ENGlobal Corporation: Q1 2012 10Q Analysis

The 10Q was filed on the 16^th, and not later on the 15^th as advertised. Normally these quarterly filings can be tedious and a challenge to search through but there are some important details that indicate a deteriorating situation at ENGlobal. Some of those details further support the previous idea that the numbers were embellished. I understand that other issues are occurring on a daily basis so I will try to cover the important ‘indicator’ items and illuminate those that are critical.

Before I dive into the 10Q I wanted to ask those of you that are investors to look at the ballot which is asking you for another half million shares with more undoubtedly ending up with your BOD. If you doubt this assumption do a little research over the last 10 years and see where the majority of ENG options and restricted stock have gone. I won’t opine on this but simply ask you if they deserve stock payment?

Now let’s get into the latest 10Q and look at statements and numbers. When you look at the Consolidated Balance Sheets (Unaudited) on page 4 of the 10Q notice these line items (the figures shown are in thousands): 

Item 1)

Costs and estimated earnings in excess of billings (CIEB) on uncompleted contracts:

3/31/2012            12/31/2011

$12,573                 $6,790

An increase of $5.783 million since 12/31/2011…

This line indicates the Company has incurred approximately $5.8 million in additional project costs on fixed price contracts for which it has not billed to their client. So why does this matter? An increase in CIEB has a negative impact on CASH and could impact the Company’s ability to make payroll, pay vendors and suppliers and meet statutory obligations. Why does this happen?  Options as to what is causing this increase include delays in getting client billings out the door due to inefficient processes and/or administrative approvals, bad contractual terms on billing milestones or project failures to meet milestone deliverables. All of options are the results of decisions made by or controlled by ENG management. Regardless of the reason, the current trend is going in the wrong direction.  CIEB as of December 31, 2010 was only $3.146 million. Do you like this fast-paced trend?

Item 2)

Notes Payable

3/31/2012            12/31/2011

$336                       $0

           

An increase of $336k since 12/31/2011…

ENGlobal must have to sign notes with vendors and materials suppliers to get equipment and materials for client projects.

Item 3)

Billings in excess of costs and estimated earnings (BIEC) on uncompleted contracts:      

3/31/2012            12/31/2011

$2,236                   $4,421

This line indicates the Company has lost approximately $2.2 million in pre-billings for project costs on fixed price contracts billed to their client. So why does this matter? A decrease in BIEC also has a negative impact on CASH and again could impact the Company’s ability to make payroll, pay vendors and suppliers and meet statutory obligations. Why does this happen?  Options as to what is causing this increase include delays in getting client billings out the door due to inefficient processes and/or administrative approvals, bad contractual terms on billing milestones or project failures to meet milestone deliverables. All of these options are the results of decisions made by or controlled by ENG management. Regardless of the reason, the current trend is going in the wrong direction.  BIEC as of December 31, 2010 was $0.947 million.

Item 4)
Other Current Liabilities (totals)  

3/31/2012            12/31/2011
$2,331                    $3,072

Remember this section covering Reserve from previous 10K comments?  This was the table that included the $2.1 million of “known”, but not detailed, liabilities.  It appears they paid the accrued interest of $86k and cleared the $655k in customer prepayments for a net change of $741k.  Just an FYI, customer prepayments are where clients are billed and then prepay for services yet performed at the end of one reporting period and then services are performed and earned in a later reporting period.  Hopefully the reduction of the $655k in these liabilities was taken against the later produced AR billings for those delayed services and not as a credit against the costs on those projects. Could that be the reason for the GP improvement in FS?  Time will tell if this is the case because when the later AR billings do not get cleared by the client (because he has already paid in a prior period) they will have to be written off or charged back to the projects and result in much lower GP in the current reporting period.

As you remember in the last two posts I alerted readers to how operating contingencies and reserve can be used to embellish earnings. Since the practice is not regulated you will see no required disclosure statements. However, it does show up as a sudden and abnormal increase in GP and margins. That did seem to happen and let's dive into this from where we left off in the last post. I would recommend new readers to review the last two postings to prepare for this new information.

Page 20: “Our gross profit and gross profit margin increased primarily due to reduced variable costs and improved efficiencies in our Automation Segment, resulting in higher profit margins.” [On the CC the CEO stated this was the problem segment!]  “However, we are still affected by intense competition and pricing pressures. In addition, our E&C and Field Solutions segments experienced increases in gross profit and gross profit margins due to higher revenues and increased efficiencies.”

I think the problem is variable conclusions and variable accounting as you may conclude as you read on. Let us look at one of those mentioned divisions that experienced increases and compare it to the previous year – Field Solutions (FS).

Q1 2011 Q2 2011   Rev 21,692  18,020   GP 1,659 7.6%  1,208 6.7%   SG&A 2,081 9.6%  964 5.3%   Oper Inc (422) -1.9%  244 1.4% Q3 2011 Q4 2011   Rev 19,306 16,126   GP 1,685 8.7% 1,289 8.0%   SG&A 1,567 8.1% 1,069 6.6%   Oper Inc 118 0.6% 220 1.4%  YTD 2011  Q1 2012   Rev  75,144  16,268   GP  5,841 7.8%  1,762 10.8%   SG&A  5,681 7.6%  1,030 6.3%   Oper Inc  160 0.2%  732 4.5%

The four quarters and YTD of 2011 are represented along with 1Q 2012 for comparison. The percentages given are percent of revenue for the applicable time period. Notice most prominently is that FS made more profit, $732,000, in Q1 2012 than in all of 2011, which came in at only $160,000! At 2011 GP percentages they should have made ~ $500,000 less. Look at the GP and Operating income for all four quarters of 2011, then the YTD and compare to Q1 2012. Why the sudden and extraordinary jump in profit and margins to 4.5%?  The Q1 2012 Field Solutions GP margins of 10.8 % even beat Engineering & Construction same period margins of 9.6%! My guess is that FS had more operating contingency money available than E&C. Does this meet your smell test?

