350, Total 68 105 232 A380 and B787 (Exhibit 76). This is guided to aid airline cost Note: AF-KLM as detailed in 2012 registration document and fleet order press release as at 19 June 2013; IAG as detailed in 1Q13 and fleet order press releases as at 31 May 2013; and bases, particularly through improved fuel burn efficiency, and Lufthansa as at 14 May 2013 in conference presentation. will also support the value of debt structures collateralised by Source: Company Data, Morgan Stanley Research the aircraft. Exhibit 77 EETC coupons vs. 3-month LIBOR: benchmark rates Record EETC coupons should not surprise given low have been a driver of EETC coupon reduction benchmark rates 11 1.3 EETCs Financial media headlines have focused on the record-low 10 1.2

1.1 EETC coupon rates achieved recently. US Airways priced an 9

EETC in April with a rate of 3.95% on the A tranche – the first 1.0 8 time a sub-4% rate has been priced. Given the low interest rate 0.9 7 environment, we would expect EETC coupon rates to contract, 0.8

6 % 3mth LIBOR however. This is because the market will price the EETC in % Coupon EETC 0.7 relation to the reference interest rate. Exhibit 77 shows the 5 0.6 relationship between movement in EETC-A tranche coupons LIBOR 4 0.5 and 3-month LIBOR rates since June 2009 (the US Federal 3 0.4 Funds rate has remained static throughout this period at 0.25%). Jun Jun 12 Jun Jun 11 Jun Jun 10 Jun Jun 09 Mar 13 Mar Mar 12 Mar Mar 11 Mar Mar 10 Mar Sep 12 Sep 12 Dec Sep 11 Sep 11 Dec Sep 10 Sep 10 Dec Sep 09 Sep 09 Dec Investor focus should be on EETC spread rather than Source: Thomson Reuters, Morgan Stanley Research absolute coupon Exhibit 78 Analysis of the spread between EETC coupons and bench- Spread between EETC coupon and 3-month LIBOR mark rates gives a clearer window on the condition of the EETC (pp): trend of contraction market. Exhibit 78 shows the percentage point spread between 11 reported EETC A-tranche coupon and 3-month LIBOR, with a 10 contraction since 2009. The latest US airline A-tranche in the 9 market at the time of writing (4.95% coupon for Hawaiian 8 Airlines’ debut EETC on 14 May 2013) priced 445bps above 7 LIBOR. The median EETC spread since 2009 is 570bps, with Median 5.70 the highest being 983bps in October 2009 and the lowest 6 305bps in March 2012. 5 4.45 4

3 Spread between EETC Coupon & LIBOR 3mth % 3mth LIBOR & Coupon EETC between Spread 2 Jun 12 Jun Jun 11 Jun Jun 10 Jun Jun 09 Jun Mar 13 Mar Mar 12 Mar Mar 11 Mar Mar 10 Mar Sep 12 Sep Dec 12 Sep 11 Sep Dec 11 Sep 10 Sep Dec 10 Sep 09 Sep Dec 09 Source: Thomson Reuters, Morgan Stanley Research

MORGAN STANLEY RESEARCH

July 22, 2013 Commercial Aviation — A Renewed Lease of Life

Does the market price airline EETCs We see potential for EETC coupons to tighten further correctly? We ascribe numeric values to the Standard & Poor’s and Moody’s credit rating scales, whereby one equates to the The closest proxy to the EETC is the unenhanced Equipment lowest possible credit rating and 20 to the highest. We apply Trust Certificate (ETC). US and Canadian railroads have these scales to airline EETC and railroad-rated debt issued in issued very significant volumes of ETCs over many decades. 2012 and so far in 2013. The higher the numerical value, the Railroad ETCs derive from the same jurisdictional basis as higher the indicated credit quality of the debt security, and the airline EETCs, with sections 1164-1174 of the US Bankruptcy lower we would expect the coupon to be. Code offering similar asset protection for investors to that encased in Section 1110 for airlines. There has been a lack of Exhibit 81 illustrates the observations (using Moody’s ratings) recent railroad ETC issuance, however, so we cast our analytic with an R-squared value of 0.504 between credit rating and net wider to encompass the whole of the railroad debt market, coupon. In Exhibit 82, we test the values (this time we examine and consider how the relationship between debt credit rating S&P ratings) on the densest part of the plot scattering, which and coupon compares in railroad debt versus airline EETCs. falls in the rating range of A to BB+. We note that the railroad debt coupons are skewed to lower coupons versus Exhibit 79 similarly-rated airline EETCs. At its most extreme, the Railroad debt coupons versus 3-month LIBOR difference equates to 500bps. This suggests airline EETC 11 1.3 investors may be demanding an unwarranted premium for debt 10 1.2 that carries similar default risk to certain railroad securities. LIBOR 9 1.1 What could drive an EETC spread tightening? 8 1 We believe two factors could cause spreads to tighten: greater 7 0.9 liquidity and investor safety. Combined, these could transform 6 0.8 airline EETCs into a stable credit product in the long term. Debt coupon % LIBOR 3 mth % mth 3 LIBOR 5 0.7

4 0.6  Market liquidity: Liquidity is likely to improve through i) an Railroad debt increase in the number of airlines undertaking EETCs; ii) 3 0.5 an increase in issuance for refinancing of older aircraft 2 0.4 types and not just for new deliveries; iii) emergence of new Jul 09 Jul 10 Jul 11 Jul 12 Jul Apr 09 09Oct Apr 10 10Oct Apr 11 11Oct Apr 12 12Oct Apr 13 Jan 10 Jan 11 Jan 12 Jan 13 Jan Jan 09 Jan airline obligors, potentially including European flag carriers Source: Thomson Reuters, Morgan Stanley Research that offer new EETC investor bases; and iv) diversification into more non-pure airline issuers, such as funds (for Exhibit 80 example, Doric) and lessors (such as AWAS and ILFC). Spread between railroad debt coupon and 3-month LIBOR: trading at median 190bps below airline EETC 6.0  Safety for investors: Any premium demanded by investors would lessen through actions or events that 5.5 reduce the perceived risk of holding EETCs. The Cape 5.0 Town Convention could be a significant step in de-risking

4.5 Median 3.80 aircraft-backed investments. The US is also a fertile

4.0 ground to add to EETC case history. Moody’s decision not to downgrade American Airlines’ EETC to junk status 3.5 3.80 despite the airline filing for bankruptcy in 2011, and 3.0 American’s subsequent ability to issue a new EETC in 2.5 2013 while under bankruptcy court protection highlights

2.0 the potential of the EETC model to protect investors from extreme changes in the underlying obligor’s legal and Spread between Railroad debt coupon & LIBOR 3mth % 3mth LIBOR & coupon debt Railroad between Spread 1.5 financial position. 1.0 Jul09 Jul10 Jul11 Jul12 Jan 09 Jan 10 Jan 11 Jan 12 Jan 13 Jan Mar 09 Mar 10 Mar 11 Mar 12 Mar 13 Mar Sep 09 Sep 09 Nov 10 Sep 10 Nov 11 Sep 11 Nov 12 Sep 12 Nov May 09 May 10 May 11 May 12 May 13 May Source: Thomson Reuters, Morgan Stanley Research

MORGAN STANLEY RESEARCH

July 22, 2013 Commercial Aviation — A Renewed Lease of Life

Exhibit 81 2012-13 debt credit ratings versus debt coupon (%): airline EETC and railroad debt Airline EETCs (blue) are lower rated and higher priced than railroad debt (red) INVEST. 20 GRADE

y = -1.4178x + 19.477 10 R2 = 0.5043

DEFAULT 0 1.00 2.00 3.00 4.00 5.00 6.00 7.00 8.00 9.00 10.00 Coupon %

Note: We subscribe numeric values to Moody’s credit rating scale in order to provide a plot value. Source: Thomson Reuters, Morgan Stanley Research

Exhibit 82 An opportunity for repricing? A snapshot of Standard & Poor’s A to BB+ rating suggests a skew of railroad debt toward cheaper pricing versus Airline EETCs with the same credit rating (2012 and 2013YTD issuance) A 17.0 Airline EETCs Railroad debt

16.5

16.0

15.5

15.0

14.5

14.0

13.5

13.0

12.5

BB+ 12.0 1.00 2.00 3.00 4.00 5.00 6.00 7.00 Coupon %

Note: We subscribe numeric values to Standard & Poor’s credit rating scale in order to provide a plot value. Source: Thomson Reuters, Morgan Stanley Research

