VSE CORP quarterly report, Q3 FY2019

VSE Corporation 10-Q Summary

Business Context and Reporting Period

VSE Corporation is a diversified services and supply-chain company serving the U.S. Department of Defense, U.S. Postal Service, federal agencies, and commercial customers. Its three reportable segments are Supply Chain Management, Aviation, and Federal Services. This unaudited Form 10-Q covers the three and nine months ended September 30, 2019, compared with the corresponding 2018 periods.

VSE acquired 1st Choice Aerospace on January 10, 2019, expanding its Aviation Group into commercial aircraft maintenance, repair and overhaul services and products. John A. Cuomo became CEO and President effective April 15, 2019.

Financial Performance and Liquidity

Metric	Q3 2019	Q3 2018	9M 2019	9M 2018
Revenue	$198.3 million	$168.9 million	$557.4 million	$516.2 million
Operating income	$17.2 million	$15.7 million	$45.4 million	$41.1 million
Net income	$10.5 million	$10.0 million	$27.0 million	$25.8 million
Diluted EPS	$0.95	$0.92	$2.45	$2.37
Operating cash flow	Not separately provided	Not separately provided	$17.4 million	$3.4 million

Q3 revenue increased 17.4%; nine-month revenue increased 8.0%. Operating income increased 9.7% and 10.4%, respectively. Net income increased 4.9% in Q3 and 4.6% for the nine months.
Approximate operating margins were 8.7% in Q3 2019 and 8.3% in Q3 2018; nine-month margins were 8.2% and 8.0%, respectively. Approximate net margins were 5.3% and 5.9% in Q3 and 4.8% and 5.0% for the nine months.
Interest expense increased to $3.7 million in Q3 and $10.3 million for the nine months, primarily due to higher borrowings used to finance the 1st Choice Aerospace acquisition.
Cash and cash equivalents were $1.1 million at September 30, 2019, compared with $0.2 million at December 31, 2018. Operating cash flow improved substantially, but working-capital needs remained significant.
Inventory increased to $202.8 million from $166.4 million, and unbilled receivables increased to $54.2 million from $41.3 million. Contract liabilities declined slightly to $4.9 million.
Total long-term debt, net of debt issuance costs, was $268.5 million versus $160.6 million at December 31, 2018. This included $73.3 million of term debt and $197.0 million of revolver borrowings.
The company had a $300 million revolving facility, with $72 thousand of letters of credit outstanding. The credit agreement permits up to an additional $100 million of aggregate facility capacity, subject to conditions.
At September 30, 2019, VSE was in compliance with its debt covenants. Total Funded Debt/EBITDA was 3.13x versus a maximum of 3.50x, and Fixed Charge Coverage was 3.03x versus a minimum of 1.20x.
Interest rates on portions of debt ranged from 4.53% to 6.25%, with a 4.91% effective rate on aggregate debt. Interest-rate swaps had a combined notional amount of $125 million.
Dividends declared were $0.09 per share in Q3 and $0.26 per share for the nine months. The credit agreement generally limits annual cash dividends to $6 million absent specified exceptions.

Material Changes Versus the Prior Comparable Period

The Aviation Group was the principal growth driver. Revenue increased 74.1% in Q3 and 59.5% for the nine months, while operating income increased 200.7% and 103.3%, respectively. 1st Choice Aerospace contributed approximately $17.9 million of Q3 revenue and $45.1 million for the nine months.
Supply Chain Management revenue increased 6.8% in Q3 but declined 0.7% for the nine months. Nine-month operating income declined 4.9%, reflecting lower DoD sales and higher administrative costs, partly offset by commercial-customer growth.
Federal Services revenue was broadly flat in Q3 but declined 7.5% for the nine months, primarily because of a $40.8 million reduction in Foreign Military Sales work. Nine-month operating income nevertheless increased 5.7% because lower-margin work declined and margins improved on other programs.
The 2018 results included a $1.7 million gain from the sale of a government-wide acquisition contract; no comparable gain was recorded in 2019.
Corporate, CEO succession, Federal Services leadership succession, and acquisition-related costs reduced operating income by approximately $0.5 million in Q3 and $2.3 million for the nine months.
Cash used in investing activities was $120.3 million, including approximately $113 million for the 1st Choice Aerospace acquisition and approximately $5 million for an operating facility. Financing activities provided $103.8 million, largely through increased bank borrowings.
VSE adopted ASC 842 lease accounting on January 1, 2019, recording a $24.3 million right-of-use asset, a $29.6 million operating lease liability, and a $1.9 million after-tax cumulative-effect increase to retained earnings. The adoption did not materially affect operating results or cash flows.

Guidance, Outlook, Risks and Unusual Items

The filing does not provide quantitative company-wide revenue or earnings guidance. Management reported optimism regarding Aviation, citing strong 1st Choice Aerospace performance, international distribution growth, and expansion into larger commercial aerospace markets.
Federal Services faces a challenging year. The Red River Army Depot Equipment Related Services contract was scheduled to expire in November 2019, and successor contracts will require competitive bidding. Federal Services bookings and funded backlog declined to $190 million and $252 million, respectively, from $284 million and $345 million in the comparable 2018 period.
The USPS next-generation delivery vehicle procurement is progressing more slowly than expected. USPS revenue declined approximately 2.4% for the first nine months, and the timing and effect of the fleet transition remain uncertain.
Approximately $10.8 million of unbilled receivables represented revenue recognized under risk funding without formalized funding at September 30, 2019, compared with $4.7 million at December 31, 2018. VSE believes reimbursement is due but is exposed to funding and collection risk.
1st Choice Aerospace purchase accounting remained preliminary. The transaction includes potential earn-out payments of up to $40 million; $25.0 million was recorded as the estimated acquisition-date fair value of the earn-out obligation. Final valuation adjustments could be material.
Goodwill totaled approximately $259 million. VSE identified its Aviation and Akimeka reporting units as having limited impairment headroom in the prior annual assessment—approximately 6% and 30%, respectively—and stated that adverse changes in cash-flow projections, discount rates, market multiples, or carrying values could result in future impairment.
The company accrued a probable loss related to an overtime lawsuit involving employees at the Red River Army Depot. Management does not currently expect additional material liability, but the ultimate outcome cannot be assured.
VSE is exposed to variable interest rates, government funding delays, contract reductions or nonrenewals, customer concentration, inventory and receivables volatility, acquisition integration risk, and potential government investigations or contract-related penalties.

Key Facts Investors Should Verify

Whether Aviation growth from 1st Choice Aerospace and international distribution is sustainable after acquisition-related benefits and increased amortization.
Progress on replacing or renewing the Red River Army Depot program and the effect of lower Federal Services bookings and backlog.
Timing and funding of USPS next-generation vehicle procurement and related effects on Supply Chain Management revenue.
Conversion of unbilled receivables and risk-funded work into billed, collected cash.
Debt reduction capacity, covenant headroom, variable-rate exposure, and compliance with dividend restrictions.
Final purchase-accounting values and earn-out liabilities for 1st Choice Aerospace.
Results of the fourth-quarter 2019 goodwill impairment testing for the Aviation and Akimeka reporting units.
Resolution and potential additional exposure from the overtime litigation and any government contract investigations.