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 March 31, 2004 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.) 2550 Huntington Avenue Alexandria, Virginia 22303-1499 (Address of Principal Executive Offices) (Zip Code) Registrant's Telephone Number, Including Area Code: (703) 960-4600 Securities registered pursuant to Section 12(b) of the Act: None Securities registered pursuant to Section 12(g) of the Act: Common Stock, par value $.05 per share (Title of Class) Indicate by check mark whether the Registrant is an accelerated filer (as defined in Rule 12b-2 of the Act). Yes [ ] No [x] 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 [ ] Number of shares of Common Stock outstanding as of April 27, 2004: 2,218,886. VSE Corporation and Subsidiaries Forward Looking Statements This filing contains statements which, to the extent they are not recitations of historical fact, constitute "forward looking statements" under federal securities laws. All such 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 VSE Corporation ("VSE" or the "Company") results to differ materially from those anticipated in the forward looking statements contained in this filing, see VSE's "Narrative Description of Business", "Management's Discussion and Analysis of Financial Condition and Results of Operations" and "Notes to Consolidated Financial Statements" contained in VSE's Annual Report and Form 10-K for the fiscal year ended December 31, 2003 (Form 10-K) filed with the Securities and Exchange Commission. Readers are cautioned not to place undue reliance on these forward looking statements, which reflect management's analysis only as of the date hereof. The Company undertakes no obligation to publicly revise these forward looking statements to reflect events or circumstances that arise after the date hereof. Readers should carefully review the risk factors described in other documents the Company files from time to time with the Securities and Exchange Commission, including this and other Quarterly Reports on Form 10-Q to be filed by the Company subsequent to its Annual Report on Form 10-K and any Current Reports on Form 8-K filed by the Company. -2- PART I. Financial Information Item 1. Financial Statements VSE Corporation and Subsidiaries Consolidated Financial Statements Consolidated Balance Sheets - ------------------------------------------------------------------------------- (in thousands except share and per share amounts)
March 31, December 31, 2004 2003 ---- ---- (Unaudited) Assets Current assets: Cash and cash equivalents . . . . . . . . . . . . $ 10,233 $ 9,843 Accounts receivable, principally U.S. Government, net . . . . . . . . . . . . . . 24,232 21,835 Deferred tax assets . . . . . . . . . . . . . . . 943 819 Other current assets . . . . . . . . . . . . . . . 1,396 1,379 -------- -------- Total current assets . . . . . . . . . . . . . . 36,804 33,876 Property and equipment, net . . . . . . . . . . . . 3,566 3,038 Deferred tax assets . . . . . . . . . . . . . . . . 254 297 Intangible assets, net . . . . . . . . . . . . . . . 1,054 1,054 Other assets . . . . . . . . . . . . . . . . . . . . 2,602 2,511 -------- -------- Total assets . . . . . . . . . . . . . . . . . . $ 44,280 $ 40,776 ======== ======== Liabilities and Stockholders' Investment Current liabilities: Accounts payable . . . . . . . . . . . . . . . . . $ 17,704 $ 14,634 Accrued expenses . . . . . . . . . . . . . . . . 5,479 5,760 Dividends payable . . . . . . . . . . . . . . . . 89 88 -------- -------- Total current liabilities . . . . . . . . . . . 23,272 20,482 Deferred compensation . . . . . . . . . . . . . . . 1,276 1,236 -------- -------- Total liabilities . . . . . . . . . . . . . . . 24,548 21,718 -------- -------- Commitments and contingencies Stockholders' investment: Common stock, par value $.05 per share, authorized 5,000,000 shares; issued 2,218,886 in 2004 and 2,214,136 shares in 2003 . . . . . . . . . . . . 111 110 Paid-in surplus . . . . . . . . . . . . . . . . . 3,980 3,928 Deferred stock-based compensation . . . . . . . . (15) (17) Retained earnings . . . . . . . . . . . . . . . . 15,656 15,037 -------- -------- Total stockholders' investment . . . . . . . . . 19,732 19,058 -------- -------- Total liabilities and stockholders' investment . $ 44,280 $ 40,776 ======== ========
The accompanying notes are an integral part of these financial statements. -3- VSE Corporation and Subsidiaries Consolidated Financial Statements Consolidated Statements of Income (Unaudited) - ------------------------------------------------------------------------------ (in thousands except share and per share amounts)
For the three months ended March 31, 2004 2003 ---- ---- Revenues, principally from contracts . . . . . . . . $ 42,610 $ 26,462 Costs and expenses of contracts . . . . . . . . . . 41,463 25,765 --------- --------- Gross profit . . . . . . . . . . . . . . . . . . . . 1,147 697 Selling, general and administrative expenses . . . . 12 42 Interest income, net . . . . . . . . . . . . . . . . (19) (16) --------- --------- Income before income taxes . . . . . . . . . . . . . 1,154 671 Provision for income taxes . . . . . . . . . . . . . 446 239 --------- --------- Net income . . . . . . . . . . . . . . . . . . . . . $ 708 $ 432 ========= ========= Basic earnings per share: Net income . . . . . . . . . . . . . . . . . . . . . $ 0.32 $ 0.20 ========= ========= Basic weighted average shares outstanding 2,216,216 2,187,038 ========= ========= Diluted earnings per share: Net income . . . . . . . . . . . . . . . . . . . . . $ 0.31 $ 0.19 ========= ========= Diluted weighted average shares outstanding 2,286,613 2,224,845 ========= =========
The accompanying notes are an integral part of these financial statements. -4- VSE Corporation and Subsidiaries Consolidated Financial Statements Consolidated Statements of Stockholders' Investment (Unaudited) - ------------------------------------------------------------------------------------------ (in thousands except per share data)
