Boeing (NYSE:BA) has been burned more than once by its capped-price development contract for the KC-46 Pegasus aerial refueling tanker. Due to a variety of blunders and unexpected complications, development costs have soared far above the contract cap of $4.824 billion. Boeing has been forced to cover the cost overruns out of its own pocket.
On Thursday, Boeing announced yet another earnings charge for the KC-46 program, after it had to make last-minute hardware changes to one of the tanker's refueling mechanisms. That said, the company is finally on track to meet its revised development and production schedule -- and ultimately to turn the KC-46 Pegasus into a successful project.
One more big charge
As part of the KC-46 development contract, the U.S. Air Force agreed to cover no more than $500 million in cost overruns. The rest was to be Boeing's responsibility.
Boeing had already run through its whole $500 million cushion by 2014, but the cost overruns have only gotten worse since then. In July 2015, Boeing recorded a $536 million after-tax charge, largely to cover the cost of redesigning the KC-46 fuel system and retrofitting the initial test airplanes.
The company took an additional $156 million after-tax charge earlier this year to cover increased costs related to beginning low-rate production before the flight test program was completed.
However, Boeing has encountered more problems in recent months. In trying to refuel a C-17 transport plane from the KC-46, Boeing discovered that the turbulence caused by flying the two large aircraft side by side placed excessive pressure on the boom that delivers fuel. At first, Boeing hoped to solve the problem with a software tweak. However, it ultimately decided to use a hardware fix.
This contributed to a five-month delay of the first KC-46 delivery, from March 2017 to August 2017. Not surprisingly, these development problems have forced Boeing to take an additional charge -- this time for $393 million after tax -- which will show up in the company's Q2 earnings report.
Fortunately, Boeing's KC-46 Pegasus development woes appear to be drawing to a close. The recent hardware fix for the refueling boom succeeded. As a result, Boeing has been able to use the boom to refuel both the C-17 and the A-10 Warthog.
With that, Boeing has finally completed "Milestone C" -- proving that the KC-46 can receive fuel from a KC-10 tanker and can refuel five different Air Force aircraft. As a result, the Air Force is expected to officially approve low-rate initial production for the first 19 aircraft next month.
It's still possible that Boeing will encounter more snags on the KC-46 Pegasus. For example, it is behind schedule on certifying the wing aerial refueling pods, a secondary refueling system. Those won't be ready until late 2018. Any development problems that crop up between now and then could lead to further earnings charges.
Nevertheless, Boeing has completed most of the major development activities now, so any future cost overruns are likely to be much smaller than the massive charges it has taken in the past year.
A few years of problems -- decades of profit
Clearly, Boeing has done a poor job of managing the KC-46 development program. There have been too many unexpected problems during the past several years, causing delays and substantial cost overruns. But on the bright side, now that Boeing has demonstrated the tanker's key refueling capabilities, it can start shifting its focus to production.
As disappointing as the past few years have been, the KC-46 Pegasus is still likely to be a major profit center for Boeing in the long run. The Air Force already plans to buy 179 aircraft. Including potential follow-on orders from the U.S. as well as international sales, Boeing believes it could eventually sell 400 KC-46 tankers for $80 billion.
The KC-46 fleet will also generate high-margin service and support revenue for Boeing for decades to come. Twenty years from now, the recent spate of earnings charges will probably seem like a small price to pay to get a valuable franchise off the ground.