VSE Corp: Form 10-Q for the period ended Sep 30, 2023

Business Overview

We are a diversified aftermarket products and services company providing maintenance, repair and overhaul ("MRO") services, parts distribution, logistics, supply chain management and consulting services for transportation assets to commercial and government markets.

Recent Developments

Sale of Federal and Defense Segment

In May 2023, we entered into a definitive agreement to sell our Federal and Defense (“FDS”) business to an affiliate of Bernhard Capital Partners Management LP. On September 27, 2023, the parties mutually agreed to terminate the agreement. Neither party paid any termination fees. We still intend to pursue divestiture of the segment with an entity that can support its growth plans. As a result of the May 2023 agreement, and because we still intend to divest the business, in accordance with ASC 205-20, Presentation of Financial Statements - Discontinued Operations, results of operations for FDS are reported in income from discontinued operations within the consolidated statements of operations for the three and nine months ended September 30, 2023 and 2022, and the carrying value of the related assets and liabilities are presented within assets and liabilities held-for-sale on the consolidated balance sheets as of September 30, 2023 and December 31, 2022. See Note (3) "Discontinued Operations" to the consolidated financial statements for further information.

Acquisitions

In July 2023, we completed our previously announced acquisition of Desser Holding Company LLC ("Desser Aerospace"), a global aftermarket solutions provider of specialty distribution and MRO services.

In September 2023, we entered into an Asset Purchase and License Agreement with Honeywell International Inc. to exclusively manufacture, sell, market, distribute, and repair certain Honeywell fuel control systems (the "Honeywell FCS Acquisition").

See Note (2) "Acquisitions" to the consolidated financial statements for further information.

Underwritten Public Offering

In July 2023, we initiated a public offering of the Company's common stock relating to the issuance and sale of 2,846,250 shares at a public offering price of $48.50 per share. The offering closed in two transactions, and net proceeds of $129.1 million was received by the Company, which were used to repay outstanding borrowings under our revolving credit facility and for general corporate purposes. See Note (1) "Nature of Operations and Basis of Presentation" to the consolidated financial statements for further information.

Business Trends

The following discussion provides a brief description of some of the key business factors impacting our results of operations detailed by segment.

Aviation Segment

During the third quarter, our strong program execution of new and existing distribution awards, an expansion of product offerings and MRO capabilities, increased market activity, and contributions from the Desser Aerospace acquisition produced strong results, with quarterly revenue reaching $152.4 million for the three months ended September 30, 2023, representing a 48% increase year-over-year. Market growth and share gains have resulted in a 54% and 46% year-over-year increase in repair and distribution revenue, respectively, during the three months ended September 30, 2023, compared to the same period for the prior year. Our growth has been driven by several strategic initiatives, including the introduction of new products and service capabilities to our portfolio, further strengthening our position in the market. Additionally, expanding our partnerships with Original Equipment Manufacturers has provided us new opportunities, including access to new markets with an established customer base. We believe the July 2023 acquisition of Desser Aerospace will increase our exposure to the high-growth, higher-margin aviation distribution and MRO markets. We believe that the combination of Desser Aerospace’s distribution and MRO capabilities coupled with VSE Aviation’s aftermarket business capabilities and offerings creates a platform for geographic expansion into international markets and provides opportunities to cross-sell products and services. Furthermore, we believe that

-21- the Honeywell FCS Acquisition to exclusively manufacture, sell, market, distribute, and repair certain Honeywell fuel control systems expands our existing capabilities and provides access to new customers and end markets while strengthening our partnership with Honeywell.

Fleet Segment

During the third quarter, growth in our Fleet segment was driven by contributions from commercial fleet customers, e-commerce fulfillment volume, and the United States Postal Service ("USPS"). The solid performance of our USPS program is supported by the expansion of the installed base of USPS vehicles and continued support of legacy vehicles. We have made significant progress in executing our revenue diversification strategy through the successful launch of our new e-commerce fulfillment and distribution center, including the completion of initial inventory investments. These strategic initiatives have been instrumental in our ability to capture new customers and drive revenue growth within e-commerce fulfillment. Our commercial revenues were 47% of total Fleet segment revenue for the three months ended September 30, 2023, compared to 39% for the same period in the prior year, demonstrating the continued success of our diversification strategy.