Deferred Total Common Stock Paid-In Stock-based Retained Stockholders' Shares Amount Surplus Compensation Earnings Investment ------ ------ ------- ------------ -------- ---------- Balance at December 31, 2001 2,150 $ 107 $ 3,294 $ - $13,074 $16,475 Net income for the year - - - - 652 652 Exercised stock options 33 2 213 - - 215 Tax benefit of options exercised - - 22 - - 22 Issuance of stock 3 - 29 - - 29 Dividends declared ($.16) - - - - (350) (350) ----- ----- ------- ----- ------- ------- Balance at December 31, 2002 2,186 109 3,558 - 13,376 17,043 Net income for the year - - - - 2,011 2,011 Exercised stock options 25 1 270 - - 271 Tax benefit of options exercised - - 14 - - 14 Deferred stock-based compensation - - 42 (42) - - Amortization of deferred stock-based compensation - - - 25 - 25 Issuance of stock 3 - 44 - - 44 Dividends declared ($.16) - - - - (350) (350) ----- ----- ------- ----- ------- ------- Balance at December 31, 2003 2,214 110 3,928 (17) 15,037 19,058 Net income for the period - - - - 708 708 Exercised stock options 5 1 36 - - 37 Tax benefit of options exercised - - 14 - - 14 Deferred stock-based compensation - - 2 (2) - - Amortization of deferred stock-based compensation - - - 4 - 4 Dividends declared ($.04) - - - - (89) (89) ----- ----- ------- ----- ------- ------- Balance at March 31, 2004 2,219 $ 111 $ 3,980 $ (15) $15,656 $19,732 ===== ===== ======= ===== ======= =======
The accompanying notes are an integral part of these financial statements. -5- VSE Corporation and Subsidiaries Consolidated Financial Statements (Unaudited) Consolidated Statements of Cash Flows - ------------------------------------------------------------------------------- (in thousands)
For the three months ended March 31, 2004 2003 ---- ---- Cash flows from operating activities: Net income . . . . . . . . . . . . . . . . . . . . . . $ 708 $ 432 Adjustments to reconcile net income to net cash provided by (used in) operating activities: Depreciation and amortization . . . . . . . . . . . . 262 278 Loss on sale of property and equipment . . . . . . . - 4 Deferred taxes . . . . . . . . . . . . . . . . . . . (81) (68) Tax benefit of options exercised . . . . . . . . . . 14 2 Amortization of deferred stock-based compensation . . 4 - Change in operating assets and liabilities: (Increase) decrease in: Accounts receivable . . . . . . . . . . . . . . . . . (2,397) (885) Other current assets and noncurrent assets . . . . . (108) (406) Increase (decrease) in: Accounts payable and deferred compensation . . . . . 3,110 (961) Accrued expenses . . . . . . . . . . . . . . . . . . (281) (391) ------- ------- Net cash provided by (used in) operating activities 1,231 (1,995) ------- ------- Cash flows from investing activities: Purchase of property and equipment . . . . . . . . . . . (790) (138) ------- ------- Net cash used in investing activities (790) (138) ------- ------- Cash flows from financing activities: Dividends paid . . . . . . . . . . . . . . . . . . . . . (88) (87) Proceeds from issuance of common stock . . . . . . . . . 37 30 ------- ------- Net cash used in financing activities (51) (57) ------- ------- Net increase (decrease) in cash and cash equivalents . . . 390 (2,190) Cash and cash equivalents at beginning of period . . . . 9,843 4,210 ------- ------- Cash and cash equivalents at end of period . . . . . . . $10,233 $ 2,020 ======= =======
The accompanying notes are an integral part of these financial statements. -6- VSE CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) Basis of Presentation The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States for interim financial information and the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included. Operating results for the three months ended March 31, 2004 are not necessarily indicative of the results that may be expected for the year ending December 31, 2004. For further information refer to the consolidated financial statements and footnotes thereto included in the VSE Corporation Annual Report on Form 10-K for the year ended December 31, 2003. The Company operates within one reportable segment. Use of Estimates in the Preparation of Financial Statements The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management 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 the allowance for doubtful accounts and accruals for loss contracts, contract disallowance and self insured health claims. Debt VSE has a revolving loan agreement with a bank under which the Company can borrow up to $15 million, subject to certain conditions, including a borrowing formula based on billed receivables. Under the loan agreement, the Company pays a fixed annual commitment fee and interest on any borrowings at a prime-based rate or an optional LIBOR-based rate. The expiration date of the revolving loan is May 31, 2005. The loan agreement contains collateral requirements by which Company assets secure amounts outstanding, restrictive covenants that include minimum tangible net worth and profitability requirements, a limit on annual dividends, and other affirmative and negative covenants. There were no amounts borrowed under this loan agreement as of March 31, 2004 or December 31, 2003. There was no interest expense incurred on this loan in 2004 and 2003. -7- VSE CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) Accounting for Stock-based Compensation The Company accounts for stock-based employee compensation using the intrinsic value method prescribed in APB Opinion No. 25 and related interpretations. If compensation costs for the Company's stock options had been determined based on SFAS No. 123, "Accounting for Stock-Based Compensation," the Company's net income and earnings