VSE CORP quarterly report, Q3 FY2015

VSE Corporation 2015 Q3 Form 10-Q Summary

Business context and reporting period

VSE Corporation filed an unaudited Form 10-Q for the quarter and nine months ended September 30, 2015. VSE provides supply-chain management, aviation maintenance, repair and overhaul, parts distribution, logistics, engineering, information technology, energy, and consulting services to U.S. government, commercial, and aviation customers.

The company operates through four reportable segments: Supply Chain Management, Aviation, Federal Services, and IT, Energy and Management Consulting. The January 2015 acquisition of four aviation businesses significantly expanded the company’s commercial aviation operations and is included in results beginning January 28, 2015.

Financial performance and key metrics

Metric	Three months ended September 30, 2015	Three months ended September 30, 2014	Nine months ended September 30, 2015	Nine months ended September 30, 2014
Revenue	$137.4 million	$101.7 million	$389.3 million	$329.1 million
Operating income	$13.2 million	$7.2 million	$35.4 million	$29.2 million
Net income	$6.5 million	$3.9 million	$17.2 million	$15.2 million
Diluted EPS	$1.20	$0.72	$3.19	$2.83
Operating margin	9.6%	7.1%	9.1%	8.9%
Net margin	4.7%	3.8%	4.4%	4.6%

Products revenue increased to $83.6 million in the third quarter and $233.6 million for the nine-month period. Services revenue declined to $53.8 million in the third quarter and $155.7 million for the nine-month period.
For the nine months, Supply Chain Management generated $144.4 million of revenue and $26.2 million of operating income. Aviation generated $87.6 million of revenue and $6.8 million of operating income.
Federal Services revenue declined 24% year over year for the nine months to $117.8 million, with operating income declining to $0.5 million from $4.3 million.
IT, Energy and Management Consulting revenue declined 15% to $39.5 million for the nine months, while operating income declined 25% to $3.9 million.
Interest expense increased to $7.0 million for the nine months from $3.2 million, primarily because of acquisition-related borrowing.
The effective income tax rate was 39.6% for the nine months, compared with 38.3% in the prior-year period.

Cash flow, debt, liquidity, and balance sheet

Net cash provided by operating activities was $18.5 million for the nine months, down from $39.7 million in 2014. Working-capital uses included $8.8 million for inventory and $5.3 million for receivables.
Investing activities used $198.7 million, including $191.2 million for the Aviation Acquisition and $7.8 million for property and equipment.
Financing activities provided $180.2 million, primarily from acquisition-related borrowings. Cash and cash equivalents declined slightly from $263 thousand at December 31, 2014 to $194 thousand at September 30, 2015.
Total bank debt was approximately $245.9 million at September 30, 2015, compared with $48.6 million at December 31, 2014. This included $142.5 million of term debt and $103.4 million of revolving debt.
The revolving facility had maximum availability of $150 million, with no outstanding letters of credit. The credit agreement permits up to an additional $75 million of aggregate facility capacity, subject to conditions.
Debt carried variable rates based on LIBOR or the prime rate. After hedging, the aggregate effective interest rate was 3.25%, with rates on portions of debt ranging from 2.69% to 4.5%.
The company had $205.2 million of current assets and $88.4 million of current liabilities. Receivables were $75.8 million and inventories were $113.7 million at September 30, 2015.
VSE was in compliance with its debt covenants. The actual Total Funded Debt/EBITDA ratio was 3.07x versus a 3.50x maximum, and the Fixed Charge Coverage Ratio was 1.64x versus a 1.20x minimum.
VSE paid $1.7 million of dividends during the nine months, or $0.31 per share. The credit agreement limits annual cash dividends to $6 million when specified conditions are satisfied.