Results of Operations

Consolidated Results of Operations

The following table summarizes our consolidated results of operations (in thousands):

Revenues. Revenues increased for the three months ended September 30, 2023, as compared to the same period in the prior year due to growth in our Aviation segment of $49.7 million and our Fleet segment of $14.2 million. See "Segment Operating Results" section below for further discussion of revenues by segment.

Revenues increased for the nine months ended September 30, 2023, as compared to the same period in the prior year due to growth in our Aviation segment of $89.4 million and our Fleet segment of $38.3 million. See "Segment Operating Results" section below for further discussion of revenues by segment.

Costs and Operating Expenses. Costs and operating expenses increased for the three and nine months ended September 30, 2023, as compared to the same periods in the prior year primarily due to increases in revenue. Costs and operating expenses for our operating segments increase and decrease in conjunction with the level of business activity and revenues generated by each segment. See "Segment Operating Results" for discussion of cost and operating expenses by segment.

Operating Income. Operating income increased for the three months ended September 30, 2023, compared to the same period of the prior year primarily due to an increase of $10.9 million for our Aviation segment and $2.0 million for our Fleet segment. See "Segment Operating Results" for a discussion of operating income by segment. The operating income increase attributable to our segments was partially offset by an increase in corporate costs, including acquisition and integration costs incurred during the current period.

Operating income increased for the nine months ended September 30, 2023, compared to the same period of the prior year primarily due to an increase of $28.3 million for our Aviation segment and an increase of $4.0 million for our Fleet segment. See "Segment Operating Results" for a discussion of operating income by segment. The operating income increase attributable to our

-22- segments was partially offset by an increase in corporate costs, including acquisition and integration costs incurred during the current period.

Interest Expense. Interest expense increased for the three and nine months ended September 30, 2023, as compared to the same periods in the prior year primarily due to an increase in our debt facility borrowings and a higher average interest rate on borrowings outstanding.

Provision for Income Taxes. Our effective tax rate for continued operations was 27.9% and 25.8% for the three and nine months ended September 30, 2023, respectively, and 25.2% and 26.1% for the three and nine months ended September 30, 2022, respectively. Our tax rate is affected by discrete items that may occur in any given year but may not be consistent from year to year. Permanent differences such as foreign derived intangible income deduction, Section 162(m) limitation, capital gains tax treatment, state income taxes, certain federal and state tax credits and other items caused differences between our statutory U.S. Federal income tax rate and our effective tax rate. The higher effective tax rate for the three months ended September 30, 2023, primarily resulted from various transaction costs incurred in 2023 in connection with the Desser Aerospace acquisition that was disallowed for tax purposes. The lower effective tax rate for the nine months ended September 30, 2023, was attributable to higher pre-tax book income reported in the current year.

Segment Operating Results

Aviation Segment Results

The results of operations for our Aviation segment were as follows (in thousands):

Revenues. Revenues for our Aviation segment increased for the three months ended September 30, 2023, compared to the same period of the prior year primarily driven by contributions from our acquisition of Desser Aerospace, recently initiated distribution contract wins and improved demand for our commercial aerospace products and services resulting from strong end market activity in global commercial air travel. Aviation distribution revenue increased $34.0 million, or 46%, and repair revenue increased $15.7 million, or 54%, for the three months ended September 30, 2023, compared to the same period in the prior year.

Revenues for our Aviation segment increased for the nine months ended September 30, 2023, compared to the same period of the prior year primarily driven by contributions from our acquisition of Desser Aerospace, recently initiated distribution contract wins and improved demand for our commercial aerospace products and services resulting from strong end market activity in global commercial air travel. Aviation distribution revenue increased $54.4 million, or 24%, and repair revenue increased $35.0 million, or 45%, for the nine months ended September 30, 2023, compared to the same period in the prior year.