per share would have been as follows (in thousands, except per share amounts): Three Months Ended March 31, 2004 2003 ---- ---- Net income, as reported $ 708 $ 432 Add: Total stock-based employee compensation expense as reported under intrinsic value method (APB No. 25) for all awards, net of related tax effects 3 -- Deduct: Total stock-based compensation expense determined under fair value based method (SFAS No. 123) for all awards, net of related tax effects (19) (24) ----- ----- Pro forma net income $ 692 $ 408 ===== ===== Earnings per share: Basic - as reported $0.32 $0.20 Diluted - as reported $0.31 $0.19 Basic - pro forma $0.31 $0.19 Diluted - pro forma $0.30 $0.18 Earnings Per Share Basic earnings per share have 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 and shares reacquired during the period are weighted for the portion of the period that they were outstanding. Diluted earnings per share have been computed in a manner consistent with that of basic earnings per share while giving effect to all potentially dilutive common shares that were outstanding during each period. Potentially dilutive common shares include incremental common shares issuable upon exercise of stock options. -8- VSE CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) Three Months Ended March 31, 2004 2003 ---- ---- Basic weighted average common shares outstanding 2,216,216 2,187,038 Diluted effect of options 70,397 37,807 --------- --------- Diluted weighted average common shares outstanding 2,286,613 2,224,845 ========= ========= Litigation The Company and its subsidiaries have, in the normal course of business, claims against them. In the opinion of management, the resolution of any such claims will not have a material adverse effect on the Company's results of operations or financial position. -9- ITEM 2. Management's Discussion and Analysis of Financial Condition and Results of Operations Executive Overview VSE Organization The term "VSE" or "Company" refers to VSE and its subsidiaries and divisions unless the context indicates operations of the parent company only. VSE's business operations consist primarily of services performed by the Company's wholly owned subsidiaries and unincorporated divisions. Energetics Incorporated ("Energetics") is currently VSE's only active subsidiary. VSE's Human Resource Systems, Inc. ("HRSI") subsidiary was active in 2003, but not in 2004. The sole HRSI contract expired on May 31, 2003, and this work was continued on a new contract in a VSE division. Active divisions include BAV Division ("BAV"), Coast Guard Division ("VCG"), Communications and Engineering Division ("CED") beginning in February 2003, Fleet Maintenance Division ("FMD"), Management Sciences Division ("MSD"), Systems Engineering Division ("SED," formerly Land Systems Division), and Value Systems Services Division ("VSS"). In February 2003, VSE began phasing out the operations of its Telecommunications Technologies Division ("TTD") and expects all TTD contractual obligations will be satisfied and operations will cease in 2004. Some of TTD's technical capabilities have been transferred to other VSE divisions. The Company uses multiple operating divisions to bid on and perform contract work. The use of these divisions enables the Company to use an operating structure that is flexible and well-suited to perform certain types of contract work. The Company anticipates that it will continue using its operating divisions to bid and perform new contract work to serve the needs of customers. Management believes that this strategy best positions the consolidated entity for future revenue growth. VSE Services The Company is engaged principally in providing engineering, design, logistics, management and technical services to the U.S. Government (the "government"), other government prime contractors, and commercial entities. The largest customer for the services rendered by the Company is the U.S. Department of Defense ("Defense"), including agencies of the U.S. Army, Navy, and Air Force. BAV is a major provider of logistics, training, and technical assistance in support of the Navy's ship transfer program. VCG provides similar services to the U.S. Coast Guard. FMD supports the Navy by providing a variety of services including ship installation efforts, combat systems inspections, ship repair and overhaul availability planning, harpoon weapons management, ordnance alteration, and air combat logistics. VSS provides the Navy with outsourcing decision assistance. SED provides the Army with engineering and technical support for ground weapons, logistics and training services, material procurement support, and prototype development support for combat vehicles. MSD provides the Army, other government agencies, and commercial organizations with quality training services for product, process, and management optimization. CED provides management oversight and coordinates support efforts for a variety of Department of Defense agency work orders. -10- The Company has also provided support services to the U.S. Postal Service for over twenty years and is continuing to support this customer through its VSS Division. Energetics is focused on providing the Department of Energy and other government and industry customers with expert consulting services in environmental management and energy supply, resource management, and conservation. TTD has offered products, services, and support in network, multimedia, and audio-visual technology. This includes design, installation, management and support for voice, data, multimedia and related projects. Business Terminations and New Business Start-ups In February 2003, VSE decided to terminate operations of TTD due to declining revenues and significant losses sustained by this division. TTD continued work on uncompleted contracts during 2003 to satisfy its contractual obligations