Will WTO vote really matter?

Update, 0815 AM PDT: Boeing just responded to email questions posed last week, mainly dealing with WTO issues but also with the airplane. Here is the exchange.

Q. How can Boeing and its supporters be pursuing legislation in Congress that amounts to self-help, which is illegal under WTO rules?

A. I think this question is best answered by the sponsors of the legislation.

Q. If the Northrop mark-up of 10%-15% is correct and even if you take into account the WTO findings on Airbus @ $5m per plane (which would be illegal under WTO rules, but supposing this is done anyway), the elimination of NOC seems to more than make up for any such penalty, what is Boeing’s reaction to this math?

A. We won’t have a reaction to any hypothetical pricing scenarios. The U.S. Air Force will evaluate price in this competition.

Q. Do you agree that a WTO finding against Boeing would likewise have to be assessed by USAF and added back into Boeing’s cost?

A. You might want to engage the USTR concerning potential “findings” in the future.

Q. Please update Boeing’s previously stated, generalized concern about the fixed price aspect of the contract. Is this a continuing concern and how much of a concern is it to the company? How much affect does this have on the ability to submit “a financially responsible proposal”?

A. We stated previously that stable, clear requirements and mature technologies are critical to a successful fixed-price development acquisition. The current acquisition approach will be successful if (government and industry in partnership) adhere to these parameters. Boeing is committed to working with this contracting approach in partnership with the customer as the process moves forward.

Q. Please comment on the risk factors to Boeing of having a developmental airplane derived from the troubled Italian tanker platform, and how much uncertainty this adds to creating a financially responsible proposal.

A. I’m not sure why you’ve focused solely on the Italian KC-767…especially since we’ve delivered all four KC-767Js to our Japan customer and they’re flying real missions in operational squadrons. That said, we have mitigated tremendous risk through our international tanker programs and strongly believe we can limit risk in our U.S. Air Force offering.

Original Post:

The US House of Representatives last week voted to direct the USAF to take into consideration the WTO finding that Airbus illegally benefited from improper subsidies during the development of a family of airplanes.

This includes the A330-200 on which the EADS KC-45 is based. EADS plans to bid this airplane in the USAF KC-X competition.

The US Senate must go along. We don’t know at this point if this is something the President must sign or not.

Never mind that this action is completely illegal to the very WTO rules Boeing, the US Trade Representative and the Congressional supports seem to cherish.

But does it really matter? The answer may surprise everyone, but it may very well not matter. EADS still could offer an airplane that will be Boeing on price.

Here’s why.

Three significant things have happened that will help EADS and a fourth is likely to happen very soon.

  1. Northrop Grumman withdrew from the competition. Initially this was viewed as a huge and fatal blow to the EADS hopes for the tanker. But with NG’s withdrawal also goes its profit margin mark-up. Defense consultant Michel Murleuzeau of G2 Solutions in Kirkland (WA) estimated to Flight International that this mark-up was 10% to 15%. We do the math in our companion posting today.
  2. The Euro-to-dollar exchange rate has been tanking, to the benefit of Airbus. We talk about this below.
  3. Boeing doesn’t have a real airplane to offer. The KC-767 NewGen is conceptual. Boeing doesn’t definitively know the airplane’s development costs–it can only estimate it. Given the program fiasco of the Italian KC-767 tanker from which the KC-767NG is derived, there is a real risk about the development costs Boeing faces–and the fixed price contract provision is a major worry. More on this below.
  4. And then there is the kicker: the WTO Interim Report on the European complaint against Boeing’s alleged illegal subsidies is due this month. Boeing figures it will be found guilty, but it’s gambling the penalties will pale compared with the $5bn+ associated with the A330. Boeing’s talking points are already out to its supporters and employees, downplaying the prospect of the anticipated WTO-Boeing findings. Airbus officials believe Boeing faces illegal subsidies at least as onerous as those tagged to Airbus, and suggest it will be even more so.

Let’s take these one at a time.

Northrop’s withdrawl

We talk about this more in our companion post, but in a nutshell, Northrop’s withdrawal means the company’s mark-up and profit-margin over the EADS portion is now history. We’ve asked several people what this figure is, and we are told only it is “significant.” As noted above, G2’s Murluzeau estimates this to be 10%-15% of the $184m bid price Northrop submitted in 2008. This, alone, far outweighs the estimated $5m penalty Boeing and its supporters suggest is associated with the WTO-Airbus ruling.

The falling Euro

This is a Big Deal for Airbus and it is all, for the moment, in Airbus’ favor. Below is a chart from x-rates.com (no kidding; they need a new name).

