Orbital ATK [OA] on Wednesday reported strong earnings in its second quarter despite a slight drop in sales, but the company said the results are preliminary due to an ongoing review of accounting matters with the company’s four-year old small caliber ammunition contract with the Army that is expected to have a loss over its 10-year term.
David Thompson, president and CEO of Orbital ATK, said at the outset of the company’s investor call that that its financial results were “mixed” given lower than expected sales while profit margins exceeded expectations and cash flow was strong.
The accounting issue related to small caliber ammunition production at the government-owned, contractor-operated Lake City Army Ammunition Plant in Missouri stems from legacy ATK aggressively bidding a recompete on that $2.3 billion contract and the company failing to sufficiently curb production costs, which will result in a loss over the contract term, Thompson and other Orbital ATK officials said.
The charge stemming from the ammunition contract is expected to be between $400 million and $450 million pre-tax and between $250 million and $280 million after-tax, Orbital ATK said. The company expects to restate financial statements for last year and the first quarter of 2016.
The accounting issue was discovered during a corporate-wide review of the company’s many contracts and so far the issue appears to be isolated to the small ammo contract, Thompson said. The cost trends on the contract were “obscured” by the implementation of a new enterprise resource planning system, Garrett Pierce, the company’s chief financial officer, said on the call.
The officials said that there wasn’t any malfeasance or misbehavior associated with the accounting issue.
Orbital ATK will record no margin on the ammunition contract but the primary headwind going forward will be about a $25 million dent to free cash flow this year and next versus earlier expectations. Even though the company expects a loss over the term of the contract, Thompson said it will continue to find ways to cut costs in the program.
Net income in the quarter increased 32 percent to $72.1 million, $1.23 earnings per share (EPS), from $54.8 million (92 cents EPS) a year ago, driven by higher operating income across all three of the company’s segments, a lower tax rate and favorable pension adjustments. Operating margin rose 2 percent to 11 percent.
Excluding costs related to the merger more than a year ago between Orbital Sciences and Alliant Techsystems, adjusting net income in the quarter was $79 million ($1.35 EPS), which beat consensus estimates by three cents.
At the segment level, operating income was up on higher margins in the Launch Vehicles division, higher sales in defense electronics and missile products, and higher margins in the Advanced Programs division within the Space Systems Group.
Sales in the quarter fell 2 percent or $23 million to $1.1 billion. Orbital ATK said that declines at the Space Systems and Flight Systems Groups more than offset an increase at the Defense Systems Group.
At Space and Flight Systems, revenues were down related to launch vehicles and commercial satellites. Thompson said the commercial satellite industry is in the down phase of the business cycle and that orders this year are coming in later than expected. Defense revenues were higher on electronics and missile products.
With sales lower than expected in the quarter and continued softness in commercial satellites, Orbital ATK lowered its top line guidance for the year to $4.5 billion from prior expectation of between $4.6 billion and $4.7 billion. With a better than expected tax rate and margin performance, the company increased the low end of its adjusted per share guidance by a nickel to $5.30 and left the top of the range unchanged at $5.50.
The free cash headwind at Lake City combined with the weak commercial satellite market led Orbital ATK to lower its free cash flow guidance this year by $50 million to between $225 million and $275 million. In the quarter, free cash flow was nearly $111 million.
Orbital ATK returned $35 million in cash to shareholders in the quarter in the form of dividends and share repurchases.
Orders in the quarter were nearly $1.6 billion and firm backlog at the end of the quarter was $8.5 billion, up 1 percent versus a year ago. Total backlog stood at $15.2 billion, 25 percent higher than a year ago.
Investors reacted negatively to Orbital ATK’s results on Wednesday, sending the company’s shares down just over 20 percent to close at $70.79 from Tuesday’s close of $88.77. Cowen & Co. downgraded the company’s stock from outperform to market perform.