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 September 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 October 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)
 
September 30,
 
December 31,
 
2019

2018
Assets
 
 
 
Current assets:
 
 
 
Cash and cash equivalents
$
1,095

 
$
162

Receivables, net
69,793

 
60,004

Unbilled receivables, net
54,151

 
41,255

Inventories, net
202,811

 
166,392

Other current assets
12,652

 
13,407

Total current assets
340,502

 
281,220

 
 
 
 
Property and equipment, net
43,792

 
49,606

Intangible assets, net
142,907

 
94,892

Goodwill
259,212

 
198,622

Operating lease right-of-use assets
24,375

 

Other assets
16,845

 
14,488

Total assets
$
827,633

 
$
638,828

 
 
 
 
Liabilities and Stockholders' equity
 

 
 

Current liabilities:
 

 
 

Current portion of long-term debt
$
10,716

 
$
9,466

Accounts payable
71,668

 
57,408

Current portion of earn-out obligation
10,700

 

Accrued expenses and other current liabilities
45,314

 
37,133

Dividends payable
987

 
871

Total current liabilities
139,385

 
104,878

 
 
 
 
Long-term debt, less current portion
257,815

 
151,133

Deferred compensation
17,417

 
17,027

Long-term lease obligations, less current portion

 
18,913

Long-term operating lease liabilities
25,124

 

Earn-out obligation
14,300

 

Deferred tax liabilities
17,732

 
18,482

Total liabilities
471,773

 
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
327,191

 
301,073

Accumulated other comprehensive (loss) income
(1,291
)
 
146

Total stockholders' equity
355,860

 
328,395

Total liabilities and stockholders' equity
$
827,633

 
$
638,828


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

-4-

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 September 30,
 
For the nine months ended September 30,
 
 
2019
 
2018
 
2019
 
2018
Revenues:
 
 
 
 
 
 
 
 
Products
 
$
96,832

 
$
85,886

 
$
279,608

 
$
264,678

Services
 
101,494

 
83,045

 
277,748

 
251,544

Total revenues
 
198,326

 
168,931

 
557,356

 
516,222

 
 
 
 
 
 
 
 
 
Costs and operating expenses:
 
 

 
 

 
 

 
 

Products
 
81,988

 
72,256

 
237,661

 
222,816

Services
 
93,568

 
77,810

 
256,355

 
239,536

Selling, general and administrative expenses
 
541

 
863

 
2,911

 
2,412

Amortization of intangible assets
 
5,014

 
4,005

 
14,985

 
12,013

Total costs and operating expenses
 
181,111

 
154,934

 
511,912

 
476,777

 
 
 
 
 
 
 
 
 
Gain on sale of contract
 

 
1,700

 

 
1,700

 
 
 
 
 
 
 
 
 
Operating income
 
17,215

 
15,697

 
45,444

 
41,145

 
 
 
 
 
 
 
 
 
Interest expense, net
 
3,706

 
2,340

 
10,262

 
6,697

 
 
 
 
 
 
 
 
 
Income before income taxes
 
13,509

 
13,357

 
35,182

 
34,448

 
 
 
 
 
 
 
 
 
Provision for income taxes
 
2,982

 
3,323

 
8,154

 
8,611

 
 
 
 
 
 
 
 
 
Net income
 
$
10,527

 
$
10,034

 
$
27,028

 
$
25,837

 
 
 
 
 
 
 
 
 
Basic earnings per share
 
$
0.96

 
$
0.92

 
$
2.47

 
$
2.38

 
 
 
 
 
 
 
 
 
Basic weighted average shares outstanding
 
10,970,123

 
10,881,106

 
10,953,581

 
10,874,331

 
 
 
 
 
 
 
 
 
Diluted earnings per share
 
$
0.95

 
$
0.92

 
$
2.45

 
$
2.37

 
 
 
 
 
 
 
 
