Inside Boeing's Sweet Deal

Is it a stealth bailout by the military or just smart business on both sides?

It seemed like a good idea at the time. The U.S. Air Force needed tanker planes to refuel its jets, Boeing (BA ) Co. needed orders. Pentagon purse strings were tight, but with creative accounting and strategic politicking, Air Force brass and Boeing executives crafted what they see as a stroke of bureaucratic brilliance: a $19.6 billion deal under which the service will lease 100 new 767s to replace its KC-135s tankers, and Boeing's production line will keep humming.

That was before the firestorm. The novel deal has drawn heat from all sides. Watchdog groups on the Right and Left see it as a brazen Boeing bailout. Defense Dept. civilians say Boeing was asking too much, while others say a lease's finance charges drive up the cost. Even just-departed Budget Director Mitch Daniels at one point called the idea "irresponsible." Senator John McCain (R-Ariz.) blasts the arrangement as a "profligate waste of federal revenues." And at least three congressional committees are looking into the deal, which could still be blocked.

The tanker lease -- and the unusual and secretive way it was developed -- raised plenty of red flags during an intensive review by BusinessWeek. Congress awarded the lease to Boeing before any hearings or competing bids. To make leasing seem cheaper than buying, the Air Force tinkered with key assumptions about the planes' cost. The agreement includes a potential 15% profit for Boeing, triple its margin on commercial planes. Without high-powered lobbying -- reaching right into the Oval Office -- Boeing couldn't have overcome objections from White House budgeteers and the top echelons of the Defense Dept.

The implications go far beyond this deal. By leasing instead of laying out the cash upfront to buy the planes, the Air Force pushed spending into the future, allowing it to get new tankers without cutting other programs. And the Pentagon plans more leasing, potentially rewriting the rules for how it spends $200 billion a year. "The precedent is horrific," says Keith Ashdown of Taxpayers for Common Sense, a watchdog group. Leasing could "become this end run around procurement."

A huge policy shift wasn't on anyone's mind in February, 2001, when Boeing execs approached the Air Force with an idea: Why not buy planes from Boeing's languishing 767 production line to replace the service's tanker fleet? The 545 KC-135s -- 43 years old on average -- account for 90% of the Air Force tanker fleet.

A month later, Chicago-based Boeing created a unit to sell its widebodies as tankers. Its goal: Capture foreign markets, then return to the U.S. for sales. Later that year, Boeing beat out European Aeronautic Defence & Space Co. (EADS), Parent of Europe's Airbus, to sell four tankers to Italy and four to Japan.

September 11 injected urgency into Boeing's Pentagon strategy. Commercial airlines were in a tailspin, and Boeing was caught in the downdraft. Its commercial workforce shrank from 127,000 to 65,000 today. Meanwhile, the war on terror put a premium on tankers. Missouri-based b2 stealth bombers had to refuel five times en route to Afghanistan, while patrols over 27 u.s. cities put f-15 and f-16 fighters in the air for 12-hour shifts.

Boeing saw an opening. The air force saw "a motivated seller" willing to sell low, says Marvin R. Sambur, the service's acquisition chief. Since a purchase would require full funding upfront, which the Air Force didn't have, a lease seemed to be a solution. With interest rates low, a lease could approach the purchase price. The costs could be spread over 11 years, from 2006 to 2017.

Boeing brought the idea to House Speaker J. Dennis Hastert (R-Ill.), whose state is home to Boeing headquarters. In December, 2001, hastert aides say, he and Senate Appropriations Committee Chairman Ted Stevens (R-Alaska) agreed to slip wording into a 2002 funding bill to let the defense dept. Lease 100 Boeing 767s as tankers and four 737s for VIP transport. "The notion that this would help Boeing at a time when they were facing trouble was not lost on anybody," says a top Senate aide. "The question is whether or not that delegitimizes the other goals."

Some lawmakers and watchdogs say it does. "It appears to be a corporate subsidy," charges Grover Norquist, president of the conservative Americans for Tax Reform. The Office of Management & Budget's Daniels argued the lease would cost more than a purchase. Defense Secretary Donald H. Rumsfeld and top aides questioned the price tag. And the Air Force at that point hadn't made tankers a priority since 80% of deployed tankers were always ready to fly.

Under pressure, the Air Force asked EADS to submit a bid in early 2002. The company claims its offer was 40% cheaper than Boeing's. But EADS's plane didn't meet Air Force specs. Boeing would be the winner -- if there were a deal.

That was still no certainty. So Boeing and its allies ratcheted up the political pressure. Representative Norm Dicks (D-Wash.) tried to bring top Defense officials along; Hastert worked the White House, Dicks says. Boeing dispatched Continental Airlines (CAL ) execs to show Pentagon brass how commercial aircraft leases work. "The Air Force was using our commercial aircraft agreement to benchmark against Boeing's," says Continental spokesman Rahsaan Johnson.

Boeing also rallied its suppliers. "We encouraged them to be part of the debate," says Rudy F. deLeon, head of Boeing's Washington office and a former top Pentagon official. DeLeon had reason to be optimistic. Beyond support from congressional heavy hitters, Boeing and its employees had made $2 million in political donations in 2000, including a $100,000 company gift to George W. Bush's inaugural committee, according to the Center for Responsive Politics. Senate filings say Boeing's 2002 lobbying budget totaled $6.3 million.

