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Saturday, November 1, 2008

Eurowatch

Giovanni de Briganti

Helicopter Industry Faces Perfect Storm

PARIS — The world’s helicopter industry, boosted to unprecedented levels of prosperity by a steady growth in orders during the past decade, would do well to prepare for the perfect storm that is now looming just over the horizon. And its effects are likely to be felt all the more keenly that all manufacturers have expanded their production facilities in anticipation that the good times would last.

Even before the financial crisis hit in October, it was clear that military expenditure in the Western world was headed for a sharp decline, as governments reduce defense budgets to cope with the rising cost of social programs. As always, defense spending is the first to be pruned because, politically, it is the least painful for governments.

Just on the basis of the approaching economic recession, both the military and civil helicopter markets have reason to fear a downturn.

Reduced military spending will not only reduce the money that is available to buy new helicopters, but also to repair and "reset" those that are already in service, and which have taken a beating during their deployment on combat missions in Afghanistan and Iraq.

Britain’s defense ministry, for example, is facing a £2 billion ($3.4 billion) cash crunch, and Future Lynx is one program that is rumored as a candidate for the budget axe. In France, a rise in defense spending is predicated on the defense ministry selling off surplus property — probably not a good bet given the state of the real estate market — and the situation is similar throughout Western Europe.

A second negative factor facing the helicopter industry, and again distinct from the financial crisis, is that the world’s economies were already heading for a recession. Previous economic down-cycles have shown that helicopters (together with general and business aviation) and other non-essential goods and services are the first to suffer. Now that economists are talking about the recession continuing until the end of 2009, at best, the downdraft is likely to be stronger than during the last (and milder) recession in the mid-1990s.

This is especially true of the oil industry. Traditionally, exploration (and thus helicopter usage) increases when higher oil prices make it profitable to look for new fields. In the present context, however, oil companies will be very careful when investing in exploration, as the wild swings we have seen in oil prices this year (from $70 to $147 a barrel, and back down to $80) make it difficult to determine when new fields can be profitable.

So, just on the basis of the approaching economic recession, both the military and civil helicopter markets have reason to fear a downturn. But the recession is not alone.

A third factor likely to complicate the industry’s troubles is, of course, the financial crisis which exploded in mid- September. How long it runs, and how deeply it eats into the fabric of the world’s economy, is anyone’s guess, but it is already clear that banks have dramatically cut back on loans, which means that it’s well-nigh impossible to borrow money in most of the world.

This will obviously have very negative effects on the industry. Prospective buyers will have to cancel or defer orders as their financing dries up because, as for airlines, profit margins in the helicopter industry are too low to allow operators to finance their acquisitions from cash flow or profits.

Compared to previous crises, a new danger lurks this time around: the possible collapse of military outsourcing contracts paid for through Private Finance Initiatives. This financial instrument gives industry a turnkey, long-term contract to provide a service to a military customer, who pays for it in installments. The great (but unsaid) advantage is that the money is paid from the military operations budget, and not from the acquisition budget, so defense ministries in effect keep it off their books. Britain, a great believer and a pioneer in this type of arrangement, has used it to finance its Defence Helicopter Flying School and other projects.

But for the PFI business model to work, contractors must be able to borrow money at an affordable rate to buy the hardware (in this case, the helicopters), the installations and pay for operations. Given how the credit market now looks, it is not only very likely that new PFI arrangements will be possible for quite some time; it is also possible that, unless contractors were particularly prudent in locking in their financing, some of these ventures may have to be, at the very least, revisited.

And this is particularly bad news for helicopter manufacturers, who were counting on the military outsourcing business, and PFI-like financing, to create a new, rich and lasting revenue stream. This now looks unrealistic.

The financial crisis will obviously hit all kinds of businesses throughout the world. But it will probably hit the helicopter industry worse than others.

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