Global Aerospace

23 February 2000
Byron K. Callan Global Coordinator (1) 212 449-1394 Andrew Clifton: (44) 171 772-2539 David Ainsworth: (1) 212 449-1312 Suzanne Kecmer: (1) 212 449-6725 Pete Deighton Marketing Analyst (44) 171 772-1890

Combat Fighter Aircraft Outlook

Replacement Needs, Exports Drive Upturn

Highlights:

Fighter aircraft production to increase For now, a balance between U.S. and Europe

Global Securities Research & Economics Group Global Fundamental Equity Research Department Copyright 2000 Merrill Lynch, Pierce, Fenner & Smith Inc.
RC#60205505

#5434

Combat Fighter Aircraft Outlook 23 February 2000

Executive Summary:
Fundamentally Intact
Compared to our 1999 review of the outlook for combat fighter aircraft, our 2000 review shows some slippage in deliveries of major types in 2000-02 because of the timing of recent awards. Furthermore, we stopped projecting deliveries for the Boeing F-15, subsequent to unsuccessful competitions for Greece and Israel in 1999. However, our core view on this sector of the aerospace and defense market is fundamentally intact: Replacement of older aircraft purchased in the 1970s and 1980s underpins production rate increases from 2001 through 2005, and probably through 2010. The current generation of multi-role combat fighter aircraft is much more capable than ones they replace. Introduction of these new aircraft could prompt additional purchases in regions where military tensions remain high. Military aircraft programs are important to firms we follow, with BAE SYSTEMS, Boeing and Northrop Grumman deriving the highest percentage of sales from this activity. For 2000, we estimate that none of the companies we follow will derive more than 25% of its sales from advanced fighter aircraft production.

and the outcome of several international campaigns. The integration of the two major European defense suppliers will be closely watched because of issues that bedeviled U.S. majors in 1998 (Boeing) and 1999 (Raytheon and Lockheed Martin). A related issue is how military aircraft production is sorted out, particularly Eurofighter. EADS brings Mirage 2000, Rafale and Eurofighter under one corporations control. Prototypes of the Joint Strike Fighter should be flying this year and a decision on the program is expected in March 2001. This is the largest military aircraft program ever and an important issue for investors is whether the DoD sticks with its original plan for a winner-take-all contract award or if the DoD modifies its acquisition strategy. The acquisition strategy could be altered to ensure that the loser in JSF survives and so that there is more competition in the military aircraft market. Key campaigns to watch include a contract from the UAE for F-16 fighters and a small, but politically important, campaign in Norway that pits the F-16 against the Eurofighter. The UAE contract is important to get the Block 60 version of the F-16 underway. Finally, the outcome of the U.K. BVRAAM/Meteor missile should be watched because of its implications for Eurofighter. One advantage the U.S. has had in international campaigns has been the ability to offer fighters with AMRAAM (Advanced Medium Range Airto-Air Missile). Equipping Eurofighter with an improved medium range air-to-air missile could make it a more potent competitor in the 2008 and beyond time period when the missile is in production.

What Was New in 1999

Last years report looked at the motif of transition and continuity. In hindsight, there was more transition than there was continuity: Production of the Boeing F-15 will probably end in 2000. The outlook for the Lockheed Martin F-16 was enhanced with wins in Greece and Israel. Aerospatiale Matra and Daimler Chrysler announced a merger, to form EADS. The U.S. Congress moved to cut funding for the Lockheed Martin/Boeing F-22 fighter. For many investors, this raised a debate that has been underway for quite some time in Washington over the affordability of tactical fighter aircraft programs. An air war that NATO fought against Yugoslavia was initially heralded as the triumph of air power. However, more recent assessments suggest that air power still has a way to go in delivering its own military victories.

A Better Balance
For the next five years, Europes combat aircraft offerings should be fairly balanced with those of the U.S. The U.S. F22 is too expensive for many nations, although it could eventually be bought by the handful of countries that purchased the F-15 (Israel, Japan, and Saudi Arabia). We have not seen the F/A-18E/F come up in many major export campaigns. This leaves that F-16 as the major contender of U.S. aircraft designs that are now in production. In contrast to prior decades, Europe has a broader array of offerings. An agreement reached in 1995 for BAE SYSTEMS to market the Gripen opens this aircraft to a wider set of customers. Europe is also offering the Mirage 2000, Rafale and Eurofighter. Joint Strike Fighter could have a very powerful impact on the market, beginning in 2003-05. But this will depend on its costs and whether it is adhering to a schedule for design and production. Europe now has no direct answer to JSF, although BAE SYSTEMS is a partner on the Lockheed Martin team.

What to Watch for in 2000

For 2000, the most important issues in the tactical combat aircraft market include the integration of EADS and of BAE SYSTEMS, the status of the Joint Strike Fighter program

Combat Fighter Aircraft Outlook 23 February 2000

Forecast Shows Trough Deliveries in 2000-01

We estimate that total deliveries of U.S.-built multi-role combat aircraft could trough in 2001 at 64 aircraft. This trough occurs because of our assumption that F-15 production ends and because of a further decline in F-16 production. However, we estimate that deliveries rise back to 160-170 aircraft in 2004-05 on F-16 exports and rampups on domestic purchases of F-22s and F/A-18E/Fs. For Europe, we estimate that deliveries will hover at approximately 30 aircraft in 2000-01, but that they should climb to over 100 aircraft by 2004, mainly because of production of the Eurofighter.

Investment Implications
The conclusions of this report are in accord with our investment stances and earnings estimates for firms we follow. The need to replace aging military equipment should result in fairly steady growth for the sector in the 2000s. Slips in the timing of contract awards do not detract from this thesis.

Global Team
Byron K. Callan.................................................................. (1) 212 449-1394 Global Coordinator Byron_Callan@ml.com Canada Ihor Danyliuk........................................................................ Ihor_Danyliuk@ca.ml.com Singapore Chey Hoon Sim.................................................................... CheyHoon_Sim@ml.com UK & Continental Europe Andrew Clifton...................................................................... (44) 171 772-2539 Andrew_Clifton@ml.com United States David M. Ainsworth.............................................................. (1) 212 449-1312 David_Ainsworth@ml.com Suzanne E. Kecmer............................................................. (1) 212 449-6725 Suzanne_Kecmer@ml.com Marketing Analyst Pete Deighton ...................................................................... (44) 171 772-1890 Pete_Deighton@ml.com (65) 330-7205 (416) 369-2818

Combat Fighter Aircraft Outlook 23 February 2000

CONTENTS
n Section Executive Summary Forecast and Investment Issues Status of the Worlds Inventory: Who Owns What 1999 Campaigns and Wars: What Changed? 2000 Focus on Funding Debates, Competitions and EADS Competitions A Better Balance Between Europe and the U.S. Appendix: Aircraft Data 1. 2. Page 2 5 11

3.

17

4.

20

5.

22

6.

26

Combat Fighter Aircraft Outlook 23 February 2000

1.

Forecast and Investment Issues

We have believed that the replacement of older fighter aircraft would be a principal driver of new combat aircraft demand in the future. 1999 saw several campaigns decided that underscored this contention. We expect U.S. fighter aircraft units produced to increase from a low of 64 units in 2001 to 160-170 units by 2005. European production could increase from 30 units to approximately 110 units over the same period. There is no pure play on military aircraft, but many firms we follow benefit.

