VSE Corporation 2017 Third-Quarter Form 10-Q Summary
Business Context and Reporting Period
VSE Corporation is a diversified services provider supporting the U.S. Department of Defense, U.S. Postal Service, federal civilian agencies, and commercial customers. Its reportable segments are Supply Chain Management, Aviation, and Federal Services. This unaudited filing covers the three and nine months ended September 30, 2017, compared with the corresponding 2016 periods.
Federal customers represented 71.4% of nine-month 2017 revenue, including the Department of Defense at 53.0% and USPS at 24.1%. The Federal Services Group accounted for 54% of total nine-month revenue.
Key Financial Metrics
| Metric | Three Months Ended September 30 | Nine Months Ended September 30 |
|---|---|---|
| Revenue | $174.2 million, up 1% | $565.3 million, up 19% |
| Operating income | $12.2 million, down 10% | $41.4 million, up 8% |
| Operating margin | 7.0%, versus 7.9% | 7.3%, versus 8.0% |
| Net income | $6.6 million, versus $7.1 million | $21.7 million, versus $19.6 million |
| Basic EPS | $0.61, versus $0.66 | $2.01, versus $1.82 |
| Cash flow from operations | Not separately provided | $39.5 million, versus $28.4 million |
Products generated $260.6 million of nine-month revenue, while services generated $304.7 million. The nine-month effective tax rate was 36.6%, compared with 36.4% in 2016. Dividends declared were $0.13 per share for the first nine months, and approximately $2.1 million of dividends were paid.
Liquidity, Debt, and Balance Sheet
- Cash and cash equivalents were $0.5 million at September 30, 2017, compared with $0.4 million at December 31, 2016.
- Total assets were $619.0 million, down from $661.8 million, primarily reflecting lower receivables, property and equipment, and amortizing intangible assets.
- Gross bank borrowings were approximately $182.1 million, down from $216.3 million at year-end 2016. Debt net of deferred financing costs was approximately $180.8 million.
- The term loan balance was $100.0 million and revolving borrowings were approximately $82.1 million. The revolving facility had a maximum capacity of $150 million and no outstanding letters of credit.
- Required term-loan payments after September 30, 2017 were approximately $5.6 million in 2017, $28.1 million in 2018, $30.0 million in 2019, and $36.3 million in 2020. The loan agreement expires in January 2020.
- The effective interest rate on aggregate outstanding debt was 3.36%. The company used interest-rate swaps with an aggregate notional amount of $85 million.
- VSE reported compliance with its debt covenants. The Total Funded Debt/EBITDA ratio was 2.19x versus a maximum of 3.00x, and the Fixed Charge Coverage Ratio was 1.99x versus a minimum of 1.20x.
Material Changes Versus the Prior Comparable Period
- Revenue growth was concentrated in Federal Services, which increased 36% for the first nine months to $305.7 million. Growth reflected higher Foreign Military Sales activity, the RRAD ERS program, and increased Army-related work.
- Supply Chain Management revenue increased 8% for the first nine months, but operating income declined 4% to $25.6 million. Profit margin fell to 15.6% from 17.5%, primarily because of increased USPS competition and lower-margin Department of Defense sales.
- Aviation revenue declined 4% for the first nine months to $96.0 million, and operating income declined 30% to $6.9 million. Lower parts-distribution demand and weaker engine MRO performance affected the third quarter.
- Federal Services operating margin improved to 3.4% from 2.2%, although third-quarter and nine-month results included contract-related losses of approximately $1.2 million and $1.6 million, respectively.
- Operating cash flow increased $11.1 million year over year, benefiting from improved collections and working-capital movements. Cash used in investing activities fell to $1.7 million from $5.4 million, while financing cash use increased to $37.8 million, primarily due to debt repayments.
- Interest expense declined modestly because of lower average borrowings. The 2016 comparison included an $18.5 million earn-out obligation payment and a $1.3 million earn-out valuation adjustment that did not recur in 2017.
Guidance, Outlook, Risks, and Unusual Items
The filing does not provide formal quantitative revenue or earnings guidance. Management expects continued growth initiatives across the three operating groups and cites strong funded backlog in Federal Services. Nine-month Federal Services bookings were $398 million, revenue was $306 million, and funded contract backlog was $403 million.
- Management expects no further loss on the identified Federal Services contract before its expected completion in the fourth quarter of 2017.
- USPS vehicle procurement and future parts demand could affect Supply Chain Management revenue. Management is positioning the business to support both new and existing USPS vehicles.
- Aviation performance remains pressured by lower parts demand, although management is pursuing new MRO programs, original equipment manufacturer distribution agreements, international opportunities, and government-related work.
- Akimeka and VSE Aviation remain at risk of future goodwill impairment. At September 30, 2017, goodwill was approximately $29.8 million for Akimeka and $104.5 million for VSE Aviation. Their estimated fair values exceeded carrying values by approximately 12% and 10%, respectively.
- The company remains exposed to variable interest rates, government funding delays, contract de-obligations, customer concentration, and fluctuations in receivables, inventory, and payables.
- VSE agreed in principle to settle Hawaii litigation, with the settlement expected to be fully funded by insurers. A separate aviation-related lawsuit seeks more than $1.0 million; management does not expect either matter to have a material adverse effect, although litigation outcomes remain uncertain.
- The company adopted certain share-based payment, inventory, and goodwill impairment accounting updates without significant impact. Revenue recognition changes under ASC 606 are expected to affect award-fee timing, aviation MRO and fixed-price contract recognition, and certain service-contract patterns beginning January 1, 2018. The cumulative transition adjustment had not yet been quantified.
Important Facts for Investors to Verify
- Whether Federal Services growth and the $403 million funded backlog convert into revenue and cash flow as expected.
- Whether Aviation demand and margins recover sufficiently to avoid a goodwill impairment.
- Whether Supply Chain Management can offset USPS pricing pressure with DoD and commercial growth.
- The timing and funding of required debt repayments and the company’s ability to maintain covenant compliance.
- The effect of ASC 606 adoption and the eventual January 1, 2018 cumulative equity adjustment.
- The final terms and insurer funding of the Hawaii litigation settlement, and developments in the aviation lawsuit.