Boeing 777 Rises While 787 Falls
We’ve been struck by a barrage of recent news stories about Boeing’s commercial aircraft. Unlike the usual one-dimensional “Boeing is evil” or “Boeing is All-American” stories, some of the recent ones were “think-pieces” that caused us to nod our heads in agreement.
Our interest in Boeing’s supply chain and program management challenges is well-established, with published articles such as this one discussing “surprise production delays” to the 787 program, or this one discussing the 787 program’s nightmarish supply chain management problems. We believe that lessons learned too late and too painfully by Boeing’s commercial aircraft programs can be used to avoid similar problems on our clients’ complex defense programs. So we thought we’d recap some of the recent news stories for your edification.
First, on December 20, 2010, Bloomberg reported that “Boeing plans to boost output of the 777 jet 66 percent by 2013” to more than 8 aircraft per month. Boeing had previously announced (in March 2010) that 2011 production rates would be increasing from 5 to 7 planes per month.
Bloomberg reported that—
The 777 is offered in a variety of configurations and seats more than 400. The average list price is about $258.2 million. Boeing has delivered 907 of the 777 aircraft since it entered service in 1995 and has an order backlog of more than 260 planes.
But while the 777 program flies high, the troubled 787 “Dreamliner” program is mired in continued problems. As Bloomberg reported, “delays [are mounting] on the Dreamliner, now about three years behind schedule amid parts shortages, manufacturing mistakes, and redesigns.” The article reported that Boeing was preparing “to announce a seventh delay” to the program, which “may be more than six months because of fresh problems….”
On that same day (December 20, 2010), the Seattle Times reported that “After a good long time of bashing workers in the Puget Sound region, Boeing's Chicago executives are now depending on them to fix the unfolding disaster of the Long Delayed 787 Dreamliner.” Finding silver lining where others saw only ominous clouds, the author (Jon Talton) noted that, “Ironically, [Boeing’s] troubles are providing a backstop for local aerospace employment at a time when Washington [State’s] modest jobs recovery has stalled.” But that fortunate happenstance didn’t detract from the “ominous truth” that “Boeing has bet the company on the Dreamliner and now faces cost overruns of $12 billion or more,” according to the article.
Going a bit deeper, Mr. Talton probed the Boeing management culture and asserted that it contributed to the precarious 787 program situation. He wrote—
At the least, the experience of doing the 787 on the cheap with a globalized supply chain should shake the foundations of ‘Welchism,’ the brutal management style, intimidating anti-employee bias and mania for quick results of retired General Electric chief executive Jack Welch. Yes, the one once foolishly lionized as the best CEO in history and whose influence has ruined countless companies. GE itself has quietly backed away from many Welch ideas gone sour, not least the financial services play that became part of the global banking panic. Boeing's executive suite is populated with Welch disciples who long poo-pooed Boeing's historic careful, engineering-based culture.
Mr. Talton pointed his readers at an “astonishing article” published in the Seattle Times just a few days before, on December 18, 2010, that provided details of the Dreamliner’s panoply of current problems. The article, penned by Dominic Gates, asserted that—
As Boeing prepares to announce yet another delay for the 787 Dreamliner — at least three months, possibly six or more — the crucial jet program is in even worse shape than it appears. The problems go well beyond the latest setback, an in-flight electrical fire last month that has grounded the test planes. A year after the airplane's first flight, the cascade of systems failures caused by that fire, as well as two major problems since summer with the 787's Rolls-Royce engine, have raised red flags with aviation regulators.
A top Federal Aviation Administration (FAA) official 10 days ago warned Boeing that without further proof of the plane's reliability, it won't be certified to fly the long intercontinental routes that airlines expect it to serve.
Meanwhile, on the production side, one veteran employee on the 787 said he's witnessing ‘the perfect storm of manufacturing hell.’ The global supply chain is at a standstill, and outside the Everett factory the rows of partly finished jets will take many months to complete. …
Among the 787's lesser ongoing problems is ‘rain in the plane,’ the term used for heavy condensation dripping inside the jet's composite plastic fuselage. Yet that issue is piddling compared with the major flaws that have brought a wave of successive delays.