The Direct and Indirect Importance of Fighter Aircraft to Defense/Aerospace Stocks Fighter and bomber aircraft programs contribute 10%-25% of sales for select companies we follow
Fighter and bomber aircraft programs account for significant sales and operating profits of many of the companies we follow. Companies are directly impacted by new production of fighters. They are also indirectly impacted by sales of electronics, weapons and services that equip and sustain fighter and bomber inventories. Table 1 shows the estimated contribution of combat aircraft-related programs to the 2000 sales estimates for some of the companies we follow. Table 1 includes our estimate of: Sales from aircraft prime and major subcontractor positions Sales of airborne electronic warfare, avionics and radar Sales of air-to-air and air-to-ground missiles and munitions

Note that the BAE figure in Table 1 excludes any of the estimated revenues from the Al Yamamah programs with Saudi Arabia. This is now primarily a support and services operations, although it is heavily centered upon military aircraft. If the whole contract value were to be included, then the figure for BAE would be 40%. We have not included companies that derive less than an estimated 10% of sales from combat aircraft programs.
Table 1: Estimated 2000 Sales Contribution of Fighter Aircraft-Related Products and Services
Company BAE SYSTEMS Northrop Grumman Boeing Lockheed Martin EADS
Source: MLPF&S

Percent of sales 25% 19% 17% 12% 10%

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

An Aging Inventory Needs To Be Replaced World inventory of fighters declined in1999

Each year we aggregate data on the combat aircraft holdings of countries, as presented by the IISS (International Institute for Strategic Studies). In October, the IISS releases a publication called The Military Balance which has a wealth of information on the defense budgets, military force structure and individual equipment holdings of countries. We review the data in order to examine broader investment themes. The total number of combat aircraft in inventory is declining. For 1995, based on IISS data, we estimated that there were 26,800 fighter aircraft in the inventories of militaries and for 1999, we estimate the total declined to 22,700. This has resulted

Combat Fighter Aircraft Outlook 23 February 2000

mostly from the retirement of aircraft by countries that comprise the former Soviet Union and China. Year-over-year changes are imprecise. Numbers have jumped around, in part, due to changes in estimates made by IISS. China does not disclose the size of its armed forces, so IISS relies on a number of sources. U.S. data may have been incorrect for 1998. Official U.S. data does not show a drop from 1997 to 1998.
Table 2: How Inventories of Fighters Have Changed
United States China Russia
Source: IISS, MLPF&S

1995 4,554 4,747 2,700

1996 4,090 4,988 2,239

1997 4,073 3,589 2,525

1998 3,743 3,427 2,478

1999 4,076 3,355 1,744

Demand for new combat aircraft is driven mainly by the need to replace older aircraft purchased in the 1970s and 1980s. We estimate that approximately 10% of the worlds inventory of fighters are in the hands of countries that could not afford to replace them. Countries with annual defense expenditures of less than $1 billion are not in a position to buy Western-built multi-role fighter aircraft. There have been instances of Russian sales of advanced MiG-29s to Bangladesh and of Su-27s to Eritrea and Ethiopia; however, we think that these cases probably involve white tails or aircraft sold out of Russian air force inventory.

Combat Fighter Aircraft Outlook 23 February 2000

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

Table 3 shows our forecast of deliveries of U.S. fighters for 2000-05. There have been several changes from the forecast we published in February 1999, when we last reviewed the outlook for U.S. fighter deliveries: We show production of the Boeing F-15 ending in 2000. Compared to our year-ago forecast, we show lower Lockheed Martin F-16 deliveries in 2000 and 2001. This is due to delays in contracts, particularly for a UAE buy. We assume that Taiwan and Turkey will place follow-on orders for F-16s. Currently, there is nothing in Lockheed Martins backlog to suggest this. We no longer have an Other line item for F-16s

Table 3: U.S. Deliveries Trough in 2001
1998 Lockheed Martin F-16 Bahrain Egypt Greece Israel Singapore South Korea Taiwan Turkey U.S. UAE Subtotal, F-16 Lockheed Martin F-22 Boeing F-15 U.S. Israel Saudi Arabia Other Subtotal, F-15 Boeing F/A-18C/D U.S. Finland Switzerland Subtotal, F/A-18C/D Boeing F/A-18E/F U.S. Total U.S. fighters
Source: MLPF&S

1999 10 5 35 36 20 5 111 -

2000E 10 10 7 8 5 40 5

2001E 20 5 25 3

2002E 4 15 10 29 7

2003E 30 12 20 10 25 97 12

2004E 15 18 20 25 10 25 113 22

2005E 25 20 25 10 25 105 22

20 18 30 55 22 1 145 1

7 15 18 40

7 15 18 40

7 5 12 24

6 10 13 29

6 17 23

18 18

215

12 186

24 111

36 64

36 72

36 145

36 171

36 163

Combat Fighter Aircraft Outlook 23 February 2000

Deliveries of European-Built Fighters Should Climb Sharply from 2000 to 2005
Table 4 shows our forecast of deliveries of European fighters for 2000-05. A sale of 15 Aerospatiale-Dassault Mirage 2000s to Greece that was announced in 1999 should enable the company to avoid a production line break in the program. Compared to last years forecast, we have: Reduced annual deliveries of Gripens. Sweden should take approximately 17 per annum. South African deliveries will not start until 2007, compared to our prior estimate of 2003. There are slight variations in the data for Dassault. We added Greece to the Eurofighter/Typhoon delivery schedule based on its order last year.

Table 4: European Production Rate Ramp Up Driven by Eurofighter

1998 Eurofighter/Typhoon Germany Greece Italy Spain U.K. Other Subtotal, Eurofighter Saab JAS Gripen (BAe) Sweden South Africa Subtotal, Gripen Dassault Mirage 2000 France Greece Qatar UAE Subtotal, Mirage 2000 Dassault Rafale France Other Subtotal, Rafale Total European production
Source: MLPF&S

1999 -

2000E -

2001E 1 1 1 3

2002E 5 6 5 6 22

2003E 12 9 6 15 42

2004E 15 10 10 7 20 10 72

2005E 15 10 10 7 20 10 72

16 16

16 16

17 17

17 17

17 17

17 17

17 17

17 17

10 6 16

10 3 13

10 10

5 5

5 5 10

5 15 20

10 10

15

14

32

29

4 31

5 30

1 50

9 88

15 114

14 103

Investment Recommendations
We think it is important for investors to recognize that defense is a business that tends to operate on very long cycles. The life span of a fighter aircraft, from design to retirement of the last production unit, can be 30 years or more. The investment conclusions we have noted in this report do not differ all that much from prior years reports we have published on this subject: An upturn in military aircraft production is emerging and production rates may

Combat Fighter Aircraft Outlook 23 February 2000 not peak until late this decade. This upturn provides visibility to the earnings and cash flow streams of companies that build fighter aircraft or that supply weapons, systems and parts that are used on aircraft.

We have mixed investment opinions on companies with direct and indirect exposure to fighter aircraft and bomber markets. Our forecast suggests that growth in aircraft deliveries probably will not begin to be evidenced by the financial results of companies we follow until 2001. Here are investment opinion summaries of major military aircraft and electronic suppliers we cover: n Aerospatiale Matra/EADS

Key fighter programs are Mirage 2000, Rafale and Eurofighter

Our opinion on Aerospatiale Matra is currently Accumulate. This companys main exposure to military aircraft is its 46% ownership of Dassault Aviation, the manufacturer of the Mirage and Rafale. The Group is scheduled to merge with DaimlerChrysler Aerospace (Dasa) and Spains Casa to form the European Aeronautic, Defense and Space company (EADS) by the end of June. This will introduce the additional exposure of those two companies stakes in Eurofighter, which are 30% and 13% respectively. It remains to be seen how the new company will address the issue of these two competing products in the business portfolio. Additional exposure to the combat aircraft space is gained from Aerospatiale Matras 37.5% interest in the enlarged missiles business, Matra BAe Dynamics. We await more detailed news on the financial structure, strategy and prospects of the new Group. These are expected to be forthcoming over the next few months as it prepares for its stock offerings, which are expected to occur in the May/June period. We believe there is considerable potential arising from the new Groups 80% ownership of Airbus and the scope for restructuring the entity. A successful implementation of this cross-border merger should also allow further benefits in the areas of missiles, space and helicopters. n Boeing

