Even before the defense department unveiled its final strategy for acquiring a new aerial-refueling tanker yesterday, Northrop Grumman was deep into preparations for announcing that it would not bid. Pentagon officials had sent Northrop and its rival, Boeing, clear signals that the final acquisition strategy would be little changed from that described in the draft solicitation, and Northrop CEO Wes Bush had repeatedly warned that his company would not bid if that were the case. The company estimates it will cost nearly $100 million to assemble a proposal for the latest round of tanker competition, but it believes that money would be wasted on a losing proposal under the terms described in the solicitation.
It is not hard to see why Northrop is unhappy. The solicitation basically consists of two parts: performance requirements and price. The performance requirements consist of 372 “mandatory” features that each offeror must satisfy to participate. Both teams are bidding planes that can satisfy all of the requirements. But because there is no credit for exceeding the requirements, once their performance features are proven the competition is all about price. And since Northrop’s modified A330 is much bigger than Boeing’s 767, it is certain to cost more. Bottom line: Northrop Grumman loses.
Northrop has always planned to offer an aggressive price, not unlike the way it Airbus partner underbids Boeing in commercial competitions for the same planes. The World Trade Organization has stated that Airbus is able to price aggressively in part because it receives improper subsidies from European governments — nearly $6 billion in the case of the A330. Since the defense department has elected to ignore the WTO finding in its tanker deliberations, Airbus potentially could have offered an attractive price there too. But its plane is so much bigger than Boeing’s 767 and Airbus is currently in so much financial trouble due to cost overruns on the A380 airliner and A400M military transport that its pricing power has been diminished. In addition, the tanker solicitation penalizes the bigger Northrop-Airbus plane by adjusting its price upward to reflect higher fuel consumption and military construction costs (so it can fit into hangers). Northrop had been hoping for the opposite outcome: additional credit in the comparisons for a plane that can carry more fuel and cargo over greater distances.
Boeing isn’t happy that the WTO findings were excluded from tanker deliberations, and it believes the price adjustments made for fuel burn and construction costs understate the burden of operating the bigger A330. But it’s a lot happier than Northrop Grumman, which views the final terms of competition as a gift to Boeing by the Obama Administration. Myles Walton of Oppenheimer & Company pointed out in a February 24 research note that under Northrop Grumman’s new financial performance metrics, the company’s management is rewarded more for the returns its money generates than growth in revenues. By that measure, the tanker solicitation looks like an unattractive opportunity because bid and proposal money would probably be squandered, and even if the company somehow won, the visibility on future returns would be murky given fixed-pricing requirements.
Of course, nobody knows how Northrop Grumman’s chairman will respond if he gets a call from defense secretary Robert Gates pressuring him to bid. After all, Northrop generates most of its revenues from sales to the military. But if the company follows through on its commitment not to bid, then the Pentagon will be in a fix: with only one qualified offeror, there will be no proposals to compare and less pressure on that sole supplier to offer a low price. Sole source contracts are usually justified on the argument that there is only one qualified supplier or that timely execution is of compelling urgency, but in this case Northrop’s supporters will argue the government forced a second qualified offeror from the competition. So for all its efforts to make the latest round of tanker competition “objective” and “transparent,” the Pentagon still faces a fight in Congress over how it should proceed.
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