VSE CORP 10-Q

Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations Business Overview We are a diversified aftermarket products and services company providing maintenance, repair and overhaul ("MRO") services, parts distribution, logistics, supply chain management and consulting services for transportation assets to commercial and government markets. Recent Developments Sale of Federal and Defense Segment In May 2023, we entered into a definitive agreement to sell our Federal and Defense business to Bernhard Capital Partners Management LP for a total consideration of up to $100.0 million, consisting of a $50.0 million cash payment at the closing of the transaction and an earn-out payment of up to $50.0 million, subject to the achievement of certain milestones. The transaction is expected to close in late 2023 or early 2024. In accordance with ASC 205-20, Presentation of Financial Statements - Discontinued Operations, we determined that the criteria for discontinued operations presentation were met during the second quarter of 2023 and results for the three and six months ended June 30, 2023 and 2022 for our Federal and Defense segment are reported in income from discontinued operations within the consolidated statements of operations and the carrying value of the related assets and liabilities are presented within assets and liabilities held for sale on the consolidated balance sheets as of June 30, 2023 and December 31, 2022. See Note (3) "Discontinued Operations" to the consolidated financial statements for further information. Desser Aerospace Acquisition In July 2023, we completed our previously announced acquisition of Desser-Graham Partnership, L.P. ("Desser Aerospace"), pursuant to the terms of the purchase agreement dated May 3, 2023, for a preliminary purchase price of $124.0 million, subject to post-closing adjustments. Concurrent with the closing of the transaction, we sold, in a separate transaction, Desser Aerospace’s propriety solutions businesses to Loar Group Inc. (“Loar”) for cash consideration of approximately $30.0 million (the “Loar Sale”). The acquisition was funded with proceeds from a new term loan (see Note (13) "Subsequent Events" - Credit Agreement Amendment for further information), together with proceeds from the Loar Sale and additional borrowings under our revolving credit facility. Underwritten Public Offering In July 2023, we initiated a public offering of the Company's common stock relating to the issuance and sale of 2,475,000 shares at a public offering price of $48.50 per share. The offering closed on July 24, 2023 and we received net proceeds of $112.7 million in connection with the offering, net of issuance costs. We intend to use substantially all of the net proceeds from this offering to repay outstanding borrowings under our revolving credit facility and any remaining amounts for general corporate purposes. Business Trends The following discussion provides a brief description of some of the key business factors impacting our results of operations detailed by segment. Aviation Segment During the second quarter, our strong execution on new and existing distribution programs and increase in MRO activity produced positive results, with quarterly revenue reaching $124.7 million for the three months ended June 30, 2023, representing a 19% increase year-over-year. Market growth and share gains have resulted in a 37% and 13% year-over-year increase in repair and distribution revenue, respectively, during the three months ended June 30, 2023, compared to the same period for the prior year. Our growth has been driven by several strategic initiatives, including the introduction of new products and service capabilities to our portfolio, further strengthening our position in the market. Additionally, expanding our partnerships with Original Equipment Manufacturers has provided us with a competitive edge, allowing successful entry into new markets with an established customer base. We believe our acquisition of Desser Aerospace in July 2023 will increase our exposure to the high-growth, higher-margin aviation distribution and MRO markets. We believe that the combination of Desser Aerospace’s distribution and repair capabilities with VSE Aviation’s aftermarket business creates a platform for geographic expansion into international markets and provides opportunities to cross-sell products and services. -18- Table of Contents Fleet Segment During the second quarter, growth in our Fleet segment was driven by strong contributions from commercial fleet customers, e-commerce fulfillment volume, and the United States Postal Service ("USPS"). The strong performance in our USPS program is supported by the expansion of our installed base of vehicles and continued support of legacy vehicles. We have made significant progress in executing our revenue diversification strategy through the successful launch of our new e-commerce fulfillment and distribution center, including the completion of initial inventory investments. These strategic initiatives