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July 22, 2013

Morgan Stanley does and seeks to do business with companies covered in Morgan Stanley Research. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of Morgan Stanley Research. Investors should consider Morgan Stanley Research as only a single factor in making their investment decision. For analyst certification and other important disclosures, refer to the Disclosure Section, located at the end of this report. * = This Research Report has been partially prepared by analysts employed by non-U.S. affiliates of the member. Please see page 2 for the name of each non-U.S. affiliate contributing to this Research Report and the names of the analysts employed by each contributing affiliate. += Analysts employed by non-U.S. affiliates are not registered with FINRA, may not be associated persons of the member and may not be subject to NASD/NYSE restrictions on communications with a subject company, public appearances and trading securities held by a research analyst account.

M O R G A N S T A N L E Y B L U E P A P E R

Commercial Aviation A Renewed Lease of Life Aircraft manufacturers can expect to enjoy several years of strong demand, as order flows remain healthy, financing is getting easier and growth in aircraft lessors smooths the cycle. Three factors give us confidence this cycle will be stronger for longer:

Backlog confidence is rising. Backlogs for aircraft OEMS (original equipment manufacturers) are at all-time highs and now come from a more diversified customer base. High oil prices are driving demand for fuel-efficient aircraft, airlines in developed markets need to replace older fleets, and growth is still robust in emerging markets. Our bottom-up analysis of Boeing and Airbus backlogs suggest a low risk of cancellations.

Financing hurdles are easing. EM banks and export credit agencies have allowed DM airlines to focus on return-enhancing replacements and EM airlines on expansion. We look at new financing opportunities available as the EETC market opens beyond the US, which should help airlines with attractive fleet orders to finance in the high-yield market.

Leasing companies are playing a crucial role. Often overlooked, the proliferation of aircraft lessors plays a vital role in stabilising the commercial OEM cycle, enhancing the capital base, diversifying the customer base and bringing liquidity to the market.

Who will benefit? EADS, Boeing and B/E Aerospace are clear beneficiaries of the strong cycle. Suppliers may see lower aftermarket revenues, but we like Rolls and Safran for their young fleet exposure. Leasing company Air Lease looks attractive for its young fleet. Airlines IAG and Turkish should gain the most from EETCs. We also like Pratt, via United Technologies, for its backlog.

MORGAN STANLEY RESEARCH G l o b a l

Rupinder Vig1 +44 20 7425 2687 [email protected]

Penny Butcher1 +44 20 7425 6698 [email protected]

John Godyn2 +1 212 761 6605 [email protected]

Nigel Coe2

+1 212 761 5574 [email protected]

Aerospace & Defence, Airlines, Multi-Industry *See page 2 for all contributors to this report 1 Morgan Stanley & Co. International plc+ 2 Morgan Stanley & Co. LLC

Morgan Stanley Blue Papers focus on critical investment themes that require coordinated perspectives across industry sectors, regions, or asset classes.

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M O R G A N S T A N L E Y R E S E A R C H

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

Contributors to this Report

European Aerospace & Defence Rupinder Vig1 + 44 20 7425 2687 [email protected] Jonathan Ackerley1 + 44 20 7425 8754 [email protected]

European Airlines Penelope Butcher1 + 44 20 7425 6698 [email protected] Suzanne Todd1 + 44 20 7425 8316 [email protected] Jaime Rowbotham1 + 44 20 7425 5409 [email protected] Daniel Ruivo1 + 44 20 7425 5816 [email protected]

US Aerospace & Defense / US Airlines John Godyn2 +1 212 761 6605 [email protected] Nathan Hong2 +1 212 761 3212 [email protected] Christopher Phifer +1 212 761-1736 [email protected]

US Multi Industry Nigel Coe2 +1 212 761 5574 [email protected] Michael Sang2 +1 212 761 7092 [email protected] Jiayan Zhou2 +1 212 761 5766 [email protected]

EEMEA Turkey Airlines Nida Iqbal3 +971 4 709 710 [email protected]

Asia Pacific Airlines Edward Xu4 +852 2239 1521 [email protected] Li Mao4 +852 2239 1523 [email protected]

Japan Airlines Takuya Osaka5 +81 3 5424 5915 [email protected] Haruka Yamada5 +81 3 5424 5323 [email protected]

Australia Airlines Scott Kelly6 +61 2 9770 1583 [email protected] Julia Weng6 +61 2 9770 1197 [email protected]

Latin America Airlines Eduardo Couto7 +55 11 3048 6133 [email protected] Augusto Ensiki2 +1 212 761 7134 [email protected]

1 Morgan Stanley & Co. International plc+ 2 Morgan Stanley & Co. LLC 3 Morgan Stanley & Co. International plc (DIFC Branch)+

4 Morgan Stanley Asia Limited+ 5 Morgan Stanley MUFG Securities Co., Ltd.+

6 Morgan Stanley Australia Limited+ 7 Morgan Stanley C.T.V.M. S.A.+

See page 65 for recent Blue Paper reports.

We are grateful to Manish Ramuka and Chris Phifer for their contribution to this report.

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Table of Contents

Executive Summary 4

Part 1: Why this cycle could continue to positively surprise 12

Part 2: Backlog analysis – more resilient than you might think 28

Part 3: The Internationalisation of EETCs Eases Financing Concerns 37

Part 4: Leasing – adding stability to the OEM cycle 48

Part 5: Infrastructure: progress in addressing potential capacity

constraint 51

Appendix 1 – Commercial aviation: A 40-year review 53

Appendix 2 – Airbus and Boeing installed fleet analysis 58

Appendix 3 – Airbus and Boeing backlog analysis 60

Appendix 4 – Airbus global market forecasts 62

Appendix 5 – Boeing’s global market forecasts 64

Recently Published Blue Papers 65

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Executive Summary

OEM cycle: stronger for longer.

There is strong demand for more fuel-efficient aircraft in today’s high oil price environment. We are confident that this, coupled with replacement demand in developed markets and growth demand in emerging markets, will see the current cycle stay stronger for longer. Our conviction is underpinned by three positive trends, which we explore in detail in this Blue Paper.

1. The OEM backlog is increasingly diverse and resilient. We analyse every aircraft order currently in the backlog to assess i) the financial health of each airline and ii) the likelihood that it will fulfil each order placed. Our analysis puts at risk 10% of the total backlog at Airbus and 8% at Boeing due to poor financial health of the airline placing the order. As both companies have a backlog worth more than seven years of production, we think they still have strong visibility (significantly more than for the average global industrial player).

2. The headwinds in aircraft financing are easing. In our Blue Paper of June last year, we showed how the market underestimated the fact that aircraft financing requirements were rising while traditional sources of financing were falling. This, we felt, could rein in airlines’ capital expenditure, hamper capacity growth and increase risks to the OEM back¬log. This thesis has played out. With airlines now more disciplined on capacity decisions, profitability has improved and shares have appreciated, in many cases by more than 100%. For aerospace, the impact was limited due to help from export credit agencies and new sources of financing (such as EM banks). Today, we show that financing issues may be easing with the opening of the international Enhanced Equipment Trust Certificate (EETC) market, which offers a new financing avenue to airlines, particularly those that might otherwise have difficulty in obtaining financing.

3. The importance of leasing companies is overlooked. The market fails to appreciate the full potential of leasing companies, in our view. Not only do they take on residual risk associated with aircraft; they also enhance liquidity across all aircraft. Moreover, they help diversify backlogs and enhance the capital base available for financing aircraft.

The OEM backlog is at record levels. According to the International Civil Aviation Organisation, revenue passenger kilometres (RPK) have risen by 6.7% on average since 1962, expanding at a rate of 1.65 times global GDP, driven by improvements in technology and production costs, rising consumer and corporate wealth, and deregulation. This traffic growth has seen OEM backlogs rise to record levels as developed markets order planes for replacement and emerging markets order planes for growth. EADS and Boeing have a total combined gross backlog of just over 14,000 aircraft (close

to 10,000 firm orders), equivalent to more than seven years of production.

A more diverse and resilient backlog, easing aircraft financing headwinds and infrastructure progress could see the OEM cycle remain stronger for longer. Aerospace OEMs should benefit, as should airlines that have large fleet replacement needs and/or are well capitalised.

Financing this backlog has been tough, but is getting easier. In last year’s Blue Paper, we discussed how we estimated $300 billion of aircraft financing was required over the next three years, more than half of the $574 billion of the past 20 years combined. We believed that this significant requirement was under-appreciated by the market given that the bulk of it would need to be made up from non-internal sources such as banks, sovereigns and/or lessors. With the major austerity and regulatory changes that were taking place in European and US banking markets, we felt the burden of responsibility could fall on a much narrower range of participants and potentially put order backlogs at risk.

Airlines: capacity tight, profitability up. We thought last year that this issue would improve discipline on capacity decisions. In the year since we published that Blue Paper, capacity has remained tight, particularly in the mature markets of the US and Europe. Profitability has improved and shares have appreciated, in many cases by more than 100%. The continuance of high oil prices curbs the ability to self-finance significant aircraft purchases and is supportive of continuing capacity discipline.

Aerospace: demand still strong. Last year, we did not anticipate a material impact on the OEMs from this issue, as we thought that the need to replace old aircraft with new, coupled with replacement demand out of developed markets and growth in emerging markets, would keep demand up. This has indeed been the case, with 2012 seeing a total of 2,314 orders (for a book-to-bill ratio of 1.95 times) and 2013 to date also seeing positive trends with 1,326 orders so far (for a book-to-bill of 2.21 times). OEM strength has also been underpinned by a shift away from traditional financing sources (such as European banks) towards export credit agencies and emerging market and Japanese banks.

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Our bottom-up analysis of the entire backlog gives us confidence the OEM cycle is well placed to continue to show strength. In this Blue Paper one of the focus topics is our belief in the ongoing strength of the OEM cycle, something that many investors have questioned given the positive trends seen in the last few years. To this end we have carried out a full analysis of every order currently in the Airbus and Boeing backlog, customer by customer. With the help of our global airlines teams we have analysed each order on the basis of i) their financial health and ii) their likely fulfilment, of the backlog. Our results reveal that ~10% of the Airbus backlog and ~8% of the Boeing backlog could be at risk as a result of poor financial health of the airlines. When assessing likely order fulfilment (due, for example, to low traffic in the region or infrastructure constraints), we estimate an additional ~8% is put at risk for Airbus and ~6% for Boeing. Given that both OEMs have a backlog of over 14,000 aircraft, the risk outlined above would still leave both companies with considerable visibility (more than the average global industrial player). Geographically, our analysis suggests that airlines in India are most vulnerable.

The need for more efficient aircraft and demand from emerging markets are strong growth drivers. Over the past decade, fuel costs have more than doubled as a percentage of revenues. This has led to significant demand for new, more fuel-efficient aircraft (such as the A320neo, B737MAX, B787 and A350XWB). This has been coupled with continuing demand from emerging markets (EM), which now make up 47% of the backlog versus just 15% in 1990, and replacement demand out of developed markets (DM), where ageing fleet is a concern. This adds to our view that the OEM cycle can continue to show strength and the depth of diversity of the backlog should instil confidence.

The introduction of EETCs could be a real game changer… EETCs are a form of aircraft financing often used in the US but extremely rarely in Europe, and are a focus topic in this Blue Paper. They are capital market instruments largely issued and rated on the value of the aircraft secured, rather than the creditworthiness of the airline borrower. Only four EETCs have been issued so far in Europe, by the financing vehicles of Air France and Iberia, between 1999 and 2004. Our in-depth analysis of the EETC market and its implications indicates that the appeal of EETCs (especially in Europe) will be very high and adds a further avenue for airlines to finance their new aircraft demands (particularly those whose creditworthiness would otherwise restrict severely their ability to obtain financing).

…and leasing companies will play an important, under-appreciated role in underpinning the backlog. The proliferation of aircraft lessors plays a crucial yet

under-appreciated role in enhancing the stability of the commercial OE cycle, for a number of reasons. (1) Lessors take on the residual risk associated with aircraft, reducing the risk of new aircraft orders for airlines. (2) Lessors enhance liquidity across all aircraft, but primarily across younger aircraft in demand, which encourages airlines toward the market segment to which OEMs are most closely tied. (3) The presence of lessors further diversifies an OEM’s customer base and can ‘introduce’ an OEM to new customers. (4) Lessors enhance the capital base available for financing aircraft, thereby increasing access to capital for an OEM’s customers and reducing airlines cost of debt, regardless of the interest rate environment. (5) Lessors increasingly represent a source of orders in themselves for the OEMs.

Progress has been made in easing infrastructure constraints. Markets remain concerned that long-term traffic growth could be constrained by infrastructure. In this Blue Paper, we examine the recent progress seen at Rome and Istanbul airports. Both cities had several bidders for the work, showing that private capital is available so airport capacity investment need not be a burden for governments – it can actually be a source of revenue. In other places (such as Munich and London), lack of political support – as opposed to capital – has seen little progress made.

Airlines: the internationalisation of the EETC market offers a new financing avenue for non-US airlines that may have faced financing challenges in the past, as it centres on aircraft collateral value rather than airline creditworthiness. As long as a high oil price environment persists, we would expect credit investors to be most attracted to airline debt backed by the most fuel-efficient assets, suggesting those airlines with large order books for new aircraft types could attract more favourable financing terms and potentially could lower their average cost of debt. We expect that well capitalised airlines will continue to have ready access to financing. In this Blue Paper we take a detailed look at the EETC market including recent transactions by IAG.

Aerospace: the opening of the EETC market should have a beneficial knock-on effect. Airlines aside, the EETC market may help those companies that have placed orders for delivery a few years out and still need to put financing in place. Our key stocks to play this theme are EADS, Boeing and B/E Aerospace. On the flipside, a strong OEM cycle with greater retirement of younger aircraft could see earnings risk at aftermarket names that rely on servicing for profit. For those wanting to play the aftermarket, we prefer stocks with younger fleet exposures, such as Rolls-Royce and Safran.

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Exhibit 1 Developed markets had a major share of backlog in 1990…

0.0%

20.0%

40.0%

60.0%

Afric

a

LatA

m a

ndC

arib

bean

Mid

dle

East

Asia

Pac

ific

Eur

ope

Nor

thAm

eric

a

Unk

now

nar

ea

1990 2013

Source: Ascend, Morgan Stanley Research

Exhibit 2 …but emerging markets have now caught up

0.0%

20.0%

40.0%

60.0%

80.0%

100.0%

Developed Region Emerging Market

1990 2013


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Our order of preference for likely beneficiaries and most challenged Availability & Cost of Finance Backlog, Traffic & EM

Exposure Fuel Volatility – Rising Trends Infrastructure

Constraints

Key Beneficiaries ()

Well capitalised, incumbent airlines with attractive backlogs, increased use of lessors.

EM based/partnered airlines, OEMs with high backlog exposure EM, and suppliers with younger fleet exposure.

Well capitalised, low-cost and young fleet airlines.

Hub airports in major population centres and airlines with high slot shares at hubs.

Most Challenged ()

OEMs and their supply chain, balance sheet constrained airlines.

Airlines only focused on Western markets.

Balance sheet constrained airlines and old generation exposed supply chain/MRO.

New entrant, growing EM airlines unable to access DM population centres.

Neutral (~) Acceleration of replacement cycle likely for OEMs, but traffic volumes likely constrained.

OEMs and lessors: boost in wide-body demand, but traffic volumes constrained.

EU AEROSPACE

EADS ~

Rolls-Royce ~ ~

Safran ~ ~

MTU ~ ~

US AEROSPACE

Boeing ~

B/E Aerospace

Spirit AeroSystems ~

EU AIRLINES

IAG

Turkish Airlines ~

EU AIRPORTS

Vienna Airport ~ ~ ~

Zurich Airport ~ ~ ~

ADP ~ ~ ~

US MULTI-INDUSTRIAL

General Electric ~ ~

Honeywell ~ ~ ~ ~

United Technologies

~ ~ ~

US LESSORS

Air Lease

~

Source: Morgan Stanley Research

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Sub-sector Stock Picks EU Aerospace (Rupinder Vig): Top Pick – EADS We believe EADS is best placed to benefit from a stronger OE cycle... Within our European coverage universe, EADS looks best placed to benefit from a longer, stronger cycle. Further, the record level of backlog and its diversity should give visibility on EADS’s earnings into the medium term, and the need for new, more efficient aircraft should support demand.

…and the international opening of EETCs. A common investor concern is how airlines will finance the very large backlog in place. With the EETC market opening up, aircraft financing should become less of a headwind. This market should also make a notable difference to airlines that have lower creditworthiness, as EETCs are largely issued and rated on the value of the aircraft secured (as opposed to the airline’s creditworthiness). This is good news for OEMs, and we regard EADS as a clear play on this theme in Europe. We should also see a positive impact on suppliers such as Rolls-Royce, Safran and MTU, which have sizeable exposure to the Airbus and Boeing backlog.

However, the benefits for commercial OEMs come at the expense of aftermarket growth. A stronger OEM cycle is clearly good news for new aircraft deliveries, and a less restrictive financing environment should also help. Although this should have a positive impact on the supply chain, it is a double-edged sword, as the stronger OEM cycle and the availability of new, more efficient aircraft could also increase aircraft retirements, which would hurt aftermarket revenues.

US Aerospace (John Godyn): Top Picks – Boeing, B/E Aerospace Our findings support our bullish view on the commercial OE cycle. First, structural EM-driven traffic growth is supportive of original equipment (OE) demand, as nascent, under-penetrated aviation markets are traditionally stimulated through price, which requires aircraft with the lowest operating costs capable of high utilisation. Second, even with relatively sluggish traffic growth in developed markets, there is a strong case for replacement demand amid continued high fuel prices, which have effectively eliminated the supply overhang of parked aircraft. Third, easy access to aircraft financing at attractive rates is a major factor driving a preference for new aircraft across airlines. Fourth, robust EM-driven demand and continued globalisation are particularly supportive of wide-body

demand – a segment to which the OEMs and supply chain are historically more leveraged.

As always with macro-cyclicals, our views assume no macro shock – but, importantly, we would argue that the current OE cycle should be more resilient even if one did occur. Although we are not believers in the ‘there is no cycle anymore’ view of the OE cycle, we do believe that the cycle is far more stable and resilient to macro shocks than in the past. The depth of current backlog is unprecedented, at an all-time high in terms of years of production. The breadth of the backlog has also improved considerably, lending diversification to what was once a concentrated portfolio of customers. In addition, the proliferation of aircraft lessors plays an important, under-appreciated role in enhancing the stability of the cycle.

Stock implications: We are bullish on Boeing (Overweight), the OE cycle bellwether, as evidence mounts that the company is executing well on rate increases, which should ultimately set the stage for margin expansion. We also believe B/E Aerospace (Overweight) is well suited to benefit from the themes we have outlined above, in spite of its recent run – particularly if there is a renewed interest in product across the customer base. Although we are less excited about the aftermarket segment, companies with strong market positions, the ability to offset volume weakness with price, and acquisition-led growth prospects look attractive; we favour TransDigm Group (Overweight).

EU Airlines (Penelope Butcher): Top Picks – IAG, THY We see International Consolidated Airlines Group (IAG), the parent of British Airways, as a key beneficiary of the international opening of the EETC debt financing market. Of the developed European airlines under our coverage, we estimate that IAG’s 2013-15 gross capital expenditure obligation is the largest versus its 2013 cash balance, at a ratio of 2.56 times versus a sector median of 1.34. IAG also has the highest aggregate 2013-15 gross capital expenditure to operating cash flow, on our numbers, at a ratio of 1.11 versus a sector median of 0.86. This suggests that IAG may prefer to finance its capital expenditure through external financing rather than internal cash flows. Its ability to tap external financing is therefore critical to IAG’s fleet management plan. The group’s success in tapping the EETC market in June gives us confidence that it now has a much better chance of obtaining such financing. This is important, because IAG recently

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committed to significant new capital expenditure obligations for 24 additional B787 aircraft and 50 A350s beyond our 2013-15 forecast period. Our estimates suggest that gross capital expenditure for these deliveries could be around €5 billion, equivalent to the requirement for 2013-15. We also believe the EETC market may allow IAG to reduce its average cost of debt, which stands at 4.7% today. As our calculations show later in this Blue Paper, a 40% mix of EETC at a 4% coupon in IAG’s current debt structure could lower the average cost of debt by 110bps and bring down the group’s annual interest expense by €53 million (-23%).

We also believe emerging market airline Turkish Airlines (THY) will benefit from the EETC opening. The company has launched an ambitious expansion plan to double its fleet from 202 aircraft in 2012 to 423 by 2021, primarily adding narrow-body B737-8MAX and A320 neo aircraft. THY does not provide capex guidance, but we estimate that gross capex in 2013-15 equates to 21.4% of revenues in the period, versus 5.4-8.8% at the European legacy carriers. The company is committed to 8.6 times its 2013 cash balance, which is far above the developed European range of 0.55-2.56, suggesting it is likely to require external financing. The company has historically financed aircraft purchases 85% via support from export credit agencies. It has highlighted EETCs, JOLCOs (Japanese operating leases with call option) and bond issuances as potential sources of financing for its current fleet expansion plan.