Fighters important, but commercial aerospace is key investment theme

Boeings valuation is currently driven mainly by expectations for its commercial aircraft deliveries and operating performance. However, Boeing is the leading military aircraft supplier in the U.S. and is the prime contractor on the C-17 transport (which is not dealt with in this report), the F/A-18E/F fighter and has one-third of the value of the F-22. Production of the F/A-18C/D and F-15 is winding down. Boeing is also competing for the Joint Strike Fighter program. Our projections for Boeings military aircraft business show a stable sales outlook. We rate Boeing Accumulate/Buy, mainly because we expect improvement in commercial aircraft margin which should more than offset a decline in deliveries of large civil aircraft. Capital structure remains conservative and completion of the Hughes Satellite buy in mid-2000 could again enable the company to buy back its shares. n BAE SYSTEMS

We recently upgraded our opinion

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

Combat Fighter Aircraft Outlook 23 February 2000

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

Resolution of near-term issues could uncover earnings power

Our opinion of Lockheed Martin is Neutral/Buy. Key Lockheed Martin military fighter programs include the F-16 and F-22. We expect growth in sales from both programs in the 2001-04 timeframe. Additionally, Lockheed Martin supports the F-117 stealth strike aircraft and is competing for the Joint Strike Fighter program. Lockheed Martin had a difficult 1998-99 for reasons that had little to do fighter aircraft programs. Sales and profit margin expectations for the C-130J airlifter proved to be too optimistic and there were several issues that arose in Space and in Space diversification programs. Our opinion is Neutral/Buy mainly because we would like to see several near-term issues resolved at the company and because 2000 earnings are heavily skewed to the fourth quarter. Issues include the timing of a contract award from the UAE for F-16 fighters, timing of the COMSAT acquisition and space activities. n Northrop Grumman

Driven by electronics growth

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

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Combat Fighter Aircraft Outlook 23 February 2000

2. Status of Worlds Inventory: Who Owns What

Based on data gathered by IISS, we estimate that in mid-1999, the worlds militaries had 22,700 fighters and 997 bombers. This compared to 23,700 fighters and 863 bombers in mid-1998. By far, the U.S. has the most modern inventory of military aircraft. Russias aircraft holdings continue to decline and Chinas holdings remain overwhelmingly obsolete. Europe is beginning to modernize aircraft holdings procured in the 1960s and 1970s.

Stage Setting Focus is on advanced combat aircraft

Our definition of the combat aircraft market encompasses supersonic and subsonic advanced fighter, fighter/bomber, and interceptor combat aircraft. This year, we have included medium and strategic bombers because these aircraft are now used mainly for conventional (non-nuclear) missions. We have not considered the market for specialized support aircraft, such as transports, surveillance, and maritime patrol aircraft. We have also excluded trainers from consideration, such as the Raytheon JPATS (now called the T-4 Texan) program, MiG-AT, as well as light attack aircraft/trainers, such as the British Aerospace Hawk. These aircraft types generally do not compete against multi-role aircraft, although they are a factor when discussing replacement demand. In particular, the British Aerospace Hawk can be used as a trainer or light attack/air defense aircraft and is replacing aging supersonic fighters.

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

Most modern designs stem from 1970s

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

Useful aircraft designed in 1960s

Useful includes fighters and specialized strike aircraft that tend to be of 1960s and 1970s vintage although, in some instances, designs were conceived in the late 1950s. The exceptions to this age cohort are the British Aerospace Harrier/Boeing AV-8B and the Sukhoi Su-25. U.S. built types include the A-6, A-7, A-10, F-111 and F-4. European-built aircraft include the Saab Viggen and the Sepcat Jaguar. Russian designs include the MiG-23/-27 and the MiG-25. We have included the B-52 bomber in this category, even though it is an ancient aircraft. However, its electronic self-defense system and ability to carry large quantities of stand-off smart weapons make it very useful, as evidenced by its deployment to threaten Iraq in 1997 and 1998. The Russian Tu-95 is considered "useful" as well.

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Combat Fighter Aircraft Outlook 23 February 2000

n Old/Obsolescent

Some designs can be traced back to late 1940s

Old includes aircraft designs from the 1940s and 1950s. In terms of the quantities in service, the largest single type is the Chinese J-6. This is a copy of the MiG-19, which first entered production in 1955. Other types include the MiG-21 and a Chinese copy called the J-7/F-7 (J if it flies within China or F if it was exported), the Lockheed-built F-104, Dassault Mirage III/-5 and the Sukhoi7/17/20/22. We have included the Northrop F-5, in this category, because the basic design stems from the 1950s. However, the aircraft could be included in Useful, because of its capabilities, particularly when upgraded with more modern avionics and air-to-air missiles. Chinese H-5 and H-6 are included in "Old". The H-5 is the Chinese version of the Russian Illyushin Il-28, a tactical bomber that first flew in 1948 and the H-6 is the Chinese version of the Tupolev Tu-16. The Tu-16 first flew in 1952. Where we believe appropriate, we have made some adjustments to IISSs estimates of aircraft holdings. These mainly involve the holdings of developing countries and/or in situations where there is more recent data available. These instances include estimates for Afghanistan, Cuba, Iran and Iraq, none of which are likely to be markets for Western aircraft in the coming years.

Total Inventory of Aircraft Fell From 1998 China and Russia continue to retire aircraft
The total inventory of combat aircraft fell in 1999, compared to 1998. IISS can change inventory totals, based on new information, but our counting of data in the 1999/2000 Military Balance shows the total number of fighters declined by approximately 1,000 to 22,737 from 23,694 in 1998. The biggest single cause of the decline was in the inventory of J-6 aircraft in China (from 2,195 in 1998 to 1,795 in 1999) and a decline in Russias inventory of fighters from 2,756 in 1998 to 2,055 in 1999. We suspect that the decline in J-6 figures may have to do with a reassessment of the fighter inventory in China. Figures for Russias fleet of MiG-31s and Su-24s probably have to do with reductions in the size its holdings.

U.S. Has Largest, Most Modern Force

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

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Combat Fighter Aircraft Outlook 23 February 2000

Exhibit 1: U.S. Has Largest Fleet of Modern Combat Aircraft
4,000 3,500 Number of modern aircraft 3,000 2,500 2,000 1,500 1,000 500 0
St at e R s us G sia er m an Ta y iw an Is ra e Sa Ukr l ud ain U ni te i Ar e d ab K in ia gd om Fr an c Tu e rk ey N Ja et pa he n rla nd s Eg yp C an t ad a Ita G ly re ec e In B dia e K or lgi ea um ,S ou th Sp ai n B el ar Sw us e U zb de ek n is A tan us tr D ali en a m ar k

Source: MLPF&S, IISS

U ni te d

In addition to a modern fleet of fighters and bombers, the U.S. also has: A dedicated fleet of specialized support aircraft, including AWACS and airborne early warning, signal intelligence gathering and electronic warfare aircraft. A fleet of tankers. The Air Force has 547 KC-135 tankers (this is a military aircraft that was the basis for the Boeing 707). No other country comes remotely close to this size inventory. Made extensive investments in the modernization of the munitions that are carried by its aircraft. Some of the highest pilot training time in the world.

U.S. has the most modern Air Force

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

Size alone is not a pre-condition for success

It does not account for the limitations imposed by geography. The U.S. cannot bring its entire inventory of aircraft to bear on a single country. Distance and availability of air bases will limit the number of aircraft that can be deployed. Air defense systems must be considered. Russian-supplied air defense equipment has become much more sophisticated and the risks posed by manportable and by systems carried on light armored vehicles has made operations below 15,000 feet risky.

