Segment Results of Operation and Financial Condition

Commercial Airplanes

Business Environment and Trends

Airline industry environment Commercial aviation has been impacted by an economic downturn that began in 2001 and continued through 2003. In addition, the industry suffered a tremendous shock from the terrorist attacks of September 11, 2001.

Air travel worldwide has not fully recovered to the volume carried by the airlines in 2000, which has negatively affected profitability for many airlines. Late in 2002 traffic began to recover, and holiday travel indicated that the industry recovery was underway. However, the Iraq War and Severe Acute Respiratory Syndrome (SARS) outbreak in early 2003 caused the industry to again retract and delayed recovery. Overall, the industry produced another year of losses led by full service airlines in the U.S. In contrast, low-cost carriers in the U.S. and in Europe are reporting positive financial results and continue to grow operations. European network airlines are expected to show better results than their U.S. counterparts for their fiscal year end. Likewise, Asian airlines are expected to fare better overall than their U.S. counterparts because traffic to and from Asia has nearly rebounded to pre-SARS levels.

Our estimated timetable for industry recovery has been delayed. We presently expect the recovery in air traffic that started in 2003 to result in renewed demand for capacity in 2004. Overall, airlines are expected to generate another year of losses in 2003 before producing a small profit in aggregate for 2004. The projection of sustained profitability in 2004 is expected to lead to an order recovery in 2005, with delivery growth expected to begin in 2006. The major uncertainty facing the industry is the impact of any additional unforeseen exogenous shocks similar to the 2003 SARS outbreak and the Iraq War. The industry could also face unexpected consequences of events that have already occurred, such as the terrorist attacks of September 11, 2001.

Our 20-year forecast of the average long-term growth rate in passenger traffic is 5.1% annually, based on projected average worldwide annual economic real growth of 3.2%. Based on global economic growth projections over the long term, and taking into consideration an increasingly competitive environment, increasing utilization levels of the worldwide airplane fleet and requirements to replace older airplanes, we project a $1.9 trillion market for new airplanes over the next 20 years. This is a long-term forecast; historically, while factors such as the Gulf War and increased ticket charges for security have had significant impact over the span of several years, they have not dramatically affected the longer-term trends in the world economy, and therefore, our market outlook.

Inherent business risks Commercial jet aircraft are normally sold on a firm fixed-price basis with an indexed price escalation clause. Our ability to deliver jet aircraft on schedule is dependent upon a variety of factors, including execution of internal performance plans, availability of raw materials, performance of suppliers and subcontractors, and regulatory certification. The introduction of new commercial aircraft programs and major derivatives involves increased risks associated with meeting development, production and certification schedules.

The worldwide market for commercial jet aircraft is predominately driven by long-term trends in airline passenger traffic. The principal factors underlying long-term traffic growth are sustained economic growth, both in developed and emerging countries, and political stability. Demand for our commercial aircraft is further influenced by airline industry profitability, world trade policies, government-to-government relations, environmental constraints imposed upon aircraft operations, technological changes, and price and other competitive factors.

Industry competitiveness The commercial jet aircraft market and the airline industry remain extremely competitive. We expect the existing long-term downward trend in passenger revenue yields worldwide (measured in real terms) to continue into the foreseeable future. The market liberalization in Europe has continued to enable low-cost airlines to rapidly gain market share. These airlines have increased the downward pressure on airfares, making it similar to the competitive environment in the U.S. This results in both near-term and continued price pressure on our products. Major productivity gains are essential to ensure a favorable market position at acceptable profit margins.

Continued access to global markets remains vital to our ability to fully realize our sales potential and long-term investment returns. Approximately half of Commercial Airplanes' third-party sales and contractual backlog are from customers based outside the U.S.

We face aggressive international competitors that are intent on increasing their market share. They offer competitive products and have access to most of the same customers and suppliers. Airbus has historically invested heavily to create a family of products to compete with ours. They plan to deliver the first A380, with more capacity than a 747, in early 2006. Regional jet makers Embraer and Bombardier, coming from the less than 100-seat commercial jet market, continue to develop larger and more capable airplanes. This market environment has resulted in intense pressures on pricing and other competitive factors.