 
Diluted weighted average shares outstanding
 
11,060,081

 
10,935,112

 
11,035,951

 
10,916,989

 
 
 
 
 
 
 
 
 
Dividends declared per share
 
$
0.09

 
$
0.08

 
$
0.26

 
$
0.23












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 September 30,
 
For the nine months ended September 30,
 
 
2019
 
2018
 
2019
 
2018
Net income
 
$
10,527

 
$
10,034

 
$
27,028

 
$
25,837

 
 
 
 
 
 
 
 
 
Change in fair value of interest rate swap agreements, net of tax
 
(16
)
 
28

 
(1,437
)
 
362

 
 
 
 
 
 
 
 
 
Other comprehensive (loss) income, net of tax
 
(16
)
 
28

 
(1,437
)
 
362

 
 
 
 
 
 
 
 
 
Comprehensive income
 
$
10,511

 
$
10,062

 
$
25,591

 
$
26,199










































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 September 30, 2019
 
 
 
 
 
Additional
Paid-In
Capital
 
Retained
Earnings
 
Accumulated
Other
Comprehensive
Loss
 
Total
Stockholders'
Equity
 
Common Stock
 
 
 
 
 
Shares
 
Amount
 
 
 
 
Balance at June 30, 2019
10,970

 
$
549

 
$
29,411

 
$
317,652

 
$
(1,275
)
 
$
346,337

Net income

 

 

 
10,527

 

 
10,527

Other comprehensive loss, net of tax

 

 

 

 
(16
)
 
(16
)
Dividends declared ($0.09 per share)

 

 

 
(988
)
 

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

 
$
549

 
$
29,411

 
$
327,191

 
$
(1,291
)
 
$
355,860




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

 
$
544

 
$
26,490

 
$
283,767

 
$
515

 
$
311,316

Net income

 

 

 
10,034

 

 
10,034

Other comprehensive income, net of tax

 

 

 

 
28

 
28

Dividends declared ($0.08 per share)

 

 

 
(871
)
 

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

 
$
544

 
$
26,490

 
$
292,930

 
$
543

 
$
320,507




























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)

 
Nine months ended September 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

 

 

 
27,028

 

 
27,028

Stock-based compensation
84

 
5

 
2,779

 

 

 
2,784

Other comprehensive loss, net of tax

 

 

 

 
(1,437
)
 
(1,437
)
Dividends declared ($0.26 per share)

 

 

 
(2,854
)
 

 
(2,854
)
Balance at September 30, 2019
10,970

 
$
549

 
$
29,411

 
$
327,191

 
$
(1,291
)
 
$
355,860




 
Nine months ended September 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

 

 

 
25,837

 

 
25,837

Stock-based compensation
42

 
2

 
2,020

 

 

 
2,022

Other comprehensive income, net of tax

 

 

 

 
362

 
362

Dividends declared ($0.23 per share)

 

 

 
(2,504
)
 

 
(2,504
)
Balance at September 30, 2018
10,881

 
$
544

 
$
26,490

 
$
292,930

 
$
543

 
$
320,507






















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 nine months ended September 30,
 
 
2019
 
2018
Cash flows from operating activities:
 
 
 
 
Net income
 
$
27,028

 
$
25,837

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

 
 

Depreciation and amortization
 
20,622

 
18,984

Deferred taxes
 
(1,230
)
 
(1,733
)
Stock-based compensation
 
2,592

 
2,146

Gain on sale of contract
 

 
(1,700
)
  Changes in operating assets and liabilities, net of impact of acquisitions:
 
 

 
 

Receivables, net
 
(2,380
)
 
738

Unbilled receivables, net
 
(12,896
)
 
11,298

Inventories, net
 
(29,540
)
 
(36,448
)
Other current assets and noncurrent assets
 
(481
)
 
3,518

Accounts payable and deferred compensation
 
11,793

 
(14,972
)
Accrued expenses and other current and noncurrent liabilities
 
1,931

 
(3,010
)
Long-term lease obligations
 

 
(1,237
)
 
