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NASA Targets $6 Billion in Extra Costs on Moon Program

Motley Fool - Tue Jun 20, 5:55AM CDT

NASA's Project Artemis effort to put Americans back on the moon is literally out of this world. Unfortunately -- if figuratively -- so is its cost.

We've been writing about the skyrocketing price tag on Artemis for more than half a decade now -- the $2.5 billion price tag on each Space Launch System (SLS) moon rocket, the interminable delays in getting SLS ready for launch, and even the successful Artemis I mission last year that finally sent a rocket to the moon and back, and arguably saved Project Artemis from cancellation.

And yet, Project Artemis still faces risks -- to itself and to investors as well.

Rocket launching towards the moon.

Image source: Getty Images.

The Inspector General would like to have a word with Artemis

The latest argument over Project Artemis concerns cost overruns on the engines that power SLS, the mega-rocket built by Boeing(NYSE: BA), Northrop Grumman(NYSE: NOC), and Aerojet Rocketdyne (NYSE: AJRD) that will carry astronauts to the moon. Late last month, NASA's Office of Inspector General (OIG) published a report specifically addressing cost inflation in SLS's solid rocket boosters (built by Northrop) and RS-25 rocket engines (built by Aerojet).

In total, OIG estimates that Project Artemis will cost taxpayers $93 billion from 2012 (when it began) through 2025 (when Artemis III is expected to make the first crewed moon landing since 1972) -- a sum OIG describes as "enormous" -- with billions more to follow.

Spending on the SLS engines alone will consume some $13.3 billion through 2031, estimates OIG. What's more, the original cost estimate for this part of Artemis was supposed to be only $7.3 billion. Thus OIG concludes that this part of the program is responsible for "approximately $6 billion in cost increases and over six years in schedule delays above NASA's original projections."

Who's to blame?

This shouldn't have happened -- obviously. And OIG has identified the culprit for why it happened: "NASA used cost-plus contracts at times where we believe fixed-price contracts should have been considered to potentially reduce costs."

The good news (for taxpayers -- but not necessarily for investors) is that due in large part to OIG's efforts, "NASA is [finally] undertaking efforts to make the SLS more affordable." And specifically, the space agency is "moving toward a fixed-price contract structure for booster production and establishing cost reduction targets on the production of new RS-25 engines."

What it means for investors

That's the crux of the issue, really. Historically, NASA (and the U.S. government in general) have often treated its aerospace and defense contractors as a sort of government utility, providing services, charging the cost of those services, and then adding a bit of profit margin to reward the defense contractors for their work -- hence the name: "Cost plus."

This is part of the reason Aerojet Rocketdyne, for example, is able to maintain its strong 8.9% operating profit margins (according to data from S&P Global Market Intelligence).

The problem with this approach (from a taxpayer's perspective -- not necessarily from an investor's) is that cost-plus contracts, by their nature, encourage a contractor to work inefficiently because, well, the higher the cost, the higher the plus -- meaning more money for the contractor. There's simply no incentive on the contractor's part to cut costs because doing so necessarily cuts the contractor's revenues and profits as well.

And cost overruns naturally result.

In contrast, a shift to fixed-price contracts will shift the burden for cost overruns from the government to the contractor. If a contractor bids $1 billion, say, to perform a certain service, but operates slowly and inefficiently such that it actually costs it $2 billion to provide the service, then the contractor eats that $1 billion loss.

What it means specifically for investors in these two space contractors

Over the long term, investors in all aerospace and defense contractors should be aware of the government's shift toward fixed-price contracts. On the one hand, this shift will encourage space companies to operate more efficiently (and may, as a result, boost profit margins if they succeed). On the other hand, though, contractors will no longer be guaranteed a profit on their government contracts and may lose money or see profit margins shrink (if they fail).

In the nearer term, investors in Aerojet Rocketdyne have more to fear from this trend than do investors in Northrop Grumman.

Among OIG's specific recommendations for cutting costs on Project Artemis, it is urging NASA to, at a minimum, insist that the 11 (out of 18) RS-25 engines, which Aerojet Rocketdyne has not yet built, be built under a fixed-price contract. What's more, if possible, OIG urges that all 18 RS-25 engines -- including the seven that have already been built -- be renegotiated and put in a fixed-price contract.

If NASA is successful in making these recommended changes, potentially all or part of the $6 billion in extra costs charged to build SLS's engines could shift back to Aerojet Rocketdyne. At a minimum, the recommended changes would mean that any future cost overruns would become the contractor's responsibility.

In my opinion, this poses a clear and present danger to profit margins at Aerojet Rocketdyne. Caveat investor.

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Rich Smith 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.

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