Commercial aerospace and defence stocks have followed the rest of the market downward as concerns increase about the global impact of a recession in the U.S.

The depth of the slowdown will determine which of the two subsectors will be the better investment. If a recession occurs, stocks of companies that have exposure to defence may well be better bets than those focused on commercial aerospace. In a recession, orders for commercial aircraft are often postponed while defence orders remain in place.

But if recession worries prove to be overdone, the pendulum could swing the other way. In that case, analysts tend to prefer commercial aerospace: traffic, particularly in emerging markets, has increased and replacement demand in the U.S. is strong, as is demand for business jets.

The key to being a major player in the defence subsector is the ability to bid on U.S. contracts, as defence budgets — particularly that of the U.S. — drive demand. Bethesda, Md.-based Lockheed Martin Corp. , the world’s largest defence contrac-tor with revenue of $41.9 billion in the fiscal year ended Dec. 31, 2007, has the home-court advantage. It is difficult for foreign companies to bid on U.S. contracts.

(All figures are in U.S. dollars unless otherwise noted.)

But although the U.S.’s defence budget will probably be higher this year than last, that trend is unlikely to last. Over the next two years, investors will begin to anticipate smaller budgets and factor that into their investment decisions, putting downward pressure on defence stocks.

The commercial aircraft subsector, on the other hand, is divided into three segments: large commercial aircraft, regional jets and business jets. Their sales cycles, however, don’t always run in tandem.

For instance, demand for business jets is currently very good, says Mark Chaput, portfolio manager with I.G. Investment Management Ltd. in Montreal. Assuming the U.S. doesn’t go into recession — the U.S. comprises about 50% of the market — there could be three years of growth left in the segment, he says. If there is a downturn in the U.S., the first thing companies will do is delay purchases of new jets. That would hit the segment hard.

A major player in business jets is Falls Church, Va.-based General Dynamics Corp. Its estimated revenue of $27.3 billion for the fiscal year ended Dec. 31, 2007, also includes defence equipment.

Demand for large commercial aircraft is also quite good. There is new capacity and global air traffic has been growing by about 6% a year. Chaput says this segment is at less risk than business jets — as long as the recession is confined to the U.S. If there is a marked slowdown in global growth, however, the segment would be affected significantly.

The International Air Trans-portation Association called for only 4% growth in 2008 global traffic in its December forecast, not enough to cause orders to plunge.

Chicago-based Boeing Co. and Paris-based European Aeronautic Defence and Space Co. , are the biggest players in the large aircraft segment.

Currently, the anticipated launch of Boeing’s 787 plane — a mid-sized, wider-body aircraft — is putting it in the lead. Given the age of U.S. aircraft fleets, the 787 will benefit from significant replacement demand. As well, Boeing, along with other U.S.-based companies, has the advantage of a U.S. dollar falling against the euro.

Both Boeing and EADS are also in the defense subsector. In the case of Boeing, about 50% of its $66.9 billion in estimated revenue for its fiscal year ended Dec. 31, 2007, was from defence orders. In EADS’s case, 25% of its estimated 2007 revenue of 39.3 billion euros ($53.7 billion) was from defence contracts.

Despite the strength of the business jet and large aircraft segments, there’s no growth in regional jets, Chaput says. Today’s very high cost of fuel, which has sent the cost per seat soaring, is the main reason. Airlines have as many, if not more, regional jets as they need, and there is little replacement demand.

All aerospace segments have an after-sales service market, which provides steady income through long-term contracts.

Here’s a look at closer look at the four companies:

> Boeing Co. Analysts and inves-tors aren’t happy about recent delays in the launch of the 787. Its first flight has been postponed until the end of the third quarter of 2008 from the end of the second quarter.

@page_break@However, Chaput and a Jan. 16 report from New York-based Argus Research Co. both say the resulting drop in Boeing’s share price — to less than $80 from a high of $107 in October — has been overdone, providing a good buying opportunity. Boeing shares closed at $78.40 a share on Jan. 18.

Chaput believes earnings per share could peak at $9-$10 in the next three to four years, up from an estimated $5 a share in 2007. He doesn’t think the delays in launching the 787 are indicative of design risk but are the result of delays in suppliers ramping up production. He points out that 80%-85% of Boeing’s backlog of aircraft orders are non-U.S.

The Argus report has a “buy” rating on Boeing and is “optimistic about long-term prospects.” The 12-month target price was reduced in the report, however, to $95 a share from $120 “to reflect near-term pressures.”

A report out of the New York office of UBS Securities LLC is much more pessimistic: it has a “sell” recommendation on the stock, with a 12-month target price of $80 a share — down from a target price of $95 a share on Oct. 24, 2007. As contracts for aircraft contain penalties if deliveries are late, the UBS report raises concerns that recent and possible future delays to the launch of the 787 will trigger penalties.

Net income for the nine months ended Sept. 30, 2007, was $1.1 billion, vs $694 million in the same period a year earlier. Revenue was $16.5 billion vs $14.7 billion. Long-term debt was $7.6 billion as of Sept. 30.

> European Aeronautic Defence And Space Co. Some analysts and investors have concerns that EADS is subject to government interference, particularly concerning job-security issues, which prevents the kind of efficiencies Boeing has been able to achieve by outsourcing.

However, a report from UBS has a short-term “buy” rating and a longer-term “neutral” rating on EADS shares. Reports from both UBS and New York-based J.P. Morgan Securities Inc. have a 12-month target price of 25 euros a share, well up from the 17.11 euros ($25) the shares closed at on Jan. 18.

