UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-Q

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934

For the Quarter Ended June 30, 2019       Commission File Number:  0‑3676

VSE CORPORATION
(Exact Name of Registrant as Specified in its Charter)
DELAWARE
54-0649263
(State or Other Jurisdiction of
(I.R.S. Employer
Incorporation or Organization)
Identification No.)

6348 Walker Lane
 
 
 
 
Alexandria, Virginia
 
22310
 
www.vsecorp.com
(Address of Principal Executive Offices)
 
(Zip Code)
 
(Webpage)

Registrant's Telephone Number, Including Area Code:  (703) 960-4600

Securities registered pursuant to Section 12(b) of the Act:
Title of each class
 
Trading Symbol
 
Name of each exchange on which registered
Common Stock, par value $0.05 per share
 
VSEC
 
The NASDAQ Global Select Market

Securities registered pursuant to Section 12(g) of the Act:  None

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes [x]    No [ ]

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (section 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  Yes [x]    No [ ]

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of "accelerated filer and large accelerated filer" in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer [ ] 
Accelerated filer [x]
Non-accelerated filer [ ]
Smaller reporting company [ ]
 
Emerging growth company [ ]

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transaction period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act.
Yes [ ]    No [ ]

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).
Yes [ ]    No [x]

Number of shares of Common Stock outstanding as of July 22, 2019: 10,970,123



 
TABLE OF CONTENTS
 
 
 
 
 
 
 
 
 
Page
 
 
 
 
 
ITEM 1.
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
ITEM 2.
 
 
 
ITEM 3.
 
 
 
ITEM 4.
 
 
 
 
 
 
 
 
ITEM 1.
 
 
 
ITEM 2.
 
 
 
ITEM 6.
 
 
 
 
 
 
 



-2-

Table of Contents

VSE Corporation and Subsidiaries


Forward Looking Statements

This report contains statements that, to the extent they are not recitations of historical fact, constitute "forward looking statements" under federal securities laws. All such forward looking statements are intended to be subject to the safe harbor protection provided by applicable securities laws. For discussions identifying some important factors that could cause actual results of VSE Corporation ("VSE," the "Company," "us," "our" or "we") to differ materially from those anticipated in the forward looking statements contained in this report, see VSE's discussions captioned "Business," "Risk Factors," "Management's Discussion and Analysis of Financial Condition and Results of Operations" and "Notes to Consolidated Financial Statements" contained in VSE's Annual Report on Form 10-K for the fiscal year ended December 31, 2018 filed with the U.S. Securities and Exchange Commission ("SEC") on March 7, 2019 ("2018 Form 10-K").

Readers are cautioned not to place undue reliance on these forward looking statements, which reflect management's analysis only as of the date hereof. We undertake no obligation to revise publicly these forward looking statements to reflect events or circumstances that arise after the date hereof. Readers should carefully review the risk factors described in our 2018 Form 10-K and in the reports and other documents the Company files from time to time with the SEC, including this and other Quarterly Reports on Form 10-Q and any Current Reports on Form 8-K that we have filed or will file with the SEC subsequent to December 31, 2018.

-3-

Table of Contents

PART I.  Financial Information

Item 1.    Financial Statements

VSE Corporation and Subsidiaries

Unaudited Consolidated Balance Sheets
(in thousands except share and per share amounts)
 
June 30,
 
December 31,
 
2019

2018
Assets
 
 
 
Current assets:
 
 
 
Cash and cash equivalents
$
760

 
$
162

Receivables, net
74,012

 
60,004

Unbilled receivables, net
45,961

 
41,255

Inventories, net
197,213

 
166,392

Other current assets
15,232

 
13,407

Total current assets
333,178

 
281,220

 
 
 
 
Property and equipment, net
44,216

 
49,606

Intangible assets, net
147,921

 
94,892

Goodwill
259,212

 
198,622

Operating lease right-of-use assets
25,256

 

Other assets
16,992

 
14,488

Total assets
$
826,775

 
$
638,828

 
 
 
 
Liabilities and Stockholders' equity
 

 
 

Current liabilities:
 

 
 

Current portion of long-term debt
$
10,091

 
$
9,466

Accounts payable
74,310

 
57,408

Current portion of earn-out obligation
10,700

 

Accrued expenses and other current liabilities
39,428

 
37,133

Dividends payable
987

 
871

Total current liabilities
135,516

 
104,878

 
 
 
 
Long-term debt, less current portion
268,985

 
151,133

Deferred compensation
17,201

 
17,027

Long-term lease obligations, less current portion

 
18,913

Long-term operating lease liabilities
25,716

 

Earn-out obligation
14,300

 

Deferred tax liabilities
18,720

 
18,482

Total liabilities
480,438

 
310,433

 
 
 
 
Commitments and contingencies (Note 6)


 


Stockholders' equity:
 

 
 

Common stock, par value $0.05 per share, authorized 15,000,000 shares; issued and outstanding 10,970,123 and 10,886,036, respectively
549

 
544

Additional paid-in capital
29,411

 
26,632

Retained earnings
317,652

 
301,073

Accumulated other comprehensive (loss) income
(1,275
)
 
146

Total stockholders' equity
346,337

 
328,395

Total liabilities and stockholders' equity
$
826,775

 
$
638,828


The accompanying notes are an integral part of these unaudited consolidated financial statements.

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Table of Contents

VSE Corporation and Subsidiaries

Unaudited Consolidated Statements of Income
(in thousands except share and per share amounts)
 
 
For the three months ended June 30,
 
For the six months ended June 30,
 
 
2019
 
2018
 
2019
 
2018
Revenues:
 
 
 
 
 
 
 
 
Products
 
$
93,875

 
$
90,119

 
$
182,776

 
$
178,792

Services
 
95,236

 
80,275

 
176,254

 
168,499

Total revenues
 
189,111

 
170,394

 
359,030

 
347,291

 
 
 
 
 
 
 
 
 
Costs and operating expenses:
 
 

 
 

 
 

 
 

Products
 
79,380

 
75,834

 
155,673

 
150,560

Services
 
87,347

 
75,971

 
162,787

 
161,726

Selling, general and administrative expenses
 
988

 
730

 
2,370

 
1,549

Amortization of intangible assets
 
4,980

 
4,004

 
9,971

 
8,008

Total costs and operating expenses
 
172,695

 
156,539

 
330,801

 
321,843

 
 
 
 
 
 
 
 
 
Operating income
 
16,416

 
13,855

 
28,229

 
25,448

 
 
 
 
 
 
 
 
 
Interest expense, net
 
3,398

 
2,182

 
6,556

 
4,357

 
 
 
 
 
 
 
 
 
Income before income taxes
 
13,018

 
11,673

 
21,673

 
21,091

 
 
 
 
 
 
 
 
 
Provision for income taxes
 
3,120

 
2,922

 
5,172

 
5,288

 
 
 
 
 
 
 
 
 
Net income
 
$
9,898

 
$
8,751

 
$
16,501

 
$
15,803

 
 
 
 
 
 
 
 
 
Basic earnings per share
 
$
0.90

 
$
0.80

 
$
1.51

 
$
1.45

 
 
 
 
 
 
 
 
 
Basic weighted average shares outstanding
 
10,969,899

 
10,881,106

 
10,945,172

 
10,870,887

 
 
 
 
 
 
 
 
 
Diluted earnings per share
 
$
0.89

 
$
0.80

 
$
1.50

 
$
1.45

 
 
 
 
 
 
 
 
 
Diluted weighted average shares outstanding
 
11,072,745

 
10,918,927

 
11,023,685

 
10,907,777

 
 
 
 
 
 
 
 
 
Dividends declared per share
 
$
0.09

 
$
0.08

 
$
0.17

 
$
0.15














The accompanying notes are an integral part of these unaudited consolidated financial statements.