and will finish work in 2004 before ceasing operations. Some of TTD's technical capabilities were transferred to other VSE divisions. The loss of future revenue associated with the termination of TTD operations is not expected to be significant compared to total future VSE revenue, while the elimination of TTD losses is expected to improve future VSE profits. In January 2003, VSE formed its Communications and Engineering Division (CED) upon the award of a multi-year Rapid Response support contract by the U.S. Army Communications-Electronics Command (CECOM). If all options are exercised, this contract has a potential total ceiling of $2.9 billion over an eight-year period. The contract is a multiple award, indefinite delivery, indefinite quantity contract, and VSE revenues from it are expected to be considerably less than the contract ceiling amount. While actual revenue estimates for VSE from this contract cannot be predicted, it is expected that this contract will contribute to future VSE revenue growth. Management Outlook VSE believes that its short term outlook, based on expected revenue growth under existing contracts, is more positive than in recent years. The Taiwan ship transfer work on the BAV contract (see "BAV Contract" below) is expected to contribute significantly to near term revenue growth. Revenues are also growing in several of VSE's other divisions. VSE's company wide funded backlog at March 31, 2004, was approximately $147 million, as compared to approximately $83 million at December 31, 2003. Profit margins in most of VSE's divisions have increased in recent quarters and are expected to improve further as the Company's revenue base grows. The Company has a positive cash flow and cash of approximately $10.2 million as of March 31, 2004. This positive short-term trend is tempered by two areas of concern to management. The CED Rapid Response support contract incurred pretax losses of approximately $963 thousand in 2003, its first year of operation, and an additional $325 thousand during the first three months of 2004 as additional task orders were funded. While management has addressed this issue by adopting a less aggressive pricing strategy, this contract may continue to incur losses in 2004. VSE has accrued liabilities of approximately $275 thousand for probable future losses associated with this contract's operations as of March 31, 2004. The second concern involves the utilization of the Company's primary office facility. VSE does not always occupy all of the space in its primary leased office facility and has from time to time subleased parts of this facility to other tenants. During 2003, some of the Company's larger subtenants did not renew their subleases with VSE, and the facility remains underutilized as of March 31, 2004. The Company has had -11- some partial success in finding new tenants to sublease space and believes that the majority of the available space will be subleased by the end of 2004, but the potential exists for continued underutilization of the facility that could negatively impact earnings in 2004. The longer term outlook for VSE centers on the uncertainty associated with the renewal of the BAV contract. The U.S. Navy intends to solicit bids for a new contract in 2004 and BAV will aggressively pursue the award of the new contract. BAV is confident in its ability to win this award and continue work on the ship transfer program; however, the size of this effort will entice other companies to offer strong competition. Accordingly, there can be no assurance that BAV will win the new contract. If BAV fails to win the new contract, VSE will suffer a significant loss of future revenue and profits. To mitigate this risk, VSE is exploring potential acquisition opportunities. The Company intends to continue these efforts in 2004. Government Procurement Policies and Practices VSE's business is subject to the risks arising from economic conditions and political factors that may impact the budgets and program funding of customers served through VSE's contracts. VSE's revenues have historically been subject to annual fluctuations resulting from changes in the level of Defense spending. Future budgetary and funding decisions by government lawmakers or Defense restructuring efforts could affect the types and level of services provided by VSE to its government customers and could potentially have a material adverse impact on the Company's results of operations or financial condition. The revenues of the Company depend on its ability to win new contracts and on the amount of work ordered by the government under the Company's existing contracts. The Company's ability to win new contracts is affected by government acquisition policies and procedures, including government procurement practices that in some years have tended toward bundling work efforts under large comprehensive ("omnibus") management contracts. This emphasis on large contracts presents challenges to winning new contract work, including making it more difficult for the Company to qualify as a bidder, increasing the level of competition due to the award of fewer contracts, and forcing the Company into competition with larger organizations that have greater financial resources and larger technical staffs. Competing for these contracts requires the Company to use teams of subcontractors to be able to offer the range of technical competencies needed to do the work. While the use of subcontractors on a large scale basis allows the Company to compete for this work, profit margins on subcontract work are lower than on work performed by Company personnel, thereby reducing the Company's overall profit margins. The use of subcontractors on government contracts also raises certain performance and financial risks to VSE in that government prime contractors are usually obligated to ensure compliance