An accounting fiddle has undermined the credibility of the board and mangement at Leighton Holdings, as Blueprint Bob explains.

The media’s got it horribly wrong in the first reaction to what appeared to be a reasonable interim profit Wednesday from Leighton Holdings, the country’s biggest building and construction group, and significant contract miner.

The immediate line in the reaction was to accept at face value the confident tone from Leighton in the announcement, showing a 20% rise in net earnings to $91 million, a rise in dividend from 18c to 20c a share, lots more projects and a big rise in revenues.

However, in doing so the media completely missed the real story – Leighton expects at least $180m profit – in this early report from the Fairfax website and the ABC.

But not the harder heads in the investor community. After being surprised by that curious announcement almost a week ago that revealed an odd accounting change, designed to drag profits forward to this year from next, investors were wary of Leighton.

They quickly read past the nice stuff and found buried deep in the report, more information about the impact that accounting change has had on Leighton profits.

The answer was not good for the company and a shock to many investors. More than 40% of net after tax earnings in the six months to December 2004 came from that accounting change.

Stripping the $42 million impact from the accounting change from the $90.9 million reported, investors realised Leighton actually earned only $48.9 million, not nearly enough, and a sign that the company’s finances are under pressure.

Leighton earned $110 million last year in a result slashed by the costs of the Southland Coal mining project and the Spencer Street and Sydney Hilton contract problems. The company forecast earnings this year of $180 million and says they remain the guidance.

But that’s with the bolstering from the accounting change. What the real figure is, no one has worked out yet. It could be around $90 to $100 million, perhaps less than the reduced figure in 2004.

While the company’s earnings were bolstered by this accounting change (Crikey highlighted the wider industry’s woes earlier this week in Low-ball bids and building problems).

the company has also been hit by raw materials shortages, higher costs and price rises for steel, tyres, concrete, wood and a host of other products. A major road project in the Philippines is in trouble and will cost a lot of money to fix up, and the company is unclear on how many of its contracts it is inflation protected by the client absorbing price rises.

So the company’s shares plunged sharply in early afternoon trading, the second such fall in a week.

Leighton shares finished down 56c on Wednesday at $10.44, around $2 under the level before last Thursday’s ASX briefing was released.

That was last Thursday and after the release, Leighton shares fell sharply on worries that the company was dragging forward profits from 2006 to bolster the $180 million earnings estimate this year. The accounting change was signalled in this Corporate File briefing on the ASX by Leighton CFO, Dieter Adamases. Those worries by investors have now been confirmed.

Here’s the Leighton interim statement issued on Wednesday.

In it the extent of the contribution from this accounting change was outlined, but buried deep in the lengthy report. After describing the accounting change and the reason for it, the report said “The effect of the above on net profit after tax at 31 December 2004 is $42 million”.

The company in the report baldy, without any obvious qualification, said it earned $90.9 million, an increase of 20%.

But from comments to the media there’s been a sharp contraction in earnings in the past six months as profit margins have been battered by shortages of raw materials, high prices, labour productivity problems on some contracts and the high costs of working out troubled deals in Australia and in the Philippines.

Revenues from all the company’s businesses and joint ventures jumped almost $1 billion, to $3.58 billion in the half, according to Wal King.

That’s a rise of more than 38%, and yet claimed earnings rose only 20%, shouldn’t that indicate warning bells? When claimed earnings rise at almost half the rate of the revenue line, its case for worry. But strip out the impact of the accounting change and profits have gone backwards on a 38% rise in revenue!

The higher interim dividend of 20c a share represents around $54 million in payout, based on 272 million shares issued. It’s covered, but by the profit bolstered by the accounting change. Without it, there’s a shortfall of around $14 million.

Wal King made a big point of how good Leighton’s return on equity is, but in relation to the company’s revenue and order book, equity is not an important factor.

Contractors are similar to retailers. They book large contracts on low margins, hoping scale in ordering materials, financing and labour negotiations can keep costs under control and drive profits.

That’s now under pressure at Leighton.

With Hochtief of Germany now the majority shareholder, return on equity is a secondary measure.

In an industry were margins are notoriously thin, its the pre-tax margin that’s an important, vital even, indicator of health(just as in retailing). Leighton’s pre-tax margin in Asia is less than 4% and in all its businesses, less than 3%.

Somehow the phrase profitless prosperity springs to mind.