-5-

Table of Contents

VSE Corporation and Subsidiaries

Unaudited Consolidated Statements of Comprehensive Income
(in thousands)
 
 
For the three months ended June 30,
 
For the six months ended June 30,
 
 
2019
 
2018
 
2019
 
2018
Net income
 
$
9,898

 
$
8,751

 
$
16,501

 
$
15,803

 
 
 
 
 
 
 
 
 
Change in fair value of interest rate swap agreements, net of tax
 
(729
)
 
123

 
(1,421
)
 
334

 
 
 
 
 
 
 
 
 
Other comprehensive (loss) income, net of tax
 
(729
)
 
123

 
(1,421
)
 
334

 
 
 
 
 
 
 
 
 
Comprehensive income
 
$
9,169

 
$
8,874

 
$
15,080

 
$
16,137









































The accompanying notes are an integral part of these unaudited consolidated financial statements.

-6-

Table of Contents

VSE Corporation and Subsidiaries

Unaudited Consolidated Statements of Stockholders' Equity
(in thousands except per share data)

Three months ended June 30, 2019
 
 
 
 
 
Additional
Paid-In
Capital
 
Retained
Earnings
 
Accumulated
Other
Comprehensive
Loss
 
Total
Stockholders'
Equity
 
Common Stock
 
 
 
 
 
Shares
 
Amount
 
 
 
 
Balance at March 31, 2019
10,950

 
$
547

 
$
28,788

 
$
308,742

 
$
(546
)
 
$
337,531

Net income

 

 

 
9,898

 

 
9,898

Stock-based compensation
20

 
2

 
623

 

 

 
625

Other comprehensive loss, net of tax

 

 

 

 
(729
)
 
(729
)
Dividends declared ($0.09 per share)

 

 

 
(988
)
 

 
(988
)
Balance at June 30, 2019
10,970

 
$
549

 
$
29,411

 
$
317,652

 
$
(1,275
)
 
$
346,337




Three months ended June 30, 2018
 
 
 
 
 
Additional
Paid-In
Capital
 
Retained
Earnings
 
Accumulated
Other
Comprehensive
Income
 
Total
Stockholders'
Equity
 
Common Stock
 
 
 
 
 
Shares
 
Amount
 
 
 
 
Balance at March 31, 2018
10,881

 
$
544

 
$
26,490

 
$
275,887

 
$
392

 
$
303,313

Net income

 

 

 
8,751

 

 
8,751

Other comprehensive income, net of tax

 

 

 

 
123

 
123

Dividends declared ($0.08 per share)

 

 

 
(871
)
 

 
(871
)
Balance at June 30, 2018
10,881

 
$
544

 
$
26,490

 
$
283,767

 
$
515

 
$
311,316



























The accompanying notes are an integral part of these unaudited consolidated financial statements.

-7-

Table of Contents

VSE Corporation and Subsidiaries

Unaudited Consolidated Statements of Stockholders' Equity (continued)
(in thousands except per share data)

Six months ended June 30, 2019
 
 
 
 
 
Additional
Paid-In
Capital
 
Retained
Earnings
 
Accumulated
Other
Comprehensive
Income (Loss)
 
Total
Stockholders'
Equity
 
Common Stock
 
 
 
 
 
Shares
 
Amount
 
 
 
 
Balance at December 31, 2018
10,886

 
$
544

 
$
26,632

 
$
301,073

 
$
146

 
$
328,395

Cumulative effect of adoption of ASU 2016-02, net of tax

 

 

 
1,944

 

 
1,944

Net income

 

 

 
16,501

 

 
16,501

Stock-based compensation
84

 
5

 
2,779

 

 

 
2,784

Other comprehensive loss, net of tax

 

 

 

 
(1,421
)
 
(1,421
)
Dividends declared ($0.17 per share)

 

 

 
(1,866
)
 

 
(1,866
)
Balance at June 30, 2019
10,970

 
$
549

 
$
29,411

 
$
317,652

 
$
(1,275
)
 
$
346,337




Six months ended June 30, 2018
 
 
 
 
 
Additional
Paid-In
Capital
 
Retained
Earnings
 
Accumulated
Other
Comprehensive
Income
 
Total
Stockholders'
Equity
 
Common Stock
 
 
 
 
 
Shares
 
Amount
 
 
 
 
Balance at December 31, 2017
10,839

 
$
542

 
$
24,470

 
$
267,902

 
$
181

 
$
293,095

Cumulative effect of adoption of ASU 2014-09, net of tax

 

 

 
1,695

 

 
1,695

Net income

 

 

 
15,803

 

 
15,803

Stock-based compensation
42

 
2

 
2,020

 

 

 
2,022

Other comprehensive income, net of tax

 

 

 

 
334

 
334

Dividends declared ($0.15 per share)

 

 

 
(1,633
)
 

 
(1,633
)
Balance at June 30, 2018
10,881

 
$
544

 
$
26,490

 
$
283,767

 
$
515

 
$
311,316






















The accompanying notes are an integral part of these unaudited consolidated financial statements.

-8-

Table of Contents

VSE Corporation and Subsidiaries

Unaudited Consolidated Statements of Cash Flows
(in thousands)
 
 
For the six months ended June 30,
 
 
2019
 
2018
Cash flows from operating activities:
 
 
 
 
Net income
 
$
16,501

 
$
15,803

Adjustments to reconcile net income to net cash provided by operating activities:
 
 

 
 

Depreciation and amortization
 
13,637

 
12,723

Deferred taxes
 
(312
)
 
(888
)
Stock-based compensation
 
1,982

 
1,676

  Changes in operating assets and liabilities, net of impact of acquisitions:
 
 

 
 

Receivables, net
 
(6,599
)
 
1,131

Unbilled receivables, net
 
(4,706
)
 
9,604

Inventories, net
 
(23,942
)
 
(34,352
)
Other current assets and noncurrent assets
 
(3,914
)
 
4,227

Accounts payable and deferred compensation
 
14,149

 
(6,164
)
Accrued expenses and other current and noncurrent liabilities
 
(2,744
)
 
(6,568
)
Long-term lease obligations
 

 
(816
)
 
 
 
 
 
Net cash provided by (used in) operating activities
 
4,052

 
(3,624
)
 
 
 
 
 
Cash flows from investing activities:
 
 

 
 

Purchases of property and equipment
 
(6,303
)
 
(1,880
)
Proceeds from the sale of property and equipment
 
4

 
46

Cash paid for acquisitions, net of cash acquired
 
(112,660
)
 

 
 
 
 
 
Net cash used in investing activities
 
(118,959
)
 
(1,834
)
 
 
 
 
 
Cash flows from financing activities:
 
 

 
 

Borrowings on loan agreement
 
300,726

 
359,554

Repayments on loan agreement
 
(182,516
)
 
(349,534
)
Payment of debt financing costs
 

 
(1,692
)
Payments on capital lease obligations
 

 
(707
)
Payments of taxes for equity transactions
 
(955
)
 
(641
)
Dividends paid
 
(1,750
)
 
(1,522
)
 
 
 
 
 
Net cash provided by financing activities
 
115,505

 
5,458

 
 
 
 
 
Net increase in cash and cash equivalents
 
598

 

Cash and cash equivalents at beginning of period
 
162

 
624

Cash and cash equivalents at end of period
 
$
760

 
$
624







The accompanying notes are an integral part of these unaudited consolidated financial statements.

-9-


VSE CORPORATION AND SUBSIDIARIES
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2019
Table of Contents



(1) Nature of Business and Basis of Presentation

Our accompanying unaudited consolidated financial statements have been prepared in accordance with U.S. generally accepted accounting principles ("U.S. GAAP") for interim financial information and the instructions to SEC Form 10-Q and Article 10 of SEC Regulation S-X. Accordingly, such financial statements do not include all of the information and footnotes required by U.S. GAAP for complete financial statements. In our opinion, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included. Operating results for the three and six months ended June 30, 2019 are not necessarily indicative of the results that may be expected for the fiscal year ending December 31, 2019. For further information refer to the consolidated financial statements and footnotes thereto included in our 2018 Form 10-K.