We see no major benefit from the introduction of EETCs for our other Overweight-rated airlines – easyJet, Ryanair and Lufthansa. We do not expect the low-cost carriers to face

particular headwinds in funding aircraft, be it by internal means (both Ryanair and easyJet now operate on-balance-sheet net cash positions) or eternal (leasing, bank loans or bonds). The EETC is merely one more in a range of available options. The opening of the EETC market is unlikely to be a game changer for legacy carrier Lufthansa, either, as the attraction of the EETC lies in allowing less creditworthy airlines to issue investment-grade debt, whereas Lufthansa already enjoys corporate investment grade status.

EU Airports (Jaime Rowbotham): Top Picks – ADP, Vienna Airport, Zurich Airport Despite the low traffic growth we are seeing today, medium- to long-term growth expectations remain good. This, coupled with potential infrastructure capacity constraints, bodes well for volumes and pricing at the main European airports. We find the airports space attractive, and our preferred names are ADP, Vienna Airport and Zurich Airport. We expect traffic to pick up again in 2H13, after declining so far this year, and this should help trading multiples expand. We estimate that the airports trade on average on c.8 times EBITDA in 2013, compared to their recent historical range of 7-10 and the significantly higher multiples in recent private transactions (Vinci Airports paid 15 times EBITDA for ANA in Portugal, Manchester Airports Group paid 16 times EBITDA for Stansted in the UK and PSP Investments acquired Hochtief’s airports for 10 times EBITDA). Moreover, capital expenditure for these airports is falling, which should allow companies to lower their leverage over the next few years, increasing the scope for larger shareholder returns or acquisitions.

Exhibit 3 EU airlines: capital expenditure analysis – legacy and EM growth airlines see relatively high capex burdens, but financing availability reduces risk of cash flow shortfalls while re-fleeting takes place Aggregate gross capex forecast as proportion of

Aggregate gross capex 13-15e Market Cap

Revenue13-15e

Gross Cash (YE13e)

Operating CF13-15e

AF-KLM 4,404 2.24x 5.4% 1.04x 0.78xIAG 5,000 0.86x 8.8% 2.56x 1.11xLufthansa 8,279 1.16x 8.6% 2.14x 0.86xeasyJet 1,040 0.19x 7.6% 0.91x 0.56xRyanair 2,098 0.21x 12.3% 0.55x 0.50xAir Arabia 3,232 0.53x 27.7% 1.34x 1.11xTurkish 14,061 1.26x 21.4% 8.60x 1.52xMEDIAN 0.86x 8.8% 1.34x 0.86xNote: Market cap as of 16 July 2013 close. Source: Thomson Reuters, Morgan Stanley Research estimates

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US Leasing (John Godyn): Top Picks – Air Lease Our work reinforces our view that aircraft leasing fundamentals are poised to improve. Among the lessors, we prefer Air Lease (AL) as we believe it benefits from a number of advantages over peers, including a well articulated earnings growth strategy; the largest order book among public lessors; the youngest fleet of high-quality assets; a conservative balance sheet with more debt capacity; and opportunity for higher returns on equity.

We think some lessors can be valued as part of the aerospace supply chain. As the parallel goes, many aerospace suppliers have a close relationship with an OEM that affords the supplier a preferential position on a programme and earn revenue on a certain percentage of the units that the OEM sells. This allows the supplier to share in the demand curve that an OEM faces and benefit from the visibility associated with record backlogs. In many ways, AL shares these characteristics. Many in the industry feel that the company has cultivated relationships with the manufacturers that are second-to-none among public lessors. The management team also has a long history of being on new aircraft design committees, and launch customers for those aircraft. As a result, the company is on a very short list of lessors (only GE Capital Aviation Services (GECAS) and AL of late) that are positioned to benefit from launch customer pricing and/or relationships. Moreover, on subsequent aircraft orders, AL can get incremental discounts by introducing new customers to a particular manufacturer’s aircraft type. AL sells its OE-purchased inventory forward (and is nearly sold out of inventory to 2015), effectively simulating the ‘revenue backlog’ that many aerospace suppliers benefit from through their association with the OEMs. All of these points parallel the characteristics that define aerospace suppliers. Importantly, we believe trading like an aerospace supplier should drive an increased focus on price/earnings multiples and enhance multiple stability – points in direct contrast to the bear case on the stock, which is that its multiple converges to much cheaper aircraft leasing peers over time.

US Multi-Industrial (Nigel Coe): Top Picks – United Technologies Commercial aviation is a meaningful end-market for United Technologies, Honeywell and GE. The two largest players by revenues are United Technologies and GE through their respective engine segments, Pratt & Whitney and GE Aviation. We think improvements in engine technology have been, and will remain, the key driver of aircraft efficiency and

thus growth in the backlog. Honeywell participates primarily as an OEM and aftermarket supplier of aircraft electronics.

Pratt, through United Technologies, is our favoured way to play the strong backlog. The company has the highest aerospace mix in our coverage universe, and is well positioned to benefit from the 12,000 plane backlog. Management recently reiterated plans to double revenue at Pratt from $12.2 billion to over $24 billion by 2020, which implies attractive annual revenue growth of over 7% (CAGR), outpacing the mid-single-digit growth we have seen in long-term aircraft deliveries and worldwide traffic growth.

The GTF will be the main driver of Pratt’s revenue upside. Management expects the GTF engine, also known as the PW1000G, to generate upwards of $400 billion over the life of the programme. Pratt’s recent acquisition of the IAE joint venture from Rolls-Royce brings with it significant high-margin aftermarket content, which we think will provide a margin bridge to offset dilution from the initial GTF deliveries, starting in 2014 with the CSeries.

GE Aviation is also attractive, but a much smaller part of the overall business. We estimate that GE has just 14% of the backlog, but the company retains a 50% share of the CFM engine economics through a joint venture with Snecma. That said, GE’s engine business (including military) represented just 15% of consolidated revenues in 2012, so a much smaller driver of share price performance than at United Technologies.

Numbers can be deceptive, as GE and Rolls-Royce’s strength lies in wide-bodies. The cost of the engine and eventual maintenance are proportional to the size of the aircraft. Put another way, bigger planes require bigger (or more) engines, which in turn require more expensive maintenance, repair and operations. As such, having wide-body content is important. We note that 100% of Rolls-Royce engines are for wide-body aircraft, driven largely by their positions on the 787 and A350. Similarly, 70% of GE’s backlog is on wide-bodies, a number that will likely drift upwards once the 777-x takes orders. In stark contrast, 95% of Pratt’s backlog is for narrow-body content.

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Exhibit 4 EE/MI aerospace and defence exposure by stock

0%

6%

12%

18%

24%

30%

36%

ITW DOV ETN EE/MI AME GE HON UTX

ITW = Illinois Tool Works, DOV = Dover, ETN = Eaton Corp, EE = electrical equipment, MI = multi-industrial, AME = Ametek, GE = General Electric, HON = Honeywell International, UTX = United Technologies. Source: Company data (2012), Morgan Stanley Research

Exhibit 5 Pratt has a solid share on a number of key aircraft platforms Engine OEM

Plane CFM GE Pratt RR

In production

Airbus A320 Family CFM56 V2500,

PW6000 Airbus A330 CF6 PW4000 Trent 700Airbus A380 GP7000 GP7000 Trent 900Boeing 737NG CFM56 747-8 GEnx 767 CF6 JT9D PW4000 RB211 777 GE90 PW4000 Trent 800 787 GEnx Trent 1000Embraer E-Jet CF34 Bombardier C-jet CF34 In development

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

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Part 1: Why this cycle could continue to positively surprise

Expect a stronger OEM cycle fuelled by replacement demand in developed markets, growth in emerging markets and the need for more efficient aircraft

Over the past decade, fuel costs have more than doubled as a percentage of revenues, driving demand for new, more fuel-efficient aircraft (such as the A320neo, B737MAX, B787 and A350XWB). This has been coupled with continuing demand from emerging markets (which now make up almost half of the backlog versus just over 15% in 1990) and replacement demand in developed markets. All of this should see the OEM cycle continue to surprise positively, and the level and depth of diversity of the backlog should instil confidence.

Macro and political issues have not constrained demand for new aircraft Since the birth of the jet age (c.1960), growth in the commercial aviation sector has consistently exceeded GDP across the globe. According to the International Civil Aviation Organisation, RPKs have risen by 6.7% on average since 1962, expanding at a rate of 1.65 times global GDP, driven by improvements in technology and production costs, rising consumer and corporate wealth, and deregulation.

In recent years, however, growth rates have contracted (by 3% on average in 2007-11) as the global financial crisis and sovereign woes in Europe have taken their toll. 2009 saw an unprecedented contraction in global GDP growth, which was reflected in a similar volume and yield contraction among the global airlines. This was particularly pronounced in the US and Europe, which, together, still represent around 60% of global traffic volumes. While year-to-date traffic trends were tracking close to 4.3% in May, IATA expects this will moderate towards ~4.5% growth over the whole of 2013, suggesting another year of below-average traffic growth for the industry.

Traffic growth rates may be slowing, but the same cannot be said of aircraft fleet growth. In fact, we believe there is a disconnect between volume trends, financing availability and the aircraft backlog at key manufacturers Boeing and Airbus. The backlog of deliveries and options stands at ~14,000 aircraft (~10,000 firm orders – Boeing and Airbus only). If we assume that all of these deliveries are incremental to the installed fleet base today, this would see the installed fleet grow by 86% (CAGR of 8% through 2020, 5.5% on firm orders only). If we conservatively assume that ~30% of the installed base is ‘old generation’ and therefore only 70% of the backlog is slated

for growth, fleet growth is still almost double passenger growth trends in the past decade.

EM growth remains important for global traffic trends – favourable for new aircraft demand. Ultimately, global traffic growth is the best overall indicator of demand for aircraft, as traffic strength drives the need for capacity growth and healthier margins across airlines, which stimulates capital expenditure and aircraft replacement decisions. In contrast, without the benefit of a rising global demand environment, we believe global airline operating margins are likely to suffer and a lack of profitability across customers will lead to less demand for aircraft. Consistent with prior rebounds, as the global economy rebounded from the financial crisis, year-on-year traffic (measured in RPKs) recovered as well, even exceeding growth rates seen during most of the pre-financial crisis cycle. However, since this initial burst, global traffic growth has been on a positive but decelerating trend, underperforming the last cycle and historical average growth rates – a fact that has weighed on aftermarket but not OE trends.

Air travel remains labour- and capital-intensive High fixed costs mean that any drop in revenue has a disproportionate impact on earnings. The airline industry has a high level of fixed obligations, which limits the ability to obtain additional financing; restricts the ability to respond nimbly to the competitive environment; and increases vulnerability to economic conditions. Fixed obligations include debt, aircraft leases and financing, aircraft purchase commitments, airport development and other facilities. As a result of the substantial fixed costs, a decline in revenue results in a disproportionately high percentage decline in earnings.

Airlines are far more capital-intensive than other service industries. Air transportation is a service and, by nature, labour-intensive. In 2011, labour costs amounted to 16% of total expenses, with fuel at 30%, together accounting for almost 50% of the cost base. However, unlike most service providers, airlines are also highly capital-intensive. Depreciation, maintenance and aircraft rental account for 22-23% of expenses. The need for substantial amounts of capital has a significant impact on the balance sheet and cash flow because, over time, the industry has only been able to generate around 50% (usually less) of its capital requirements from internally generated cash flow. The debt-to-equity ratio for the European airlines we cover averages 2-3 times, but ranges

12



from net cash at the healthiest end to 4-5 times at the financially weaker end of the sector.

An airline’s profitability record has often affected access to traditional financing sources, but other sources (such as export credit) have filled the gap. Over the past 20 years (half of the jet aircraft era), the net profit margin for the global industry has averaged 1.8%. Excluding years of extreme exogenous shock (1990-93, 2001, 2008-09), the average is still only 2.8%. In the same period, capital expenditure has totalled $1,075 billion, of which 46.6% came from internal cash flow, leaving $574 billion to be tapped from the capital markets. According to industry forecaster Airline Monitor, this funding requirement could reach $650-700 billion in the next 10 years.

High fixed costs exist at the individual aircraft level. The average cost per ASK has been decreasing as the average size of aircraft has increased. This has been driven in part by technology, helping fuel and labour productivity, and making better use of infrastructure such as expensive monopolistic airports. For airlines, marginal costs for additional passengers transported are very low, which reinforces price discounting. Variable costs per aircraft, however, are significant and have increased as jet fuel prices have risen in the last few years. The fall in operating costs with aircraft size drives the importance of route density.

This feature also leads to network effects: adding a connection not only creates additional revenues and costs on the new route but also enables additional traffic/revenue to be generated for existing connections. The combination of these two dynamics drives the business model of network airlines, where feeder flights to hubs provide the customers that make larger planes economical to fly on higher-density, longer-haul connections. Hubs are also a key driver of code-sharing, which brings in additional feeder flights operated by other airlines.

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

consistent with the average age worldwide but find themselves older than the average in Latin America, the Middle East and Rest of World (RoW), where the average age profile has changed. This lends support to the outer years for Boeing and Airbus backlogs as the US carriers replace their ageing fleets. Unsurprisingly, rising fuel prices have been a key catalyst in driving average aircraft ages lower, so are highly correlated with replacement demand.

Exhibit 6 The fuel efficiency of new aircraft has improved sharply …

Source: Lee, IATA

Exhibit 7 … but fuel costs as a percentage of revenues have more than doubled in the past decade

0%

10%

20%

30%

40%

2000 2002 2004 2006 2008 2010 2012

Source: Company data, Morgan Stanley Research

13



Exhibit 8 Fuel costs have replaced labour as the largest component of airline cost structures

0%

10%

20%

30%

40%

1Q72

1Q75

1Q78

1Q81

1Q84

1Q87

1Q90

1Q93

1Q96

1Q99

1Q02

1Q05

1Q08

1Q11

Fuel

as

% o

f Tot

al O

p. E

xpen

ses

Source: US A4A Cost Index, Morgan Stanley Research

Exhibit 9 Unsurprisingly, rising fuel prices have been highly correlated with replacement demand

0

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900

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raft

$0.00

$0.50

$1.00

$1.50

$2.00

$2.50

$3.00

$3.50

Fuel Price

Fuel price Replacement aircraft

Source: US A4A Cost Index, Ascend: Western Jets as of 31/12/12, Morgan Stanley Research

To be fair, high fuel prices can be a double-edged sword, but today they are very much a tailwind for the OE cycle. Rising fuel prices can be a negative for new aircraft demand if fuel prices rise so quickly that they put a number of airlines at risk of a liquidity squeeze. It is therefore unsurprising that airline stocks have a long history of being negative correlation with the oil price. However, persistently high, or even slowly rising, fuel prices are positive for new aircraft demand as they raise the premium that airlines place on young, fuel-efficient aircraft. Unless fuel prices rise or a major demand shock occurs without a commensurate fall in fuel prices, we expect high fuel prices to continue to put pressure on airlines to replace older, less efficient aircraft.

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

To assess this, we have carried out an in-depth analysis of the efficiency advantage of a number of new aircraft. To ascertain whether the economic benefit of purchasing a new aircraft outweighs the capital cost, we have compared a number of new aircraft to their predecessors. For single-aisle aircraft, we have compared the A320neo to the current A320 and the B737 MAX to the B737-700. For wide-bodies, we have compared the A350-900 to the B777-200 as well the B787-9 to the B777-200. We compare the fuel cost of these aircraft to gauge the potential saving that the successor aircraft provides. While this approach has its limitations, in that running costs and flight usage will be different for each airline, we believe the analysis provides a good indication of the potential economic benefit to an airline.

Another limitation is that running costs and flight usage will be different for each type of aircraft. We think accuracy on the single-aisle planes is relatively high, as the next generation of planes in this class should not differ much at all in terms of operational deployment, weight or capacity. For the wide-body aircraft, however, the comparison is more complex so we have included seat capacity information to reflect these differences.

Exhibit 10 Fuel makes up over 50% of an airline’s running costs

Fuel Expense,

58%Flight Crew Expense,

18%

Rent, 3%

Depreciation, 6%

Maintenance, 15%

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

14



Exhibit 11 What are the potential savings from a new, more efficient aircraft? Aircraft Comparison Potential fuel cost saving

A320 NEO vs. A320 17%B737 MAX vs. B737-700 17%A350-900 vs. B777-700 14%B787-9 vs. B777-700 23%Source: Airline Monitor, Morgan Stanley Research

The results suggest airlines can make significant savings replacing old aircraft with new, more efficient aircraft. Our analysis shows that there are significant savings to be made from replacing older aircraft with new, more efficient ones. Clearly the oil price is an important input into this analysis and, at a fuel price significantly lower than current levels, the economic benefits of a new aircraft would fall to a level that might make airlines reconsider their purchasing requirements.

For the B737 MAX and the A320neo, we estimate a saving of 17% in fuel costs over their current equivalents. Given that fuel costs make up over half of an airline’s running costs, a 17% saving here is attractive. If we assume an 8% saving on the running costs for each new plane, this would more than cover the financing cost that could be seen as a potential downside to renewing the fleet.

For wide-body aircraft, similar savings look possible. The A350-900 can be seen as a direct replacement for the B777-200 for airlines, with almost identical seating and the same wide-body domestic or long-haul capabilities. Our analysis indicates a potential saving of 14%; for the B787-9 the saving is higher, at 23%.

Exhibit 12 The efficiency gain from a new aircraft is very significant and clearly justifies the capital cost involved

Single-Aisle

Airbus Boeing

(A320 NEO vs. A320) (B737 MAX vs. B737-700)

A320 A320 NEO % Savings B737-700 B737 MAX % SavingsSeat Capacity 150 - 220 150 - 220 Seat Capacity 130 - 150 126 - 180 Block Hours 1,651,733 1,651,733 Block Hours 1,940,918 1,940,918 Gallons of Fuel 1,298,618 1,106,661 Gallons of Fuel 1,341,919 1,145,142 Fuel Expense 3,884,440 3,310,257 Fuel Expense 4,172,387 3,560,553 Fuel Cost Per Gallon 2.99 2.99 Fuel Cost Per Gallon 3.11 3.11 Gallons of Fuel Per Block Hour 786 670 Gallons of Fuel Per Block Hour 691 590 Fuel Cost Per Block Hour 2,352 2,004 17% Fuel Cost Per Block Hour 2,150 1,834 17%

Wide-Body Airbus Boeing

(A350-900 vs. B777-200) (B787-9 vs. B777-200)

B777-200 A350-900 % Savings B777-200 B787-9 % SavingsSeat Capacity 314 - 440 314 - 475 Seat Capacity 314 - 440 250 - 290 Block Hours 646,250 646,250 Block Hours 646,250 646,250 Gallons of Fuel 1,430,657 1,260,188 Gallons of Fuel 1,430,657 1,163,250 Fuel Expense 4,405,008 3,880,131 Fuel Expense 4,405,008 3,581,659 Fuel Cost Per Gallon 3.08 3.08 Fuel Cost Per Gallon 3.08 3.08 Gallons of Fuel Per Block Hour 2,214 1,950 Gallons of Fuel Per Block Hour 2,214 1,800 Fuel Cost Per Block Hour 6,816 6,004 14% Fuel Cost Per Block Hour 6,816 5,542 23%

Source: Airline Monitor, Morgan Stanley Research

15



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

There will always be a skew towards the younger planes. As global traffic continues to double every 15 years or so, the need for new planes just to cover the increasing demand has seen delivery rates at Airbus and Boeing continue to grow, and many older planes are kept in service as there is a genuine need to fill a capacity gap.

By 1997 the average age had risen to almost 13.5 years. This change over just seven years was the result of production rates at the OEMs failing to match the rapid a rapid increase in passenger air traffic. While the proportion of ‘young’ aircraft (up to 10 years old) in the fleet increased, the fact that older aircraft had to remain in service skewed the average age upwards.

As of the end of 2012, the average age of the global fleet was back at 12 years (in line with the average age in 1990). Increasing production rates at the OEMs have been better able to replace older aircraft, even as traffic has continued to grow.

Retirements averaged 88 per year between 1990 and 2000 – largely B727s and later B747s … The average age for retirement of Boeing 727s has been just under 30 years, and Boeing saw a steady stream of retirements at the end of their economic life until the beginning of this decade. Similarly, the Boeing 747 has an average retirement age of over 26 years. As a result, these retirements can be seen as ‘natural’, rather than driven by any particular need or advantage to retiring a plane earlier.

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

Exhibit 13 Average age of the global commercial fleet

Average age of installed base

10

11

12

13

14

15

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012


Exhibit 14 Global fleet age progression

51%57% 56% 52% 54% 53% 52% 57%

31%27% 29% 38% 35% 36% 36% 33%

18% 16% 15% 11% 11% 10% 12% 11%

1990 1995 2000 2005 2009 2010 2011 20120-10 Years 11-20 Years >20 Years


Exhibit 15 As the capacity gap narrows, will deliveries and retirements as a % of the installed base converge?