with U.S. Government regulations relative to the performance by subcontractors. Other government procurement practices that can affect the Company's revenues are the use of past performance criteria that may preclude entrance into new government markets and government social programs that limit contract work to small, woman, or minority owned businesses. Additional risk factors that could potentially affect the Company's results of operations are the government's right to terminate contracts for convenience, the government's right to not -12- exercise all of the option periods on a contract, and funding delays caused by government political or administrative actions. Beginning in 2004, Section 843 of the Defense Authorization Act will limit the length of contracts awarded by the Defense Department to five years total. The Company is unable to predict what impact this will have on future contract awards and revenues. BAV Contract VSE's BAV Division has a contract with the U.S. Navy to provide engineering, technical and logistical support services associated with the sale, lease, or transfer of Navy ships to foreign governments. This cost-plus contract is a ten-year contract awarded in 1995 and has a total ceiling value of over one billion dollars over the life of the contract. Revenues generated by this contract accounted for approximately 50% and 51% of consolidated revenues during the three month periods ended March 31, 2004 and 2003, respectively, and funded backlog was approximately $104 million as of March 31, 2004, as compared to approximately $48 million as of December 31, 2003. Contract terms specify award fee payments to BAV that are determined by performance and level of contract activity. Award fees are made three times during the year and a contract modification authorizing the award fee payment is issued subsequent to the period in which the work is performed. The Company does not recognize award fee income until the contract modification authorizing the award fee is certain. Due to such timing, and to fluctuations in the level of revenues, profits as a percentage of revenues will fluctuate from period to period. As of March 31, 2004, award fee has been recognized for work performed through the award fee period ended December 31, 2003. The level of revenues and associated profits resulting from fee income generated by this contract varies depending on a number of factors, including the timing of ship transfers and associated support services ordered by foreign governments and economic conditions of potential customers worldwide. The Company has experienced significant quarterly and annual revenue fluctuations and anticipates that future quarterly and annual revenues will be subject to significant variations primarily due to changes in the level of activity on this contract. The U.S. Navy has approved the transfer of four U.S. Navy ships to Taiwan, with work related to this transfer to be performed under the BAV contract. This transfer is expected to result in an increase in the revenues of BAV during the time this work is performed beginning in 2004. BAV has received a contract delivery order related to this work in early 2004 of approximately $100 million, of which $49 million is funded as of March 31, 2004. The original BAV contract ending date was in 2005. The Navy recently modified the original contract for the purpose of ensuring continuity of work with respect to the transfer of ships to Taiwan. The modification provided contractual coverage for this specific work effort into 2007. The U.S. Navy has announced that it intends to issue a new contract for the overall ship transfer program through a competitive bidding process that will begin in 2004. BAV does not expect that the Navy will award the new contract until after 2004. There can be no assurance that BAV will win the award for the follow-on contract. If BAV fails to win this new contract award, it could have a material adverse impact on the Company's future results of operations and financial condition. -13- Global Economic Conditions and Political Factors VSE's business is subject to the risks arising from global economic conditions and political factors associated with current and potential customers served through VSE's contracts with the U.S. Government. An economic slowdown in countries served under the BAV contract could adversely affect sales. Failure by the government of a potential foreign customer to approve and fund acquisition of U.S. Navy ships serviced under the BAV contract could adversely affect sales. In any one year, a significant amount of the Company's revenues may result from sales on the BAV contract to a single foreign government. During the three months ended March 31, 2004 and 2003, revenues associated with BAV contract sales to Egypt accounted for approximately 26% and 37% of the Company's revenues, respectively. Revenues in 2004 are expected to include large amounts of BAV contract sales to both Egypt and Taiwan. In addition to the effect on BAV contract work, international tensions can also affect work by FMD on U.S. Navy ships when they are deployed outside of U.S. Navy facilities and are unavailable for maintenance work during this time period. Adverse results arising from these global economic and political risks could potentially have a material adverse impact on the Company's results of operations. Concentration of Revenues (in thousands) For the three months ended March 31, 2004 2003 Source of Revenue Revenues % Revenues % - ----------------- -------- - -------- - BAV Egypt $ 11,242 26% $ 9,841 37% BAV Taiwan 8,038 19% 1,601 6% BAV Other 1,974 5% 2,083 8% -------- ---- -------- ---- Total BAV 21,254 50% 13,525 51% VSE Other 21,356 50% 12,937 49% -------- ---- -------- ---- Total Revenues $ 42,610 100% $ 26,462 100% ======== ==== ======== ==== Critical Accounting Policies