Mr. Gates wrote—
Boeing has bet its future on the 787 … the company aimed to reduce the cost and risk by outsourcing an unprecedented share of manufacturing and design work to partners around the globe. … Yet the 787 has run into more trouble than any previous Boeing jet. … The 20 built but incomplete Dreamliners sitting in Everett are emblematic of all that has gone wrong. They are so far from done that the total number of unfinished jobs [tasks] exceeds 105,000. … Mechanics can complete only about 500 jobs a month out on the field, and perhaps 1,000 jobs a month … inside the factory.
These jets have no seats or sidewalls, and many interior systems are missing or incomplete. … Mechanics installed temporary air conditioning units after those fitted initially kept failing. Horizontal tails poorly built by Alenia in Italy are still being reworked. With the workmanship on the tails varying from one plane to the next, mechanics have to painstakingly customize the fixes plane by plane.
According to the article, Boeing has developed a controversial work-around plan to address the 20 problem planes needing work. That work-around plan is to—quite literally—work around the problems. As Mr. Gates reported—
With its parked Dreamliners many months from completion, Fancher said Boeing is likely to skip over earlier planes that need more work and move up the delivery of some later-built, more completed jets.
‘You may see us hopping around a bit,’ he said, adding that it's a matter of balancing the most efficient way to finish the work with the customers' need to get a specific jet by a specific date.
The worker dealing with the backlog puts it differently: ‘They've dug a hole so deep, they have no choice but to go around it and leave the hole there.’
In addition, Mr. Gates reported on several significant problems with the 787 engines—designed and build by Rolls-Royce. He reported that, “the engine and electrical issues have also raised crucial questions late in the program about the plane's reliability, potentially affecting regulators' certification of the airplane.” Reportedly, the FAA has warned Boeing executives that, “in the current state of the program, the jet cannot be certified for long-distance transocean and transpolar flights,”
Mr. Gates also noted that, “Also drawing separate FAA scrutiny is repeated poor-quality workmanship in the 787 fuel tank, including issues with fasteners.” He reported that latter problem “reaches back into the 787 supply pipeline, which continues to stutter.” According to the article, Boeing has had to halt movement of planes on its final assembly line, as well as halt deliveries of “major sections” of the aircraft to Everett, in order to create a “balancing act” that allows “some suppliers to catch up with others and to slow the flow onto Paine Field of new planes needing to have the latest fixes applied.”
To sum up his article, Mr. Gates reported that—
Employees working on the 787 complain about insufficient oversight of suppliers and a management system that the senior engineer called ‘totally broken.’ ‘This program is not like anything we've seen,’ said the veteran 787 employee. ‘It's a screwed-up mess.’
Normally we would stop there, but there’s one more thought-provoking article to bring to your attention. It discusses a problem that may be far worse than any reported in the Seattle Times or Bloomberg. Mr. Michael Mandel wrote an article with the interesting title, “Knowledge Capital Writedown at Boeing?” in the Wall Street Pit online publication.
Mr. Mandel postulated that, “What’s going on here is a breakdown of Boeing’s outsourcing strategy, and a possible breakdown of Boeing as well.” He noted that, “In the short run, outsourcing may have increased the risks and costs [of the 787 Dreamliner program] rather than decreased them.” According to Mr. Mandel, “Part of the problem is low quality of parts from partners who were supposed to shoulder a lot of the burden.” But Mr. Mandel asserts that the supplier quality problems are not the real long-term issue, because “these problems can all be fixed, at a cost.”
In his view, the real problem with Boeing’s strategy is the loss of its intellectual property—the knowledge of how to design and build commercial aircraft.
Mr. Mandel cites a year-old Harvard Business Review blog post by Dick Nolan, who is a professor at the University of Washington. Mr. Mandel quotes Professor Nolan as follows—
In trying to keep down Airbus, Boeing may be creating a much more dangerous competitor, one that likely will come from Japan, China, or India — countries that will own the markets for new airplanes in the near future and are in various stages of building their own commercial-airplane-manufacturing industries.