MORGAN STANLEY RESEARCH

July 22, 2013 Commercial Aviation — A Renewed Lease of Life

EETCs and debt service costs

What might successful EETC issuance BA EETC coupon 30% below 2012 cost of debt from banks mean for financing costs at IAG? BA’s dollar-weighted mean coupon for its debut EETC of 4.847% was very similar to that achieved by Air Canada Air Canada EETC coupon 30% below 2012 cost of debt (Exhibit 87 and Exhibit 88). We calculate that the mean coupon Exhibit 86 shows the upgrade in debt rating that the EETC was slightly higher than IAG’s 2012 average cost of debt, which delivered to Air Canada using Moody’s methodology. The we estimate at 4.7%. IAG has benefited from contracting highest graded tranche was notched seven grades above the finance lease rates, which have fallen as the benchmark rate corporate rating. The coupon achieved on this A-tranche was (3-month LIBOR) has reduced (Exhibit 92) – finance lease 4.125%. On a dollar-weighted basis the mean coupon overall rates have contracted from 6.15% in 1997 to 3.29% in 2012. for the EETC equated to 4.822%. By comparison, Air Canada’s However, IAG’s bank debt and other loans have consistently 2012 cost of debt (interest expense to average gross debt, both come at a higher cost to finance leases. We calculate an adjusted to exclude pensions) was 6.90%. Thus, the EETC average cost of debt from banks and other borrowings of A-tranche had a cost of debt 40% lower than the 2012 average 7.00% in 2012 and 5.52% in 2011. cost of debt, and on a dollar-weighted basis the EETC had a cost of debt 30% lower than the 2012 average cost of debt. IAG could gain from replacement of bank debt with EETCs IAG has the most to gain, in our view, from directing efforts to reduce the cost of non-finance lease debt. EETCs provide a Air Canada EETC detail new mechanism to non-US airlines to help achieve this. In Air Canada launched an EETC, its first, on 24 April 2013. The key Exhibit 84, we look at various hypothetical scenarios showing features of the transaction were: the impact on IAG’s 2012 debt and service costs from an increase of EETCs in the airline’s debt mix. We assume a • $424.4 million class A certificates (A-tranche) with an  4.00% EETC coupon. As previously noted, at current interest expected maturity of May 2025; rate levels, we consider this to be a reasonable scenario. BA’s  • $181.9 million class B certificates (B-tranche) with an top-rated tranche launched at 4.625%. Air Canada secured an expected maturity of May 2021; and A-tranche at 4.125%. US Airways has issued at sub-4% levels.

 • $108.3 million class C certificates (C-tranche) with a bullet At 20% EETC penetration, we calculate that the average cost maturity of May 2018. of debt would reduce by 50bps to 4.17% with interest cost €24 The spread paid over the benchmark Treasury for the EETC was million lower as a result. 20% penetration would equate to tighter than Air Canada’s last debt listing in July 2010. The EETC around €1 billion of EETC issuance. At 40% EETC penetration, C-tranche rated B (by S&P) priced with a coupon spread 592bps we assume the average cost of debt would be 110bps lower at above Treasury, which was a tighter spread than the 749-790bps 3.57%, and €53 million would be saved on financing costs – a spread of the higher rated B+ bonds of 2010. The EETC A-tranche reduction of 23%. A ~40% long-term penetration level has priced with a coupon of 4.125%, a spread of 176bps over the precedent: Delta Airlines had $4,314 million pass-through trust benchmark. and EETC proceeds outstanding as at 31 December 2012, comprising 34% of its gross debt balance.

Exhibit 83 In Exhibit 85, we take a 40% EETC penetration and flex the Air Canada ratings: EETC A-tranche is rated coupon lower from our initial 4% assumption. Versus 2012 investment grade by all agencies reported, at a 3% coupon and 40% EETC mix, debt costs Fitch Moody S&P would be reduced to €154 million (€72 million reduction). At a EETC – A A Baa3 A- 2% coupon and 40% EETC mix, the reduction would be €92 EETC – B BB+ B1 BB million. By way of context, the lowest-priced EETC is a US EETC – C BB- B3 B Airways April 2013 issue priced at 3.95%. Ryanair stated at its Airline N/A WR B- 2013 investor day on 20 June that it had received advice that it Source: Thomson Reuters, Morgan Stanley Research could price an EETC below 3%.

MORGAN STANLEY RESEARCH

July 22, 2013 Commercial Aviation — A Renewed Lease of Life

Exhibit 84 EETC penetration analysis 1: IAG 2012 debt cost under four theoretical EETC mix scenarios All assume an EETC coupon of 4% €250m

4.67%, €226m

€225m 4.47%, €217m Fin Lease 63% Other 37% EETC 0% 4.17%, €202m Fin Lease 60% FY12 Actual Other 30% €200m EETC 10% Fin Lease 60% 3.87%, €187m Other 20% EETC 20% Fin Lease 60% 3.57%, €173m Other 10% Annual expense €m interest €175m 0% to 40% EETC mix EETC 30% 110 bps contraction Fin Lease 60% €53m cost saving Other 0% EETC 40%

€150m 3.4% 3.6% 3.8% 4.0% 4.2% 4.4% 4.6% 4.8% IAG average cost of debt

Note: Finance lease cost 3.29% and other debt cost of 7.00% in line with 2012 actual. Source: Morgan Stanley Research estimates

Exhibit 85 EETC penetration analysis 2: IAG 2012 debt cost under four theoretical EETC coupon scenarios All assume an EETC mix at 40% of debt €180m 3.57%, €173m

€170m EETC 4.00% 3.37%, €163m

€160m EETC 3.50% 3.17%, €154m

€150m EETC 3.00% 2.97%, €144m

€140m EETC 2.50% 2.77%, €134m 40% EETC mix, 4.00% to Annualinterest expense €m 2.00% coupon 80 bps contraction €130m EETC 2.00%

€120m 2.7% 2.8% 2.9% 3.0% 3.1% 3.2% 3.3% 3.4% 3.5% 3.6% 3.7% IAG average cost of debt

Note: Finance lease cost 3.29% and other debt cost of 7.00% in line with 2012 actual. Source: Morgan Stanley Research estimates

MORGAN STANLEY RESEARCH

July 22, 2013 Commercial Aviation — A Renewed Lease of Life

Exhibit 86 Air Canada: Illustration of rating upgrade achieved via 2013 EETC EETC A-tranche cost of debt was 40% lower than the corporate 2012 average cost of debt MOODY'S ENTITY RATING COUPON SOURCE REDUCTION CHANGE VS CORP COST 22 Aaa 21 Aa1 20 Aa2 19 Aa3 18 A1 17 A2 16 A3 15 Baa1 14 Baa2 13 Baa3 EETC Tranche A +7 notch 4.125% Reported -2.775% 12 Ba1 11 Ba2 10 Ba3 9 B1 EETC Tranche B 5.375% Reported -1.525% 8B2 +3 notch 7 B3 EETC Tranche C 6.625% Reported -0.275% 6 Caa1 Corporate rating +1 notch 6.900% MS calc FY12 cost of debt 5Caa2 4Caa3 3Ca 2C 1/ Source: Moody’s Investor Services, Company Data, Morgan Stanley Research

Exhibit 87 Air Canada’s April 2013 EETC debut Volume-weighted mean coupon of 4.82% compared to Air Canada’s 2012 average cost of debt of 6.9% Issuer Instrument Tranche Amount Issued $M Amount Issued €M Issue Date Maturity Coupon % Liquidity Facility Fitch Moody S&P Air Canada EETC A 424.4 326.6 24 Apr 13 15/11/2026 4.125 18mth A Baa3 A- Air Canada EETC B 181.9 140.0 24 Apr 13 15/11/2022 5.375 18mth BB+ B1 BB Air Canada EETC C 108.3 83.3 24 Apr 13 15/05/2018 6.625 no facility BB- B3 B Total 714.6 549.9 Weighted mean 4.822 Source: Company Data, Thomson Reuters, credit rating agencies, Morgan Stanley Research. Note: Euro conversion at spot rate of 24 April 2013 of 1.29955.

Exhibit 88 BA’s June 2013 EETC debut Volume-weighted mean coupon of 4.85% compared to IAG’s 2012 average cost of debt of 4.7% Issuer Instrument Tranche Amount Issued $M Amount Issued €M Issue Date Maturity Coupon % Liquidity Facility Fitch Moody S&P BA EETC A 721.6 551.9 25 Jun 2013 20 Dec 2025 4.625 18mth A Baa1 A BA EETC B 205.4 157.1 25 Jun 2013 20 Dec 2021 5.625 18mth BBB- Ba1 BBB Total 927.0 709.0 Weighted mean 4.847 Source: Company Data, Thomson Reuters, credit rating agencies, Morgan Stanley Research. Note: Euro conversion at spot rate of 25 June 2013 of 1.30745.

