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William H. Alderman President Alderman & Company

Investment Themes in the MRO Sector of the Aerospace and Defense Industry. William H. Alderman President Alderman & Company. Oklahoma City, Oklahoma May 1, 2005. Agenda. Introduction Aerospace in Oklahoma Investment Themes in Aerospace MRO . Introduction Aerospace in Oklahoma

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William H. Alderman President Alderman & Company

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  1. Investment Themes in the MRO Sector of the Aerospace and Defense Industry William H. Alderman President Alderman & Company Oklahoma City, Oklahoma May 1, 2005

  2. Agenda • Introduction • Aerospace in Oklahoma • Investment Themes in Aerospace MRO

  3. Introduction • Aerospace in Oklahoma • Investment Themes in Aerospace MRO

  4. Introduction: Our Firm Alderman & Company • A boutique investment bank focused exclusively in the aerospace and defense industries • Our primary work is advising sellers in mergers and acquisitions transactions • We also provide a broad array of ancillary services, such as valuations, strategic planning, and management consulting in regard to operational and financial restructurings

  5. Introduction: Bio William Alderman • Bank of New England, Assistant Vice President 1985-1987 • Bankers Trust Company, Associate 1989-1990 • General Electric Company, Vice President, GECAS 1990-1995 • Aviation Sales Company, Senior Vice President 1996-1999 • Fieldstone, Managing Director 1999-2000 • Founded Alderman & Company 2001 Education • MBA J.L. Kellogg, Northwestern University 1989 • AB Kenyon College 1984 • The Taft School 1980 Licenses • FAA: Pilot (PPSEL) • NASD: 7, 24, 63 & 65 Honors • GE Circle of Excellence, 1995 • Academic All-Ohio Soccer Team 1983; Kearney Award 1983 & 1984

  6. Introduction: Sample Transactions

  7. Introduction: Sample Clients

  8. Introduction • Aerospace in Oklahoma • Aerospace MRO Investment Themes • Defense • Civilian

  9. Aerospace in Oklahoma • Aerospace is Oklahoma’s largest industry • More than 400 aerospace companies in Oklahoma generate an annual payroll of $5 billion and an industrial output of $12 billion • Average Annual Wage: $54,419 Sources: Oklahoma Aeronautics Commission, as cited in The Journal Record (Oklahoma City, OK) November 21, 2005, and Oklahoma Department of Commerce, Research & Economic Analysis Division, 2005 Aerospace Cluster Analysis.

  10. Aerospace in Oklahoma • 42,458 Direct Jobs; 3% of state employment Sources: Oklahoma Aeronautics Commission, as cited in The Journal Record (Oklahoma City, OK) November 21, 2005, and Oklahoma Department of Commerce, Research & Economic Analysis Division, 2005 Aerospace Cluster Analysis.

  11. Aerospace in Oklahoma Tinker Air Force Base • 732 buildings comprising 15.5 million sq. ft. • 24,000+ employees • Comparable to a city with population of nearly 30,000 • The largest single-site employer in Oklahoma with an annual payroll exceeding $1.1B • Home to seven major Department of Defense, Air Force and Navy activities with critical national defense missions. • Tinker's largest organization is the Air Logistics Center (ALC), worldwide manager for a wide range of aircraft, engines, missiles, software and avionics and accessories components. Source: Global Security.org, Air Force Bases.

  12. Investment Themes in Aerospace MRO Air Force Materiel Command: 78,000 personnel Cradle-to-grave oversight for Air Force aircraft • Testing • Acquisitions • Logistics and Support (MRO) Logistics & Support: Air Logistics Centers (ALC) • Ogden Air Logistics Center, Hill AFB, Utah, provides logistics, support, maintenance, distribution and engineering management for the F-16, C-130A, A-10, B-2, KC-135, T-38, T-37 and 22 other actively flying. • Oklahoma City Air Logistics Center, Tinker AFB, Okla., repairs and maintains bomber, refueling and reconnaissance aircraft, among others. Cradle-to-grave support for a variety of aircraft, including the E-3 AWACS, C/KC-135, B-52 and B-1. • Warner Robins Air Logistics Center, Robins AFB, Ga., provides product support, purchasing and supply-chain management, and depot maintenance. It has management and engineering responsibility for repairing, modifying and overhauling the F-15, C-130 and all Air Force helicopters.