To finance the development of the 787 and secure global orders, Boeing agreed not only to outsource an unprecedented amount of the plane’s parts to partners in Europe, Japan, and China, but also to transfer to them unprecedented know-how. Before the 787, Boeing had retained almost total control of airplane design and provided suppliers precise engineering drawings for building parts (called ‘build to print’). The only exception was jet engines, which have long been designed and manufactured by suppliers such as GE, Rolls-Royce, and Pratt & Whitney.
The 787 program departed from this practice. Boeing effectively gave Tier 1 suppliers a large part of its proprietary manual, ‘How to Build a Commercial Airplane,’ a book that its aeronautical engineers have been writing over the last 50 years or so. Instead of ‘build to print,’ Boeing provided suppliers with performance specifications for parts and components and collaboratively worked with them in the design and manufacturing of major components such as the wing, fuselage section, and wing box
According to Mr. Mandel, one of the beneficiaries is the Commercial Aircraft Corp. of China, who has just “taken its first set of orders for the C919, a potential competitor to the … Boeing 737.”
Taken together, these recent stories present a picture of an utter failure of a supply chain management strategy. It seems clear (in hindsight) that Boeing pushed design responsibility down to suppliers that were unready to take it, relied on the quality and workmanship of untried and possibly untrained foreign workforces, and failed to compensate for the lack of a quality-focused culture by implementing rigorous quality inspections at every hand-off. As a result, Boeing has experienced long schedule delays, huge cost overruns, and a production nightmare that it may not be able to overcome in the short term. And in the long term, it may have sold off its intellectual property “crown jewels” for a pittance, and given its competitors the means they needed to compete against it in the global marketplace.
And yet, as we ponder those Boeing executives who blessed the failed strategy, who trumpeted the cost and risk reductions from global outsourcing, and who presided over the failure of that strategy—we’re confident that they all received very nice salaries and large incentive compensation packages.
Industry and President Obama Align While DOD Continues to Attack Its Industrial Base
We almost titled this article, “The Vast DOD Conspiracy,” because it seems to us that there is something amiss here, as if the Department of Defense didn’t get the memo about jobs and exports and manufacturing and—did we mention jobs? We decided to go with a less catchy, more awkward title, because we have no evidence the Secretary of Defense Gates and his military service chiefs are engaged in a conspiracy to sabotage President Obama’s attempts to jump-start the economy (and perhaps win reelection) through focusing on manufacturing and exporting durable goods such as defense articles.
You be the judge.
Fact 1:
On March 11, 2010, President Obama issued Executive Order 13534, entitled “National Export Initiative”. EO 13534 established as policy the initiative—
… to improve conditions that directly affect the private sector’s ability to export. The NEI will help meet my Administration’s goal of doubling exports over the next 5 years by working to remove trade barriers abroad, by helping firms—especially small businesses—overcome the hurdles to entering new export markets, by assisting with financing, and in general by pursuing a Government-wide approach to export advocacy abroad, among other steps.
EO 13534 established an Export Promotion Cabinet (EPC) to develop and coordinate implementation of the NEI. Fourteen (14) positions were named to the EPC—among them the Secretary of State, the Secretary of Commerce and the Secretary of Labor. Notably absent from the EPC was the Secretary of Defense, even though aerospace/defense exports are a large component—and among the fastest growing—of total U.S. exports.
Fact 2:
On December 9, 2010, the Whitehouse announced significant changes to the existing export control system, designed to “ease restrictions on items that are less security-sensitive,” according to one report. This editorial at National Defense Magazine notes that, “Unlike previous attempts at revamping export regulations, this one comes at a time when the United States needs to create jobs, and export sales are seen as essential to future recovery.” Although Secretary of Defense Gates has supported arms export control reforms in past speeches, his voice seemed to be missing from the current efforts, as were the voices of the Joint Chiefs and the leaders of the military services. A search of the DOD website failed to locate any recent articles on the topic.
