F-35 Reality Check Ten Years On, Part 2: The Jobs Mirage and Other Stories
 
(Source: defense-aerospace.com; published May 21, 2012)
 
By Giovanni de Briganti
 
 

Given the contractual arrangements of the F-35 program, it is not clear how many foreign subcontractors will be able to win production orders and – more importantly – whether any of these contracts will actually generate the work-load and profits anticipated by foreign governments. (L-M photo)
PARIS --- Most F-35 partner governments have, at various times, tried to justify joining the F-35 program by the production work the program will provide to their industry, and the high-tech jobs this work will create and support.

However, as for the program’s technical promises reviewed in Part 1, (‘Fifth-Generation’ and Other Myths) the facts are hidden behind a P.R. smokescreen.

The truth is that no partner country has a guaranteed work-share on the program. Being an F-35 partner only gives the right to compete for contracts, with no guarantees of winning, and there is no entitlement to any work at all, however much a country has invested, except for major partners Italy and the United Kingdom.

Furthermore, prospective subcontractors are expected to make all the necessary investments needed to compete for production orders, again with no guarantee of actually winning any work. Finally, companies bidding for work are expected to assume all foreign exchange risk. More on this below.

All of this leaves program prime contractor Lockheed Martin with the best of all worlds, as it is able to award subcontracts to the lowest bidder, and to then transfer work to a cheaper source, or to the country with the best currency exchange rate, while itself benefiting from US dollar-denominated contracts awarded by the Pentagon.

Subcontractors from the partner nations, on the other hand, are much worse off: heavy investments, low profit margins, one- or two-year contracts without any guarantee of renewal, and payments made in US dollars, irrespective of which currency they operate in.

Such is the industrial work-sharing arrangement that Lockheed and the US government have succeeded in foisting on their F-35 partners in the name of efficiency and affordability. This one-sided arrangement has replaced long-standing principles such as “just return” and direct offset contracts that were used in previous international projects, like the European F-16 program, and which are still used in export contracts.

1. No guaranteed work, no offsets, no net return?

Contrary to what some partner governments have stated or implied, there is no contractual obligation for foreign partners to buy the F-35 in order to participate in its production: financially contributing to development is enough.

Conversely, buying the aircraft is no guarantee of winning any production work, either.

In return for having contributed several hundred million dollars to F-35 development, the Netherlands (Tier 2) and the five Tier 3 partner countries have obtained a single privilege: their industry is allowed to compete and bid for production work.

There are only two exceptions to this basic rule: Britain (and BAE Systems), as the only foreign Tier 1 partner, is guaranteed a major share of production work while Italy, the second-largest foreign partner, has obtained the right to establish (at its own cost) a Final Assembly and Check-Out (FACO) facility which will be operated by Alenia Aermacchi, its main aerospace contractor. This, however, does not give Alenia any special privilege when it comes to bidding for production work.

None of the other partner nations, nor their industries, have any guarantee of winning work, because contracts will simply go to the lowest compliant bidder. This is a crucial aspect of the program that most partner governments have glossed over or ignored in their eagerness to highlight the billions of dollars of orders they will generate for their industry. The truth is far less compelling, but a failure to win contracts can always be explained away as due to a company’s lack of competitiveness.

2. Pay to work?

Because F-35 production contracts are awarded to the company offering the lowest price, there is an obvious incentive for these bidders to invest in the most efficient machinery and work-force to lower their production costs and thus improve their chances of winning production work.

This can lead to heavy costs and to financial imbalances, as one Australian company which went bankrupt waiting for delayed Lockheed orders found out to its expense.

Production Parts, a Melbourne Airport West company which employed 85 people, spent A$6.25 million on equipment needed to fill JSF contracts that were to be worth more than $40 million, the Canberra Times reported on Sept. 22, 2011, and was considering doubling its staff to 170 in expectation of even more production work.

However, the company went into administration on September 2, 2011 because the investment proved too heavy for the amount of F-35-related work it finally obtained, although the strength of the Australian dollar and the slow-down in defense spending also contributed, the newspaper said.

While Production Parts was a small company which might have been overly optimistic as to its financial capacities, contractual problems also affect bigger firms.

Italy’s Alenia Aermacchi, for example, had invested to prepare for the production of 1,251 F-35 wing assemblies, but had only received a firm order from Lockheed Martin for 100 pre-production ship-sets. This meant is stood to lose $10 million on just this initial order, as it was unable to recoup its investment on the only contract which Lockheed was willing to guarantee.

