SCT - Scott Tech

[Snoopy]

You’re not the only Scott supporter! Really appreciate your insights into the financials.

My understanding is if a contract milestone payment exceeds revenue received, Scott has paid a subbie or for materials in advance of billing the client for the work, therefore it’s a liability until the client pays for it. I’d classify that as WIP, and is a risk and should not be included in profit calcs.

Let's take a job where Scott takes on a project and due to time constraints they need to farm out some of that project work to a sub contractor. This is not a theoretical example. This is exactly what Scotts have had to do in the past at their Christchurch base. The work outsourced is not outside the scope of what the skilled engineers at Scott's can normally tackle. The sub contracting is purely due to a timing issue where Scott's engineers have been switched away from the project to help complete something else within the wider company, resulting in an unplanned for shortage of in house workers.

From a client perspective, Scott completes the project work on time. I think what you are implying Bullfrog is that, in this case, Scotts have ticked off the job. But as a result of Scotts having to await billing from their sub contractor, there may be a delay in receiving the bill from the sub contractor and passing on that part of the bill to the end client. Thus in the period the sub contracting work is done but has not been paid for by Scotts and/or passed on to the final client then such work becomes a 'contracting liability'.

I put it to you that the 'Work In Progress' (WIP) in these circumstances is the same work that Scotts in house team are doing in parallel for the same client. So I find it hard to come to terms with your remark that the execution risk or payment risk is any different to the risk that Scott's own engineers face in not doing the job properly and not being paid. In summary I think such work should be included in the net profit figures for the period and not rolled into a later period as the current accounting treatment seems to regard as the proper way to present things. Maybe I need to take it up with the auditors?

SNOOPY

[Snoopy]

$16.385m - $12.264m = $4,121m

of profit at the half year that they haven't really earned yet. And when the declared total half year NPAT is $4.714m, that means the real half year profit figure is a rather paltry $0.593m. Could that explain why the nevertheless welcome half year dividend of 2cps is unimputed?

Due to an error in my calculations, the underlying profit was not a paltry $0.593m. So the reason for the lack of imputation credits is probably the same as that which former CEO Chris Hopkins reported in AR2019, prior to the payment of that years final dividend.

"The final dividend will not be fully imputed due to the greater portion of earnings being generated offshore."

With zero imputation credits for the upcoming half year dividend payment, does this mean that zero earnings were recorded onshore? The EBITDA margins for HY2021 in the territories in which Scott's operate make interesting reading.

HY2021	Revenue {A}	Normalised EBITDA {B}	EBITDA margin {B}/{A}
Scott Europe	$28.2m	$2.6m	9.3%
Scott Australasia	$51.1m	$5.8m	11.4%
Scott China	$1.5m	$6.1m	24.7%
Scott North America	$19.1m	$3.5m	18.2%

China is leading the EBITDA contribution, But China is the smallest business unit, and when there is not a big project on there (such as HY2020) they are at the bottom of the class (EBITDA margin for China was -31.5% for HY2020).

With the continued talking up (and rightly so) of Auckland based Rocklabs, and fully accepting that Christchurch (which handles US and Oz based appliance manufacturing clients) may be a drag, 'zero profit' is not consistent with the HY Presentation Slide 8 comment:

"Strong rebuild in the ANZ work program, largely driven by mining and meat sectors."

Perhaps the strong rebuild in the work program is a forward indicator of profit, and the current half year is a result of the lower level order book from six months ago (PRHY2021 Slide 9)? Or maybe it is the Oz Workshops turning out all of those highly profitable 'Bladestop' bandsaws that is the source of those bumper Australasian turnover? I guess if the next dividend comes out with some Aussie Franking Credits attached (and that would suit majority owner JBS Australia), the question of New Zealand's unprofitability will be answered?

SNOOPY

[bullfrog]

Let's take a job where Scott takes on a project and due to time constraints they need to farm out some of that project work to a sub contractor. This is not a theoretical example. This is exactly what Scotts have had to do in the past at their Christchurch base. The work outsourced is not outside the scope of what the skilled engineers at Scott's can normally tackle. The sub contracting is purely due to a timing issue where Scott's engineers have been switched away from the project to help complete something else within the wider company, resulting in an unplanned for shortage of in house workers.

From a client perspective, Scott completes the project work on time. I think what you are implying Bullfrog is that, in this case, Scotts have ticked off the job. But as a result of Scotts having to await billing from their sub contractor, there may be a delay in receiving the bill from the sub contractor and passing on that part of the bill to the end client. Thus in the period the sub contracting work is done but has not been paid for by Scotts and/or passed on to the final client then such work becomes a 'contracting liability'.

