A bit of history
We first wrote about the Air Force's attempt to acquire a new refueling tanker for its air fleet 13 years ago, when Boeing CEO Phil Condit was forced to leave office in the wake of an ethics scandal. In an attempt to control costs, the Air Force had approached Boeing about the possibility of leasing, rather than buying, 100 modified Boeing 767 commercial airliners to serve as flying gas stations. Boeing loved the idea, which apparently would have been more profitable for it than selling the aircraft outright. Unfortunately, it liked the idea so much that it ended up offering one Pentagon official, with influence over the deal's outcome, a job at Boeing -- an apparent conflict of interest.
Needless to say, the lease deal never actually went through.
Multiple false starts and false finishes ensued before, in 2010, Boeing beat out both rival Northrop Grumman (NYSE:NOC) and its one-time partner Airbus (NASDAQOTH:EADSY) and won a new deal to sell the Air Force as many as 179 new tankers (KC-46, based on -- wouldn't you know it -- the 767 airframe!) for $31.5 billion. Follow-on orders from the Air Force, plus potential orders from U.S. allies abroad, could lead to as many as 400 sales over the course of the program -- and perhaps $80 billion in combined revenues.
Of course, to get the loot, Boeing first had to build the airplane, and get it certified to fly.
Back to the future
Fast-forward to today, and Boeing is finally there. Last week, the U.S. Air Force announced that Boeing's KC-46A Pegasus has "received Milestone C approval" and therefore "is ready to enter into production."
Sometime within the next few weeks, the Pentagon is expected to award Boeing the first of two low-rate initial production (LRIP) contracts to begin building the plane. Assuming all goes well with these first two lots, approval to begin full-rate production will likely follow some years later.
The Air Force expects to pay $2.8 billion to purchase the 19 KC-46A tankers contained in Boeing's first two production lots, which works out to an initial cost of $147.4 million per plane. And if you think that sounds like a lot of money -- it isn't.
In fact, according to Boeing's official price list, a civilian model 767-300 Freighter lists for $199.3 million. And the 767-300F doesn't have to carry all of the fancy electronics that go into making a military aircraft combat-capable -- detecting enemies and dodging missiles and so on (to say nothing of the equipment needed to enable air-to-air fuel transfers). All those extra goodies cost money, yet believe it or not, in its zeal to beat out Northrop Grumman and Airbus and win this contract, Boeing agreed to charge less for the plane with those extras, than it charges for planes without.
Result: So far, between pricing its KC-46A bid too low and incurring penalties for taking too long to build it, Boeing has already had to write off $1.3 billion in pre-tax charges to income on its Pegasus program.
What it means to investors
Now that the plane has been certified, though, are all of Boeing's problems behind it? Management would like you to think so, but I'm not so sure.
Back when Boeing was still vying against Northrop and Airbus to win KC-46, Airbus described Boeing's winning bid as "very, very aggressive." In fact, Boeing bid 10% cheaper than Airbus's offer to build a similar plane -- essentially giving up defense contractors' rule-of-thumb 10% profit margin just to win the business.
Conceding defeat, Airbus called Boeing's bid "much lower than [Airbus] would have gone," and with losses mounting on the program, now we see why. Boeing's only hope at this point is that it can find a way to build the KC-46 cheaper than it has started out costing (perhaps by spreading out production costs across its civilian 767 operations, to gain production efficiencies), and/or win enough international orders to generate similar efficiencies, to help build its profit margin back up.
Stay tuned to the Fool for more news on that front.
Fool contributor Rich Smith does not own shares of, nor is he short, any company named above. You can find him on Motley Fool CAPS, publicly pontificating under the handle TMFDitty, where he's currently ranked No. 301 out of more than 75,000 rated members.
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