An accounting issue related to a logistics contract in L-3 Communications’ [LLL] aerospace segment that was withheld from the company’s corporate staff led to a negative reaction on Wall Street and drove second quarter earnings lower, the company reported on Thursday.
L-3 said results are preliminary pending the completion of an ongoing internal review of the matter. The company warned that the charges could increase related to the accounting misconduct once the review is completed. L-3 took an $84 million pre-tax charge against earnings and reduced its sales by $43 million stemming from the accounting issue.
The company said that sales and profit related to the fixed-price maintenance and support logistics contract were overstated and that contract cost overruns were inappropriately deferred. It also said the charges relate to periods going back to 2011 through the second quarter of 2014.
Michael Strianese, L-3’s chairman, president and CEO, said on an investor call Thursday that the misconduct was also concealed from external auditors. He said the company has fired four employees and a fifth has resigned over the matter. He also said that he doesn’t expect the matter to affect the company’s relationship with its customer.
Ralph D’Ambrosio, L-3’s chief financial officer, declined to discuss the misconduct in detail but noted that the business unit reports to a sector organization, which in turn reports to segment leadership. He said the concealment of the issue from the corporate staff occurred at all three levels of the aerospace segment and that the terminated employees that were fired worked at all three levels.
Strianese said that the misconduct doesn’t extend beyond the aerospace segment and appears to be “primarily” contained to the affected business unit. While the investigation is ongoing, nothing has been found to suggest there has been wrongdoing at other contracts within the aerospace segment, he said.
“We are extremely disappointed that our established policies, code of ethical conduct and controls were violated in this instance,” Strianese said in a statement. “This does not represent the way we do business, and we are thoroughly addressing it.” He added on the earnings call that the company will take “prudent steps” necessary to ensure it doesn’t recur and also said that the issue doesn’t “detract from the good work” done by the rest of the company’s employees.
D’Ambrosio said that he is “outraged” about the behavior related to logistics contract and added that the work generates about $150 million annually in sales with low margins. The contract, which was won in late 2010 and runs through Jan. 2015, is “now in a loss position,” he said.
L-3’s shares closed Thursday at $104.96, down $14.68 or just over 12 percent.
Net income in the quarter fell 14 percent to $156 million, $1.75 earnings per share (EPS), from $181 million ($1.99 EPS), missing analysts’ estimates by 21 cents per share. Operating margins declined a half-percent to 8.9 percent. Sales dipped 6 percent to $3 billion from $3.2 billion.
Results at the company’s segments were mixed, with sales and profit both down at aerospace primarily due to the accounting matter. The company’s overall sales with the Defense Department were down 8 percent, with one-fifth of the decline due to the drawdown of U.S. military activity in Afghanistan, D’Ambrosio said.
Sales to international and commercial customers, which accounted for 28 percent of L-3’s business in the quarter, were up 2 percent from a year ago. D’Ambrosio said that the company still expects more than 30 percent of its business this year from international and commercial customers.
L-3 lowered its earnings guidance for 2014 to reflect the investigation into the logistics contract. Per share results are forecast to be between $7.90 and $8.10, 30 cents below prior guidance. The erosion in earnings will be somewhat mitigated by increasing share repurchases, which will lower the stock count.
Free cash flow, which was $241 million in the quarter, will be between $900 million and $950 million, down from the previous projection of $1 billion.
L-3 raised its sales outlook by $75 million to reflect new business wins and award timing although the guidance range essentially remains unchanged at between $12 billion and $12.2 billion.
Orders in the quarter were $3.3 billion and funded backlog stood at $10.7 billion, up 3 percent since the end of 2013.