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Another Red Flag Raised on Friede Goldman

An independent research firm is questioning the company's accounting methods and their impact on earnings in recent quarters.

With investors already fretting over

Friede Goldman's


pending merger with

Halter Marine

(HLX) - Get Helix Energy Solutions Group, Inc. Report

and worrying about project delays, yet another red flag has been hoisted.

On June 22, the

Center for Financial Research and Analysis

, an independent research firm known for detecting misleading accounting practices, issued a five-page analysis of Friede's financials. It concludes that Friede's increased use of aggressive accounting methods may have boosted earnings in recent quarters. Among its issues, CFRA says Friede has falling margins, weakening operating cash flow and a questionable rise in unbilled receivables. It also includes in its backlog a contract it hasn't definitely sealed, CFRA notes.

Friede dismisses the report's conclusions as erroneous. "Our business is comprised of a handful of contracts, all of which are individually significant, so a timing difference

in billing on one contract can make a difference in what the balance sheet looks like," says Jobie Melton, Friede's chief financial officer. "Therefore, it's really difficult to make any valid inferences related to the overall status of the business from simply a change in the balance sheet elements from one period to the next."

In addition, many of the report's assertions are old news, having been disclosed in

Securities and Exchange Commission

filings and conference calls, notes John Alford, a Friede executive vice president. For instance, Friede's decrease in gross profit "is something that everyone knows," Alford says.

Still, the report comes as nervousness among Friede investors is growing.

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The concern began last year as industry-wide demand for rigs declined and daily rental rates plunged. However, Friede made several key acquisitions, grew revenue and beat earnings estimates. Bulls still believe in the company. Bo McKenzie, an analyst at


, twice in June reiterated his buy rating, even though he lowered his earnings estimates for this year due to rig construction delays. He reduced his 1999 estimate to $1.45 from $1.60. He's positive on Friede's franchise position in the industry, its growth prospects and the Halter merger, which he says will bring $20 million in savings in the first year. (Jefferies has done underwriting for Friede.)

But investors clearly are troubled. Friede's stock has tumbled almost 20% since the merger announcement on June 2. It closed Wednesday at 13 11/16, off 5/16. And Friede has trailed the sector's 60% rally since March's


production cuts; in the same period, Friede is up 26%.

Friede Shares Underperform
The company has a long way to go to catch up with
the rally in other oil-service issues

Source: Bigcharts.

All this uncertainty has led short-sellers to pounce. Short interest jumped to 2.4 million shares as of June 15, a 14.7% increase over the May figures. Shorts argue that there won't be any new rigs ordered for years due to the global oversupply.

Among the concerns highlighted by the CFRA is Friede's backlog, which includes a $143 million contract to build a rig for a Brazilian company that has yet to secure financing. The Brazilian company is applying for a loan guarantee from the

U.S. Maritime Administration

, which should enable it to secure private-sector financing more easily.

However, the company is still finalizing its application, according to Friede, which says it's confident of approval. The loan guarantee determination takes approximately 60 days after the application is filed, so the earliest the financing can be expected is late in the third quarter.

Excluding this contract, Friede's backlog stood at $264 million at March 31, down 40% from a year ago. As a percent of revenue, Friede's backlog has declined dramatically from a year ago, both with and without the Brazilian contract, CFRA notes. This is where the Halter merger comes in handy: The combined company would have had a backlog of $1.1 billion at March 31.

Investors may also be intrigued by the surge in unbilled receivables. CFRA cautions that a sudden jump in revenue that have been booked but which the company cannot turn around and bill the client for can indicate cost overruns or lower project cost estimates. Unbilled receivables at Friede increased by $14.4 million in the fourth quarter from $100,000 in the third quarter, and by an additional $13.7 million in the first quarter.

Friede says the jump was simply a matter of timing. In April, one of the contracts met a milestone that allowed the company to bill the customer, says Friede's Melton. And in the past year, Friede has experienced no cost overruns on any of its fixed-price contracts, which make up the bulk of its business, he says.

Then there's the gross-margin issue. Gross margins slipped to 18% in the first quarter from 27% in the year-ago period. Friede says this is simply due its current business mix. Its higher dollar volume of new construction work carries lower margins than the conversion and retrofit work it did more of in past quarters. Margins were also affected, but to a lesser degree, by Friede's use of higher-cost subcontracted labor, hired to meet delivery deadlines.

But CFRA notes that Friede's March quarter margins would have been even lower had the company not amortized $600,000 related to its acquisition of a Canadian shipyard in early 1998 to offset its cost of revenue, an aggressive move. Melton, the CFO, says it would have been inappropriate to characterize the item in "other income," as CFRA advocates.

Another item in the report pertains to a plunge in billings in excess of costs, or cash collections made prior to services rendered. CFRA notes that a decline in this figure can indicate depletion of a future revenue source or possibly more aggressive accounting than in prior periods.

Melton says this too is a matter of timing. "If the March financial statement had been done

a few weeks later it would have looked completely different," he says. A $50 million payment Friede received completely turned around CFRA's assertion, he adds.

But for now, it seems investors are buying the view from the outside.