The preparation of financial statements in conformity with U.S. GAAP requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Significant estimates affecting the financial statements include accruals for contract disallowance reserves, award fee revenues, costs to complete on fixed price contracts, recoverability of goodwill and intangible assets, and earn-out obligations.

Recently Adopted Accounting Pronouncements

In February 2016, the Financial Accounting Standards Board ("FASB") issued Accounting Standards Update ("ASU") No. 2016-02, Leases (Topic 842) ("ASC 842"), to increase transparency and comparability among organizations by recognizing lease assets and lease liabilities on the balance sheet and disclosing key information about leasing arrangements. The new standard is required to be adopted using a modified retrospective method and is effective for reporting periods beginning after December 15, 2018, with early adoption permitted. In July 2018, the FASB provided an alternative transition method of adoption through ASU No. 2018-11, Targeted Improvements, which provides entities with an optional transition method to apply the transition provisions of ASU 2016-02 at the beginning of the period of adoption.
On January 1, 2019, we adopted ASC 842 using the alternative transition method provided by ASU 2018-11 recording right-of-use assets and lease liabilities for our existing leases as of January 1, 2019, as well as a cumulative-effect adjustment to retained earnings of initially applying the new standard as of January 1, 2019. We have elected the package of practical expedients permitted under the transition guidance, which does not require reassessment of prior conclusions related to lease identification, lease classification, and treatment for initial direct lease costs. We have not elected the practical expedients pertaining to the use of hindsight and land easements.
The adoption of new lease standard resulted in the recharacterization of our headquarters lease, which was accounted for using the financing method under previously existing build-to-suit accounting rules, to an operating lease under ASC 842. Upon adoption of the new lease standard on January 1, 2019, we recorded a right-of-use asset of $24.3 million, property and equipment of $2.8 million, and operating lease liability of $29.6 million, with immaterial changes to other balance sheet accounts. The recharacterization resulted in a cumulative-effect adjustment to retained earnings of approximately $1.9 million, net of taxes, as of January 1, 2019. The new standard did not have a significant impact on our consolidated results of operations or cash flows.

(2) Acquisition

On January 10, 2019, our wholly owned subsidiary VSE Aviation, Inc. ("VSE Aviation") acquired 100% of the equity of 1st Choice Aerospace Inc. ("1st Choice Aerospace"), a provider of maintenance, repair and overhaul ("MRO") services and products for new generation and legacy commercial aircraft. 1st Choice Aerospace has operations in Florida and Kentucky. We have retained key members of 1st Choice Aerospace's management team under three-year employment contracts with five-year non-compete covenants.

The initial purchase consideration paid at closing for 1st Choice Aerospace was approximately $113 million, which included $1.1 million as an estimated net working capital adjustment. We will also be required to make earn-out payments of up to $40 million if 1st Choice Aerospace meets certain financial targets during 2019 and 2020. Approximately $1.1 million of our closing payments was deposited into an escrow account to secure the sellers' indemnification obligations. Any amount remaining in such escrow account at the end of the indemnification period less any then pending indemnification claims will be distributed to the sellers. 1st Choice Aerospace's results of operations are included in our Aviation Group in the accompanying unaudited consolidated financial statements beginning on the acquisition date of January 10, 2019. 1st Choice Aerospace had unaudited revenues of approximately $27.3 million

-10-


VSE CORPORATION AND SUBSIDIARIES
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2019
Table of Contents


and operating income of approximately $5.9 million before amortization of intangible assets of approximately $2.0 million and allocated corporate costs of approximately $780 thousand from the acquisition date through June 30, 2019.

We are in the process of finalizing our valuation of the 1st Choice Aerospace assets acquired and liabilities assumed. The fair values assigned to our 1st Choice Aerospace earn-out obligation and intangible assets acquired were based on preliminary estimates, assumptions, and other information compiled by management, including independent valuations that utilized established valuation techniques. Therefore, these provisional amounts are subject to change as we complete the valuations throughout the measurement period, which will extend throughout 2019.

Based on our preliminary valuation, the total estimated purchase price has been allocated to assets acquired (including identifiable intangible assets and goodwill) and liabilities assumed, as follows (in thousands):
Description
 
Fair Value
Cash
 
$
396

Accounts receivable
 
7,409

Inventories
 
6,879

Prepaid expenses and other current assets
 
382

Property and equipment
 
4,044

Intangibles - customer related
 
55,000

Intangibles - trade name
 
8,000

Goodwill
 
60,590

Operating lease right-of-use assets
 
2,643

Other assets
 
333

Other current liabilities
 
(5,244
)
Long-term operating lease liabilities
 
(2,376
)
 
 
$
138,056

 
 
 
Cash consideration
 
$
113,056

Acquisition date estimated fair value of earn-out obligation
 
25,000

Total
 
$
138,056


The estimated value attributed to customer relationships is being amortized on a straight-line basis using weighted average useful lives of 17 years. The estimated value attributed to trade name is being amortized on a straight-line basis over nine years. The preliminary amount of goodwill recorded for our 1st Choice Aerospace acquisition was approximately $61 million, all of which is expected to be amortizable for income tax purposes. The goodwill recognized reflects the strategic advantage of expanding our sustainment services into the aviation supply chain market.

We incurred approximately $154 thousand and $408 thousand of acquisition-related expenses during the three months and six months ended June 30, 2019, respectively which are included in selling, general and administrative expenses. The following VSE consolidated pro forma results are prepared as if the 1st Choice Aerospace acquisition had occurred on January 1, 2018. This information is for comparative purposes only and does not necessarily reflect the results that would have occurred or may occur in the future.

The unaudited consolidated pro forma results of operations are as follows (in thousands except per share amounts):
 
 
Three months ended June 30,
 
Six months ended June 30,
 
 
2019
 
2018
 
2019
 
2018
Revenue
 
$
189,111

 
$
181,569

 
$
360,589

 
$
368,988

Net Income
 
$
10,025

 
$
8,870

 
$
17,064

 
$
16,171

Basic earnings per share
 
$
0.92

 
$
0.82

 
$
1.56

 
$
1.49

Diluted earnings per share
 
$
0.91

 
$
0.81

 
$
1.55

 
$
1.48



-11-


VSE CORPORATION AND SUBSIDIARIES
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2019
Table of Contents



(3) Revenue

Disaggregated Revenue
Our revenues are derived from contract services performed for the United States Postal Service ("USPS"), United States Department of Defense ("DoD") agencies or federal civilian agencies and from the delivery of products to our clients. Our customers also include various other government agencies and commercial entities.