“For this reason, the Defence Administration, as part of its industrial policy brief, intervened to ensure that Lockheed increased its commitment to a level that allowed the Italian company to obtain a necessary return on its substantial initial investment,” Lt. Col. Antonio Zuliani, chief spokesman for Italy’s National Armaments director, told defense-aerospace.com April 20. “This issue was finally resolved to the mutual satisfaction of both companies,” he added.

Zuliani denied a report that Alenia Aermacchi was required to make a substantial cash payment to Lockheed Martin because it could not produce parts at the price that had been agreed originally. “No such penalty exists in the [F-35] contracts,” he said.

The existence of cash penalties for non-achievement of contractual prices was also denied by Lockheed F-35 spokesman Michael J. Rein, who said in an April 19 e-mail statement said that “Lockheed Martin did not request any 'penalty payment' from Alenia Aermacchi,” and that none would be requested in future.

Rein added that “Lockheed Martin awards contracts on a competitive, best value basis to ensure worldwide industrial participation for the global fleet expected to be more than 3,000 aircraft. All foreign F-35 production contracts are bid in U.S. dollars. Past performance is taken into account as we prepare, develop and negotiate future contracts and re-bids.”

3. US dollar’s decline impacts competitiveness

The first contractual anomaly is that all F-35 production subcontracts are drawn up in US dollars, with no compensatory clause in case of major currency variations during the contract’s duration.

Given the wild gyrations in the exchange value of the US dollar over the past decade compared to customer’s currencies (Australian and Canadian dollars, Euro, UK sterling, etc.), a foreign company winning a contract in US dollars could well end up losing money if the US dollar weakens significantly. And large exchange rate swings are inevitable over the F-35 program’s planned 30-year life.

So, while for example a British company might win with the lowest bid when the pound sterling is weak compared to the dollar, it could lose the work if a rising sterling made its widget more expensive than one manufactured by an American, Australian, Canadian or Danish competitor.

An example can illustrate the perverse effects of exchange rate variations.In April 2002, one US dollar was worth 1.13 euros, while last month – 10 years later – it was only worth 0.75 euros, a drop of about 34%.

So, all things being equal, a part that cost 10 euros (then worth $8.85) to make in 2002 now costs about $13.3 when converted at today’s rate, which makes it all but impossible for foreign firms to remain competitive with US industry.

And, since Lockheed awards orders on “a competitive, best value basis,” a company that suddenly finds that its prices are increased as the dollar’s value drops stands to lose its contracts, or lose its bids for new contracts.

While Australia, Canada, the Netherlands and Norway have most energetically used the jobs/work angle to rationalize their continued commitment to the program, it is in fact for Italy that this aspect is most critical.

Running the future F-35 Final Assembly and Check-Out (FACO) facility being built at Cameri air base, near Novara, is the only military business that will support its troubled aerospace major, Alenia Aermacchi, as work on the Tornado and Typhoon programs winds down.

4. The case of Italy: High-volume, low-margin?

To date, Italy has invested about 1.8 billion euros in the F-35’s development, and another 650-850 million euros (estimates vary) to build the FACO facility which, although to be operated by Alenia Aermacchi, is owned by the state. However, despite this investment, Italian industry is not guaranteed any F-35 production work unless its prices are competitive with those of other countries and of Lockheed Martin.

This was stressed by Gen. Domenico Esposito, Italy’s director-general of air force armaments, during a Feb. 1, 2012 hearing (in Italian only—Ed.) by the Chamber of Deputies’ defense committee.

“Alenia must remain competitive; it simply cannot produce at a higher cost than Lockheed Martin. If Lockheed Martin, which is now producing probably its 50th wing assembly, is far enough [along the learning curve] that it can reduce its production costs, we have to keep up with them” or lose the work.

Esposito added that, as of early 2012, Italian firms had won orders worth $539 million, of which $222 million in 2011. “If we maintain our commitment to the program, this type of work, at the end of the day, will have an estimated value of up to $14 billion for Italy” provided Italian industry remains competitive, he said.

But neither Esposito nor his boss, MoD Secretary-General and National Armaments Director Gen. Claudio Debertolis, were able to provide clear answers to committee members who wanted to know how much of the work intended for Italian industry would be production, rather than assembly, work, and what profit margins it will allow.

