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Areas of Coverage: Commercial Aerospace & Defense

Outlook for Commercial Aerospace: Commercial airline orders at Boeing and Airbus were strong in 2005 and 2006; however, U.S. airlines did not fully participate in the order rally as they have historically. Domestic orders accounted for approximately 25 percent of 2005-2006 worldwide orders compared to the 50-year average of 50 percent. As a result, we would expect domestic orders to increase in 2007-2008 and expect approximately 9,200 orders through 2010.

We believe the rebound in domestic orders will likely be driven by four key factors: one, aging airline fleet — approximately one-third of the U.S. airline fleet has an average age of 19 years; two, the need for fuel-efficient aircraft — in our view, with high fuel costs airlines need more fuel efficient aircraft, some of which could provide a 20 percent-30 percent cost savings advantage; three, airlines improving financially — revenue, income and cash have grown significantly with added pricing and utilization; and, four, a recovering economy supporting air traffic growth absorbs excess capacity, causing pricing to improve.

Outlook for Defense: U.S. defense companies benefited from steadily rising defense spending driven by: one, increasing global threats (terrorism, rogue states and modernizing conventional forces); and, two, the need to transform and modernize to adapt to the current post-Cold War environment.

Historically, defense spending is highly correlated to threat levels, and we believe the threat environment remains high. As a result, we expect continued growth in defense spending (at least through 2009). In our opinion, there is some budgetary flexibility for continued growth in defense spending, as government revenue growth exceeds outlay (spending) growth — resulting in a reducing deficit. Nevertheless, we believe many defense companies are trading at appropriate valuation levels, and therefore we have a neutral stance on the industry.

Buys: K&F Industries (KFI), Orbital Sciences (ORB), Raytheon (RTN)

Top Picks: B/E Aerospace (BEAV); Boeing (BA)

Why Boeing? We believe Boeing shares currently offer investors an attractive investment opportunity due to improving operating margins, higher aircraft deliveries, a very competitive product portfolio, rising ROIC and strong free cash generation. In our opinion, 2005 was the first year of a six- to seven-year order cycle that should lead to steady delivery growth at least through 2013. As a result, we anticipate strong margin improvement to result from restructuring during the prior downturn. The defense segment at Boeing is also winning new business and surprising industry competitors with low-cost, low-risk solutions. For the first-time in a long while, Boeing appears to be firing on all cylinders. Our target price is $102.

Why B/E Aerospace? B/E Aerospace is a leading manufacturer of aircraft interiors (seats, food/beverage equipment, oxygen equipment) for commercial aircraft and regional and business jets with most market share positions averaging 50 percent. We anticipate end-market demand to increase approximately 20 percent annually through 2008. B/E operating margins are expected to increase significantly through 2009 on higher volumes, a favorable product mix, previous restructuring efforts and lower research costs. Therefore, given the potential for strong top-line growth and significant margin improvement, we believe B/E is capable of 25 percent growing earnings over the next five years. Our target price is $39.

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Chris Quilty

Raymond James

727-567-2602

[email protected]

Area of Coverage: Commercial Aerospace & Defense

Strong Buys: EDO Corp. (EDO); Harris Corp (HRS); KVH Industries (KVHI)

Outperform: HEICO (HEI); Teledyne Tech (TDY)

Comments on EDO: [On Dec. 5, 2006] the Naval Sea Systems Command (NAVSEA) issued a pre-solicitation notice naming five contractors qualified to compete on the CREW 2.1 spiral contract to procure up to 10,000 Vehicle- Mounted Counter Radio-Controlled IEDs (i.e. bomb jammers) with an estimated contract value of $500+ million. Both EDO’s Communications & Countermeasure business (located in Thousand Oaks, Calif.) and the company’s recently-acquired Impact Science & Technology business were cited as “…among the only [companies] capable of satisfying the government’s requirements,” in this limited competition procurement (contracted on an “unusual and compelling urgency basis”).

We are currently forecasting sales of $33 million in 2007, but EDO’s participation on the 2.1 spiral could radically alter the company’s outlook (EBIT margins are likely to be two times the corporate average).

Although EDO’s participation in this contract is by no means assured, the company’s odds appear pretty good. Further, with the stock trading at only about 12.6 times the consensus 2007 EPS estimate of $1.72 (vs. the industry median of 18.8 times), it would be hard to argue that this opportunity is fairly priced into the stock.