VSE's consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States, which require VSE to make estimates and assumptions. The Company believes the following critical accounting polices affect our more significant judgments, estimates and assumptions used in the preparation of its consolidated financial statements. Revenue Recognition Substantially all of the Company's services are performed for its customers on a contract basis. The three primary types of contracts used are cost-type contracts, time and materials contracts, and fixed-price contracts (70%, 18% and 12%, respectively, of the Company's revenues in 2003). Revenues result from work performed on these contracts by the Company's employees and from pass-through of costs for material and work performed by subcontractors. -14- Revenues on cost-type contracts are recorded as contract allowable costs are incurred and fees earned. Profits on cost-type contracts are equal to the fees that are earned. The BAV contract terms specify award fee payments that are determined by performance and level of contract activity. Award fees are made three times during the year and a contract modification authorizing the award fee payment is issued subsequent to the period in which the work is performed. The Company does not recognize award fee income until the contract modification authorizing the award fee is certain. Due to such timing, and to fluctuations in the level of revenues, profits as a percentage of revenues on this contract will fluctuate from period to period. Revenues for time and materials contracts are recorded on the basis of contract allowable labor hours worked times the contract defined billing rates, plus the cost of materials used in performance on the contract. Profits on time and material contracts result from the difference between the cost of services performed and the contract defined billing rates for these services. Revenues on fixed-price service contracts are recorded as services are provided. Revenues on other fixed-price contracts are recorded as costs are incurred, using the percentage-of-completion method of accounting. Profits on fixed-price contracts result from the difference between the incurred costs and the revenue earned. The Company will occasionally perform work at risk, which is work that is performed prior to the government formalizing funding for such work. Revenue related to work performed at risk is not recognized until it can be reliably estimated and its realization is probable. VSE recognizes this "risk funding" as revenue when the associated costs are incurred or the work is performed. As of March 31, 2004, VSE has recognized approximately $498 thousand in risk funding. VSE believes that it will receive funding for all of this risk funding revenue. VSE is at risk of loss for any risk funding not received. The Company provides for anticipated losses on contracts by a charge to income during the period in which losses are first identified. Long-Lived Assets In assessing the recoverability of long-lived assets, including goodwill and other intangibles, VSE must make assumptions regarding estimated future cash flows and other factors to determine the fair value of the respective assets. If these estimates or their related assumptions change in the future, VSE may be required to record impairment charges for these assets not previously recorded. Goodwill Goodwill and intangible assets with indefinite lives are instead subject to a review for impairment at least annually. As of March 31, 2004, the Company had approximately $1.1 million of unamortized goodwill associated with its acquisition of Energetics in 1995. If at some time in the future it is determined that impairment has occurred, such impairment could potentially have a material adverse impact on the Company's results of operations or financial condition. -15- Contingencies From time to time VSE is subject to proceedings, lawsuits and other claims related to environmental, labor and other matters. VSE is required to assess the likelihood of any adverse judgments or outcomes to these contingencies as well as potential ranges of probable losses and establish reserves accordingly. The amount of reserves required may change in future periods due to new developments in each matter or changes in approach to a matter such as a change in settlement strategy. Income Taxes The carrying value of VSE net deferred tax assets is based on assumptions regarding VSE's ability to generate sufficient future taxable income to utilize these deferred tax assets. If the estimates and related assumptions regarding VSE's future taxable income change in the future, VSE may be required to record valuation allowances against its deferred tax assets, resulting in additional income tax expense. Results of Operations The following table sets forth certain items, including consolidated revenues, pretax income and net income, and the changes in these items for the three month periods ended March 31, 2004 and 2003 (in thousands): 2004 Compared to 2004 2003 2003 ---- ---- ---- Revenues . . . . . . . . . . . . . . . . . $42,610 $26,462 $16,148 ======= ======= ======= Income before income taxes . . . . . . . . $ 1,154 $ 671 $ 483 Provision for income taxes . . . . . . . . 