  13. Aerospace in Oklahoma Tinker • Located 200 miles from the geographic center of the country. • Named in honor of Major General Clarence L. Tinker of Oklahoma, who served and died in WWII. • Tinker was conceived in 1940 by a group of Oklahoma City civic leaders who actively responded to the military’s quest to develop an aviation maintenance and supply depot in the center of the country. • In 1999 Tinker was awarded the largest engine repair contract in the history of the Air Force, valued at $10.2 billion over 15 years.

  14. Aerospace in Oklahoma Tinker • Provides “nose-to-tail” MRO services for more than 2,000 aircraft and 23,000 engines in the DOD arsenal • Aircraft: B-1, B-2, B-52, C/KC-135, E-3, VC-25, VC-137 • Engines: TF30, TF33, F101, F107, F108, F110, F118, F110-400, TF30-414A, J79 CFM56-2A-2 • Awards roughly $5 billion per year to private industry

  15. Aerospace in Oklahoma Tulsa • An aerospace hub for civilian maintenance, repair and overhaul of private sector aircraft • Aerospace employers include: American Airlines, Boeing, Honeywell, Lufthansa and NORDAM. Plus an additional 200 small- to medium-sized companies engaged to support the industry. All have major facilities in Tulsa.

  16. Aerospace in Oklahoma AMR Tulsa Maintenance & Engineering Base • Established in 1946 • American Airlines is one of the few remaining carriers still doing its own heavy maintenance. • 8,300 employees • Maintains American's fleet of MD-80, B737, Boeing 757, Airbus A300 aircraft and Pratt and Whitney JT-8 and GE CF6-80 engines. Sources: American Airlines, Tulsa Board of Commissioners

  17. Introduction • Aerospace in Oklahoma • Investment Themes In Aerospace MRO

  18. Investment Themes in Aerospace MRO Aerospace MRO Defined • MRO: “Maintenance, Repair and Overhaul” • Every and anything that happens to an aircraft or any component thereof after the date the aircraft is delivered to the (first) customer • Market Size: $53 billion annually • $20 Billion Defense (United States) • $38 Billion Civil (worldwide) Source: Aviation Week, April, 2006

  19. Investment Themes in Aerospace MRO • What areas of the Aerospace MRO market present attractive investment opportunities for industry participants and fund managers? • What are the high demand areas within this market over the next 5-10 years?

  20. Investment Themes in Aerospace MRO Investment Opportunities in the Defense Aviation MRO • Strong demand for routine maintenance • High utilization rates • Aging fleet • Very high demand for Upgrades & Modifications (“Mods”) Investment Opportunities in Civil Aviation MRO • Rising demand for “outsourced maintenance” • Rising demand from Asia • Increasing market share of PMA products

  21. Investment Themes in Defense Aviation MRO

  22. Investment Themes in Aerospace MRO U.S. Naval, Air and Ground supremacy is absolute • U.S. air combat loss ratios in Afghanistan were not significantly higher than peacetime training losses • U.S. air combat loss from enemy fire was negligible U.S. ICBM arsenal provides limited tactical benefit • The “old” nuclear arsenal provides limited value in the War Against Terror U.S. Cold War era combat equipment remains unsurpassed – but is it effective today?

  23. Investment Themes in Aerospace MRO Gone – threat of Sino/Soviet Invasion • Defense: Protection of nation and national interests through assured mutual destruction from massive arsenals of nuclear weapons New – threat of Terrorism & Rogue States • Defense: Protection of nation and national interests through agile, intelligent, networked, rapidly deployable war fighting assets

  24. Investment Themes in Aerospace MRO New threat: terrorists and rogue states • Hidden and hardened targets • Urban warfare • Attacks with Weapons of Mass Destruction • Chemical (VX, mustard gas, etc.) • Biological (anthrax, smallpox, etc.) • Radiological (dirty bombs) Requires new war fighting technologies • Faster, Lighter, Smarter The paradigm has shifted.

  25. Investment Themes in Aerospace MRO Faster, Lighter and Smarter • Combat supremacy through information superiority • IRAQ-1: 99 mps (megabits per second avg.) • IRAQ-2: 3,200 mps • C4ISR • Command • Control • Communications • Computers • Intelligence • Surveillance • Reconnaissance Source: American Forces Information Service, Office of the Assistant Secretary of Defense for Public Affairs, 3/31/04.