have been instrumental in our ability to capture new customers and drive revenue growth within e-commerce fulfillment. Our commercial revenues were 47% of total Fleet segment revenue for the three months ended June 30, 2023 compared to 40% for the same period in the prior year, demonstrating the continued success of our diversification strategy. Results of Operations Consolidated Results of Operations The following table summarizes our consolidated results of operations (in thousands): Three months ended June 30, Six months ended June 30, 2023 2022 Change ($) Change (%) 2023 2022 Change ($) Change (%) Revenues $ 205,223 $ 169,761 $ 35,462 21 % $ 393,810 $ 330,081 $ 63,729 19 % Costs and operating expenses 184,586 159,226 25,360 16 % 356,395 307,529 48,866 16 % Operating income 20,637 10,535 10,102 96 % 37,415 22,552 14,863 66 % Interest expense, net 7,366 3,872 3,494 90 % 13,346 7,482 5,864 78 % Income from continuing operations before income taxes 13,271 6,663 6,608 99 % 24,069 15,070 8,999 60 % Provision for income taxes 3,182 1,908 1,274 67 % 5,860 4,026 1,834 46 % Net income from continuing operations $ 10,089 $ 4,755 $ 5,334 112 % $ 18,209 $ 11,044 $ 7,165 65 % Revenues. Revenues increased for the three months ended June 30, 2023 as compared to the same period in the prior year primarily due to growth in our Aviation segment of $19.7 million and our Fleet segment of $15.8 million. See "Segment Operating Results" section below for further discussion of revenues by segment. Revenues increased for the six months ended June 30, 2023 as compared to the same period in the prior year primarily due to growth in our Aviation segment of $39.7 million and our Fleet segment of $24.1 million. See "Segment Operating Results" section below for further discussion of revenues by segment. Costs and Operating Expenses. Costs and operating expenses increased for the three and six months ended June 30, 2023 as compared to the same periods in the prior year primarily due to increases in revenue. Costs and operating expenses for our operating segments increase and decrease in conjunction with the level of business activity and revenues generated by each segment. See "Segment Operating Results" for discussion of cost and operating expenses by segment. Operating Income. Operating income increased for the three months ended June 30, 2023 compared to the same period of the prior year primarily due to an increase of $9.3 million for our Aviation segment and $2.5 million for our Fleet segment. See "Segment Operating Results" for a discussion of operating income by segment. The operating income increase attributable to our segments was partially offset by an increase in corporate costs, including acquisition and integration costs incurred during the current period. Operating income increased for the six months ended June 30, 2023 compared to the same period of the prior year primarily due to an increase of $17.4 million for our Aviation segment and an increase of $2.0 million for our Fleet segment. See "Segment Operating Results" for a discussion of operating income by segment. The operating income increase attributable to our segments was partially offset by an increase in corporate costs, including acquisition and integration costs incurred during the current period. Interest Expense. Interest expense increased for the three and six months ended June 30, 2023 as compared to the same periods in the prior year primarily due to a higher average interest rate on borrowings outstanding. -19- Table of Contents Provision for Income Taxes. Our effective tax rate for continued operations was 24.0% and 24.3% for the three and six months ended June 30, 2023, respectively, and 28.6% and 26.7% for the three and six months ended June 30, 2022, respectively. Our tax rate is affected by discrete items that may occur in any given year, but may not be consistent from year to year. Permanent differences such as foreign derived intangible income deduction, Section 162(m) limitation, capital gains tax treatment, state income taxes, certain federal and state tax credits and other items caused differences between our statutory U.S. Federal income tax rate and our effective tax rate. The lower effective tax rate for the three and six months ended June 30, 2023 primarily resulted from book income in connection with the fair market value increase in our Company Owned Life Insurance plan in the period ended June 30, 2023 that was reversed for tax purposes as opposed to book expense in the same period in 2022. Segment Operating Results Aviation Segment Results The results of operations for our Aviation segment were as follows (in thousands): Three months ended June 30, Six months ended June 30, 2023 2022 Change ($) Change (%) 2023 2022 Change ($) Change (%) Revenues $ 124,729 $ 105,019 $ 19,710 19 % $ 237,964 $ 198,309 $ 39,655 20 % Costs and operating expenses 108,946 98,569 10,377 11 % 206,517 184,237 22,280 12 % Operating income $ 15,783 $ 6,450 $ 9,333 145 % $ 31,447 $ 14,072 $ 17,375 123 % Profit percentage 12.7 % 6.1 % 13.2 % 7.1 % Revenues. Revenues for our Aviation segment increased for the three months ended June 30, 2023 compared to the same period of the prior year primarily driven by contributions from recently initiated distribution contract wins and improved demand for our commercial aerospace products and services resulting from continued recovery in global commercial air travel. Aviation distribution revenue increased $10.1 million, or 13%, and repair revenue increased $9.6 million, or 37%, for the three months ended June 30, 2023 compared to the same period in the prior year. Revenues for our Aviation segment increased for the six months ended June 30, 2023 compared to the same period of the prior year primarily driven by contributions from recently initiated distribution contract wins and improved demand for our commercial aerospace products and services resulting from continued recovery in global commercial air travel. Aviation distribution revenue increased $20.4 million, or 14%, and repair revenue increased $19.3 million, or 40%, for the six months ended June 30, 2023 compared to the same period in the prior year. Costs and operating expenses. Costs and operating expenses increased for the three months ended June 30, 2023 compared to the same period of the prior year primarily due to increased revenues. Costs and operating expenses for this segment included expenses for amortization of intangible assets associated with acquisitions and allocated corporate costs. Expense for amortization of intangible assets was $2.5 million for the three months ended June 30, 2023 compared to $2.3 million for the same period in the prior year. Allocated corporate costs were $3.0 million for the six months ended June 30, 2023 compared to $2.8 million for the same period in the prior year. Costs and operating expenses increased for the six months ended June 30, 2023 compared to the same period of the prior year primarily due to increased revenues. Costs and operating expenses for this segment included expenses for amortization of intangible assets associated with acquisitions and allocated corporate costs. Expense for amortization of intangible assets was $5.0 million for the six months ended June 30, 2023 compared to $4.7 million for the same period in the prior year. Allocated corporate costs were $6.2 million for the six months ended June 30, 2023 compared to $5.7 million for the same period in the prior year. Operating income. Operating income increased for the three and six months ended June 30, 2023 compared to the same period of the prior year primarily due to revenue growth and a favorable shift in sales mix and pricing. -20- Table of Contents Fleet Segment Results The results of operations for our Fleet segment were as follows (in thousands): Three months ended June 30, Six months ended June 30, 2023 2022 Change ($) Change (%) 2023 2022 Change ($) Change (%) Revenues $ 80,494 $ 64,742 $ 15,752 24 % $ 155,846 $ 131,772 $ 24,074 18 % Costs and operating expenses 72,640 59,376 13,264 22 % 142,093 120,025 22,068 18 % Operating income $ 7,854 $ 5,366 $ 2,488 46 % $ 13,753 $ 11,747 $ 2,006 17 % Profit percentage 9.8 % 8.3 % 8.8 % 8.9 % Revenues. Revenues for our Fleet segment increased for the three months ended June 30, 2023 compared to the same period of the prior year primarily due to increases from commercial customers of $12.0 million, or 46%, and other government customers of $5.0 million, or 13%. These increases were partially offset by decreased revenues from DoD customers of $1.3 million. Commercial customer revenue growth was driven by our commercial fleet and e-commerce fulfillment business. Revenues from other government customers increased primarily due to increased support of legacy USPS vehicle fleets. Revenues for our Fleet segment increased for the six months ended June 30, 2023 compared to the same period of the prior year primarily due to increases from commercial customers of $16.7 million, or 31%, and other government customers of $10.3 million, or 14%. These increases were partially offset by decreased revenues from DoD customers of $3.0 million. Commercial customer revenue growth was driven by our commercial fleet and e-commerce fulfillment business. Revenues from other government customers increased primarily due to increased support of legacy USPS vehicle fleets. Costs and operating expense. Costs and operating expenses increased for the three months ended June 30, 2023 compared to the same period of the prior year primarily due to increased revenues. In addition, costs and operating expenses for this segment included expenses for amortization of intangible assets associated with acquisitions and allocated corporate costs. Expense for amortization of intangible assets was $1.1 million for the three months ended June 30, 2023 compared to $1.7 million for the same period in the prior year. Expense for allocated corporate costs was $2.0 million for the three months ended June 30, 2023 and $1.8 million for the same period in the prior year. Costs and operating