“Assembling costly parts does not mean there is a high added value,” committee member Ettore Rosato said during the hearing. “There are companies with a very large turnover and very small margins, and I wouldn’t want Italy to assemble very costly parts on which it would have very small returns.”

Whatever the ultimate results, it is clear that a lot of water will pass under the bridge before Italy will be able to recoup, through its industry’s subcontracting and assembly work, the almost 3 billion euros it has so far contributed to the program – even without counting the cost of actually buying the aircraft.

In a second, follow-on hearing on Feb. 7, Gen. Debertolis told MPs that “We now have a problem with Lockheed Martin, which is insisting on very low costs, much lower than what Alenia can sustain, because we are thinking short-term. Our job will be to force Lockheed to committ itself, from the very beginning, to guaratee Alenia’s prices over the entire production run. This will allow Alenia to invest even if this means posting a loss because it will be sure of recouping its investment in the short term, and to post a profit in the longer term.”

“If there were no [industrial] returns on the wings, that would be a big problem, and it would fast become a political one. We are however resolving the question, and work is continuing in the meantime,” Debertolis said.

Obviously, the same considerations also apply to Australian, Canadian, Danish, Dutch, Norwegian and Turkish companies, but the effects will be even more perverse as these countries have no guaranteed work allocation similar to Italy’s FACO facility.

5. Great expectations getting smaller

The continued slippages in F-35 production are also playing havoc with subcontractor amortization plans and, thus, their cash-flow. Alluding to this problem, one Australian industry executive quoted by the Canberra Times remarked that ''Production Parts could be 'the canary in the mine'….. Having a contract is one thing, but when the orders don't come through there is no cash flow,” either.

F-35 contractors finance their investments in the expectation that contracts – and related payments – will arrive at given dates. When contracts are delayed by several years, the companies have no incoming cash to pay down their investments, and this causes cash-flow difficulties and, in the case of Precision Parts, even bankruptcy.

A related difficulty is the constant reduction of the size of Low-Rate Initial Production batches and their stretching out. The latest such decision, announced in February as part of the FY2013 budget request, reduces F-35 procurement by 13 aircraft in FY13, and by a total of 179 aircraft between FY13 and FY17.

This means that any company that had invested for F-35 production in the expectation of receiving orders and payments for work on those 179 aircraft now finds itself with proportionally lower payments, stretched out over a longer period. Its bills coming due have been neither postponed nor reduced, however.

In short, a sure recipe for failure, especially for the small and medium enterprises that Australia, Canada and the European partners have enticed into joining the F-35 industrial program with the promise of profitable work and technology transfer. Italy, for example, has 25 SMEs lined up for F-35 work, and more are likely to be attracted by the lure of work when other aircraft programs dry up.

Governments, however, are already beginning to back-pedal on their promises. The Canadian government has now revised downwards the size of the golden F-35 pot it promised in terms of industrial benefits.

Industry Canada now estimates Canadian companies are eligible to bid on as much as US$9.8 billion in contracts — down from an estimate of US$12 billion just last year, The Canadian Press reported May 4. However, none of these figures are guaranteed, as the Opposition New Democratic defense spokesman stressed in the same article.

But, even then, a senior government official told a parliamentary committee that “this projection assumes the contracts are renewed throughout the nearly 50 years the fighter is expected to be in service,” the newspaper reported.

To date, a decade into the program, Canadian companies have signed US$435 million in F-35 contracts, the paper added, out of the C$12 billion the government expected its industry to win.

Canada’s Auditor-General, in his celebrated April 3 report, voiced “concerns about the basis of the projections of industrial benefits for Canadian companies [as] Projections made by the prime contractors were (and continue to be) extrapolated over the entire production period.”

The report adds that the far greater share of projected benefits “are based on a combination of opportunities…. that are available through competition to companies from partner countries,” but they “are the least certain, since Canadian companies must compete against companies from other partner countries.”

The Auditor-General also noted that prior to signing on to the program, senior defense decision-makers were warned “that industrial benefits could not be guaranteed under the (Joint Strike Fighter) program.”

6. No offsets for partners, only for OTS buyers

What all this means is that F-35 partner nations have given up their right to industrial offsets in exchange for the right to bid on contracts their industry might, or might not win, and on which it might, or might not, make money, and then only if currency exchange rates remain favorable.

Given that very high offset rates are normal for large fighter purchases – India and Switzerland have both requested 100% of the contract value for the fighter purchases they are now negotiating – it is clear that the F-35 partner nations accepted a very bad deal, since it is arithmetically obvious that none will be able to offset its F-35 purchase by anywhere near 100%.