Worldwide, airplane sales are generally conducted in U.S. dollars. Fluctuating exchange rates affect the profit potential of our major competitors, all of whom have significant costs in other currencies. The recent decline of the U.S. dollar relative to their local currencies is putting unusual pressure on their future revenues and profits. While this may seem like an advantage to us, it contains a potential threat in that competitors may react by aggressively reducing costs, potentially improving their longer-term competitive posture. Airbus has indicated that they are adopting this approach, and plan more than 10% reduction in costs by 2006. If the dollar strengthens by then, Airbus could use the extra efficiency to gain market share and develop new products.

We are focused on improving our processes and continuing cost-reduction efforts. We continue to leverage our extensive customer support services network for airlines throughout the world to provide a higher level of customer satisfaction and productivity. (See Fleet Support discussion.) As an example, we have made on-line access available to all airline customers for engineering drawings, parts lists, service bulletins and maintenance manuals. These efforts enhance our ability to pursue pricing strategies that enable us to maintain leadership at satisfactory margins. While we are focused on improving our processes and continuing cost reduction activities, events may occur that will prevent us from achieving planned results.

Summary Recent signs of recovery and the continued expectation for long-term growth in air travel are encouraging. For example, December 2003 air traffic levels matched the air traffic levels of December 2000. This is the first time passenger demand returned to pre-September 11 levels. This is somewhat offset by the increasing levels of competition in both airlines and airplane manufacturing. Overall, the commercial airplane market has great potential. We are well positioned in the 100-seat and above commercial jet airplane market, and intend to remain the airline industry's preferred supplier through emphasis on product offerings and customer service that provide the best overall value in the industry.

Operating Results

Revenues Commercial Airplanes revenue is derived primarily from commercial jet aircraft deliveries. The decline in revenue in 2003 compared to 2002 and 2002 compared to 2001 was primarily due to the decline in the commercial aviation market, as discussed above in the "Business Environment and Trends" section, resulting in fewer commercial jet aircraft deliveries.

Commercial jet aircraft deliveries as of December 31, including deliveries under operating lease, which are identified by parentheses, were as follows:

The cumulative number of commercial jet aircraft deliveries as of December 31 were as follows:

The undelivered units under firm order* as of December 31 were as follows:

Total commercial jet aircraft deliveries for 2004 are currently projected to approximate 285 aircraft. For 2005, commercial jet aircraft deliveries are currently projected to be in the same range as 2004. As of January 29, 2004, the delivery forecast for 2004 is essentially sold out and approximately 90% sold for 2005. Commercial Airplanes segment revenues for 2004 are projected to be approximately $20 billion.

Operating earnings Beginning in the first quarter of 2003, Commercial Airplanes segment operating earnings are presented based on the program accounting method. Prior year amounts, based on unit costing, have been revised to reflect the program method of accounting. (See Note 23.) This revision has no impact on amounts reported in our Consolidated Statements of Operations.

During the third quarter of 2003, we decided to end production of the 757 program, with the final aircraft scheduled to be produced in late 2004 and delivered in the second quarter of 2005. The decision was based on a thorough assessment of market demand for the airplane. The decision resulted in a pre-tax earnings charge of $184 million.

The decline in operating earnings in 2003 compared to 2002 was primarily due to the reduction in revenue as a result of lower delivery volume, a goodwill impairment charge of $341 million, a $184 million charge resulting from the decision to end production of the 757 program, and increased pension expense, all of which was partially offset by improved operating efficiency and reduced research and development expense. The decline in operating earnings in 2002 compared to 2001 was primarily due to the reduction in revenue as a result of lower delivery volume driven by the decline in the commercial aviation market; offset by improved operating efficiency and reduced research and development expense. In general, the commercial aviation market decline has resulted in the lengthening of the time needed to produce the accounting quantities, which is described below in the "Accounting Quantity" section.