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

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Combat Fighter Aircraft Outlook 23 February 2000

Exhibit 2 shows the 25 largest combat aircraft fleets in the world. Total figures have been broken down by holdings of modern, useful or old aircraft. China has a large air force, but its almost entirely comprised of old designs. Russia still on paper has the third largest air force in the world.
Exhibit 2. The Top 25 Largest Combat Aircraft Fleets
4,500 4,000 3,500 3,000 2,500 2,000 Useful 1,500 1,000 500 0 United States Russia Taiw an Ukraine Syria Egypt Israel Greece Libya Poland Japan Sweden Iran Modern Old

Source: IISS, MLPF&S

Number of aircraft

Large Quantities of 1950s-Designed Aircraft Remain in Service

Exhibit 3 shows that a surprising feature of the worlds inventory of tactical combat aircraft is the high percentage of aircraft designs from the 1950s that are still in service.
Exhibit 3: Old Aircraft Are Still Big Part of World Inventory

Old 36%

Modern 38%

Useful 26%

Source: MLPF&S, IISS

14

Combat Fighter Aircraft Outlook 23 February 2000 The MiG-21 and Chinese version of this aircraft, the J-7, represent the largest single aircraft type in service.
Exhibit 4: Aircraft Types of Which More Than 800 Are In Use
3,500

3,000

2,500

2,000

1,500

1,000

500

0 MiG-21/F-7/J7 F-16 J-6 F-5 F-15 F/A-18 MiG-29 MiG-23/-27 Su-24 F-4 Tornado

Source: MLPF&S, IISS

Whats The Available Market? Countries considering new aircraft have many options
Just because there are more than 22,000 aircraft in use around the world does not mean that there will be sales over the next 20 years of aircraft to replace all these that are now in service. Some countries simply will not be able to afford new multi-role combat aircraft and others will not be buying from Western countries, either because the West will not sell or because they want to foster their own aerospace industries and will instead rely on indigenous designs. Furthermore, there are other options available to countries, other than just buying new aircraft: Ballistic missiles, such as SCUD, have offered greater assurance of striking at threats at a fraction of the cost of maintaining a squadron or two of multi-role fighters. The military utility of these missiles is limited because of their accuracy and size of the warhead they carry. Another option is to buy attack helicopters to replace fighters. Slovakia stated its plans to do this in 1999. Finally, there are light, subsonic fighters, such as the BAE SYSTEMSs Hawk, which appeals to many countries. The sophistication and capability of attack helicopters also entails that they are contenders in fighter aircraft replacement schemes. This is particularly true of countries that face internal insurgencies and/or expect that any major military contingency they find themselves in will be in an alliance with other advanced military powers.

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

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Combat Fighter Aircraft Outlook 23 February 2000

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

Unavailable to West 30%

Available to West 60%

Cannot Afford 10%

Source: MLPF&S

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Combat Fighter Aircraft Outlook 23 February 2000

3. 1999 Campaigns and Wars: What Changed?

Military conflicts again highlighted the value of advance aerospace systems in 1999. The Boeing F-15 did not score any export victories in 1999 and hence, its production will likely end in 2000-01. In the U.S., a funding cut to the F-22 program underscored tension over tactical fighter modernization.

Yugoslavia Highlighted Airpower Yugoslavia v. NATO has mixed implications for airpower
One of the key events that has impacted the outlook for military aircraft in 1999 was the 78-day air war between NATO and Yugoslavia. NATO flew 37,000 sorties (one-aircraft mission), while Yugoslavia flew 10 air intercept missions during the war. The lessons learned from the conflict were somewhat contradictory and so far, have not lived up to initial investor expectations. These lessons included: The very wide disparity between U.S. and European aerospace military capabilities. The U.S. flew in eighty percent of the strike missions. The air forces of most European countries were of limited use because of the lack of all-weather day/night target designators, smart weapons and electronic warfare systems. The utility of strategic bombers. B-2 bombers were used for strikes on heavily defended portions of Yugoslavia. The inability of NATO forces to locate stationary or dispersed tactical military targets. Reluctance to engage low-level air defense systems. Importance of GPS-guided weapons. Utility of UAVs. Unmanned aerial vehicles were used for targeting and reconnaissance. The need for numbers. The number of aircraft committed to the campaign was initially small, but the need for continuous pressure resulted in a far greater commitment than was originally envisioned.

One of the great ironies of the conflict was that Rep. Jerry Lewis (R-CA) used the experience as a justification to block procurement funding of the F-22. NATO lost just two aircraft during the entire campaign (an F-117 and an F-16) and otherwise dominated airspace over Yugoslavia. The success of NATO air power raised the issue of whether more modern fighters were needed. The other irony is that there has only been limited movement within Europe to narrow the gap between the defense capabilities of its armed forces and those of the U.S. There has been a move to create an independent military force in Europe that would be separate it from NATO. However, there have not been commensurate moves to step up spending on tankers, munitions, electronic warfare and support measures aircraft and space-based assets that could make this force independent of the U.S.

F-16 and Eurofighter Score Big Wins F-16 sweeps Greece, Israel Eurofighter gets first export
As we discussed in our forecast above, the big winners of 1999 were the F-16 and the Eurofighter. The Mirage 2000 also had a decent year and a selection by Greece enabled Dassault to bridge a potential line break in 2001. Greek decisions in 1999 on the modernization of its air force were significant. In early 1999, it announced its intention to buy 60-90 Eurofighters, with initial deliveries beginning in 2005. Greece will be an industrial partner on the program as a result of this. Greece also announced in April, its decision to

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Combat Fighter Aircraft Outlook 23 February 2000

buy more than 50 Block 50 F-16s. The F-15 looked like it had a good chance in this competition, but the cost of introducing a new aircraft was a factor in the final decision. Greece operates 40 F-16C/Ds. Greece also announced that it would buy 15 Mirage 2000-5s. Israel selected the F-16 for its fighter modernization program. A contract was signed on January 14 for 50 F-16s, with a value of $1.34 billion. Israel has options for another 60 F-16s. These aircraft will replace A-4s and Kfirs that Israel now operates. Deliveries will begin in early 2003. A contract was concluded with Egypt in August 1999 for 24 F-16C/Ds, valued at $324 million to Lockheed Martin. Deliveries begin in 2001 and should last about 15 months.

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

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

EADS and Implications for Fighter Market EADS needs to sort out offerings
On October 15, Frances Aerospatiale Matra and Germanys Dasa announced their intention to merge to create EADS. Subsequently, agreement has been reached to include Spains Casa. The combination is expected to complete by the middle of this year. It will result in EADS holding a large, if minority, stake in the 2 major European military aircraft manufacturers. Aerospatiale Matra owns 46% of Dassault Aviation (manufacturer of the Mirage and Rafale), with Dasa and Casa holding stakes in the Eurofighter consortium of 30% and 13% respectively. Note that there are currently discussions underway investigating the inclusion of Finmeccanica (which owns 19.5% of Eurofighter) in a shared military aircraft venture, which would then own 62.5% of the program. The Italian company is also in discussions with BAE SYSTEMS regarding this issue. We are unsure as to how integrated the 2 competing platforms can be within the new corporate structure. In view of the advance development and production stage of each product, manufacturing efficiencies would not appear to be achievable, even theoretically. It is possible that some arrangement could be arrived at regarding sales and marketing in export markets, although several barriers can be envisaged. These include the nature of the ownership of each product, the perceived respective strengths in export markets and the existing commitment for each type. The formation of EADS does not alter our view that there will only be one European next generation product. Perhaps the issue that it does most raise is whether the two parties are brought together through the existing BAE SYSTEMS/Dassault relationship, or through EADS. In the meantime, we expect Eurofighter and Rafale to co-exist for at least the next decade.

The F-22 Funding Debate F-22 should be procured despite 1999 controversy
One of the surprising developments of 1999 was that the Lockheed Martin/Boeing F-22 fighter came under attack in Congress. Tactical combat aircraft modernization programs in the U.S. have been very controversial because of the budget resources they consume and because of questions about the wisdom of sustaining a large inventory of relatively short-range fighter aircraft, given changing military threats.

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Combat Fighter Aircraft Outlook 23 February 2000 In July, Rep. Jerry Lewis (R-CA), who heads the defense procurement subcommittee of the House Appropriations Committee proposed zeroing a $1.8 billion procurement request for the F-22. This set off all sorts of alarm bells that rang even louder when the House passed an appropriations bill that included the subcommittee recommendation. A compromise was worked out between the House and Senate, but the issue highlighted the extent of debate over next generation fighter aircraft.