Fact 3:
On December 15, 2010, President Obama held “his largest private meeting with [private industry] chief executive officers since he entered the White House,” according to this story at Bloomberg.com. Among the CEOs at the meeting were James McNerney (Boeing), David Cote (Honeywell), Greg Brown (Motorola), and Jeffrey Immelt (GE). According to this Wall Street Journal report, “President Barack Obama pressed 20 corporate chief executives Wednesday to suggest policies that would spur them to ‘start investing in job creating enterprises.’”
Fact 4:
A recent editorial by Lt. General Lawrence Farrell, Jr. (USAF, Retired) in National Defense Magazine questioned the Department of Defense’s commitment to its industrial base. He wrote—
As the defense sector heads toward a future of flat or declining budgets, the health of the industrial base and its critical capabilities becomes a prime concern.
It is not yet apparent that senior policy makers have begun to assess what industrial capabilities must be preserved. Ensuring that the United States is able to maintain core industrial competencies must be a priority before a fiscal downturn becomes reality.
Although General Farrell listed several specific concerns, one that caught our attention is the impact of bureaucratic procurement processes—and intrusive DCAA audits—on the ability of munitions industry to support the needs of warfighters. General Farrell wrote—
For many companies, the contracting process continues to create unnecessary burdens that hamper their ability to support the military’s needs. … [Munitions industry] Survey responders said that a lack of timely procurements has affected business …. Seven of 12 said these delays have caused production lines to go cold, and half of the companies laid workers off. Finally nine of 12 stated that these delays in contracting caused a reduction in revenue for the year. Based on the results of the survey, it appears that the cutbacks in industry were not a result of reduced budgets, but were caused by bureaucratic delays — including Defense Contract Audit Agency (DCAA) audits — that have impeded the timely execution of appropriated funds. … One company reported that a post-award audit started in 2007 and is currently on hold. Another reported that a contracting officer removed a DCAA auditor after a year of little progress and restarted the audit. In some cases, the trouble is inconsistent DCAA procedures, which may vary from one region of the country to another. Different audit functions within a single program are conducted separately and not coordinated. This has resulted in multiple repetitive audits by different agencies and individuals. Adding to these issues are poor communications between procurement contracting officers and auditors, and a general lack of experience in contracting officers. All of the issues have led to slow, cumbersome processes and a lack of qualified experts in critical positions.
We are not going to make any over-the-top accusations in this article. We will ask, however, whether Pentagon leadership shares its Commander-in-Chief’s focus on job creation through partnership and the easing of regulatory burdens (such as antiquated arms export control rules). From our perspective, DCAA and DCMA are well into the process of imposing bureaucratic roadblocks, attacking defense contractors through flawed (but headline-grabbing) audit findings, and paralyzing the already slow-as-molasses defense acquisition system.
President Obama clearly has signaled that he understands the U.S. economic recovery is dependent on job creation and that manufacturing exports are an important part of that initiative. DCAA and DCMA are acting in ways that tend to undercut the President’s agenda. It is time for DOD leadership to provide some course correction to these wayward agencies.
Why have Pentagon leaders gone silent?
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More Changes Ahead for Pentagon Procurement Practices
Our recently discovered favorite website, FierceGovernmentIT, carried a couple of recent stories that indicate some significant changes are in the works for DOD acquisition folks.
First, the site reported that the reintroduced 2011 Defense authorization bill, H.R. 6523, contained in its Section 806, a very interesting provision. The Bill, which was passed by the House and delivered to the Senate on December 17, 2010, provides that for acquisitions of certain “covered” (national security) systems, the Department of Defense may—
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Exclude sources that fail “to meet qualification standards established in accordance with Section 2319 of Title 10 of the United States Code [10 U.S.C. 2319] for the purpose of reducing supply chain risk in the acquisition of covered systems.”
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Exclude sources that fail “to achieve an acceptable rating with regard to an evaluation factor providing for the consideration of supply chain risk in the evaluation of proposals for the award of a contract or the issuance of a task or delivery order.”
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Withhold consent for contractor to subcontract with “a particular source or to direct a contractor for a covered system to exclude a particular source from consideration for a subcontract under the contract.”
Moreover, the legislation would prohibit the action(s) taken above from a bid protest review by the GAO “or in any Federal court”. And the determinations regarding supply chain risk that lead to those actions could be provided to other DOD components “or other Federal agencies”.
