Friday, August 19, 2016

Five Reasons Boeing's Big Bet On Air Force Tankers Will Pay Off Handsomely

 A Boeing KC-46A tanker refuels a C-17 airlifter (also built by Boeing) during Air Force testing in July. Aerial refueling greatly extends the reach of joint and coalition aircraft. The KC-46A will be able to refuel three fighter-size aircraft in flight at the same time.
 (U.S. Air Force / Boeing)

The Air Force announced Thursday that it has awarded the Boeing Company a $2.8 billion contract for the first two production lots of KC-46 Pegasus aerial-refueling tankers totaling 19 aircraft. The award follows an August 12 “Milestone C” approval by the Pentagon’s top weapons purchaser signaling that the tanker has surmounted development obstacles and is considered ready for production. Boeing will begin delivering the first production planes to the Air Force in about a year.

Developing the Air Force’s next-generation aerial refueler from its 767 wide-body jetliner has proven harder than Boeing anticipated. When they bid aggressively to win the fixed-price development contract in 2011, Boeing executives figured they might not hit the $4.3 billion target price the Air Force had established, but they could avoid absorbing cost overruns above the ceiling price of $4.9 billion. The way the contract was written, the government would cover 60% of costs above the target price until the ceiling was reached, and then it was all Boeing’s money.

Although Boeing engineers ended up completing the program close to their planned schedule — they used up all six months of slack built into the plan, and then some — their cost estimates proved too optimistic. The Air Force says tanker development will eventually cost $6.4 billion, meaning Boeing (a contributor to my think tank) has had to cover over a billion dollars in unexpected expenses. However, that is a small price to pay for the aerial refueling franchise that Boeing has secured. Here are five reasons why Boeing’s bet on next-gen tankers is going to pay off handsomely for shareholders.

The current program is just the beginning. The Air Force has 450 Cold War tankers that it must replace. So the present $52 billion program to build 179 next-gen tankers by 2027 is just the beginning of what will be needed. According to the Pentagon’s latest aviation funding plan, “continued procurement of KC-46s beyond FY 2027 or the acquisition of a new tanker will be necessary beginning in FY 2028.” Having invested heavily in developing and sustaining that first tranche of tankers, the Air Force is unlikely to go looking for another plane before it commences follow-on buys in 2028. Add in likely sales to foreign customers, and Pegasus production will probably be worth over $100 billion to Boeing.

Most tanker revenues are generated after delivery. Military aircraft typically cost more to sustain over a multi-decade service life than they do to manufacture. Some of those post-production costs are items like fuel, but a big chunk consists of maintenance, spare parts, repairs, and the modifications necessitated by changing threats and technology. Boeing already does a booming business in aircraft services, and it will have the inside track to participate in sustaining Pegasus. So the long-term value of KC-46 to the company is more like $200 billion rather than $100 billion. The Air Force will insist on doing some sustainment organically, but it can’t afford to reproduce the infrastructure Boeing already has for supporting 767s.

Boeing has preserved a 60-year franchise in aerial refueling. By bidding aggressively to win KC-46, Boeing preserved one of its most valuable military franchises. All of the tankers in the current Air Force fleet were built by Boeing, and the venerable KC-135s that Pegasus initially will replace — last produced in 1965 — were themselves successors to the propeller-driven KC-97 tanker that Boeing derived from its B-29 bomber. In other words, Boeing has more experience with aerial refueling than any other company in the world, and preserving that franchise was crucial to the business strategy of its defense unit.

Militarized jetliners are becoming a core offering. With the gradual waning of legacy McDonnell Douglas aircraft lines, Boeing is placing renewed emphasis on leveraging its commercial transport expertise into military markets. It has sold earlier tanker versions of the 767 to Italy and Japan, radar planes based on the 737 to Australia, South Korea and Turkey, and a commercially derived maritime patrol aircraft called Poseidon to the Navy. To the extent that it can successfully adapt its jetliners to future military missions such as refueling, surveillance and intelligence gathering, it generates important synergies (not to mention opportunities) for the whole enterprise.

Airbus is blocked from becoming an Air Force supplier. One reason Boeing bid so aggressively to beat Airbus in the competition for the tanker program is that it didn’t know how much financial help its heavily subsidized rival would get from friendly European governments. The Air Force refused to take subsidies into account, even though the World Trade Organization has ruled that the plane Airbus was offering probably wouldn’t even exist in the absence of illegal “launch aid.” Boeing bet big to win the tanker in part because allowing Airbus to become a major supplier to the Air Force (Boeing’s biggest military customer) would have impaired the long-term outlook for its entire business.

With the announcement on Thursday that KC-46 production will now commence, though, it is easier to step back and see the wisdom of Boeing’s tanker bet. One thing that has allowed America’s biggest exporter to survive while most of its former rivals in the aircraft business have disappeared is the ability to think and plan for the long term. Aircraft development and demand cycles extend over many years, so staying ahead requires being able to look beyond quarterly earnings calls. The smart bet that Boeing made on the Air Force’s next-generation tanker will still be paying dividends to shareholders and stakeholders alike long after all the executives engaged in the decision are retired and gone.

(Loren Thompson - Forbes)

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