Business Context and Reporting Period
VSE Corporation is a diversified government services, supply-chain management and aviation company serving the U.S. Department of Defense, U.S. Postal Service, federal agencies and commercial customers. The unaudited Form 10-Q covers the three months ended March 31, 2019, compared with the three months ended March 31, 2018.
- Reportable segments: Supply Chain Management, Aviation and Federal Services.
- VSE acquired 1st Choice Aerospace on January 10, 2019, adding commercial aircraft maintenance, repair and overhaul services and products to the Aviation Group.
- John A. Cuomo became CEO and President effective April 15, 2019, succeeding Maurice Gauthier.
Financial Metrics
| Metric | Q1 2019 | Q1 2018 | Change |
|---|---|---|---|
| Total revenue | $169.9 million | $176.9 million | Down $7.0 million, or 3.9% |
| Operating income | $11.8 million | $11.6 million | Up $0.2 million, or 1.9% |
| Operating margin | Approximately 7.0% | Approximately 6.6% | Improved |
| Net income | $6.6 million | $7.1 million | Down $0.4 million, or 6.4% |
| Net margin | Approximately 3.9% | Approximately 4.0% | Declined |
| Diluted EPS | $0.60 | $0.65 | Down $0.05 |
| Dividends declared per share | $0.08 | $0.07 | Increased |
Interest expense increased to $3.2 million from $2.2 million, primarily because of higher borrowings used to fund the acquisition. The effective tax rate declined to 23.7% from 25.1%, partly due to a fair-value increase in company-owned life insurance assets.
Segment Performance
| Segment | Revenue | Operating Income | Operating Margin |
|---|---|---|---|
| Supply Chain Management | $51.7 million, down 7.4% | $7.0 million, down 8.0% | 13.5% versus 13.6% |
| Aviation | $49.4 million, up 50.7% | $3.0 million, up 34.8% | 6.2% versus 6.9% |
| Federal Services | $68.8 million, down 22.0% | $3.4 million, up 36.6% | 4.9% versus 2.8% |
Cash Flow, Liquidity and Capital Structure
- Cash provided by operating activities was $2.8 million, down from $13.3 million in the prior-year quarter.
- Investing activities used $113.3 million, including $112.7 million of cash paid for the 1st Choice Aerospace acquisition and $0.6 million of capital expenditures.
- Financing activities provided $111.2 million, principally from net borrowings of $114.4 million, after debt financing costs and dividends.
- Cash and cash equivalents increased to $0.8 million from $0.2 million at December 31, 2018.
- Total principal debt was $277.1 million at March 31, 2019, consisting of a $78.3 million term loan and $198.8 million of revolving borrowings. Net debt after debt issuance costs was $275.1 million.
- The revolving facility had $300 million of maximum availability, with $198.8 million outstanding and no letters of credit outstanding at quarter-end. The agreement permits up to $100 million of additional facility capacity, subject to conditions.
- The effective interest rate on aggregate debt was 4.41%; contractual rates on portions of the debt ranged from 4.23% to 6.00%.
- VSE was in compliance with its debt covenants. Total Funded Debt/EBITDA was 3.18x versus a maximum of 3.50x, and Fixed Charge Coverage was 3.54x versus a minimum of 1.20x.
Material Changes Versus the Prior Comparable Period
- Revenue declined despite a $16.6 million increase in Aviation revenue, principally from 1st Choice Aerospace and international distribution initiatives. Federal Services revenue fell $19.4 million and Supply Chain Management revenue fell $4.2 million.
- Operating income improved modestly because lower-margin Federal Services revenue declined while margins improved on remaining work. Results included approximately $1.1 million of costs related to the CEO transition and acquisition.
- Net income declined because higher operating income was more than offset by increased interest expense and higher amortization.
- Commercial aviation revenue increased to $48.5 million from $31.5 million, while DoD revenue declined to $62.7 million from $87.7 million.
- Federal Services bookings were $51 million versus $33 million, and funded contract backlog was $278 million versus $261 million at the comparable date.
- The company adopted ASC 842 lease accounting on January 1, 2019, recording operating lease right-of-use assets and liabilities and a $1.9 million after-tax increase to retained earnings. Management reported no significant effect on operating results or cash flows.
- Goodwill increased by approximately $60.6 million and intangible assets increased substantially in connection with the acquisition. First-quarter amortization expense rose to $5.0 million from $4.0 million.
Guidance, Outlook, Risks and Unusual Items
- Management expressed optimism about Aviation, citing new international distribution programs, Singapore and Germany operations, expanded distribution agreements and expected benefits from 1st Choice Aerospace.
- Supply Chain Management remains exposed to lower USPS parts sales, slower-than-expected USPS next-generation delivery vehicle procurement and changes in the aging of the USPS fleet. First-quarter USPS sales declined approximately 3% year over year.
- Federal Services revenue was affected by lower Foreign Military Sales activity and a client-directed reduction in force on the RRAD ERS program. Management stated that these reductions were concentrated in lower-margin work.
- Unfunded or not-yet-formalized “risk funding” included in unbilled receivables was approximately $10.4 million at March 31, 2019, compared with $4.7 million at December 31, 2018. VSE expects reimbursement but remains exposed if funding is not received.
- VSE had $278 million of aggregate transaction prices allocated to unsatisfied or partially unsatisfied performance obligations, with 96% expected to be satisfied within one year.
- The VSE Aviation and Akimeka reporting units were identified as having heightened goodwill impairment sensitivity. VSE Aviation’s estimated fair value exceeded carrying value by approximately 6%, and Akimeka’s by approximately 30%.
- The company is a defendant in a proposed collective-action overtime lawsuit concerning unpaid employee breaks under a U.S. Army contract. VSE considers a loss probable and has accrued an estimated provision, although additional material liability cannot be ruled out.
- Variable-rate borrowings create exposure to higher interest rates. Interest-rate swaps covered notional amounts of $125 million at quarter-end.
- Cash dividends are subject to loan-agreement restrictions, including an aggregate annual limit of $6 million under specified conditions.
Important Facts for Investors to Verify
- Whether 1st Choice Aerospace achieves the financial targets required for up to $40 million of earn-out payments during 2019 and 2020.
- Post-acquisition Aviation revenue growth, operating margins and the ability to integrate 1st Choice Aerospace without further significant costs.
- Federal Services bookings, funded backlog conversion and the effect of Foreign Military Sales and RRAD ERS activity on future revenue.
- Operating cash-flow recovery, inventory and unbilled-receivable growth, and reliance on revolving debt to fund working capital.
- Compliance with debt covenants as borrowings remain elevated and required term-loan repayments total $78.3 million after March 31, 2019.
- Potential goodwill impairment at VSE Aviation and Akimeka if projected cash flows, discount rates or market multiples deteriorate.
- Resolution and ultimate cost of the overtime lawsuit and any government investigations or contract-related contingencies.