Management’s Discussion and Analysis

Management’s Discussion and Analysis

General environment The U.S. Department of Defense (DoD), with over 40% of the world’s defense budget, remains the principal customer of the Company’s Military Aircraft and Missile Systems business unit. Several trends are emerging that are shaping customer behavior in this business segment. U.S. force structure is shrinking and aging while the tempo of engagements worldwide remains high. The latest military activity by the United States in Afghanistan demonstrates the value of systems that can communicate with each other, can operate over longer ranges, are unmanned and provide the asymmetrical advantages of precision, persistence and selective engagement.

The ways in which institutions and events shape the defense industrial environment were illustrated almost simultaneously in 2001. From an institutional perspective, the 2001 Quadrennial Defense Review (QDR), released on September 12, 2001, identifies national security goals that promote continued modernization and transformation of the nation’s military. The policy goals are assuring allies and friends; dissuading future military competition; deterring threats to U.S. interests; and defeating aggression if deterrence fails. These goals translate into continuing demands for forward presence, rapid contingency response, homeland security, peacekeeping, humanitarian and disaster relief operations that are driving high usage of personnel and equipment that results in operating cost affordability issues. Current acquisition rates for aircraft, missiles and ships are well below the rates needed to recapitalize aging equipment while the DoD is faced with rising personnel, health care and support costs.

In light of an immediate and a durable need to maintain strong U.S. defense capabilities covering a very broad spectrum of threats and responses, near-term DoD budgets have increased, and longer-range forecasts expect DoD budgets to grow faster than anticipated prior to September 11, 2001. However, with a softening global economy and anticipated federal budget tensions, allocations to DoD procurement are unlikely to increase significantly. This suggests that the DoD will continue to focus on affordability strategies emphasizing unmanned air combat and reconnaissance vehicles, precision guided weapons and continued privatization of logistics and support activities as a means to improve overall effectiveness while maintaining control over costs. The Company’s capabilities and programs are well suited to provide the military capabilities essential to meet the challenges.

The global competitive environment is changing rapidly and it is best characterized by a trend toward consolidation, especially in Europe. The Company faces strong competition in all market segments at home and abroad. Industry consolidation in the United States has resulted in four principal prime contractors for defense aerospace systems and electronics: Boeing, Lockheed Martin, Raytheon and Northrop Grumman. Given the relatively small number of prime contractors, these companies often partner and serve as major suppliers to each other on a various number of major programs. Although there may be niche acquisitions and product portfolio exchanges at the prime contractor level, continued consolidation is likely among subcontractors.

On a global level, the Company faces strong competition from major European corporations. BAE Systems, with its acquisitions of certain U.S. defense electronics companies, has positioned itself as an incumbent competitor in the United Kingdom and in the U.S. markets. The European Aeronautics Defense & Space Corporation (EADS) is one of the largest aircraft and defense companies in the world and stands to benefit directly as Europe continues to move toward a common defense identity and industrial policy. The emergence of Matra BAe Dynamics Alenia (MBDA) into a single European weapons provider creates a formidable competitor from what was once a fragmented European industry. Agusta-Westland and Eurocopter remain the primary European rotorcraft systems providers for both defense and commercial aerospace. In response to emerging opportunities and competitive pressures internationally, the Company is actively pursuing a globalization strategy aimed at improving its competitive position in markets of interest around the world.

Product lines The Company’s Military Aircraft and Missile Systems segment produces tactical fighters, trainers, rotorcraft, military transports, tankers, tactical missiles, and special purpose airplanes for the United States and foreign governments, as well as aerospace support products and services.

In the transport market, this segment is producing 120 C-17 Globemaster transports under a multiyear contract with the U.S. Government. The U.S. Air Force has indicated a need for a total of 222 C-17s and is actively engaged in negotiating a second multiyear contract. Other products in this market are the C-32 and C-40 commercial derivative aircraft.

The primary products in the tactical aircraft market include the F/A-18E/F Super Hornet, the F-22 Raptor, the F-15 Strike Eagle, and the AV-8B Harrier. The F/A-18E/F is the U.S. Navy’s primary strike fighter. It is currently being procured under a multiyear contract that extends deliveries through late 2006. The Company and the U.S. Navy are also looking at this aircraft as a potential replacement for the EA-6B aircraft. The F-22 continues to experience strong support from the customer and was just awarded Lot 2 production. The Company continues to look for new markets for the F-15 Strike Eagle aircraft and is actively engaged in the Korean F-X fighter competition.

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