0%

2%

4%

6%

8%

10%

12%

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

Deliveries as a % of IB Retirements s a % of IB


16



Exhibit 16 Retirements as a % of installed base have closely tracked the absolute retirement number, even with the much larger installed base

0

100

200

300

400

500

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

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2010

2011

2012

No.

of R

etire

men

ts

0.0%

1.0%

2.0%

3.0%

4.0%

5.0%

As

a %

of I

nsta

lled

Bas

e

Retirements As a % of insatlled base


Exhibit 17 Average retirement age by region (last 20 years)

0.00

5.00

10.00

15.00

20.00

25.00

30.00

35.00

Mul

tinat

iona

l

Euro

pe

Oth

er

Nor

th A

mer

ica

Asi

a P

acifi

c

Mid

dlen

Eas

t

Afric

a

Latin

Am

eric

a

Source: Ascend, Thomson Reuters, Morgan Stanley Research

Most replacement demand is from mature markets (US and Europe) The US has accounted for the lion’s share of retirements. This should come as no surprise, as the US is the most mature market in terms of both traffic growth and its installed base. Until the mid-2000s the US accounted for the vast majority of global retirements, and still accounts for around half of global annual commercial retirements.

More recently, Europe and Asia have seen higher levels of retirement as their fleets have matured. As traffic growth in these markets starts to level out, retirements have increased, with new aircraft deliveries beginning to replace older ones more often than adding to capacity.

Interestingly, Latin America has seen a lot of retirements even though its civil aviation markets are relatively immature. Unlike growing markets such as the Middle East where retirements remain low, Latin America has seen significant retirements alongside rapidly growing traffic. This is indicative of a market in which growth exists, but with a strong level of operational competition, so a focus on more efficient aircraft becomes important.

While not without risk, EM remains a strong growth driver Emerging market growth moves the needle. Segmenting global traffic growth trends shows that developed market growth has been the underperformer, reflecting Eurozone weakness post the financial crisis and capacity rationalisation and consolidation in the US. In contrast, emerging market growth has been a clear area of outperformance – a trend we believe can continue for some time. Emerging markets are no longer minor contributors to global traffic, representing ~50% of traffic. With traffic growth historically correlated to real GDP trends, a major driver of the recent emerging versus developed market outperformance has been the higher real GDP trends in emerging markets than in developed economies. However, relative GDP growth is not the only explanation: deeper, potentially longer-lasting secular drivers also support emerging market traffic growth.

EM economies have a long way to catch up if they are ever to become as aircraft-loving as DM economies. Though difficult to quantify precisely due to topological and infrastructure differences, the emerging economies have far fewer aircraft than the developed economies, adjusting for differences in population and wealth. Although they are quickly closing the gap, there is still significant upside if the emerging economies can match the number of aircraft per person in developed economies, with Asia having the most upside in absolute and relative terms. Even adjusting for lower GDP per capita (given affluence drives demand for leisure travel and productivity drives demand for business travel). Asia stands out as an outlier poised for growth. Furthermore, these adjusted data imply that the ratio of aircraft per person is likely to grow more rapidly in emerging economies, as the quality of life and productivity are likely to grow faster there than in developed economies given their comparative GDP growth rates.

17



Exhibit 18 Share of system-wide last 12-month RPKs

Asia29%

Europe28%

Africa2%

North America27%

Middle East8%

Latin America6%

Note: Adjusted for leap year. Source: IATA, Morgan Stanley Research

Exhibit 19 Advanced economies’ real GDP growth

-4%

-2%

0%

2%

4%

6%

8%

1970

1973

1976

1979

1982

1985

1988

1991

1994

1997

2000

2003

2006

2009

2012

2015

Source: IMF WEO April 2013, Morgan Stanley Research forecasts from 2013 onwards

Exhibit 20 Emerging/developing economies’ real GDP growth

0%

2%

4%

6%

8%

10%

1970

1973

1976

1979

1982

1985

1988

1991

1994

1997

2000

2003

2006

2009

2012

2015

Source: IMF WEO April 2013, Morgan Stanley Research

Exhibit 21 Global fleet growth is likely to be driven by EMs

5

5.5

6

6.5

7

7.5

8

8.5

9

3 4 5 6 7 8 9Million People (Log Normalized)

Num

ber o

f Airc

raft

(Log

Nor

m.) North America

Latin America

Europe

Middle East

Australia

Africa

Asia

Note: Assumes Western Asia = Middle East. Source: United Nations Statistics Division, Census.gov, Ascend: Western Jets, Company data, Morgan Stanley Research

Exhibit 22 Despite strong gains in GDP per capita, Asia lags other regions in population-adjusted fleet size

-1-0.5

00.5

11.5

22.5

33.5

6 7 8 9 10 11 12Log Normalized GDP per Capita

Log

Nor

mal

ized

AC

per

Mill

ion_

Pe

ople

Africa

Asia

Latin

Middle East Europe

Australa

North

Note: Assumes Western Asia = Middle East. Source: United Nations Statistics Division, Census.gov, Ascend: Western Jets, Morgan Stanley Research

Exhibit 23 IATA emerging market versus developed market traffic growth spread

-40%

-20%

0%

20%

40%

60%

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

Emerging Market Less Developed MarketYoY Growth Rate Spread

Note: EM = Africa, Asia, Latin America and Middle East, DM = Europe and North America Source: IATA, Company data, Morgan Stanley Research

18



EM versus DM outperformance likely to continue for some time. A useful way to track this theme is the EM versus DM traffic growth spread. Unsurprisingly, the trends above have resulted in significant outperformance in EM domestic traffic trends versus DM over the last decade. Moreover, the secular drivers of this trend mean it is highly resilient across the cycle. Boeing’s market outlook for 2012-31 supports the view that the emerging economies will be the primary source of growth in aircraft demand going forward. Structural EM-driven traffic growth strength is supportive of OE demand, as nascent, under-penetrated aviation markets are traditionally stimulated through price, which primarily requires aircraft with the lowest operating costs capable of the highest utilisation rates – new aircraft.

Exhibit 24 Boeing market outlook supports EM growth

0%

1%

2%

3%

4%

5%

6%

7%

LatinAmerica

AsiaPacific

MiddleEast

Africa Europe CIS NorthAmerica

World

CAG

R (%

)

Traffic Growth GDP Growth Fleet Growth

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

Exhibit 25 Developing markets tend to need younger aircraft when stimulating traffic growth

0

500

1,000

1,500

2,000

2,500

3,000

3,500

Africa NorthAmerica

MidEast LatAm Euro Australia Asia0%

10%

20%

30%

40%

50%

Aircraft Greater Than 15 Yrs Old (LHS) % of Total Fleet (RHS)

Source: Ascend: Western Jets as of 12/31/2012, Morgan Stanley Research

19



Exhibit 26 Annual retirements by region

0

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500

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2012 YTD

Africa Asia PacificEurope International / Multi-NationalLatin America and Caribbean Middle EastNorth America


Exhibit 27 Annual retirements by aircraft

0

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2012

2013

707 717 720 727 737 747

757 767 777 A300 A310 A320

A330 A340 DC- Series MD-Series Other


20



Older aircraft models have a major share of retirements

B727s and B737s account for a high number of retirements. These planes fuelled the growth of US domestic commercial aviation, and have enjoyed long average working lives, with both at just over 26 years. There have also been a lot of retirements for the older DC-Series and MC-Series planes.

There has been no revolutionary aircraft to replace these planes. Even on a global scale, planes such as the B727, B737 and A320 have been able to dominate the mid-range sector with no game-changing products introduced. Changes made by Airbus and Boeing have been a more gradual, evolutionary nature, so there has been little motivation to renew aircraft. The same can be said for the older DC-Series and MC-Series planes.

So the B747 continues to be flown for over 25 years on average; but this could change. With the A380 taking the lead in the somewhat niche market for jumbo-jetliners, airlines are looking to replace their B747s with significantly more efficient wide-body aircraft, such as the B787 and A350XWB.

Backlogs show that many aircraft are set to be replaced in the coming years. As fuel costs have increased as a proportion of airlines’ operating costs, the focus on having the newest, most efficient planes possible has increased. Even factoring in some capacity expansion, many of the orders are for replacement.

Exhibit 28 Average retirement age of aircraft models

0.0 5.0 10.0 15.0 20.0 25.0 30.0 35.0 40.0

DC-Series

707

727

737

747

767

757

MD-Series

A300

A310

A320


Exhibit 29 Oil price – $ per barrel since 2000

$0

$40

$80

$120

$160

Jul/0

3

Jul/0

4

Jul/0

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6

Jul/0

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Jul/0

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Jul/1

0

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Brent Crude US$/BBL

Source: DataStream, Morgan Stanley Research

There are a lot of new planes coming to market. With the A380 and B787 both still in the process of ramping up production, they are soon to be joined by the A350 XWB, a new derivative of the B777, and of course the B737MAX and A320neo. All of these aircraft will offer significant improvements in operational efficiency, and therefore profitability, to their predecessors, and soaring fuel markets have added to market demand.

In addition, more attractive financing rates diminish the appeal of keeping older planes. As we discuss in Part 3, the cost of financing aircraft has become more attractive in recent years, and the increasing use of EETCs is set to ensure the cost of aircraft finance remains low. With fuel cost accounting for such a large part of an airline’s operational costs, the prospect of a 15-20% saving in fuel cost will more than cover the cost of finance on a new plane.

Average age of aircraft will continue to fall with increased production and launch of more fuel-efficient aircraft The average length of a commercial aircraft’s lifecycle is undoubtedly falling. The average age of the global fleet fell from 13.5 years in 1998 to 11.9 by the end of 2012, and the trend looks set to continue.

Growing traffic demand and relative inelasticity of supply have kept average ages high. Production from OEMs has risen gradually over the last two decades, but this has not matched traffic increases, meaning that older aircraft have had to be kept in service.

21



Exhibit 30 Retirements as a % of deliveries continue to trend upwards

0

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800

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1200

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2008

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2011

2012

0%

5%

10%

15%

20%

25%

30%

35%

40%

45%Retirements Deliveries Retiremnts as a % of Deliveries


Exhibit 31 Oil price versus retirements

0

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160

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$ pe

r bar

rel

0

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100

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250

300

350

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5002000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

Retirements Brent Crude


As mature markets receive their new planes, and growing markets mature, the average age is set to trend down. We presume that mature markets will seek to retire their older, less efficient planes as soon as possible, given the new wave of efficient aircraft that are now on offer. In growing markets such as Asia Pacific and China, there will come a time when airline profitability will need to focus more on cost control, so the need to retire older planes will increase.

Exhibit 32 Global GDP versus retirements

0

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250

300

350

400

450

500

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1992

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2004

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2012

-3.0%

-2.0%

-1.0%

0.0%

1.0%

2.0%

3.0%

4.0%

5.0%

6.0%Retirements (LHS) World GDP (RHS)


During this period of rising deliveries, the number of parked aircraft has remained stable, but the number going into retirement is trending up

The last few years have seen largely stable numbers of parked aircraft … After the late 1990s when the parked fleet as a percentage of the installed base approached all-time lows, the period post 2000 has seen this rise closer to 10% of the installed base.

22



Exhibit 33 The number of parked aircraft remains stable

4%

8% 8% 8%

7%

5%5% 5% 5%

7% 7%

12%11%12%

10%10%10%

9%

11%12%

11%9% 9%

10%

1990

1991

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1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

YTD

Parked Fleet as a % of Installed Base

Source: Company Data, Morgan Stanley Research

Exhibit 34 Smaller aircraft dominate Airbus’s parked aircraft

A30016%

A31012%

A3180%

A31913%

A32037%

A3217%

A3308%

A3407%

A3800%

Source: Company data (2012), Morgan Stanley Research

Exhibit 35 Airbus storage period for parked fleet by aircraft age

19 14 5

2419 4

9829

5

49

4921

< 1yr 1-3yrs >3yrsUpto 5 yrs 6-10 yrs 11-20 yrs > 20 yrs

Source: Company data (2012), Morgan Stanley Research

… while retirements have slowly been picking up as older aircraft are replaced by new, more efficient ones. While the level of parked aircraft has remained relatively stable, retirement numbers have risen steadily on the back of a raft of new, more efficient aircraft coming into service. We expect this trend to continue as new aircraft (such as the B787, A350XWB, A380, C919, A320neo and B737 MAX) come into service and ramp up towards full production.

The depth of backlog is unprecedented, with backlogs at an all-time high in terms of years of production

This cycle’s backlogs are much deeper than in past cycles. Boeing and Airbus both report book-to-bill ratios that are calculated by (as the name implies) comparing the number of aircraft added to the backlog (booked) to the number of aircraft delivered (billed) in a given period. As such, a book-to-bill ratio above 1 means the net impact of booking and delivery activity has expanded the backlog – a dynamic indicative of healthy demand for a supplier’s product. Historically, the ratio has ranged from low points of ~0.50 to high points of ~3. Boeing’s ratio is at mid-cycle levels and, per management commentary, is likely to remain above 1 in 2013. We believe the underlying OE cycle fundamentals argue for an elevated book-to-bill ratio for longer. Similarly, Airbus expects its ratio to remain above 1 throughout 2013. Boeing and Airbus’s huge backlogs in themselves contribute to demand resilience by creating scarcity, requiring airlines to jockey for position into the next economic upturn. An aircraft is purchased not just for the here-and-now, but also for the decades ahead. Airlines recognise that delaying deliveries could put the airline at the back of the queue, which could subsequently hamper competitiveness if/when the economy improves.

Exhibit 36

Backlog visibility remains near record high

0

5

10

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1992

1994

1996

1998

2000

2002

2004

2006

2008

2010

2012

Total Backlog / Current Year DeliveriesTotal Backlog / Avg. Next 3 Year Deliveries

Years of backlog

Note: Represents total Boeing and Airbus backlog and deliveries. Source: Boeing, Airbus, Morgan Stanley Research

23



Exhibit 37 Supplier book-to-bill ratios have been elevated for some time, contributing to record backlogs

0

1

2

3

4

5

6

1958

1961

1964

1967

1970

1973

1976

1979

1982

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1988

1991

1994

1997

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2012

Boo

k to

Bill

Rat

io

Boeing Airbus

Source: Boeing, Airbus, Ascend, Morgan Stanley Research

Exhibit 38 Moderate production last decade relative to new orders will extend the current cycle

BA & Airbus Orders & Deliveries

0

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1000

1500

2000

2500

3000

1987

1989

1991

1993

1995

1997

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2001

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2011

DeliveriesOrders

Source: Boeing, Airbus, Ascend, Morgan Stanley Research

Exhibit 39 BA speculative orders are a minority of the backlog

41%

37%

22%

Mature Order

Growth Order

Speculative Order

Source: Boeing (as of June 2013), Ascend, Morgan Stanley Research

Last OE cycle wasn’t overheated, adding longevity to this cycle. In spite of high order rates, build rates never showed their typical volatility across the last cycle. From last cycle’s trough year of 2003 to last cycle’s peak in 2007, total Boeing and Airbus deliveries were up 53%. By comparison, the trough-to-peak period of 1995-99 saw a 141% rise in Boeing and Airbus deliveries and the 1984-91 trough-to-peak cycle saw a 210% rise. The discipline of the OEMs in delivering modestly while enjoying strong new order demand not only saved the cycle during the financial crisis but has also laid the foundations for an extended cycle this time around.

Healthy mix of growth and replacement in Boeing’s aircraft backlog. Aircraft demand comprises two major components: replacement and growth. Within ‘growth’ there are two subcomponents. There is what one would characterise as ‘normal’ growth (air traffic growth tied to global GDP and population growth) and ‘speculative’ growth, which is typically when a young carrier attempts to seize share in existing markets or expand considerably beyond its current fleet with a stated above-market growth plan. We calculate about 41% of Boeing’s backlog is a ‘mature order’ – or one likely to be for replacement of ageing planes. Through an economic downturn, this is the most resilient segment of demand. The remainder of the backlog appears to be for growth, but of this segment less than half is made up of speculative orders. Specifically, speculative orders only account for ~22% of Boeing’s entire backlog, on our estimates.

Therefore, ‘backlog bears’ can present a case for haircutting backlogs, but by a little, in our view. In fact, if we adjusted Boeing’s current backlog by around one-fifth, its backlog would be cut from ~7 years at current production to ~5.6 years – still an extremely healthy level by historical standards. We also think it fair to make the argument that ‘froth’ in an order book – what backlog bears refer to when an order is at greater risk of being cancelled – is not a given and is dependent on the trajectory of the global economic cycle. In other words, if we see economic trends accelerate from here, what previously appeared to be froth may crystallise into much more solid demand. However, if we’re hit by a surprise shock to the business cycle, what we had calculated as solid demand may appear frothy. As such, as long as recent airline operating conditions continue, we suspect that what many argue is froth will ultimately prove relatively limited.

Emerging market demand has played a major role in a prolonged elevated book-to-bill ratio. As a result of the long build in demand worldwide, orders grew considerably faster than deliveries as carriers jockeyed for increasingly rarer slots given OEMs’ reluctance to raise rates. This conservatism was

24



not misplaced. In fact, during the financial crisis and its aftermath, rates were not cut. But with GDP growth still elevated across emerging economies and quality of life (GDP per capita) improving rapidly, we expect EM demand for air travel to continue to drive deeper backlogs through elevated book-to-bill ratios for some time to come.

Rising production rates reflect the strength of underlying demand as seen by manufacturers. Historically, Boeing and Airbus have responded to the ebbs and flows of demand for aircraft across the business cycle by adjusting production rates. Given the market power they wield in what is largely a duopoly, the companies have been able to manage their production levels in an effort to maximise their own profits. Thus, Boeing/Airbus production rates reflect demand conditions as well as both suppliers’ best efforts to maximise profitability by managing supply. As a result, we believe prospective rate increases from both Boeing and Airbus suggest the suppliers have confidence that the current cycle has legs. To be fair, the suppliers do not have a crystal ball and cannot predict when the next macro shock will come, which is why the depth of the backlog is important. But, in our view, rising production rates amid historically high backlogs and book-to-bill ratios above 1 are more likely to be a positive signal than a risk.

The breadth of the backlog has improved considerably over time, lending diversification to what used to be a much more concentrated portfolio of customers In the 1970s, the US airline fleet was around three-quarters of the global fleet, so the aerospace cycle largely followed the US economic cycle. Today, US aircraft are just one-quarter of the global fleet, lower than during the 1999 aerospace peak. Although European demand was a source of diversification, Europe’s advanced economy tended to follow the same cycles as the US. Therefore, demand for aircraft in the US was coincident with demand for aircraft in Europe. This high correlation among economies, which drove aircraft demand, as well as the high correlation of each region’s demand for aircraft and its respective economic cycle, caused the overall aerospace cycle to be more extreme.

Exhibit 40 EM demand caused orders to spike

Large Commercial Aircraft Deliveries (1995-2015E)

0

250

500

750

1,000

1,250

1,500

1,750

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E

2015

E

# of

Pla

nes

Predominant Order Acitivity Regionally:

2015+Peak

Asia/MEdemand

wave

USmajors

2009-12

Europeancarriers2007-09

Source: Ascend, Morgan Stanley Research estimates (E)

Exhibit 41 Announced production rate increases suggest suppliers have confidence in the future

0

15

30

45

737 747 767 777 787 A320 A330

Num

ber o

f Airc

raft

2010 2011 2012 2013

Note: All figures represent estimated yearend production rates. Source: Boeing, Morgan Stanley Research

Exhibit 42 Boeing backlog by geography

North America

39%

APAC 30%

Europe 16%

MidEast 7%

LATAM 7%

Africa 2%

Source: Boeing, Ascend, Morgan Stanley Research

25



Exhibit 43 Proliferation of airlines = diversity in demand

Mid East, 8%

Africa, 13%

Europe, 25%

North America, 23%

Asia Pacific, 19%

LatAm, 12%


Exhibit 44 Top 100 airlines = 65% fleet, but a long tail exists Global Airlines Number of Aricraft % Total

Top 5 World Carriers 3,354 15%Top 10 Carriers 5,072 23%Top 100 Carriers 14,073 65%World Fleet Total 21,764

Airlines % Total

Airlines with >100 planes 42 3%with 50-99 planes 44 3%with 20-49 planes 112 7%with 10-19 planes 136 9%with <10 planes 1,206 78%Number of Airlines Worlwide 1,540 100%Source: Ascend, Morgan Stanley Research

Exhibit 45 Correlation between traffic growth across regions limits the benefits of geographic diversification

R2 = 0.6452

-5%

0%

5%

10%

15%

20%

-10% -5% 0% 5% 10% 15% 20%US A4A System RPMs YoY Change (%)

Glo

bal R

PMs

YoY

Cha

nge

(%)

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

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

still dealing with the extended effects of 9/11 and a recession, other parts of the world were growing. Petrodollar wealth in the Middle East and growth across Asia, particularly China, led to a dramatic increase in aeroplane orders across this third major economic region. As a result, the US was left out of the order cycle for some time. In fact, US carriers accounted for less than ~10% of Boeing’s backlog in 2007 before recovering recently to ~35%.