Boeing also hired the Air Force's No. 2 acquisition official, Darleen Druyun, in January, 2003. Lawmakers and watchdog groups question whether she favored Boeing while negotiating the tanker deal on behalf of the Pentagon. Boeing says it didn't approach Druyun until after she retired in November, 2002, and she hasn't been involved in the tanker bid since.

But Boeing's ace in the hole turned out to be Bush. Hastert had broached the lease in private sessions with the President. At a White House meeting in October, 2002, Dicks chimed in with concerns that age-related flaws could ground the fleet. As Dicks told BusinessWeek, "if there's a failure of these planes and you can't fly them, we're screwed." Bush listened to his pitch, Dicks says, then turned to White House Chief of Staff Andrew H. Card Jr. and said: "Andy, let's get it done."

Even with Bush on board, closing the deal proved daunting. In December, 2001, OMB had pegged the total cost at $26 billion -- $150 million a plane. The price later dropped further below the $175 million or so the Japanese and Italians paid for their tankers, according to the Air Force's Sambur. But Rumsfeld's office continued to dig in its heels. "Each time we pushed back, the deal got a little better," says one top Rumsfeld aide.

To do the lease, Boeing and the Air Force had to prove that it would cost less than buying the planes. That required financial alchemy on two critical assumptions. First, the Air Force stretched out the period it used for calculating the costs. That reduced the present value used to compare the lease to a purchase. Then, the Air Force assumed efficiencies from a multiyear deal, based on Congress's O.K. Sambur says he couldn't make that assumption for a purchase since Congress had not approved a multiyear buy. Presto: a cheaper lease. "It may be bad accounting and marginally more expensive," says Thomas Donnelly, an American Enterprise Institute defense expert who backs the deal. But "anybody that can game the system, more power to 'em."

Other analysts disagree. Steven M. Kosiak of the Center for Strategic & Budgetary Assessments argues that the Air Force should use the same terms to compare buying and leasing -- and that a purchase is cheaper. "They're not willing to recognize the true costs of the program," he says. "They're pushing the can down the road."

Fights over the number-crunching produced a stalemate. Anxious to break the logjam, Hastert contacted Card in early May, 2003, to call in a chit, says a Hastert aide. Hastert had navigated Bush's $350 billion tax cut through Congress. Now he wanted Card to seal the lease deal. Hastert called Card several times over the next three weeks, says the aide. And Card called Boeing CEO Philip M. Condit twice, Boeing officials say. A White House spokeswoman said Card was seeking to protect taxpayers.

Card's message, according to Hill sources: Boeing's price was $4 million per plane too high. But he held out a sweetener -- a promise that the Air Force would order hundreds more tankers later. Additional orders let Boeing reduce its price further, to $138 million a plane. But that was still high, according to a study done for Rumsfeld's office.

A May 15 meeting involving Condit, Air Force Secretary James G. Roche. and OMB officials helped break the deadlock. Condit agreed to give the feds a rebate if Boeing sold the tanker at a lower price elsewhere, and to cap its profit margin, which meant any efficiency gains would flow back to the Pentagon. The profit cap was especially unusual because defense outfits reap higher margins as they cut production costs on fixed-price contracts.

But the concession helped close the deal. On May 22, Card told Hastert he had an agreement. The contract -- a $15.5 billion series of six-year leases, plus a $4.1 billion option to buy -- was unveiled the next day at the Pentagon. In a terse statement, OMB's Daniels praised the savings over earlier proposals.

EADS execs say they've been promised the chance to bid on the next round. "We fully intend to participate in future U.S. mission aircraft programs," says Ralph D. Crosby, chairman and CEO of EADS North America. But he shouldn't hold his breath. "A French-owned company is never going to build an airplane for the U.S. military," says Hastert spokesman John Feehery.

Despite Boeing's concessions, the tanker lease still faces opposition. McCain vows to subpoena company documents and plans hearings in his Commerce Committee. Senate Finance Committee Chairman Charles E. Grassley (R-Iowa), a tenacious Pentagon pork-fighter, questions the deal. And Pentagon civilians are holding up a required report to the Hill by challenging Air Force calculations that make the lease look more economical.

Critics also ask whether a company with Boeing's track record should be handed such a groundbreaking deal. Boeing recently acknowledged that employees stole secret documents from rival Lockheed Martin (LMT ) Corp. on a different contract. "They have been guilty of several transgressions," McCain says. "This leasing deal should not be approved until there is a full investigation." The Lockheed Martin controversy and the tanker lease "are not related," Boeing said in a statement.

Critics have already scored some victories. What started as a clear-cut sweetheart deal for Boeing at $26 billion is now a far better package for taxpayers and the Pentagon. But the benefits for Boeing go far beyond the $19.6 billion price tag. With Airbus poised to dominate the commercial market, good news for Boeing has been rare. The tanker deal just might give America's No. 1 aerospace company a new lease on life.

By Stan Crock and Lorraine Woellert in Washington, with Stanley Holmes at the Paris Air Show

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