Accounting quantity For each airplane program, we estimate the quantity of airplanes that will be produced for delivery under existing and anticipated contracts. We refer to this estimate as the "accounting quantity." The accounting quantity for each program is a key determinant of gross margins we recognize on sales of individual airplanes throughout the life of a program. See "Application of Critical Accounting Policies - Program accounting." Estimation of the accounting quantity for each program takes into account several factors that are indicative of the demand for the particular program, such as firm orders, letters of intent from prospective customers, and market studies. We review and reassess our program accounting quantities on a quarterly basis in compliance with relevant program accounting guidance.

Commercial aircraft production costs include a significant amount of infrastructure costs, a portion of which do not vary with production rates. As the amount of time needed to produce the accounting quantity increases, the average cost of the accounting quantity also increases as these infrastructure costs are included in the total cost estimates, thus reducing the gross margin and related earnings provided other factors do not change.

In general, the market for commercial aircraft has adversely affected all of our commercial aircraft programs and extended the time frame for production and delivery of the accounting quantities used for program accounting.

The estimate of total program accounting quantities and changes, if any, as of December 31 were:

Due to ongoing market uncertainty for the 717 aircraft, the accounting quantity for the 717 program has been based on firm orders since the fourth quarter of 2001. The 717 program accounting quantity was increased during 2003 due to the program obtaining additional firm orders. As of December 31, 2003, the majority of the remaining undelivered units of the 717 program consisted of 14 units to be delivered to a single customer. Due to the customer's uncertain financial condition, on a consolidated basis, these aircraft are accounted for as long-term operating leases as they are delivered. The value of the inventory for the undelivered aircraft as of December 31, 2003, remained realizable.

We have possible material exposures related to the 717 program, principally attributable to termination costs that could result from a lack of market demand. During the fourth quarter of 2003, we lost a major sales campaign, thus increasing the possibility of program termination. Program continuity is dependent on the outcomes of current sales campaigns. In the event of a program termination decision, current estimates indicate we could recognize a pre-tax earnings charge of approximately $400 million.

The accounting quantity for the 737 Next-Generation program was increased during 2003 as a result of additional orders received since the last accounting quantity extension during 2002.

Based on current demand, the time required to produce the December 31, 2002 accounting quantity for the 747 program would have extended beyond the limit allowed by our internal policy. Accordingly, the accounting quantity for this program was reduced during 2003. There was not a material impact on our consolidated financial statements as a result of the accounting quantity reduction.

The decrease in the 757 program accounting quantity during 2003 was driven by the continued lack of demand for the 757 aircraft, which ultimately led to our decision in the third quarter of 2003 to end production of the program.

The decrease in the 767 program accounting quantity during 2003 was due to the rescheduling of anticipated future 767 Tanker deliveries to the U.S. Air Force (USAF). Approximately 40% of the remaining deliveries in the current accounting quantity on the 767 program relates to the anticipated USAF tanker order.

The accounting quantity for the 777 program was increased during 2003, as a result of the program's normal progression of obtaining additional orders and delivering aircraft.

The accounting quantity for each program may include units that have been delivered, undelivered units under contract, and units anticipated to be under contract in the future (anticipated orders). In developing total program estimates all of these items within the accounting quantity must be addressed. The percentage of anticipated orders included in the program accounting estimates as compared to the number of cumulative firm orders* as of December 31 were as follows:

The U.S. Government is currently reviewing the USAF proposal for the purchase/lease combination of 100 767 Tankers. Discussions between the USAF and us have been paused, while a series of U.S. Government reviews is undertaken. As a result, on February 20, 2004, we announced that we will slow development efforts on the USAF 767 Tanker program. This slow down will result in the layoff of 100 contract employees and 50 employees, redeployment of certain other personnel, and an extension of the USAF 767 Tanker production schedule. If approved, delivery of the pre-modified aircraft from Commercial Airplanes to IDS is scheduled to begin in 2004. This anticipated order, which has a significant positive impact on the 767 program, has been incorporated into our program accounting estimates to the extent the aircraft fall within the current accounting quantity. Based on the forecasted delivery schedule and production rates the majority of these aircraft fall beyond the current accounting quantity. In order to meet the USAF's proposed schedule for delivery, as of December 31, 2003 we have incurred inventoriable contract costs of $113 million, and if the order is not received, we would also incur supplier termination penalties of $63 million. The inventoriable costs are being deferred based on our assessment that it is probable the contract will be received. If the contract is not received, these deferred costs will be charged to expense and the 767 accounting quantity and the gross margin would be significantly reduced. This would result in a material negative impact to the program's gross margin, and may impact the continuation of the 767 program. (See IDS USAF Tanker Program section for a discussion regarding the consolidated impact.)