expenses increased for the six months ended June 30, 2023 compared to the same period of the prior year primarily due to increased revenues. In addition, costs and operating expenses for this segment included expenses for amortization of intangible assets associated with acquisitions and allocated corporate costs. Expense for amortization of intangible assets was $2.6 million for the six months ended June 30, 2023 compared to $3.4 million for the same period in the prior year. Expense for allocated corporate costs was $4.0 million for the six months ended June 30, 2023 and $3.9 million for the same period in the prior year. Operating income. Operating income increased for the three and six months ended June 30, 2023 compared to the same period of the prior year primarily driven by increased revenues. Liquidity and Capital Resources Liquidity Our internal sources of liquidity are primarily from operating activities, specifically from changes in our level of revenues and associated inventory, accounts receivable and accounts payable, and from profitability. Significant increases or decreases in revenues and inventory, accounts receivable and accounts payable can affect our liquidity. Our inventory and accounts payable levels can be affected by the timing of large opportunistic inventory purchases and by distributor agreement requirements. Our accounts receivable and accounts payable levels can be affected by changes in the level of work we perform and by the timing of large purchases. In addition to operating cash flows, other significant factors that affect our overall management of liquidity include capital expenditures; and investments in the acquisition of businesses. Our primary source of external financing is our credit agreement with a bank group and includes a term loan and a revolving facility, with an aggregate maximum borrowing capacity of $350.0 million. Under the credit agreement we may elect to increase the maximum availability of the term loan, the revolving facility, or a combination of both, subject to customary lender commitment approvals. The aggregate limit of increases is $100.0 million. Our outstanding borrowings under the credit -21- Table of Contents agreement increased approximately $88.4 million for the six months ended June 30, 2023. As of June 30, 2023, we had borrowings outstanding under our term loan of $95.0 million, borrowings outstanding under our revolving facility of $282.0 million, outstanding letters of credit of $0.7 million, and $67.3 million of unused commitments under the credit agreement. In July 2023, we entered into a fifth amendment to our credit agreement which, among other things, provided for the following: (i) the extension of a new term loan in the aggregate principal amount of $90.0 million, which will mature on the same date as the existing term loan; (ii) a reduction in our capacity to incur incremental revolving or term loan credit facilities from $100.0 million to $25.0 million; (iii) quarterly amortization payments for the new term loan in the amount of $2.25 million; (iv) an increase in the maximum Total Funded Debt to EBITDA Ratio from 4.50x to 5.00x, with such ratios decreasing thereafter as indicated in the table below; (v) the addition of a tier to the top of the pricing grid if the Total Funded Debt to EBITDA ratio exceeds 4.50x; and (vi) expressly permitting the Desser acquisition and the Loar Sale. The net proceeds received under the new term loan were used to fund a portion of the cash consideration for the Desser acquisition. Testing Period Maximum Total Funded Debt to EBITDA Ratio June 30, 2023 through and including September 30, 2023 5.00 to 1.00 December 31, 2023 through and including June 30, 2024 4.75 to 1.00 September 30, 2024 4.50 to 1.00 December 31, 2024 through and including March 31, 2025 4.25 to 1.00 June 30, 2025 4.00 to 1.00 September 30, 2025 and thereafter 3.75 to 1.00 In July 2023, we entered into an underwriting agreement with William Blair & Company, L.L.C and RBC Capital Markets, acting as representatives of several underwriters, relating to the issuance and sale of 2,475,000 shares of the Company's common stock at a public offering price of $48.50 per share. Under the terms of the agreement, we granted the underwriters an option, exercisable for 30 days, to purchase up to an additional 371,250 shares of common stock. The offering closed on July 24, 2023 and we received net proceeds of $112.7 million in connection with the offering, net of issuance costs. We believe our existing balances of cash and cash equivalents, along with our cash flows from operations and debt instruments under our credit agreement mentioned above, will provide sufficient liquidity for our business operations as well as capital expenditures, dividends, and other capital requirements associated with our business operations over the next twelve months and thereafter for the foreseeable future. Cash Flows The following table summarizes our cash flows (in thousands): Six months ended June 30, 2023 2022 Net cash used in