A summary of revenues for our operating groups by customer for the three and six months ended June 30, 2019 are as follows (in thousands):
 
 
Three months ended June 30, 2019
Customer
 
Supply Chain Management
 
Aviation
 
Federal Services
 
Total
USPS
 
$
42,112

 
$

 
$

 
$
42,112

DoD
 
6,461

 
260

 
68,359

 
75,080

Commercial
 
5,090

 
54,086

 

 
59,176

Other government
 
142

 
651

 
11,950

 
12,743

 
 
$
53,805

 
$
54,997

 
$
80,309

 
$
189,111


 
 
Six months ended June 30, 2019
Customer
 
Supply Chain Management
 
Aviation
 
Federal Services
 
Total
USPS
 
$
84,795

 
$

 
$

 
$
84,795

DoD
 
11,303

 
1,155

 
125,323

 
137,781

Commercial
 
9,070

 
102,561

 
1,104

 
112,735

Other government
 
341

 
651

 
22,727

 
23,719

 
 
$
105,509

 
$
104,367

 
$
149,154

 
$
359,030


A summary of revenues for our operating groups by customer for the three and six months ended June 30, 2018 are as follows (in thousands):
 
 
Three months ended June 30, 2018
Customer
 
Supply Chain Management
 
Aviation
 
Federal Services
 
Total
USPS
 
$
43,089

 
$

 
$

 
$
43,089

DoD
 
7,525

 
1,025

 
73,637

 
82,187

Commercial
 
3,413

 
34,037

 
31

 
37,481

Other government
 
236

 
742

 
6,659

 
7,637

 
 
$
54,263

 
$
35,804

 
$
80,327

 
$
170,394


 
 
Six months ended June 30, 2018
Customer
 
Supply Chain Management
 
Aviation
 
Federal Services
 
Total
USPS
 
$
87,120

 
$

 
$

 
$
87,120

DoD
 
15,701

 
2,240

 
151,899

 
169,840

Commercial
 
6,799

 
65,572

 
233

 
72,604

Other government
 
507

 
742

 
16,478

 
17,727

 
 
$
110,127

 
$
68,554

 
$
168,610

 
$
347,291


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VSE CORPORATION AND SUBSIDIARIES
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2019
Table of Contents




A summary of revenues for our operating groups by contract type for the three and six months ended June 30, 2019 are as follows (in thousands):
 
 
Three months ended June 30, 2019
Contract Type
 
Supply Chain Management
 
Aviation
 
Federal Services
 
Total
Cost-type
 
$

 
$
169

 
$
33,496

 
$
33,665

Fixed-price
 
53,805

 
25,056

 
19,153

 
98,014

Time and materials
 

 
29,772

 
27,660

 
57,432

Total revenues
 
$
53,805

 
$
54,997

 
$
80,309

 
$
189,111


 
 
Six months ended June 30, 2019
Contract Type
 
Supply Chain Management
 
Aviation
 
Federal Services
 
Total
Cost-type
 
$

 
$
381

 
$
61,336

 
$
61,717

Fixed-price
 
105,509

 
48,992

 
39,020

 
193,521

Time and materials
 

 
54,994

 
48,798

 
103,792

Total revenues
 
$
105,509

 
$
104,367

 
$
149,154

 
$
359,030


A summary of revenues for our operating groups by contract type for the three and six months ended June 30, 2018 are as follows (in thousands):
 
 
Three months ended June 30, 2018
Contract Type
 
Supply Chain Management
 
Aviation
 
Federal Services
 
Total
Cost-type
 
$

 
$
701

 
$
41,801

 
$
42,502

Fixed-price
 
54,263

 
19,869

 
17,204

 
91,336

Time and materials
 

 
15,234

 
21,322

 
36,556

Total revenues
 
$
54,263

 
$
35,804

 
$
80,327

 
$
170,394


 
 
Six months ended June 30, 2018
Contract Type
 
Supply Chain Management
 
Aviation
 
Federal Services
 
Total
Cost-type
 
$

 
$
1,098

 
$
92,922

 
$
94,020

Fixed-price
 
110,127

 
39,373

 
32,343

 
181,843

Time and materials
 

 
28,083

 
43,345

 
71,428

Total revenues
 
$
110,127

 
$
68,554

 
$
168,610

 
$
347,291


Contract Balances
Billed receivables, unbilled receivables (contract assets), and contract liabilities are the results of revenue recognition, customer billing, and timing of payment receipts. Billed receivables, net, represent unconditional rights to consideration under the terms of the contract and include amounts billed and currently due from our customers. Unbilled receivables represent our right to consideration in exchange for goods or services that we have transferred to the customer prior to us having the right to payment for such goods or services. Contract liabilities are recorded when customers remit contractual cash payments in advance of us satisfying related performance obligations under contractual arrangements, including those with performance obligations to be satisfied over a period of time.

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VSE CORPORATION AND SUBSIDIARIES
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2019
Table of Contents


We present our unbilled receivables and contract liabilities on a contract-by-contract basis. If a contract liability exists, it is netted against the unbilled receivables balance for that contract. Unbilled receivables increased from $41.3 million at December 31, 2018 to $46.0 million at June 30, 2019, primarily due to revenue recognized in excess of billings. Contract liabilities, which are included in accrued expenses and other current liabilities in our consolidated balance sheet, decreased from $5.0 million at December 31, 2018 to $4.9 million at June 30, 2019, primarily due to revenue recognized in excess of advance payments received. For the six months ended June 30, 2019 and June 30, 2018, we recognized revenue that was previously included in the beginning balance of contract liabilities of $2.0 million and $7.7 million, respectively.
 
Performance Obligations

Our performance obligations are satisfied over time as work progresses or at a point in time. Revenues from products and services transferred to customers over time accounted for approximately 57% of our revenues for the three and six months ended June 30, 2019 and June 30, 2018, primarily related to revenues in our Federal Services Group and for MRO services in our Aviation Group. Revenues from products and services transferred to customers at a point in time accounted for approximately 43% of our revenues for the three and six months ended June 30, 2019 and June 30, 2018. The majority of our revenue recognized at a point in time is for the sale of vehicle and aircraft parts in our Supply Chain Management and Aviation groups.
As of June 30, 2019, the aggregate amount of transaction prices allocated to unsatisfied or partially unsatisfied performance obligations was $269 million. Performance obligations expected to be satisfied within one year and greater than one year are 97% and 3%, respectively. We have applied the practical expedient for certain parts sales and MRO services to exclude the amount of remaining performance obligations for (i) contracts with an original expected term of one year or less or (ii) contracts for which we recognize revenue in proportion to the amount we have the right to invoice for services performed.

During the six months ended June 30, 2019 and June 30, 2018, revenue recognized from performance obligations satisfied in prior periods was not material.


(4) Debt

Long-term debt consisted of the following (in thousands):
 
June 30,
 
December 31,
 
2019
 
2018
Bank credit facility - term loan
$
75,800

 
$
80,800

Bank credit facility - revolver loans
205,144

 
81,934

Principal amount of long-term debt
280,944

 
162,734

Less debt issuance costs
(1,868
)
 
(2,135
)
Total long-term debt
279,076

 
160,599

Less current portion
(10,091
)
 
(9,466
)
Long-term debt, net of current portion
$
268,985

 
$
151,133


We have a loan agreement with a group of banks to provide working capital, letters of credit and acquisition financing. The loan agreement, which was amended in January 2018 and expires in January 2023, has a term loan facility and a revolving loan facility. The revolving loan facility provides for revolving loans and letters of credit. Financing costs associated with the loan agreement amendment of approximately $1.5 million were capitalized and are being amortized over the five-year life of the loan. The fair value of outstanding debt as of June 30, 2019 under our bank loan facilities approximates its carrying value using Level 2 inputs based on market data on companies with a corporate rating similar to ours that have recently priced credit facilities.

Our required term loan payments after June 30, 2019 are as follows (in thousands):

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VSE CORPORATION AND SUBSIDIARIES
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2019
Table of Contents


2019
 
$
5,000

2020
 
11,875

2021
 
14,375

2022
 
15,000

2023
 
29,550

Total
 
$
75,800


The maximum amount of credit available to us under the loan agreement for revolving loans and letters of credit as of June 30, 2019 was $300 million. Subject to the terms of the loan agreement, we may borrow and repay the revolving loan borrowings as our cash flows require or permit. We pay an unused commitment fee and fees on letters of credit that are issued. We had $18 thousand and $57 thousand in letters of credit outstanding as of June 30, 2019 and December 31, 2018, respectively.

Under the loan agreement we may elect to increase the maximum availability of the term loan facility, the revolving loan facility, or both facilities, up to an aggregate additional amount of $100 million.

We pay interest on the term loan borrowings and revolving loan borrowings at LIBOR plus a base margin or at a base rate (typically the prime rate) plus a base margin. As of June 30, 2019, the LIBOR base margin was 2.50% and the base rate base margin was 1.25%. The base margins increase or decrease in increments as our Total Funded Debt/EBITDA Ratio increases or decreases, respectively.