Deferred production costs Commercial aircraft inventory production costs incurred on in-process and delivered units in excess of the estimated average cost of such units, determined as described in Note 1, represent deferred production costs. As of December 31, 2003 and 2002, there were no significant excess deferred production costs or unamortized tooling costs not recoverable from existing firm orders for the 777 program.

The deferred production costs and unamortized tooling included in the 777 program's inventory at December 31 are summarized in the following table:

As of December 31, 2003 and 2002, the balance of deferred production costs and unamortized tooling related to all other commercial aircraft programs was insignificant relative to the programs' balance-to-go cost estimates.

Fleet support We provide the operators of all our commercial airplane models assistance and services to facilitate efficient and safe aircraft operation. Collectively known as fleet support services, these activities and services include flight and maintenance training, field service support costs, engineering services and technical data and documents. Fleet support activity begins prior to aircraft delivery as the customer receives training, manuals and technical consulting support, and continues throughout the operational life of the aircraft. Services provided after delivery include field service support, consulting on maintenance, repair, and operational issues brought forth by the customer or regulators, updating manuals and engineering data, and the issuance of service bulletins that impact the entire model's fleet. Field service support involves our personnel located at customer facilities providing and coordinating fleet support activities and requests. The costs for fleet support are expensed as incurred and have been historically less than 1.5% of total consolidated costs of products and services. This level of expenditures is anticipated to continue in the upcoming years. These costs do not vary significantly with current production rates.

Research and development We continually evaluate opportunities to improve current aircraft models, and assess the marketplace to ensure that our family of commercial jet aircraft is well positioned to meet future requirements of the airline industry. The fundamental strategy is to maintain a broad product line that is responsive to changing market conditions by maximizing commonality among our family of commercial aircraft. Additionally, we are determined to continue to lead the industry in customer satisfaction by offering products with the highest standards of quality, safety, technical excellence, economic performance and in-service support.

The decrease in 2003 research and development compared to 2002 was primarily due to reduced spending on the development of the 747-400ER. The decrease in 2002 research and development compared to 2001 was primarily due to reduced spending on the development of the 777-300ER and 747-400ER. The initial delivery of the 747-400ER and the rollout of the first 777-300ER occurred in the fourth quarter of 2002. The initial delivery of the 777-300ER is expected to occur during the first half of 2004. The initial delivery of the 737-900, the largest member of the 737 Next-Generation family, occurred in the second quarter of 2001.

Despite the current downturn in the commercial aviation market, we remain confident in the long-term growth of air travel worldwide and the demand for new aircraft deliveries. We are currently focusing our new airplane product development efforts on the 7E7 program, which we expect to seat 200 to 250 passengers. In December of 2003, we received Board of Directors (BoD) approval to offer the new airplane to customers. We began to formally offer the aircraft to airlines in early 2004. Subject to additional BoD approval, full development and production is scheduled to begin in 2004, with entry into service targeted for 2008. We project an increase in our research and development spending in 2004, primarily driven by spending on the 7E7 program.

The following chart summarizes the time horizon between goahead and certification/initial delivery for major Commercial Airplanes derivatives and programs.

Backlog Contractual firm backlog for the Commercial Airplanes segment excludes customers we deem to be high risk or in bankruptcy as of the reporting date. The contractual backlog decline reflects the impact that the economic downturn has had on the airline industry. The decline in backlog in 2003 compared to 2002 and 2002 compared to 2001 represents higher delivery volume on all airplane programs relative to new orders. December 31, 2003, backlog does not include the anticipated order of 100 767 Tankers from the USAF. This order is anticipated to become a firm contract during 2004.