 
 
 
 
Net cash provided by operating activities
 
17,439

 
3,421

 
 
 
 
 
Cash flows from investing activities:
 
 

 
 

Purchases of property and equipment
 
(7,689
)
 
(2,522
)
Proceeds from the sale of property and equipment
 
4

 
51

Proceeds from the sale of contract
 

 
1,700

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

 
 
 
 
 
Net cash used in investing activities
 
(120,345
)
 
(771
)
 
 
 
 
 
Cash flows from financing activities:
 
 

 
 

Borrowings on loan agreement
 
382,501

 
468,949

Repayments on loan agreement
 
(274,969
)
 
(465,521
)
Payment of debt financing costs
 

 
(1,702
)
Payments on capital lease obligations
 

 
(1,077
)
Payments of taxes for equity transactions
 
(955
)
 
(641
)
Dividends paid
 
(2,738
)
 
(2,393
)
 
 
 
 
 
Net cash provided by (used in) financing activities
 
103,839

 
(2,385
)
 
 
 
 
 
Net increase in cash and cash equivalents
 
933

 
265

Cash and cash equivalents at beginning of period
 
162

 
624

Cash and cash equivalents at end of period
 
$
1,095

 
$
889





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

-9-


VSE CORPORATION AND SUBSIDIARIES
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
September 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 nine months ended September 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 the 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 $45.1 million

-10-


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


and operating income of approximately $10.5 million before amortization of intangible assets of approximately $3.0 million and allocated corporate costs of approximately $1.2 million from the acquisition date through September 30, 2019.

We have not finalized our assessment of the fair values of the assets acquired and liabilities assumed as there has been insufficient time between the acquisition date and the issuance of these financial statements to complete our fair value review and final determination. As the amounts recorded for certain assets and liabilities are preliminary in nature, they are subject to adjustment as additional information is obtained about the facts and circumstances that existed at the acquisition date. The final determination of fair values of certain assets and liabilities will be completed within the measurement period of up to one-year from the acquisition date as permitted under U.S. GAAP.

The 1st Choice Aerospace acquisition requires the need to use the full one-year measurement period to adequately analyze and assess several factors used in establishing the asset acquired and liability assumed fair values as of the acquisition date, including intangibles, inventory and finalizing the estimated probability of each year’s earn-out obligation target being achieved. Any potential adjustments made could be material in relation to the preliminary values presented in the table below. 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 $408 thousand of acquisition-related expenses for the nine months ended September 30, 2019, 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.


-11-


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


The unaudited consolidated pro forma results of operations are as follows (in thousands except per share amounts):
 
 
Three months ended September 30,
 
Nine months ended September 30,
 
 
2019
 
2018
 
2019
 
2018
Revenue
 
$
198,326

 
$
181,464

 
$
558,915

 
$
550,452

Net Income
 
$
10,532

 
$
10,294

 
$
27,596

 
$
26,465

Basic earnings per share
 
$
0.96

 
$
0.94

 
$
2.52

 
$
2.43

Diluted earnings per share
 
$
0.95

 
$
0.94

 
$
2.50

 
$
2.42



(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 commercial customers.

A summary of revenues for our operating groups by customer for the three and nine months ended September 30, 2019 are as follows (in thousands):
 
 
Three months ended September 30, 2019
Customer
 
Supply Chain Management
 
Aviation
 
Federal Services
 
Total
USPS
 
$
42,282

 
$

 
$

 
$
42,282

DoD
 
6,935

 
1,613

 
76,505

 
85,053

Commercial
 
6,015

 
56,839

 

 
62,854

Other government
 
137

 
734

 
7,266

 
8,137

 
 
$
55,369

 
$
59,186

 
$
83,771

 
$
198,326


 
 