As a result, despite some large-scale consolidation, the customer base has a longer tail than in the past. Today there are ~1,500 airlines around the world, and only two manufacturers of scale in the narrow-body/wide-body segments. Airlines – both passenger and cargo – are confronted with a far more competitive market between themselves in jostling for increasingly rare aircraft slot positions. One could argue that, after the first 100 global airlines, remaining carriers are too small to matter to an OEM. However, for many of these smaller airlines, the timing of a new jet delivery may be a make-or-break issue, especially with new technology playing an even larger role in a world of high fuel prices. This spike in the number of airlines should in all likelihood moderate to more reasonable levels. But this doesn’t alter the critical fact that, for now, Boeing and Airbus are in a strong position.

Diversification through geographic breadth is helpful, but is less effective during broad-based macro downturns. Given that aircraft are fungible assets (that can easily be moved from region to region), a backlog that is geographically more diversified is better positioned in the event of a negative, regionally focused shock such as 9/11, SARS or swine flu. Furthermore, a geographically diverse customer base allows the manufacturer to dynamically allocate order positions to regions that are enjoying strong demand for aircraft to the extent that geographies decouple across the business cycle and customers in an underperforming region cancel or defer orders. As a result, diversification certainly plays an important role in reducing backlog volatility. However, given that it is rare for regions to decouple for extended periods (as airline traffic trends across all regions are ultimately highly correlated), we would not overstate this benefit. In particular, during broad-based macro downturns, geographic diversification is unlikely to work as well as it would during periods of greater dispersion in regional economic activity.

26



Growth set to slow in China and India in the near to mid term, but we do not see EM concerns as an issue for civil aviation The resilience of the OE cycle has been called into question because of macro concerns in emerging markets. EM growth has been an increasing concern in recent months, and while Morgan Stanley’s economists believe there is better cyclical news on the horizon, they accept there could be some headwinds further out.

Slower growth in China has been well publicised... Our economists believe the Chinese economy will remain in transition for some time, so we would expect to see the volatility and downside risks to growth that are associated with economies in transition.

...and a similar picture is emerging more widely across Asia. Recent data show a slight deceleration in growth across the region, with external demand slowing in line with weaker data from the US and domestic demand held back by a tighter fiscal policy stance.

India’s economy is of particular concern, but again there is a more positive outlook in the mid to long term. After a difficult period during which investment activity slowed down sharply, the government has introduced structural reforms on a regular basis. These have been very well directed, and should benefit investment and growth over time.

Exhibit 46 Global trips per capita, 2011

Source: Airbus 2012 Global Markey Forecast

We do not think this presents a major risk at this stage. With over one-third of the combined backlog for Airbus and Boeing booked for customers in emerging markets, the health of these economies is clearly important. However, we believe traffic growth will remain high, as market penetration in many of these economies is very low compared with developed markets such as the US. Moreover, whereas emerging markets used to buy second-hand aircraft, many can now finance new aircraft, and are doing so in large numbers, in part to improve their perceived growth status.

China and India only make up 9% of the backlog. Growth in these two key economies is widely expected to slow down sharply, with a knock-on effect on global growth. However, they account for a very small proportion of the combined Airbus/Boeing backlog. With the level of over-booking in place, a slowdown in deliveries to either of these economies should be absorbed by OEMs, we believe.

Exhibit 47 Global split of Airbus and Boeing backlog

Africa1%

Asia Pacific23%

China5%

Europe21%India

4%

LatAm & Carribean6%

Middle East8%

North America28%

Others4%


27



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

Key findings from our bottom-up analysis of the current Airbus and Boeing backlog

Financial health of airlines • Airbus: ~10% of the total backlog could be at risk due to poor

financial health of the airlines.

• Boeing: ~8% of the total backlog could be at risk due to poor financial health of the airlines.

Likely order fulfilment by airlines • Airbus: ~10% of the backlog could be at risk of not being

delivered, due to a variety of reasons (for example, excess order placement, lower traffic growth than expected, lack of infrastructure or regional operational issues).

• Boeing: ~6% of the backlog could be at risk due of not being delivered, due to a variety of reasons (for example, excess order placement, lower traffic growth than expected, lack of infrastructure or regional operational issues).

Regional analysis • Airlines in India appear most likely to cancel orders due to their

poor financial health. We estimate that ~46% of total Indian backlog for Airbus could be at risk

• Areas with lowest cancellation risk are the Middle East, the rest of Asia and China.

• 15% of the backlog in Europe could be at risk versus 4% in North America.

The backlog at OEMs is at record levels… The backlog at Airbus and Boeing has risen steadily over past 10 years (barring the decline in 2008/09) due to the increase in aircraft demand globally. The current backlog is at record levels: at Airbus 5,102 aircraft, at Boeing 4,338).

…providing strong earnings visibility at OEMs and suppliers. Our analysis of the backlog at Airbus and Boeing suggests the total backlog provides earnings visibility for the next 10 years (at 2012 production levels, Airbus 588, and Boeing 601). Even when considering only firm orders, the backlog provides visibility for the next eight years, which is high compared with historical levels.

Exhibit 48 The aircraft backlog is at record levels Airbus Boeing Total

2001 1575 1397 2972 2002 1523 1235 2758 2003 1647 1177 2824 2004 1685 1147 2832 2005 2372 1846 4218 2006 2724 2486 5210 2007 3612 3452 7064 2008 3907 3727 7634 2009 3672 3387 7059 2010 3732 3456 7188 2011 4614 3776 8390 2012 4857 4425 9282 Current 5102 4338 9767 Note: Data represent firm orders only. Source: Ascend, Morgan Stanley Research

Exhibit 49 Both Airbus and Boeing have firm backlogs approaching 8 years of production

7,2126,900

5,1024,338

Total Backlog Firm Orders


Exhibit 50 Airbus and Boeing: historical & estimated deliveries

-

400

800

1,200

1,600

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

E

2014

E

2015

E

2016

E

Narrow-body Wide-body

Source: Boeing, Airbus, Morgan Stanley Research estimates (E)

28



Backlog in comparison to EU industrials

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

Exhibit 51 Backlog visibility remains near record high

0

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2012

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

Years of backlog

Note: Represents total Boeing and Airbus backlog and deliveries. Source: Company data, Morgan Stanley Research

Exhibit 52 Most EU A&D companies have a backlog of more than three years (at current level of earnings) (in local currency bn) Backlog (Dec 2012) 2012 Revenue Backlog in no of years

EU A&D

EADS 567 55 10

Rolls-Royce 60 12 5

Safran 49 13 4

Finmeccanica 45 17 3

BAE Systems 42 19 2

Thales 30 14 2

MTU 11 3 3

Cobham 2 2 1

EU Machinery

Alfa Laval 14 30 0.5

Metso 5 8 0.6

Outotec 2 2 0.9

EU Electricals

Siemens 101 78 1.3

Alstom 53 20 2.6

ABB 30 39 0.8

Invensys 1 2 0.6

Kuka 1 2 0.5

Rotork 0.2 1 0.4 Source: Company Data, Morgan Stanley Research

29



Methodology

We asked our global airlines analysts to rank the global backlogs of Airbus and Boeing on two parameters:

1. “Ranking the backlog on financial health of airline”. This parameter looked primarily at the financial health of the airline, and ranked the airlines on a scale of 1-5 based on each airline’s ability to fulfil the order placed. A score of 5 indicates that the airline has good financial strength and is unlikely to cancel orders, and a score of 1 indicates that it may cancel its orders due to poor financial health.

2. “Ranking the backlog on likely fulfilment of order”. This parameter focuses on whether orders already placed (and therefore in the backlog) may not be fulfilled for a variety of reasons, such as:

o low traffic;

o incorrect demand forecasts;

o lack of infrastructure;

o operational issues; or

o switch in aircraft order.

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

Focus of our analysis: Using this methodology and the data that we collated, we have tried to answer questions falling into two broad categories:

Financing risks. How strong is the current backlog for Airbus and Boeing based on the financial health of the airline? How many cancellations could the two companies see due to poor financial health of the airline industry? (Answered by our Parameter 1 in the analysis)

Forecast / capacity risk. Is there a need for such a huge backlog to increase the capacity of airlines to meet traffic demand? How many cancellations could Airbus and Boeing see due to over-bookings? Will a lack of infrastructure play a role in cancellations of aircraft? Will lower increase in traffic lead to aircraft cancellations? Could incorrect demand forecasts by airlines be a reason

for cancellations?

Airbus backlog analysis

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

Europe, and it has higher exposure to developing economies such as the Middle East and Asia, together representing 55%. Airbus has a total firm order backlog of 5,102 aircraft from global airlines.

Our analysis suggests North American airlines are in good financial health and are least likely to cancel their orders for Airbus. When considering the average ranks of all the airlines across the regions, we see that the financial health of the North American airlines is very strong; these companies are least likely to cancel their Airbus orders for financing reasons. The average rank of the financial health of airlines in North America is 4.2, whereas in India it is 2.0. Airlines in India appear most vulnerable to potential order cancellations due to poor financial health of the airlines.

Exhibit 53 Breakdown of Airbus backlog by region

China4%

Middle East13%

Europe 17%

Rest of Asia30%

India8%

Latin America7%

North America21%

Source: Ascend, Morgan Stanley Research. Note: Only Firm Order Backlog

Exhibit 54 Backlog from airlines in India is most vulnerable to cancellations (poor financial health of airlines)

0.0

1.0

2.0

3.0

4.0

5.0

NorthAmerica

MiddleEast

China Rest ofAsia

LatinAmerica

Europe India

Backlog rank on financial health of airline Backlog rank on likely fulfilment of order


30



Exhibit 55 Breakdown of Airbus backlog by rank

3%5%

35%

21%

36%

3% 4%

38% 37%

18%

1 2 3 4 5

% of Backlog on financialhealth of airline

% of Backlog on likelyfulfilment of order


There is strong demand for new aircraft from the Rest of Asia and North America, which look least likely to see cancellations due to over-booking. Airlines in the Rest of Asia and North America appear least likely to cancel orders. They are not over-booked and are expected to see significant capacity expansion in the coming years. This is followed by the Middle East, where very few airlines are over-booked in terms of order placement. The average rank for airlines in Asia and North America for likely fulfilment of orders is 3.8 versus 3.4 for the Middle East, with the lowest being for India at 2.3.

We estimate ~10% of Airbus’s backlog is at risk of cancellation due to poor financial health of airlines… Looking at the backlog for airlines that ranked 1 or 2 on the financial health metric, we found that just ~10% of Airbus’s backlog is at risk and could see cancellations. We believe that, with ~€10 billion of cash available as a buffer, Airbus could cover any loss arising from cancellations by these airlines (which have a ranking of 1 or 2), with a minimal impact on the business. In contrast, we estimate that ~55% of the backlog is very strong and unlikely to see cancellations. Our analysis demonstrates the strength of the backlog and consequently earnings visibility at EADS, and gives us comfort on aircraft financing issues.

…whereas it could see cancellations of up to 10% due to over-bookings. Analysing the backlog rank for likely order fulfilment, we estimate that Airbus could see ~10% of its backlog cancelled or deferred to future years. Within this, most of the cancellations due to over-booking are expected to come from Latin America. ~70% of the Latin American backlog is expected to be cancelled due to over-bookings. Rest of Asia is expected to see only 2% of cancellations for the same reason.

Exhibit 56 Airbus conclusion matrix Financial Health of Airline Likely Fulfilment of Order

% of Backlog at highest risk 10% 10%

% of Backlog at lowest risk 55% 52%

Highest risk region (% of regional backlog at risk) India (44%) Latin America (69%)

Lowest risk region (% of regional backlog NOT at risk) North America (85%) North America (76%) Source: Ascend, Morgan Stanley Research

31



Exhibit 57 Backlog for airlines ranking 1 on financial health metric Airlines Ranked 1 for backlog on financial health of airline Region Airline Backlog India Kingfisher Airlines 92Europe SAS 30Rest of Asia Jetstar Hong Kong 17Rest of Asia Jetstar Japan 15Europe Alitalia 14Europe airberlin 12Europe TAP Portugal 12Europe Virgin Atlantic Airways 6Europe Aegean Airlines 5Latin America Mexicana 4Europe Niki 2Total 209Source: Ascend, Morgan Stanley Research

Exhibit 58 Backlog for airlines ranking 1 on likely fulfilment of order Region Airline BacklogIndia Kingfisher Airlines 92 Europe SAS 30Rest of Asia Jetstar Hong Kong 17Europe Alitalia 14Europe airberlin 12Europe TAP Portugal 12Europe Virgin Atlantic Airways 6Europe Aegean Airlines 5Latin America Mexicana 4Europe Niki 2Total 194Source: Ascend, Morgan Stanley Research

Exhibit 59 Backlog for airlines ranking 5 on financial health metric Region Airline BacklogEurope easyJet 150 North America American Airlines 130Middle East Emirates Airline 127North America ILFC 116North America Spirit Airlines 98North America GECAS 87North America JetBlue Airways 84North America CIT Aerospace 76Europe Lufthansa 59Rest of Asia Singapore Airlines 58Rest of Asia BOC Aviation 56Latin America AviancaTaca Group 51Latin America Volaris 49North America Aviation Capital Group 49Middle East Etihad Airways 43Middle East Air Arabia 27Rest of Asia Thai Airways International 14Europe Germanwings 2Europe Swiss 2Rest of Asia SilkAir 1Total 1279 Source: Ascend, Morgan Stanley Research

Exhibit 60 Backlog for airlines ranking 5 on likely fulfilment of order Region Airline BacklogEurope easyJet 150 Middle East Emirates Airline 127North America ILFC 116Middle East Turkish Airlines (THY) 105North America Spirit Airlines 98North America GECAS 87Rest of Asia Philippine Airlines 64Europe Lufthansa 59Rest of Asia Singapore Airlines 58Rest of Asia BOC Aviation 56Rest of Asia Cebu Pacific Air 52Latin America AviancaTaca Group 51Latin America Volaris 49Middle East Etihad Airways 43Rest of Asia AirAsia X 27Middle East Air Arabia 27Rest of Asia Garuda Indonesia 19Rest of Asia Tiger Airways 15Rest of Asia Thai Airways International 14Rest of Asia Thai Smile 14Rest of Asia Indonesia AirAsia 9Rest of Asia Thai AirAsia 5Rest of Asia Malaysia Airlines 3Rest of Asia AirAsia Philippines 3Europe Germanwings 2Europe Swiss 2Rest of Asia SilkAir 1Total 1256 Source: Ascend, Morgan Stanley Research

32



Exhibit 61 Airbus backlog analysis Backlog as % of Region Backlog as % of Total Backlog

Rank Parameter 1 Parameter 2 Parameter 1 Parameter 2 Parameter 1 Parameter 2

Rest of Asia 1 32 17 2% 1% 1% 0%

2 46 8 3% 1% 1% 0%

3 317 483 22% 33% 7% 10%

4 948 624 64% 42% 20% 13%

5 129 340 9% 23% 3% 7%

Latin America 1 4 4 1% 1% 0% 0%

2 44 221 14% 68% 1% 5%

3 177 0 54% 0% 4% 0%

4 0 0 0% 0% 0% 0%

5 100 100 31% 31% 2% 2%

Europe 1 81 81 10% 10% 2% 2%

2 43 18 5% 2% 1% 0%

3 491 483 58% 57% 10% 10%

4 14 47 2% 6% 0% 1%

5 213 213 25% 25% 4% 4%

North America 1 0 0 0% 0% 0% 0%

2 40 40 4% 4% 1% 1%

3 112 209 11% 20% 2% 4%

4 244 486 24% 47% 5% 10%

5 640 301 62% 29% 13% 6%

China 1 0 0 0% 0% 0% 0%

2 12 12 7% 7% 0% 0%

3 66 66 39% 39% 1% 1%

4 92 92 54% 54% 2% 2%

5 0 0 0% 0% 0% 0%

India 1 92 92 24% 24% 2% 2%

2 77 5 20% 1% 2% 0%

3 207 279 55% 74% 4% 6%

4 0 0 0% 0% 0% 0%

5 0 0 0% 0% 0% 0%

Middle East 1 0 0 0% 0% 0% 0%

2 0 0 0% 0% 0% 0%

3 312 312 51% 51% 6% 6%

4 105 0 17% 0% 2% 0%

5 197 302 32% 49% 4% 6% Note: The rankings are provided by Morgan Stanley airline analysts globally as per rating methodology described above. Source: Ascend, Morgan Stanley Research

33



Boeing backlog analysis

Boeing has higher exposure to developed economies than to developing economies (Asia and Middle East). Boeing’s backlog profile is slightly different to that of Airbus, with higher exposure to North America and Europe (55%) and lower exposure to Middle East and Asia (38%). Boeing has a total firm order backlog of 4,338 from global airlines.

Airlines in North America are in a good financial health and are least likely to cancel orders for Boeing… Airlines in North America scored the highest rank globally on financial health and are least likely to cancel orders, our analysts believe. North American airlines ranked 4.3 on average, compared with 2.3 for Indian airlines. ~40% of Boeing’s backlog is from North America, which implies greater backlog strength and fewer cancellations.

… whereas Boeing should see lower cancellations from Latin America and North America due to over-bookings. Similar to Airbus, we think Boeing is also less likely to suffer cancellations (due to over-bookings) from North America. This is followed by Latin America, where very few airlines appear over-booked in terms of order placement. The average rank for airlines in the North America for likely order fulfilment is 3.8, compared with 3.5 for Latin America, with the lowest in India at 2.3.

Of the total Boeing backlog, ~8% could be cancelled due to poor financial health of airlines… Based on the backlog for airlines ranking 1 or 2 on financial health, we estimate that 8% of Boeing’s backlog is at risk and could see cancellations. However, ~55% of the backlog is very strong and unlikely to see cancellations for financing reasons.

… whereas it could see cancellations of up to 6% due to over bookings, we estimate. Analysing the backlog rank for likely order fulfilment, we estimate that Boeing could see ~6% of its backlog cancelled. Within this, the majority of potential cancellations from over-bookings are estimated to come from India. We expect the Middle East to see a lower number of cancellations due to over-booking.

Exhibit 62 Breakdown of Boeing backlog by region

India3%

China6%

Latin America

7%

Middle East9%

Europe 18%

North America

37%

Rest of Asia20%

Source: Ascend, Morgan Stanley Research. Note: Only Firm Order Backlog

Exhibit 63 Backlog from airlines in India is most vulnerable to cancellations (poor financial health of airlines)

0.0

1.0

2.0

3.0

4.0

5.0

NorthAmerica

LatinAmerica

Rest ofAsia

China MiddleEast

Europe India

Backlog rank on financial health of airline Backlog rank on likely fulfilment of order


Exhibit 64 Breakdown of Boeing backlog by rank

3%5%

35%

21%

36%

3% 4%

38% 37%

18%

1 2 3 4 5

% of Backlog on financialhealth of airline

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Exhibit 65 Boeing conclusion matrix Financial Health of Airline Likely Fulfilment of Order

% of Backlog at highest risk (Rank 1 & 2) 8% 6% % of Backlog at lowest risk (Rank 4 & 5) 57% 56% Highest risk region (% of regional backlog at risk) India (70%) India (70%) Lowest risk region (% of regional backlog NOT at risk) North America (97%) North America (96%) Source: Ascend, Morgan Stanley Research

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

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

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

Exhibit 69 Backlog for airlines ranking 5 on likely fulfilment of order Region Airline BacklogEurope Ryanair 175North America GECAS 110Middle East Turkish Airlines (THY) 95Middle East Emirates Airline 69North America Alaska Airlines 67North America ILFC 60Rest of Asia SilkAir 54Middle East Etihad Airways 46Latin America Copa Airlines 29Rest of Asia Scoot 20Rest of Asia Thai Airways International 18Europe Lufthansa 13Rest of Asia Singapore Airlines 8Rest of Asia Royal Brunei Airlines 5Rest of Asia Malindo Air 5Rest of Asia Malindo Air 5Europe Lufthansa Cargo 5North America UPS Airlines 4Total 788 Source: Ascend, Morgan Stanley Research

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Exhibit 70 Boeing backlog analysis Backlog as % of Region Backlog as % of Total Backlog

Rank Parameter 1 Parameter 2 Parameter 1 Parameter 2 Parameter 1 Parameter 2

Rest of Asia 1 12 1 1% 0% 0% 0%

2 67 40 8% 5% 2% 1%

3 499 604 59% 71% 12% 14%

4 127 89 15% 10% 3% 2%

5 144 115 17% 14% 3% 3%

Latin America 1 0 0 0% 0% 0% 0%

2 0 0 0% 0% 0% 0%

3 252 252 85% 85% 6% 6%

4 15 15 5% 5% 0% 0%

5 29 29 10% 10% 1% 1%

Europe 1 70 70 9% 9% 2% 2%

2 45 15 6% 2% 1% 0%

3 460 464 60% 60% 11% 11%

4 0 26 0% 3% 0% 1%

5 193 193 25% 25% 5% 5%

North America 1 42 42 3% 3% 1% 1%

2 0 1 0% 0% 0% 0%

3 2 19 0% 1% 0% 0%

4 484 1297 30% 81% 11% 30%

5 1072 241 67% 15% 25% 6%

China 1 0 0 0% 0% 0% 0%

2 18 18 7% 7% 0% 0%

3 75 75 29% 29% 2% 2%

4 166 166 64% 64% 4% 4%

5 0 0 0% 0% 0% 0%

India 1 0 0 0% 0% 0% 0%

2 76 76 70% 70% 2% 2%

3 33 33 30% 30% 1% 1%

4 0 0 0% 0% 0% 0%

5 0 0 0% 0% 0% 0%

Middle East 1 0 0 0% 0% 0% 0%

2 0 0 0% 0% 0% 0%

3 192 192 48% 48% 4% 4%

4 95 0 24% 0% 2% 0%

5 115 210 29% 52% 3% 5% Note: The rankings are provided by Morgan Stanley airline analysts globally as per rating methodology described above. Source: Ascend, Morgan Stanley Research

36



Part 3: The Internationalisation of EETCs Eases Financing Concerns

EETCs poised to launch in Europe after a decade of absence

Enhanced Equipment Trust Certificates (EETCs) are a form of aircraft financing used frequently in the US but with extreme rarity in Europe. They are capital market instruments largely issued and rated on the value of the aircraft secured, rather than the creditworthiness of the airline borrower. Only four EETCs have been issued so far in Europe, by the financing vehicles of Air France and Iberia between 1999 and 2004.