Russian Sales: VPK Sukhoi Shines Russia exports highly advanced fighters
It is important for investors to keep an eye on how Russias aircraft manufacturers are doing. Their sales efforts have created competition from time to time (Malaysia is one example) for European and U.S. firms. Russian aircraft are as capable as current generation fighters and introduction of these aircraft can spur regional modernization of air forces and air defense systems. There are two major Russian military suppliersVPK Sukhoi and MIG Military Aircraft. Of the two, VPK Sukhoi has a stronger export program underway. In 1999 it delivered Sukhoi 30s to India and concluded a contract with China for a sale of 50 Su-30s. These aircraft are comparable to the F-15. Sukhoi is also delivering aircraft Su-27s to Vietnam and is providing kits for license assembly of 200 Su-27s for China.

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Combat Fighter Aircraft Outlook 23 February 2000

4. 2000 Focus On Funding Debates, Competitions and EADS

The debate over tactical aircraft modernization funding should continue in 2000 in the U.S. Russias use of airpower in Chechnya suggests that other nations are adopting NATO war-fighting models. In Europe, the focus remains on restructuring and how EADS could impact fighter programs.

U.S. Outlook: Funding Debate Continues The debate on U.S. fighter modernization will continue in 2000
Modernization of U.S. tactical combat aircraft assets has been a much debated topic. Investors finally saw this debate spill over the Beltway (a highway that encircles Washington, DC and parts of northern Virginia and Maryland) this past summer when F-22 funding was cut. The debate is likely to continue in 2000 and beyond for a number of reasons: The Congressional Budget Office testified in March 1999 that over the next 27 years, the U.S. planned to purchase 3,700 new tactical fighters at a total cost of $340 billion. The size of the investment will attract attention. The changing geography of military threats, advances in stand-off weapons, (such as cruise missiles), and the vulnerability of large air bases and aircraft carriers to missile attacks have raised questions about the wisdom of investing in relatively short-range combat aircraft inventories. Other branches of the military have competing modernization needs. There are conflicting views on the efficiency of air power. The war with Yugoslavia was hailed by some as a demonstration of the ability of airpower alone to affect the behavior of an adversary. However, others have questioned this and pointed out that air power was incapable of preventing ethnic cleansing.

The fulcrum of the debate is apt to be the F-22 in 2000, although we do not believe that this aircraft program will again take the kind of flak thrown at it in 1999. Supporters have mustered a number of arguments for the F-22, including: It needs 50% fewer tankers to operate than an F-15. It is far more capable of engaging hostile aircraft and operating over hostile territory than current generation fighters. Unit costs should decline as aircraft production matures.

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

Joint Strike Fighter Developments Eyes on JSF in 2000

Boeing and Lockheed Martin are proceeding with development of their designs for the JSF (Joint Strike Fighter). Boeings entrant is designated the X-32 and Lockheed Martins is designated the X-35. Both companies should be flying prototypes this summer and a March 2001 down-select is anticipated. Joint Strike Fighter remains the biggest potential fighter program ever, in terms of its total value. Current plans call for three different versions of the JSFone that will be used for conventional take-off and landings, another that can land on an aircraft carrier and another with vertical take-off capability. The Air Force intends to buy 1,763 JSFs; the Navy, 480; the Marines Corps, 609 and the U.K. Royal Navy, 60. Initial operating deployment is now planned for 2008.

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Combat Fighter Aircraft Outlook 23 February 2000 The most interesting development to watch in 2000 regarding the Joint Strike Fighter is whether the DoD adheres to a plan to award a contract to build the aircraft to a single prime contractor. It has dawned on the DoD that the contractor that loses the JSF contract may exit from the fighter aircraft market and thereby create a monopoly supplier. The DoD has created a Joint Strike Fighter Review Group that is assessing how the two major competitors could behave if the existing acquisition strategy is maintained, or if other acquisition strategies should be pursued, including Split Award, Leader/Follower or Alternative Teaming at the Prime Level. Our view on Joint Strike Fighter is that there will probably be delays in the program due to funding and technical concerns. This could entail that there are more purchases of F-16s and F/A-18E/Fs and it could also impact the Marine Corps, forcing it to consider other ways to deliver close air support to its troops. We also doubt that JSF will be purchased in the numbers envisioned because of vulnerability of large airbases and/or aircraft carriers that could emerge in the post 2015 time period.

EADS European consolidation needs to be completed

The new management of EADS have publicly stated that it is aiming for completion of the new entity by the end of June. Pre-offering presentations in the Spring will provide an opportunity for the new Group to specify its strategy and outlook in the sphere of military aircraft. As we have mentioned above, EADS will have a significant stake in the 2 competing European fighter programs, Eurofighter and Rafale. We do not envisage any significant changes being made to the operating and sales structures of each platform in the current year. Perhaps the most realistic scope for synergies lies between the Dasa and Casa Eurofighter activities, although the advanced stage of the program will limit the scope for savings. The other main issue to be addressed is whether Finmeccanica chooses to combine its 19.5% interest in Eurofighter with one of the other two parties, EADS (43%) or BAE SYSTEMS (37.5%). Discussions are understood to be currently underway with both parties, and are believed to encompass combinations possibly involving related activities such as avionics, maintenance and commercial aircraft.

Other International Developments Military and sales campaigns bear on outlook

Investors should watch for the ramifications of the heavy use of airpower by Russia in its campaign against Chechen rebel forces. This is likely to bolster internal calls for modernization of the air force in Russia. Asian markets are perking up again. Thailand may acquire second-hand F-16s, as could New Zealand (although there is a political controversy over this). Malaysia is looking to buy Su-27s/-30s. Central Europe remains a potentially large market, with Poland, the Czech Republic, Hungary all looking for new aircraft to replace aging Sovietsupplied models. Austria is also looking to replace older Saab-built aircraft. Purchases are most likely to be made with initial lease of aircraft. The UAE F-16 buy remains an important issue to watch for 2000. The UAE had announced in 1998 that it wanted to buy up to 80 Block 60 versions of the F-16. This aircraft type has an agile beam radar, internal navigation/targeting systems and other enhanced electronics.

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Combat Fighter Aircraft Outlook 23 February 2000

5. Competitions A Better Balance Between Europe and the U.S.

There are a number of new aircraft campaigns in 2000-05 and there could be follow-on buys by current customers. In contrast to prior decades, the product offerings of Europe and the U.S. may be more balanced in the 2000s.

New Threats and Old Aircraft Drive Demand

The defense business is unique because there is not supply and demand of the sort that generates cycles in other businesses. Demand for military products typically rises and falls based on national security considerations, the ability of countries to pay for military equipment and on changes in technology. Different countries face different security threats. One whose primary security threat is drug traffic, border security and internal insurrection may need only light, subsonic attack aircraft, or helicopters. Another, whose threat is considered a possible attack by a highly developed adversary fielding bombers, multi-role aircraft and all supporting equipment will have a very different type of purchase in mind. We see demand for military aircraft being driven by several factors over the next five years: n Need to replace older aircraft

Replacement of older aircraft is key driver of demand

The life of an aircraft is typically measured in hours of flight. For early versions of the F-16, 4,000 hours of flight was expected before major airframe overhaul had to be done. Current generation F-16s have 8,000 flight hour life-spans. One reason that older aircraft remain in service is that they are probably not used that much. For example, the U.S. still operates B-52 bombers that were built in the early 1960s. For the much of their lives, these aircraft sat on runway alert. The stresses of combat flight entail metal fatigue. Salt water, sand and other environmental factors contribute to age. It is quite possible to rebuild an airframe, but it may not be at all economical, particularly given the costs to do so. Additionally, an older aircraft is very likely to be less capable than current and future generation systems because of its lack of stealth and avionics. The end of the Cold War entailed a procurement holiday in Europe and the U.S. and countries in the former Soviet Union simply could not afford to replace military equipment. Exhibit 6 shows how sharply U.S. buys of tactical combat aircraft had fallen since the 1980s.

