William H' Alderman

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

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 Oklahomas 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 militarys 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

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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

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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-3s 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 OM 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

• 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
• 1950s 1980s 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

• This was a high growth industry in the U.S.
• 1950 1975 Massive levels of capital expended
  to build the worlds 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 1950s

Source Air Transport Association
42
Investment Themes in Aerospace MRO
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

• 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 (NYSEHEI) 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 worlds 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

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
51
Investment Themes in Aerospace MRO

• Maintenance trends and outlook
• Rationale for a slightly lower growth rate
• The cost of a heavy check generally is 75 80
  labor and airlines are cutting labor rates and
  costs
• Improving aircraft designs and maintenance
  technologies
• New materials, such as CFRP (composites) either
  reduce incidence or actually eliminate
  probability of corrosion
• Better access to critical inspection points
• Automation Self-monitoring / self-sensing /
  smart systems
• Rationale for a higher growth rate
• Independent maintenance is a growth market
• Non-Airline providers of maintenance
• Last year airlines outsourced 55 of their
  airframe maintenance
• Outsourcing may reach 70 within 10 years

Source Annual MRO Forecast, TeamSAI and BACK
Aviation Solutions, 2006
52
Investment Themes in Aerospace MRO

• Maintenance Outsourcing - a growth market
• Commercial airlines will continue to sell or
  outsource their repair and overhaul services to
  pure play MRO companies
• Intense financial pressure on airlines to reduce
  costs
• Growing airline industry view of maintenance as
  non-core
• Growing availability of high-quality global
  suppliers for outsourced maintenance
• Declining power of labor unions

53
Investment Themes in Aerospace MRO
U.S. Outsourcing Trend
54
Investment Themes in Aerospace MRO

• Changing Maintenance Labor Markets
• Historically airline labor unions had tremendous
  power
• Threat / cost of labor actions (strikes) high
• When airlines had substantial equity value, the
  potential harm from a strike was immense
• Since 1990, airline labor unions have lost power
• Risk of liquidation is real
• Pan Am, Braniff, Eastern,
• Risk of massive down-sizing is very real
• United, USAirways, Delta
• Since 2001, legacy network carriers have shed
  165,000 jobs
• 37 reduction

Source Air Transport Association, State of the
Industry, April 2006
55
Investment Themes in Aerospace MRO

• Unions historically protected maintenance jobs
• Specific rules prevented outsourcing
• Airlines globally have been shedding maintenance
  jobs
• United Indianapolis Oakland (2003, airframes)
• Northwest Atlanta (2002, engines)
• USAirways Pittsburgh (2001, engines)
• British Airways Treforest (1991, engines)

56
Investment Themes in Aerospace MRO

• Global commercial jet maintenance providers have
  emerged
• Lufthansa Technik (DB LHT)
• Revenue 3.1 Billion
• Profit 225 million
• SR Technics (Owned by 3i)
• Revenue CHF 1.2 Billion (0.9 Billion)
• Op. Profit CHF 115 million (90 million)
• ST Engineering (SGX STE)
• Revenue 1.3 Billion
• Profit 255 million

57
Investment Themes in Aerospace MRO

• But, airframe maintenance can be a low-margin
  business
• Pemco (NYSE PAGI)
• Revenue 150 million
• Profit/(loss) (6 million)
• TIMCO (OTC BB TMAVE)
• Revenue 329 million
• Profit/(loss) (22 million)
• April 13, 2006 Greensboro, N.C.-based Timco
  warned it is in danger of violating credit
  agreements related to its senior debt held by CIT
  Group and Monroe Capital Advisors.

58
Investment Themes in Aerospace MRO

• OEMs are aggressively offering maintenance
• A competitive weapon to win new orders
• A lucrative annuity cash flow
• Long-Term Exclusive Agreements
• February 23, 2006 Federal Express entered into a
  20-year exclusive engine program (FMP) with Pratt
  Whitney (NYSE UTX), covering the airlines
  entire fleet of PW4000-94 engines
• December 8, 2005 Goodrich Corporation (NYSE GR)
  today announced an agreement with JetBlue to
  provide exclusive maintenance for all
  Goodrich-produced technology on its A320 fleet
  (actuation, lighting, fuel, utility and potable
  water systems).