The loan agreement requires us to have interest rate hedges on a portion of the outstanding term loan for the first three years after the January 2018 amendment date of the agreement. 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. We executed interest rate swap agreements in February 2019 and February 2018. The notional amount of the interest rate swap agreements was $125 million and $50 million as of June 30, 2019 and December 31, 2018, respectively.

After taking into account the impact of interest rate swap agreements, as of June 30, 2019, interest rates on portions of our outstanding debt ranged from 4.89% to 6.75%, and the effective interest rate on our aggregate outstanding debt was 5.16%.

Interest expense incurred on bank loan borrowings and interest rate hedges was approximately $3.4 million and $1.7 million for the three months ended June 30, 2019 and 2018, respectively. Interest expense incurred on bank loan borrowings and interest rate hedges was approximately $6.3 million and $3.2 million for the six months ended June 30, 2019 and 2018, respectively.

The loan agreement contains collateral requirements to secure our loan agreement obligations, restrictive covenants, a limit on annual dividends, and other affirmative and negative covenants, conditions, and limitations. Restrictive covenants include a maximum Total Funded Debt/EBITDA Ratio and a minimum Fixed Charge Coverage Ratio. We were in compliance with required ratios and other terms and conditions at June 30, 2019.



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VSE CORPORATION AND SUBSIDIARIES
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2019
Table of Contents


(5) Earnings Per Share

Basic earnings per share ("EPS") has been computed by dividing net income by the weighted average number of shares of common stock outstanding during each period. Shares issued during the period are weighted for the portion of the period that they were outstanding. Our calculation of diluted earnings per common share includes the dilutive effects for an assumed vesting of restricted stock awards.
 
 
Three months ended June 30,
 
Six months ended June 30,
 
 
2019
 
2018
 
2019
 
2018
Basic weighted average common shares outstanding
 
10,969,899

 
10,881,106

 
10,945,172

 
10,870,887

Effect of dilutive shares
 
102,846

 
37,821

 
78,513

 
36,890

Diluted weighted average common shares outstanding
 
11,072,745

 
10,918,927

 
11,023,685

 
10,907,777



(6) Commitments and Contingencies

Leases

We determine at its inception whether an arrangement that provides us control over the use of an asset is a lease. We recognize at lease commencement a right-of-use ("ROU") asset and lease liability based on the present value of the future lease payments over the lease term. Substantially all of our leases are long-term operating leases for facilities with fixed payment terms between two and 15 years. Our operating lease ROU assets are recorded in operating lease right-of-use assets on our accompanying unaudited consolidated balance sheet. The current portion of operating lease liabilities are presented within accrued expenses and other current liabilities,

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VSE CORPORATION AND SUBSIDIARIES
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2019
Table of Contents


and the non-current portion of operating lease liabilities are presented under long-term operating lease liabilities on our accompanying unaudited consolidated balance sheet.
For leases with terms greater than 12 months, we record the related asset and lease liability at the present value of lease payments over the lease term. Leases with an initial term of 12 months or less with purchase options or extension options that are not reasonably certain to be exercised are not recorded on the balance sheet. We recognize lease expense for these leases on a straight-line basis over the term of the lease.

Our lease cost for the three and six months ended June 30, 2019 included the following components (in thousands):
 
 
Three months
 
Six months
Operating lease cost
 
$
1,625

 
$
3,250

Short-term lease cost
 
175

 
299

Less: sublease income
 
(251
)
 
(540
)
Total lease cost, net
 
$
1,549

 
$
3,009


Certain of our leases include options to extend the term of the lease or to terminate the lease. When it is reasonably certain that we will exercise the option, we include the impact of the option in the lease term for purposes of determining total future lease payments. Our lease agreements do not provide a readily determinable implicit rate nor is it available to us from our lessors. Instead, we estimate our incremental borrowing rate based on information available at lease commencement in order to discount lease payments to present value.



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VSE CORPORATION AND SUBSIDIARIES
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2019
Table of Contents


The table below summarizes future minimum lease payments under operating leases, recorded on the balance sheet, as of June 30, 2019 (in thousands):
 
 
Operating Leases
Last six months of 2019
 
$
2,439

2020
 
5,384

2021
 
5,088

2022
 
5,112

2023
 
4,790

After 2023
 
14,149

Minimum lease payments
 
36,962

Less: imputed interest
 
(7,078
)
Present value of minimum lease payments
 
29,884

Less: current maturities of lease liabilities
 
(4,168
)
Long-term lease liabilities
 
$
25,716


We made cash payments of approximately $3.2 million for operating leases during the six months ended June 30, 2019, which are included in cash flows from operating activities in our unaudited consolidated statement of cash flows. The weighted average remaining lease term and discount rate for our operating leases were approximately 7.0 years and 6.0%, respectively at June 30, 2019.
As of June 30, 2019, we have additional future payments on a lease that has not yet commenced of approximately $300 thousand. This lease will commence in 2019 and has a lease term of approximately three years.
Contingencies

On or about April 19, 2018 Joseph Waggoner, on behalf of himself and all similarly situated individuals, filed a lawsuit against VSE and two of our subcontractors in the United State District Court, Eastern District of Texas, Texarkana Division, alleging overtime compensation entitlement at a rate of one and one-half times their regular rate of pay for all hours worked over 40 hours in a workweek. The plaintiffs are seeking to certify the case as a collective action for similarly situated individuals. The plaintiffs work under a contract between defendants and the United States Army at the Red River Army Depot in Texas. The plaintiffs assert that employees' 15-minute unpaid work breaks should have been included as "working hours" in calculating overtime. We believe it is probable that VSE will incur a loss related to this matter. We have accrued a loss provision for this matter, which represents our reasonable estimate related to a possible unfavorable settlement. While we do not believe that we will have any additional liability that is material, there can be no guaranty that the ultimate resolution will not result in an additional liability that is material.

Other Matters

In addition to the above-referenced legal proceeding, we may have certain claims in the normal course of business, including legal proceedings, against us and against other parties. In our opinion, the resolution of these other claims will not have a material adverse effect on our results of operations, financial position or cash flows. However, because the results of any legal proceedings cannot be predicted with certainty, the amount of loss, if any, cannot be reasonably estimated.

Further, from time-to-time, government agencies investigate whether our operations are being conducted in accordance with applicable contractual and regulatory requirements. Government investigations of us, whether relating to government contracts or conducted for other reasons, could result in administrative, civil or criminal liabilities, including repayments, fines or penalties being imposed upon us, or could lead to suspension or debarment from future government contracting. Government investigations often take years to complete and many result in no adverse action against us. We believe, based upon current information, that the outcome of any such government disputes and investigations will not have a material adverse effect on our results of operations, financial condition or cash flows.




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VSE CORPORATION AND SUBSIDIARIES
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2019
Table of Contents


(7) Business Segments and Customer Information

Business Segments

Management of our business operations is conducted under three reportable operating segments:

Supply Chain Management Group – Our Supply Chain Management Group supplies vehicle parts primarily through a Managed Inventory Program ("MIP") and direct sales to the United States Postal Service ("USPS"), the United States Department of Defense ("DoD") and to commercial customers.

Aviation Group – Our Aviation Group provides maintenance, repair and overhaul ("MRO") services, parts supply and distribution, and supply chain solutions for commercial aerospace and business and general aviation jet aircraft engines and engine accessories.

Federal Services Group – Our Federal Services Group provides engineering, industrial, logistics, foreign military sales, legacy equipment sustainment services, IT and technical and consulting services primarily to DoD and other government agencies.