Bank lending remains squeezed, enhancing the drive for EETCs As we discussed in our Blue Paper of June 2012, Commercial Aviation: Navigating a New Flight Path, the global financial crisis has reduced banks’ lending capacity and led some banks that were historically active in the aviation financing space to leave the market. Furthermore, more stringent capital requirements for banks will likely lead to a higher cost of capital in the bank market. In contrast, capital markets are open for business and could provide the deepest source of financing to the aviation industry.

The EETC market is the first choice for US airlines to finance their fleets Preferential US financing terms are available due to the existence and application of lender safeguards in Section 11101 of the US Bankruptcy Code. This entitles certain lenders to extract the aircraft in bankruptcy proceedings within 60 days of an airline filing for bankruptcy. Other jurisdictions tend not to provide such explicit insolvency protection. Since 1994, US airlines have raised nearly $67.7 billion via 138 EETC issues covering 2,036 aircraft. A recent EETC issue by US Airways in April 2013 set records by pricing below 4% yields.

Investor protection concerns previously dampened European airline EETC demand In Europe, unlike the US, there is usually no certainty as to the timeframe on insolvency or asset repossession, which makes it more challenging to obtain the desired EETC rating. In the four EETC issues to date (Air France in 2003 and Iberia in 1999, 2000, and 2004), investors required much more protection than has been seen at comparable US airline issues. This was particularly the case with the liquidity facility duration: 36 months for Air France and 36-42 months for Iberia versus the standard 18 months in US EETC issues. We think it likely that

1 http://uscode.house.gov/download/pls/11T.txt

the substantially higher costs of Air France and Iberia’s EETC issues relative to those of the US airlines, despite their generally higher credit ratings, discouraged further EETC issuance by European airlines.

Ratification of the Cape Town Convention is opening the international EETC market Insolvency provisions within an international treaty known as the Cape Town Convention offer the functional equivalent of Section 1110 to ratifying countries. The main achievement of the Convention is to bring greater certainty to repossession timeframes in a contracting state. Ratification of the Convention, already achieved by 47 signatories, is expected to enhance airlines’ access to international capital markets via EETCs. The Doric Fund launched EETCs backed by UAE aircraft in June 2012 and July 2013, and Air Canada debuted an EETC in April 2013. Both the UAE and Canada had ratified the Convention. Although the UK has yet to do so, English law is widely regarded as a stable and benign legal system where difficulties are rarely experienced with UK aircraft and financing transactions2, and this enabled IAG to launch its EETC too.

We expect firm appetite for European issued EETCs Year to date, the combined transacted volume amounts to $4,419 million versus a total 2012 volume of $4,398 million. We see potential for appetite for non-US EETCs to be even higher than for US certificates, because it should enable traditional EETC holders, which include pension funds, to diversify geographies as part of their risk management. We believe European airlines to be at the centre of this renaissance and expect this development to spark into life in 2H13 and 2014.

We use British Airways (BA) as a litmus test for EETCs The demand for fixed income investment could lead to a material reduction in borrowing costs for European airlines. Relative to other sectors, there is capital intensity and high leverage within the airline market. See the key findings of our IAG analysis later in this report.

A note on our currency assumptions: The US dollar is the base currency of aviation finance, and we have adopted it for most of our analysis here. Where an airline does not report in dollars, we have converted reported figures at calendarised average exchange rates, and forecast figures at spot rates. See notes to exhibits for details where relevant.

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

37



http://uscode.house.gov/download/pls/11T.txt



What is driving investor appetite for aircraft-backed debt?

In a long-running low interest rate environment, investors are seeking new avenues for yield Never in recent economic history have interest rates been so low across so much of the globe for so long (Exhibit 71). When rates were first cut to their current levels during 2008-09, it appeared a temporary measure; now, such rates look normal. In their search for yield, investors are rediscovering appetite for structured debt products. The emergence has been slow – in the aftermath of the 2008 banking collapse (and given its relationship with structured products) investors sought solace in investments that were perceived to be less risky. Five years on, investors appear to be restless for higher returns, particularly as real interest rates (post inflation) are negative.

Asset-backed corporate debt is seeing a revival Some $2 trillion worth of North American and European corporate bonds was issued in 2012, the highest level since 2009 (see Exhibits 72 and 73). To date this year, issuance is at 49% of 2012 levels. April 2013 saw a 4.8% yield on EUR high-yielding issuance, the lowest in a decade (Exhibit 73). Asset-backed debt is also seeing a revival, with US issuance up 5.0% in the first five months of 2013 to $85.1 billion. Global issuance of collateralised loan obligations (CLOs), a form of tranched selling of loan portfolios, stood at $44.4 billion at the five-month stage versus $15.5 billion at the same stage in 2012.

Airline asset-backed debt is increasing and diversifying EETCs are the most prevalent type of airline asset-backed debt in the US. The issuance pool has diversified, with both US (Hawaiian Airlines, May 2013) and non-US entities (Doric Fund, 2012 and 2013, and Air Canada, April 2013) debuting on the EETC market recently. There has been heavy over- subscription of recent transactions. According to Airfinance Journal (on May 30 and April 30, 2013), the recent debuts by Hawaiian Airlines and Air Canada were six and seven times over-subscribed, respectively. Turkish Airlines (26 November 2012) and Ryanair (20 May 2013 and 20 June 2013) have expressed an interest in launching debut EETCs to finance fleet deliveries.

Exhibit 71 Central bank base rates

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Source: Central banks, Morgan Stanley Research

Exhibit 72 North America and Europe corporate issuance: YTD level at 49% of 2012’s $2 trillion total

-0.20.40.60.81.01.21.41.61.82.02.22.42.6

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Exhibit 73 EUR high-yield issuance (non-financials): May 2013 yield 5.0% versus 8.3% May 2012

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Source: Markit IBoxx, Morgan Stanley Research

38



Exhibit 74 MSCI Europe Airlines Index ~200% in 18 mths: price reaction to restructures has been very favourable

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AF-KLM LUFT IAG MSCI EUROPE AIRLINES

Source: Thomson Reuters, Morgan Stanley Research

Exhibit 75 Consensus has upgraded 2015 EBIT for all names: sell-side expects 70–90% realisation of targets

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Note: AF-KLM guidance calculated as mid-point of adjusted 6-8% operating margin range with €300 million of finance cost for operating leases included, based on €28 billion revenue base. All consensus figures provided by Thomson Reuters. Source: Thomson Reuters, Morgan Stanley Research

There is appetite for European aviation-related debt Yankee issuance (a foreign issued, dollar-denominated security) from European borrowers represented close to 43% of aggregate European volume in 2012, up from 19% in 20113. Over 30% of Yankee bond issuance by volume was from the UK or Germany in 2012. US investors are keen to invest in Yankee securities because they provide attractive yields and geographic diversification without the currency risk associated with investment in debt issued outside the US. Moreover, Yankee securities are regulated by the SEC. According to Standard & Poor’s, in 2011 there was one aviation Yankee loan issuer (AWAS Aviation Group, a lessor) and one aviation- related Yankee bond issuer (Swissport International). 2012 saw two aviation Yankee loan issuers (AWAS Aviation Group and FLY Leasing) and three aviation-related Yankee bond issuers (Dufry Shop Finance, Milestone Aviation Group and Swissport International). We believe a European airline Yankee issuance would benefit from the long-term familiarity of US investors with the EETC debt structure, and the established record in debt issuance of European airlines, many of which are global brands.

The airline EETC market is boosted by industry outlook

The equity market is pricing for a healthier European airline industry by 2015 European legacy restructuring programmes (‘SCORE’ at Lufthansa, ‘Transform 2015’ at AF-KLM, and ‘Transform’ at IAG focused on the turnaround of Iberia) are likely, we think, to

3 Let’s Go Yankees! European Issuers Tap US Market’s Voracious Appetite for Yield, Standard & Poor’s, 21 March 2013

boost European airline debt attractiveness as the market expects them to restore profitability (in the case of IAG and AF-KLM, which posted operating losses in 2012) and to boost margins across the group. Airline debt attractiveness is boosted when the financial position of the obligor is expected by debt investors to improve. Share price performance and consensus estimates suggest that the market is confident that these airlines can deliver at least a very significant portion of their 2015 earnings targets (see Exhibit 74 and Exhibit 75).

Consolidation is taking place on multiple levels The European aviation industry is in the process of consolidating. Key mechanisms include i) anti-trust immune operations that enable joint operations that otherwise would be restricted under competition law; ii) airline exits (for example, Malev and Spanair in 2012) prompted by the high oil price environment and impact of the financial crisis; and iii) hub airport portfolio densification (such as IAG’s Heathrow dominance via BMI acquisition in 2012 and easyJet’s London Gatwick dominance via Flybe’s slot divestment in 2013). These actions are stimulating a reduction in capacity outlay and expectation for industry margin enhancement in the next three years.

Restructure, consolidation and new fleet can position past airline performance in the rear-view mirror American Airlines offers an extreme example of how restructuring and market consolidation can aid airline debt desirability. On 12 March 2013, it sold investment-graded EETCs while in its 15th month of bankruptcy protection (the company sought court protection on 29 November 2011). The $663 million EETC issuance included a $507 million tranche

39



priced at 4.0%, matching the then record low coupon achieved for similar airline debt by United Continental in September 2012. The sale of the EETCs was the first by an airline operating under Chapter 11 court supervision. EETC buyers may have been looking ahead to American Airlines’ upcoming merger with US Airways, which will create the world’s largest carrier by passenger traffic, and thus have been willing to invest in this new airline entity.

Attractive aircraft additions can boost EETC appetite A compelling attraction of EETCs is that the collateral can be resold worldwide, unlike almost any other collateral. In time, a new, fuel-efficient aircraft is likely to be sold on more easily than existing fleet stalwarts such as the B747 or A340, in our view. European legacy airlines are adding more efficient aircraft, including new-generation models such as the A350, A380 and B787 (Exhibit 76). This is guided to aid airline cost bases, particularly through improved fuel burn efficiency, and will also support the value of debt structures collateralised by the aircraft.

Record EETC coupons should not surprise given low benchmark rates Financial media headlines have focused on the record-low EETC coupon rates achieved recently. US Airways priced an EETC in April with a rate of 3.95% on the A tranche – the first time a sub-4% rate has been priced. Given the low interest rate environment, we would expect EETC coupon rates to contract, however. This is because the market will price the EETC in relation to the reference interest rate. Exhibit 77 shows the relationship between movement in EETC-A tranche coupons and 3-month LIBOR rates since June 2009 (the US Federal Funds rate has remained static throughout this period at 0.25%).

Investor focus should be on EETC spread rather than absolute coupon Analysis of the spread between EETC coupons and bench-mark rates gives a clearer window on the condition of the EETC market. Exhibit 78 shows the percentage point spread between reported EETC A-tranche coupon and 3-month LIBOR, with a contraction since 2009. The latest US airline A-tranche in the market at the time of writing (4.95% coupon for Hawaiian Airlines’ debut EETC on 14 May 2013) priced 445bps above LIBOR. The median EETC spread since 2009 is 570bps, with the highest being 983bps in October 2009 and the lowest 305bps in March 2012.

Exhibit 76 European legacy order books: wide-body orders dominated by new technology with double-digit unit fuel burn improvement Aircraft AF-KLM IAG Lufthansa

A320 3 19 165

A330 1 8 3

A350 25 18 A380 4 12 4B737 4

B747-8i 15B777 5 6 11B787 25 42 E190 E195 4Bombardier C 1 30Total 68 105 232Note: AF-KLM as detailed in 2012 registration document and fleet order press release as at 19 June 2013; IAG as detailed in 1Q13 and fleet order press releases as at 31 May 2013; and Lufthansa as at 14 May 2013 in conference presentation. Source: Company Data, Morgan Stanley Research

Exhibit 77 EETC coupons vs. 3-month LIBOR: benchmark rates have been a driver of EETC coupon reduction

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Exhibit 78 Spread between EETC coupon and 3-month LIBOR (pp): trend of contraction

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40



Does the market price airline EETCs correctly?

The closest proxy to the EETC is the unenhanced Equipment Trust Certificate (ETC). US and Canadian railroads have issued very significant volumes of ETCs over many decades. Railroad ETCs derive from the same jurisdictional basis as airline EETCs, with sections 1164-1174 of the US Bankruptcy Code offering similar asset protection for investors to that encased in Section 1110 for airlines. There has been a lack of recent railroad ETC issuance, however, so we cast our analytic net wider to encompass the whole of the railroad debt market, and consider how the relationship between debt credit rating and coupon compares in railroad debt versus airline EETCs.

Exhibit 79 Railroad debt coupons versus 3-month LIBOR

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Exhibit 80 Spread between railroad debt coupon and 3-month LIBOR: trading at median 190bps below airline EETC

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We see potential for EETC coupons to tighten further We ascribe numeric values to the Standard & Poor’s and Moody’s credit rating scales, whereby one equates to the lowest possible credit rating and 20 to the highest. We apply these scales to airline EETC and railroad-rated debt issued in 2012 and so far in 2013. The higher the numerical value, the higher the indicated credit quality of the debt security, and the lower we would expect the coupon to be.

Exhibit 81 illustrates the observations (using Moody’s ratings) with an R-squared value of 0.504 between credit rating and coupon. In Exhibit 82, we test the values (this time we examine S&P ratings) on the densest part of the plot scattering, which falls in the rating range of A to BB+. We note that the railroad debt coupons are skewed to lower coupons versus similarly-rated airline EETCs. At its most extreme, the difference equates to 500bps. This suggests airline EETC investors may be demanding an unwarranted premium for debt that carries similar default risk to certain railroad securities.

What could drive an EETC spread tightening? We believe two factors could cause spreads to tighten: greater liquidity and investor safety. Combined, these could transform airline EETCs into a stable credit product in the long term.

Market liquidity: Liquidity is likely to improve through i) an increase in the number of airlines undertaking EETCs; ii) an increase in issuance for refinancing of older aircraft types and not just for new deliveries; iii) emergence of new airline obligors, potentially including European flag carriers that offer new EETC investor bases; and iv) diversification into more non-pure airline issuers, such as funds (for example, Doric) and lessors (such as AWAS and ILFC).

Safety for investors: Any premium demanded by investors would lessen through actions or events that reduce the perceived risk of holding EETCs. The Cape Town Convention could be a significant step in de-risking aircraft-backed investments. The US is also a fertile ground to add to EETC case history. Moody’s decision not to downgrade American Airlines’ EETC to junk status despite the airline filing for bankruptcy in 2011, and American’s subsequent ability to issue a new EETC in 2013 while under bankruptcy court protection highlights the potential of the EETC model to protect investors from extreme changes in the underlying obligor’s legal and financial position.

41



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

y = -1.4178x + 19.477R2 = 0.5043

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

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

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

42



EETCs and debt service costs What might successful EETC issuance mean for financing costs at IAG?

Air Canada EETC coupon 30% below 2012 cost of debt Exhibit 86 shows the upgrade in debt rating that the EETC delivered to Air Canada using Moody’s methodology. The highest graded tranche was notched seven grades above the corporate rating. The coupon achieved on this A-tranche was 4.125%. On a dollar-weighted basis the mean coupon overall for the EETC equated to 4.822%. By comparison, Air Canada’s 2012 cost of debt (interest expense to average gross debt, both adjusted to exclude pensions) was 6.90%. Thus, the EETC A-tranche had a cost of debt 40% lower than the 2012 average cost of debt, and on a dollar-weighted basis the EETC had a cost of debt 30% lower than the 2012 average cost of debt.

Air Canada EETC detail

Air Canada launched an EETC, its first, on 24 April 2013. The key features of the transaction were:

• $424.4 million class A certificates (A-tranche) with an expected maturity of May 2025;

• $181.9 million class B certificates (B-tranche) with an expected maturity of May 2021; and

• $108.3 million class C certificates (C-tranche) with a bullet maturity of May 2018.

The spread paid over the benchmark Treasury for the EETC was tighter than Air Canada’s last debt listing in July 2010. The EETC C-tranche rated B (by S&P) priced with a coupon spread 592bps above Treasury, which was a tighter spread than the 749-790bps spread of the higher rated B+ bonds of 2010. The EETC A-tranche priced with a coupon of 4.125%, a spread of 176bps over the benchmark.

Exhibit 83 Air Canada ratings: EETC A-tranche is rated investment grade by all agencies Fitch Moody S&P

EETC – A A Baa3 A- EETC – B BB+ B1 BB EETC – C BB- B3 B Airline N/A WR B- Source: Thomson Reuters, Morgan Stanley Research

BA EETC coupon 30% below 2012 cost of debt from banks BA’s dollar-weighted mean coupon for its debut EETC of 4.847% was very similar to that achieved by Air Canada (Exhibit 87 and Exhibit 88). We calculate that the mean coupon was slightly higher than IAG’s 2012 average cost of debt, which we estimate at 4.7%. IAG has benefited from contracting finance lease rates, which have fallen as the benchmark rate (3-month LIBOR) has reduced (Exhibit 92) – finance lease rates have contracted from 6.15% in 1997 to 3.29% in 2012. However, IAG’s bank debt and other loans have consistently come at a higher cost to finance leases. We calculate an average cost of debt from banks and other borrowings of 7.00% in 2012 and 5.52% in 2011.

IAG could gain from replacement of bank debt with EETCs IAG has the most to gain, in our view, from directing efforts to reduce the cost of non-finance lease debt. EETCs provide a new mechanism to non-US airlines to help achieve this. In Exhibit 84, we look at various hypothetical scenarios showing the impact on IAG’s 2012 debt and service costs from an increase of EETCs in the airline’s debt mix. We assume a 4.00% EETC coupon. As previously noted, at current interest rate levels, we consider this to be a reasonable scenario. BA’s top-rated tranche launched at 4.625%. Air Canada secured an A-tranche at 4.125%. US Airways has issued at sub-4% levels.

At 20% EETC penetration, we calculate that the average cost of debt would reduce by 50bps to 4.17% with interest cost €24 million lower as a result. 20% penetration would equate to around €1 billion of EETC issuance. At 40% EETC penetration, we assume the average cost of debt would be 110bps lower at 3.57%, and €53 million would be saved on financing costs – a reduction of 23%. A ~40% long-term penetration level has precedent: Delta Airlines had $4,314 million pass-through trust and EETC proceeds outstanding as at 31 December 2012, comprising 34% of its gross debt balance.

In Exhibit 85, we take a 40% EETC penetration and flex the coupon lower from our initial 4% assumption. Versus 2012 reported, at a 3% coupon and 40% EETC mix, debt costs would be reduced to €154 million (€72 million reduction). At a 2% coupon and 40% EETC mix, the reduction would be €92 million. By way of context, the lowest-priced EETC is a US Airways April 2013 issue priced at 3.95%. Ryanair stated at its 2013 investor day on 20 June that it had received advice that it could price an EETC below 3%.

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

4.17%, €202m

3.87%, €187m

3.57%, €173m

4.67%, €226m

4.47%, €217m

€150m

€175m

€200m

€225m

€250m

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

Ann

ual i

nter

est e

xpen

se €

m

Fin Lease 63%Other 37%EETC 0%FY12 ActualFin Lease 60%

Other 30%EETC 10%

Fin Lease 60%Other 0%EETC 40%



0% to 40% EETC mix110 bps contraction€53m cost saving

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

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

3.17%, €154m

2.97%, €144m

2.77%, €134m

3.37%, €163m

3.57%, €173m

€120m

€130m

€140m

€150m

€160m

€170m

€180m

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

Ann

ual i

nter

est e

xpen

se €

m

EETC 4.00%

40% EETC mix, 4.00% to 2.00% coupon

80 bps contractionEETC 2.00%

EETC 2.50%

EETC 3.00%

EETC 3.50%

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

44



Exhibit 86 Air Canada: Illustration of rating upgrade achieved via 2013 EETC EETC A-tranche cost of debt was 40% lower than the corporate 2012 average cost of debt

MOODY'S ENTITY RATING COUPON SOURCE REDUCTIONCHANGE VS CORP COST

22 Aaa21 Aa120 Aa219 Aa318 A117 A216 A315 Baa114 Baa213 Baa3 EETC Tranche A +7 notch 4.125% Reported -2.775%12 Ba111 Ba210 Ba39 B1 EETC Tranche B 5.375% Reported -1.525%8 B2 +3 notch7 B3 EETC Tranche C 6.625% Reported -0.275%6 Caa1 Corporate rating +1 notch 6.900% MS calc FY12 cost of debt5 Caa24 Caa33 Ca2 C1 /

Source: Moody’s Investor Services, Company Data, Morgan Stanley Research

Exhibit 87 Air Canada’s April 2013 EETC debut Volume-weighted mean coupon of 4.82% compared to Air Canada’s 2012 average cost of debt of 6.9% Issuer Instrument Tranche Amount Issued $M Amount Issued €M Issue Date Maturity Coupon % Liquidity Facility Fitch Moody S&P

Air Canada EETC A 424.4 326.6 24 Apr 13 15/11/2026 4.125 18mth A Baa3 A-Air Canada EETC B 181.9 140.0 24 Apr 13 15/11/2022 5.375 18mth BB+ B1 BBAir Canada EETC C 108.3 83.3 24 Apr 13 15/05/2018 6.625 no facility BB- B3 BTotal 714.6 549.9 Weighted mean 4.822 Source: Company Data, Thomson Reuters, credit rating agencies, Morgan Stanley Research. Note: Euro conversion at spot rate of 24 April 2013 of 1.29955.

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

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Exhibit 89 BA/IAG: 2012 average cost of debt of 4.7%

-

1.00

2.00

3.00

4.00

5.00

6.00

7.00

8.00

97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12

Inte

rest

Rat

e (%

)

IAG Libor 3mth IAG median

IAG median 5.2%

Note: BA data to end December 2010, IAG data for subsequent years. Interest expense as of average debt in current and prior fiscal year. Interest costs exclude provision unwinding in 2011 and 2012. Source: Company Data, Thomson Reuters, Morgan Stanley Research

Exhibit 90 Legacy airlines rank highly in net indebtedness IAG adjusted net debt/EBITDAR 2013 4.0x, 2.7x ex-pension deficit Net Debt/EBITDAR*

13e 14e 15e

AIRA 0.4x 0.5x 0.6xAF-KLM 4.5x 3.6x 3.2xEZJ 0.4x 0.1x -0.3xIAG 4.0x 3.1x 2.3xLHA 2.4x 2.0x 1.6xRYA 0.1x NM NMTHYAO 3.4x 3.3x 3.6xMEAN 2.2x 2.1x 1.8x* EV and net debt are adjusted to include operating lease expense capitalised at 7 times and, where relevant, pension deficits. Closing prices as of 15 July, 2013. NM = Not meaningful. Source: Morgan Stanley Research estimates

Exhibit 91 Aircraft financing maturing Investor appetite has moved to the aircraft asset risk Bank Loan Mortgages ETCs/PTCsEETCs Pooled ABS

Leveraged Leasing Bankrupt EETCsWrapped tranches

CREDIT ASSETRISK RISK

Source: Wachovia Securities

Exhibit 92 BA/IAG finance lease versus bank debt annual cost As interest rates have fallen, the cost of fleet debt (finance leases & hire purchases) has contracted from 6.15% in 1997 to 3.29% in 2012

-

2.00

4.00

6.00

8.00

10.00

97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12

Inte

rest

Rat

e (%

)

Bank & Other Fin Lease Libor 3mth

Note: BA data to end December 2010, IAG data for subsequent years. Interest expense as % of average debt in current and prior fiscal year. Interest costs exclude provision unwinding in 2011 and 2012. Source: Company Data, Thomson Reuters, Morgan Stanley Research

Where could we be wrong? Risks in our approach

Ignored related effects: The effect of low rates is not confined to airline borrowing costs. In particular, lower bond yields typically increase pension costs. This could prove an offsetting factor for an airline, particularly IAG where we estimate the pension deficit at €2.5 billion post-tax as at 31 March 2013.

Benchmark rates could rise: Never in recent economic history have interest rates been so low for so long. As shown in Exhibit 77, reducing benchmark rates has driven down the cost of EETC debt. We have assumed in this Blue Paper that rates remain stable. Clearly, there is the potential for rates to rise, which could trigger an increase in corporate debt costs.

EETC rates could rise regardless of the benchmark rate movement: We do not use this report to assess the supply or demand dynamics of the EETC market, or its future direction. Events could materialise to destabilise the market. This could lead to a closure of the market to airlines and/or an increase in price to access the market. The key risk that would destabilise confidence in the EETC market, in our view, would be the inability of a holder to realise perceived collateral value backing the paper. This could arise, for example, through an inability to repossess an aircraft or a collapse in aircraft residual value.

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Anatomy of an EETC

EETCs have been the capital market instrument of choice of US airlines The large size of EETC issues relative to that of single-aircraft financings increases the liquidity of these securities, both at initial issuance and in secondary markets. EETCs also provide scale economies related to an airline’s administrative costs of raising capital for financing aircraft.

An EETC achieves a higher credit rating than its underlying issuer For the EETC to be viable, the certificates must receive an appropriate rating. The legal effectiveness of the EETC structure enables ratings higher than those of the underlying airline or railroad. EETCs allow financiers of the subject equipment to receive, under certain circumstances, current payment of principal and interest during a reorganisation process. If payment of principal and interest on such a financing is not brought and maintained current within 60 days of the bankruptcy filing, Sections 1110 and 1168 allow for a waiver of the automatic stay of Section 362 of the US Bankruptcy Code on the creditor’s ability to foreclose on and sell the collateral pledged as security. The operation of these sections is a key reason why certificates are widely expected to have significantly lower probability of default and higher recovery than debt issued directly by the underlying obligor.

An EETC is not a direct obligation of, nor guaranteed by, the underlying airline EETCs are commonly arranged using a pass-through structure in which a trust issues the certificate and then either lends the proceeds on to the airline to fund equipment purchases or directly purchases the equipment, which it then leases to the airline. Cash payments from the airline under the note or lease are sized to meet debt service for the ETC or EETC. Because of the use of this pass-through structure, the instruments are at times referred to as pass-through certificates (PTCs).

ETCs were the 1980s precursor to EETCs ETCs emerged as transactions where one or more pieces of equipment could be financed in the capital markets using the benefits of Sections 1110 and 1168. In general, aircraft ETCs where the amount of debt was less than 80% of the value of the pledged collateral could get up to two notches of rating uplift above the corporate family or senior unsecured rating of the underlying obligor; railroad ETCs with similar leverage could get up to four notches of uplift. The lower potential uplift for airlines stems from the greater uncertainty over whether they can reorganise and retain all of their financed aircraft.

EETCs emerged in the 1990s and replaced ETCs Banks developed EETCs as improved forms of the original ETC. The principal difference is that an EETC is enhanced by the existence of a liquidity facility and, in many cases, the tiering of claims against multi-asset collateral with known inter-creditor arrangements (‘tranching’ of debt). These developments further lowered the default probability and expected loss on senior tranches and allowed EETCs to achieve incremental rating benefit versus an ETC. The earliest EETC transaction was in 1994. The last rated public aircraft ETC issuance was completed by Delta in 1996.

Repossession delay is limited to 60 days As long as the underlying airline makes the required payments under the note or lease, the trusts will have funds available to meet required interest and scheduled principal payments on the related EETC. In the event of bankruptcy of the underlying obligor, the airline must determine within 60 days of the bankruptcy filing date whether it wishes to continue to use the equipment financed under the EETC. In the event that the airline does, the US Bankruptcy Code provides for the airline to bring and/or maintain current payments on the equipment notes or leases supporting the EETC. This 60-day option for the debtor to cure defaults of the underlying equipment note indentures or leases that occur pursuant to the indenture or lease terms upon the bankruptcy filing by the underlying obligor, is the main reason why the default probability of EETCs on average is expected to differ significantly from the default probability of underlying obligors. If the airline determines that it does not wish to retain the equipment, Section 1110 allows for the automatic stay, which generally precludes secured borrowers from foreclosing on collateral during a bankruptcy proceeding, to be waived. The ability of certificate holders to claim and monetise their collateral early in the bankruptcy (perhaps before meaningful erosion of value or a state of disrepair occurs) is a key reason why higher recovery is expected on average in the event of default.

EETCs (but not ETCs) are structurally enhanced by a liquidity facility This facility is available to fund interest payments (but not principal) on the EETC in the event that the underlying notes or leases from the airline is in payment default. This could occur if the airline files for bankruptcy and elects not to retain the equipment and thus ceases payments.

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Part 4: Leasing – adding stability to the OEM cycle

Leasing – an important and under-appreciated role The proliferation of aircraft lessors plays an important and, we believe, under-appreciated role in enhancing the stability of the commercial OE cycle for a number of reasons. (1) Lessors take on the residual risk associated with aircraft, reducing the risk of new aircraft orders for airlines. (2) Lessors enhance liquidity across all aircraft, but primarily across younger aircraft in demand, which encourages airlines toward the market segment to which OEMs are most closely tied. (3) The presence of lessors further diversifies an OEM’s customer base and can ‘introduce’ an OEM to new customers. (4) Lessors enhance the capital base available for financing aircraft, thereby increasing access to capital for an OEM’s customers and reducing airlines’ cost of debt, regardless of the interest rate environment. (5) Lessors increasingly represent a source of orders in themselves for the OEMs.

1. Lessors take on the residual risk associated with new aircraft, partially de-risking aircraft transactions for airlines. The strategic use of operating leases among airlines has been growing in popularity over the decades. Even when ownership is a more cost-effective solution (as may be the case for a profitable airline able to benefit from depreciation tax shields), operators increasingly feel that they should have a minimum percentage of their fleet in the form of operating leases (anecdotally, 30-40% is frequently mentioned). This is because having a mid-single-digit amount of capacity rolling off lease in any given year facilitates the airline’s ability to cut capacity if need be. This strategy has gained momentum over the past cycle as airlines have coped with an increasingly volatile macro and operating environment. In addition, operators may be reluctant to own an aircraft for its lifetime if they are uncertain about the residual value risk of the asset. However, the presence of an aircraft lessor, which absorbs this risk, may encourage an airline to transact.

2. Lessors enhance liquidity across all aircraft, but primarily across younger aircraft in demand; this encourages airlines toward the market segment to which OEMs are most closely tied. Traditionally, young, fuel-efficient narrow-body aircraft have enjoyed the most stable residual values over time. In contrast, older aircraft and cargo aircraft have experienced the most volatility in their residual values across the business cycle. This occurs for a number of reasons, including the fact that older aircraft normally carry more residual risk as they tend to depreciate faster than younger aircraft, and that older aircraft tend to be at greater risk of obsolescence when new technology is introduced, a theme that is relevant today. As a result, lessors have a clear incentive

Exhibit 93 Airlines are increasingly willing to allow lessors to manage residual value risk

0%

10%

20%

30%

40%

50%

1990

1992

1994

1996

1998

2000

2002

2004

2006

2008

2010

2012

% o

f Tot

al F

leet

Typ

e Le

ased

Widebody Narrowbody Regional Freight

Note: Chart shows annual data as of December year-end 2012. Regions with a negligible share are excluded. Source Ascend: Western Jets, Morgan Stanley Research

Exhibit 94 Aircraft asset values highly volatile across cycle

-30%

-20%

-10%

0%

10%

20%

1991

1993

1995

1997

1999

2001

2003

2005

2007

2009

2011

2013

YoY

Cha

nge

in M

arke

t Val

ue (%

)--

Narrowbody Widebody Freighter

Note: Narrow-body = MD83, 737-300, A320-200, 737-700; wide-body=767-300, 767-200, 747-400, 777-200, A330-300, A340-300; freighter = MD11F, 747-400F. Chart uses 5-year constant age aircraft for the years that aircraft of that constant age are available. Source: Aircraft Value Analysis Company, Morgan Stanley Research

to focus their activities on the younger aircraft segment – which improves airline access to capital for young aircraft in particular. Moreover, since their assets are constantly depreciating, lessors always need to be averaging into younger aircraft – a dynamic that enhances liquidity in this segment of the market. Unsurprisingly, most lessors have low average fleet ages. This reduces lease rates in this segment, all else equal, through competition as many lessors target the same asset class. This widens the delta between new and old aircraft when an airline is facing the decision of which type of aircraft to own, and it assists in insulating new aircraft from the threat of substitution from old aircraft in the secondary market.

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Exhibit 95 Older aircraft amplify a lessor’s growth hurdle, an incentive to focus on younger aircraft

0%

10%

20%

30%

1 3 5 7 9 11 13 15 17 19 21 23 25Years of Age

% o

f Net

Airc

raft

Book

Val

ue


3. The presence of lessors further diversifies an OEM’s customer base and can ‘introduce’ an OEM to new customers. Customer concentration also plays a role in aircraft lessor risk profiles and, all else equal, more customer and geographic diversification is preferred for risk management purposes. In this way, lessors and OEMs are in alignment as both benefit from a greater degree of diversity. Although we do not have data for all lessors, using the public lessors as benchmarks we can see the typical lessor is diversified across both customers and geographies. So, to the extent that a lessor is the owner of a newly ordered aircraft – through a direct order or a sale-and-leaseback transaction – this enhances the OEM’s own goals of diversification. Exhibit 96 Top 10 customers represent 30-40% of each public lessor’s fleet

-5%

5%

15%

25%

35%

45%

AER AYR FLY AL

Cus

tom

er S

hare

of F

leet

(%)

Source: Ascend: Western Jets, Morgan Stanley Research

Exhibit 97 Lessors also geographically diversified

0%

10%

20%

30%

40%

50%

AER AYR FLY AL

Cus

tom

er S

hare

of F

leet

(%)

AER = AerCap, AL = Air Lease, AYR = Aircastle, FLY = FLY Leasing. Source: Company data for 1Q13 except for AER, which is shown as YTD as of 31 December, 2012, Morgan Stanley Research

4. Lessors enhance the capital base available for financing aircraft, thereby increasing access to capital for an OEM’s customers and reducing airlines’ cost of debt, regardless of the interest rate environment. Not only is it important for a lessor to acquire attractive assets and place them with a diversified group of customers in a range of geographies, but they also need to manage the risk profile of financing these aircraft. Furthermore, aircraft lessors, particularly those that can introduce new capital into the aircraft funding complex, are often sought after by customers and suppliers alike because of their access to capital, particularly by nascent airlines. This has been especially true for EM airlines that do not have long operating histories, so find it difficult to raise capital for aircraft on their own. As a result, aircraft lessors have a clear incentive to seek out new sources of capital, to minimise their own cost of debt through being more innovative in using financing structures that may be unavailable to most airlines, and to diversify sources of financing. The lessors can sometimes access sources of capital that are not open to the airlines, given the historically low, unleveraged asset betas of the lessors. All of these points enhance the capital base available to airlines. At the same time, the aircraft leasing industry has become more fragmented. The combination of these forces – aggressively seeking new, cheap capital and increased fragmentation – is a structural change that leads to lower financing costs irrespective of the interest rate environment, which benefits the OEMs.

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Exhibit 98 Market share of top 5 lessors over time: the industry is becoming more fragmented

0%10%20%30%40%50%60%70%80%90%

100%

1974

1977

1980

1983

1986

1989

1992

1995

1998

2001

2004

2007

2010

2013

Mar

ket S

hare

(%)

Source: Ascend: Western Jets, Company data, Morgan Stanley Research

Exhibit 99 Lessors work aggressively to reduce cost of debt

0%

2%

4%

6%

8%

AL AER FLY AYR

Cos

t of D

ebt (

%)

Note: Average LTM Effective Interest Rate as of 31 March 2013 Source: Company Data, Morgan Stanley Research

Exhibit 100 Lessors have much lower asset betas, enabling them to access sources of capital that some airlines cannot

0

0.2

0.4

0.6

0.8

1

1.2

1.4

Levered Unlevered

Beta

Lessor Avg Legacy Avg

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

Exhibit 101 Lessors themselves increasingly represent demand for new aircraft at the OEMs

1,240

1,4301,576

1,851

1,367 1,404

18.5% 17.8%18.8%

18.4%17.6%

16.3%

0

500

1,000

1,500

2,000

2007 2008 2009 2010 2011 201215%

17%

19%

21%

23%

25%Planes ordered by Lessors (LHS)% of backlog (RHS)


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

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Part 5: Infrastructure: progress in addressing potential capacity constraint

Progress on easing infrastructure constraints

Markets remain concerned that long-term traffic growth could be constrained by infrastructure. We look at the recent progress seen at Rome and Istanbul airports. Both cities had several bidders for the work, showing that private capital is available so airport capacity investment need not be a burden for governments – it can actually be a source of revenue. In other places (such as Munich and London), lack of political support – as opposed to capital – has seen little progress made.

Although infrastructure can be a constraint to traffic growth in the long term... In last year’s Blue Paper, we noted that long-term traffic growth could become constrained by infrastructure. There were 1.6 billion passengers at European airports in 2012 and, assuming passenger volume growth of 3.5% per annum from 2011 to 2030 (at the average level of current industry assumptions), unrestrained demand would be around 3 billion passengers by 2030 (1.86 times the number of passengers in 2012). ACI Europe believes that 12% of this demand may not be accommodated due to lack of airport capacity, considering current plans for airport capacity expansion. In particular it believes the capacity crunch will be more acute in Turkey, the UK, the Netherlands, Bulgaria, Hungary, Germany, Poland and Italy.

We believe it is difficult to forecast capacity increases accurately, as discussion of most expansion plans typically begins only a few years before an airport faces the capacity constraint. It is therefore relevant, we think, to look at the current picture of airport capacity, to see how it has been dealt with by different countries and airports. Of Europe’s 10 largest airports, five are facing capacity constraints: London Heathrow, London Gatwick, Istanbul, Munich and Rome. Paris, Frankfurt, Amsterdam, Madrid and Barcelona, however, all have spare airport capacity. This means that, while some countries and airports have not addressed their capacity constraints quickly enough, others have. It seems fair to believe that there will always be airports with capacity constraints, but in a framework where airports compete on a European level, those that have the available capacity can absorb some of the excess demand.

Exhibit 102 Airport passenger numbers

2012 pax (mn)

London – LHR 70.0Paris – CDG 61.6Frankfurt – FRA 57.5Amsterdam – AMS 51.0Madrid – MAD 45.2Istanbul – IST 44.9Munich – MUC 38.4Rome – FCO 37.0Barcelona – BCN 35.1London – LGW 34.2Source: ACI, Morgan Stanley Research

… some airports/countries have made progress during 2012/13 on addressing capacity. Over the past year, some progress has been made in terms of addressing capacity constraints, with Rome and Istanbul being good examples:

Third Istanbul airport: The Turkish government tendered out the construction of a third Istanbul airport to a consortium led by Limak, a Turkish conglomerate. The new airport is expected to have maximum capacity for 150 million passengers, which would make it the largest airport in Europe. Construction is expected to start during 2013/14, and the first phase should be completed by 2018.

Expansion of Rome’s airports: Aeroporti di Roma’s (ADR) plans to expand the Rome airports are not new – the project involves expanding the capacity of Fiumicino airport to 100 million passengers, for a total investment of €12 billion. However, the expansion project was strongly dependent on the airport obtaining a new regulatory framework, which would allow it to have an appropriate remuneration on its investment. ADR signed this new regulatory framework during December 2012 and will operate under a pure dual-till system, enabling it to recover its cost of capital on the investment, in particular through tariff increases.

Others have been slower to address capacity constraints, and this seems to have been driven by lack of political support, rather than capital not being available. London and Munich are good examples of where there is still no plan to solve the current capacity issues. In London, the debate has lasted for several years and both a new London airport and the construction of additional runways at Heathrow or Gatwick have been discussed. However, no decisions have yet been

51



taken. In Munich, a referendum held in 2012 voted against the construction of a third runway at the airport.

Both cases suggest that it is primarily the lack of political support that is preventing the airports from expanding, especially as the airports would be able to finance the runway expansions from operations, in our view.