The UBS report notes that EADS shares are trading at almost a 30% discount to Boeing’s, making them very cheap at less than eight times EADS’s estimated 2009 earnings. The report also notes there are significant overbookings for 2008. As well, the firm’s exposure to the Asian market is high (34%-41%) but to the slowing U.S. is low (less than 13%).

The UBS report is dubious about some of EADS’s goals to reach by 2020: a 50/50 split between its Airbus and non-Airbus businesses (Airbus accounted for 68% of sales in the nine months ended Sept. 30); an increase in after-sales service revenue to 25% of sales from around 10%; and an increase in its U.S. manufacturing exposure (97% of its employees are in Europe).

The J.P. Morgan report questions whether EADS can make the acquisitions needed to reach those goals.

EADS reported a net loss of 705 million euros in the nine months vs earnings of 867 million euros in the same period a year prior. Revenue was 27.8 billion euros vs 27.5 billion. Long-term financial liabilities were $3.3 billion as of Sept. 30.

Of EADS’s 810 million shares outstanding, 27.5% are owned by France-based holding company Société de gestion de l’aéronautique de la défense and de l’espace (SOGEADE) — which is 50%-owned by the French government and 50% by Paris-based Lagardère SCA — and 22.5% by Daimler AG.

> General Dynamics Corp. This company is more involved in defence than in aerospace, with mission-critical information systems and technologies accounting for 36.4% of the $19.7 billion in sales in the nine months ended Sept. 30; combat systems accounted for 26.1%. Shipbuilding and marine, which includes nuclear submarines, delivered 19.1% of sales and the Gulfstream business jets division accounted for 18.3%.

The Gulfstream jets are considered a jewel — “the Mercedes Benz of business jets,” as Charles Burbeck, head of global equities at HSBC Halbis Partners in London, puts it — and the division’s prospects are a major factor for those recommending the stock.

As well, as there are no companies that make only business jets, General Dynamics is seen as a very good way to get exposure to this healthy aerospace business segment.

An Oct. 25 report from UBS, for example, says there are “significantly higher margins to come for Gulfstream.” This, along with “further upside” for the marine and defence divisions — the UBS report points out that General Dynamics had favourable exposure to the conflict in Iraq — are behind the UBS report’s “buy” recommendation and its 12-month price target of $106 a share. The shares closed at $80.80 a share on Jan. 18. In its report, UBS calls General Dynamics its top large-cap defence pick.

Argus’s Jan. 17 report rated General Dynamics a “buy,” with a 12-month target price of $99 a share. This is based on large contracts for land-combat systems and electric boats, as well as robust orders and margins for Gulfstream jets.

J.P. Morgan’s Nov. 30 report recommended overweighting the stock because of the expected higher Gulfstream services revenue and improved marine sales and margins in 2009. The report notes that Gulfstream opened a new service centre on Aug. 30, 2007, which doubles its capacity and will lead to a 25% jump in high-margin service revenue in 2007 and 2008 and a 20% increase in 2009. General Dynamics is J.P. Morgan’s top large-cap pick in the aerospace and defence sector.

Burbeck offers words of caution, however, pointing out that business jets are very much tied to U.S. corporate profitability. If that starts falling, so will demand for business jets.

General Dynamic reported net income of $1.5 billion in the nine months vs $1.4 billion in same period the year prior. Revenue was $19.7 billion vs $17.5 billion. Long-term debt was $2.1 billion as of Sept. 30.

> Lockheed Martin Corp. The majority of Lockheed’s sales are to the U.S. Department of Defense and other U.S. federal government agencies. In fact, Lockheed is the largest provider of information-technology services, systems integration and training to the U.S. government. The rest of its sales are mostly to other countries’ governments.

Lockheed has four divisions:

> Aeronautics, which includes advanced military aircraft and related technologies, accounted for 29.4% of the $41.9 billion in net sales in 2007.

> Electronic systems, which includes advanced sensors, decision systems and weapons for air-, land- and sea-based platforms, accounted for 26.6% of sales.

> Systems and IT, which uses existing and emerging technologies to address customers’ needs for highly integrated systems and solutions, accounted for 24.4% of sales.

> Space systems, which includes satellites, strategic and defensive missile systems and launch services, accounted for 19.6% of sales.

Burbeck views Lockheed as a diverse company that could do quite well if investors start selling deep cyclicals. Unlike business jets, a recession in the U.S. would not cause sudden delays in purchases of defence equipment.

An Oct. 26 report by Argus rated the company a “buy,” with a target price of $120 a share and continued upside for the stock.

Reports from UBS and J.P. Morgan are both “neutral” on the stock, although UBS’s 12-month price target of $118 a share is well above the $101.88 a share at which the shares closed on Jan. 18.

UBS’s report expects Lockheed to benefit from higher defence spending, but without broader margins to increase cash flow.

The J.P. Morgan report says the potential upside includes continued margin expansion “beyond our expectations,” more aggressive share repurchases than assumed and an investor flight to safety in defence should the S&P 500 composite index decline. Downside risks include defence-subsector underperformance, cuts or delays in joint strike fighter funding by the U.S. Department of Defense, rumours about delays or cuts in funding for other major programs or an expensive acquisition.

Lockheed reported net income of $3 billion for the year ended Dec. 31, 2007, vs $2.5 billion in 2006. Net sales were $41.9 billion in 2007, vs $39.6 billion in 2006. Long-term debt was $4.3 billion as of Dec. 31. IE