Moreover, if you don’t know, the FS division is a cost-plus, low-margin segment. Let’s put all this into another perspective and look at the statement on pages 17 & 18 of the 10Q: “During the recent period of industry-wide decline in demand for the types of services ENGlobal provides, we reduced our rates significantly, as was required to obtain and retain business. Although the level of demand has increased (although FS revenues were down from Q1 2011), pricing in certain geographical markets is still extremely competitive and we have not yet been able to increase our margins to prior levels.”

By now you are feeling the contradictions. How can you make a statement like that and show massive increases in GP and Margins? This comment further supports the question of how the GP increased in the Field Services segment. There may be a valid reason but without more meaningful disclosure we are left to speculate.

Now let's deal with the Why? The CEO sees his survival as paramount even to the company’s survival. I would like to note that even Bill Coskey had the presence of mind to step back when the company trend wasn’t good. Unfortunately, it eroded further since then. But the company does have to survive for the CEO's job to continue. For that to happen, the company needs a Credit Facility to operate.

On page 11 of the 10K you see this clue: “Due to the net loss for the first quarter ended March 31, 2012, the Company failed to comply with the positive net income covenant added in the Amendment Extension and Wells Fargo has agreed not to exercise its rights with respect to this failure to comply until after May 31, 2012.”

First, we see that ENGlobal broke another covenant. They were required to make a profit in Q1. There is one motive for trying to embellish earnings by using operational contingency money buried within the segments and/or reserve money – to prevent Wells Fargo from exercising its rights (which they have agreed to delay until after 31 May). The other and primary motive is so the CEO can save his job. I say that logically because all these company conditions are known to the CEO and compare that to Bill Coskey choosing to step aside.

Second, why would the CEO agree to a covenant of positive net income approx 6 weeks ago when they should have known at the time they were not going to make a profit? If they thought then they were going to make a profit what changed in those 6 weeks? One thought is that it may be related to the increase in DEFERRED REVENUE (see the last paragraph in Note 10 – Contracts). It was stated… “The Company recognizes service revenue as soon as the services are performed. For clients that we consider higher risk, due to past payment history or history of not providing written work authorizations, we defer revenue recognition until we receive either a written authorization or a payment. The current amount of revenue deferred for these reasons is approximately $1.7 million as of March 31, 2012, compared to $0.3 million as of December 31, 2011. We expect a majority of the deferred revenue amount to be realized by year end 2012”. In Q1 deferred revenue increased $1.4 million!  Could that be a Change Order yet to be approved which was not accounted for until the end of the quarter?  Must not have been because on the CC the CEO, when asked if there were any material losses or problem projects during the period, he could not recall.  I would think he would recall a $1.4 million revenue reversal!  Maybe it's related to one of the fixed price projects announced last September, which were scheduled to be completed in Q2 of 2012.

We now should move on to stark matters.

Credit Facility

This subject is paramount for ENGlobal’s survival. In a moment you will read a statement that will resound deeply with you if you have not seen it already.

Page 22:

“Due to the net loss for the first quarter ended March 31, 2012, the Company failed to comply with the positive net income covenant in the Amendment Extension and Wells Fargo has agreed not to exercise its rights with respect to this failure to comply until after May 31, 2012.”

Item 1A under Risk Factors, p. 24:

“…If we are unable to enter into the proposed credit facility, we will not have sufficient capital to repay the Wells Fargo Credit Facility at May 31, 2012 and as a result, we would be unable to fund our working capital needs and would need to secure additional capital or financing to fund our working capital requirements and to repay the outstanding debt under the Wells Fargo Credit Facility. We cannot assure you that we will be successful in entering into a new credit facility (including the proposed credit facility), obtaining a further extension from Well Fargo beyond the current maturity date of May 31, 2012 or in connection with raising additional capital, that any amount, if raised, will be sufficient to meet our cash requirements. If the Wells Fargo Credit Facility is not repaid in full by May 31, 2012 or if the current maturity date is not otherwise extended, Wells Fargo may exercise its rights and remedies under the credit facility, including initiating foreclosure or insolvency proceedings; in such event our business will be materially and adversely affected, and we may be forced to sharply curtail or cease operations.”

How about that for a statement? I am sure independent legal council recommended it.

But there is more to this. Please put this in context with what management said only a few weeks ago in the 10K on page 42 in the Overview section under Liquidity and Capital Resources: “We believe that we have sufficient available cash required for operations for the next 12 months”

Conclusion

Management should be changed ASAP. I hear of more personnel leaving ENGlobal daily and this further erodes capacity and capability. Bills are not being paid on time (Notes Payable) and this hurts a hard earned reputation. Will ENGlobal get more ‘Feature Projects’ like the Caspian Sea Project or Government Group’s (EAS) $200 million SPAWAR contract?  I doubt it if this trend and direction continues. You have a voice, both individual and collective as investors and employees. I posted many times that in the past Senior Management and BOD was available to listen. I even remember mention of an employee hotline and investors have their avenues through Investor Relations. It is your company too. Good luck to everyone.