The US Air Force’s Tanker Gamble
(Source: defense-aerospace.com; published Feb. 25, 2011)

By Giovanni de Briganti
Perhaps inauspiciously given the Joint Strike Fighter’s poor record of meeting price and schedule goals, Boeing opted to depict its future KC-46A tanker with an F-35. (Boeing imagery)
PARIS --- When all is said and done, the Pentagon’s Feb. 24 decision to award the $30 billion KC-X tanker contract to Boeing is a huge gamble for both the company and the department.

Despite all the evidence to the contrary, the Pentagon is gambling that Boeing will be able to develop and deliver a new, highly complex tanker design in less than six years, when it needed nine years to deliver the far simpler KC-767A to the Italian air force.

However, the Pentagon has hedged its bet: its award to Boeing is a “fixed-price incentive firm” contract, not a far laxer “cost-plus” contract that it used to award. This shifts all financial risk to Boeing, and means the company would no doubt have to pay financial penalties if it failed to perform, in addition to foregoing incentive payments.

But, despite this hedge, the Pentagon could find itself with a large shortfall in air-refueling capability if Boeing failed to deliver, and it would then have no obvious recourse except to deal with EADS at whatever price that company then demanded.

Boeing, for its part, is gambling that it can develop a new aircraft combining the airframe of the 767 airliner with the digital flight deck of the still uncertified 787 Dreamliner; “new flight controls with a new design philosophy;” and an all-new, digital refueling boom that it has yet to design. And, once developed, Boeing will have to manufacture and deliver the first 18 production aircraft in just six years from now.

Boeing says the new refueling boom will have “an expanded refueling envelope, increased fuel offload rate and fly-by-wire control system,” but intriguingly says in a Feb. 24 statement that it will use “a low-risk approach to manufacturing” without offering any further explanation.

So, given the company’s past performance on the KC-767A, this is quite a gamble, and one which Boeing has no way of hedging: if it fails to meet its contractual obligations, it will have to pay substantial financial penalties out of its profits or its capital.

As the contract’s terms will not be made public, no-one knows exactly how big a financial risk Boeing is taking, and neither will Boeing’s shareholders, who by the way still don’t know how much the company had to pay in compensation to the Japan Air-Self-Defense Force and to the Italian air force for late delivery of the KC-767A.

(In fact, no one would even know Boeing delivered the first KC-767 to Italy on Jan. 27 if it hadn’t been announced by the Italian air force, since Boeing apparently decided it was not worth mentioning – or thought it best not to draw attention to the KC-767 delays just as the US Air Force was finalizing its own tanker decision.)

In the circumstances, Boeing’s may well be a Pyrrhic victory, especially as the company must have cut its profit margin to the bone to have undercut EADS’ price by over 1 percent. And, furthermore, Boeing still has to pay for the KC-46A's development.

A little arithmetic can illustrate the scope of the financial risk Boeing took to win the program, and show just how fragile are the KC-46 program’s economics.

Italy is paying $993.6 million in 2002 dollars for its four KC-767s, or about $1,093 million in today’s dollars, equivalent to $273 million per aircraft. Assuming the US Air Force pays about the same price for the first 18 KC-46As, the total works out to $4.9 billion in production costs alone.

Yet, as announced Feb. 24, the KC-46A contract is worth “over $3.5 billion” for “Engineering and Manufacturing Development” as well as the first 18 aircraft.

The clear implication is that Boeing cut its KC-767 price by about 25% to stay within the $3.5 billion contract envelope, and that it will have to pay for all of the remaining KC-46A development work with its own money as there will be nothing left out of the $3.5 billion.

By comparison, the Feb. 2008 tanker contract won by Northrop and EADS was worth $1.5 billion and covered the first four aircraft, with a $10.6 billion option for another 64; this implies a unit price of $165.6 million, much lower than the KC-46A price implied by yesterday’s announcement.

Admittedly, this is a very rough, “back of an envelope” guesstimate, but it is clear Boeing stands to lose a lot of money on this initial contract, which is a fixed-price deal with no comebacks.

And this is assuming nothing goes wrong with the KC-46A’s development -- a fairly big assumption given Boeing’s recent development record. And if this assumption proves wrong, the company’s very survival would be in play.

EADS, although understandably frustrated that it has now lost a contract it had won so decisively in 2008, needs only to sit back and wait until it can bid on the two other tanker replacement contracts, KC-Y and KC-Z, by which time Boeing’s performance on the KC-X will have become a matter of record.

Finally, it is worth noting that, despite all the hysterical rhetoric to the contrary, the issue of subsidies did not even come up, given the margin of Boeing’s victory. The more extravagant claims by some pundits that “illegal” government subsidies would allow EADS to underbid Boeing and to win unfairly were shown to be just the ill-informed, partisan rants they were.

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