McDonnell’s Future in Doubt, Auditor Says : * Aerospace: A Pentagon official tells a House panel that the No. 1 U.S. defense contractor is so weak it may cease operations. But a company spokesman says its earnings will grow.

The Pentagon’s chief auditor disclosed Thursday that McDonnell Douglas, facing hundreds of millions of dollars in previously unknown losses, is so weak financially that it may be forced to cease operations.

“We believe ongoing operations are threatened,” William H. Reed, director of the Defense Contract Audit Agency, told the oversight subcommittee of the House Energy and Commerce Committee during a hearing into the condition of McDonnell, the nation’s largest defense firm. It was unusually tough language that left the committee staff surprised.

It was also disclosed in the hearing that the Securities and Exchange Commission is investigating McDonnell’s accounting methods to determine whether they portrayed a more favorable image of the firm than was appropriate.

McDonnell Douglas Financial Vice President and Treasurer William M. Austin termed Reed’s opinions “unwarranted” and “grossly blown out of proportion,” adding that they did “not reflect the corporation’s clearly improved financial performance.” Austin asserted that McDonnell’s six-month performance through June 30 included “the best first-half operating earnings in corporate history.”

In his testimony, Reed said the Defense Department is preparing to increase its estimate of the loss that McDonnell faces on the C-17 cargo jet by another $200 million. That would mean the St. Louis-based aerospace firm may have to absorb $900 million in losses on the jet, built in Long Beach by its Douglas Aircraft unit.

In addition, McDonnell faces losses of $88 million on a secret satellite communications system known as the laser cross-link, $39 million on an advanced Stealth cruise missile and $23.8 million on a contract to improve the Tomahawk cruise missile, Reed testified. An estimated loss of $110 million also looms on the firm’s T-45 trainer jet program.

Together, the losses on the programs amount to $1.2 billion--not including the potential liabilities that the firm faces on the A-12 attack-jet program, which was canceled earlier this year. The Navy has demanded $650 million from McDonnell for that program, an amount the firm is disputing.

The SEC investigation concerns McDonnell’s handling of the A-12 cancellation in its financial statements, according to Rep. John D. Dingell (D-Mich.), chairman of the Energy and Commerce Committee.

McDonnell has counted as assets certain “claims” that it has filed or intends to file against the government on cost overruns, even though the firm has no idea whether the claims will be allowed.

“I believe it is a very unusual transaction,” Reed said. “They are unusual in my experience. I have rarely seen them.”

Dingell said McDonnell has booked assets amounting to $500 million on the basis of these anticipated claims. The SEC has a “formal investigation under way on the legitimacy of McDonnell’s terminations claims on the A-12 program and the resulting adequacy of their disclosure to stockholders,” he said.

McDonnell Douglas shares fell $1.875 to $60.875 in trading Thursday on the New York Stock Exchange.

In his testimony, Reed noted that McDonnell’s financial position has also been aided by another accounting device in which the firm purchased annuity contracts to cover future pension claims and then recognized pension fund surpluses as gains.

Officials at McDonnell--which employs 113,000 nationwide, including more than 40,000 in Southern California--declined an invitation to testify at the hearing. In an interview afterward, McDonnell spokesman Michael Burch said the accounting methods used by the firm differ little from those used by other corporations.

Another accounting dispute cited by Dingell involved the decision by the government to allow McDonnell to shift $171 million in engineering charges from research and development on the C-17 program to production. The change resulted in accelerating payment of the $171 million to McDonnell. The Pentagon’s inspector general is investigating the move.

The company has asserted strongly that it has turned the corner on its financial problems. Reed and other witnesses, however, said they doubted that McDonnell is on a substantially stronger footing than it was in April, when an audit report found serious financial problems.

“It is fair to say that the situation has improved somewhat since the April report, but it has not improved to the extent we are able to in any way mitigate our concerns about their overall condition,” Reed said.

Added Reed: “We are concerned about the ability of the corporation to raise sufficient cash to maintain ongoing operations as their debt increases and their ability to generate further cash borrowings.” However, McDonnell reported that its debt was reduced by $360 million in the quarter ended June 30.

Eleanor R. Spector, director of defense procurement, agreed that McDonnell’s condition is not good. “They have very severe financial problems,” Spector testified, “probably more severe than most of the companies we deal with right now.”

Spector said she believed that McDonnell can absorb losses of $900 million on the C-17, but was less certain about the firm’s ability to weather much larger losses forecast in recent estimates by the Office of Secretary of Defense. Those estimates suggest that the C-17 loss could hit $2.7 billion.

McDonnell has long asserted that it will break even on the program. Burch released a statement Thursday asserting that estimates of $900 million or more in losses on the C-17 are “grossly overstated” and “paint an inaccurate and misleading picture.”

The company says it will cost $7 billon to complete the current C-17 contract, not the $7.5 billion that was suggested in Thursday’s hearing.

But Reed said the company’s internal cost estimates have been plagued by “ineptitude,” noting that as of late last year, 60% of McDonnell’s cost accounting managers had less than three months experience and little training in their work.

Indeed, the company’s C-17 cost estimates last December were based on a projection that the aircraft would fly that month, even though the company already had notified the Air Force that it would not fly until June, 1991. The plane eventually flew last month.

In other testimony, Neal P. Curtin, division director at the General Accounting Office, said McDonnell has experienced significant problems in its AH-64 Apache helicopter program. The helicopter’s 30-millimeter gun has been plagued by defects from the start of the program and has never been certified as acceptable by the Army.

The Army is withholding $9.6 million from McDonnell because of defects in the gun. When the gun was tested for accuracy during its 1985 certification test, it failed 10 of 19 specifications, Curtin said.

When a battalion of 18 Apaches was sent on a mission during the Persian Gulf War, the guns on all 18 helicopters jammed, according to testimony.

The Army plans to try to hold new certification tests for the gun.