Boeing (NYSE:BA) has reversed course and decided not to compete for a $60 billion contract to replace the Air Force's intercontinental ballistic missiles, leaving Northrop Grumman (NYSE:NOC) as the sole remaining bidder involved in the government's massive Ground Based Strategic Deterrent (GBSD) contest.
The decision caught watchers off guard. Only days earlier, during the company's second-quarter earnings call, Boeing CEO Dennis Muilenburg had said, "[W]e are focused on leveraging our work to date on GBSD to help deliver this essential national security capability."
The decision, if final, would make Northrop Grumman the dominant contractor in the Pentagon's effort to modernize its nuclear arsenal. But the issue is far from settled. In a letter explaining its decision to officials, Boeing said it believes the Air Force's selection process gives Northrop an unfair advantage: "After numerous attempts to resolve concerns within the procurement process, Boeing has informed the Air Force that it will not bid."
Boeing's move appears to be a high-stakes attempt to get the Air Force to reboot the process, hopefully at more favorable terms to the aerospace giant. And while the government doesn't like to be pushed around by contractors, there is a decent chance Boeing will get its way this time around.
Replacing the Minuteman
The GBSD is a key cog in the Pentagon's $500 billion plan to modernize its nuclear arsenal and keep the nation's powerful nuclear deterrent in place. It's also one of the largest procurement contracts currently available. The government has already awarded Northrop more than $50 billion for a new long-range bomber, and has allocated more than $100 billion to a team led by General Dynamics to develop and construct a new generation of nuclear missile submarines.
Boeing's Minuteman is the incumbent international ballistic missile, but it's an aging design that the Pentagon hopes to replace by 2027. In 2017, the Air Force awarded Boeing and Northrop Grumman $349 million and $329 million, respectively, to develop competing new designs, with a goal of selecting a winner next year. Lockheed Martin had also been interested in the contract but was eliminated in 2017.
Northrop last year spent $9.2 billion to acquire Orbital ATK in part with this competition in mind, and Northrop Grumman's ownership of Orbital, the nation's primary producer of rocket motors, is at the heart of Boeing's objection. In its letter Boeing complains that the Air Force "takes no steps to mitigate Northrop's anticompetitive and inherently unfair cost, resource, and integration advantages," and says Northrop has also been unwilling to enter into an agreement that would prevent the sharing of confidential business information.
The decisions the Air Force makes in the months to come will ripple through the supply chain. In addition to the Northrop-versus-Boeing battle, this program is also pivotal for rocket engine manufacturer Aerojet Rocketdyne, which has warned lawmakers it needs to win at least part of this procurement to remain a viable supplier.
A difficult position
If Northrop were to win the GBSD competition, the company would enjoy a central position in the nuclear refresh. In addition to manufacturing the B-21 bomber, it's also contracted to provide the solid rocket motors for missiles to be launched off the new nuclear submarines.
There's a long history in the defense sector of procurement campaigns being reworked due to complaints from industry. Given the potential ramifications to the supply chain of a Northrop win, it seems quite possible that the Air Force will take Boeing's complaints seriously. There will also likely be pressure from Congress to prevent this from becoming a sole-source negotiation.
Then again, Boeing's defense unit has had a strained relationship with the Air Force of late, with the company earning a rare public rebuke from the service in 2018 due to delays and cost overruns in the long-awaited KC-46 refueling tanker program. Boeing finally delivered the first of the tankers earlier this year, only to have them grounded after inspectors found tools and other debris left inside completed aircraft.
No matter what happens, Northrop seems well positioned to at least share in some of the eventual spoils. In making its complaint, Boeing is all but conceding the importance of Orbital's technology to the effort. In almost any scenario, Northrop appears likely to at least be a key subcontractor on the GBSD.
This will take time to play out
Looking beyond the GBSD, this conflict, should it grow, could cast a damper on future defense consolidation efforts. The Pentagon and Federal Trade Commission worked hard on a consent agreement designed to avoid these issues before approving Northrop Grumman's purchase of Orbital. Hearing Boeing complain that, at least from its perspective, the agreement did not work as designed and competition is harmed will make it that much harder for future deals to be approved.
At worst, the Pentagon or regulators could come back to Northrop Grumman to demand new terms that could limit its ability to integrate Orbital, or fine the company for failure to comply, though that seems unlikely. But with lawmakers and defense officials already skeptical about the depth of the supply chain, and a transformational deal like United Technologies' planned merger with Raytheon awaiting review, investors need to be on guard for potential ripple effects coming out of Boeing's actions.
If nothing else, this latest development seems likely to push the final GBSD award out beyond the Pentagon's 2020 target date. And I'd wager it's more likely that Boeing will win some sort of a reprieve that allows it back into the competition than it is that the Air Force will simply negotiate with Northrop Grumman and be done with it.
It appears Northrop Grumman was shrewd in acquiring Orbital ATK. But even with Boeing signing off, the GBSD competition is still too early to call. Investors in the entire defense sector need to watch closely as this battle plays out.