What is “supply chain risk”? The legislation defines the term thusly—
The term ‘supply chain risk' means the risk that an adversary may sabotage, maliciously introduce unwanted function, or otherwise subvert the design, integrity, manufacturing, production, distribution, installation, operation, or maintenance of a covered system so as to surveil, deny, disrupt, or otherwise degrade the function, use, or operation of such system.
As the FierceGovernmentIT story reported—
The bill also would require establishment of four cybersecurity pilot programs, including one for ‘processes for securing the global supply chain.’ Such a pilot program would establish a framework and taxonomy for evaluating the supply chain and ‘an assessment of the viability of applying commercial practices for securely operating in an uncertain or compromised supply chain.’
Those who’ve read our rants reasoned, yet passionate, calls for managing supply chain risk will see this as yet another compelling reason to focus on such issues. For those who are new to this site, please see this article, or this one, which provide a good starting point for more research.
In a second story, FierceGovernmentIT reported that the DOD is planning to change “how it funds, buys and manages IT projects”. In a recently published report, DOD listed many reform efforts it plans to make. FierceGovernmentIT published a list of those reforms here.
As the FierceGovernmentIT article stated—
New reforms will be implemented incrementally and could require Congress to change elements of U.S. code. The report identifies five guiding principles: Deliver fast and often; incremental and iterative development and testing; rationalized requirements; and flexible/tailored processes.
The reforms involve significant changes to IT project funding, which are outlined in the article. We were interested to see that one of the reforms would be to exempt IT projects from the DOD 5000 approach to program management, “in favor of more frequent decisions”. The article also reports that the report calls for reforms to the traditional systems engineering approach. It states—
The department will shift away from the waterfall engineering process in favor of newer practices such as test-driven development, model-driven development and feature-driven developments, the report adds. Creation of a common IT infrastructure with non-proprietary interfaces will enable agile development. …
The FierceGovernmentIT article (link above) provides a link to the original DOD report, for those interested in further research.
A Government Contractor in Trouble
Headquartered in Columbia, Maryland, Integral Systems is “a leader in the secure management, delivery and distribution of data and information from space and terrestrial-based platforms into networks for military, government and commercial satellite and aerospace customers.” According to the company’s 10-K (Annual Report)—
Our revenues are derived primarily from customers in the aerospace and defense industry, particularly the Command, Control, Communications, Computers, Intelligence, Surveillance and Reconnaissance (“C4ISR”) market, and to a lesser extent, customers in other industries such as telecommunications and media. The aerospace and defense community is comprised of major government operations (including defense, civil, and homeland security) and large-scale commercial operators including satellite operators, communications companies, and other media companies. The C4ISR market primarily services the Department of Defense (‘DoD’), the intelligence community, and other governmental agencies by providing complex, networked, mission-critical systems enabling command and control of data collection, analysis and dissemination from multiple sources as well as managing key tactical communications and decision support systems. While overall defense spending is expected to grow at a slower rate than in previous administrations, we believe that the C4ISR market, and our role within it will continue to see funding priority resulting in stable or moderate growth in the marketplace. We believe that these programs, integrating advanced electronics and software to enhance the capabilities of current systems and provide the integration of multiple sensor and battle management platforms will continue to be required as the U.S. defense budget continues to respond to the current and future security environment.
That sounds promising, doesn’t it? Integral Systems seems to have found a sweet, stable market niche in one of the fastest growing areas of the aerospace and defense marketplace. Which is a good thing, since about three-quarters (72%) of company revenue comes from sales to the U.S. Government. Reflecting its key niche, 2010 revenues are up, from $160 million to $178 million.
So why can’t Integral Systems make a profit? Why did the company record a $1.5 million loss from operations, and a $2.4 million net loss?
Naturally, the answer to such a question is both long and complex. But let’s note a few—admittedly superficial—facts that may lead toward an answer to our question.