Nine months ended September 30, 2019
Customer
 
Supply Chain Management
 
Aviation
 
Federal Services
 
Total
USPS
 
$
127,077

 
$

 
$

 
$
127,077

DoD
 
18,238

 
2,768

 
201,828

 
222,834

Commercial
 
15,085

 
159,400

 
1,104

 
175,589

Other government
 
478

 
1,385

 
29,993

 
31,856

 
 
$
160,878

 
$
163,553

 
$
232,925

 
$
557,356


A summary of revenues for our operating groups by customer for the three and nine months ended September 30, 2018 are as follows (in thousands):
 
 
Three months ended September 30, 2018
Customer
 
Supply Chain Management
 
Aviation
 
Federal Services
 
Total
USPS
 
$
43,031

 
$

 
$

 
$
43,031

DoD
 
5,479

 
913

 
73,610

 
80,002

Commercial
 
3,324

 
32,641

 
62

 
36,027

Other government
 

 
446

 
9,425

 
9,871

 
 
$
51,834

 
$
34,000

 
$
83,097

 
$
168,931



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


 
 
Nine months ended September 30, 2018
Customer
 
Supply Chain Management
 
Aviation
 
Federal Services
 
Total
USPS
 
$
130,151

 
$

 
$

 
$
130,151

DoD
 
21,180

 
3,153

 
225,509

 
249,842

Commercial
 
10,123

 
98,213

 
295

 
108,631

Other government
 
507

 
1,188

 
25,903

 
27,598

 
 
$
161,961

 
$
102,554

 
$
251,707

 
$
516,222


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

 
$
315

 
$
41,691

 
$
42,006

Fixed-price
 
55,369

 
26,268

 
19,078

 
100,715

Time and materials
 

 
32,603

 
23,002

 
55,605

Total revenues
 
$
55,369

 
$
59,186

 
$
83,771

 
$
198,326


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

 
$
696

 
$
103,027

 
$
103,723

Fixed-price
 
160,878

 
75,260

 
58,098

 
294,236

Time and materials
 

 
87,597

 
71,800

 
159,397

Total revenues
 
$
160,878

 
$
163,553

 
$
232,925

 
$
557,356


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

 
$

 
$
44,638

 
$
44,638

Fixed-price
 
51,834

 
20,152

 
19,234

 
91,220

Time and materials
 

 
13,848

 
19,225

 
33,073

Total revenues
 
$
51,834

 
$
34,000

 
$
83,097

 
$
168,931


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

 
$
1,098

 
$
137,560

 
$
138,658

Fixed-price
 
161,961

 
59,525

 
51,577

 
273,063

Time and materials
 

 
41,931

 
62,570

 
104,501

Total revenues
 
$
161,961

 
$
102,554

 
$
251,707

 
$
516,222



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


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.
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 $54.2 million at September 30, 2019, primarily due to the revenue recognized as performance obligations were satisfied prior to the billing of our customers. 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 September 30, 2019, primarily due to revenue recognized in excess of advance payments received. For the nine months ended September 30, 2019 and September 30, 2018, we recognized revenue that was previously included in the beginning balance of contract liabilities of $2.1 million and $8.1 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 nine months ended September 30, 2019 and September 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 nine months ended September 30, 2019 and September 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 September 30, 2019, the aggregate amount of transaction prices allocated to unsatisfied or partially unsatisfied performance obligations was $252 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 nine months ended September 30, 2019 and September 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):
 
September 30,
 
December 31,
 
2019
 
2018
Bank credit facility - term loan
$
73,300

 
$
80,800

Bank credit facility - revolver loans
196,966

 
81,934

Principal amount of long-term debt
270,266

 
162,734

Less debt issuance costs
(1,735
)
 
(2,135
)
Total long-term debt
268,531

 
160,599

Less current portion
(10,716
)
 
(9,466
)
Long-term debt, less current portion
$
257,815

 
$
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

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


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 September 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 September 30, 2019 are as follows (in thousands):
2019
 
$
2,500

2020
 
11,875

2021
 
14,375

2022
 
15,000

2023
 
29,550

Total
 
$
73,300


The maximum amount of credit available to us under the loan agreement for revolving loans and letters of credit as of September 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 $72 thousand and $57 thousand in letters of credit outstanding as of September 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 September 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 September 30, 2019 and December 31, 2018, respectively.