This is in stark contrast to the favorable contractual terms that off-the-shelf buyers of the F-35 are expected to win, and which are downplayed in official announcements.

This very point was made by the Edmondo Cirielli, chairman of the Italian lower house’s defense committee during the same Feb. 1, 2012 hearing. “The criterion of “best value” could be seen as damaging our industry: while with Eurofighter it had an obligatory return in production work, now it has to fight to win work. This leads us to wonder if, from an economic point of view, it would not have been better to buy the aircraft off-the-shelf, as Japan is doing.”

While Lockheed Martin downplays industrial aspects of off-the-shelf sales, offsets that are forbidden to program partners are, in fact, allowed for off-the-shelf buyers.

In announcing Israel’s signing of a Letter of Offer and Acceptance (LOA) for an initial batch of 20 F-35Cs, the CEO of Israel’s Defense Ministry, Maj. Gen. (res.) Udi Shani, said “the deal also holds tremendous importance for the national economy through the manufacturer’s commitment to purchase billions of dollars’ worth of equipment from Israeli industries,” according to an Oct. 7, 2010 press release by the Israel Defense Force.

In fact, Israel’s F-35 deal is doubly sweet: first of all, it pays for the aircraft with US military aid, so at no cost to its economy, and in addition it gets the US to buy billions of dollars’ worth of equipment in exchange.

Japan, the second off-the-shelf buyer to date, has decided to buy an initial 42 F-35s for $10 billion. The DSCA’s announcement of the deal on May 1, 2012 states “There are no known offset agreements proposed in connection with this potential sale,” but a related, Dec. 21, 2011 statement by Mitsubishi Heavy Industries (MHI) says the company “has been selected by Air Staff Office, Japanese Ministry of Defense, as a potential domestic contractor to participate in manufacturing and after-servicing of Japan Air Self-Defense Force (JASDF)'s F-X…through license production and operational support.”

Again, this is a better and more certain deal than offered to the industries of partner nations.

Conclusion

As explained in great detail in the two parts of this article, the F-35 partner nations cannot back up any of the three most common claims they use to justify their decision to buy the aircraft.

1. Backers claim that only the F-35 has “fifth-generation capabilities,” including stealth and data fusion, that will ensure air supremacy in the future.

In fact, even if its development is a complete success, most of the “revolutionary” capabilities the F-35 will bring to the party in a decade or so, when it finally enters service, already exist. Its advances will mostly be a question of degree, and not the quantum leap in combat capabilities that its backers allege.

And, if the F-22 is anything to go by, the F-35’s sensors and electronics will be so outdated by the time it enters service that it will require several very costly upgrades. As the latest estimate for bringing the F-22 fleet up to scratch is over $8 billion – and that’s for only part of the 150 aircraft now in service -- the mind truly boggles at how much it might cost to upgrade 400 or 500 early production F-35s.

2. Backers also claim that only the F-35 allows full interoperability with US forces and within future allied coalitions.

The inanity of using interoperability to justify buying the F-35 was clearly stated by NATO's supreme allied commander transformation, Gen. Stephane Abrial, a former chief of staff of the French air force, when he testified before the Canadian House of Commons Defence Committee on May 3.

According to a May 4 report published by Canada’s Postmedia news, Abrial told the committee that “We do not advocate a single type of aircraft, single type of ships, single type of rifles….We never wanted to make sure everyone has the same equipment: that's not our goal." Abrial said interoperability has to do primarily with training and ensuring all NATO forces have sufficient skills to function as one on the battlefield, not flying the same aircraft.

3. The third common justification used by partner nations is job creation: buying the F-35 guarantees highly profitable, high-tech work for the buyer’s national aerospace industry, they claim.

As this overview makes clear, the F-35 is the only international aircraft program in recent history to guarantee no industrial benefits whatsoever to its partners.

In reality, partner nations have given up the certainty of license-production and direct and indirect offsets in exchange for the chance of bidding on some contracts.

Never has the folly of giving up a bird in the hand for the faint prospect of many in the bush been so obvious.

This is a further reason why soldiers should stick to soldiering, instead of thinking they can negotiate international agreements, and why politicians should take military recommendations on equipment with a large pinch of salt.

Taxpayers and aerospace workers in the F-35 partner nations will now have ample opportunity, over the next 30 years, to appreciate just how good a deal their governments negotiated.

-ends-

(Edited for style on May 22)

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