I put it to you that the 'Work In Progress' (WIP) in these circumstances is the same work that Scotts in house team are doing in parallel for the same client. So I find it hard to come to terms with your remark that the execution risk or payment risk is any different to the risk that Scott's own engineers face in not doing the job properly and not being paid. In summary I think such work should be included in the net profit figures for the period and not rolled into a later period as the current accounting treatment seems to regard as the proper way to present things. Maybe I need to take it up with the auditors?

SNOOPY

Maybe I’m not quite right with calling it WIP, as it could be completed work, but I do have a stumbling block in including a liability in a profit figure. Until the work is accepted and paid for by the client, regardless of who does it, the expenditure to undertake that work is a liability.

Bottom line is Scott have had a couple of horror reports, but I have confidence in the leadership team to make the hard decisions that make Scott a good long term investment.

[Snoopy]

Maybe I’m not quite right with calling it WIP, as it could be completed work, but I do have a stumbling block in including a liability in a profit figure. Until the work is accepted and paid for by the client, regardless of who does it, the expenditure to undertake that work is a liability.

I guess it comes back to the question:

Are your workers 'liabilities', because you are contracted to give them a pay cheque each month, or an 'asset' because it is those workers that do the jobs that allow you to bill end line customers for a job well done?

An 'Account receivable' last time I looked is thought of as an 'asset' even though it is work that has not been paid for. As a company owner you don't think about the expenditure (wages) that you have already paid to allow the customers to be billed, because you are contracted to pay your employees anyway. If, however, you have to hire external contractors to complete the work then I can understand why you might regard money paid to contractors as a 'liability' until the end line customer pays the bill that pays the contractors wages. But whether you think of employees or contractors differently like that is, IMO, more a mindset. I think it is one of those questions without a black or white answer. Who was it that said you have to spend money to make money?

Going back to that original definition by Scott's themselves:

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3/ A Contract Liability, as part of a long term project contract, arises if a particular milestone payment exceeds the revenue recognised to date.

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I do wonder why any customer would pay more than they have been asked to pay? Or am I reading into that definition something that is not there?

SNOOPY

[Ferg]

Snoopy

Late edit: the SCT wording is terrible that you have quoted which is not helping you.

Deducting the 2 figures gives you the nett balance of work in progress of $4m that is sitting on the Balance Sheet. In most cases (where project costs exceed zero), this has very little bearing on the profit recognised given the low margin %. So no adjustments should be made to their reported profits from this derived figure. From memory I outlined contract accounting in the Mercer thread - found it here:
https://www.sharetrader.co.nz/showth...l=1#post840594

You need to get your thinking around contract WIP where the accounting "appears" to be backwards. A liability owing to a subbie or for some equipment is actually a contract WIP asset, not a contract WIP liability which I have seen you state in this and the Mercer thread. Refer to the example journals pasted below from the Mercer thread.

From the Mercer thread:

"Construction accounting (simplistically) works like this:

Invoice (say deposit) to customer:

• Debit Receivables (and is eventually paid)
  
• Credit Contract WIP

Costs incurred on contract:

• Debit Contract WIP
  
• Credit Payables (and eventually paid)

Each contract is separately tracked. Those with a nett credit balance are classified as contract liabilities at year end, whilst those with a nett debit balance are classified as contract assets.

Profit is released to the P&L on large contracts according to percentage complete:

• debit Contract WIP
  
• credit P&L.

So the nett credit balance shows good working capital management in that Receivables are ahead of Payables. And while a credit balance is like deferred income, very little will actually be profit (being the project Margin).

Reading p33 of the [MGL] AR I see nothing that contradicts the above. Think of contract debit balances as a prepayment. The risk with large projects is if you overstate the costs completed to date, then you get a higher % complete and can take a higher % into profit. I'm not saying that is happening (and I haven't checked) but one way of checking this is by looking at the average days in payables to see if there is any any monkey business and/or how many projects have a nett debit balance. The other thing to be wary of is projects with debit balances may be concealing a project loss - again I'm not suggesting that is the case, just providing some background info."

If after reading this you interpret it as showing some sort of accounting impossibility or something nonsensical, then I suggest you work through some examples. If you would like to learn this in more depth, then I'm available for a fee.

Links for contract WIP accounting principles:
https://simplestudies.com/principles_of_long_term_contract_accounting.html
https://accounting-simplified.com/if...ion-contracts/
The worked examples I can find online are not helpful so I do not recommend reading those.

Trust me on this: there is nothing to take up with the auditors regarding the contract accounting. If the auditors have expressed concerns about contract accounting, they will be referring to the accuracy of the % complete calculation, which has two key variables being costs incurred to date (easy to check) and total estimated costs for the project (hard to check).

FERG

[Snoopy]

Snoopy

Late edit: the SCT wording is terrible that you have quoted which is not helping you.

Deducting the 2 figures gives you the nett balance of work in progress of $4m that is sitting on the Balance Sheet. In most cases (where project costs exceed zero), this has very little bearing on the profit recognised given the low margin %. So no adjustments should be made to their reported profits from this derived figure.

