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August 19, 2016
On Breaking Defense this morning, Colin Clark notes that Boeing has just won “$2.8 billion for KC-46 tanker low rate production”. That’s good news. As multiple reporters have written this year, the company has had to overcome one delay after another, with problems “more complex than realized,” and particularly with the aircraft’s refueling boom. Clark summarizes his article with a pair of questions and answers: “Will the aircraft make money for Boeing? Almost certainly. Will Boeing be able to produce it at the rate the Air Force expects, and will it perform as well as the service hopes? We’ll see.” I think, however, that he might have that backwards. For Boeing, like rival Airbus, will make its aircraft work regardless of how much money is lost along the way. At some point, though, it should stop that.

First, let’s recount a little history. After two sordid earlier efforts, Boeing won the KC-X competition in March 2011, promising to develop and build 179 KC-46 Pegasus aerial tankers for $31.5 billion, or about $176 million per plane. That sum was fully $3.5 billion, or 11 percent, less than Airbus bid to develop and build 179 KC-45 Multi-Role Tanker-Transports (MRTTs). At the time, Ralph Crosby of EADS North America called Boeing’s bid “very, very aggressive,” and much less than his company had contemplated offering. Fresh from the near-failure of the A400M program in 2010, Airbus was not about to bid too aggressively again. At the time, plenty of analysts wondered whether Boeing would make money on the project.

On paper, the winner indeed appeared to have bid far too low. Boeing’s current average list price for 767 freighters (the aircraft on which the KC-46 is based) is $199.3 million. Airbus’s current average list price for A330 freighters (the aircraft on which the KC-45 is based) is $234.7 million. Jetliners worldwide are generally priced in dollars, not euros, and that was important to Airbus, which bore exchange rate risk that Boeing did not. Of course, no airline actually pays those fake prices; they’re just starting points for lengthy negotiations. What they do indicate is that Airbus’s opening position today is 18 percent higher than Boeing’s. So Boeing had some maneuvering room.

How much it used is the question. Airbus was willing to bid low to secure indirect financing for a factory in the United States, where building in dollar-demoninated costs would obviate those currency risks, and where the labor costs were not higher than in Germany or France. Boeing was willing to bid low to prevent all that. Because the Boeing plane was smaller and thus less expensive to build, Boeing could do so. The problem with bidding too aggressively was that it might not leave room for fixing the unforeseen problems that always arise in new product development. With a fixed-cost program, the government wouldn’t be picking up the cost overrun. The commercial rivalry with Airbus had long been intense, but not quite self-destructive.

Next, let’s turn to the contract at hand. Boeing will receive $2.8 billion for the first two lots (7 and 12 aircraft) of low-rate initial production (LRIP). That’s a production price (excluding the mostly-completed development) of $147 million per plane. The figure is about 26 percent below the list price of the underlying freighter, before all the military electronics and refueling gear that a tanker needs. The USAF plans to buy a total of 179 KC-46s in the program, before presumably running another competition for the KC-Y aircraft. Boeing may have offered laddered pricing for later lots, but we can take the $147 million per plane as a rough figure, and conclude that the whole program henceforth will cost 179 planes x $0.147 billion/plane = $26.313 billion. The development contract had a cost cap of $4.9 billion, so that’s about right.

But how much will Boeing earn? As with most big contractors, Boeing’s margins in its defense and space businesses have generally hovered around 10 percent, which is rather lower than its long-standing margins for commercial aircraft. The government usually pays all (not just most) of the development costs, and pays ahead of time, but also has greater buying power than the airlines. And remember, Airbus and others were greatly surprised at how aggressively Boeing bid back in 2011, before any problems emerged.

Earlier this year, the full magnitude of that problem was made known: Boeing’s cost overrun in developing the KC-46A has been $1.3 billion. The cost is sunk, but that's the nut the company must make to consider the program successful. Earning back $1.3 billion through revenues of $26.3 billion, merely to break even, requires a profit margin of about 5 percent overall. As noted above, that’s just half what the company typically manages. Also as noted above, we can anticipate that Boeing will learn how to build the KC-46s somewhat faster and for less money. Whether it can manage several hundred basis points better than planned over 179 aircraft is another matter. Add the cost of capital, and the whole thing can be labeled a financial fiasco.

Now let’s turn to Airbus and its problems. Some fifteen years ago, a four-engined turboprop transport seemed a great way to bridge a gap in the market between Lockheed’s C-130 Hercules and Boeing’s C-17 Globemaster III. Fast forward to this past June. In Defense News, Lars Hoffman reported the German Federal Ministry of Defence has been talking to other countries about the prospect of a small, joint fleet of C-130s. Germany retains plans for a large fleet of Airbus’s A400M Atlas transports, but the program is behind schedule, and the Luftwaffe's recent experience in Mali indicates that a smaller airplane is needed for air commando missions and entry into smaller, rougher airfields. All the same, the big turboprop can go many places, and made an impressive demonstration of that short-field performance at last month's Farnborough Air Show.

The bigger problem was the disastrous fixed-price development contract that, in the words of CEO Tom Enders back in 2010, “put the whole of Airbus in jeopardy.” At the time, I calculated Ender’s assertion to be a slight exaggeration, but Airbus was hardly making big money from the project. As I noted last month, Airbus has conceded that many of the problems with the A400M are indeed the company’s. As Defense News also reported in June (though with a now-broken link), Airbus is even now “still focusing on fixing cracks on its propeller gearbox and cracks on the central part of the fuselage on some aircraft.” Airbus will get these fixed too, just with its own money. Once it writes off those costs, it will start from a great marginal position in pitching the airplane to the US Air Force, whose earliest C-17s are now 20 years old, and whose C-130s cannot move most armored vehicles.

At one time, the A400M was a dream project for Airbus. At one time, the KC-46 was a must-win for Boeing—so much so that the company bought the business, basically to keep Airbus from planting a flag in the United States with a factory in Mobile. As it turned out, Alabama is such a great place to build airliners that the-now-American Airbus built it anyway. So much for that strategy. Management at both Airbus and Boeing have indicated of late that their commercial businesses are far more important to their respective companies than their military work. Their shareholders by-and-large agree. Their military customers would just like to see schedules met. With the worst of the KC-46 and A400M programs hopefully past, we can further hope that Airbus and Boeing can be past some of the more self-destructive behaviors of their long-standing rivalry. These occasional, massive over-promises have done nothing for public confidence in military procurement.

James Hasik is a senior fellow at the Brent Scowcroft Center on International Security.