The operating segments reported below are the segments of the Company for which separate financial information is available and for which segment results are evaluated regularly by our Chief Executive Officer in deciding how to allocate resources and in assessing performance. We evaluate segment performance based on consolidated revenues and operating income. Net sales of our business segments exclude intersegment sales as these activities are eliminated in consolidation. Our segment information is as follows (in thousands):
 
 
Three months ended June 30,
 
Six months ended June 30,
 
 
2019
 
2018
 
2019
 
2018
Revenues:
 
 
 
 
 
 
 
 
Supply Chain Management Group
 
$
53,805

 
$
54,263

 
$
105,509

 
$
110,127

Aviation Group
 
54,997

 
35,804

 
104,367

 
68,554

Federal Services Group
 
80,309

 
80,327

 
149,154

 
168,610

Total revenues
 
$
189,111

 
$
170,394

 
$
359,030

 
$
347,291

 
 
 
 
 
 
 
 
 
Operating income:
 
 

 
 

 
 

 
 

Supply Chain Management Group
 
$
7,557

 
$
8,168

 
$
14,545

 
$
15,764

Aviation Group
 
5,204

 
2,846

 
8,252

 
5,107

Federal Services Group
 
5,059

 
3,606

 
8,444

 
6,084

Corporate/unallocated expenses
 
(1,404
)
 
(765
)
 
(3,012
)
 
(1,507
)
Operating income
 
$
16,416

 
$
13,855

 
$
28,229

 
$
25,448



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VSE CORPORATION AND SUBSIDIARIES
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2019
Table of Contents


Customer Information

Our revenues by customer is as follows (dollars in thousands):
 
 
Three months ended June 30,
 
Six months ended June 30,
Customer
 
2019
 
%
 
2018
 
%
 
2019
 
%
 
2018
 
%
USPS
 
$
42,112

 
22.3
%
 
$
43,089

 
25.3
%
 
$
84,795

 
23.6
%
 
$
87,120

 
25.1
%
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
U.S. Navy
 
22,202

 
11.8
%
 
35,696

 
20.9
%
 
42,807

 
11.9
%
 
78,281

 
22.5
%
U.S. Army
 
47,333

 
25.0
%
 
41,548

 
24.4
%
 
84,052

 
23.4
%
 
84,335

 
24.3
%
U.S. Air Force
 
5,545

 
2.9
%
 
4,943

 
2.9
%
 
10,922

 
3.1
%
 
7,224

 
2.1
%
Total - DoD
 
75,080

 
39.7
%
 
82,187

 
48.2
%
 
137,781

 
38.4
%
 
169,840

 
48.9
%
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Commercial aviation
 
54,086

 
28.6
%
 
34,037

 
20.0
%
 
102,561

 
28.6
%
 
65,572

 
18.9
%
Other commercial
 
5,090

 
2.7
%
 
3,444

 
2.0
%
 
10,174

 
2.8
%
 
7,032

 
2.0
%
Total - Commercial
 
59,176

 
31.3
%
 
37,481

 
22.0
%
 
112,735

 
31.4
%
 
72,604

 
20.9
%
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Other government
 
12,743

 
6.7
%
 
7,637

 
4.5
%
 
23,719

 
6.6
%
 
17,727

 
5.1
%
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Total
 
$
189,111

 
100
%
 
$
170,394

 
100
%
 
$
359,030

 
100
%
 
$
347,291

 
100
%


(8) Goodwill and Intangible Assets

Changes in goodwill for the six months ended June 30, 2019 are as follows (in thousands):
 
 
Supply Chain Management
 
Federal Services
 
Aviation
 
Total
Balance as of December 31, 2018
 
$
63,190

 
$
30,883

 
$
104,549

 
$
198,622

Increase from acquisition
 

 

 
60,590

 
60,590

Balance as of June 30, 2019
 
$
63,190

 
$
30,883

 
$
165,139

 
$
259,212


Intangible assets consist of the value of contract and customer-related intangible assets, acquired technologies and trade names. Amortization expense was approximately $5.0 million and $10.0 million for the three and six months ended June 30, 2019, respectively, and $4.0 million and $8.0 million for the three and six months ended June 30, 2018, respectively.


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VSE CORPORATION AND SUBSIDIARIES
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2019
Table of Contents


Intangible assets, net were comprised of the following (in thousands):
 
 
Cost
 
Accumulated Amortization
 
Accumulated
Impairment Loss
 
Net Intangible Assets
June 30, 2019
 
 
 
 
 
 
 
 
Contract and customer-related
 
$
228,094

 
$
(94,185
)
 
$
(1,025
)
 
$
132,884

Acquired technologies
 
12,400

 
(9,096
)
 

 
3,304

Trade names
 
24,670

 
(12,937
)
 

 
11,733

Total
 
$
265,164

 
$
(116,218
)
 
$
(1,025
)
 
$
147,921

 
 
 
 
 
 
 
 
 
December 31, 2018
 
 

 
 

 
 

 
 

Contract and customer-related
 
$
173,094

 
$
(86,076
)
 
$
(1,025
)
 
$
85,993

Acquired technologies
 
12,400

 
(8,533
)
 

 
3,867

Trade names
 
16,670

 
(11,638
)
 

 
5,032

Total
 
$
202,164

 
$
(106,247
)
 
$
(1,025
)
 
$
94,892



(9) Fair Value Measurements

The accounting standard for fair value measurements defines fair value, and establishes a market-based framework or hierarchy for measuring fair value. The standard is applicable whenever assets and liabilities are measured at fair value.

The fair value hierarchy established in the standard prioritizes the inputs used in valuation techniques into three levels as follows:

Level 1–Observable inputs–quoted prices in active markets for identical assets and liabilities;

Level 2–Observable inputs-other than the quoted prices in active markets for identical assets and liabilities–includes quoted prices for similar instruments, quoted prices for identical or similar instruments in inactive markets and amounts derived from valuation models where all significant inputs are observable in active markets; and

Level 3–Unobservable inputs–includes amounts derived from valuation models where one or more significant inputs are unobservable and require us to develop relevant assumptions.

The following table summarizes the financial assets and liabilities measured at fair value on a recurring basis as of June 30, 2019 and December 31, 2018 and the level they fall within the fair value hierarchy (in thousands):
Amounts Recorded at Fair Value
 
Financial Statement Classification
 
Fair Value Hierarchy
 
Fair Value June 30, 2019
 
Fair Value December 31, 2018
Non-COLI assets held in Deferred Supplemental Compensation Plan
 
Other assets
 
Level 1
 
$
611

 
$
403

Interest rate swap agreements
 
Accrued expenses/Other current assets
 
Level 2
 
$
1,699

 
$
195

Earn-out obligation - short-term
 
Current portion of earn-out obligation
 
Level 3
 
$
10,700

 
$

Earn-out obligation - long-term
 
Earn-out obligation
 
Level 3
 
$
14,300

 
$


Non-COLI assets held in our deferred supplemental compensation plan consist of equity funds with fair value based on observable inputs such as quoted prices for identical assets in active markets and changes in fair value are recorded as selling, general and administrative expenses.
We account for our interest rate swap agreements under the provisions of ASC 815, Derivatives and Hedging, and have determined that our swap agreements qualify as highly effective cash flow hedges. The fair value of the swap agreements, which is a liability

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VSE CORPORATION AND SUBSIDIARIES
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2019
Table of Contents


of approximately $1.7 million, has been reported in accrued expenses at June 30, 2019. The fair value of the swap agreements, which was an asset of approximately $195 thousand, was reported in other current assets at December 31, 2018. The offset, net of an income tax effect of approximately $424 thousand and $49 thousand, was included in accumulated other comprehensive income in the accompanying balance sheets as of June 30, 2019 and December 31, 2018, respectively. The amounts paid and received on the swap agreements are recorded in interest expense in the period during which the related floating-rate interest is incurred. We determine the fair value of the swap agreements based on a valuation model using primarily observable market data inputs.

We utilized an income approach to determine the fair value of our 1st Choice Aerospace acquisition earn-out obligation. Significant unobservable inputs used to value the contingent consideration include projected revenue and cost of services and the discount rate. If a significant increase or decrease in the discount rate occurred in isolation, the result could be significantly higher or lower fair value measurement.


