McDonnell Loss on C-17 Put at $600 Million
McDonnell Douglas stands to lose an estimated $600 million by overrunning contract ceilings on the development and initial production phases of its military C-17 cargo jet, according to a key internal Air Force study.
The losses would compound an already difficult cash squeeze facing the nation’s largest defense contractor, resulting from overruns on other military programs and heavy investments in commercial aircraft work.
The assessment, recently presented to Under Secretary of the Air Force John Welch Jr., found that the company’s Douglas Aircraft unit in Long Beach will spend an estimated $7.1 billion to complete development and the first two production contracts for six C-17s. That would break Douglas’ $6.5-billion ceiling on the contracts by about $600 million.
Since the C-17 is being built under fixed-price contracts, McDonnell would bear the additional costs.
Under a complex arrangement with the Air Force, McDonnell would assume a financial loss only if it overran the combined ceilings for development and the first two production contracts for the C-17. Although earlier reports indicated that McDonnell would far overrun its development contract, the new study is the first indication that the company could have overshot its more critical production ceiling.
A company spokesman disputed the Air Force’s overrun estimate, saying that McDonnell continues to believe it will complete the contracts under the ceiling.
Indeed, the company has refused to acknowledge the possibility of a C-17 overrun in discussions with the Air Force, which for a time this year suspended periodic contract payments to the firm, according to reliable sources in the Pentagon. The suspension came after the Air Force lost confidence in McDonnell’s own cost estimates on the C-17.
The Air Force plans to buy 120 of the huge C-17 cargo jets for $30 billion, making it the service’s largest fixed-price program and creating extraordinary risk for McDonnell Douglas.
“The consequences are so severe,” said one knowledgeable source. “It is a wild roller coaster ride.”
The company’s assertion that it will break even on the C-17 program presumes that it eventually will recoup money from the Air Force, based on legal claims McDonnell has not yet made, according to a filing with the Securities and Exchange Commission.
The filing, McDonnell’s quarterly 10Q form, included this statement:
“The estimate of contract break even includes $125 million of future revenue from expected recovery on claims to be presented to the Air Force. These claims are supported by extensive work done by outside counsel and McDonnell Douglas in analyzing facts, law and estimates of damages. Although McDonnell Douglas believes it will realize such amounts of claims revenue, any resolution will include negotiation with the Air Force or litigation, and the ultimate realization and receipt of future claims revenues may vary from current estimates.”
In the same filing, McDonnell reversed $93 million in profits previously reported on the C-17, saying that it anticipated breaking even on the program.
The moves have raised significant concern among investors.
“They are skating on the edge and there is no mystery about it,” said Howard Rubel, aerospace analyst at C. J. Lawrence, Morgan Grenfell. “The most important thing for them right now is to retain the confidence of their customer and their employees.”
Rubel said that task would be difficult, but was not impossible. “What they have to do is not a cake walk,” he said. “Is it a deep dark black hole? I don’t think so.”
Not surprisingly, the Air Force has been unwilling to accept McDonnell’s presumption that future claims would forestall overruns on the C-17. After the Air Force concluded that the firm would overrun its ceiling, it decided to release $59 million of McDonnell’s recent request for a $387-million progress payment.
The decision to decline paying the full amount was based on the determination that McDonnell had failed to complete enough work on the program to warrant the $387 million, according to a Pentagon source.
The new Air Force study, termed the “C-17 Cost Performance Review,” was directed by Brig. Gen. John M. Nauseef, comptroller of the Air Force Systems Command. Air Force spokesmen declined to comment Tuesday.
A Pentagon source noted that different methods exist for estimating the cost to complete a contract and that the Nauseef study’s $7.1-billion estimate on the C-17 is an average of those methodologies.
Douglas spokesman Don Hanson said any estimates that show the firm overrunning its contracts are “only estimates.” He added, “I suspect you could find other estimates in other parts of the Air Force.”
Last month, McDonnell Vice President Michael Burch asserted that the firm was far from a financial crisis and that it had “hundreds of millions of dollars before we would exceed our debt coverage.”
The Nauseef study is the first high-level assessment to conclude that McDonnell would overrun the combined ceilings on its three C-17 contracts.
Company officials have said throughout this year that Douglas’ performance on the C-17 has been improving and that it has met all of its critical milestones. But the firm has acknowledged that it is facing some difficulties in the work.
Douglas had hoped to complete assembly of the first C-17 in November, but will miss that target, Hanson acknowledged. The firm must finish assembly of the first aircraft before the Air Force can award a contract for the third production lot of C-17s. That award is scheduled for December, but would be withheld if the firm fails to complete the first plane next month.
C-17 COST OVERRUNS
McDonnell Douglas’ work on the C-17 is being done under fixed-price contracts, meaning the company bears costs over the ceiling. The losses would compound an already-difficult cash squeeze facing the corporation.
Program Target Ceiling phase price price Engineering $4.2 bil. $4.9 bil. development Prod. lot 1 $656 mil. $757 mil. (fiscal ‘88--2 aircraft) Prod. lot 2 $782 mil. $908 mil. (fiscal ‘89--4 aircraft) Total $5.7 bil. $6.6 bil.
ESTIMATED COST: $7.1 BILLION