After taking into account the impact of interest rate swap agreements, as of September 30, 2019, interest rates on portions of our outstanding debt ranged from 4.53% to 6.25%, and the effective interest rate on our aggregate outstanding debt was 4.91%.

Interest expense incurred on bank loan borrowings and interest rate hedges was approximately $3.6 million and $1.9 million for the three months ended September 30, 2019 and 2018, respectively. Interest expense incurred on bank loan borrowings and interest rate hedges was approximately $9.9 million and $5.1 million for the nine months ended September 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 September 30, 2019.



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VSE CORPORATION AND SUBSIDIARIES
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
September 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 September 30,
 
Nine months ended September 30,
 
 
2019
 
2018
 
2019
 
2018
Basic weighted average common shares outstanding
 
10,970,123

 
10,881,106

 
10,953,581

 
10,874,331

Effect of dilutive shares
 
89,958

 
54,006

 
82,370

 
42,658

Diluted weighted average common shares outstanding
 
11,060,081

 
10,935,112

 
11,035,951

 
10,916,989



(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, 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 nine months ended September 30, 2019 included the following components (in thousands):
 
 
Three months
 
Nine months
Operating lease cost
 
$
1,465

 
$
4,715

Short-term lease cost
 
146

 
445

Less: sublease income
 
(251
)
 
(791
)
Total lease cost, net
 
$
1,360

 
$
4,369


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 to discount lease payments to present value.



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


The table below summarizes future minimum lease payments under operating leases, recorded on the balance sheet, as of September 30, 2019 (in thousands):
 
 
Operating Leases
Last three months of 2019
 
$
972

2020
 
5,486

2021
 
5,192

2022
 
5,156

2023
 
4,790

After 2023
 
14,149

Minimum lease payments
 
35,745

Less: imputed interest
 
(6,654
)
Present value of minimum lease payments
 
29,091

Less: current maturities of lease liabilities
 
(3,967
)
Long-term lease liabilities
 
$
25,124


We made cash payments of approximately $4.8 million for operating leases during the nine months ended September 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 6.8 years and 6.0%, respectively at September 30, 2019.

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 States 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. Because 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
September 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 September 30,
 
Nine months ended September 30,
 
 
2019
 
2018
 
2019
 
2018
Revenues:
 
 
 
 
 
 
 
 
Supply Chain Management Group
 
$
55,369

 
$
51,834

 
$
160,878

 
$
161,961

Aviation Group
 
59,186

 
34,000

 
163,553

 
102,554

Federal Services Group
 
83,771

 
83,097

 
232,925

 
251,707

Total revenues
 
$
198,326

 
$
168,931

 
$
557,356

 
$
516,222

 
 
 
 
 
 
 
 
 
Operating income:
 
 

 
 

 
 

 
 

Supply Chain Management Group
 
$
7,843

 
$
7,783

 
$
22,388

 
$
23,547

Aviation Group
 
6,568

 
2,184

 
14,820

 
7,291

Federal Services Group
 
4,524

 
6,186

 
12,968

 
12,270

Corporate/unallocated expenses
 
(1,720
)
 
(456
)
 
(4,732
)
 
(1,963
)
Operating income
 
$
17,215

 
$
15,697

 
$
45,444

 
$
41,145



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


Customer Information

Our revenues by customer is as follows (dollars in thousands):
 