(10) Income Taxes

Our effective tax rate was 24.0% and 23.9% for the three and six months ended June 30, 2019, respectively, and 25.0% and 25.1% for the three and six months ended June 30, 2018, respectively. Income tax expense during interim periods is based on our estimated annual effective income tax rate plus any discrete items that are recorded in the period in which they occur. Our tax rate is affected by discrete items that may occur in any given year, but may not be consistent from year to year. The lower effective tax rate for the six months ended June 30, 2019 primarily results from the fair value increase of approximately $1.6 million to our COLI assets.


(11) Recently Issued Accounting Pronouncements Not Yet Adopted

In August 2018, the FASB issued ASU No. 2018-13, Disclosure Framework-Changes to the Disclosure Requirements for Fair Value Measurement, which eliminates certain disclosures related to transfers and the valuations process, modifies disclosures for investments that are valued based on net asset value, clarifies the measurement uncertainty disclosure, and requires additional disclosures for Level 3 fair value measurements. The new standard is effective for fiscal years beginning after December 15, 2019 with early adoption permitted. We currently are assessing the impact that this standard will have on our consolidated financial statements.
In August 2018, the FASB issued ASU No. 2018-15, Customer’s Accounting for Implementation Costs Incurred in a Cloud Computing Arrangement That Is a Service Contract, which clarifies the accounting for implementation costs in cloud computing arrangements. The new standard is effective for fiscal years beginning after December 15, 2019 with early adoption permitted. We currently are assessing the impact that this standard will have on our consolidated financial statements.


-22-

Table of Contents

Item 2.    Management's Discussion and Analysis of Financial Condition and Results of Operations


Executive Overview

Customers and Services

We are a diversified services and supply chain management company that assists our customers in maintaining, extending the service life, and improving the performance of their transportation equipment and other assets and systems. We provide logistics and distribution services for systems and equipment and professional and technical services to the United States Government (the "government"), including the United States Department of Defense ("DoD"), the United States Postal Service ("USPS"), federal civilian agencies, and to commercial and other customers. Our largest customers are the DoD and the USPS. Our operations include supply chain management solutions, parts supply and distribution, and maintenance, repair and overhaul (“MRO”) services for vehicle fleet, aviation and other customers; vehicle and equipment maintenance and refurbishment; logistics; engineering; energy services; IT and health care IT solutions; and consulting services.

Acquisition

In January 2019, we acquired 1st Choice Aerospace Inc. ("1st Choice Aerospace"), a provider of component MRO services and products for new generation and legacy commercial aircraft families. 1st Choice Aerospace has operations in Florida and Kentucky and operates as part of our Aviation Group. We have retained certain key management members of the former ownership group.

CEO Succession

In March of 2019, we announced that Maurice “Mo” Gauthier would step down as a Company officer and director after 11 years of dedicated service, and that our Board of Directors elected John Cuomo to the position of CEO and President and to the Board of Directors effective April 15, 2019.

Organization and Segments

We have three reportable segments aligned with our operating groups: 1) Supply Chain Management; 2) Aviation; and 3) Federal Services.

Supply Chain Management Group - Our Supply Chain Management Group provides sourcing, acquisition, scheduling, transportation, shipping, logistics, data management and other services to assist our clients with supply chain management efforts. Operations of this group are conducted by our wholly owned subsidiary Wheeler Bros., Inc., which supports the USPS, commercial truck fleets, and DoD with fleet management and maintenance solutions, managed inventory services, and other vehicle parts solutions. The primary revenue source for this group is generated from the sale of vehicle parts and performance of mission critical supply chain services to support the USPS delivery fleet.

Aviation Group - Our Aviation Group provides parts supply and distribution, supply chain solutions, and MRO services for commercial aerospace and business and general aviation aircraft, engines and accessories. This group offers a range of complementary services and supplies to a diversified client base of commercial and regional airlines, corporate and private aircraft owners, aviation manufacturers, other aviation MRO providers, cargo transporters and agricultural clients.

Federal Services Group - Our Federal Services Group performs foreign military sales services, refurbishment services to extend and enhance the life of existing vehicles and equipment, fleet-wide ship and aircraft support, aircraft sustainment and maintenance, and other technical, management, engineering, logistics, maintenance, configuration management, prototyping, technology, and field support services. Customers include the U.S. Navy and Marine Corps, U.S. Army and Army Reserve, U.S. Air Force, and various other DoD and federal government customers. Significant work efforts for this group include assistance to the U.S. Navy in executing its Foreign Military Sales (“FMS”) Program for surface ships sold, leased or granted to foreign countries, our Red River Army Depot Equipment Related Services Program (“RRAD ERS”) providing on-site logistics support for Red River Army Depot at Texarkana, Texas, our Fort Benning Logistics Support Services Program supporting base operations and logistics at Fort Benning, Georgia, our U.S. Army Reserve vehicle refurbishment program, various vehicle and equipment refurbishment and maintenance programs for U.S. Army commands, and various task orders under the U.S. Air Force Contract Field Teams (“CFT”) Program.


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Our Federal Services Group also provides energy and environmental consulting services and IT solutions and services for various DoD and federal civilian agencies, including the United States Department of Energy; the Social Security Administration; the National Institutes of Health; customers in the military health system; and other government agencies and commercial clients.

Concentration of Revenues
 
 
(dollars in thousands)
 
 
 
 
For the six months ended June 30,
 
 
2019
 
 
 
2018
 
 
Source of Revenue
 
Revenues
 
%
 
Revenues
 
%
USPS
 
$
84,795

 
24
 
$
87,120

 
25
FMS Program *
 
35,932

 
10
 
69,443

 
20
Other
 
238,303

 
66
 
190,728

 
55
Total revenues
 
$
359,030

 
100
 
$
347,291

 
100
     * Our Aviation Group utilizes the Federal Services Group's FMS Program to sell its gas turbine MRO services to the DoD.


Management Outlook

Our 2019 operating results are trending upward, with increases in revenues and operating income. The increases have occurred for the second quarter and six months as compared to prior year periods and on a second quarter to first quarter basis for 2019. Our acquisition of 1st Choice Aerospace in January 2019 and implementation of new distribution programs in 2018 have enhanced our Aviation Group revenues and operating income. While our Federal Services Group and Supply Chain Management Group experienced revenue challenges on a prior year comparison basis, revenue for both groups has increased from the first quarter to second for 2019.

Aviation Group

Our focus on opening international distribution businesses in Singapore and Germany and our acquisition of 1st Choice Aerospace has thrust our Aviation Group into commercial airlines markets that are larger and have greater growth potential than our traditional business and general aviation markets. Products and services provided by these three newer businesses now comprise close to 30% of revenues for this group. We will continue to build our traditional business and general aviation market lanes while transitioning into our newer commercial aerospace markets.

Our Singapore operation began generating revenue in the second quarter of 2018 as we extended new product lines to new end-user clients in the Asia-Pacific market. Our facility in Germany is transitioning from a repair shop to a regional distribution business, and associated revenues have increased. We have extended key distribution agreements to new geographic markets. We believe our distribution initiatives will provide sustainable revenue sources with viable growth potential that will enhance our future results. The addition of 1st Choice Aerospace broadens our product lines and client base, and we see opportunities to strategically align 1st Choice Aerospace’s offerings with our existing domestic and international markets, including our Singapore and European initiatives. Since acquisition, 1st Choice Aerospace has performed as we expected.

While revenues, operating income and inventory may experience fluctuations due to market demand and the mix of products sold, we are optimistic about the outlook for our Aviation Group.