  26. Investment Themes in Aerospace MRO Source: ODUSD (Industrial Policy)

  27. Investment Themes in Aerospace MRO Aerospace MRO Investment Opportunities in Defense 1) Fleet Upgrades • Need to bring legacy weapons systems into the network • Cost-effectiveness of upgrades versus new spends • Historical experience with time and cost overruns on completely new weapons systems 2) Routine Maintenance • The U.S. military spends $20 billion each year on maintenance and parts for its aircraft, at all levels from field to depot. • Depot-level heavy maintenance costs $8 billion, roughly half of which is done by the private sector Source: American Forces Information Service, Office of the Assistant Secretary of Defense for Public Affairs, 3/31/04 The Logistics Management Institute (LMI), 2005

  28. Investment Themes in Aerospace MRO Upgrades: Putting the old platforms “on the Network” • C4ISR • New Avionics • New Sensors • New Targeting Systems • New high-bandwidth secure communications

  29. Investment Themes in Aerospace MRO First flown in 1954 First flown in 1977 Hercules first flown in 1954 Source: ODUSD (Industrial Policy); Alderman & Company analysis

  30. Investment Themes in Aerospace MRO Upgrades: Putting old platforms on the Network • E-3 AWACS • Militarized version of Boeing 707-320B • First E-3’s received in 1977 • Recent modifications include addition of GPS • Enhancing the Network • C-130 Avionics Modernization Program (AMP) • Avionics upgrades (500 aircraft) • Six digital displays and new flight management system • Network enabled • Boeing chosen to design, develop, integrate, test, fabricate and install the new system

  31. Investment Themes in Aerospace MRO Upgrades: Updating certain legacy systems • CH-47 Chinook • First delivered 1962 • Avionics upgrades • Common Avionics Architecture System (CAAS) • Forward Looking Infrared (FLIR) • UH-60 Black Hawk • First delivered 1974 • Avionics upgrades • Common Avionics Architecture System (CAAS) • Multi-node radar

  32. Investment Themes in Aerospace MRO The O&M budget is roughly the same size as the procurement budget

  33. Investment Themes in Aerospace MRO Example: KC-135 • 490 total KC-135s in the fleet • Boeing (NYSE: BA) and their subcontractor Pemco (NASDAQ: PAGI) perform roughly half of all KC-135 PDMs (approx. 80/year). The Air Force handles the balance in-house at Tinker. Source: U.S. Air Force Fact Sheet KC-135, March 2006 OMB Overhaul & Maintenance, November 3, 2003 & August 23, 2005

  34. Investment Themes in Aerospace MRO Depot Maintenance – Investment commentary Pluses: • The fleet is flying at high tempo • High utilization rates result in high maintenance costs • Fleet is aging and requires increasing maintenance • Tinker: In 2005 awarded $5 billion in contracts to private industry Minuses: • Congressional limits on “outsourcing” • Section 2466 of Title 10; No more than 50% of funding for depot maintenance and repair workload across any military department or defense agency can be contracted to industry • Limit had been 36% until 1991 Source: U.S. General Accounting Office, GAO/T-NSIAD-00-112

  35. Investment Themes in Aerospace MRO Weekly Closing Prices, 6/30/2003 – 4/24/2006 Major Players in Defense Aviation MRO Sector returns have far exceeded overall market performance

  36. Investment Themes in Aerospace MRO Defense MRO Summary • The 5-10 year outlook for defense MRO is good • Stable demand for depot level maintenance • High demand for aircraft upgrades • Sector equities have been performing very well

  37. Investment Themes in Civil Aviation MRO

  38. Investment Themes in Aerospace MRO Historical Framework 1950’s – 1980’s: Golden Years of Aviation in the U.S. • Development of a global consumer market • Growth of intercontinental jet networks • Advancements in airline technology and infrastructure • Speed, comfort, and safety improvement • Jet overtakes rail/marine as preferred mode of long-distance travel • U.S. Deregulation 1979

