Boeing's Troubled Tanker Is 1 Step Closer to Entering Service

In the past few years, Boeing's (NYSE: BA) military aircraft business has executed a strategic pivot. Whereas the company has a long history of designing fighters and bombers for the U.S. military, it plans to focus most of its effort on commercial derivatives going forward. The goal is to reduce costs and speed development by adapting proven commercial jet designs to meet the military's requirements.

Today, the most important commercial derivative in Boeing's military aircraft pipeline is the KC-46 Pegasus tanker. The process of adapting the Boeing 767 jet as a military tanker hasn't been nearly as smooth as originally expected. But on the bright side, the KC-46 is finally close to being ready for delivery to the U.S. Air Force.

Cost overruns have plagued the KC-46 program

To overcome stiff competition from a joint bid by Airbus and Northrop Grumman, Boeing offered a capped development budget for the KC-46 Pegasus tanker. The U.S. Air Force agreed to pay up to $4.9 billion in development costs, with Boeing responsible for any cost overruns beyond that level.

Unfortunately, development costs soared well past expectations. For example, while the KC-46 is derived from the 767, Boeing discovered that some of the wiring design did not meet military standards for redundancy, forcing a costly redesign and rework of already-produced aircraft. Additionally, the system for guiding the refueling boom has needed tweaks to address shadows and glare when the sun is at certain angles relative to the aircraft.

Boeing has reported a series of substantial earnings charges in recent years due to the cost of designing and implementing fixes for these issues. As of the end of the second quarter, these charges totaled $3.4 billion before tax, according to Defense News.

Boeing takes a big step forward

On Tuesday, Boeing announced that it had reached a major milestone for the KC-46 program, completing the FAA certification process nearly three years after the first flight test.

Late last year, Boeing received an amended type certificate for the KC-46. That means the FAA certified "that the fundamental design of the KC-46 tanker is safe and reliable," according to the company. This week, Boeing finished the second step of the FAA certification process, as the agency issued a supplemental type certificate for the KC-46, "verifying that its refueling and mission avionics systems meet FAA requirements."

Boeing noted that the KC-46 isn't fully cleared for takeoff yet. It still needs to receive a military type certificate from the U.S. Air Force. However, flight testing for that certification was completed two months ago, so the company expects final approval within a few months. That would allow deliveries to begin before the end of 2018.

From cash drain to cash cow?

In recent years, the KC-46 program has been a source of losses for Boeing, as development expenses rocketed past the $4.9 billion cost cap negotiated by the Air Force. Nevertheless, Boeing's management has high hopes for the program in the long run.

The Air Force plans to buy at least 179 KC-46 tankers by 2027 for a total acquisition cost of more than $35 billion. There's a good chance that the Air Force will eventually decide to buy even more KC-46s. International sales also present a substantial opportunity for Boeing. As a result, the company has estimated that program sales could be around 400 units. This sizable fleet will then drive a multidecade stream of lucrative service contracts.

In short, the KC-46 program will soon shift from being a multiyear drain on Boeing's finances to being a long-term cash cow. This should help power the next step up for cash flow at the U.S. aerospace giant.

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