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Combat Fighter Aircraft Outlook 23 February 2000

Exhibit 6. U.S. Fighter Buys Have Dropped Sharply
500

450

400 Number of tactical combat aircraft per FY budget

350

300

250

200

150

100

50

0 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000

Source: MLPF&S, Congressional Budget Office

n New military threats from modernization of other air forces

Replacement can heighten regional tensions

Replacing older aircraft with newer ones often entails stepped up capability. Taiwan and China are examples of countries that began modernizing antiquated air forces with far more capable equipment. In Chinas case, the modernization is based on the Su-27/-30 procurement and development of the J-10. In Taiwan, it has centered on procurement of the F-16s and Mirage 2000s. In this instance the modernization plans of each have fed off one another. Similar patterns can be observed in the Middle East and Latin America. n Advances, proliferation of air defense systems

Air defenses make replacement necessary

Yugoslav air defense kept NATO forces from operating below 15,000 feet and an unwillingness to risk casualties meant that attack helicopters were not deployed. Russia has been selling the S-300 air defense system and Raytheon and Aerospatiale Matra are offering advanced surface to air missile systems. This will impact aircraft demand because aircraft that are incapable of operating in a more strenuous air defense environment will need to be replaced. n Harmonization with allies, political consideration A final consideration in military aircraft demand is that purchases can be made in order to better align a defense force with that of a larger power and/or in order to diversify supply sources. South Africa, for example, chose not to include U.S. fighters when it evaluated replacement of older Mirage aircraft. Similarly, Central European campaigns are unlikely to see Russian built aircraft chosen because they are not easily integrated into NATO.

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Combat Fighter Aircraft Outlook 23 February 2000

Upcoming Campaigns
Table 5 shows upcoming campaigns for tactical combat aircraft.
Table 5: Potential Fighter Buys
Country Austria Brazil Chile China Czech Republic Norway Poland Saudi Arabia South Korea Syria Vietnam
Source: MLPF&S

Requirement 30 72-149 20 500 20-30 20 60 or more 75 120 50 50

Decision 2000 2003-5 2000 on-going 2000-01 2000-01 2001-02 2001 2002 2000 on-going

Contenders F-16, Gripen Mirage, Gripen, New design likely to buy second-hand aircraft Su-27, J-10, FC-1 F-16, Gripen, F/A-18 F-16, Eurofighter F-16, Gripen, Mirage 2000 F-16, Gripen, Eurofighter F-15, Su-30, Eurofighter, Rafale Su-27, MiG-29 Su-27

An Emerging Balance Between the U.S. and Europe Europes offerings are more evenly matched with U.S. in 2000
Table 6 captures a change that we believe is important to consider in the coming decade namely that there is a balance between the offerings of the U.S. and Europe. For the next 2-3 years, most campaigns are apt to see the F-16 pitched against the Gripen, Mirage 2000 and the Eurofighter. We are not aware of campaigns where the F/A-18E/F is under serious consideration and the F-22 could be purchased by only a small number of countries acceptable to the U.S. and who could afford the aircraft. Rafale is also not prominent in upcoming campaigns, although Dassault continues to market the aircraft. The competitive landscape thus differs somewhat, compared to prior decades. In the 1980s and 1990s, the U.S. was able to offer lightweight fighters (the F-20, briefly) and medium multi-role aircraft (the F/A-18 and F-16). Finally, the F-15 was available as well. Key points in several competitions was the ability of the U.S. to offer AMRAAM missiles that allowed aircraft to engage others at far greater ranges than aircraft equipped with European-built missiles. In the 1980s and early-mid 1990s, Europe offered the Mirage 2000 and Tornado. Rafale has been offered, but it did not score any export successes. The 2000s represent a change in the competitive landscape: The F-16 is now the major aircraft type being offered by the U.S. The F/A18C/D is winding down production and F-15 production is ending. The Saab/BAE SYSTEMS agreement to jointly market Gripen has expanded the market reach of this aircraft. Gripen is similar to the F-16.

Go-ahead on the Eurofighter program has made this a more viable offering and the win in Greece underscores this. Eurofighter does not have a radar that is as capable as the F16 Block 60 aircraft (it is mechanically steered, not an agile beam radar), but the BVRAAM/Meteor missile program should result in the aircraft being equipped with a medium range air-to-air missile that is more capable than AMRAAM. Europe is able to offer the Mirage 2000, the Gripen, Rafale and Eurofighter. European aircraft are largely equipped with European electronics and avionics. The Mirage 2000 was first introduced in 1985 and most of the buying seems limited to countries that already own the aircraft and are buying it because of attrition in their fleets. Gripen is a lightweight multi-role fighter in service with Sweden and ordered by South Africa while Eurofighter is being procured by the U.K., Italy, Germany, Spain and Greece. France is procuring Rafale.

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Combat Fighter Aircraft Outlook 23 February 2000 The point here is that Europe is offering a wider range of fighters than it has in prior decades. This is shown in Table 6. In the 1960s and early 1970s, most European air forces were equipped with U.S.-built F-104s and the U.K. operated some F-4s.
Table 6: A Comparison of European and U.S. Combat Aircraft Offerings
1970 U.S. Light fighter/bombers F-5 A-7 1970 Europe Jaguar Mirage 5 1980 U.S. A-10 A-7 F-5/-20 F-16 F/A-18 A-6 1980 Europe Hawk Harrier Jaguar Mirage 2000 Viggin F-16 F/A-18 1990 U.S. 1990 Europe Hawk Harrier 2000 U.S. 2000 Europe Hawk 2010 U.S. KTX-2? 2010 Europe Mako?

Medium/multi-role

F-4 A-6

Buccaneer

Mirage 2000 F-16 Gripen F/A-18E/F

Gripen JSF Eurofighter F/A-18E/F Rafale Mirage 2000 F-22

Eurofighter Rafale Gripen(?)

Heavy/multi-role
Source: MLPF&S

F-14 F-111

F-15

Tornado

F-15

Tornado

There are several issues to watch: The Gripen and F-16 are the only two advanced multi-role aircraft that address the low-end of the global fighter market. There are still several hundred Northrop F-5s, Dassault Mirage IIIs, 5s and F1s, and Mikoyen MiG21s in service around the world. It remains to be seen how the Gripen and F16 do against one another. Additionally, we wonder if there is not room for a cheaper supersonic fighter to meet this long-term market need. One of the advantages that the U.S. has played in the late 1980s and 1990s is that its aircraft offerings have included the AMRAAM (Advanced Medium Range Air-to-Air Missile). A key issue over the next ten years is whether Europe develops an advanced medium range air-to-air missile independently of the U.S. The U.K. BVRAAM (Beyond Visual Range Air-to-Air Missile) program will be very important to watch because if the European Meteor missile is selected and if its development is not marred by cost or technical issues, then Europe could be in a position by the 2005-10 timeframe to offer Eurofighter with armaments that are independent of the U.S. Industry sources indicate that Europe lags the U.S. in radar, but BVRAAM/Meteor could make Eurofighter even more attractive. Europe now appears to have no answer to the Joint Strike Fighter or F-22. If the Joint Strike Fighter is developed within the price range ($28-$35 million each) that is expected for the aircraft, if could emerge as the logical replacement for a number of aircraft types in the 2010 period.

AMRAAM advantage offset by METEOR/BVRAAM

JSF could tilt market back to U.S. favor

The balance that now exists in the fighter market could again tilt to the U.S. by the end of this decade, depending on how Joint Strike Fighter fares. If this aircraft lives up to its advertised promise as an affordable replacement for F-16s, Mirages, Harriers and other aircraft types, then it could sweep competitions at the end of the decade when it is available and in production. This, however, is beyond most investors horizons.

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Combat Fighter Aircraft Outlook 23 February 2000

6.

