Why is the Air Force paying Boeing $2.6 billion for just 2 planes

Boeing (BA 1.27%) it might end up selling its defense unit — but it’s not out of the defense business just yet. In a huge announcement that could provide a clue to the company’s future, the US Air Force (USAF) confirmed last week that it had awarded Boeing $2.56 billion to build for it “two prototype E-weapon systems 7A representative from an operational point of view”.

The contract was the largest award listed in the Defense Department’s Aug. 9 daily contract update — by a factor of four. (Second place went to a Lockheed Martin $611 million Navy radar systems contract.) Even more important than the dollar value is that the Boeing contract has plenty of room for growth.

What the Air Force buys from Boeing

Boeing’s E-7A Wedgetail aircraft is designed for airborne early warning and control (AEW&C) of moving targets. The most famous example of this technology is the Air Force’s E-3 Sentry AWACS (an acronym for Airborne Warning and Control System), which was first introduced in 1977 and which the Air Force plans to upgrade and replace it gradually.

Boeing already produces an E-7 Wedgetail (introduced in 2012 and based on the planemaker’s 737 Next Generation airliner), primarily for foreign militaries. The E-7A will be an upgrade of that platform, and the Air Force wants Boeing to accelerate its development by producing a few “rapid prototypes” — hence the large contract.

Early releases of any new weapon system tend to cost more than once the system has reached full-scale production. But the price on this the contract still seems pretty big. For context, a 2012 contract to build four plain-vanilla E-7 Wedgetails for South Korea cost that country just $1.7 billion — barely $400 million per plane. Instead, the Air Force will pay about 3 times as much for each of the first two E-7As.

The urgency of the Air Force’s request for rapid prototypes — needed to make a production decision in 2026 — probably helps explain why it is willing to pay so much more for these planes. But even so, “fast” seems like a pretty flexible term. According to the Air Force itself, Boeing is not expected to deliver the E-7A prototype until 2028 – two years. after the production decision will be made!

What it means for Boeing

Much rests on how this decision goes for Boeing (and for Northrop Grumman (NYSE: NOC)also building the E-7A’s radar). Beyond the first two planes, the Air Force plans to buy two dozen more Wedgetails — 26 in all. And beyond the USAF, Breaking Defense notes that global demand for the E-7A could grow the program 2- to 3-fold. Boeing could eventually sell 50 to 70 units of this new AWACS and build up to six aircraft per year once production is fully ramped up.

How much money that ultimately means for Boeing remains to be seen. Breaking Defense quoted Air Force acquisition chief Andrew Hunter praising Boeing’s willingness to “get their pencils out and sharpen them and do a good job of reducing the cost of the rapid prototyping program” — though not quite at the level the Koreans paid 12. years ago.

Until we know the final price, however, all we have to work with is the price of the prototype: $1.3 billion per bird. So what could this do for Boeing?

Well, with strong warning that this is probably a ceiling the contract’s potential value, $1.3 billion per plane, or more than 70 Wedgetails in total, implies a total program value of $91 billion for Boeing. Of course, investors should temper that expectation by realizing that prices will fall as production ramps up — and understanding that if Boeing only builds six planes a year at most, then that $91 billion would be spread over more a decade of production.

Even so, the final number could still end up looking very attractive, on the order of $8 billion or $9 billion a year, or about a third of the revenue Boeing’s defense unit generates today, according to the data from S&P Global Market Intelligence. And that doesn’t even take into account the continued revenue Boeing expects to generate from aircraft maintenance, upkeep and upgrades for years to come. Remember that the E-3 Sentries that the Wedgetail replaces have been flying for nearly 50 years.

All things considered, this seems like pretty great news for Boeing. With contracts like this, perhaps Boeing should consider sticking with its defense business after all.