 
Three months ended September 30,
 
Nine months ended September 30,
Customer
 
2019
 
%
 
2018
 
%
 
2019
 
%
 
2018
 
%
USPS
 
$
42,282

 
21.3
%
 
$
43,031

 
25.5
%
 
$
127,077

 
22.8
%
 
$
130,151

 
25.2
%
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
U.S. Navy
 
30,123

 
15.2
%
 
37,013

 
21.9
%
 
72,930

 
13.1
%
 
115,294

 
22.4
%
U.S. Army
 
48,529

 
24.5
%
 
38,167

 
22.6
%
 
132,581

 
23.8
%
 
122,502

 
23.7
%
U.S. Air Force
 
6,401

 
3.2
%
 
4,822

 
2.9
%
 
17,323

 
3.1
%
 
12,046

 
2.3
%
Total - DoD
 
85,053

 
42.9
%
 
80,002

 
47.4
%
 
222,834

 
40.0
%
 
249,842

 
48.4
%
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Commercial aviation
 
56,839

 
28.7
%
 
32,641

 
19.3
%
 
159,400

 
28.6
%
 
98,213

 
19.0
%
Other commercial
 
6,015

 
3.0
%
 
3,386

 
2.0
%
 
16,189

 
2.9
%
 
10,418

 
2.0
%
Total - Commercial
 
62,854

 
31.7
%
 
36,027

 
21.3
%
 
175,589

 
31.5
%
 
108,631

 
21.0
%
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Other government
 
8,137

 
4.1
%
 
9,871

 
5.8
%
 
31,856

 
5.7
%
 
27,598

 
5.4
%
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Total
 
$
198,326

 
100
%
 
$
168,931

 
100
%
 
$
557,356

 
100
%
 
$
516,222

 
100
%


(8) Goodwill and Intangible Assets

Changes in goodwill for the nine months ended September 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 September 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 $15.0 million for the three and nine months ended September 30, 2019, respectively, and $4.0 million and $12.0 million for the three and nine months ended September 30, 2018, respectively.


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


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

 
$
(98,278
)
 
$
(1,025
)
 
$
128,791

Acquired technologies
 
12,400

 
(9,378
)
 

 
3,022

Trade names
 
24,670

 
(13,576
)
 

 
11,094

Total
 
$
265,164

 
$
(121,232
)
 
$
(1,025
)
 
$
142,907

 
 
 
 
 
 
 
 
 
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 September 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 September 30, 2019
 
Fair Value December 31, 2018
Non-COLI assets held in Deferred Supplemental Compensation Plan
 
Other assets
 
Level 1
 
$
651

 
$
403

Interest rate swap agreements
 
Accrued expenses/Other current assets
 
Level 2
 
$
1,720

 
$
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

 
$



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


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 of approximately $1.7 million, has been reported in accrued expenses at September 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 $429 thousand and $49 thousand, was included in accumulated other comprehensive income in the accompanying balance sheets as of September 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 22.1% and 23.2% for the three and nine months ended September 30, 2019, respectively, and 24.9% and 25.0% for the three and nine months ended September 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 nine months ended September 30, 2019 primarily results from the fair value increase of approximately $1.7 million to our COLI assets and an increase in foreign-derived intangible income ("FDII") deduction estimated for 2019.


(11) Recently Issued Accounting Pronouncements Not Yet Adopted

In June 2016, the FASB issued ASU No. 2016-13, Measurement of Credit Losses on Financial Instruments, which requires companies to record an allowance for expected credit losses over the contractual term of financial assets, including short-term trade receivables and contract assets, and expands disclosure requirements for credit quality of financial assets. We will adopt the new standard effective January 1, 2020. We currently are assessing the impact that this standard will have on our consolidated financial statements.
In August 2018, the FASB issued ASU No. 2018-13, 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.



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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 MRO services and products for new generation and legacy commercial aircraft. 1st Choice Aerospace has operations in Florida and Kentucky and operates as part of our Aviation Group.

CEO Succession

Our Board of Directors appointed John A. Cuomo as Chief Executive Officer and President and as a member of 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.