Costs and operating expenses. Costs and operating expenses increased for the three months ended September 30, 2023, compared to the same period of the prior year primarily due to increased revenues. Costs and operating expenses for this segment included expenses for amortization of intangible assets associated with acquisitions and allocated corporate costs. Expense for amortization of intangible assets was $3.2 million for the three months ended September 30, 2023, compared to $2.3 million for the same period in the prior year. Allocated corporate costs were $3.1 million for the three months ended September 30, 2023, compared to $3.3 million for the same period in the prior year.

Costs and operating expenses increased for the nine months ended September 30, 2023, compared to the same period of the prior year primarily due to increased revenues. Costs and operating expenses for this segment included expenses for amortization of intangible assets associated with acquisitions and allocated corporate costs. Expense for amortization of intangible assets was $8.1 million for the nine months ended September 30, 2023, compared to $7.0 million for the same period in the prior year. Allocated corporate costs were $9.3 million for the nine months ended September 30, 2023, compared to $9.1 million for the same period in the prior year.

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Operating income. Operating income increased for the three and nine months ended September 30, 2023, compared to the same period of the prior year primarily due to revenue growth and a favorable shift in sales mix and pricing.

Fleet Segment Results

The results of operations for our Fleet segment were as follows (in thousands):

Revenues. Revenues for our Fleet segment increased for the three months ended September 30, 2023, compared to the same period of the prior year primarily due to increases from commercial customers of $12.0 million, or 47%, and other government customers of $2.4 million, or 6%. Commercial customer revenue growth was driven by our commercial fleet and e-commerce fulfillment business. Revenues from other government customers increased primarily due to increased support of legacy USPS vehicle fleets.

Revenues for our Fleet segment increased for the nine months ended September 30, 2023, compared to the same period of the prior year primarily due to increases from commercial customers of $28.8 million, or 36%, and other government customers of $12.7 million, or 11%. These increases were partially offset by decreased revenues from DoD customers of $3.2 million. Commercial customer revenue growth was driven by our commercial fleet and e-commerce fulfillment business. Revenues from other government customers increased primarily due to increased support of legacy USPS vehicle fleets.

Costs and operating expense. Costs and operating expenses increased for the three months ended September 30, 2023, compared to the same period of the prior year primarily due to increased revenues. In addition, costs and operating expenses for this segment included expenses for amortization of intangible assets associated with acquisitions and allocated corporate costs. Expense for amortization of intangible assets was immaterial for the three months ended September 30, 2023 compared to $1.5 million for the same period in the prior year. Expense for allocated corporate costs was $2.0 million for the three months ended September 30, 2023 and 2022.

Costs and operating expenses increased for the nine months ended September 30, 2023 compared to the same period of the prior year primarily due to increased revenues. In addition, costs and operating expenses for this segment included expenses for amortization of intangible assets associated with acquisitions and allocated corporate costs. Expense for amortization of intangible assets was $2.6 million for the nine months ended September 30, 2023, compared to $5.0 million for the same period in the prior year. Expenses for allocated corporate costs was $6.1 million for the nine months ended September 30, 2023, and $5.9 million for the same period in the prior year.

Operating income. Operating income increased for the three and nine months ended September 30, 2023, compared to the same period of the prior year primarily driven by increased revenues.

Liquidity and Capital Resources

Liquidity

Our internal sources of liquidity are primarily from operating activities, specifically from changes in our level of revenues and associated inventory, accounts receivable and accounts payable, and from profitability. Significant increases or decreases in revenues and inventory, accounts receivable and accounts payable can affect our liquidity. Our inventory and accounts payable levels can be affected by the timing of large opportunistic inventory purchases and by distributor agreement requirements. Our accounts receivable and accounts payable levels can be affected by changes in the level of work we perform and by the timing of large purchases. In addition to operating cash flows, other significant factors that affect our overall management of liquidity include capital expenditures, and investments in the acquisition of businesses.

Our primary sources of external financing are the capital markets and our credit agreement. Our credit agreement is with a bank group and includes a term loan and a revolving facility, with an aggregate maximum borrowing capacity of our revolving facility

-24- of $350.0 million. Under the credit agreement we may elect to increase the maximum availability of the term loan, the revolving facility, or a combination of both, subject to customary lender commitment approvals. The aggregate limit of increases is $25.0 million. Our outstanding borrowings under the credit agreement increased approximately $174.9 million for the nine months ended September 30, 2023. As of September 30, 2023, we had borrowings outstanding under our term loan of $182.5 million, borrowings outstanding under our revolving facility of $281.0 million, outstanding letters of credit of $0.7 million, and $68.3 million of unused commitments under the credit agreement.

