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How Lockheed Shaved $3 Billion Off F-35 Costs

Lou Whiteman, The Motley Fool

Lockheed Martin (NYSE: LMT) has selected Raytheon (NYSE: RTN) to replace Northrop Grumman (NYSE: NOC) as supplier of a key sensor system on its F-35 fighter aircraft, a move the lead contractor said will save the program more than $3 billion.

Raytheon was selected to develop and deliver the next-generation distributed aperture system (DAS) for the F-35, a series of six cameras mounted around the aircraft that allows pilots a full-range of vision -- including directly below the aircraft -- day and night through video that is fed into the helmet.

F-35A

A Lockheed Martin F-35A. Image source: Lockheed Martin.

The current generation of F-35s have a DAS supplied by Northrop, but Lockheed said Raytheon would take over as supplier as soon as 2023 with the plane's 15th procurement lot. The switch had been expected (though details of the potential savings weren't previously disclosed). It is part of a broader push by Lockheed to appease government buyers and bring down the cost of what is expected to be the most expensive weapons platform in world history.

Cheaper and better

Lockheed Martin, in announcing the decision, said that the next-generation system will reduce operation cost by 50% while costing 45% less per unit, saving more than $3 billion overall. The company insists quality is not being sacrificed, saying that the new Raytheon system is five times more reliable than the technology it replaces and twice as capable in performance.

"The supply-chain competition for the next-generation F-35 distributed aperture system resulted in significant cost savings, reliability and performance improvements," Greg Ulmer, general manager of the F-35 program for Lockheed, said in a statement. "We are aggressively pursuing cost reduction across the F-35 enterprise, and this initiative is a clear demonstration of our unrelenting commitment to reduce costs and deliver transformational capabilities for the war fighter."

Northrop bowed out of the competition earlier this year, with company president Kathy J. Warden telling investors on an April earnings call that Northrop had determined the rebid was "not attractive to us." Northrop in recent quarters has pulled out of a number of competitions, citing a need to be financially prudent when deciding where to devote its resources.

The company will still have exposure to the F-35 as maker of its APG-81 radar, and will support existing DAS systems.

More to come

Other improvements are in the works. Lockheed is developing a revamped electro-optical targeting system (EOTS) for the F-35, a companion sensor system that -- as the name suggests -- assists in air-to-air and air-to-ground weapons targeting. Lockheed developed the original EOTS in-house and is expected to do the same for the modernized version. It promises to both bring down overall costs and solve issues the current system has in steering laser-guided weapons.

Elsewhere, United Technologies unit Pratt & Whitney is developing an upgraded engine for the F-35 with a better thermal management system designed to help the jet manage upgraded weapons and sensors. According to a report from the website Inside Defense, Pratt & Whitney military engine head Matthew Bromberg told reporters that the company hopes to cut the operating cost of the F-35 engine from $7,000 per hour to $3,500 per hour within 10 years. If so, the cost would be about the same as older-generation aircraft, including the F-16.

What the customer demands

Donald Trump put Lockheed Martin on notice concerning the cost of the F-35 shortly after his election victory, using Twitter to call the trillion-dollar-plus F-35 program "out of control." Trump also suggested an alternative, Boeing's F/A-18F Super Hornet. Whether that older-generation technology really could rival the F-35 is open to debate, but the message to Lockheed Martin was clear.

Lockheed engaged in tense negotiations with the Pentagon earlier this year over how much to charge for the latest batch of fighters. Despite pressure from lawmakers, the company needs to be careful not to bring down its cost-per-unit too quickly, as the government expects each batch to be priced at a discount to the last.

The best way to relieve the pressure is to make progress on costs. Lockheed Martin hopes to get the unit cost of the F-35 below $80 million by 2020, compared to a minimum of $95 million currently. And while lingering quality issues remain, Lockheed has seemingly had some success in making its production more efficient. The Government Accountability Office, in a report earlier this month, said the average number of hours of labor needed to manufacture a baseline F-35A has dropped by more than half to 41,541, from 108,355 in 2012.

Confirm holding pattern

With the F-35 contributing more than one-third of Lockheed Martin's revenue, a figure that is likely to only go up over time, the program is essential to the success of the company. The F-35 is not at risk of being cut altogether. But progress on costs could determine how many planes the Pentagon buys, and how many allies sign on. And that, in turn, could determine whether the F-35 becomes a blockbuster success for Lockheed.

Lockheed is the most expensive of the pure-play prime defense contractors, trading at 37.68 times trailing-12-month earnings, and the F-35 progress is no reason to buy in now. But with each milestone hit and cost reduction announced, current shareholders can sleep a little easier. There's been a lot of drama surrounding the F-35 over the years, but Lockheed Martin is slowly showing it has the program under control.

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Lou Whiteman has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.