Boeing Down on Pentagon Move

The government has ordered more studies on the controversial Air Force contract.
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Updated from 11:01 a.m. ET

The Pentagon's decision to delay final ruling on

Boeing's

(BA) - Get Report

$23.5 billion contract to provide refueling tankers for the Air Force puts a major crimp in the company's plans to end production of the 767 passenger jet, with potentially massive charges hanging in the balance.

Defense Secretary Donald Rumsfeld late Tuesday ordered another round of studies, which will be completed around November, to determine if the Air Force needs additional refueling tankers, which are based on the 767 passenger jet. The decision is another in a series of blows to Boeing, which warned in a

Securities and Exchange Commission

filing that a cancellation could result in a $270 million to $300 million charge to earnings.

In response, Boeing expressed muted optimism that it would successfully sign the deal, backing the Pentagon's choice to study the contract. Recently, Boeing shares were down 25 cents, or 0.6%, to $44.45.

"We respect the Secretary's decision to defer his decision until November," said Doug Kennett, spokesperson for the company. "We believe the Analysis of Alternatives and Mobility Capability Study are important. We firmly believe that the 767 tanker is the only solution that fulfills all 26 of the Air Force's stated requirements."

While the company remains hopeful that it will win the tanker deal, Wall Street remains doubtful and recommended that investors assume that it will fall through.

"We remain of the opinion that no investor should hold Boeing shares if they cannot accept the risk of a multiple hundred-million dollar charge that could be necessary if the deal is cancelled," said Jim Higgins, analyst for Credit Suisse First Boston, in a research report. "We have no confidence that the tanker deal will 'fly' for Boeing." (CSFB does and seeks to do banking business with the companies covered in its research reports.)

The Political Battle Over Boeing

The recent news has prompted Boeing to reassess its chances.

"We are reviewing if today's announcement requires us to change our assessment of probability," Kennett said in a statement late Tuesday. "The language in Secretary Rumsfeld's announcement is consistent with the language in the House of Representatives' budget for 2005. ... If, in fact, this or any other information that becomes available requires us to change our assessment of probability, we'll make the appropriate disclosure."

Indeed, the House of Representative's version of the 2005 budget was a notable bright spot in Boeing's battle to keep its tanker deal. Two weeks ago, the House of Representatives' Armed Services Committee passed the 2005 Defense Authorization Bill, which set aside $95 million to expedite the Air Force's plans to lease and buy tankers.

But while the House seems to support Boeing, the Pentagon's own internal studies of the contract do not. Recently, the Pentagon's inspector general had previously recommended that the government explore alternatives to buying the tankers and said the current contract overcharged the government by $4.5 billion. And earlier this month, the Defense Science Board said the Air Force lacks a "compelling material or financial reason" to buy the tankers, arguing they were unnecessary.

Boeing's status with the Pentagon has been in chaos since a hiring scandal blew up around the contract last year, eventually leading to the ouster of CEO Phil Condit. As recently as last week during a meeting with analysts, the company expressed confidence it would ultimately get the Pentagon pact, with CEO Harry Stonecipher saying: "We have a customer who wants them very badly, and that's the Air Force, they're the customer. The customer has not changed their mind one iota about wanting the 767 tanker program that made its way through Congress ... and was in the 2004 defense spending bill."

The Pentagon's move to delay making an official ruling on Boeing's contract could have been politically motivated, said Higgins. The studies are to be completed around November, which would come after the presidential elections, but still allow time for the project's funding in the Bush administration's fiscal-year 2006 budget request.

"Given the heavily politicized debate surrounding the tanker," Higgins said, "we believe this decision is being made to eliminate distractions and defer a potentially controversial decision about the tanker until after the presidential election."

A $500 Million Charge?

The delay will impact Boeing's plan to wind down production of its 767 passenger jet in the next two years. Because the tankers are based on the commercial 767 jet platform, the company needs to keep the production line going, but with just 22 jets left to deliver, time is running out.

"Once that line is shut down, it is prohibitively expensive to restart it. That's why the timing of the government decision on whether to purchase military versions of the 767 is being watched so closely," said Peter Jacobs, analyst at Ragen MacKenzie. "Making things a little bit more complicated is that Boeing needs to make a decision six to 12 months before the last 767 is built." (Ragen MacKenzie does not have investment banking interests, but Jacobs owns shares of Boeing stock and rates the company a buy.)

A spokesperson for Boeing said that the November delay will not impact the production line, because the company has received new orders to produce tankers for Italy and Japan and continues to market the aircraft to a number of customers. A decision on the future of the 767 production line would not be necessary until next spring, the company said.

Ultimately, in a worst-case scenario, where Boeing lost the tanker deal and closed the 767 production line, Jacobs said that the company would be hit with more than just a $300 million charge.

"There would be two charges," Jacobs said. "One is for the capitalized expenditures incurred so far for developing a tanker version of the 767. That could be between $200 million and $300 million. Now, the indirect affect of a cancellation of the program would be that the 767 needs to be shut down. That could result in a $100 million to $200 million change. Really, we're looking at $400 to $500 million, total."

Jacobs estimates that a charge of that magnitude would impact Boeing's earnings by 40 cents a share, after taxes, which would offset the better-than-expected earnings guidance the company gave a few weeks ago. But, given Boeing's timing on the closure of the 767 line, any charge likely would impact 2005 earnings.

Not Good, But Not So Bad, Either

Given the size of Boeing's operation -- the company is expected to generate $52 billion in revenue in fiscal 2004 -- dramatic weakness in shares related to the tanker deal could create an investment opportunity.

Analysts say the underlying trends are improving for Boeing, which recently raised guidance, telling investors that low-cost carriers are clamoring for jets. Furthermore, Boeing's next-generation 7E7 Dreamliner appears to be popular with customers.

All Nippon Airways

became the 7E7's launch customer, buying 50 aircraft with a value of $6 billion.

"Even if Boeing lands this tanker program and five years out gets up to full steam, it would only account for 5% of Boeing's defense and space revenue and less than 3% of company's total revenue," said Jacobs. "While an important program, it does not upset the apple cart, but it does create a speed bump on an improving story."