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.

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Concentration of Revenues
 
 
(dollars in thousands)
 
 
 
 
For the nine months ended September 30,
 
 
2019
 
 
 
2018
 
 
Source of Revenue
 
Revenues
 
%
 
Revenues
 
%
USPS
 
$
127,077

 
23
 
$
130,151

 
25
FMS Program
 
63,201

 
11
 
103,955

 
20
Other
 
367,078

 
66
 
282,116

 
55
Total revenues
 
$
557,356

 
100
 
$
516,222

 
100


Management Outlook

We finished the third quarter of 2019 with increases in revenues and operating income over both the third quarter of the prior year and the second quarter of the current year. Our 1st Choice Aerospace acquisition in January 2019 and new distribution programs implemented in 2018 are driving our Aviation Group to stronger results. Quarterly revenues for our Supply Chain Management Group improved over the prior year and prior quarter of the current year. Quarterly revenues for our Federal Services Group were flat compared to the prior year and improved over the prior quarter of the current year.

Aviation Group

Our Aviation Group results have benefited from strong performance of both our distribution and MRO businesses. Growth in our distribution services has been driven by our international operations in Singapore and Germany. Growth in our MRO services has been driven by our acquisition of 1st Choice Aerospace. We believe that our international distribution businesses and our acquisition of 1st Choice Aerospace have positioned us in commercial airline markets that are larger and have greater growth potential than our traditional business and general aviation markets. Products and services provided by these newer businesses comprise approximately 42% of revenues for this group in 2019. We will continue to service our traditional business and general aviation market lanes while focusing on growth in 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 has transitioned from a repair shop to a regional distribution business and its 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's financial performance has exceeded our expectations. 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. We are capturing new customers and increasing revenue using e-commerce solutions. Overall revenues for the third quarter showed improvement over both the third quarter of the prior year and the second quarter of 2019.

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-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 2% for the nine months ended September 30, 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 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

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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 NGDV transition, embracing emerging technologies spanning the next decade or longer.

Federal Services Group

We recently hired new leadership for our Federal Services Group as we prepare to navigate through a challenging year ahead for this group with a sharper focus on growth. The contract for our RRAD ERS program is scheduled to expire in November 2019 and our work on this program will cease. While this program has been one of our more significant revenue generators, our profit margins have been modest. In the coming year, we have other significant programs for which we will have to compete for the successor contracts.

Our Federal Services Group revenues declined in the first nine months of 2019 compared to the same period of 2018 due primarily to a decrease in our FMS revenues. This decline has been partially offset by increases in revenues on other programs. This change in the mix of contract work has benefited our profit margins.

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 nine months ended September 30, 2019 and 2018, and funded contract backlog as of September 30, 2019 and 2018 was as follows (in millions):
 
 
2019
 
2018
Bookings
 
$
190

 
$
284

Revenues
 
$
233

 
$
252

Funded Contract Backlog
 
$
252

 
$
345


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 $10.8 million and $4.7 million as of September 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. We estimate the fair value of our reporting units using a weighting of fair values derived from the income approach and market

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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 except for 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. 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. We will perform our annual goodwill impairment test during the fourth quarter of 2019 and will perform a quantitative assessment of the fair value of our VSE Aviation reporting unit. As of September 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. We will perform our annual goodwill impairment test during the fourth quarter of 2019 and will perform a quantitative assessment of the fair value of our Akimeka reporting unit. The carrying value of Akimeka as of September 30, 2019 included goodwill of approximately $30.9 million.

As of September 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
 
Nine months
 
Change
 
 
 ended September 30,
 
 ended September 30,
 
Three
 
Nine
 
 
2019
 
2018
 
2019
 
2018
 
Months
 
Months
Revenues
 
$
198,326

 
$
168,931

 
$
557,356

 
$
516,222

 
$
29,395

 
$
41,134

Costs and operating expenses
 
181,111

 
154,934