Material changes versus the prior comparable period

Revenue increased 35% in the third quarter and 18% for the nine months, primarily from the Aviation Acquisition and growth in Supply Chain Management.
Operating income increased 84% in the third quarter and 21% for the nine months. Supply Chain Management profit increased, while Federal Services and IT, Energy and Management Consulting produced lower nine-month results.
The revenue mix shifted materially toward products and commercial aviation. Supply Chain Management and Aviation represented 59% of total nine-month revenue, compared with 39% for Supply Chain Management alone in the prior-year period.
Commercial revenue increased to $92.2 million, or 23.7% of nine-month revenue, from $2.7 million, or 0.8%, in the prior-year period, primarily because of the Aviation Acquisition.
Federal government revenue concentration decreased, although the USPS remained the largest customer source at $136.9 million, or 35.1% of nine-month revenue.
Total assets increased to $624.7 million from $355.3 million, primarily because of the Aviation Acquisition. Goodwill increased by $92.3 million and net intangible assets increased to $153.6 million.
The Aviation Acquisition had preliminary total consideration of approximately $218.0 million, including $191.9 million of cash consideration and a $26.1 million acquisition-date earn-out obligation. Additional earn-out payments of up to $40 million may be required, subject to performance targets.
Funded backlog for Federal Services and IT, Energy and Management Consulting was $214 million at September 30, 2015, compared with $192 million at September 30, 2014. Nine-month bookings increased to $184 million from $164 million.

Guidance, outlook, risks, contingencies, and unusual items

Management stated that diversification, Supply Chain growth, and the Aviation Acquisition were driving 2015 growth and higher profitability. Management expected traditional government-services results to remain below 2014 levels for the year, although quarterly performance had begun to stabilize.
Management identified the USPS fleet transition, commercial fleet opportunities, aviation-market expansion, potential future Foreign Military Sales activity, and the Fort Benning logistics-support contract as growth opportunities.
The company’s Akimeka reporting unit, which had approximately $29.8 million of goodwill, was identified as being at risk of a future impairment if projected cash flows or market conditions deteriorate. The annual goodwill impairment review was scheduled for the fourth quarter of 2015.
Operating results were affected by Aviation Acquisition amortization expense of approximately $4.6 million for the nine months, acquisition-related expenses of approximately $488 thousand, and Aviation earn-out valuation expense of approximately $508 thousand.
VSE had one uncompleted bonded project with an aggregate bonded amount of approximately $3 million. The project was subject to subcontractor claims and disputes and was expected to be completed in early 2016.
Material litigation included a Hawaii wrongful-death action related to a 2011 fireworks explosion, the Anchorage lawsuit involving ICRC, a related insurance-coverage lawsuit filed in August 2015, and a Nebraska lawsuit concerning fireworks-storage services. The company could not predict the outcome of certain matters, although it did not expect the Hawaii litigation to materially affect its financial position or results.
Variable-rate debt creates exposure to higher interest rates. Interest-rate swaps covered $125 million of debt at September 30, 2015.
The company stated that its disclosure controls and procedures were effective and that no material change had occurred in internal control over financial reporting during the quarter.

Important facts for investors to verify

Whether Aviation integration, revenue growth, and projected synergies support returns sufficient to justify the acquisition consideration and increased leverage.
The company’s ability to reduce revolving debt and meet scheduled term-loan repayments while maintaining adequate liquidity, given only $194 thousand of cash at quarter-end.
Progress in Federal Services and IT, Energy and Management Consulting, including backlog conversion, contract awards, Fort Benning performance, and the impact of reduced or expired programs.
The fourth-quarter goodwill impairment analysis, particularly for the Akimeka reporting unit and the newly acquired Aviation reporting assets.
Changes in USPS, DoD, federal civilian-agency, and commercial-customer concentration and the effect of government funding delays or contract de-obligations.
Potential cash requirements for Aviation earn-outs, litigation, bonded-project claims, and other contingencies.
The effect of interest-rate movements, hedge terms, debt covenants, and the annual dividend limitation on future earnings and shareholder returns.