It looks like Boeing (NYSE:BA) will finally be building the U.S. military's newest aerial tanker, not just because it was officially awarded the contract, but because the only real threat in the bidding process - EADS - has decided not to cry foul this time. See, the contract was first given to Boeing in 2004, then to a Northrop Grumman (NYSE:NOC)/EADS duo in 2008 and then back to Boeing a few days ago as part of a long and often unclear assessment process.
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Certainly, congratulations are in order, but the story here isn't the overt one of Boeing's impending new revenue of $31.5 billion for the tankers and up to $100 billion in total revenue for parts and service. Rather, the message investors of any military contractor may want to absorb is this - EADS (on its own this time) simply decided to walk away, leaving the money on the table.
The stated reason for letting it go was simply that the company respected the Pentagon's final decision, and that it couldn't feasibly bid any lower. In reality, though, one has to wonder if EADS recognized that it just wasn't worth the risk now that the U.S. military has finally decided to clamp down on cost overruns.
That Was Then, This is Now
This new tanker deal is a bit different than most military contracts have been up until this point. This is a fixed-cost contract, meaning any cost overruns won't be supported or co-paid by the Pentagon. If Boeing can't do it at its proposed price, that's Boeing's problem, and it will be Boeing's expense.
It's a stark turnaround from the gravy train defense contractors enjoyed in a post-911 world, where budget-busting projects only cost the military more money - not the weapons manufacturer. With funding drying up in a major way for all the Federal government's major needs, there's just no more room for that type of reckless spending. As such, fixed-cost contracts are the new norm.
Not up For the Challenge
The new era of financial constraint poses more than a mere annoyance for weapons builders. In fact, sticking to a budget may require a corporate culture overhaul these companies are simply not able to muster. For proof, look no further than Boeing. Its 787 Dreamliner passenger jet is not only three years overdue, but it's also a stunning 120% over budget.
Other military contractors aren't any more constrained or effective. Defense Department officials have said Lockheed-Martin's (NYSE:LMT) MEADS (Medium Extended Air Defense System) program is on the chopping block due to cost overruns. The same goes for Raytheon's (NYSE:RTN) surface-launched medium range air-to-air missile program, and several other in-development initiatives.
In fact, over the last five years, the Pentagon has spent $300 billion more than it was actually authorized to spend. The next five years won't be the same. It may never be the same again, now that fixed-cost contracts are the new norm.
The historical attraction investors have had to defense contractors was largely based on the infinitely-deep pockets of the government. With that no longer being the case, the defense sector is just another group of stocks facing the same competitive struggles other companies do. The problem is, that's not a situation they're used to, and they may not handle it well. (For related reading, also take a look at War's Influence On Wall Street.)
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