VSE Corporation 2016 Q3 Form 10-Q Summary
Business Context and Reporting Period
VSE Corporation is a diversified provider of supply-chain, aviation maintenance, repair and overhaul, federal sustainment, engineering, logistics, information technology and consulting services. Its principal customers include the U.S. Department of Defense and the U.S. Postal Service. The filing covers the three and nine months ended September 30, 2016; financial statements are unaudited.
Operations are reported through four segments: Supply Chain Management, Aviation, Federal Services, and IT, Energy and Management Consulting. A two-for-one stock split was completed in August 2016, and historical share and per-share data were retrospectively adjusted.
Key Financial Metrics
| Metric | Three Months Ended September 30, 2016 | Three Months Ended September 30, 2015 | Nine Months Ended September 30, 2016 | Nine Months Ended September 30, 2015 |
|---|---|---|---|---|
| Revenue | $172.8 million | $137.4 million | $476.9 million | $389.3 million |
| Operating income | $13.6 million | $13.2 million | $38.2 million | $35.4 million |
| Operating margin | 7.9% | 9.6% | 8.0% | 9.1% |
| Net income | $7.1 million | $6.5 million | $19.6 million | $17.2 million |
| Net margin | 4.1% | 4.7% | 4.1% | 4.4% |
| Diluted EPS | $0.65 | $0.60 | $1.81 | $1.59 |
Revenue increased 26% in the third quarter and 22% for the first nine months. Operating income increased 3% and 8%, respectively, while net income increased 9% and 14%. Margin pressure reflected the mix of lower-margin Federal Services work and changing Supply Chain Management product sales.
- Products represented $254.3 million of nine-month revenue; services represented $222.6 million.
- Cash provided by operating activities was $28.4 million, compared with $18.5 million in the prior-year period.
- Capital expenditures were $5.4 million, and net cash used in investing activities was $5.4 million. Prior-year investing cash use included approximately $191.2 million for the aviation acquisition.
- Cash used in financing activities was $23.2 million, including $18.5 million of earn-out payments and $1.8 million of dividends.
- Cash and cash equivalents were $0.6 million at September 30, 2016, compared with $0.7 million at December 31, 2015.
- Total assets were $639.4 million, including $128.9 million of inventory, $86.1 million of receivables, $198.6 million of goodwill and $130.9 million of net intangible assets.
Debt and Liquidity
Total bank borrowings were approximately $233 million at September 30, 2016, consisting of approximately $120.6 million of term debt and $112.6 million of revolving debt. The revolving facility had maximum availability of $150 million, with approximately $11 thousand of letters of credit outstanding. The loan agreement expires in January 2020 and permits up to $75 million of additional aggregate facility capacity, subject to its terms.
Interest rates on portions of outstanding debt ranged from 2.77% to 4.50%, and the effective rate on aggregate debt was 3.18%. Interest-rate swaps covered portions of the term and revolving loans. Scheduled term-loan payments after September 30, 2016 were approximately $4.7 million in 2016, $21.6 million in 2017, $28.1 million in 2018, $30.0 million in 2019 and $36.2 million in 2020.
The company reported compliance with its debt covenants. The Total Funded Debt/EBITDA ratio was 2.93x versus a maximum of 3.25x, and the Fixed Charge Coverage Ratio was 1.73x versus a minimum of 1.20x. Liquidity remains dependent on operating cash flow, collections, inventory management and availability under the revolving facility.
Material Changes Versus the Prior Comparable Period
- Federal Services revenue increased 78% in the quarter and 61% year to date, driven primarily by the Foreign Military Sales program, the RRAD ERS program and Fort Benning logistics work. Federal Services operating margin declined to 0.9% in the quarter from 2.7%.
- Aviation revenue increased 5% in the quarter, while operating income increased 87% to $4.0 million. The comparison benefited from sales mix, bulk inventory purchases, facility cost reductions and the absence of certain prior-period earn-out charges.
- Supply Chain Management revenue increased 2% in the quarter and 5% year to date, but quarterly operating income declined 5% because of lower-margin government and commercial product mix.
- IT, Energy and Management Consulting revenue declined 3% in the quarter and 12% year to date, primarily due to contract expirations, lower client orders and follow-on work awarded to small businesses. Year-to-date operating income declined 31%.
- The Aviation Acquisition earn-out was terminated early. Approximately $18.5 million was paid during the first nine months, including a final payment of approximately $10.5 million in July 2016; no earn-out obligation remained at September 30, 2016.
- Federal Services and IT funded-contract bookings increased to $405 million from $184 million, and funded backlog increased to $400 million from $214 million.
- Revenue concentration shifted toward the Department of Defense, which represented 43.8% of nine-month revenue versus 33.1% in the prior-year period. USPS represented 28.3% versus 35.1%.
Guidance, Outlook, Risks and Unusual Items
Management stated that revenue growth had continued on both a year-over-year and sequential basis and expected the trend to continue through the remainder of 2016. Management cited new Federal Services programs, increased bookings and a $400 million funded backlog as support for the federal contracting outlook.
Management expects USPS-related revenue to remain at current levels over the next two to three years while the Postal Service evaluates replacement delivery vehicles. The company was not selected as part of an industry team for the vehicle replacement competition but intends to pursue aftermarket, original-content, program-management and warranty opportunities. The timing and scope of the USPS fleet transition remain uncertain.
- The company recorded a $1.2 million reserve and approximately $494 thousand of legal expenses related to the Heritage Litigation. The estimated probable loss range was $1.2 million to $5.5 million, with the final court decision pending.
- In connection with the Heritage matter, VSE voluntarily disclosed potential government overbilling estimated at approximately $1.5 million and continues to cooperate with the Treasury Department Inspector General.
- Other litigation includes a Hawaii wrongful-death action and the Anchorage Lawsuit; outcomes cannot be predicted, although management did not expect the Hawaii matter to have a material adverse effect. The filing states that the potential effect of the Anchorage matter cannot currently be predicted.
- Growth may require additional inventory, capital investment and borrowing, potentially limiting debt reduction or increasing future debt levels.
- Government funding delays, contract expirations, competitive bidding, changing program demand, customer concentration, variable interest rates and potential goodwill impairment are material risks.
- Akimeka's goodwill reporting unit had only an approximately 9% fair-value cushion over carrying value in the prior impairment analysis, making it sensitive to deterioration in projected cash flows or market conditions.
Important Facts for Investors to Verify
- Whether Federal Services revenue growth converts into sustainable operating margins, given the quarter's 0.9% segment margin.
- The final outcome and ultimate cost of the Heritage Litigation, including potential additional payments, interest and government claims.
- Cash conversion and working-capital requirements, particularly inventory and receivables growth relative to operating cash flow.
- Debt paydown capacity, covenant headroom and refinancing or interest-rate exposure through the January 2020 loan maturity.
- The durability of the $400 million funded backlog and $405 million of bookings, including contract funding, performance timing and possible de-obligations.
- The effect of USPS fleet replacement timing and the company's ability to secure aftermarket or related support work.
- Potential impairment of goodwill and acquired intangible assets, especially in the IT, Energy and Management Consulting segment.