In July 2023, we entered into a fifth amendment to our credit agreement which, among other things, provided for the following: (i) the extension of a new term loan in the aggregate principal amount of $90.0 million, which will mature on the same date as the existing term loan; (ii) a reduction in our capacity to incur incremental revolving or term loan credit facilities from $100.0 million to $25.0 million; (iii) quarterly amortization payments for the new term loan in the amount of $2.25 million; (iv) an increase in the maximum Total Funded Debt to EBITDA Ratio from 4.50x to 5.00x, with such ratios decreasing thereafter as indicated in the table below; (v) the addition of a tier to the top of the pricing grid if the Total Funded Debt to EBITDA ratio exceeds 4.50x; and (vi) expressly permitting the Desser Aerospace acquisition and subsequent and simultaneous business sale to Loar.

In July 2023, we entered into an underwriting agreement with William Blair & Company, L.L.C and RBC Capital Markets, acting as representatives of several underwriters, relating to the issuance and sale of 2,846,250 shares of the Company's common stock at a public offering price of $48.50 per share. The issuance and sale of shares pursuant to the agreement was executed in two transactions, with the first transaction closing on July 24, 2023, and the second transaction closing on July 28, 2023. We received proceeds of $129.1 million in connection with the offerings, net of issuance costs.

We believe our existing balances of cash and cash equivalents, along with our cash flows from operations and debt instruments under our credit agreement mentioned above, will provide sufficient liquidity for our business operations as well as capital expenditures, dividends, and other capital requirements associated with our business operations over the next twelve months and thereafter for the foreseeable future.

Cash Flows

The following table summarizes our cash flows (in thousands):

Cash used in operating activities increased $45.6 million for the nine months ended September 30, 2023, as compared to the same period of the prior year. The increase was primarily due to greater use of cash for inventory purchases.

Cash used in investing activities increased $224.7 million for the nine months ended September 30, 2023, as compared to the same period of the prior year. The increase was primarily due to cash paid for acquisitions, net of cash acquired of $218.7 million related to acquisitions during the current year as discussed in Note (2) "Acquisitions" to the consolidated financial statements.

Cash provided by financing activities increased $291.1 million for the nine months ended September 30, 2023, as compared to the same period of the prior year. The increase was primarily due to the receipt of $129.1 million in proceeds related to our public

-25- underwritten offering of our common stock in July 2023 and overall higher proceeds from net borrowings of our debt during the current period due primarily to the increase in our term loan facility.

We paid cash dividends totaling $3.9 million or $0.30 per share during the nine months ending September 30, 2023. Pursuant to our credit agreement, our payment of cash dividends is subject to annual restrictions. We have paid cash dividends each year since 1973.

Other Obligations and Commitments

There have not been any material changes to our other obligations and commitments that were included in our Annual Report on Form 10-K for the year ended December 31, 2022.

Inflation and Pricing

There have not been any material changes to this disclosure from those discussed in our most recently filed Annual Report on Form 10-K.

Off-Balance Sheet Arrangements

We do not have any off-balance sheet arrangements that have, or are reasonably likely to have, a current or future material effect on our financial condition, changes in financial condition, revenue or expenses, results of operations, liquidity, capital expenditures or capital resources.

Disclosures About Market Risk

Interest Rate Risk

Our credit agreement provides available borrowing to us at variable interest rates. Our interest expense is impacted by the overall global economic and interest rate environment. The inflationary environment has also resulted in central banks raising short-term interest rates. Accordingly, future interest rate changes could potentially put us at risk for a material adverse impact on future earnings and cash flows. To mitigate the risks associated with future interest rate movements we have employed interest rate hedges to fix the rate on a portion of our outstanding borrowings for various periods.

For additional information related to our debt and interest rate swap agreements, see Note (5) and Note (6), respectively, to our Consolidated Financial Statements contained in this report.

Other than as discussed above, there have been no material changes to our market risks from those discussed in our most recently filed Annual Report on Form 10-K.

