Changes in Percentage-of-Completion Estimates: Earnings Bonanza

Earnings Season
With the quarterly earnings season well underway, investors and other interested parties will spend lots of time analyzing company filings, with a special emphasis on earnings per share. One of the most popular benchmarks for measuring a company’s performance is to compare its actual results to the estimated results predicted by the handful of dedicated analysts following that company. These analysts follow the company in extreme detail, and typically have informed connections, and know enough about the company’s goings-on that they are able to estimate what the company’s earnings will be, and they’re usually pretty accurate. So much so, that when a company “misses” the analysts’ estimates, investors usually react negatively to the unfavorable earnings “surprise”. And when a company beats the analysts’ estimates, the stock usually gets a boost.

Defense Stock Roundup
Zacks Investment Research recently published an analysis of the earnings results of the big defense contractors, such as Northrop Grumman (NYSE: NOC), Raytheon (NYSE: RTN), and others.

Over the last five trading sessions, second-quarter results from the defense primes have grabbed the headlines. Although the defense contractors witnessed lower revenues in the quarter, the picture was overall reassuring with a number of earnings beats.

Interestingly, the blog notes, as quoted above, that despite lower revenues, earnings for these companies were positive. But we’ve noticed what we believe is an under-appreciated element in these companies’ earnings. They all use the percentage-of-completion method of recognizing revenue on long-term contracts. This is a highly subjective accounting policy that depends almost entirely on management estimates, and changes in these estimates can have an enormous impact on a given period’s financial results.Analysts usually try to eliminate special items when comparing actual earnings to the estimates. These one-time or non-recurring adjustments do not reflect the underlying and ongoing business of the company, goes the reasoning.

We’ve compiled an analysis of just the second quarter of 2014, and the results are very interesting.

Analysis of Defense Stock Earnings, Adjusted for POC Changes in Estimates
In the analysis below, we present five of the leading defense contractors and the impact of their estimate changes related to percentage-of-completion accounting.

POC CAE Table 1

The table above shows the impact of the change in estimate on pre-tax income and diluted earnings per share (EPS). It shows the company’s actual EPS, and the last column “AA Adjusted EPS” shows the company’s EPS with the impact of the change in estimate backed out.

As you can see, these changes in estimates can have a very significant impact on earnings. Lockheed Martin (NYSE: LMT) increased income by $440 million, or $0.88 per share, through adjustments to these estimates. (See the Appendix below for an excerpt from their 10-Q describing the adjustment.)

In the next table, we compare the adjusted EPS from the table below to the Consensus Estimate1. First, it shows the companies’ reported earnings, the consensus estimates for the related period, and the earnings “surprise” as it has been reported in the news (particularly in the Zacks Analyst Blog). Next, the table below shows how the companies’ earnings compare to the consensus estimates after the percentage-of-completion adjustments are backed out.

POC CAE Table 2

Amazingly, five out of five meet or beat earnings estimates using reported EPS, but four out of five miss the estimates after the percentage-of-completion adjustment is removed.

Earnings Quality
It is important to note that we are not suggesting these companies are guilty of direct earnings management. Rather, we are merely pointing out the inherent risk in the percentage-of-completion method, which is deeply reliant on estimates. Schilit and Perler, in their classic book on accounting gimmicks, note that this method of revenue recognition is notoriously difficult to get right, and the nature of the method allows for ample “wiggle room”. Revenue under this method is an especially high-risk area: hard to account and even harder to audit.

L3 Communications (NYSE: LLL) provides a good example of the risks associated with percentage-of-completion. Just yesterday, they filed an 8-K disclosing that “the Company is currently conducting an internal review” and that they expect to incur significant charges due to accounting errors related to contract-accounting revenue recognition.

The review relates to accounting matters at the Company’s Aerospace Systems segment, and is being conducted with the assistance of outside accounting and legal advisors. The Company currently expects to incur an aggregate pre-tax charge of $84 million against operating income and a related reduction in net sales of approximately $43 million. Of these charges, approximately $50 million relates to periods prior to 2014, and approximately $34 million relates to the first half of 2014, of which $30 million relates to the second quarter of 2014. Additionally, as a result of the review, the Company has lowered its estimated operating income for the Aerospace Systems segment by approximately $35 million for the second half of 2014.

The adjustments primarily relate to contract cost overruns that were inappropriately deferred and overstatements of net sales, in each case with respect to a fixed-price maintenance and logistics support contract. The period of performance on this contract began December 1, 2010, and is scheduled to end on January 31, 2015. The Company believes that the amounts associated with these adjustments are the result of misconduct and accounting errors at the Aerospace Systems segment. The misconduct included concealment from L-3’s Corporate staff and external auditors.

The table below shows the effect of the company’s percentage-of-completion adjustments for the past five periods, including fiscal year 2013.

POC CAE Table 3

Judging from the 8-K disclosure, the errors in revenue for L3 appear to be fraud-related. This is a clear case of the risks associated with percentage-of-completion. We believe investors and analysts would do well to pay close attention to these adjustments.

Appendix: Example of POC Change in Estimate Disclosure
The following is an excerpt from Lockheed Martin’s 6/29/14 10-Q, describing the adjustment in the footnotes to the financial statements:


Changes in Estimates

Accounting for contracts using the percentage-of-completion method requires judgment relative to assessing risks, estimating contract sales and costs (including estimating award and incentive fees and penalties related to performance), and making assumptions for schedule and technical issues. Due to the number of years it may take to complete many of our contracts and the scope and nature of the work required to be performed on those contracts, the estimation of total sales and costs at completion is complicated and subject to many variables and, accordingly, is subject to change. When adjustments in estimated total contract sales or estimated total costs are required, any changes from prior estimates are recognized in the current period for the inception-to-date effect of such changes. When estimates of total costs to be incurred on a contract exceed estimates of total sales to be earned, a provision for the entire loss on the contract is recorded in the period in which the loss is determined.

In addition, comparability of our segment sales, operating profit, and operating margins may be impacted, favorably or unfavorably, by changes in profit booking rates on our contracts accounted for using the percentage-of-completion method of accounting…. Our consolidated net adjustments not related to volume, including net profit booking rate adjustments and other matters, net of state income taxes, increased segment operating profit by approximately $440 million and $965 million for the quarter and six months ended June 29, 2014 and $585 million and $1.1 billion for the quarter and six months ended June 30, 2013. These adjustments increased net earnings by approximately $285 million ($.88 per share) and $625 million ($1.93 per share) for the quarter and six months ended June 29, 2014 and $380 million ($1.17 per share) and $685 million ($2.10 per share) for the quarter and six months ended June 30, 2013.

1. The Consensus Estimate is obtained from Zacks Investment Research. See here, here, here, here, and here.