While Trump Fumes, F-35 Subcontractors Reap Bumper Profits and Buyer Countries Quake
(Source: Defense-Aerospace.com; posted Jan 23, 2017)

By Giovanni de Briganti
PARIS --- While the F-35 program continues to struggle with high costs, international contractors are benefiting from windfall profits of up to 40 percent on the program thanks to the US dollar’s appreciation over their national currencies.

The size of the windfall varies according to the date of the subcontract award and to the national currency, with the greatest variation -- + 39.6% -- being registered in Turkey, where several companies, including Roketsan and Aselsan, are developing missiles and subsystems for the F-35.

The second-largest variation plays in favor of Norway, with potential 30% windfall profits for Kongsberg Gruppe, the largest local F-35 contractor, and Nammo, which is contracted to make 25mm ammunition for the aircraft’s automatic cannon.

The smallest exchange rate variation is registered in Israel, where the potential windfall only amounts to 9.4%, which is still however an appreciable profit top-up given the tight margins that Lockheed Martin, the main contractor, is forcing on its suppliers.

In other words, while the Pentagon struggles to lower F-35 production costs, and with incoming US President Donald J. Trump tweeting about the “tremendous cost and cost overruns of the Lockheed Martin F-35,” the program’s foreign contractors are reaping bumper profits.

This is due to the F-35’s contracting structure. All foreign subcontracts are labeled in US dollars, with an exchange rate that is fixed for the contract’s duration, normally five years. Whatever the exchange rate variations during that term, the exchange rate does not change.

This is unsurprising, because neither Lockheed, the Pentagon nor foreign subcontractors could base their business plans and production plans on ever-changing exchange rates, but this very stability constitutes another program vulnerability. Lockheed Martin did not reply to an e-mail seeking details of F-35 contractual exchange rates.

What goes around comes around

For the time being, the rising dollar means that the dollar amounts give foreign subcontractors an unexpected extra profit margin of about 20% on average.

Conversely, the next time the dollar’s exchange rate value drops, the process will reverse itself, and foreign contractors will be paid less when they convert their dollar payments into their local currencies. Given the tight profit margins, it is not sure that the smaller companies might survive a sudden drop in the dollar’s value, if they are just coping in the middle of the current exchange rate boom.

A case in point is Chemring, a troubled British manufacturer, which announced on Jan 17 that it had returned to profit, thanks to the favorable dollar/sterling exchange rate.

As reported by the Telegraph on Jan 19, “Chemring enjoyed a boost from the weaker pound, driving up full-year revenues 26.5pc to £477m” whereas, at 2015 exchange rates, “the rise was 16.7pc…. On a statutory basis, Chemring made a pre-tax profit of £8m, reversing the previous year’s £9.1m loss” thanks to the dollar’s appreciation.

Other F-35 subcontractors across the world are enjoying a similar boom.

But while F-35 contractors see their revenues and profits inflated by the dollar’s exchange rate appreciation, F-35 customer governments, who pay for their aircraft in dollars, are seeing a similar explosion in the cost of their aircraft.

USD rise explode F-35 costs

Each F-35 that Turkey has ordered is now 40% more expensive in its local currency, while Norway can expect to pay a 28% premium and Britain 25% at today’s exchange rates. And the three F-35 partners in the Eurozone would pay 23% more if their F-35s were delivered today, as the bulk of an aircraft’s price is paid on delivery.

This will obviously wreak havoc on annual budgets and multiyear defense plans, as once voted into law by national Parliaments budgets are difficult if not impossible to change. The Netherlands governing coalition, for example, set a ceiling for its F-35 procurement, which forced it to reduce the number of aircraft it buys from the original 65 to 37 in 2014.

A further increase of 23% in acquisition costs means that, unless the government coalition negotiates another agreement, the number of F-35s for the Dutch air force might well be reduced by over one-fifth, or about 7-8 aircraft, to under 30.

When we last looked at this issue, in September 2015, the value of the US dollar – and thus the cost of each F-35 to Eurozone buyers - had increased by 22% in one year -- rising from €0.73 in mid-2014 to €0.89 now. It is now €0.93 – an increase of about 5% in euro terms but much higher for other currencies.

Canceling F-35 cost reductions

The F-35 Joint Program Office often claims – without any substantiation -- that it is reducing aircraft unit costs by 3-4% in each successive annual order. While this may add up over time to reduce acquisition costs for the US armed services, foreign buyers have no such luck: even assuming these 3-4% cost reductions are real, they are more than wiped out by the dollar’s rise.

For Turkey, for example, dollar-denominated F-35 prices would have to drop by over 40% just to be visible – an impossibility. So, whatever happens, foreign buyers will see the cost of their F-35s continue to increase by very substantial margins, whatever the JPO’s success in lowering costs, unless the US dollar’s value drops very substantially.

Most European countries, egged on by the United States and fearful of further Russian expansionism in Russia, have announced plans to increase their defense spending, which could limit the negative effects of the dollar’s appreciation, but higher dollar prices will also affect other American-made or -supplied weapons, and thus eat into the purchasing power of defense modernization budgets.

Story history
-- Jan 23, 2017: replaced graphic of foreign exchange variations as original contained errors.


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