  39. Investment Themes in Aerospace MRO Hartsfield Atlanta International Airport ATL 1961 (“Jet” terminal) IAD 1962 LHR 1955 (main terminal) PHL 1953 (main terminal) This was a high growth industry in the U.S. • 1950 – 1975: Massive levels of capital expended to build the world’s commercial aviation network IAH 1969 DFW 1973 ORD 1962

  40. Investment Themes in Aerospace MRO This was a REGULATED Industry • 1950s – 1970s: Routes and fares regulated, making aviation a “safe place to invest” with “good growth prospects” and “high profit margins” for many suppliers. But how good was the business model – from a consumer perspective? • Fares high • Service poor • Little competition • Few frequencies

  41. Investment Themes in Aerospace MRO The rate of growth in the U.S. market began declining in the 1950’s Source: Air Transport Association

  42. Investment Themes in Aerospace MRO Source: Air Transport Association US

  43. Investment Themes in Aerospace MRO With deregulation came the decline of U.S. legacy carriers • Outright Liquidation • Pan Am • Eastern • Liquidation via merger • American - TWA • America West - USAirways • Reorganizations (bankruptcies) • Continental (1990s) • Delta • Northwest • United

  44. Investment Themes in Aerospace MRO SINCE 2000, US AIRLINES, IN AGGREGATE, HAVE LOST $42 BILLION Source: Air Transport Association VP & Chief Economist John Heimlich, April 14, 2006

  45. Investment Themes in Aerospace MRO Commercial Aviation – the next 10 years • Deregulation has finally taken hold globally and fares will remain low throughout the forecast period worldwide • Traffic will rise slowly in the U.S., as the market is mature • Traffic will rise much faster in the developing world, fueled by global economic development and low airfares • Globally, fares are no longer able to support inefficient operations • Continuous airline focus on reducing costs • Automation: airport kiosks, internet ticket sales • New methods and practices • “Low Cost Carriers” • Use of PMA parts • Maintenance trends

  46. Investment Themes in Aerospace MRO southwest Low-Cost Carriers have 30+% of U.S. market • U.S. legacy airlines have tried to follow suit

  47. Investment Themes in Aerospace MRO Low-Cost Carrier fleets continue to grow Source: Company public records and Alderman & Company research

  48. Investment Themes in Aerospace MRO PMA Parts • Alternative Replacement Parts • U.S. FAA regulatory approval designation - Parts Manufacturing Authority (“PMA”) • Parts approved by regulatory agencies (US: FAA, Europe: EASA) but NOT manufactured by the original equipment manufacturer (OEM) • PMA parts are typically 30% - 50% lower cost than OEM • $300 million market in 2005. Potentially $1.2 billion within 5 years. • Major Players • Heico (NYSE:HEI) 25% owned by Lufthansa • Wincer West • Timken (NYSE: TKR) • Pratt & Whitney (NYSE: UTX) • Manufacturing 100 replacement parts for CFMI engines • Announced February, 2006 Source: David Jensen, Aviation Today, March 1, 2006

  49. Investment Themes in Aerospace MRO Overview of Commercial MRO Market • $38+ Billion worldwide • Maintenance represents roughly 10% of the average airlines' costs; with 35-40% being for parts and the balance for labor • North America is the world’s largest market • 42% of world consumption • $16.6 billion • Western Europe • 22% • $8.5 billion • Asia-Pacific region - not including China or India • 15% • $5.7 billion • China & India • Today: 4% (China - 3%, India – 1%) • 5-10 years: possibly 15% of world MRO demand Source: Aerostrategy, March, 2006

  50. Investment Themes in Aerospace MRO Outlook • Maintenance unit costs have fallen nearly 20% in the U.S. in past 5 years • $14.9 per 1,000 ASM in 2001 • $12.1 per 1,000 ASM in 2005 • Manufacturers continue to develop better aircraft designs and materials technologies to reduce maintenance costs • Operators continue to reduce waste and increase efficiency • MRO expenditures will not increase as fast as the rate of growth in air travel • World RPM is forecast to grow by 5.1% • World commercial jet MRO forecast to grow 4.7% per annum . Sources: Aviation Week, April 12, 2006, “Annual MRO Forecast”, TeamSAI and BACK Aviation Solutions, 2006, Embraer Market Outlook, 3rd Edition, 2006-2025

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