Appendix: Aircraft Data

Major Aircraft Types

Table 7 summarizes key data for multi-role fighters now in production or development. We have used estimates of fly-away costs--not total cost of each aircraft type. Total cost includes the research and development costs of designing and providing tooling for the building of the aircraft. Costs vary with the production run and the complexity of the aircraft. A J-7 is not even remotely comparable to more advanced designs.
Table 7: Fly Away Prices for Different Aircraft Types
Country China Aircraft Type J-7 Mirage 2000 Rafale F/S-X Su-27/-30 MiG-29 Gripen Ching Kuo Eurofighter Manufacturer Chengdu Aircraft Industrial Corp. Dassault " " Mitsubishi Sukhoi Mikoyan Saab/British Aerospace Aero Industry Dev. Center Brit. Aerospace/Daimler/ Alenia/CASA British Aerospace Boeing Lockheed Martin Boeing Boeing Lockheed Martin Unit Price $2-$3 35 55 60 30-45 25 30 30 70

Costs and capabilities vary widely

France

Japan Russia

Sweden Taiwan U.K/Germany/ Italy/Spain U.K.

Harrier Tornado F-15E F-16C F/A-18C F/A-18E F-22

40 40 55-80 25-35 25 55 80-100

U.S.A

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

n Boeing F/A-18

F/A-I18 C/D phases out of production replaced by E/F Version

The F/A-18 is a multi-role fighter/bomber that now comprises the backbone of the U.S. Navy's carrier aviation fleet. The aircraft was designed in the early 1970s and in 1976, the Navy chose this Northrop-designed, McDonnell Douglas built aircraft to replace A-4s and A-7s then in service. The Navy now has 195 F/A-18As and Bs and 330 F/A-18C/Ds and the Marine Corps flies 300 F/A-18s. International customers for the aircraft include Spain, Canada, Australia, Finland and Switzerland, Kuwait and Malaysia. These countries all operate the aircraft in land-based modes. An improved version of the F/A-18, called the E/F is now being procured and first flight occurred in December 1995. This aircraft will be used to modernize U.S. Navy carrier aviation (notably as a replacement for 1960s-vintage A-6 strike aircraft) and it incorporates several improvements over the C/D. The program has been managed differently than others, with more emphasis on integrated product development, low rate expandable tooling concepts and design for manufacture and assembly. The E/F is about 25% bigger in volume than the C/D. It is stealthier and has a greater payload and longer range. The U.S. currently plans to buy at least 548 F/A-18E/Fs. We believe that this will

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Combat Fighter Aircraft Outlook 23 February 2000 depend on how the Joint Strike Fighter program progresses. If JSF is a success, then this number, or fewer, could be bought. If, as we expect, JSF slips, then more F/A-18E/Fs could be bought that 548. n Boeing F-15

End of the line in 2000

The U.S. Air Force selected McDonnell Douglas in 1969 to build a replacement aircraft for the F-4 Phantom and F-106 interceptors then in service. The principal mission of the F-15 was, and remains air superiority. The aircraft has been in production since the early 1970s and there are 440 F-15s in service with the U.S. Air Force in the air superiority role. In 1984, the Air Force selected a modified version of the F-15 over a modified version of the F-16 to fulfill a requirement for a long-range "strike" aircraft that could be used to attack ground targets. This selection resulted in the "E" version of the aircraft and the "E" version can carry a payload of up to 12 tons of bombs of bombs over a distance of 750 miles. There are 204 F-15Es in service. Production for the U.S. Air Force has been completed. The production line remains open today because of orders from Israel and Saudi Arabia. Saudi Arabia ordered 72 of a modified version of the F-15 called the "S" version in 1992 and Israel has ordered 25 of the so-called "I" version. Deliveries from these two orders should be completed by 2000. There are several potential international customers for the F-15 and it is possible that this aircraft resumes in production. A follow-on buy is possible from Saudi Arabia. New operators could include Egypt, South Korea, and Turkey. n Lockheed Martin/Boeing F-22

F-22 enters production

The F-22 remains the highest priority program in the Air Force and is intended to replace the F-15 in air superiority missions. The current goal of the U.S. Air Force is to buy 442 F-22s. First production delivery is scheduled for 2001 and the program is split between Lockheed Martin and Boeing. Lockheed Martin has 2/3 of the share of the program and Boeing the remaining 1/3. The F-22 will be a radical improvement over existing U.S. fighter aircraft. The aircraft is stealthy and its modern avionics offers a pilot unprecedented situational awareness. For example, the F-22 can identify a threat aircraft through radar or an electro-optic sensor and then can prioritize threats and the distance at which they could launch air-to-air missiles. The aircraft engine can "super cruise" which means it can fly at supersonic speed without resorting to a fuel-gulping afterburner. The Air Force currently plans to buy 339 F-22s. We believe a smaller buy is probable. n Lockheed Martin F-16

Exports drive prospects

Lockheed acquired the General Dynamics Fort Worth division in 1993 and thereby added the F-16 program and one third of the F-22 (it already had one third) to its portfolio. The U.S. Air Force selected the F-16 in 1975 as a lightweight alternative to the F-15. In 1976, this aircraft received a major international boost when it was chosen by Belgium, Norway, Netherlands and Denmark in the socalled "deal of the century." There are more F-16s in use than any other western built aircraft in the world. The F-16 has evolved from a lightweight air superiority fighter to a multi-role fighter bomber. The aircraft is still production for the U.S. Air Force from orders placed in FY98. The backlog of undelivered F-16s stands at approximately 150 and international customers who are, or who should receive F-16s over the next five years include Taiwan, Turkey, Egypt and Israel. F-16s are licensed produced in Turkey and in South Korea. The Japanese FS-X is a modified version of the F16 and is not included in the backlog. However, Lockheed Martin should benefit from technology transferred from this project and will produce certain major

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Combat Fighter Aircraft Outlook 23 February 2000

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

Pan-European program

This air superiority fighter has been developed by a consortium of European enterprises and the program is managed by Eurofighter Jagdflugzeng in Munich. Eurofighter was conceived in the early 1980s to counter next generation Russian fighters and was to replace F-4 Phantoms, F-104 Starfighters, Tornado ADVs, as well as some ground attack aircraft in service with NATO air forces. The program's structure is largely dictated by work share requirements that, in turn are dictated by the potential buy and costs borne by different countries participating on the program. Britain will claim a 37.5% share of the work, Germany a 30% share, Italy will have a 19.5% share and Spain, the rest. Britain intends to buy 230 aircraft, Germany around 180. Spain will be 87 and Italy 165. Major contractors involved on the program include British Aerospace (front fuselage, part of the wing), DASA (center fuselage and tail), Alenia (rear fuselage, part of the wing) and CASA, (half of the rear fuselage and part of the wing). n Saab/BAE SYSTEMS Gripen

Sweden and South Africa have ordered

The Gripen is a lightweight multi-role fighter that is being developed for modernization of the Swedish Air Force. Saab Scania is the principal contractor on the program. The JAS Industry Group includes Saab and other major partners are Volvo Flygmotor, Ericsson and FFV. The Gripen was designed in the 1980s and prototypes have been flying since 1988. The aircraft will enter production in 1996 and Sweden has planned buy 140 of the aircraft. The aircraft is lighter, at approximately 7.3 tons empty, than many other aircraft discussed in this report (which weigh between 9 to 20 tons) and in some ways, is comparable to the F-16. Its multi-role capabilities come from pods, weapons and missiles that can be loaded onto the aircraft, depending on the mission. Because Sweden relies on conscription for its armed forces, the aircraft was designed with ease of maintenance in mind. In June 1995, British Aerospace concluded an agreement with JAS to market the Gripen internationally and access 45% of the production on export sales. n EADS-Dassault Mirage 2000

Production could extend to late 2000s

The Mirage 2000 is an improved version of the earlier generation of Mirage aircraft. The French Air Force decided to buy the Mirage 2000 in 1975 as an interceptor/air superiority fighter. Like other air superiority fighters, subsequent modifications to the aircraft have resulted in multi-role and specialized strike versions of the aircraft. The French Air Force is now taking delivery of the Mirage 2000s under a buy that should be completed by 2000. Mirage 2000 has been exported to several countries, notably India, Greece, Peru and Abu Dhabi. In 1992, Taiwan ordered 60 of the Mirage 2000-5 version and deliveries were completed in 1998. n EADS-Dassault Rafale The Rafale is a new design that was first unveiled in the early-1980s and incorporates advanced materials, flight controls and avionics. First flight occurred in 1986. The aircraft is a multi-role one and in 1989, the French government ordered the aircraft. Initially, it will replace older Mirage and Jaguar strike aircraft in the French Air Force and will be the basis for the French Navy's carrier-based

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Combat Fighter Aircraft Outlook 23 February 2000

France is only buyer so far

air fleet, replacing 1960s-vintage Crusaders and Super Entendards France now has a total requirement for 86 for its Navy (assuming two carriers are built) and 234 for its Air Force. First delivery of the aircraft is scheduled for 1998 and the jet should remain in production through the next decade. The Rafale has not yet received any export commitments, however, the aircraft has been offered in a competition the UAE is holding for advanced fighter procurement. n MIG-MAPO MiG-29

Not clear if new production is occurring

The MiG-29 was developed in the early 1970s and it became operational with Soviet forces in 1985. The aircraft was conceived as an air superiority fighter and its maneuverability and flight characteristics are as good as anything the West now has in production. The key features of the aircraft include an innovative short-range airto-air missile system (the "sight" is mounted in the pilot's helmet and the short-range missiles carried by the aircraft is among the most agile in the world). Criticisms of the aircraft include its short range and reliability of its avionics and engines. Production of the aircraft for Russian air forces was completed in 1994 and it has been exported to a number of countries, including Iraq, India, Iran North Korea, East Germany, Hungary, Poland, Yugoslavia and Syria. Based on Military Balance data, we estimate that there are over 1,000 MiG-29s in service around the world. We continue to hear and read conflicting statements about whether or not this aircraft is still in production. n Sukhoi Su-27/-30

Mainstay Russian export

The Su-27 is evolving into a family of multi-role combat aircraft Although the aircraft was conceived in the late 1960s, the first prototypes did not fly until the late 1970s and the aircraft has been in operation with the Russian Air Force since 1984. The aircraft is different from the MiG-29 because it was conceived as a long-range interceptor. Its range and size are advantages over this competitor and have enabled Sukhoi to make significant modifications to the aircraft. It too is as capable as most of the Western aircraft now in production and one of its advantages is the ability to carry up to six beyond-visual-range-type missiles. There are several different versions of the Su-27 that are now being offered. These include the Su-27 all weather fighter/bomber, the Su-30, which is a long-range version of the Su-27 equipped with a more powerful radar and able to assign targets to other aircraft, the Su-30MK, which is a two-seat multi-role fighter and the Su-34, which is a long-range strike version. Sukhoi is developing an improved version of the Su-27 that is referred to as the Su-35. The Su-27's Western equivalent is the F-15. The Su-27/-30 exports are picking up. China operates approximately 50 Su-27s and has been negotiating for the license production of the aircraft. India has ordered 40 Su-30MKs and deliveries began in 1997. Vietnam has ordered the aircraft and several are in operation.

Development Costs of Major Aircraft Programs

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

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Combat Fighter Aircraft Outlook 23 February 2000

Table 8: Development Costs For Several Major Aircraft Programs
Country U.S. Aircraft A-12 F-20 Tigershark F/A-18E/F F-22 Joint Strike Fighter LCA Lavi Ching Kuo Eurofighter Company or Enterprise McDonn. Doug./General Dynamics Northrop Boeing Lockheed Martin/Boeing Lockheed Martin v. Boeing Hindustan Aeronautics IAI AIDC British Aerospace, DaimlerChrysler CASA, Alenia Mitsubishi/Lockheed Martin Samsung Aerospace/Lockheed Martin Development cost +$5 billion $1.2 billion $6 billion $10-$12 billion $26 billion +$1.9 billion +$1.5 billion $1.5 billion $10 billion Status canceled cancelled in Nov. 1986 in production development development development cancelled production late-stage development

India Israel Taiwan U.K./Germany Italy/Spain Japan South Korea

Source: MLPF&S

FSX KTX-2

+$3 billion $2 billion

In production development

Who Does What

Table 9 shows major suppliers of different components of military aircraft.
Table 9: National Champions Exist In Europe. U.S. Has Multiple Sources
United States Airframes Boeing Lockheed Martin Northrop Grumman General Electric Pratt & Whitney Garrett Raytheon Northrop Grumman Lockheed Martin Northrop Grumman Lockheed Martin Litton Raytheon ITT Avionics, other Litton Honeywell Rockwell Collins BFGoodrich Lockheed Martin Thomson CSF BAE SYSTEMS Smith Industries Finmeccanica Daimler Chrysler France U.K. Italy Finmeccanica Germany Daimler Chrysler Russia Mikoyan Sukhoi Sweden SAAB

Dassault/Aerospatiale BAE SYSTEMS

Engines

SNECMA

Rolls Royce

Fiat

MTU

Saturn Klimov

Radar

Thomson CSF

BAE SYSTEMS

Finmeccanica

Daimler Chrysler

Ericsson

Electronic selfprotect

Dassault Electronique BAE SYSTEMS

Finmeccanica

Daimler Chrysler

Ericsson

Source: MLPF&S

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Combat Fighter Aircraft Outlook 23 February 2000

[LLL, BA, LIT] MLPF&S was a manager of the most recent public offering of securities of this company within the last three years. [NOC] An officer, director or employee of MLPF&S or one of its affiliates is an officer or director of this company. Opinion Key [X-a-b-c]: Investment Risk Rating(X): A - Low, B - Average, C - Above Average, D - High. Appreciation Potential Rating (a: Int. Term - 0-12 mo.; b: Long Term - >1 yr.): 1 - Buy, 2 - Accumulate, 3 - Neutral, 4 Reduce, 5 - Sell, 6 - No Rating. Income Rating(c): 7 - Same/Higher, 8 - Same/Lower, 9 - No Cash Dividend. Copyright 2000 Merrill Lynch, Pierce, Fenner & Smith Incorporated (MLPF&S). This report has been issued and approved for publication in the United Kingdom by Merrill Lynch, Pierce, Fenner & Smith Limited, which is regulated by SFA, and has been considered and issued in Australia by Merrill Lynch Equities (Australia) Limited (ACN 006 276 795), a licensed securities dealer under the Australian Corporations Law. The information herein was obtained from various sources; we do not guarantee its accuracy or completeness. Additional information available. Neither the information nor any opinion expressed constitutes an offer, or an invitation to make an offer, to buy or sell any securities or any options, futures or other derivatives related to such securities ("related investments"). MLPF&S and its affiliates may trade for their own accounts as odd-lot dealer, market maker, block positioner, specialist and/or arbitrageur in any securities of this issuer(s) or in related investments, and may be on the opposite side of public orders. MLPF&S, its affiliates, directors, officers, employees and employee benefit programs may have a long or short position in any securities of this issuer(s) or in related investments. MLPF&S or its affiliates may from time to time perform investment banking or other services for, or solicit investment banking or other business from, any entity mentioned in this report. This research report is prepared for general circulation and is circulated for general information only. It does not have regard to the specific investment objectives, financial situation and the particular needs of any specific person who may receive this report. Investors should seek financial advice regarding the appropriateness of investing in any securities or investment strategies discussed or recommended in this report and should understand that statements regarding future prospects may not be realized. Investors should note that income from such securities, if any, may fluctuate and that each security's price or value may rise or fall. Accordingly, investors may receive back less than originally invested. Past performance is not necessarily a guide to future performance. Foreign currency rates of exchange may adversely affect the value, price or income of any security or related investment mentioned in this report. In addition, investors in securities such as ADRs, whose values are influenced by the currency of the underlying security, effectively assume currency risk.

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