Every 10 cent rise or fall in the dollar to the Euro means $1bn EBIT (Earnings Before Interest and Taxes) to Airbus. The chart above shows about a 25 cent decline in the Euro to the dollar since the first of the year–or $2.5bn in savings to Airbus. If Airbus hedges at this level against a rise in the Euro, or the Euro stays about at this rate, a level Airbus officials believe is a fair exchange rate, this will help EADS in its bid for the tanker.

We have no idea what the flow-through benefit on the lower exchange rate to the tanker bid will be, but we would not be surprised if it is no small change. There is market speculation that the Euro could reach parity with the dollar or even fall below the dollar.

Add this benefit to the EADS bid price.

Boeing development costs

We would not want to be in Boeing’s shoes on this one. The KC-767NG is a plane that doesn’t exist based on a design that doesn’t, as yet, work. The developmental costs are an unknown, only an estimate, and while Boeing has lots of Lessons Learned from the International Tanker program (Japan and Italy), the Italian tankers still have not been delivered. Are the problems solved? Boeing won’t say but absent deliveries, it would seem not.

To solve the problems, what does Boeing have to do for the KC-767NG? And what is Boeing doing that offers a better airplane (such as a 787-derived cockpit, probably a 767-300ERF wing and winglets and who-knows-what-else) but for which there remain unknown developmental risks?

The fixed price contract provision bothered Boeing (and Northrop) when the Draft RFP was issued in September last year and it remains a concern. Boeing’s Defense unit CEO reiterated this during the May 10 investors’ day. Officials in recent weeks said they must prepare a “financially responsible” bid.

The fixed price contract is one aspect that scared off Northrop. EADS says it knows its developmental costs because it is in production with the KC-30, which is 80%-90% (depending on who’s talking) identical to the KC-45 to be offered the USAF. Boeing’s tanker costs for the International program were way, way over budget and resulted in a big write-off. The developmental costs for its KC-767NG are only estimates.

Boeing’s Jim Albaugh, president of Boeing Commercial, was president of Boeing’s defense unit in 2008. He says most of the costs in the tanker are with Boeing Commercial Airplanes, and he doesn’t want to “be the guy who lost this twice.” We talk more about this in our companion piece, but Albaugh clearly is going to be more aggressive on pricing than was Scott Carson, president of BCA in 2008.

Advantage on this one: EADS.

Boeing WTO ruling

Here is the real wild card, and this may or may not come back to bite Boeing right in the tail pipe–and it is the topic on which we have written a ton of opinion and all of it that Boeing ought to have stayed away from the entire WTO debate.

What if Airbus is right and Boeing is wrong and the WTO finds Boeing received illegal subsidies and received a lot of it improperly? Under the last minute changes to the House bill, the WTO Boeing report would have to be considered by the USAF as well–and this has the potential to hurt Boeing, perhaps badly.

Conclusion: when you consider the items above, don’t consider it a “lock” that Boeing’s success in Congress puts EADS at a disadvantage. We think the price on just the airplane could still be highly competitive, and as we noted previously, could hoist Boeing on its own petard.

Where we believe the real challenge to EADS will be is in the life cycle and MilCon (military infrastructure construction costs). These are the areas where Boeing should have a substantial advantage. We discuss this more in our companion post.

5 Comments on “Will WTO vote really matter?

  1. Pingback: Let’s talk about the planes « Leeham News and Comment

  2. “What if Airbus is right and Boeing is wrong and the WTO finds Boeing received illegal subsidies and received a lot of it improperly?”

    What if Airbus is just blowing smoke, and the WTO issues a lukewarm, tepid ruling on the Euro case?

    • You see to it that you have legislation in place before that
      becomes obvious ;-?

  3. 1) the 767NG development risk… It did surprise me Boeing didn’t do some public Risk Reduction work on their 767NG plan.
    Some wind tunnel tests or something on the boom system just to take away from the worry the top brass might have on this. Then again… they do have a couple of tankers in service and the Aussies are waiting just like the Italians
    So it is to Boeing’s detriment, but how massive could it be after being divided by 179 a/c

    2) The wording of the amendment clearly only requires the AF to consider WTO rulings – a status the USvsEU case achieves soon and the EUvsUS case won’t reach for at least half a year.
    the wording in that respect is brilliant, Though Boeing does hurt itself on any other defense COTS/derivative contract

  4. Scott, I do not know the exact wording of this proposed measure (Law?) so my question is, has it been worded in such a way that they do not also have to take into consideration the US Foreign Sales Corporation WTO case, which was ruled against the US (and Boeing, amongst others)?

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