operating activities $ (65,091) $ (20,138) Net cash (used in) provided by investing activities (16,291) 327 Net cash provided by financing activities 85,244 19,664 Net increase (decrease) in cash and cash equivalents $ 3,862 $ (147) Cash used in operating activities increased $44.9 million for the six months ended June 30, 2023 as compared to the same period of the prior year. The increase was primarily due to greater use of cash for inventory purchases. Cash used in investing activities was $16.3 million for the six months ended June 30, 2023 compared to cash provided by investing activities of $0.3 million for the same period of the prior year. The change was primarily due to cash paid for the acquisition of Precision Fuel in the current period. Cash provided by financing activities increased $65.6 million for the six months ended June 30, 2023 as compared to the same period of the prior year. The increase was primarily due to overall higher proceeds from net borrowings of our debt during the current period. -22- Table of Contents We paid cash dividends totaling $2.6 million or $0.20 per share during the six months ending June 30, 2023. Pursuant to our bank loan agreement, our payment of cash dividends is subject to annual restrictions. We have paid cash dividends each year since 1973. Other Obligations and Commitments There have not been any material changes to our other obligations and commitments that were included in our Annual Report on Form 10-K for the year ended December 31, 2022. Inflation and Pricing There have not been any material changes to this disclosure from those discussed in our most recently filed Annual Report on Form 10-K. Off-Balance Sheet Arrangements We do not have any off-balance sheet arrangements that have, or are reasonably likely to have, a current or future material effect on our financial condition, changes in financial condition, revenue or expenses, results of operations, liquidity, capital expenditures or capital resources. Disclosures About Market Risk Interest Rate Risk Our credit agreement provides available borrowing to us at variable interest rates. Our interest expense is impacted by the overall global economic and interest rate environment. The inflationary environment has also resulted in central banks raising short-term interest rates. Accordingly, future interest rate changes could potentially put us at risk for a material adverse impact on future earnings and cash flows. To mitigate the risks associated with future interest rate movements we have employed interest rate hedges to fix the rate on a portion of our outstanding borrowings for various periods. In July 2023, we executed a fixed interest rate swap that hedges the variability in interest payments on $100.0 million of floating rate debt. For additional information related to our debt and interest rate swap agreements, see Note (5) and Note (6), respectively, to our Consolidated Financial Statements contained in this report. There have been no material changes to our market risks from those discussed in our most recently filed Annual Report on Form 10-K. Critical Accounting Policies, Estimates and Judgments Our consolidated financial statements are prepared in accordance with United States generally accepted accounting principles ("U.S. GAAP"), which require us to make estimates and assumptions. Certain critical accounting policies affect the more significant accounts, particularly those that involve judgments, estimates and assumptions used in the preparation of our consolidated financial statements, including revenue recognition, inventory valuation, business combinations, goodwill and intangible assets, and income taxes. If any of these estimates, assumptions or judgments prove to be incorrect, our reported results could be materially affected. Actual results may differ significantly from our estimates under different assumptions or conditions. See "Item 7. Management Discussion and Analysis of Financial Condition and Results of Operations" and Note (1) "Nature of Business and Summary of Significant Accounting Policies" in our 2022 Annual Report on Form 10-K for further discussions of our significant accounting policies and estimates. There have been no significant changes in our critical accounting estimates during the six months ended June 30, 2023 from those disclosed in our most recently filed Annual Report on Form 10-K. Recently Issued Accounting Pronouncements For a description of recently announced accounting standards, including the expected dates of adoption and estimated effects, if any, on our consolidated financial statements, see Note (1) "Nature of Business and Summary of Significant Accounting Policies -23- Table of Contents — Recent Adopted Accounting Pronouncements” to our Consolidated Financial Statements included in our Annual Report on Form 10-K for the year ended December 31, 2022. Item 3. Quantitative and Qualitative Disclosures About Market Risk See "Disclosures About Market Risk" in Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations.