VSE CORP quarterly report, Q3 FY2012

VSE Corporation 2012 Third-Quarter Form 10-Q Summary

Business Context and Reporting Period

VSE Corporation provides sustainment, logistics, engineering, refurbishment, supply-chain management, information technology, energy, infrastructure, construction-management and consulting services primarily to U.S. Department of Defense and federal civilian agencies, including the U.S. Postal Service. The company reports five segments: Federal, International, IT, Energy and Management Consulting, Infrastructure, and Supply Chain Management.

This unaudited Form 10-Q covers the three and nine months ended September 30, 2012, compared with the corresponding 2011 periods. VSE had 5,286,706 common shares outstanding as of October 20, 2012.

Financial Results and Key Metrics

Metric	Q3 2012	Q3 2011	9M 2012	9M 2011
Total revenue	$148.2 million	$159.9 million	$431.8 million	$469.7 million
Operating income	$11.9 million	$11.4 million	$36.2 million	$25.6 million
Operating margin	8.0%	7.1%	8.4%	5.4%
Net income	$6.0 million	$6.1 million	$18.9 million	$14.5 million
Net margin	4.0%	3.8%	4.4%	3.1%
Diluted EPS	$1.12	$1.16	$3.57	$2.76

Services revenue was $322.3 million for the first nine months, down from $414.3 million, while product revenue increased to $109.4 million from $55.5 million, primarily reflecting the Wheeler Bros. supply-chain business acquired in June 2011.
Nine-month operating income increased 42% despite the 8% revenue decline, as lower-margin programs declined and higher-margin work became a larger part of the mix.
Interest expense increased to $5.5 million for the first nine months from $2.0 million, primarily reflecting acquisition-related debt and the associated financing structure.
The nine-month effective tax rate was 38.4%, compared with 38.6% in 2011.
Cash provided by operating activities was $41.0 million, compared with $30.8 million in the prior-year period. Capital expenditures were $11.6 million, including approximately $9 million related to the corporate headquarters move.
Cash used in investing activities was $16.2 million, compared with $178.8 million in 2011, when the company paid approximately $175 million for the Wheeler Bros. acquisition.
Cash used in financing activities was $24.4 million, compared with $142.6 million of financing inflows in 2011. Cash and cash equivalents increased to $0.9 million from $0.5 million at December 31, 2011.
At September 30, 2012, total bank debt was approximately $148.8 million, consisting of $96.8 million of term borrowings and $52.0 million of revolving borrowings. Including other debt classifications, balance-sheet long-term and current debt totaled approximately $148.2 million.
The company had $125 million of revolving-loan and letter-of-credit capacity, with $1.3 million of letters of credit outstanding, and could elect to increase the facility to $175 million.
The effective interest rate on aggregate debt after hedging was 3.33%; reported debt rates ranged from 2.47% to 3.87%.
Funded backlog was $297 million at September 30, 2012, compared with $305 million at September 30, 2011. Nine-month bookings were $460 million, compared with $396 million.

Material Changes Versus the Prior Comparable Period

Revenue decreased $11.7 million, or 7%, in the third quarter and $38.0 million, or 8%, for the first nine months. The principal drivers were declines in International Group and Federal Group activity, including the completion or expiration of the R2 program and lower Foreign Military Sales activity.
Federal Group nine-month revenue fell 37% to $98.3 million, but operating income increased 20% to $7.1 million as lower-margin R2 subcontract work was replaced in part by higher-margin Army Reserve vehicle-refurbishment work.
International Group revenue fell 19% for the first nine months, while operating income increased 5%, helped by contract award fees and improved margins.
IT, Energy and Management Consulting revenue declined 8% for the first nine months, but operating income increased 12%, partly due to reductions in the Akimeka earn-out liability.
Infrastructure Group revenue declined 23% for the first nine months and the segment recorded a $3.1 million operating loss, compared with $0.6 million of operating income in 2011.
Supply Chain Management contributed $109.7 million of nine-month revenue and $18.5 million of operating income. Quarter revenue declined 2% and operating income declined 11%, partly because of temporary customer order-processing delays.
The company recorded a $3.9 million impairment charge in the third quarter: approximately $2.4 million for ICRC goodwill and approximately $1.5 million for contract-related intangible assets and the ICRC trade name.
The company recognized approximately $12 million of Infrastructure Group revenue, including approximately $2 million of fee income, after settling outstanding Port of Anchorage fee and subcontractor-cost claims.
WBI achieved performance targets for an earn-out period ending June 30, 2012. VSE paid approximately $7.1 million to the sellers, and total remaining earn-out obligations were approximately $8.9 million at September 30, 2012.

Guidance, Outlook, Risks and Unusual Items

Management stated that revenue declines have primarily occurred in lower-margin programs and expressed an expectation that current revenue levels could be sustained or modestly improved in the following year, with potential for further improvement thereafter. No specific revenue or earnings guidance was provided.
Management identified the Army Reserve vehicle-refurbishment program, Foreign Military Sales work, USPS supply-chain services and potential USPS fuel-efficient vehicle production as growth opportunities.
Sequestration and changing federal budget priorities could delay or cancel contract awards and reduce demand, particularly in some energy and information-technology programs. Management believes several larger programs are relatively less exposed because they are self-funded, foreign-government funded or support service-life extension.
Management stated that it would continue evaluating the operations and future viability of the Infrastructure Group following losses at ICRC, the impairment charges and a $1.3 million bad-debt reserve.
The Port of Anchorage project was suspended because of technical difficulties and insufficient funding; future option years were not exercised and VSE’s work ended in May 2012.
VSE was in compliance with its debt covenants at September 30, 2012. Actual ratios were 2.47-to-1 funded debt-to-EBITDA versus a 3.25-to-1 maximum, 1.46-to-1 fixed-charge coverage versus a 1.20-to-1 minimum, and 0.97-to-1 asset coverage versus a 0.80-to-1 minimum.
The company has variable-rate debt and interest-rate swaps; future interest-rate changes could affect earnings and cash flow after the swaps expire or amortize.
The company disclosed four Hawaii lawsuits seeking unspecified damages. Management does not believe the matters will be material, although litigation outcomes cannot be predicted with certainty.
The statements are interim unaudited financial statements, and management cautioned that quarterly results are not necessarily indicative of full-year results.

Most Important Facts for Investors to Verify

Whether revenue stabilization or modest growth occurs after the decline in FMS, R2 and other legacy programs.
The sustainability of improved operating margins and the extent to which results depend on nonrecurring earn-out adjustments, award fees and the Port of Anchorage settlement.
Future performance and viability of ICRC and the broader Infrastructure Group after the impairment and bad-debt charges.
Wheeler Bros. order-processing trends, USPS Managed Inventory Program performance and remaining contingent earn-out payments.
Debt repayment requirements, revolving-borrowing needs, covenant headroom and exposure to variable interest rates.
The effects of sequestration, federal budget reductions, contract protests, funding delays and customer concentration.
Potential developments in the Hawaii litigation and other government investigations or contract claims.