From the half year report consolidated balance sheet:

$16.385m (Contract Liabilities) - $12.264m (Contract Assets) = $4.121m (Work in Progress) as at 28-02-2021

If I use the net profit margin for the half year (my post 939), we might expect this 'work in progress' to generate a profit of:

0.04512 x $4.121m = $0.186m. Not huge. But not small enough to have 'very little bearing on the profit recognised' - to my way of thinking.

Looking at the equivalent reference period from the previous year

$9.346m (Contract Liabilities) - $26.762m (Contract Assets) = minus $17.414m (Work in Progress) as at 29-02-2020

Negative work in progress? How can that be?

SNOOPY

[Snoopy]

From the half year report consolidated balance sheet:.


$16.385m (Contract Liabilities) - $12.264m (Contract Assets) = $4.121m (Work in Progress) as at 28-02-2021

If I use the net profit margin for the half year (my post 939), we might expect this 'work in progress' to generate a profit of:

0.04512 x $4.121m = $0.186m. Not huge. But not small enough to have 'very little bearing on the profit recognised' - to my way of thinking.

Looking at the equivalent reference period from the previous year

$9.346m (Contract Liabilities) - $26.762m (Contract Assets) = minus $17.414m (Work in Progress) as at 29-02-2020

Negative work in progress? How can that be?

After working through Ferg's extensive reply, I have the answer to my question. Work In Progress (WIP) is the summation of many going concern contracts that are not itemised out at annual report level. WIP can be negative if the negative components of that itemised list sum to a larger absolute number than the positive components. Ferg has identified a couple of contract types where WIP is negative.

1/ Where the amount invoiced is greater than the costs and the profit.

2/ Where the customer has made a deposit in advance of any work being done.

But if we use Ferg's I= E +G + H formula, where:

I = Work In Progress
E = Costs to date (generally a positive figure)
G = Jobs Invoiced to date (generally a negative figure)
H = Profit Recognised (generally a positive figure)

We can imagine a third instance of a 'negative WIP' component. That is where the costs of the project never cover the invoices to the customer: i.e. the job is loss making. So how does all this relate to the SCT situation? My next task is to find out!

SNOOPY

[Ferg]

Where did my post #947 go to which Snoopy refers? An hour of work plus a future reference point on contract accounting gone....was someone unhappy with the formatting?

[Ferg]

We can imagine a third instance of a 'negative WIP' component. That is where the costs of the project never cover the invoices to the customer: i.e. the job is loss making.

Snoopy check your logic of "loss making" versus the worked example I provided that has since been deleted. I'm hoping you grabbed a copy or replicated it? Is it a loss-making contract or a profitable contract (or it could be either?) where the costs do not meet the amounts invoiced? Or am I misunderstanding what you mean by "cover"? Also, with the word "never" - can such a situation exist (where total debits never match the credits) in light of the income recognition rules?

I recommend using debit and credit balance terminology, rather than "negative WIP", to avoid potential confusion. Normally "WIP" refers to work in progress which is naturally a debit balance being an accumulation of costs (e.g. capital work in progress), whereas "contract WIP" refers to contract/construction accounting where good cash flow management naturally results in a credit balance (e.g. customer deposits per the example I posted). So negative WIP in the context of SCT contracts would be referring to negative contract WIP, and given the numbers are naturally credits, negative contract WIP would make that a debit balance. However, using the word WIP, which is naturally a debit, means negative WIP is a credit balance - a potential source of confusion. IMO better to avoid confusion by using consistent contract WIP terminology and debit/credits.

Tonight I will re-post the worked example with skinnier notes to appease the anonymous post-deleter so we have that information available for future reference.

Lastly, given you are only seeing 2 values in the AR of a possible 9 or 10 meaningful figures, it will be difficult to unpick SCT contract WIP. Instead you will need to look to the notes and/or commentary that refers to the pipeline and margins.

FERG

P.S. I am using your method of capitalising my name at the end of the post for our discussions given my propensity for editing posts. The capitalised signature shows I am finished with my edits.

[Snoopy]

Where did my post #947 go to which Snoopy refers? An hour of work plus a future reference point on contract accounting gone....was someone unhappy with the formatting?

Tonight I will re-post the worked example with skinnier notes to appease the anonymous post-deleter so we have that information available for future reference.

I did read your post Ferg to get what I wanted out of it. I hoped to go back later for a more comprehensive look so was rather shucked to see the post deleted. Generally the only reasons for deleting are copyright issues, or if the post is abusive. Your post certainly was w--i--d--e. It could have been made narrower by referencing your very useful notes at the end of each line and putting them below the table. I will be looking forward to the reappearance of your post in a 'slimmed down; form.

It is strange the moderators deleted it, rather than just sending you a note to change the formatting if indeed that really was the problem.

SNOOPY