Critical Accounting Policies, Estimates and Judgments

Our consolidated financial statements are prepared in accordance with United States Generally Accepted Accounting Principles ("U.S. GAAP"), which require us to make estimates and assumptions. Certain critical accounting policies affect the more significant accounts, particularly those that involve judgments, estimates and assumptions used in the preparation of our consolidated financial statements, including revenue recognition, inventory valuation, business combinations, goodwill and intangible assets, and income taxes. If any of these estimates, assumptions or judgments prove to be incorrect, our reported results could be materially affected. Actual results may differ significantly from our estimates under different assumptions or conditions. See "Item 7. Management Discussion and Analysis of Financial Condition and Results of Operations" and Note (1) "Nature of Business and Summary of Significant Accounting Policies" in our 2022 Annual Report on Form 10-K for further discussions of our significant accounting policies and estimates. There have been no significant changes in our critical accounting estimates during the nine months ended September 30, 2023, from those disclosed in our most recently filed Annual Report on Form 10-K.

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Recently Issued Accounting Pronouncements

For a description of recently announced accounting standards, including the expected dates of adoption and estimated effects, if any, on our consolidated financial statements, see Note (1) "Nature of Business and Summary of Significant Accounting Policies — Recent Adopted Accounting Pronouncements” to our Consolidated Financial Statements included in our Annual Report on Form 10-K for the year ended December 31, 2022.

See "Disclosures About Market Risk" in Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations.

Evaluation of Disclosure Controls and Procedures

Our management has evaluated, with the participation of our Chief Executive Officer and Chief Financial Officer, the effectiveness of the disclosure controls and procedures (as defined in Rules 13a-15(e) or 15d-15(e) under the Securities Exchange Act of 1934, as amended (the "Exchange Act")). Based on this evaluation, our Chief Executive Officer and Chief Financial Officer have concluded that, as of September 30, 2023, our disclosure controls and procedures were effective to ensure that information we are required to disclose in reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in SEC rules and forms and that such information is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure.

Changes in Internal Control Over Financial Reporting

In connection with our acquisition of Desser Aerospace, certain areas of internal control over financial reporting changed. These areas are primarily related to integrating our corporate functions such as entity level controls and certain financial reporting controls. Certain control structure items remain in operation at Desser Aerospace, primarily related to information technology, inventory management, human resources, processing and billing of revenues, and collection of those revenues. The control structure at Desser Aerospace has been modified to appropriately oversee and incorporate these activities into the overall control structure. We will continue to evaluate the need for additional internal controls over financial reporting.

There have been no additional changes in our internal control over financial reporting during the quarterly period covered by this report that materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

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The risk factors disclosed in our Annual Report on Form 10-K for the fiscal year ended December 31, 2022 ("2022 Form 10-K”) should be considered together with information included in this Quarterly Report on Form 10-Q for the quarter ended September 30, 2023, and under "Forward-Looking Statements" and "Management's Discussion and Analysis of Financial Condition and Results of Operations." The risk factors set forth in our 2022 Form 10-K are updated by adding the following:

Circumstances associated with divestitures could adversely affect the Company's results of operations and financial condition.

We may periodically divest or seek to divest of certain businesses, including businesses or assets included in our Federal and Defense segment that are no longer a part of our ongoing strategic plan. A decision to divest or discontinue a business or product line may result in asset impairments, including those related to goodwill and other intangible assets, and losses upon disposition, both of which could have adverse effect on our results of operations and financial condition. In addition, we may encounter difficulty in finding buyers or executing alternative exit strategies at acceptable prices and terms and in a timely manner and prospective buyers may have difficulty obtaining financing. These divestitures may require significant investment of time and resources and may disrupt our business, distract management from other responsibilities, and may involve the retention of certain current or future liabilities in order to induce a buyer to complete a divestiture or may otherwise result in losses on disposal or continued financial involvement in the divested business, including through indemnification or other arrangements, for a period of time following the transaction, which could adversely affect our financial results. We may not be successful in managing these or any other significant risks that we may encounter in divesting or discontinuing a business or product line, which could have a material adverse effect on our business.