446 239 207 ------- ------- ------- Net income . . . . . . . . . . . . . . . $ 708 $ 432 $ 276 ======= ======= ======= Revenues increased by approximately 61% for the three month period ended March 31, 2004, as compared to the same period of 2003. The primary reasons for the increase in revenues were 1) an increase in work performed under the BAV contract, including increased revenues associated with the Taiwan ship transfer; 2) the CED Rapid Response contract received work orders that generated revenues in 2004, as compared to the prior year when the contract was awarded in February of 2003 and did not generate revenues in that year's first three months; and 3) increased levels of work performed by FMD due primarily to the Navy's elevated readiness requirements. Work requirements and revenues also increased significantly in other VSE divisions, including SED, VCG, and MSD. Revenues of Energetics and VSS were relatively unchanged. The loss of revenues associated with the phase out of TTD was not significant in relation to total company revenues. Pretax income increased by approximately 72% for the three months ended March 31, 2004, as compared to the same period of 2003. The increase in pre-tax income was primarily due to 1) the increase in revenues and the profits -16- associated with these additional revenues; 2) higher profit margins in SED, FMD, MSD, and Energetics attributable in part to the revenue growth and the Company's ability to spread corporate fixed costs over a larger revenue base; and 3) the elimination of any significant losses in TTD in 2004 as compared to TTD pre-tax losses of approximately $161 thousand in the same period of 2003. The increase in pre-tax income in this period was partially offset by losses incurred on the CED Rapid Response support contract. Financial Condition VSE's financial condition did not change materially during the three months ended March 31, 2004. The Company's largest assets are its cash and cash equivalents and its accounts receivable. The largest liabilities are its accounts payable and accrued expenses. Accounts receivable increased approximately $2.4 million, and accounts payable increased approximately $3.1 million during the first three months of 2004 due to an increase in the level of work in March 2004 and the associated billings to customers and subcontractor payments required to perform this work. Cash and cash equivalents increased approximately $390 thousand in the first three months of 2004 as a result of a combination of 1) net income; 2) the timing of customer billings and subcontractor activity and associated payments and expenditures associated with facilities expansion, improvement, and repairs. The increase in total stockholders' investment in this period resulted primarily from earnings and dividend activity and from the exercise of stock options. Liquidity and Capital Resources Cash Flows Cash and cash equivalents increased by approximately $390 thousand during the three months ended March 31, 2004. The increase in cash and cash equivalents during this period resulted from cash provided by operating activities of approximately $1.2 million, cash used in investing activities of approximately $790 thousand, and cash used in financing activities of approximately $51 thousand. Investing activities consisted of expansion and improvement of facilities of approximately $499 thousand and purchases of property and equipment, net of dispositions, of approximately $291 thousand. Financing activities consisted of dividend payments and proceeds received from the issuance of common stock. Cash and cash equivalents decreased by approximately $2.2 million during the three months ended March 31, 2003. The decrease in cash and cash equivalents during this period resulted from cash used in operating activities of approximately $2 million, cash used in investing activities of approximately $138 thousand, and cash used in financing activities of approximately $57 thousand. Investing activities consisted of purchases of property and equipment, net of dispositions. Financing activities consisted of dividend payments and proceeds received from the issuance of common stock. The difference between cash provided by operating activities of approximately $1.2 million in 2004 as compared to cash used in operating activities approximately $2 million in 2003 is primarily due to changes in the levels of accounts receivable and accounts payable resulting from increases in revenue -17- and associated subcontractor activity and receivables collections, and from an increase in net income. Quarterly cash dividends at the rate of $.04 per share were paid during the three months ended March 31, 2004. Under its bank loan agreement, VSE's payment of cash dividends is subject to a maximum annual rate. VSE has paid cash dividends each year since 1973. Liquidity The Company's internal sources of liquidity result primarily from operating activities, specifically from changes in the level of revenues and associated accounts receivable and accounts payable from period to period, and from profitability. Significant increases or decreases in revenue and accounts receivable and accounts payable can cause significant increases or decreases in internal liquidity. Accounts receivable arise primarily from billings made by the Company to the government or other government prime contractors for services rendered and payments received on accounts receivable represent the principal source of cash for the Company. Accounts receivable levels can be affected by contract retainages, differences between the provisional billing rates authorized by the government compared to the costs actually incurred by the Company, government delays in processing administrative paperwork for contract funding, and the timing of large materials purchases and subcontractor efforts used in performance on the Company's contracts. Accounts payable arise primarily from purchases of subcontractor services and materials used by the Company in the performance of its contract work. Payments made on accounts payable, along with payments made to satisfy employee payroll and payroll associated expenses, make up the principal cash requirements of the Company. Accounts payable levels can be affected by changes in the level of contract work performed by the Company and by the timing of large materials purchases and subcontractor efforts used in performance on the Company's contracts. Other cash requirements