Source PR Newswire
59
Investment Themes in Aerospace MRO

• Major Players in Commercial Aviation MRO

Weekly Closing Prices, 6/30/2003 4/23/2006
U.S. MRO providers have recently had poor
financial results.
60
Aerospace in Oklahoma

• Despite good demand, US MRO providers have had
  issues...
• Customer bankruptcies
• Excess capacity keeps margins down
• Indianapolis (United)
• Winston-Salem (USAirways)
• Pittsburgh (USAirways)
• Oakland (Alaska)
• Profits have been elusive
• Direct labor margin 20 /-
• Billing rate in US approx. 43 / hour
• Billing rates have been flat since 2001
• Direct Labor cost approx. 34 (fully burdened)
• Overhead 15 to 20
• Net margin negative

Source Professional Aviation Maintenance
Association Annual Survey
61
Investment Themes in Aerospace MRO

• Commentary on AMR Tulsa
• Instead of shedding its maintenance operations,
  AMR is seeking to build maintenance into a profit
  center for the airline
• Pluses
• AMR-TUL is the worlds largest airline
  maintenance base
• This business model has been very successful for
  Lufthansa
• Lufthansa has very high labor costs
• But Lufthansa has world-class quality and very
  high efficiency
• Minuses
• In-house U.S. airline maintenance operations have
  historically not had the level of cost efficiency
  necessary to profitably compete
• This has never been successful for a U.S. airline
• "We know we are bucking the trend of the
  aviation industry by keeping most of our
  maintenance work in house. Carmine Romano, Vice
  President-Tulsa Base Maintenance AMR Press
  Release March, 2005

Source American Airlines press release March,
2005
62
Investment Themes in Aerospace MRO

• Commentary on AMR Tulsa
• Vision 2025 In 2003 Tulsa County approved an
  increase in the sales tax to fund numerous
  regional economic development activities.
• One of the Vision 2025 projects was a
  22.3-million grant/loan to AMR to expand AMR-TUL
  (Americans maintenance base at Tulsa)
• Under the terms of the funding, American Airlines
  agreed to consolidate all of its Boeing 737 heavy
  maintenance in Tulsa and also agreed to move its
  major CFM-56 engine work to TUL.
• AMR-TUL provides nearly 8,000 skilled high-wage
  jobs and thus Vision 2025 should be a successful
  project, aiding retention of quality jobs and
  fostering economic activity in the Tulsa Area
• AMR is well on the road to recovery, with a stock
  price that has risen from 1.38/share on 3/13/03
  to 24.12 today (4/25/06).

63
Investment Themes in Aerospace MRO

• But the AMR-TUL project is not without risk
• There have been similar projects that have not
  fared well.
• United Airlines built a 540-million maintenance
  center in Indianapolis in the early 1990s
• State and local funding total 300 million
• The center was expected to create 7,500
  high-paying jobs by 2004
• The facility was closed in 2003
• The shuttered maintenance center is a stark, and
  unusually vivid, reminder of the risk inherent in
  gambling public money on corporate ventures to
  bring high-paying jobs Louis Uchitelle (George
  Polk Award winner 1996), New York Times, November
  10, 2003.

64
Investment Themes in Aerospace MRO

• Civil MRO Summary
• The 5-10 year outlook for commercial jet MRO is
  good
• Worldwide airlines are outsourcing maintenance
• The U.S. market remains temporarily difficult
• Weak financial condition of the customers
• Low margins
• Leading providers are building profitable
  billion-dollar global franchises - with
  attractive financial returns

65
Investment Themes in Aerospace MRO

• Closing Remarks
• Civil MRO is an attractive market for
  higher-return investing
• This market is in flux
• Shifting business models
• There are substantial credit risks in the U.S.
• Outsourced maintenance should be a growth market
  worldwide for the next 5-10 years
• Leading providers are building profitable
  billion-dollar global franchises
• Defense MRO is an attractive market for
  lower-risk investing
• Demand for maintenance on U.S. military aircraft
  should remain high for the next 5 years, due to
  high utilization rates of aging aircraft
• Upgrade programs are a high-margin, high-growth
  market
• No credit risk (on a prime contract basis)

66
Investment Banking For the Aerospace and
Defense Industry Alderman Company, LLC 50
Washington Street Seventh Floor South Norwalk, CT
06854 Tel [phone] Fax (203)
286-1604 www.aldermanco.com balderman_at_aldermanco.c
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