The tender for the third Istanbul airport also showed that private capital is available for airport investments. In fact, not only did the several bidders for the tender propose to fully fund the capital expenditure, but they also proposed to pay the government a concession fee for doing so. This suggests that expanding airport capacity investment does not necessarily need to be a burden for governments; it can actually be a revenue source.

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Appendix 1 – Commercial aviation: A 40-year review From protection to liberalisation…

When commercial aviation was in its infancy, airlines were conceived as a form of public utility and in some instances as a proud symbol of national identity. These public-service objectives overshadowed the business aspects of the industry, causing profit delivery to be a secondary target. Despite public sector motives, keeping costs and fares low were rarely primary objectives and government-owned airlines, in particular, often emphasised employment as a key goal. Regulators accepted the costs as reported by the airlines and applied a uniform rate of return to obtain an approved fare. Thus, the sector was insulated from market forces and inter-company competition. Route rights were awarded by regulators, often after lengthy hearing processes and with little regard for suitable fit with existing networks.

The 1978 US Deregulation Act cut government control over fares and domestic routes, and offered US airlines the first opportunity to prioritise business considerations. Almost 20 years after the US airline industry was deregulated, the EU implemented its final package for re-regulating the intra-EU aviation market in 1997. This ended constraints on EU carriers operating beyond member state borders and enabled an EU carrier to make unrestricted services on any given route within the EU. Low-fare start-ups easyJet and Ryanair were the first carriers to establish base airports outside their member states.

For many European airlines, direct and indirect government help has remained the last resort to stay in business. Well known listed carriers, such as Air France, Alitalia and Iberia, pledged to restructure extensively in exchange for direct government aid during the 1990s. Indirect government aid has come in numerous packages – for example, lack of fuel taxation, low landing charges at government-owned airports and credit guarantees. The abolition of existing slot rules (‘use it or lose it’) during the current industry crisis has also protected the traditional players. This has allowed aircraft to be grounded and flexible implementation of flight schedules without jeopardising valuable slot positions. Under normal circumstances, airlines would have been forced to return unused slots to the pool for redistribution.

Exhibit 103 State aid and capital injections for European airlines – pre September 2001 Capital Injection $mn State-owned Sabena (1991) 1,800 Iberia (1992) 830 Aer Lingus (1993) 240 TAP Portugal (1994) 1,965 Air France (1994) 3,300 Olympic (1994) 2,245 Alitalia (1997/2004) 2,208 Not classified as state aid Air France (1991) 338 Sabena (1995) 267 Iberia (1995) 593 Private sector BA (1993) 690 KLM (1994) 620 Lufthansa* (1994) 710 Finnair (1992/4/5) 175 * German government also contributed ~€800 million to the Lufthansa pension fund in 1995. Source: Morgan Stanley Research

1990 brought a seminal event in the shape of the first Gulf War. This combined the use of airlines as a target for terrorist attacks with an oil price shock due to constraints on oil production from the Middle East. 1991 saw the first decline in year-on-year growth in world airline traffic as passengers avoided travelling. The demand shock was combined with a fuel price hike after the invasion of Kuwait, leading to a four- year period (1990-94) when the global airlines recorded a collective loss of $20.4 billion, of which US carriers accounted for $11 billion. Of the 12 largest US carriers, five declared bankruptcy, with two ending up being liquidated. The financial situation was exacerbated by over-ordering of aircraft during the 1980s, which led to excessive capacity in the market in the early 1990s.

In post mid-1990s recovery, the industry began to turn towards cost control and away from the elusive quest for market share. IT advances also enabled dynamic pricing systems to be introduced so that traffic growth could be accommodated with more modest capacity outlay. Profit and shareholder value became more prominent objectives, although they remained difficult to deliver.

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… but plagued by low returns and value destruction

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

Suppliers and other industries in the air transport value chain do generate sufficient profits to pay investors a normal return, in some cases with returns on capital well into double figures. However, airlines stand out in the value chain as earning the lowest returns and bearing virtually the highest risk. The most profitable sectors in the value chain are relatively small compared to the capital invested in the airlines.

Today, over $500 billion of investors’ capital is tied up in the airline industry. In a ‘normal’ industry investors would earn at least the cost of capital, implying a return of $40 billion per year. In fact, over the past decade investors have seen their capital earn $20 billion per year less than it would have earned if invested elsewhere. Even at the top of the last cycle, over $9 billion of investor value was destroyed. Over the last 40 years, the global aviation industry has delivered an average net margin of just 0.1%4. Even in 2010, the best year of the last decade, the global industry’s $18 billion net profit equated to a margin of 3.2% versus a cost of capital estimated at 7-8%.

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

4 IATA, “Vision 2050”, 12 February 2011

Exhibit 104 Global airline profitability since 1970

Source: ICAO, IATA, Morgan Stanley Research

Exhibit 105 Air traffic RPKs have expanded tenfold in 40 years

100

300

500

700

900

1100

1970 1974 1978 1982 1986 1990 1994 1998 2002 2006 2010

World GDP World scheduled RPKs World Trade Source: ICAO, IATA, Haver, Morgan Stanley Research

Exhibit 106 ROIC has persistently lagged WACC for the sector

Source: IATA Economics and forecasts

54



Consistently low airline industry profits over the past 40 years aggregate a wide variety of performances. There have been a small number of airlines that have performed far better than average. During the 2000s the average airline generated an EBIT margin of just 0.7%. Excluding small airlines, fewer than 15 managed to produce an average EBIT margin in excess of 8%. Most fail to earn their cost of capital over business cycles of 8-10 years. This is despite operational streamlining often through outsourcing activities such as maintenance and handling), cutting non-core routes, more sophisticated yield management, increased load factors, the emergence of ancillary revenues and forging global alliances, which now command anti-competition immunity on certain routes.

The weighted average cost of capital for the average airline in normal times is 7-8%. For the typical airline, it takes a dollar of invested capital to generate a dollar of revenue each year. So, to generate a return on capital equal to its cost – really the minimum investors will expect – airlines need to generate earnings as a percentage of revenues – that is, an EBIT margin of 8% or more. However, EBIT needs to be adjusted for accounting distortions such as operating leases and some hedging instruments. Consistently low airline industry profits over the past 40 years aggregate a wide variety of performances. A small number of airlines have performed far better than average. During the 2000s the average airline generated an EBIT margin of just 0.7%. Excluding small airlines, fewer than 15 managed to produce an average EBIT margin of more than 8% (such as Ryanair, Copa, Allegiant, Emirates, Turkish Airlines, Singapore Airlines and Southwest).

Analyst Global Trend Summary

The US: Recent trends have been somewhat lacklustre, with much of 2Q13 passenger revenue per available seat mile (PRASM) underperforming expectations. That said, most US airlines reported a pick-up in PRASM in June, which bodes well for the summer. We think PRASM will continue to accelerate into the summer – hence our Attractive view on the US Airline industry, which is based on: continued capacity restraint; a backdrop of sluggish GDP and high fuel prices tempering competitive pressure; healthier balance sheets, cash flow and capital returns; M&A; and relatively attractive valuations. We do not believe that the industry has completely ‘restructured’ or is permanently different, but we do firmly believe the industry’s structure has improved enough to amplify both the length and breadth of the current cycle versus prior ones (barring a macro shock). To be bullish on the cycle is to prefer legacy airlines; our top picks are Delta Air Lines and United Continental Holdings (both Overweight), but among the low-cost carriers we prefer Allegiant Travel (Equal-weight) and Spirit Airlines

(Overweight) to the old guard of Southwest Airlines and JetBlue Airways (both Underweight).

Europe and Turkey: Short-haul traffic trends remain robust in cross-border Europe, and pricing development was solid into the Easter trading period. Most airlines have reported continued growth in load factors during the 2Q13 as well. On the long-haul side, divergent performance continues between the transatlantic and Asian routes – US routes show good volume and pricing trends, whereas volumes to Asia have been more sluggish, with many carriers citing increased pricing competition from Asia-based players. Low-cost carriers have been the clear outperformers in Europe thanks to sustained performance in yield momentum, driven by a combination of price rises at the legacy airlines and capacity withdrawals from the smaller regional carriers.

We are seeing strong booking trends into the summer season and, coupled with a relatively steady fuel price environment, see this as broadly positive for the sector. We identify three key focal points into year-end: a) review of short-haul capacity planning into the winter season – several carriers have indicated they will undertake route reviews (AF-KLM, Alitalia, LOT are some key examples); b) progress on cost-cutting programmes at the legacy carriers – the major three (AF-KLM, IAG and Lufthansa) each have ambitious 2015 profitability goals that are largely focused on labour, fleet and back-office restructuring; and c) updates in the regulatory and taxation environment in Europe – many carriers have been disappointed by austerity-related taxes levied via air traffic charges or rate changes at airports. As many EU countries are still in the deleveraging process, we see further tax rises as a potential risk issue for the sector. Our key stock picks are easyJet, Ryanair and IAG (all rated Overweight).

Turkish carriers have enjoyed strong growth momentum, with high demand driving an increase in load factors of +3.5 percentage points to ~79% for Turkish Airlines in 1H and +4 percentage points to 78.3% for Pegasus in 1Q13 on significant capacity growth. We expect THY’s traffic to continue to grow strongly in 2H13 and rate the stock Overweight, given positive yield inflection trends with 1Q13 yields up year on year after six quarters of negative yields; and strong traffic growth and load factor improvement.

Latin America: Brazilian airlines continue to cut capacity to raise profitability as cost pressures rise. Both Gol Airlines and Latam Airlines have reported improved passenger revenue per available seat kilometre (PRASK), through higher yields at Gol and higher load factors at Latam), and this is particularly important given the recent rapid devaluation of the Brazilian

55



Real versus the US dollar. We expect deeper capacity cuts than airlines had previously planned, due in part to a growing FX overhang and a moderate traffic growth outlook given our economists’ soft GDP forecast.

In Mexico, air traffic has been fairly healthy, as seen in high-single-digit to low-double-digit passenger increases at major airports. The healthiest region remains Central America, served by Copa Airlines. We expect low-cost carriers to continue to take share and believe that Copa’s targeted growth strategy will drive profit growth there. Consistent with these views, we are Overweight on Copa due to its solid fundamentals, with high growth and margins, but less optimistic about other airlines in the space.

China/Hong Kong: In 1H13, Chinese airlines achieved robust traffic (RPK) momentum, with 12% growth year on year and a 0.7 percentage point improvement in passenger load factor to 82%, in line with our expectations. However, we were surprised by a sharp decline in domestic passenger yield in 2Q13, especially a 10% year-on-year slump for all airlines. We attribute this to several factors: 1) Macro weakness – Chinese GDP growth slowed to 7.7% year on year in 1Q and 7.5% in 2Q, and domestic consumption growth also slowed down, implying lower demand for air travel. 2) Negative government policies – more stringent restrictions on official spending have led to a ~20% contraction in travel demands for first/business class. 3) Exogenous events: avian flu (H7N9) and the Sichuan earthquake in 2Q13 also slowed down air travel demands. 4) Traffic diversion from high-speed rail – Beijing-Guangzhou, Guangzhou-Shenzhen and Beijing-Shanghai high-speed rail links began operation, and pricing competition intensified. We therefore expect a challenging environment in 4Q13 after the traditional summer peak, with no sign of recovery.

Risks of a renminbi depreciation and/or an oil price rebound in 2H13, if they materialised, would serve as major negative factors for Chinese/Hong Kong airlines. Finally, we are increasingly concerned about competition from high-speed rail trains, which offer discounts on major routes (Beijing-Shanghai, Beijing-Guangzhou and Guangzhou-Shenzhen) for business and first-class passengers, effective from July 10, 2013. Therefore, we are Underweight on Cathay Pacific, China Eastern, China Southern and Air China.

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

yen depreciation and rising crude oil prices will push back profit growth in F3/14, although much of this negativity already appears priced into stocks, given recent underperformance.

Australia trends: Domestic capacity appears to be moderating, with both Qantas and Virgin Australia targeting 3-5% ASK growth from July to December 2013 (versus 8-10% over the previous 12 months). However, leisure demand has been softening as the Australian economy, showing increasing signs of stress, and corporate travel also appears to be slowing. To put this into context, as general mining activity slows, mining travel (a combination of production and exploratory work) make up ~50% of AMEX Corporate Travel's total volume in the region. Further capacity curtailment is required to keep yield growth positive and stabilise profits. We expect uncertainty to persist in the domestic market over the next six months, driven by Virgin Australia taking 60% ownership in Tiger Australia (which needs to increase scale in order to lower unit costs and reverse its losses); the outlook for corporate travel showing early signs of deterioration; and swings in the Australian dollar (a lower AUD has a negative impact on profitability, but could see foreign airlines start to withdraw capacity in/out of Australia), which could help Qantas’ international market share. Within this context, we are Overweight on Qantas and Equal-weight on Virgin Australia.

Exhibit 107 Sequential change in monthly global RPK

-15%

-10%

-5%

0%

5%

10%

15%

20%

25%

Jan

Feb Mar AprMay Ju

n Jul

Aug Sep OctNov Dec

Current

+/- 1 Std. Dev.

Average

Note: Based on data starting in 2002. Data adjusted for leap year and Chinese New Year. Source: IATA, Morgan Stanley Research

56



Exhibit 108 Sequential change in monthly ASK

-10%

-5%

0%

5%

10%

15%

Jan

Feb Mar AprMay Ju

n Jul

Aug Sep OctNov Dec

Current

+/- 1 Std. Dev.Average

Note: Based on data starting in 2002. Data adjusted for leap year and Chinese New Year. Source: IATA, Morgan Stanley Research

Exhibit 109 Global PLF long-term trend

-10

-8

-6

-4

-2

0

2

4

6

8

10

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

40%

45%

50%

55%

60%

65%

70%

75%

80%

85%

90%

YoY Pt Change (LHS)PLF (RHS)12 per. Mov. Avg. (PLF (RHS))

Note: Data adjusted for leap year. Source: IATA, Morgan Stanley Research

Exhibit 110 Global RPK long-term trend

-30%

-20%

-10%

0%

10%

20%

30%

40%

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

0

100

200

300

400

500

600

YoY % Change (LHS)RPK (RHS)12 per. Mov. Avg. (RPK (RHS))


Exhibit 111 Global ASK long-term trend

-15%

-10%

-5%

0%

5%

10%

15%

20%

25%

30%

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

200

250

300

350

400

450

500

550

600

650

YoY % Change (LHS)ASK (RHS)12 per. Mov. Avg. (ASK (RHS))


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Appendix 2 – Airbus & Boeing installed fleet analysis Exhibit 112 Current Airbus installed base by age Up to 5 years 6-10 years 11-20 years 21-30 years > 30 years Total

A300 25 30 4 59A310 11 44 55A320 Family 2,155 1,374 1,393 216 5,138A330 408 257 221 2 888A340 25 108 175 3 311A380 95 8 103Total 2,683 1,747 1,825 295 4 6,554% of Total 41% 27% 28% 5% 0% Source: Ascend

Exhibit 113 Current Boeing installed base by age Up to 5 years 6-10 years 11-20 years 21-30 years > 30 years Total

717 33 112 145727 3 20 23737 Family 1,893 1,162 1,671 482 91 5,299747 6 14 222 125 12 379757 27 386 235 8 656767 53 48 348 225 5 679777 333 262 414 1,009787 50 50DC-9 2 42 44MD-80 99 423 8 530MD-90 68 68Total 2,335 1,546 3,320 1,495 186 8,882% of Total 26% 17% 37% 17% 2% Source: Ascend

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Exhibit 114 Current Airbus installed base by region Africa Asia Pacific China Europe India Latin America Middle East North America Total

A300 4 9 6 3 37 59A310 15 11 19 10 55A320 Family 124 697 763 1,813 149 437 263 892 5,138A330 28 292 110 215 16 36 112 79 888A340 32 46 12 157 16 48 311A380 47 5 18 33 103Total 188 1,106 896 2,217 165 489 512 981 6,554% of Total 3% 17% 14% 34% 3% 7% 8% 15% Source: Ascend

Exhibit 115 Current Boeing installed base by region Africa Asia Pacific China Europe India Latin America Middle East North America Total

717 19 20 106 145727 7 3 4 5 4 23737 Family 289 805 743 1,319 135 387 98 1,523 5,299747 9 116 8 147 4 49 46 379757 9 28 32 126 6 2 453 656767 32 169 11 110 54 13 290 679777 26 363 31 185 24 12 203 165 1,009787 4 24 2 6 3 5 6 50DC-9 10 1 10 23 44MD-80 18 23 44 31 43 371 530MD-90 11 1 56 68Total 404 1,562 825 1,953 169 507 419 3,043 8,882% of Total 5% 18% 9% 22% 2% 6% 5% 34% Source: Ascend

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Appendix 3 – Airbus and Boeing backlog analysis Exhibit 116 Airbus’s current backlog by delivery year 2013 2014 2015 2016 >2016 Total

A320 Family 286 450 501 388 2,296 3,921A330 66 89 42 8 29 234A350 7 37 55 517 616A380 19 31 35 30 44 159Total 371 577 615 481 2,886 4,930% of Total 8% 12% 12% 10% 59% Source: Ascend

Exhibit 117 Boeing’s current backlog by delivery year 2013 2014 2015 2016 >2016 Total

737 Family 308 386 402 307 1,760 3,163747 4 11 11 26767 6 2 8777 61 68 64 31 70 294787 71 130 126 135 379 841Total 450 597 603 473 2,209 4,332% of Total 10% 14% 14% 11% 51% Source: Ascend

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Exhibit 118 Airbus’s current backlog by customer region Africa Asia Pacific China Europe India Latin America Middle East North America Unknown Total

A320 Family 34 1132 220 691 346 306 240 890 62 3921A330 13 102 20 24 20 6 12 34 3 234A350 29 183 10 68 5 37 178 105 1 616A380 2 41 33 5 77 1 159Total 78 1458 250 816 376 349 507 1029 67 4930% of Total 2% 30% 5% 17% 8% 7% 10% 21% 1% Source: Ascend

Exhibit 119 Boeing’s current backlog by customer region Africa Asia Pacific China Europe India Latin America Middle East North America Unknown Total

737 Family 23 528 211 438 75 238 84 1301 265 3163747 2 5 5 13 1 26767 6 2 8777 8 85 6 38 3 4 85 28 37 294787 29 189 35 153 31 59 127 191 27 841Total 62 813 257 642 109 303 296 1520 330 4332% of Total 1% 19% 6% 15% 3% 7% 7% 35% 8% Source: Company Data, Morgan Stanley Research

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Appendix 4 – Airbus global market forecasts Exhibit 120 New passenger deliveries by region

2012-2021 2022-2031 2012-2031

% of World Deliveries

(2011-2020)


(2021-2030)


(2011-2030)

Asia Pacific 4,505 5,113 9,618 35% 35% 35%Europe 2,815 2,886 5,701 22% 20% 21%North America 2,580 3,271 5,851 20% 23% 21%Latin America 1,004 1,081 2,085 8% 7% 8%Middle East 1,007 899 1,906 8% 6% 7%Africa 413 544 957 3% 4% 3%CIS 492 737 1,229 4% 5% 4%World demand 12,816 14,531 27,347 100% 100% 100%Source: Company Data, Morgan Stanley Research

Exhibit 121 36% of deliveries will be in Asia through 2031

Europe 21%

North America

21%

Latin America

8%

Middle East 7%

Africa3%

CIS4%

Asia Pacif ic36%


Exhibit 122 Of total deliveries, 69% are expected to be single-aisle

Small twin aisle, 4518, 17%

Intermediate twin aisle, 1907, 7%

Large aircraft, 1331, 5%

Single Aisle, 19165, 71%


Exhibit 123 70% of traffic is expected to be in growth markets

24%

37%

57%

70%76%

63%

43%

30%

1970 1990 2010 2030

Rest of World Traffic Within & between USA, Canada, Western Europe, & Japan


Exhibit 124 Highest RPK to be in Asia Pacific

Europe23%

North America

20%

Middle East11%

Asia Pacific33%

Africa3%

CIS4%

Latin America

6%


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Exhibit 125 LCC traffic to increase to 19% (from 15%) by 2030

5% 5%10%

5%

15%

4% 3%

10%

4%

20%

60% 59%

Regional &Affiliate

Charter GlobalNetwork

MajorNetwork

SmallNetwork

Low CostCarriers

2011 RPK 2031e RPK

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

Exhibit 126 US to take the lion’s share of deliveries

Country No. of

Aircraft Country In Billion

USD

USA 5,289 PRC 634.0PRC 4,272 USA 544.0India 1,232 UAE 223.9Germany 986 India 173.7UK 979 Germany 137.1Russia 958 UK 129.8UAE 882 Russia 113.7Brazil 781 Australia 102.1Ireland 702 Brazil 100.1Australia 652 Japan 98.2Source: Company Data, Morgan Stanley Research

