Boeing starts low-rate production of KC-46 tanker

EVERETT — Boeing’s new aerial refueling tanker, the KC-46 Pegasus is already in production, though it hasn’t flown yet.

The first two to be delivered to the U.S. Air Force are on the final assembly line in the company’s Everett plant, CEO Dennis Muilenburg said Wednesday during a conference call with stock analysts and reporters.

The Air Force isn’t expected to give its final approval to put the plane into production until April 2016.

Cost overruns in the tanker’s development lowered the company’s core earnings per share for second quarter from $2.39 to $1.62, which still beat the $1.37 expected by analysts.

The company spent $2 billion buying back 14 million shares, which helped soften the blow. Boeing management also predict better than expected performance in other areas will help.

Boeing delivered a record 197 aircraft in the second quarter, and booked 171 orders. Free cash flow surged to $2.6 billion for the quarter, and sales of $24.5 billion exceeded the $24.3 billion predicted by analysts polled by Bloomberg.

The Chicago-based company lowered its annual profit forecast, putting it between $7.70 and $7.90 a share. That’s a 50 cent drop from the range before the tanker overruns were announced.

The latest overrun of $536 million after taxes came from problems recently discovered with the tanker’s integrated fuel system. It pushed the total cost overrun to $1.26 billion above the $4.9 billion fixed-price contract.

The problems have delayed the flight test program. The KC-46 is expected to fly by September, nine months behind schedule. Due to the delays, the Air Force has pushed back its decision to move to production from October to next April. The military could use the decision to get contract concessions from Boeing, but there is no risk to its order for 179 tankers by 2027, analysts say.

Quietly moving to production early has happened before. Boeing began assembling its P-8, a submarine-hunting plane based on the 737, before the Navy gave it the go-ahead. Starting production early gives Boeing more time to manage any unforeseen complications.

Boeing “has virtually no margin for error” if it’s going to deliver the first 18 tankers by August 2017, said Ken Herbert, a stock analyst with Canaccord Genuity, in a research note sent to clients. He rates the company’s stock as “buy”.

“Boeing has no choice but to start to produce more aircraft prior to the Air Force” production decision, Herbert said.

Muilenburg assured analysts that Boeing would deliver the planes on time. “We have our arms around this,” he said.

Two factors drove up the cost of the fuel system rework. It is the last major system to be installed on the airplane, so having to work around the other systems added to the cost. Also, the fixes had to be applied to the four test airplanes and the two in initial production, he said.

The KC-46 is based on the 767, but it has a new fuel system with much larger capacity compared to other 767-based tankers Boeing has made for military forces in Japan and Italy.

The KC-46 can carry 212,299 pounds of fuel versus about 160,000 pounds on the earlier 767 tankers. The KC-46’s boom can transfer 1,200 gallons per minute to another aircraft. The earlier tanker’s boom can do about 900 gallons per minute. The KC-46 also has four more internal fuel tanks.

“The components are larger, more complex. It’s an entirely different system than on the 767,” said the industry insider, who spoke on the condition of anonymity because he was talking about details he had not been authorized to publicly discuss.

Muilenburg said executing development programs on time and budget is a risk that the company will have to handle during his tenure.

“I think the tanker is a good reminder to us to hone (in) on that effort,” he said.

The company plans to increase 767 production to two planes a month next year, and could consider further rate increases after that, he said.

FedEx this week announced an order for 50 767 freighters, the biggest single order in the wide-body airplane’s history.

The aerospace giant could consider rate decreases for current production 777 models in 2016, he said.

The 777 has been a cash cow for Boeing, but it is being replaced by the 777X, which begins production in 2018 and is expected to enter service with airlines in 2020.

Delivery slots for current 777s are full through 2016 and more than half filled for 2017. Boeing has added 44 orders and commitments for the jetliner this year, and several sales campaigns are going on now, Muilenburg said.

The company continues to spend more making 787 Dreamliners than it collects from customers, about $23 million per plane based on financial data released Wednesday. That’s the average amount the company pushes into the future on each 787, using an accounting measure called deferred production costs.

The 787 program’s deferred costs rose $790 million last quarter to a total of $27.7 billion, a 2.9 percent increase. That is partially due to inventory increases ahead of next year’s production rate increase to 12 airplanes a month, a 20 percent jump.

That is consistent with many analysts’ expectations, which include deferred costs peaking at between $28 billion and $29 billion. That amount does not include the plane’s development costs, between $15 billion and $20 billion.

Deferred costs are expected to rise into 2016.

Per unit cost has already fallen 35 percent over the last 210 787-8 deliveries, and by 30 percent in the first 34 787-9 deliveries.

Lessons learned on the 787-8 helped bring costs down faster on the bigger 787-9, Boeing Chief Financial Officer Greg Smith said.

The growth rate for deferred costs will drop significantly in the last three months of the year, and the program will break even on a per unit basis in 2016, he said.

Wednesday’s call was Muilenburg’s first since taking over July 1 from his predecessor, Jim McNerney, who was also on the call.

Muilenburg said the priorities during his tenure are first, investing in innovation, then returning cash to shareholders, and finally, when it makes sense, acquisitions.

Overall, he stressed continuity with Boeing’s recent leadership. Before becoming CEO, he ran Boeing’s defense and space division, which is based in St. Louis. He began his career with Boeing in metro Puget Sound more than 30 years ago.

He has a “very deep appreciation” for the company’s Washington workforce, he said when asked about the lingering bitterness over the company’s most recent contracts with its two biggest unions. “I have a great deal of respect for our team.”

He did not say whether Boeing will continue to oppose the International Association of Machinists and Aerospace Workers’ (IAM) efforts to organize the company’s North Charleston plant, which houses one of its two 787 Dreamliner assembly lines.

The company has a backlog of nearly 5,700 commercial airplane orders worth approximately $430.8 billion at list prices. Boeing’s military and space division has a backlog worth approximately $48.4 billion.

Bloomberg contributed to this report. Dan Catchpole: 425-339-3454;; Twitter: @dcatchpole.

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