MORGAN STANLEY RESEARCH

July 22, 2013 Commercial Aviation — A Renewed Lease of Life

Exhibit 89 Exhibit 92 BA/IAG: 2012 average cost of debt of 4.7% BA/IAG finance lease versus bank debt annual cost 8.00 As interest rates have fallen, the cost of fleet debt

7.00 (finance leases & hire purchases) has contracted from 6.15% in 1997 to 3.29% in 2012 6.00 IAG median 5.2% 10.00

5.00

8.00 4.00

Interest Rate (%) Rate Interest 3.00 6.00

2.00 IAG Libor 3mth IAG median 4.00 1.00 (%) Rate Interest

- 2.00 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 Bank & Other Fin Lease Libor 3mth Note: BA data to end December 2010, IAG data for subsequent years. Interest expense as of average debt in current and prior fiscal year. Interest costs exclude provision unwinding in 2011 - and 2012. Source: Company Data, Thomson Reuters, Morgan Stanley Research 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12

Note: BA data to end December 2010, IAG data for subsequent years. Interest expense as % Exhibit 90 of average debt in current and prior fiscal year. Interest costs exclude provision unwinding in Legacy airlines rank highly in net indebtedness 2011 and 2012. Source: Company Data, Thomson Reuters, Morgan Stanley Research IAG adjusted net debt/EBITDAR 2013 4.0x, 2.7x ex-pension deficit Where could we be wrong? Risks in our Net Debt/EBITDAR* approach 13e 14e 15e AIRA 0.4x 0.5x 0.6x Ignored related effects: The effect of low rates is not confined AF-KLM 4.5x 3.6x 3.2x to airline borrowing costs. In particular, lower bond yields EZJ 0.4x 0.1x -0.3x typically increase pension costs. This could prove an offsetting IAG 4.0x 3.1x 2.3x factor for an airline, particularly IAG where we estimate the LHA 2.4x 2.0x 1.6x RYA 0.1x NM NM pension deficit at €2.5 billion post-tax as at 31 March 2013. THYAO 3.4x 3.3x 3.6x MEAN 2.2x 2.1x 1.8x Benchmark rates could rise: Never in recent economic * EV and net debt are adjusted to include operating lease expense capitalised at 7 times and, history have interest rates been so low for so long. As shown in where relevant, pension deficits. Closing prices as of 15 July, 2013. NM = Not meaningful. Source: Morgan Stanley Research estimates Exhibit 77, reducing benchmark rates has driven down the cost of EETC debt. We have assumed in this Blue Paper that rates Exhibit 91 remain stable. Clearly, there is the potential for rates to rise, Aircraft financing maturing which could trigger an increase in corporate debt costs. Investor appetite has moved to the aircraft asset risk Bank Loan Mortgages ETCs/PTCsEETCs Pooled ABS Leveraged Leasing Bankrupt EETCs EETC rates could rise regardless of the benchmark rate Wrapped tranches movement: We do not use this report to assess the supply or CREDIT ASSET demand dynamics of the EETC market, or its future direction. RISK RISK Events could materialise to destabilise the market. This could

Source: Wachovia Securities lead to a closure of the market to airlines and/or an increase in price to access the market. The key risk that would destabilise confidence in the EETC market, in our view, would be the inability of a holder to realise perceived collateral value backing the paper. This could arise, for example, through an inability to repossess an aircraft or a collapse in aircraft residual value.

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July 22, 2013 Commercial Aviation — A Renewed Lease of Life

Anatomy of an EETC

EETCs emerged in the 1990s and replaced ETCs EETCs have been the capital market instrument of choice of US Banks developed EETCs as improved forms of the original ETC. The airlines principal difference is that an EETC is enhanced by the existence of a The large size of EETC issues relative to that of single-aircraft liquidity facility and, in many cases, the tiering of claims against financings increases the liquidity of these securities, both at initial multi-asset collateral with known inter-creditor arrangements issuance and in secondary markets. EETCs also provide scale (‘tranching’ of debt). These developments further lowered the default economies related to an airline’s administrative costs of raising capital probability and expected loss on senior tranches and allowed EETCs for financing aircraft. to achieve incremental rating benefit versus an ETC. The earliest An EETC achieves a higher credit rating than its underlying EETC transaction was in 1994. The last rated public aircraft ETC issuer issuance was completed by Delta in 1996. For the EETC to be viable, the certificates must receive an appropriate Repossession delay is limited to 60 days rating. The legal effectiveness of the EETC structure enables ratings As long as the underlying airline makes the required payments under higher than those of the underlying airline or railroad. EETCs allow the note or lease, the trusts will have funds available to meet required financiers of the subject equipment to receive, under certain interest and scheduled principal payments on the related EETC. In the circumstances, current payment of principal and interest during a event of bankruptcy of the underlying obligor, the airline must reorganisation process. If payment of principal and interest on such a determine within 60 days of the bankruptcy filing date whether it financing is not brought and maintained current within 60 days of the wishes to continue to use the equipment financed under the EETC. In bankruptcy filing, Sections 1110 and 1168 allow for a waiver of the the event that the airline does, the US Bankruptcy Code provides for automatic stay of Section 362 of the US Bankruptcy Code on the the airline to bring and/or maintain current payments on the equipment creditor’s ability to foreclose on and sell the collateral pledged as notes or leases supporting the EETC. This 60-day option for the security. The operation of these sections is a key reason why debtor to cure defaults of the underlying equipment note indentures or certificates are widely expected to have significantly lower probability leases that occur pursuant to the indenture or lease terms upon the of default and higher recovery than debt issued directly by the bankruptcy filing by the underlying obligor, is the main reason why the underlying obligor. default probability of EETCs on average is expected to differ An EETC is not a direct obligation of, nor guaranteed by, the significantly from the default probability of underlying obligors. If the underlying airline airline determines that it does not wish to retain the equipment, EETCs are commonly arranged using a pass-through structure in Section 1110 allows for the automatic stay, which generally precludes which a trust issues the certificate and then either lends the proceeds secured borrowers from foreclosing on collateral during a bankruptcy on to the airline to fund equipment purchases or directly purchases the proceeding, to be waived. The ability of certificate holders to claim and equipment, which it then leases to the airline. Cash payments from the monetise their collateral early in the bankruptcy (perhaps before airline under the note or lease are sized to meet debt service for the meaningful erosion of value or a state of disrepair occurs) is a key ETC or EETC. Because of the use of this pass-through structure, the reason why higher recovery is expected on average in the event of instruments are at times referred to as pass-through certificates default. (PTCs). EETCs (but not ETCs) are structurally enhanced by a liquidity ETCs were the 1980s precursor to EETCs facility ETCs emerged as transactions where one or more pieces of This facility is available to fund interest payments (but not principal) on equipment could be financed in the capital markets using the benefits the EETC in the event that the underlying notes or leases from the of Sections 1110 and 1168. In general, aircraft ETCs where the airline is in payment default. This could occur if the airline files for amount of debt was less than 80% of the value of the pledged bankruptcy and elects not to retain the equipment and thus ceases collateral could get up to two notches of rating uplift above the payments. corporate family or senior unsecured rating of the underlying obligor;

railroad ETCs with similar leverage could get up to four notches of uplift. The lower potential uplift for airlines stems from the greater uncertainty over whether they can reorganise and retain all of their financed aircraft.

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July 22, 2013 Commercial Aviation — A Renewed Lease of Life

Part 4: Leasing – adding stability to the OEM cycle

Exhibit 93 Leasing – an important and under-appreciated role Airlines are increasingly willing to allow lessors to The proliferation of aircraft lessors plays an important and, we believe, manage residual value risk under-appreciated role in enhancing the stability of the commercial 50% Widebody Narrowbody Regional Freight OE cycle for a number of reasons. (1) Lessors take on the residual risk

associated with aircraft, reducing the risk of new aircraft orders for 40% airlines. (2) Lessors enhance liquidity across all aircraft, but primarily across younger aircraft in demand, which encourages airlines toward 30% the market segment to which OEMs are most closely tied. (3) The presence of lessors further diversifies an OEM’s customer base and 20% can ‘introduce’ an OEM to new customers. (4) Lessors enhance the capital base available for financing aircraft, thereby increasing access 10%

to capital for an OEM’s customers and reducing airlines’ cost of debt, Leased Type Fleet Total of % regardless of the interest rate environment. (5) Lessors increasingly 0% represent a source of orders in themselves for the OEMs. 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012

Note: Chart shows annual data as of December year-end 2012. Regions with a negligible 1. Lessors take on the residual risk associated with new share are excluded. Source Ascend: Western Jets, Morgan Stanley Research aircraft, partially de-risking aircraft transactions for Exhibit 94 airlines. The strategic use of operating leases among airlines Aircraft asset values highly volatile across cycle has been growing in popularity over the decades. Even when 20% Narrowbody Widebody Freighter ownership is a more cost-effective solution (as may be the case for a profitable airline able to benefit from depreciation tax 10% shields), operators increasingly feel that they should have a minimum percentage of their fleet in the form of operating 0% leases (anecdotally, 30-40% is frequently mentioned). This is because having a mid-single-digit amount of capacity rolling off -10% lease in any given year facilitates the airline’s ability to cut capacity if need be. This strategy has gained momentum over -20%

the past cycle as airlines have coped with an increasingly (%)-- Change in Market Value YoY volatile macro and operating environment. In addition, -30%

operators may be reluctant to own an aircraft for its lifetime if 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 they are uncertain about the residual value risk of the asset. Note: Narrow-body = MD83, 737-300, A320-200, 737-700; wide-body=767-300, 767-200, 747-400, 777-200, A330-300, A340-300; freighter = MD11F, 747-400F. Chart uses 5-year However, the presence of an aircraft lessor, which absorbs this constant age aircraft for the years that aircraft of that constant age are available. risk, may encourage an airline to transact. Source: Aircraft Value Analysis Company, Morgan Stanley Research to focus their activities on the younger aircraft segment – which 2. Lessors enhance liquidity across all aircraft, but improves airline access to capital for young aircraft in primarily across younger aircraft in demand; this particular. Moreover, since their assets are constantly encourages airlines toward the market segment to which depreciating, lessors always need to be averaging into younger OEMs are most closely tied. Traditionally, young, fuel-efficient narrow-body aircraft have enjoyed the most stable aircraft – a dynamic that enhances liquidity in this segment of residual values over time. In contrast, older aircraft and cargo the market. Unsurprisingly, most lessors have low average aircraft have experienced the most volatility in their residual fleet ages. This reduces lease rates in this segment, all else values across the business cycle. This occurs for a number of equal, through competition as many lessors target the same reasons, including the fact that older aircraft normally carry asset class. This widens the delta between new and old aircraft more residual risk as they tend to depreciate faster than when an airline is facing the decision of which type of aircraft to younger aircraft, and that older aircraft tend to be at greater risk own, and it assists in insulating new aircraft from the threat of of obsolescence when new technology is introduced, a theme substitution from old aircraft in the secondary market. that is relevant today. As a result, lessors have a clear incentive