Supply Chain Management Group

Our Supply Chain Management Group continues to increase parts sales and supply chain and inventory management support services to commercial customers. Our commercial client base includes companies in a wide array of businesses that have vehicle fleets required to meet mission critical delivery or service schedules, and we are capturing new customers and increasing revenue using e-commerce solutions. Overall revenues for the second quarter showed improvement over first quarter of 2019, and have returned to second quarter 2018 levels.

We are closely monitoring the USPS next-generation delivery vehicle (“NGDV”) procurement effort, which is progressing slower than the USPS had previously expected. We are also positioning ourselves to support newly procured vehicles eventually placed in service and aging vehicles that remain in service. While it will likely be several years before the NGDV is placed in service in significant numbers, the USPS has begun some shorter-term annual vehicle acquisitions through the procurement of commercial off-

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the-shelf ("COTS") mass-market vehicles and the retirement of some of its aging COTS vehicles. This transition has contributed to a decline in sales to the USPS of about 3% for 2019. As the new COTS vehicles begin to age, we expect the demand for replacement parts will increase. As a matter of USPS practice, we are a provider of replacement parts for all 231,000 USPS vehicle fleet assets, including the COTS vehicles. While we cannot predict with certainty the impact of the USPS NGDV procurement and concurrent retirement of older fleet assets on our future revenues, we believe that our years of service, unique knowledge of this client’s complex operational model and maintenance facility processes and procedures, and our superior performance strategically position us to continue to serve as a key vehicle fleet sustainment partner regardless of source or vintage. We expect to continue supporting USPS during its comprehensive vehicle transition initiatives, embracing emerging technologies spanning the next decade or longer.

Federal Services Group

Our Federal Services Group revenues declined in the first six months of 2019 compared to the same period of 2018 due primarily to a decrease in our FMS revenues. A reduction in work performed on our RRAD ERS contract due to a client directed reduction in force in May 2018 adversely affected revenue on this program for the first quarter of 2019, but an increase in the workforce restored revenues to prior year levels for the second quarter of 2019. The revenue declines have occurred in our lower margin work, resulting in minimal loss of operating income. We have increased operating income through cost reductions and margin improvements on our other work.

Bookings and Funded Backlog

Revenues for federal government contract work performed by our Federal Services Group depend on contract funding (“bookings”), and bookings generally occur when contract funding documentation is received. Funded contract backlog is an indicator of potential future revenue. While bookings and funded contract backlog generally result in revenue, we may occasionally have funded contract backlog that does not generate revenue due to contract expiration, reduction in work levels or de-obligation upon contract completion.

A summary of our bookings and revenues for our Federal Services Group for the six months ended June 30, 2019 and 2018, and funded contract backlog as of June 30, 2019 and 2018 was as follows (in millions):
 
 
2019
 
2018
Bookings
 
$
123

 
$
189

Revenues
 
$
149

 
$
169

Funded Contract Backlog
 
$
269

 
$
339


We will occasionally perform contract work prior to formalizing contract funding ("risk funding"). Revenue related to work performed under risk funding is not recognized until it can be reliably estimated and its realization is probable. We recognize such revenue when the associated costs are incurred or the work is performed. We are at risk of loss for any risk funding not received. Included in our unbilled receivables are revenues recognized for which we have not received formalized funding of approximately $11.4 million and $4.7 million as of June 30, 2019 and December 31, 2018, respectively. We believe that we are entitled to reimbursement and expect to receive all of this funding.


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 Recently Issued Accounting Pronouncements in Note 11 of the Notes to our Unaudited Consolidated Financial Statements in this report.


Critical Accounting Policies

Our consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States, which require us to make estimates and assumptions. See our 2018 Form 10-K for a full discussion of our critical accounting policies.

Goodwill and Intangible Assets

Goodwill is subject to a review for impairment at least annually. We perform an annual review of goodwill for impairment during the fourth quarter and whenever events or other changes in circumstances indicate that the carrying value may not be fully recoverable.

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We estimate the fair value of our reporting units using a weighting of fair values derived from the income approach and market approach. Under the income approach, we calculate the fair value of a reporting unit based on the present value of estimated future cash flows. Cash flow projections are based on our estimates of revenue growth rates and operating margins, taking into consideration industry and market conditions. The discount rate used is based on a weighted average cost of capital adjusted for the relevant risk associated with the characteristics of the business and the projected cash flows.

In the fourth quarter of 2018, we performed our annual goodwill impairment analysis for each of our reporting units with goodwill. The results of the impairment analysis indicated that our reporting units had fair values substantially in excess of their carrying values with the exception of our VSE Aviation and Akimeka reporting units.

The fair value of our VSE Aviation reporting unit, within our Aviation Group, exceeded its carrying value by approximately 6%. VSE Aviation achieved its 2018 earnings projections primarily due to growth in our Singapore distribution operation. While revenues and operating income in years prior to 2018 did not meet our cash flow projections, primarily due to a decreased demand for new parts and slower than anticipated development of new business opportunities, we believe that those conditions were temporary and that the overall outlook for our VSE Aviation business remains consistent with our long-term projections. Under the income approach, we used a 13.5% discount rate (a 100 basis point increase from the discount rate used in the prior year annual analysis), a compounded annual revenue growth rate of approximately 8% over a seven-year period, and a long-term revenue growth rate of three percent in the terminal year. Our compounded annual growth rate over the seven-year period is primarily based on projected organic growth, which is corroborated by market studies related to our aviation business, and significant initiatives, including international opportunities for parts distribution and gas turbine MRO services provided to our U.S. government customer. We believe the discount rate properly reflects the risks in our future cash flows assumptions including the risk that the new business opportunities take longer to develop or do not meet our expectations. Under the market approach, we estimated a fair value based on comparable companies' market multiples of revenues and earnings before interest, taxes, depreciation and amortization ("EBITDA") and factored in a control premium and applied such multiples to both of VSE Aviation's historical and one-year projected revenues and EBITDA. Negative changes in the key assumptions used in the annual impairment analysis or an increase in the carrying value may result in a future impairment of this reporting unit's goodwill.

Based on the results of the annual impairment analysis performed, we have determined that VSE Aviation is at risk of a future goodwill impairment if there are future declines in our cash flow projections or if we are unsuccessful in implementing our revenue growth plans. Additionally, the fair value of VSE Aviation could be adversely affected by other market factors such as an increase in the discount rate used in the income approach or a decrease in the market multiples used in the market approach, or an increase in the carrying value of this reporting unit. As of June 30, 2019 our balance sheet included goodwill associated with VSE Aviation of approximately $104.5 million.

The fair value of our Akimeka reporting unit, within our Federal Services Group, exceeded its carrying value by approximately 30%. Akimeka has experienced a reduction in services performed in prior years due to a decline in services ordered by clients on contracts and a loss of work performed on expiring contracts for which the follow-on work was often awarded to small businesses as set-aside contracts. These factors have been considered in the projections used in our impairment analysis. Based on the results of our analysis, our assessment is that we remain at risk of a future goodwill impairment if there is further deterioration of projected cash flows or negative changes in market factors, such as an increase in the discount rate used in the income approach or a decrease in the market multiples used in the market approach, or an increases in carrying value of this reporting unit. The carrying value of Akimeka as of June 30, 2019 included goodwill of approximately $30.9 million.

As of June 30, 2019, we have no intangible assets with indefinite lives and we had an aggregate of approximately $259 million of goodwill associated with our acquisitions.



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Results of Operations

Our results of operations are as follows (dollars in thousands):
 
 
Three months
 
Six months
 
Change
 
 
 ended June 30,
 
 ended June 30,
 
Three
 
Six
 
 
2019
 
2018
 
2019
 
2018
 
Months
 
Months
Revenues
 
$
189,111

 
$
170,394

 
$
359,030

 
$
347,291

 
$
18,717

 
$
11,739

Costs and operating expenses
 
172,695

 
156,539

 
330,801

 
321,843

 
16,156

 
8,958

Operating income
 
16,416

 
13,855

 
28,229