First, we note that the company made several recent acquisitions in its Product Group segment. The acquisitions created an integration challenge, according to this story at SpaceNews.com. The story reported—
Integral in 2010 incurred costs related to its acquisition of CVG-Avtec. [CEO Paul] Casner said this acquisition took management’s attention away from other aspects of the business and is in part responsible for what he said were disappointing financial results.
‘There’s no two ways about it, this has been a tough year and our shareholders have shouldered much of the burden,’ Casner said.
Casner said the Satcom Solutions division did not perform to expectations in 2010, in part because of the CVG-Avtec acquisition. He referred to the division’s results as ‘the elephant in the room’ at Integral. Part of the problem, he said, was delayed contract awards and a mix of contracts that, taken together, resulted in lower profitability.
We took a look at Integral’s 10-K and noted that the Products Group segment saw a revenue increase of more than 40%, but that the revenue increase was offset by a 60% increase in segment operating expenses. According to management, the increase in operating expenses was attributable to—
… an increase in corporate allocated expenses of $8.2 million, an increase in operating expense of $3.6 million incurred by the SATCOM Solutions division, $1.9 million relating to the satID division, which was acquired in the second quarter of Fiscal Year 2009, $2.1 million of overhead expense associated with the reclassification to selling, general, and administrative expense, $0.3 million relating to an increase in selling expense, and $0.3 million relating to research and development.
We don’t have all the details, but we also noted that the company’s percentage of fixed-price contract work increased, from a 2009 level of 55% to a 2010 level of 67%. The accounting changes described above, coupled with an increase in fixed-price work, would certainly tend to negatively impact operating results.
One lesson that might be learned here is to consider the impact of an acquisition on such items as allocated corporate expenses before deciding to make the acquisition. If the new revenue and headcount attracts more corporate costs, then the existing project portfolio will become more expensive. If the work is firm fixed-price, then the company will see degradation in project gross margins.
But of course that’s not the whole story—nor do we mean to imply that we can tell the whole story in this article. Again, we are simply noting some interesting points that came to our attention while researching the company.
We also noted that the company has faced some legal problems in its recent past. According to the 10-K report—
On March 1, 2007, we learned that the Securities and Exchange Commission (the “SEC”) had issued a formal order of investigation regarding the Company, and we and subsequently certain of our then officers received subpoenas in connection with the investigation. The investigation by the SEC and a related inquiry by NASDAQ included questions as to whether Gary A. Prince was acting as a de facto executive officer of the Company prior to his promotion to the position of Executive Vice President and Managing Director of Operations of the Company in August 2006. The investigation and inquiry also included questions as to whether Mr. Prince was practicing as an accountant before the SEC while an employee of the Company. Mr. Prince agreed with the SEC in 1997 to a permanent injunction barring him from practicing as an accountant before the SEC, as part of a settlement with the SEC related to Mr. Prince’s guilty plea to charges brought against him for conduct principally occurring in 1988 through 1990 while he was employed by Financial News Network, Inc. and United Press International. In March 2007, we terminated the employment of Mr. Prince. Under the supervision of a Special Committee established by the Board, the Company also took other remedial action and provided full cooperation to the SEC in the investigation.
On July 30, 2009, the SEC and the Company each announced that a final administrative settlement had been reached concluding the SEC’s investigation as to the Company. Under the administrative settlement the Company… consented to a ‘cease and desist’ order requiring future compliance with certain provisions of the Securities Exchange Act and the SEC Exchange Act rules. The order does not require the Company to pay a monetary penalty. The SEC states in the order that in determining to accept the settlement it considered both the remediation efforts promptly undertaken by the Company, and the cooperation the SEC staff received from the Company. Shortly after the settlement with the SEC, representatives of the Company met with various officials at NASDAQ. As a result of that meeting the Company learned that the NASDAQ inquiry had been closed out with no actions required of the Company.
In conjunction with its announcement of the administrative settlement, the SEC also disclosed that it was instituting separate civil actions against Mr. Prince and two other former officers of the Company. The Company has indemnification obligations to these individuals pursuant to the terms of separate Indemnification.
Certainly, company management was distracted by the potentially damaging SEC investigation and legal actions, by the NASDAQ inquiry, and by the ongoing civil actions against the former company executives. But that’s not the whole story, either. The company also had significant problems with its DCAA auditors.
The company reported in its 10-K—
Our Military & Intelligence Group cost-plus contracts are driven by pricing based on cost incurred to perform services under contracts with the U.S. government. Cost-based pricing is determined under the Federal Acquisition Regulation, which provide guidance on the types of costs that are allowable in establishing prices for goods and services and allowability and allocability of costs to contracts awarded by the U.S. government. We have incurred allocable costs that we believe are allowable and reimbursable under our cost-plus-fee contracts, and that are included in our revenue. These costs are subject to audit by the Defense Contract Audit Agency (“DCAA”); therefore, revenue recognized on our cost-plus contracts is subject to adjustment upon audit by DCAA. We established a revenue rate reserve of $6.6 million for costs incurred for which ultimate reimbursement is uncertain. The Incurred Cost Submission (“ICS”) for our Columbia-based government operations has been audited by the DCAA through the Fiscal Year ended September 30, 2005. The ICS for our RT Logic subsidiary has been audited by the DCAA through September 30, 2006. The ICS for our SATCOM Solutions division has been audited by the DCAA through December 31, 2005. Newpoint, SAT, and Lumistar are not currently subject to audits by the DCAA. ….
In the fourth quarter of Fiscal Year 2010, the DCAA formally issued a Report on Audit of Post Award Accounting Systems (the “Accounting Systems Audit Report”) that found, as of January 27, 2010, our accounting system to be inadequate and identified certain significant deficiencies in our accounting systems, controls, policies and procedures. As a result of this determination … our administrative contracting officers are required to consider, with respect to cost-plus contracts, whether it is appropriate to suspend a percentage of progress payments or reimbursement of costs proportionate to the estimated cost risk to the U.S. government, considering audit reports or other relevant input, until we submit a corrective action plan acceptable to the contracting officers and correct the deficiencies. In addition, in order for us or any other entity to be awarded any new cost-plus contract, the administrative contracting officer must determine that such entity has the necessary operating and accounting controls to be determined ‘responsible’ under the Federal Acquisition Regulation. … We do not believe that the issues raised in the Accounting Systems Audit Report have materially adversely affected our business, financial condition or results of operations up to now, and we do not believe that they will have a material adverse impact on our business, financial condition or results of operations in the future. We are working diligently to resolve these accounting deficiencies and believe that they will be successfully resolved. However, the Accounting Systems Audit Report has the potential to materially adversely impact our ability to obtain future cost-plus contracts from the U.S. government, could result in certain payments under existing cost-plus contracts being delayed or suspended, and the DCAA could, as a result of a subsequent audit, reduce the billing rates that it has provisionally approved, causing us to refund a portion of the amounts we have received with respect to cost-plus contracts.
The SpaceNews.com made much of the company’s DCAA problems. It reported—
The Defense Contract Audit Agency (DCAA) has determined in an audit that Integral Systems has ‘internal control deficiencies’ in the way it handles cost-plus contracts for the Defense Department, which is Integral’s biggest customer.
In a Dec. 8 conference call with investors, Casner said the DCAA audit findings have not affected any contracts or revenue. But in a Dec. 8 filing with the SEC, Integral said the audit could put into jeopardy the company’s future cost-plus contracts with the Defense Department.
Integral Chief Financial Officer Christopher B. Roberts said during the call that the company has made progress in addressing the financial control issues but was not able to complete the job in fiscal year 2010.
We noted that, in addition to the DCAA findings regarding the company’s accounting system internal controls, the company also established a $6.6 million reserve for potential questioned costs related to its incurred costs. When profitability is so tight, that’s gotta hurt.
To sum up, we don’t know this company. We’ve never worked for them or with them, and we don’t know anybody who has. But we look at the company and see a government contractor in trouble, struggling to comply with myriad contract compliance issues while integrating multiple acquisitions and supporting outside investigations and litigation.
We see a company that ought to be making a decent profit while growing each year, but that can’t seem to overcome its challenges. We hope 2011 will be kinder to Integral Systems than 2010 was.
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