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July 22, 2013 Commercial Aviation — A Renewed Lease of Life

Exhibit 95 Exhibit 97 Older aircraft amplify a lessor’s growth hurdle, an Lessors also geographically diversified incentive to focus on younger aircraft 50% 30%

40%

20% 30%

20% 10% Customer Share of Fleet (%) 10% % of Net Aircraft Book Value 0% 0% AER AYR FLY AL 1 3 5 7 9 1113151719212325 Years of Age AER = AerCap, AL = Air Lease, AYR = Aircastle, FLY = FLY Leasing. Source: Company data for 1Q13 except for AER, which is shown as YTD as of 31 December, Source: Company Data, Morgan Stanley Research 2012, Morgan Stanley Research

3. The presence of lessors further diversifies an OEM’s 4. Lessors enhance the capital base available for customer base and can ‘introduce’ an OEM to new financing aircraft, thereby increasing access to capital for customers. Customer concentration also plays a role in an OEM’s customers and reducing airlines’ cost of debt, aircraft lessor risk profiles and, all else equal, more customer regardless of the interest rate environment. Not only is it and geographic diversification is preferred for risk important for a lessor to acquire attractive assets and place management purposes. In this way, lessors and OEMs are in them with a diversified group of customers in a range of alignment as both benefit from a greater degree of diversity. geographies, but they also need to manage the risk profile of Although we do not have data for all lessors, using the public financing these aircraft. Furthermore, aircraft lessors, lessors as benchmarks we can see the typical lessor is particularly those that can introduce new capital into the aircraft diversified across both customers and geographies. So, to the funding complex, are often sought after by customers and extent that a lessor is the owner of a newly ordered aircraft – suppliers alike because of their access to capital, particularly through a direct order or a sale-and-leaseback transaction – by nascent airlines. This has been especially true for EM this enhances the OEM’s own goals of diversification. airlines that do not have long operating histories, so find it Exhibit 96 difficult to raise capital for aircraft on their own. As a result, Top 10 customers represent 30-40% of each public aircraft lessors have a clear incentive to seek out new sources lessor’s fleet of capital, to minimise their own cost of debt through being more innovative in using financing structures that may be 45% unavailable to most airlines, and to diversify sources of financing. The lessors can sometimes access sources of 35% capital that are not open to the airlines, given the historically low, unleveraged asset betas of the lessors. All of these points

25% enhance the capital base available to airlines. At the same time, the aircraft leasing industry has become more fragmented. The combination of these forces – aggressively 15% seeking new, cheap capital and increased fragmentation – is a

Customer Share of Fleet (%) structural change that leads to lower financing costs 5% irrespective of the interest rate environment, which benefits the OEMs. AER AYR FLY AL -5%

Source: Ascend: Western Jets, Morgan Stanley Research

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July 22, 2013 Commercial Aviation — A Renewed Lease of Life

Exhibit 98 Exhibit 101 Market share of top 5 lessors over time: the industry Lessors themselves increasingly represent demand is becoming more fragmented for new aircraft at the OEMs

2,000 Planes ordered by Lessors (LHS) 25% 100% 1,851 % of backlog (RHS) 90% 1,576 80% 23% 1,500 1,430 1,404 70% 1,367 1,240 60% 21%

50% 1,000 18.8% 40% 18.4% 18.5% 17.8% 19% 30% 17.6% Market Share(%)Market 20% 500 16.3% 17% 10% 0% 0 15% 2007 2008 2009 2010 2011 2012 1974 1977 1980 1983 1986 1989 1992 1995 1998 2001 2004 2007 2010 2013 Source: Company Data, Morgan Stanley Research Source: Ascend: Western Jets, Company data, Morgan Stanley Research

Exhibit 99 5. Lessors in themselves are increasingly a source of Lessors work aggressively to reduce cost of debt orders. All lessors face a natural growth headwind as their 8% asset base depreciates each year, with those dealing in older aircraft tending to experience more of a headwind as a percentage of current asset value. Simplistically, this headwind 6% begins at 3.4% per year and grows as a function of aircraft age (calculated using the standard lessor policies of a 25-year depreciable life and a 15% residual value). As a result, lessors 4% increasingly find that new order books play a major role in creating the growth plans that they need. Moreover, being in possession of attractive delivery slots for sought-after aircraft Cost of Debt (%) of Debt Cost 2% can improve the economics of a lease transaction, as an airline may find that the only way it can acquire the latest technology in a reasonable time is to deal with a lessor. As such, lessors 0% are increasingly incentivised to place orders directly with AL AER FLY AYR Boeing and Airbus. Not surprisingly, they have become a larger

Note: Average LTM Effective Interest Rate as of 31 March 2013 source of new aircraft orders for the OEMs over time – a trend Source: Company Data, Morgan Stanley Research that we expect to continue. Exhibit 100 Lessors have much lower asset betas, enabling them to access sources of capital that some airlines cannot 1.4 Lessor Avg Legacy Avg

1.2

0.8

Beta 0.6

0.4

0.2

0 Levered Unlevered

Lessors = AerCap, Aircastle and FLY Leasing; Legacies = Delta Air Lines, US Airways and United Continental. Source: Thomson Reuters, Company Data, Morgan Stanley Research

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July 22, 2013 Commercial Aviation — A Renewed Lease of Life

Part 5: Infrastructure: progress in addressing potential capacity constraint

Progress on easing infrastructure constraints Exhibit 102 Airport passenger numbers Markets remain concerned that long-term traffic growth could be 2012 pax (mn) constrained by infrastructure. We look at the recent progress seen at London – LHR 70.0 Rome and Istanbul airports. Both cities had several bidders for the Paris – CDG 61.6 work, showing that private capital is available so airport capacity Frankfurt – FRA 57.5 investment need not be a burden for governments – it can actually be Amsterdam – AMS 51.0 a source of revenue. In other places (such as Munich and London), Madrid – MAD 45.2 lack of political support – as opposed to capital – has seen little Istanbul – IST 44.9 progress made. Munich – MUC 38.4 Rome – FCO 37.0 Barcelona – BCN 35.1 Although infrastructure can be a constraint to traffic London – LGW 34.2 Source: ACI, Morgan Stanley Research growth in the long term... In last year’s Blue Paper, we noted that long-term traffic growth could become constrained by … some airports/countries have made progress during infrastructure. There were 1.6 billion passengers at European 2012/13 on addressing capacity. Over the past year, some airports in 2012 and, assuming passenger volume growth of progress has been made in terms of addressing capacity 3.5% per annum from 2011 to 2030 (at the average level of constraints, with Rome and Istanbul being good examples: current industry assumptions), unrestrained demand would be around 3 billion passengers by 2030 (1.86 times the number of  Third Istanbul airport: The Turkish government tendered passengers in 2012). ACI Europe believes that 12% of this out the construction of a third Istanbul airport to a demand may not be accommodated due to lack of airport consortium led by Limak, a Turkish conglomerate. The capacity, considering current plans for airport capacity new airport is expected to have maximum capacity for 150 expansion. In particular it believes the capacity crunch will be million passengers, which would make it the largest airport more acute in Turkey, the UK, the Netherlands, Bulgaria, in Europe. Construction is expected to start during Hungary, Germany, Poland and Italy. 2013/14, and the first phase should be completed by 2018.

 Expansion of Rome’s airports: Aeroporti di Roma’s We believe it is difficult to forecast capacity increases (ADR) plans to expand the Rome airports are not new – accurately, as discussion of most expansion plans typically the project involves expanding the capacity of Fiumicino begins only a few years before an airport faces the capacity airport to 100 million passengers, for a total investment of constraint. It is therefore relevant, we think, to look at the €12 billion. However, the expansion project was strongly current picture of airport capacity, to see how it has been dealt dependent on the airport obtaining a new regulatory with by different countries and airports. Of Europe’s 10 largest framework, which would allow it to have an appropriate airports, five are facing capacity constraints: London Heathrow, remuneration on its investment. ADR signed this new London Gatwick, Istanbul, Munich and Rome. Paris, Frankfurt, regulatory framework during December 2012 and will Amsterdam, Madrid and Barcelona, however, all have spare operate under a pure dual-till system, enabling it to recover airport capacity. This means that, while some countries and its cost of capital on the investment, in particular through airports have not addressed their capacity constraints quickly tariff increases. enough, others have. It seems fair to believe that there will always be airports with capacity constraints, but in a framework Others have been slower to address capacity constraints, where airports compete on a European level, those that have and this seems to have been driven by lack of political the available capacity can absorb some of the excess demand. support, rather than capital not being available. London and Munich are good examples of where there is still no plan to solve the current capacity issues. In London, the debate has lasted for several years and both a new London airport and the construction of additional runways at Heathrow or Gatwick have been discussed. However, no decisions have yet been

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July 22, 2013 Commercial Aviation — A Renewed Lease of Life

taken. In Munich, a referendum held in 2012 voted against the The tender for the third Istanbul airport also showed that private construction of a third runway at the airport. capital is available for airport investments. In fact, not only did the several bidders for the tender propose to fully fund the Both cases suggest that it is primarily the lack of political capital expenditure, but they also proposed to pay the support that is preventing the airports from expanding, government a concession fee for doing so. This suggests that especially as the airports would be able to finance the runway expanding airport capacity investment does not necessarily expansions from operations, in our view. need to be a burden for governments; it can actually be a revenue source.

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July 22, 2013 Commercial Aviation — A Renewed Lease of Life

Appendix 1 – Commercial aviation: A 40-year review

From protection to liberalisation… Exhibit 103 State aid and capital injections for European airlines When commercial aviation was in its infancy, airlines were – pre September 2001 Capital Injection $mn conceived as a form of public utility and in some instances as a State-owned proud symbol of national identity. These public-service Sabena (1991) 1,800 objectives overshadowed the business aspects of the industry, Iberia (1992) 830 causing profit delivery to be a secondary target. Despite public Aer Lingus (1993) 240 sector motives, keeping costs and fares low were rarely TAP Portugal (1994) 1,965 Air France (1994) 3,300 primary objectives and government-owned airlines, in Olympic (1994) 2,245 particular, often emphasised employment as a key goal. Alitalia (1997/2004) 2,208 Regulators accepted the costs as reported by the airlines and Not classified as state aid applied a uniform rate of return to obtain an approved fare. Air France (1991) 338 Thus, the sector was insulated from market forces and Sabena (1995) 267 Iberia (1995) 593 inter-company competition. Route rights were awarded by Private sector regulators, often after lengthy hearing processes and with little BA (1993) 690 regard for suitable fit with existing networks. KLM (1994) 620 Lufthansa* (1994) 710 The 1978 US Deregulation Act cut government control over Finnair (1992/4/5) 175 * German government also contributed ~€800 million to the Lufthansa pension fund in 1995. fares and domestic routes, and offered US airlines the first Source: Morgan Stanley Research opportunity to prioritise business considerations. Almost 20 1990 brought a seminal event in the shape of the first Gulf years after the US airline industry was deregulated, the EU War. This combined the use of airlines as a target for terrorist implemented its final package for re-regulating the intra-EU attacks with an oil price shock due to constraints on oil aviation market in 1997. This ended constraints on EU carriers production from the Middle East. 1991 saw the first decline in operating beyond member state borders and enabled an EU year-on-year growth in world airline traffic as passengers carrier to make unrestricted services on any given route within avoided travelling. The demand shock was combined with a the EU. Low-fare start-ups easyJet and Ryanair were the first fuel price hike after the invasion of Kuwait, leading to a four- carriers to establish base airports outside their member states. year period (1990-94) when the global airlines recorded a collective loss of $20.4 billion, of which US carriers accounted For many European airlines, direct and indirect government for $11 billion. Of the 12 largest US carriers, five declared help has remained the last resort to stay in business. Well bankruptcy, with two ending up being liquidated. The financial known listed carriers, such as Air France, Alitalia and Iberia, situation was exacerbated by over-ordering of aircraft during pledged to restructure extensively in exchange for direct the 1980s, which led to excessive capacity in the market in the government aid during the 1990s. Indirect government aid has early 1990s. come in numerous packages – for example, lack of fuel taxation, low landing charges at government-owned airports In post mid-1990s recovery, the industry began to turn and credit guarantees. The abolition of existing slot rules (‘use towards cost control and away from the elusive quest for it or lose it’) during the current industry crisis has also protected market share. IT advances also enabled dynamic pricing the traditional players. This has allowed aircraft to be grounded systems to be introduced so that traffic growth could be and flexible implementation of flight schedules without accommodated with more modest capacity outlay. Profit and jeopardising valuable slot positions. Under normal shareholder value became more prominent objectives, circumstances, airlines would have been forced to return although they remained difficult to deliver. unused slots to the pool for redistribution.

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July 22, 2013 Commercial Aviation — A Renewed Lease of Life

… but plagued by low returns and value destruction Exhibit 104 Global airline profitability since 1970 Over the past 40 years the post-tax profit of the airline industry worldwide has averaged only 0.1% of revenues. There are a small number of airlines that consistently generate a return on capital that exceeds its cost – which include a handful of low-cost carriers, full-service network and regional airlines, and can be found in all the major regions. However, there is no simple reason for their success compared with the persistently poor profitability of most of the industry.

Suppliers and other industries in the air transport value chain do generate sufficient profits to pay investors a normal return, in some cases with returns on capital well into double figures.

However, airlines stand out in the value chain as earning the Source: ICAO, IATA, Morgan Stanley Research lowest returns and bearing virtually the highest risk. The most Exhibit 105 profitable sectors in the value chain are relatively small Air traffic RPKs have expanded tenfold in 40 years compared to the capital invested in the airlines.

1100 Today, over $500 billion of investors’ capital is tied up in the airline industry. In a ‘normal’ industry investors would earn at 900 least the cost of capital, implying a return of $40 billion per year. 700 In fact, over the past decade investors have seen their capital earn $20 billion per year less than it would have earned if 500 invested elsewhere. Even at the top of the last cycle, over $9 billion of investor value was destroyed. Over the last 40 years, 300 the global aviation industry has delivered an average net 100 4 margin of just 0.1% . Even in 2010, the best year of the last 1970 1974 1978 1982 1986 1990 1994 1998 2002 2006 2010 decade, the global industry’s $18 billion net profit equated to a World GDP World scheduled RPKs World Trade margin of 3.2% versus a cost of capital estimated at 7-8%. Source: ICAO, IATA, Haver, Morgan Stanley Research

Exhibit 106 Michael Porter applied his Five Forces framework to illuminate ROIC has persistently lagged WACC for the sector the reasons why airline profitability is so poor, through the forces of rivalry, new entrants, customer and supplier bargaining power, and the threat of substitutes. There are few industries where all five forces act so strongly to depress profitability as they do in the airline industry. Rivalry is intense, driven by a perishable product, difficulty in sustaining product differentiation, high fixed and low marginal costs, high exit barriers, capacity that can only be increased stepwise, and volatile markets. The threat of new entrants is also high. Over 1,300 new airlines have been established in the past 40 years. Barriers to entry are low as market access is increasingly liberalised, economies of operational scale are limited, access to distribution channels is easy and consumer switching costs Source: IATA Economics and forecasts are low.

4 IATA, “Vision 2050”, 12 February 2011

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July 22, 2013 Commercial Aviation — A Renewed Lease of Life

Consistently low airline industry profits over the past 40 years (Overweight) to the old guard of Southwest Airlines and aggregate a wide variety of performances. There have been a JetBlue Airways (both Underweight). small number of airlines that have performed far better than average. During the 2000s the average airline generated an Europe and Turkey: Short-haul traffic trends remain robust in EBIT margin of just 0.7%. Excluding small airlines, fewer than cross-border Europe, and pricing development was solid into 15 managed to produce an average EBIT margin in excess of the Easter trading period. Most airlines have reported 8%. Most fail to earn their cost of capital over business cycles continued growth in load factors during the 2Q13 as well. On of 8-10 years. This is despite operational streamlining often the long-haul side, divergent performance continues between through outsourcing activities such as maintenance and the transatlantic and Asian routes – US routes show good handling), cutting non-core routes, more sophisticated yield volume and pricing trends, whereas volumes to Asia have been management, increased load factors, the emergence of more sluggish, with many carriers citing increased pricing ancillary revenues and forging global alliances, which now competition from Asia-based players. Low-cost carriers have command anti-competition immunity on certain routes. been the clear outperformers in Europe thanks to sustained performance in yield momentum, driven by a combination of The weighted average cost of capital for the average airline in price rises at the legacy airlines and capacity withdrawals from normal times is 7-8%. For the typical airline, it takes a dollar of the smaller regional carriers. invested capital to generate a dollar of revenue each year. So, to generate a return on capital equal to its cost – really the We are seeing strong booking trends into the summer season minimum investors will expect – airlines need to generate and, coupled with a relatively steady fuel price environment, earnings as a percentage of revenues – that is, an EBIT margin see this as broadly positive for the sector. We identify three key of 8% or more. However, EBIT needs to be adjusted for focal points into year-end: a) review of short-haul capacity accounting distortions such as operating leases and some planning into the winter season – several carriers have hedging instruments. Consistently low airline industry profits indicated they will undertake route reviews (AF-KLM, Alitalia, over the past 40 years aggregate a wide variety of LOT are some key examples); b) progress on cost-cutting performances. A small number of airlines have performed far programmes at the legacy carriers – the major three (AF-KLM, better than average. During the 2000s the average airline IAG and Lufthansa) each have ambitious 2015 profitability generated an EBIT margin of just 0.7%. Excluding small goals that are largely focused on labour, fleet and back-office airlines, fewer than 15 managed to produce an average EBIT restructuring; and c) updates in the regulatory and taxation margin of more than 8% (such as Ryanair, Copa, Allegiant, environment in Europe – many carriers have been Emirates, Turkish Airlines, Singapore Airlines and Southwest). disappointed by austerity-related taxes levied via air traffic charges or rate changes at airports. As many EU countries are Analyst Global Trend Summary still in the deleveraging process, we see further tax rises as a potential risk issue for the sector. Our key stock picks are The US: Recent trends have been somewhat lacklustre, with easyJet, Ryanair and IAG (all rated Overweight). much of 2Q13 passenger revenue per available seat mile (PRASM) underperforming expectations. That said, most US Turkish carriers have enjoyed strong growth momentum, with airlines reported a pick-up in PRASM in June, which bodes well high demand driving an increase in load factors of +3.5 for the summer. We think PRASM will continue to accelerate percentage points to ~79% for Turkish Airlines in 1H and +4 into the summer – hence our Attractive view on the US Airline percentage points to 78.3% for Pegasus in 1Q13 on significant industry, which is based on: continued capacity restraint; a capacity growth. We expect THY’s traffic to continue to grow backdrop of sluggish GDP and high fuel prices tempering strongly in 2H13 and rate the stock Overweight, given positive competitive pressure; healthier balance sheets, cash flow and yield inflection trends with 1Q13 yields up year on year after six capital returns; M&A; and relatively attractive valuations. We quarters of negative yields; and strong traffic growth and load do not believe that the industry has completely ‘restructured’ or factor improvement. is permanently different, but we do firmly believe the industry’s structure has improved enough to amplify both the length and Latin America: Brazilian airlines continue to cut capacity to breadth of the current cycle versus prior ones (barring a macro raise profitability as cost pressures rise. Both Gol Airlines and shock). To be bullish on the cycle is to prefer legacy airlines; Latam Airlines have reported improved passenger revenue per our top picks are Delta Air Lines and United Continental available seat kilometre (PRASK), through higher yields at Gol Holdings (both Overweight), but among the low-cost carriers and higher load factors at Latam), and this is particularly we prefer Allegiant Travel (Equal-weight) and Spirit Airlines important given the recent rapid devaluation of the Brazilian

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July 22, 2013 Commercial Aviation — A Renewed Lease of Life

Real versus the US dollar. We expect deeper capacity cuts yen depreciation and rising crude oil prices will push back profit than airlines had previously planned, due in part to a growing growth in F3/14, although much of this negativity already FX overhang and a moderate traffic growth outlook given our appears priced into stocks, given recent underperformance. economists’ soft GDP forecast. Australia trends: Domestic capacity appears to be In Mexico, air traffic has been fairly healthy, as seen in moderating, with both Qantas and Virgin Australia targeting high-single-digit to low-double-digit passenger increases at 3-5% ASK growth from July to December 2013 (versus 8-10% major airports. The healthiest region remains Central America, over the previous 12 months). However, leisure demand has served by Copa Airlines. We expect low-cost carriers to been softening as the Australian economy, showing increasing continue to take share and believe that Copa’s targeted growth signs of stress, and corporate travel also appears to be strategy will drive profit growth there. Consistent with these slowing. To put this into context, as general mining activity views, we are Overweight on Copa due to its solid slows, mining travel (a combination of production and fundamentals, with high growth and margins, but less exploratory work) make up ~50% of AMEX Corporate Travel's optimistic about other airlines in the space. total volume in the region. Further capacity curtailment is required to keep yield growth positive and stabilise profits. We China/Hong Kong: In 1H13, Chinese airlines achieved robust expect uncertainty to persist in the domestic market over the traffic (RPK) momentum, with 12% growth year on year and a next six months, driven by Virgin Australia taking 60% 0.7 percentage point improvement in passenger load factor to ownership in Tiger Australia (which needs to increase scale in 82%, in line with our expectations. However, we were surprised order to lower unit costs and reverse its losses); the outlook for by a sharp decline in domestic passenger yield in 2Q13, corporate travel showing early signs of deterioration; and especially a 10% year-on-year slump for all airlines. We swings in the Australian dollar (a lower AUD has a negative attribute this to several factors: 1) Macro weakness – Chinese impact on profitability, but could see foreign airlines start to GDP growth slowed to 7.7% year on year in 1Q and 7.5% in withdraw capacity in/out of Australia), which could help Qantas’ 2Q, and domestic consumption growth also slowed down, international market share. Within this context, we are implying lower demand for air travel. 2) Negative government Overweight on Qantas and Equal-weight on Virgin Australia. policies – more stringent restrictions on official spending have led to a ~20% contraction in travel demands for first/business Exhibit 107 class. 3) Exogenous events: avian flu (H7N9) and the Sichuan Sequential change in monthly global RPK earthquake in 2Q13 also slowed down air travel demands. 4) 25% Current Traffic diversion from high-speed rail – Beijing-Guangzhou, 20% Average Guangzhou-Shenzhen and Beijing-Shanghai high-speed rail 15% +/- 1 Std. Dev. links began operation, and pricing competition intensified. We 10% therefore expect a challenging environment in 4Q13 after the 5% traditional summer peak, with no sign of recovery. 0% Risks of a renminbi depreciation and/or an oil price rebound in -5% 2H13, if they materialised, would serve as major negative -10% factors for Chinese/Hong Kong airlines. Finally, we are -15% increasingly concerned about competition from high-speed rail n r l p a un Ju Ja Feb M Apr May J Aug Se Oct Nov Dec trains, which offer discounts on major routes (Beijing-Shanghai, Beijing-Guangzhou and Guangzhou-Shenzhen) for business Note: Based on data starting in 2002. Data adjusted for leap year and Chinese New Year. Source: IATA, Morgan Stanley Research and first-class passengers, effective from July 10, 2013. Therefore, we are Underweight on Cathay Pacific, China Eastern, China Southern and Air China.

Japan trends: Passenger growth across domestic and international routes has been tepid, due to the overhang from yen depreciation and weakness (particularly in tourism demand) on China routes, although Southeast Asia and long-haul US/European routes to/from Japan are trending much better. We maintain an In-Line view on the industry as

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July 22, 2013 Commercial Aviation — A Renewed Lease of Life

Exhibit 108 Exhibit 110 Sequential change in monthly ASK Global RPK long-term trend 40% 600 15% Current Average 30% 500 10% +/- 1 Std. Dev. 20% 400 5% 10% 300 0% 0% 200 -10% -5% -20% YoY % Change (LHS) 100 -10% RPK (RHS) -30% 12 per. Mov. Avg. (RPK (RHS)) 0 r r y g t an p Jul u ov ec J Feb Ma A Ma Jun A Sep Oc N D 1 2 3 4 5 6 7 8 9 0 0 0 0 0 0 0 0 0 0 1 0 0 0 0 0 0 0 0 Note: Based on data starting in 2002. Data adjusted for leap year and Chinese New Year. 2 2 2 2 2 2 2 2 20 20 2011 2012 2013 Source: IATA, Morgan Stanley Research Note: Data adjusted for leap year. Source: IATA, Morgan Stanley Research

Exhibit 109 Exhibit 111 Global PLF long-term trend Global ASK long-term trend 10 90% 30% 650 8 85% 25% 600 6 80% 20% 550 4 75% 2 70% 15% 500 0 65% 10% 450 -2 60% 5% 400 -4 55% 0% 350 YoY Pt Change (LHS) -6 PLF (RHS) 50% -5% 300 YoY % Change (LHS) -8 12 per. Mov. Avg. (PLF (RHS)) 45% -10% ASK (RHS) 250 -10 40% 12 per. Mov. Avg. (ASK (RHS)) -15% 200 1 8 1 03 04 06 07 10 13 00 0 0 005 0 0 00 0 01 0 3 2 2002 2 2 2 2 2 2 2009 2 2 2012 2 001 002 003 004 005 01 2 2 2 2 2 2006 2007 2008 2009 2010 2011 2012 2 Note: Data adjusted for leap year. Source: IATA, Morgan Stanley Research Note: Data adjusted for leap year. Source: IATA, Morgan Stanley Research

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July 22, 2013 Commercial Aviation — A Renewed Lease of Life

Appendix 2 – Airbus & Boeing installed fleet analysis

Exhibit 112 Current Airbus installed base by age Up to 5 years 6-10 years 11-20 years 21-30 years > 30 years Total A300 25 30 4 59 A310 11 44 55 A320 Family 2,155 1,374 1,393 216 5,138 A330 408 257 221 2 888 A340 25 108 175 3 311 A380 95 8 103 Total 2,683 1,747 1,825 295 4 6,554 % of Total 41% 27% 28% 5% 0% Source: Ascend

Exhibit 113 Current Boeing installed base by age Up to 5 years 6-10 years 11-20 years 21-30 years > 30 years Total 717 33 112 145 727 3 20 23 737 Family 1,893 1,162 1,671 482 91 5,299 747 6 14 222 125 12 379 757 27 386 235 8 656 767 53 48 348 225 5 679 777 333 262 414 1,009 787 50 50 DC-9 2 42 44 MD-80 99 423 8 530 MD-90 68 68 Total 2,335 1,546 3,320 1,495 186 8,882 % of Total 26% 17% 37% 17% 2% Source: Ascend

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July 22, 2013 Commercial Aviation — A Renewed Lease of Life

Exhibit 114 Current Airbus installed base by region Africa Asia Pacific China Europe India Latin America Middle East North America Total A300 4 9 6 3 37 59 A310 15 11 19 10 55 A320 Family 124 697 763 1,813 149 437 263 892 5,138 A330 28 292 110 215 16 36 112 79 888 A340 32 46 12 157 16 48 311 A380 47 5 18 33 103 Total 188 1,106 896 2,217 165 489 512 981 6,554 % of Total 3% 17% 14% 34% 3% 7% 8% 15% Source: Ascend

Exhibit 115 Current Boeing installed base by region Africa Asia Pacific China Europe India Latin America Middle East North America Total 717 19 20 106 145 727 7 3 4 5 4 23 737 Family 289 805 743 1,319 135 387 98 1,523 5,299 747 9 116 8 147 4 49 46 379 757 9 28 32 126 6 2 453 656 767 32 169 11 110 54 13 290 679 777 26 363 31 185 24 12 203 165 1,009 787 4 24 2 6 3 5 6 50 DC-9 10 1 10 23 44 MD-80 18 23 44 31 43 371 530 MD-90 11 1 56 68 Total 404 1,562 825 1,953 169 507 419 3,043 8,882 % of Total 5% 18% 9% 22% 2% 6% 5% 34% Source: Ascend

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July 22, 2013 Commercial Aviation — A Renewed Lease of Life

Appendix 3 – Airbus and Boeing backlog analysis

Exhibit 116 Airbus’s current backlog by delivery year 2013 2014 2015 2016 >2016 Total A320 Family 286 450 501 388 2,296 3,921 A330 66 89 42 8 29 234 A350 7 37 55 517 616 A380 19 31 35 30 44 159 Total 371 577 615 481 2,886 4,930 % of Total 8% 12% 12% 10% 59% Source: Ascend

Exhibit 117 Boeing’s current backlog by delivery year 2013 2014 2015 2016 >2016 Total 737 Family 308 386 402 307 1,760 3,163 747 4 11 11 26 767 6 2 8 777 61 68 64 31 70 294 787 71 130 126 135 379 841 Total 450 597 603 473 2,209 4,332 % of Total 10% 14% 14% 11% 51% Source: Ascend

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July 22, 2013 Commercial Aviation — A Renewed Lease of Life

Exhibit 118 Airbus’s current backlog by customer region Africa Asia Pacific China Europe India Latin America Middle East North America Unknown Total A320 Family 34 1132 220 691 346 306 240 890 62 3921 A330 13 102 20 24 20 6 12 34 3 234 A350 29 183 10 68 5 37 178 105 1 616 A380 2 41 33 5 77 1 159 Total 78 1458 250 816 376 349 507 1029 67 4930 % of Total 2% 30% 5% 17% 8% 7% 10% 21% 1% Source: Ascend

Exhibit 119 Boeing’s current backlog by customer region Africa Asia Pacific China Europe India Latin America Middle East North America Unknown Total 737 Family 23 528 211 438 75 238 84 1301 265 3163 747 2 5 5 13 1 26 767 6 2 8 777 8 85 6 38 3 4 85 28 37 294 787 29 189 35 153 31 59 127 191 27 841 Total 62 813 257 642 109 303 296 1520 330 4332 % of Total 1% 19% 6% 15% 3% 7% 7% 35% 8% Source: Company Data, Morgan Stanley Research

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July 22, 2013 Commercial Aviation — A Renewed Lease of Life

Appendix 4 – Airbus global market forecasts

Exhibit 120 New passenger deliveries by region % of World % of World % of World Deliveries Deliveries Deliveries 2012-2021 2022-2031 2012-2031 (2011-2020) (2021-2030) (2011-2030) Asia Pacific 4,505 5,113 9,618 35% 35% 35% Europe 2,815 2,886 5,701 22% 20% 21% North America 2,580 3,271 5,851 20% 23% 21% Latin America 1,004 1,081 2,085 8% 7% 8% Middle East 1,007 899 1,906 8% 6% 7% Africa 413 544 957 3% 4% 3% CIS 492 737 1,229 4% 5% 4% World demand 12,816 14,531 27,347 100% 100% 100% Source: Company Data, Morgan Stanley Research

Exhibit 121 Exhibit 123 36% of deliveries will be in Asia through 2031 70% of traffic is expected to be in growth markets

Rest of World Traffic Within & between USA, Canada, Western Europe, & Japan Middle Africa CIS 76% 70% Eas t 4% 3% 63% 7% 57% Latin Asia America Pac if ic 43% 37% 8% 36% 30% 24%

North America 1970 1990 2010 2030 21% Europe Source: Company data, Morgan Stanley Research

21% Exhibit 124 Source: Company data, Morgan Stanley Research Highest RPK to be in Asia Pacific

Exhibit 122 Latin CIS Africa Of total deliveries, 69% are expected to be single-aisle America 4% 3% Small 6% Single twin Middle Asia Aisle, aisle, East Pacific 19165, 4518, 11% 33% 71% 17% Intermedi ate twin aisle, 1907, 7% North America 20% Europe Large 23%

aircraft, Source: Company data, Morgan Stanley Research 1331, 5%

Source: Company data, Morgan Stanley Research

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Exhibit 125 LCC traffic to increase to 19% (from 15%) by 2030 2011 RPK 2031e RPK 60% 59%

20% 15% 10%10% 5% 5% 5% 4% 3% 4%

Regional & Charter Global Major Small Low Cost Affiliate Network Network Network Carriers

LCC = Low-cost carrier. Source: Company data, Morgan Stanley Research

Exhibit 126 US to take the lion’s share of deliveries No. of In Billion Country Aircraft Country USD USA 5,289 PRC 634.0 PRC 4,272 USA 544.0 India 1,232 UAE 223.9 Germany 986 India 173.7 UK 979 Germany 137.1 Russia 958 UK 129.8 UAE 882 Russia 113.7 Brazil 781 Australia 102.1 Ireland 702 Brazil 100.1 Australia 652 Japan 98.2 Source: Company Data, Morgan Stanley Research

Exhibit 127 New deliveries by region Single-aisle aircraft Twin-aisle aircraft Very large aircraft

6000

4000

2000

0 North Europe CIS Middle Africa Asia Latin America East Pacific America

Source: Company data, Morgan Stanley Research

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July 22, 2013 Commercial Aviation — A Renewed Lease of Life

Appendix 5 – Boeing’s global market forecasts

Exhibit 128 Exhibit 131 Boeing’s market delivery forecast, 2012-31 Some 70% of deliveries expected to be single-aisle Regional Jets Large Region Aeroplanes % of World Deliveries 6% 2% Asia Pacific 12,030 35% Europe 7,290 21% Tw in-aisle 23% North America 7,760 23% Middle East 2,370 7% Latin America 2,510 7% C.I.S. 1,140 3% Africa 900 3% Total 34,000 100% Source: Company Data, Morgan Stanley Research

Exhibit 129 About one-third of deliveries to be in Asia Pacific C.I.S. Africa 3% Latin America 3% 7% Single-aisle 69%

Source: Company data, Morgan Stanley Research Middle East Asia Pacific 7% 36% Exhibit 132 …and airline traffic distribution by region in 2031 Asia North Middle Latin Pacific America Europe East America Africa Asia Pacific 61% 19% 22% 44% 1% 10% North America 11% 39% 21% 10% 31% 5% North America Europe 15% 24% 30% 24% 26% 43% 23% Middle East 12% 4% 10% 13% - 19% Latin America - 13% 9% - 41% 2% Africa 1% 1% 8% 9% 1% 21%

Europe All traffic to/from region 100% 100% 100% 100% 100% 100% 21% Source: Company Data, Morgan Stanley Research

Source: Company data, Morgan Stanley Research

Exhibit 130 Airline traffic distribution by region in 2011 Asia North Middle Latin Pacific America Europe East America Africa Asia Pacific 58% 15% 17% 37% 1% 7% North America 15% 50% 23% 10% 34% 5% Europe 16% 23% 36% 30% 30% 52% Middle East 10% 3% 8% 16% - 15% Latin America - 8% 9% - 34% 1% Africa 1% 1% 7% 7% 1% 20% All traffic to/from region 100% 100% 100% 100% 100% 100% Source: Company Data, Morgan Stanley Research

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July 22, 2013 Commercial Aviation — A Renewed Lease of Life

Morgan Stanley Blue Papers

Morgan Stanley Blue Papers address long-term, structural business changes that are reshaping the fundamentals of entire economies and industries around the globe. Analysts, economists, and strategists in our global research network collaborate in the Blue Papers to address critical themes that require a coordinated perspective across regions, sectors, or asset classes.

