Business Context and Reporting Period
VSE Corporation provides sustainment, logistics, engineering, technical, information technology, consulting, and vehicle-parts services primarily to the U.S. Department of Defense, U.S. Postal Service, federal civilian agencies, and other government customers. The filing covers the unaudited three and nine months ended September 30, 2014, compared with the corresponding 2013 periods.
The company reported four operating groups: Supply Chain Management, International, Federal, and IT, Energy and Management Consulting. VSE planned to combine the International and Federal groups into one management group and reportable segment beginning in 2015.
Key Financial Metrics
| Metric | Three Months 2014 | Three Months 2013 | Nine Months 2014 | Nine Months 2013 |
|---|---|---|---|---|
| Revenue | $101.7 million | $111.1 million | $329.1 million | $349.3 million |
| Operating income | $7.2 million | $9.5 million | $29.2 million | $32.1 million |
| Operating margin | 7.1% | 8.5% | 8.9% | 9.2% |
| Income from continuing operations | $3.9 million | $5.3 million | $16.1 million | $17.6 million |
| Net income | $3.9 million | $5.3 million | $15.2 million | $17.4 million |
| Net margin | 3.8% | 4.8% | 4.6% | 5.0% |
| Diluted EPS | $0.72 | $1.00 | $2.83 | $3.27 |
| Operating cash flow | Not separately provided | Not separately provided | $39.7 million | $39.6 million |
Revenue declined 8% in the third quarter and 6% for the nine-month period. Operating income declined 24% and 9%, respectively. Net income declined 27% for the quarter and 13% for the nine months. The nine-month effective tax rate increased to 38.3% from 36.5%, partly because federal tax credits benefiting 2013 expired.
Cash and cash equivalents were $328 thousand at September 30, 2014, compared with $220 thousand at December 31, 2013. Receivables declined to $63.8 million from $78.4 million, while inventories increased to $47.0 million from $39.3 million.
Total bank borrowings were approximately $57.3 million at September 30, 2014, down from $89.7 million at December 31, 2013. This consisted of approximately $31.3 million of term debt and $26 million of revolving debt. The effective interest rate on aggregate debt was 2.05%, and all interest-rate hedges expired June 30, 2014. The company had $125 million of revolving-loan and letter-of-credit capacity, with an option to increase availability to $175 million.
VSE generated $39.7 million of operating cash flow, used $2.7 million for capital expenditures, and used $36.9 million in financing activities, including $32.5 million of net bank-loan repayments, $2.0 million of earn-out payments, and $1.5 million of dividends. The company paid $0.28 per share in dividends during the first nine months, subject to loan-agreement restrictions.
Material Changes Versus the Prior Comparable Period
- Supply Chain Management revenue increased 12% for both the quarter and nine months, primarily from higher USPS Managed Inventory Program revenue. Nine-month operating income increased 6%, but third-quarter operating income declined 15% because of a $2.0 million earn-out obligation adjustment.
- International revenue declined 30% in the quarter and 19% for the nine months, mainly because the U.S. Treasury Seized Assets Program was substantially completed in March 2014. International operating income fell 87% in the quarter and 37% for the nine months.
- Federal revenue was approximately flat in the quarter but declined 4% for the nine months. Nine-month operating income declined 39%; third-quarter operating income improved because the prior-year period included an interruption in Army Reserve work.
- IT, Energy and Management Consulting revenue declined 19% in the quarter and 18% for the nine months due to lower customer orders and the expiration of a contract. Nine-month operating income declined 17%.
- Funded contract backlog declined to $194 million from $268 million at September 30, 2013, while bookings declined to $292 million from $407 million. WBI revenue is generally not included in funded backlog because bookings occur at the time of sale.
- Fixed-price revenue represented 60% of nine-month revenue, compared with 52% in 2013; cost-type revenue increased to 31% from 23%, while time-and-materials revenue declined to 9% from 25%.
Guidance, Outlook, Risks, Contingencies, and Unusual Items
Management did not provide specific earnings or revenue guidance. Management expects continued pressure from reduced government spending, changing federal priorities, and increased competition. It is adjusting its cost structure, eliminating certain management positions, and consolidating the International and Federal groups. Approximately $400 thousand of severance costs were incurred in the third quarter; management expects approximately $4 million of annual savings beginning in the fourth quarter of 2014.
Key growth and stability programs include the USPS Managed Inventory Program, which is primarily self-funded through USPS operating revenues, and the U.S. Navy Foreign Military Sales program, which is largely funded by foreign governments. FMS activity may benefit if Congress approves naval vessel transfers, but timing remains uncertain.
Egyptian Navy support revenue was approximately $25 million for the first nine months of 2014, compared with approximately $48 million for full-year 2013. Operations were affected by political unrest, workforce evacuation, and reduced staffing. The outlook depends on conditions in Egypt and U.S.-Egyptian relations.
U.S. Army Reserve vehicle-refurbishment revenue was approximately $40 million for the first nine months of 2014. Portions of the related contractual coverage expired in August 2014, and management stated that future work levels and recompete outcomes remain uncertain. The Treasury asset-forfeiture program, which generated approximately $36 million in 2013, was substantially completed by March 2014.
WBI earn-out obligations were remeasured at approximately $9.2 million, resulting in a $2.8 million charge for the first nine months and approximately $2.0 million in the third quarter. The obligation depends on projected EBITDA and other valuation assumptions.
Two discontinued-operation bonded projects remained incomplete, with aggregate bonded amounts of approximately $4 million. VSE recorded an $898 thousand after-tax loss for the first nine months, primarily related to claims and disputes, and expected completion in early 2015. The company is also involved in Hawaii wrongful-death litigation and litigation concerning the Port of Anchorage project; the filing states that the ultimate effects cannot presently be determined, although management does not currently expect the Hawaii matter to have a material adverse effect.
Debt covenants were satisfied at September 30, 2014. Actual ratios were 1.01 to 1 for Total Funded Debt/EBITDA versus a maximum of 2.50 to 1, 1.36 to 1 for Fixed Charge Coverage versus a minimum of 1.20 to 1, and 1.78 to 1 for Asset Coverage versus a minimum of 1.00 to 1. Variable-rate debt is no longer hedged, creating exposure to higher interest rates.
Most Important Facts for Investors to Verify
- Whether declining funded backlog and bookings translate into further revenue pressure in 2015.
- The durability and profitability of USPS MIP growth, including the effect of future WBI earn-out adjustments.
- The amount and timing of Army Reserve, Egyptian Navy, and FMS work, including contract extensions, vessel transfers, and political developments.
- Whether the planned International/Federal consolidation produces the expected $4 million of annual savings.
- Debt repayment requirements, covenant compliance, dividend restrictions, and exposure to unhedged variable interest rates.
- The ultimate cost of the discontinued-operation bond claims and the Hawaii and Anchorage litigation.
- The effect of the higher effective tax rate and the expiration of federal tax credits on future earnings.