Exhibit 127 New deliveries by region

0

2000

4000

6000

NorthAmerica

Europe CIS MiddleEast

Africa AsiaPacific

LatinAmerica

Single-aisle aircraft Twin-aisle aircraft Very large aircraft


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Appendix 5 – Boeing’s global market forecasts Exhibit 128 Boeing’s market delivery forecast, 2012-31 Region Aeroplanes % of World DeliveriesAsia Pacific 12,030 35%Europe 7,290 21%North America 7,760 23%Middle East 2,370 7%Latin America 2,510 7%C.I.S. 1,140 3%Africa 900 3%Total 34,000 100%Source: Company Data, Morgan Stanley Research

Exhibit 129 About one-third of deliveries to be in Asia Pacific

Asia Pacific36%

Europe21%

North America23%

Middle East7%

Latin America7%

C.I.S.3%

Africa3%


Exhibit 130 Airline traffic distribution by region in 2011

Asia Pacific

North America Europe

Middle East

Latin America Africa

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

Exhibit 131 Some 70% of deliveries expected to be single-aisle

Large2%

Tw in-aisle23%

Single-aisle69%

Regional Jets6%


Exhibit 132 …and airline traffic distribution by region in 2031

Asia Pacific

North America Europe

Middle East

Latin America Africa

Asia Pacific 61% 19% 22% 44% 1% 10%North America 11% 39% 21% 10% 31% 5%Europe 15% 24% 30% 24% 26% 43%Middle East 12% 4% 10% 13% - 19%Latin America - 13% 9% - 41% 2%Africa 1% 1% 8% 9% 1% 21%All traffic to/from region 100% 100% 100% 100% 100% 100%Source: Company Data, Morgan Stanley Research

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

Recently Published Blue Papers

Emerging Markets What If the Tide Goes Out? June 13, 2013

Releasing the Pressure from Low Yields Should Insurers Consider Re-risking Investments? March 15, 2013

Japan and South Korea The Yen Tide Does Not Lift All Boats May 30, 2013

Global Autos Clash of the Titans: The Race for Global Leadership January 22, 2013

Global Steel Steeling for Oversupply May 23, 2013

Big Subsea Opportunity Deep Dive January 14, 2013

US Manufacturing Renaissance Is It a Masterpiece or a (Head) Fake? April 29, 2013

eCommerce Disruption: A Global Theme Transforming Traditional Retail January 6, 2013

Natural Gas as a Transportation Fuel Energy Market Wild Card April 16, 2013

China – Robotics Automation for the People December 5, 2012

Global Semiconductors Chipping Away at Returns April 15, 2013

Global Emerging Market Banks On Track for Growth November 19, 2012

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Wholesale & Investment Banking Outlook Global Banking Fractures: The Implications April 11, 2013

Social Gambling Click Here to Play November 14, 2012

Key Secular Themes in IT

Monetizing Big Data September 4, 2012

The China Files The Logistics Journey Is Just Beginning April 24, 2012

Chemicals ‘Green is Good’ – The Potential of Bioplastics August 22, 2012

Solvency The Long and Winding Road March 23, 2012

MedTech & Services Emerging Markets: Searching for Growth August 6, 2012

Wholesale & Investment Banking Outlook Decision Time for Wholesale Banks March 23, 2012

Commercial Aviation Navigating a New Flight Path June 26, 2012

Banks Deleveraging and Real Estate Implication of a €400-700bn Financing Gap March 15, 2012

Mobile Data Wave Who Dares to Invest, Wins June 13, 2012

The China Files China’s Appetite for Protein Turns Global October 25, 2011

Global Auto Scenarios 2022 Disruption and Opportunity Starts Now June 5, 2012

The US Healthcare Formula Cost Control and True Innovation June 16, 2011

Tablet Landscape Evolution Window(s) of Opportunity May 31, 2012

Cloud Computing Takes Off Market Set to Boom as Migration Accelerates May 23, 2011

Any

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Financials: CRE Funding Shift EU Shakes, US Selectively Takes May 25, 2012

China High-Speed Rail On the Economic Fast Track May 15, 2011

Asian Inflation Consumers Adjust As Inflation Worsens March 31, 2011

The China Files European Corporates & China’s Megatransition

October 29, 2010

Wholesale & Investment Banking Reshaping the Model March 23, 2011

Petrochemicals Preparing for a Supercycle

October 18, 2010

Global Gas A Decade of Two Halves March 14, 2011

Solvency 2 Quantitative & Strategic Impact, The Tide is Going Out

September 22, 2010

Tablet Demand and Disruption Mobile Users Come of Age February 14, 2011

The China Files US Corporates and China’s Megatransition

September 20, 2010

The China Files Chinese Economy through 2020 November 8, 2010

Brazil Infrastructure Paving the Way

May 5, 2010

The China Files Asian Corporates & China’s Megatransition

November 8, 2010

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

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

M O R G A N S T A N L E Y B L U E P A P E R Morgan Stanley & Co. Limited (“Morgan Stanley”) is acting as financial advisor to International Consolidated Airlines Group, S.A. (“IAG”) in connection with IAG’s announcement on November 8, 2012, that IAG’s wholly owned subsidiary Veloz Holdco, S.L. (Sociedad Unipersonal) intends to launch a tender offer for 100% of the share capital of Vueling Airlines, S.A.. IAG has agreed to pay fees to Morgan Stanley for its professional services. Please refer to the notes at the end of the report.

Morgan Stanley is currently acting as financial advisor to JetBlue Airways Corporation (“JetBlue”) in regards to its review of strategic alternatives for its wholly owned subsidiary, LiveTV. JetBlue has agreed to pay fees to Morgan Stanley for its financial services, including transaction fees that are subject to the consummation of any resulting transaction. Please refer to the notes at the end of the report.

Morgan Stanley & Co. Limited is acting as financial adviser to Ryanair Holdings plc in relation to the proposed cash offer for Aer Lingus Group plc. Morgan Stanley & Co International plc acts as corporate broker to Ryanair Holdings plc. Please refer to the notes at the end of the report.

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M O R G A N S T A N L E Y B L U E P A P E R Disclosure Section Share prices for stocks mentioned as of close on July 18, 2013: , ADP Aeroports de Paris €77.62, Air China HK$5.32, Air Lease $28.50, Allegiant Travel $106.03, B/E Aerospace $69.99, Boeing $107.63, Cathay Pacific HK$13.24, China Eastern HK$2.41, China Southern HK$2.90, Copa Holdings $104.58, Delta Air Lines $20.56, Deutsche Lufthansa €15.35, EADS €42.22, easyJet 1, 406p, Flughafen Zurich SFr 497.25, General Electric $23.63, Gol Airlines $3.61, Honeywell $82.97, International Consolidated Airlines Group €3.29, JetBlue Airways $6.83, Latam Airlines $15.07, MTU Aero Engines €72.12, Qantas A$1.33, Rolls-Royce 1,200p, Ryanair €7.33, Safran €43.25, Southwest Airlines $13.78, Spirit AeroSystems $23.51, Spirit Airlines $34.17, TransDigm $138.75, Turkish Airlines TL8.06, United Continental Holdings $34.49, United Technologies $101.34, Vienna International Airport €45.56 and Virgin Australia A$0.47.

Morgan Stanley & Co. International plc, authorized by the Prudential Regulatory Authority and regulated by the Financial Conduct Authority and the Prudential Regulatory Authority, disseminates in the UK research that it has prepared, and approves solely for the purposes of section 21 of the Financial Services and Markets Act 2000, research which has been prepared by any of its affiliates. As used in this disclosure section, Morgan Stanley includes RMB Morgan Stanley (Proprietary) Limited, Morgan Stanley & Co International plc and its affiliates. For important disclosures, stock price charts and equity rating histories regarding companies that are the subject of this report, please see the Morgan Stanley Research Disclosure Website at www.morganstanley.com/researchdisclosures, or contact your investment representative or Morgan Stanley Research at 1585 Broadway, (Attention: Research Management), New York, NY, 10036 USA. For valuation methodology and risks associated with any price targets referenced in this research report, please email [email protected] with a request for valuation methodology and risks on a particular stock or contact your investment representative or Morgan Stanley Research at 1585 Broadway, (Attention: Research Management), New York, NY 10036 USA. Analyst Certification The following analysts hereby certify that their views about the companies and their securities discussed in this report are accurately expressed and that they have not received and will not receive direct or indirect compensation in exchange for expressing specific recommendations or views in this report: Penelope Butcher, Nigel Coe, John Godyn, Rupinder Vig. Unless otherwise stated, the individuals listed on the cover page of this report are research analysts. Global Research Conflict Management Policy Morgan Stanley Research has been published in accordance with our conflict management policy, which is available at www.morganstanley.com/institutional/research/conflictpolicies. Important US Regulatory Disclosures on Subject Companies As of June 28, 2013, Morgan Stanley beneficially owned 1% or more of a class of common equity securities of the following companies covered in Morgan Stanley Research: Copa Holdings, EADS, Gol Airlines, Honeywell International, International Consolidated Airlines Grp, JetBlue Airways, Rolls-Royce, Ryanair, Safran, TransDigm Group Inc.. Within the last 12 months, Morgan Stanley managed or co-managed a public offering (or 144A offering) of securities of Boeing Co., EADS, General Electric Co., Gol Airlines, International Consolidated Airlines Grp, TransDigm Group Inc., United Continental Holdings, Inc.. Within the last 12 months, Morgan Stanley has received compensation for investment banking services from B/E Aerospace Inc, BAE SYSTEMS, Boeing Co., Delta Air Lines, Inc., Deutsche Lufthansa AG, EADS, easyJet, Finmeccanica, General Electric Co., Gol Airlines, Honeywell International, International Consolidated Airlines Grp, JetBlue Airways, Qantas Airways, Ryanair, Safran, Southwest Airlines, Spirit AeroSystems Holdings Inc, Spirit Airlines Inc., TransDigm Group Inc., United Continental Holdings, Inc., United Technologies Corp. In the next 3 months, Morgan Stanley expects to receive or intends to seek compensation for investment banking services from ADP (Aeroports de Paris), Air China Ltd., Air Lease Corp, Allegiant Travel, B/E Aerospace Inc, BAE SYSTEMS, Boeing Co., Cathay Pacific Airways, China Eastern Airlines, Cobham, Copa Holdings, Delta Air Lines, Inc., Deutsche Lufthansa AG, EADS, easyJet, Finmeccanica, Flughafen Zurich (Unique), General Electric Co., Gol Airlines, Honeywell International, International Consolidated Airlines Grp, JetBlue Airways, Latam Airlines Group SA, MTU Aero Engines Holding, Qantas Airways, Ryanair, Safran, Southwest Airlines, Spirit AeroSystems Holdings Inc, Spirit Airlines Inc., Thales SA, TransDigm Group Inc., Turkish Airlines, United Continental Holdings, Inc., United Technologies Corp, Vienna Int'l Airport. Within the last 12 months, Morgan Stanley has received compensation for products and services other than investment banking services from ADP (Aeroports de Paris), Air Lease Corp, B/E Aerospace Inc, BAE SYSTEMS, Boeing Co., Cathay Pacific Airways, Copa Holdings, Delta Air Lines, Inc., Deutsche Lufthansa AG, EADS, easyJet, Finmeccanica, General Electric Co., Gol Airlines, Honeywell International, International Consolidated Airlines Grp, JetBlue Airways, Qantas Airways, Rolls-Royce, Ryanair, Safran, Southwest Airlines, Spirit AeroSystems Holdings Inc, TransDigm Group Inc., Turkish Airlines, United Continental Holdings, Inc.. Within the last 12 months, Morgan Stanley has provided or is providing investment banking services to, or has an investment banking client relationship with, the following company: ADP (Aeroports de Paris), Air China Ltd., Air Lease Corp, Allegiant Travel, B/E Aerospace Inc, BAE SYSTEMS, Boeing Co., Cathay Pacific Airways, China Eastern Airlines, Cobham, Copa Holdings, Delta Air Lines, Inc., Deutsche Lufthansa AG, EADS, easyJet, Finmeccanica, Flughafen Zurich (Unique), General Electric Co., Gol Airlines, Honeywell International, International Consolidated Airlines Grp, JetBlue Airways, Latam Airlines Group SA, MTU Aero Engines Holding, Qantas Airways, Ryanair, Safran, Southwest Airlines, Spirit AeroSystems Holdings Inc, Spirit Airlines Inc., Thales SA, TransDigm Group Inc., Turkish Airlines, United Continental Holdings, Inc., United Technologies Corp, Vienna Int'l Airport. Within the last 12 months, Morgan Stanley has either provided or is providing non-investment banking, securities-related services to and/or in the past has entered into an agreement to provide services or has a client relationship with the following company: ADP (Aeroports de Paris), Air China Ltd., Air Lease Corp, Allegiant Travel, B/E Aerospace Inc, BAE SYSTEMS, Boeing Co., Cathay Pacific Airways, China Eastern Airlines, China Southern Airlines, Copa Holdings, Delta Air Lines, Inc., Deutsche Lufthansa AG, EADS, easyJet, Finmeccanica, General Electric Co., Gol Airlines, Honeywell International, International Consolidated Airlines Grp, JetBlue Airways, Latam Airlines Group SA, Qantas Airways, Rolls-Royce, Ryanair, Safran, Southwest Airlines, Spirit AeroSystems Holdings Inc, Thales SA, TransDigm Group Inc., Turkish Airlines, United Continental Holdings, Inc., United Technologies Corp. Morgan Stanley & Co. LLC makes a market in the securities of Air Lease Corp, Allegiant Travel, B/E Aerospace Inc, Boeing Co., China Southern Airlines, Copa Holdings, Delta Air Lines, Inc., General Electric Co., Gol Airlines, Honeywell International, JetBlue Airways, Latam Airlines Group SA, Ryanair, Southwest Airlines, Spirit AeroSystems Holdings Inc, Spirit Airlines Inc., TransDigm Group Inc., United Continental Holdings, Inc., United Technologies Corp. Morgan Stanley & Co. International plc is a corporate broker to Rolls-Royce. The equity research analysts or strategists principally responsible for the preparation of Morgan Stanley Research have received compensation based upon various factors, including quality of research, investor client feedback, stock picking, competitive factors, firm revenues and overall investment banking revenues. Morgan Stanley and its affiliates do business that relates to companies/instruments covered in Morgan Stanley Research, including market making, providing liquidity and specialized trading, risk arbitrage and other proprietary trading, fund management, commercial banking, extension of credit, investment services and investment banking. Morgan Stanley sells to and buys from customers the securities/instruments of companies covered in Morgan Stanley Research on a principal basis. Morgan Stanley may have a position in the debt of the Company or instruments discussed in this report. Certain disclosures listed above are also for compliance with applicable regulations in non-US jurisdictions. STOCK RATINGS

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M O R G A N S T A N L E Y B L U E P A P E R Morgan Stanley uses a relative rating system using terms such as Overweight, Equal-weight, Not-Rated or Underweight (see definitions below). Morgan Stanley does not assign ratings of Buy, Hold or Sell to the stocks we cover. Overweight, Equal-weight, Not-Rated and Underweight are not the equivalent of buy, hold and sell. Investors should carefully read the definitions of all ratings used in Morgan Stanley Research. In addition, since Morgan Stanley Research contains more complete information concerning the analyst's views, investors should carefully read Morgan Stanley Research, in its entirety, and not infer the contents from the rating alone. In any case, ratings (or research) should not be used or relied upon as investment advice. An investor's decision to buy or sell a stock should depend on individual circumstances (such as the investor's existing holdings) and other considerations. Global Stock Ratings Distribution (as of June 30, 2013)

For disclosure purposes only (in accordance with NASD and NYSE requirements), we include the category headings of Buy, Hold, and Sell alongside our ratings of Overweight, Equal-weight, Not-Rated and Underweight. Morgan Stanley does not assign ratings of Buy, Hold or Sell to the stocks we cover. Overweight, Equal-weight, Not-Rated and Underweight are not the equivalent of buy, hold, and sell but represent recommended relative weightings (see definitions below). To satisfy regulatory requirements, we correspond Overweight, our most positive stock rating, with a buy recommendation; we correspond Equal-weight and Not-Rated to hold and Underweight to sell recommendations, respectively Coverage Universe Investment Banking Clients (IBC)

Stock Rating Category Count % of Total Count

% of Total IBC

% of Rating Category

Overweight/Buy 1020 36% 410 39% 40%Equal-weight/Hold 1263 44% 485 47% 38%Not-Rated/Hold 109 4% 24 2% 22%Underweight/Sell 469 16% 123 12% 26%Total 2,861 1042 Data include common stock and ADRs currently assigned ratings. An investor's decision to buy or sell a stock should depend on individual circumstances (such as the investor's existing holdings) and other considerations. Investment Banking Clients are companies from whom Morgan Stanley received investment banking compensation in the last 12 months. Analyst Stock Ratings Overweight (O). The stock's total return is expected to exceed the average total return of the analyst's industry (or industry team's) coverage universe, on a risk-adjusted basis, over the next 12-18 months. Equal-weight (E). The stock's total return is expected to be in line with the average total return of the analyst's industry (or industry team's) coverage universe, on a risk-adjusted basis, over the next 12-18 months. Not-Rated (NR). Currently the analyst does not have adequate conviction about the stock's total return relative to the average total return of the analyst's industry (or industry team's) coverage universe, on a risk-adjusted basis, over the next 12-18 months. Underweight (U). The stock's total return is expected to be below the average total return of the analyst's industry (or industry team's) coverage universe, on a risk-adjusted basis, over the next 12-18 months. Unless otherwise specified, the time frame for price targets included in Morgan Stanley Research is 12 to 18 months. For Australian Property stocks, each stock's total return is benchmarked against the average total return of the analyst's industry (or industry team's) coverage universe, instead of the relevant country MSCI Index, on a risk-adjusted basis, over the next 12-18 months. Analyst Industry Views Attractive (A): The analyst expects the performance of his or her industry coverage universe over the next 12-18 months to be attractive vs. the relevant broad market benchmark, as indicated below. In-Line (I): The analyst expects the performance of his or her industry coverage universe over the next 12-18 months to be in line with the relevant broad market benchmark, as indicated below. Cautious (C): The analyst views the performance of his or her industry coverage universe over the next 12-18 months with caution vs. the relevant broad market benchmark, as indicated below. Benchmarks for each region are as follows: North America - S&P 500; Latin America - relevant MSCI country index or MSCI Latin America Index; Europe - MSCI Europe; Japan - TOPIX; Asia - relevant MSCI country index. . Important Disclosures for Morgan Stanley Smith Barney LLC Customers Citi Research publications may be available about the companies or topics that are the subject of Morgan Stanley Research. Ask your Financial Advisor or use Research Center to view any available Citi Research publications in addition to Morgan Stanley research reports. Important disclosures regarding the relationship between the companies that are the subject of Morgan Stanley Research and Morgan Stanley Smith Barney LLC or Morgan Stanley or any of their affiliates, are available on the Morgan Stanley Wealth Management disclosure website at www.morganstanley.com/online/researchdisclosures. For Morgan Stanley specific disclosures, you may refer to www.morganstanley.com/researchdisclosures. Each Morgan Stanley Equity Research report is reviewed and approved on behalf of Morgan Stanley Smith Barney LLC. This review and approval is conducted by the same person who reviews the Equity Research report on behalf of Morgan Stanley. This could create a conflict of interest. Other Important Disclosures Morgan Stanley & Co. International PLC and its affiliates have a significant financial interest in the debt securities of Air Lease Corp, B/E Aerospace Inc, BAE SYSTEMS, Boeing Co., Delta Air Lines, Inc., Deutsche Lufthansa AG, EADS, Finmeccanica, General Electric Co., Honeywell International, International Consolidated Airlines Grp, JetBlue Airways, Qantas Airways, Southwest Airlines, Thales SA, United Continental Holdings, Inc., United Technologies Corp. Morgan Stanley is not acting as a municipal advisor and the opinions or views contained herein are not intended to be, and do not constitute, advice within the meaning of Section 975 of the Dodd-Frank Wall Street Reform and Consumer Protection Act. Morgan Stanley produces an equity research product called a "Tactical Idea." Views contained in a "Tactical Idea" on a particular stock may be contrary to the recommendations or views expressed in research on the same stock. This may be the result of differing time horizons, methodologies, market events, or other factors. For all research available on a particular stock, please contact your sales representative or go to Client Link at www.morganstanley.com. The recommendations of Eduardo Couto in this report reflect solely and exclusively the analyst's personal views and have been developed independently, including from the institution for which the analyst works. Morgan Stanley Research does not provide individually tailored investment advice. Morgan Stanley Research has been prepared without regard to the circumstances and objectives of those who receive it. Morgan Stanley recommends that investors independently evaluate particular investments and strategies, and encourages investors to seek the advice of a financial adviser. The appropriateness of an investment or strategy will depend on an investor's circumstances and objectives. The securities, instruments, or strategies discussed in Morgan Stanley Research may not be suitable for all investors, and certain investors may not be eligible to purchase or participate in some or all of them. Morgan Stanley Research is not an offer to buy or sell any security/instrument or to participate in any trading strategy. The value of and

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