Recently Published Blue Papers

Emerging Markets Releasing the Pressure What If the Tide Goes Out? from Low Yields June 13, 2013 Should Insurers Consider Re-risking Investments? March 15, 2013

Japan and South Korea Global Autos The Yen Tide Does Not Lift Clash of the Titans: The Race All Boats for Global Leadership May 30, 2013 January 22, 2013

Global Steel Big Subsea Opportunity Steeling for Oversupply Deep Dive May 23, 2013 January 14, 2013

US Manufacturing eCommerce Disruption: A Renaissance Global Theme Is It a Masterpiece or a Transforming Traditional (Head) Fake? Retail April 29, 2013 January 6, 2013

Natural Gas as a China – Robotics Transportation Fuel Automation for the People Energy Market Wild Card December 5, 2012 April 16, 2013

Global Semiconductors Global Emerging Market Chipping Away at Returns Banks April 15, 2013 On Track for Growth November 19, 2012

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July 22, 2013 Commercial Aviation — A Renewed Lease of Life

Wholesale & Investment Social Gambling Banking Outlook Click Here to Play Global Banking Fractures: November 14, 2012 The Implications April 11, 2013

Key Secular Themes in IT The China Files Any The Logistics Journey Is Just Beginning Monetizing Big Data April 24, 2012 September 4, 2012

Chemicals Solvency ‘Green is Good’ – The The Long and Winding Road Potential of Bioplastics March 23, 2012 August 22, 2012

MedTech & Services Wholesale & Investment Emerging Markets: Banking Outlook Searching for Growth Decision Time for Wholesale August 6, 2012 Banks March 23, 2012

Commercial Aviation Banks Deleveraging and Navigating a New Flight Real Estate Path Implication of a €400-700bn June 26, 2012 Financing Gap March 15, 2012

Mobile Data Wave The China Files Who Dares to Invest, Wins China’s Appetite for Protein June 13, 2012 Turns Global October 25, 2011

Global Auto Scenarios The US Healthcare Formula 2022 Cost Control and True Disruption and Opportunity Innovation Starts Now June 16, 2011 June 5, 2012

Tablet Landscape Cloud Computing Takes Off Evolution Market Set to Boom as Window(s) of Opportunity Migration Accelerates May 31, 2012 May 23, 2011

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July 22, 2013 Commercial Aviation — A Renewed Lease of Life

Financials: CRE Funding China High-Speed Rail Shift On the Economic Fast Track EU Shakes, US Selectively May 15, 2011 Takes May 25, 2012

Asian Inflation The China Files Consumers Adjust As European Corporates & Inflation Worsens China’s Megatransition March 31, 2011 October 29, 2010

Wholesale & Investment Petrochemicals Banking Preparing for a Supercycle Reshaping the Model October 18, 2010 March 23, 2011

Global Gas Solvency 2 A Decade of Two Halves Quantitative & Strategic March 14, 2011 Impact, The Tide is Going Out September 22, 2010

Tablet Demand and The China Files Disruption US Corporates and China’s Mobile Users Come of Age Megatransition February 14, 2011 September 20, 2010

The China Files Brazil Infrastructure Chinese Economy through Paving the Way 2020 May 5, 2010 November 8, 2010

The China Files Asian Corporates & China’s Megatransition November 8, 2010

To find downloadable versions of these publications and information on Other Morgan Stanley reports, visit www.morganstanley.com

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July 22, 2013 Commerical Aviation – A Renewed Lease of Life

Morgan Stanley & Co. Limited (“Morgan Stanley”) is acting as financial advisor to International Consolidated Airlines Group, S.A. M(“IAG”)ORGA inN connection STANLEY with IAG’sBLUE announcement PAPER on November 8, 2012, that IAG’s wholly owned subsidiary Veloz Holdco, S.L. (Sociedad Unipersonal) intends to launch a tender offer for 100% of the share capital of Vueling Airlines, S.A.. IAG has agreed to pay fees to Morgan Stanley for its professional services. Please refer to the notes at the end of the report. Morgan Stanley is currently acting as financial advisor to JetBlue Airways Corporation (“JetBlue”) in regards to its review of strategic alternatives for its wholly owned subsidiary, LiveTV. JetBlue has agreed to pay fees to Morgan Stanley for its financial services, including transaction fees that are subject to the consummation of any resulting transaction. Please refer to the notes at the end of the report. Morgan Stanley & Co. Limited is acting as financial adviser to Ryanair Holdings plc in relation to the proposed cash offer for Aer Lingus Group plc. Morgan Stanley & Co International plc acts as corporate broker to Ryanair Holdings plc. Please refer to the notes at the end of the report.

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MORGAN STANLEY BLUE PAPER Disclosure Section Share prices for stocks mentioned as of close on July 18, 2013: , ADP Aeroports de Paris €77.62, Air China HK$5.32, Air Lease $28.50, Allegiant Travel $106.03, B/E Aerospace $69.99, Boeing $107.63, Cathay Pacific HK$13.24, China Eastern HK$2.41, China Southern HK$2.90, Copa Holdings $104.58, Delta Air Lines $20.56, Deutsche Lufthansa €15.35, EADS €42.22, easyJet 1, 406p, Flughafen Zurich SFr 497.25, General Electric $23.63, Gol Airlines $3.61, Honeywell $82.97, International Consolidated Airlines Group €3.29, JetBlue Airways $6.83, Latam Airlines $15.07, MTU Aero Engines €72.12, Qantas A$1.33, Rolls-Royce 1,200p, Ryanair €7.33, Safran €43.25, Southwest Airlines $13.78, Spirit AeroSystems $23.51, Spirit Airlines $34.17, TransDigm $138.75, Turkish Airlines TL8.06, United Continental Holdings $34.49, United Technologies $101.34, Vienna International Airport €45.56 and Virgin Australia A$0.47. Morgan Stanley & Co. 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Morgan Stanley uses a relative rating system using terms such as Overweight, Equal-weight, Not-Rated or Underweight (see definitions below). MMorganORGA StanleyN STANLEY does not assign BLUE ratings PAPERof Buy, Hold or Sell to the stocks we cover. Overweight, Equal-weight, Not-Rated and Underweight are not the equivalent of buy, hold and sell. Investors should carefully read the definitions of all ratings used in Morgan Stanley Research. In addition, since Morgan Stanley Research contains more complete information concerning the analyst's views, investors should carefully read Morgan Stanley Research, in its entirety, and not infer the contents from the rating alone. In any case, ratings (or research) should not be used or relied upon as investment advice. An investor's decision to buy or sell a stock should depend on individual circumstances (such as the investor's existing holdings) and other considerations. Global Stock Ratings Distribution (as of June 30, 2013) For disclosure purposes only (in accordance with NASD and NYSE requirements), we include the category headings of Buy, Hold, and Sell alongside our ratings of Overweight, Equal-weight, Not-Rated and Underweight. Morgan Stanley does not assign ratings of Buy, Hold or Sell to the stocks we cover. Overweight, Equal-weight, Not-Rated and Underweight are not the equivalent of buy, hold, and sell but represent recommended relative weightings (see definitions below). To satisfy regulatory requirements, we correspond Overweight, our most positive stock rating, with a buy recommendation; we correspond Equal-weight and Not-Rated to hold and Underweight to sell recommendations, respectively

Coverage Universe Investment Banking Clients (IBC) % of % of % of Rating Stock Rating Category Count Total Count Total IBC Category Overweight/Buy 1020 36% 410 39% 40% Equal-weight/Hold 1263 44% 485 47% 38% Not-Rated/Hold 109 4% 24 2% 22% Underweight/Sell 469 16% 123 12% 26% Total 2,861 1042

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Currently the analyst does not have adequate conviction about the stock's total return relative to the average total return of the analyst's industry (or industry team's) coverage universe, on a risk-adjusted basis, over the next 12-18 months. Underweight (U). The stock's total return is expected to be below the average total return of the analyst's industry (or industry team's) coverage universe, on a risk-adjusted basis, over the next 12-18 months. Unless otherwise specified, the time frame for price targets included in Morgan Stanley Research is 12 to 18 months. For Australian Property stocks, each stock's total return is benchmarked against the average total return of the analyst's industry (or industry team's) coverage universe, instead of the relevant country MSCI Index, on a risk-adjusted basis, over the next 12-18 months. 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July 22, 2013 Commerical Aviation – A Renewed Lease of Life

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