include the acquisition of capital assets for office and computer support, facilities improvements, and the payment of cash dividends. The Company invested approximately $499 thousand related to expansion and improvement of facilities at two locations during the three months ended March 31, 2004, and plans additional spending of approximately $250 thousand in 2004. These expenditures are for the expansion of its facility in Ladysmith, Virginia in support of the expected growth in its System Engineering Division and improvements at its primary office facility in Alexandria, Virginia. VSE's external sources of liquidity consist of a revolving bank loan agreement that provides loan financing based on the Company's accounts receivable (see "Notes to Consolidated Financial Statements"). The bank financing complements the internal sources of liquidity by providing increasing levels of borrowing capacity as accounts receivable levels increase. The bank loan agreement provided loan financing up to a maximum commitment of $15 million as of March 31, 2004. The Company has determined that the $15 million commitment is adequate to cover current and future liquidity requirements. The Company has not borrowed against this loan in 2004 or 2003. Performance of work under the BAV contract has the potential to cause substantial requirements for working capital; however, management believes that current cash surpluses, cash flows from future operations, and the bank loan commitment are adequate to meet current operating cash requirements. -18- Inflation and Pricing Most of the contracts performed by VSE provide for estimates of future labor costs to be escalated for any option periods provided by the contracts, while the non-labor costs included in such contracts are normally considered reimbursable at cost. VSE property and equipment consists principally of computer systems equipment and furniture and fixtures. The overall impact of inflation on replacement costs of such property and equipment is expected to be insignificant. Disclosures About Market Risk Interest Rates VSE's bank loan financing provides available borrowing to the Company at variable interest rates. The Company has not borrowed significant amounts on the loan in recent years. Accordingly, the Company does not believe that any movement in interest rates would have a material impact on future earnings or cash flows. If VSE were to significantly increase borrowings on the current loan arrangement, future interest rate changes could potentially have such a material impact. Foreign Currency While a significant amount of the Company's business results from the services provided by BAV related to the transfer of ships to foreign governments, the BAV contract payments are made by the U.S. Government in U.S. dollars. Additionally, most funding requirements to support work performed or services purchased in foreign countries are made in U.S. dollars, and the infrequent disbursements that are made in foreign currencies are reimbursable to BAV in post conversion dollars. Foreign currency transactions of other VSE divisions or subsidiaries are virtually non-existent. Accordingly, the Company does not believe that it is exposed to any material foreign currency risk. -19- VSE CORPORATION AND SUBSIDIARIES Item 3. Quantitative and Qualitative Disclosures About Market Risks See "Disclosures About Market Risk" in Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations. Item 4. Controls and Procedures Based on their most recent evaluation, which was completed within 90 days of the filing of this Form 10-Q, the Company's Chief Executive Officer and Chief Financial Officer believe the Company's disclosure controls and procedures (as defined in Securities Exchange Act of 1934 Rules 13a-14 and 15d-14) are effective to ensure that information required to be disclosed by the Company's management, including its principal executive officer and principal financial officer, as appropriate, to allow timely decisions regarding required disclosure. There were no significant changes in the Company's internal control over financial reporting or other factors that could significantly affect these controls subsequent to the date of their evaluation and there were no corrective actions with regard to significant deficiencies and material weaknesses. PART II. Other Information Item 1. Legal Proceedings The Company and its subsidiaries have, in the normal course of business, claims against them. In the opinion of management, the resolution of any such claims will not have a material adverse effect on the Company's results of operations or financial position. Item 6. Exhibits and Reports on Form 8-K (a) Exhibits. Exhibit No. ----------- 10.1 Employment Agreement dated as of March 10, 2004, by and between VSE Corporation and Thomas G. Dacus 10.2 VSE Corporation Deferred Supplemental Compensation Plan effective January 1, 1994, and as amended through March 9, 2004 31.1 Section 302 CEO Certification 31.2 Section 302 CFO and PAO Certification 32.1 Section 906 CEO Certification 32.2 Section 906 CFO and PAO Certification -20- (b) Reports on Form 8-K. The Registrant filed a Current Report on Form 8-K on February 26, 2004, in which the Registrant furnished its financial results for the fiscal year 2003. Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has omitted all other items contained in "Part II. Other Information" because such other items are not applicable or are not required if the answer is negative or because the information required to be reported therein has been previously reported. -21- VSE CORPORATION AND SUBSIDIARIES SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. VSE CORPORATION Date: April 28, 2004 /s/ D. M. Ervine ______________________________________ D. M. Ervine Chairman, President, Chief Executive Officer and Chief Operating Officer -22-