VSE Corporation — Q2 2018 Form 10-Q Summary
Business Context and Reporting Period
VSE Corporation is a diversified products distribution and services company serving the U.S. Department of Defense, U.S. Postal Service, other government agencies, and commercial customers. Operations are organized into Supply Chain Management, Aviation, and Federal Services. This unaudited report covers the three and six months ended June 30, 2018, compared with the corresponding 2017 periods.
Financial Performance and Position
| Metric | Q2 2018 | Q2 2017 | Six Months 2018 | Six Months 2017 |
|---|---|---|---|---|
| Revenue | $170.4 million | $193.9 million | $347.3 million | $391.2 million |
| Operating income | $13.9 million | $15.0 million | $25.4 million | $29.2 million |
| Net income | $8.8 million | $7.8 million | $15.8 million | $15.1 million |
| Diluted EPS | $0.80 | $0.72 | $1.45 | $1.39 |
| Operating margin | 8.1% | 7.7% | 7.3% | 7.5% |
| Effective tax rate | 25.0% | 38.2% | 25.1% | 38.1% |
Products revenue was $90.1 million in Q2 and $178.8 million year to date; services revenue was $80.3 million and $168.5 million, respectively. The Federal Services Group generated $80.3 million of Q2 revenue and $168.6 million year to date, representing approximately 49% of year-to-date revenue. Aviation generated $35.8 million in Q2 revenue and $68.6 million year to date, while Supply Chain Management generated $54.3 million and $110.1 million, respectively.
Six-month operating cash flow was negative $3.6 million, compared with positive $19.0 million in 2017. The principal use was a $34.4 million increase in inventory, primarily strategic Aviation inventory purchases. Investing cash flow was negative $1.8 million, principally for $1.9 million of capital expenditures. Financing cash flow was positive $5.5 million, including net bank borrowings and dividends.
Cash and cash equivalents were $0.6 million at June 30, 2018, unchanged from December 31, 2017. Total assets were $640.7 million, including $164.4 million of inventory, $102.9 million of net intangible assets, and $198.6 million of goodwill. Total liabilities were $329.4 million and stockholders' equity was $311.3 million.
Bank debt outstanding was $183.7 million before approximately $2.4 million of unamortized financing costs, compared with $173.7 million at December 31, 2017. This included $97.5 million of term debt and $86.2 million of revolving borrowings. The revolving facility had maximum availability of $300 million, subject to the agreement. The effective interest rate on aggregate debt was 3.77%. The company was in compliance with its debt covenants; funded debt to EBITDA was 2.36x versus a 3.00x maximum, and fixed-charge coverage was 2.54x versus a 1.20x minimum.
Material Changes Versus the Prior Comparable Period
- Q2 revenue declined 12% and six-month revenue declined 11%, primarily because of lower Federal Services activity.
- Federal Services revenue decreased 23% in Q2 and 21% year to date, reflecting FMS delivery-order processing delays, completion of two Army programs in 2017, and a reduced scope on the Red River Army Depot contract.
- Federal Services operating income declined 10% in Q2 and 23% year to date, partly due to lower FMS award-fee income.
- Supply Chain Management revenue declined 4% in Q2 and 2% year to date, primarily because USPS appeared to defer vehicle-fleet maintenance. Its operating margin declined to 15.1% in Q2 and 14.3% year to date.
- Aviation revenue increased 10% in Q2 and 6% year to date, with operating income increasing 10% and 4%, respectively. Margins remained broadly stable.
- Net income and EPS increased despite lower revenue, mainly because the Tax Cuts and Jobs Act reduced the effective tax rate from approximately 38% to 25%.
- Inventory increased substantially to support Aviation growth initiatives, contributing to negative operating cash flow and higher borrowings.
Accounting, Outlook, Risks, and Unusual Items
Effective January 1, 2018, VSE adopted ASC 606 using the modified retrospective method. The adoption increased opening retained earnings by $1.7 million and changed the timing of recognition for award fees, Aviation maintenance and repair services, and certain fixed-price contracts. Reported six-month net income was $15.8 million; without ASC 606 adoption, the filing shows $15.2 million.
Management reported delays in government funding and FMS delivery orders, but expects Aviation growth initiatives, including new product lines and a Singapore operation, to provide longer-term opportunities. VSE extended exclusive distribution rights with a key original equipment manufacturer through 2024. Supply Chain Management is pursuing commercial fleet customers and e-commerce opportunities, while USPS vehicle procurement and fleet-transition timing remain uncertain.
Federal Services bookings were $189 million for the first six months of 2018, compared with $281 million in 2017. Funded Federal Services backlog was $339 million at June 30, 2018, compared with $386 million at June 30, 2017; 96% of disclosed remaining performance obligations were expected to be satisfied within one year.
Key risks include government funding and contract timing, customer concentration, variable interest rates, contract cost estimates, award-fee judgments, inventory requirements, and potential goodwill impairment. VSE Aviation goodwill was approximately $104.5 million and was identified as vulnerable to impairment if projected cash flows weaken or discount rates increase. Akimeka goodwill was approximately $29.8 million and was also identified as subject to impairment risk.
Reported contingencies include an aviation crash lawsuit, an overtime collective-action lawsuit, and an approximately $27 million U.S. Air Force-related claim involving Prime Turbines and DynCorp. Management believes the likelihood of a material adverse effect is remote, but losses cannot presently be estimated with certainty. The company also remains subject to potential government investigations related to contractual and regulatory compliance.
The loan agreement limits annual cash dividends to $6 million, subject to conditions. VSE paid approximately $1.5 million of dividends during the first six months. The company expects to adopt the new lease accounting standard on January 1, 2019 and was still evaluating its impact.
Important Facts for Investors to Verify
- Whether Federal Services bookings, FMS delivery-order processing, and funded backlog recover after the reported delays.
- Whether Aviation revenue growth converts into adequate returns relative to the $34.4 million inventory increase and additional borrowings.
- The sustainability of the approximately 25% effective tax rate and the final impact of the Tax Cuts and Jobs Act measurement period.
- Compliance with debt covenants, scheduled term-loan repayments, variable-rate exposure, and revolver utilization.
- Potential impairment of Aviation and Akimeka goodwill if operating results or valuation assumptions deteriorate.
- Developments in the disclosed litigation and the approximately $27 million USAF-related claim.
- The effect of USPS fleet maintenance deferrals and future vehicle procurement on Supply Chain Management revenue.