# VSE CORP (VSEC) FY 2023 MD&A Verbatim Item 7 Management's Discussion and Analysis from VSE CORP's 10-K for fiscal year 2023. SEC filing source: https://www.sec.gov/Archives/edgar/data/102752/000010275224000017/vsec-20231231.htm Accession: 0000102752-24-000017 Filing date: 2024-03-08 Report date: 2023-12-31 Extracted structurally from real Item 7 body heading to real Item 7A/8 boundary. Published MD&A gate trimmed front/tail over-capture. Confidence: high Company profile: /company/VSEC/ All MD&A years: /company/VSEC/mda/ Previous year: /company/VSEC/mda/fy2022/ (FY 2022) Next year: /company/VSEC/mda/fy2024/ (FY 2024) ITEM 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations The following discussion and analysis should be read in conjunction with our consolidated statements and related notes included in Item 8. "Financial Statements and Supplementary Data" of this Annual Report on Form 10-K. The following generally discusses 2023 and 2022 items and year-to-year comparisons between 2023 and 2022. Discussions of 2021 items and year-to-year comparisons between 2022 and 2021 that are not included in this Form 10-K can be found under Item 7. "Management's Discussion and Analysis of Financial Condition and Results of Operations" in our Annual Report on Form 10-K for fiscal year ended December 31, 2022, filed with the SEC on March 10, 2023. Business Overview We are a leading provider of aftermarket distribution and maintenance, repair and overhaul ("MRO") services for air and land transportation assets for commercial and government markets. Our operations are conducted within two reportable segments aligned with our operating segments: Aviation and Fleet. Recent Developments Sale of Federal and Defense Segment In May 2023, we announced our decision to sell our Federal and Defense segment. As a result, we have reported the results of operations for the Federal and Defense segment as discontinued operations for all periods presented. See Note (3) "Discontinued Operations" to our Consolidated Financial Statements for further information. In February 2024, we entered into two separate agreements to sell substantially all of the Federal and Defense segment assets. See Note (18) "Subsequent Events" for further information. Acquisition of Turbine Controls, Inc. On February 29, 2024, we signed a definitive agreement to acquire Turbine Controls, Inc. ("TCI"), a leading provider of aftermarket MRO support services for complex engine components, as well as engine and airframe accessories, across commercial and military applications. See Note (18) "Subsequent Events" for further information. 2023 Acquisitions In February 2023, we completed the acquisition of Precision Fuel Components, LLC ("Precision Fuel"), a provider of MRO services for engine accessories and fuel systems supporting the business and general aviation ("B&GA") market. In July 2023, we completed the 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 were received by the Company, which were used to repay outstanding borrowings under our revolving credit facility and for general corporate purposes. See Note (15) "Capital Stock" 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. -19- Table of Contents Aviation Segment Our Aviation segment has seen favorable results due to successful investments in growth initiatives, resulting in a 33% increase in annual revenue, totaling $544 million in 2023. The expansion of our distribution services was driven by strong execution of new and existing programs. Our repair business experienced growth driven by increased market share in the commercial and B&GA sectors. These factors, combined with our growth initiatives, led to a 29% increase in distribution revenue and a 46% increase in repair revenue in 2023 compared to the prior year. In 2023, we secured key multi-year distribution deals for both domestic and new international markets, including an expansion of our flagship distribution agreement with Pratt & Whitney Canada supporting Europe, the Middle East, and Africa. These new distribution initiatives are expected to drive sustainable and recurring revenue with growth opportunities, contributing to future positive results. Investments in the Aviation segment are focused on businesses and programs that broaden our portfolio and reach new customers and geographies. The February 2023 acquisition of Precision Fuel expands our product offerings and customer base, offering strategic cross-selling opportunities and market share in niche B&GA related markets. The July 2023 acquisition of Desser Aerospace supports our tip-to-tail aircraft distribution and MRO services strategy and provides a platform for international expansion. The September 2023 Honeywell FCS Acquisition allows us to exclusively manufacture and support certain of Honeywell's fuel control systems on four key engine platforms. The Aviation segment is expected to see continued growth due to progress on new initiatives and recent acquisitions, offering a favorable outlook for 2024. Fleet Segment Our Fleet segment continues to see growth in revenue from commercial fleet customers and e-commerce fulfillment, as the segment moves towards revenue diversification. Fleet is executing its revenue diversification strategy by acquiring new customers and expanding product options for the e-commerce fulfillment business. Commercial customer revenue continues to experience strong growth, increasing 45% in 2023 compared to the prior year. We anticipate continued growth as we extend our reach to meet the increasing demand from the commercial market. In 2023, commercial revenues were 48% of total Fleet segment revenue compared to 40% in 2022, demonstrating the continued success of our revenue diversification strategy. To support commercial revenue, Fleet opened a new distribution warehouse and e-commerce center of excellence in Olive Branch, MS (near Memphis, TN), in January 2023. The new facility, which is 450,000 square feet, enhances Fleet's geographical coverage and product offerings for customers. The launch of this new location allowed Fleet to keep up with the growing demand for e-commerce fulfillment. Additionally, we generated steady revenue from our support of the United States Postal Services ("USPS") delivery vehicle fleet through supplying parts and managing inventory, with revenue increasing 8% in 2023 compared to the prior year. We continue to monitor USPS vehicle procurement and are ready to support both new vehicles added to the fleet and existing vehicles still in service. Our experience and understanding of the USPS' needs strategically position us to remain a key partner. We are committed to remaining agile and supporting the USPS during its vehicle transition. We expect continued growth within our commercial channels, coupled with stable contributions from the USPS. Results of Operations The following table summarizes our consolidated results of operations (in thousands): [[GREPCENT_TABLE]] [["","Years ended December 31,"],["","2023","","2022","","Change ($)","","Change (%)"],["Revenues","$","860,488","","","$","669,448","","","$","191,040","","","29","%"],["Costs and operating expenses","772,492","","","615,844","","","156,648","","","25","%"],["Operating income","87,996","","","53,604","","","34,392","","","64","%"],["Interest expense, net","31,083","","","17,893","","","13,190","","","74","%"],["Income from continuing operations before income taxes","56,913","","","35,711","","","21,202","","","59","%"],["Provision for income taxes","13,761","","","9,052","","","4,709","","","52","%"],["Net income from continuing operations","$","43,152","","","$","26,659","","","$","16,493","","","62","%"]] [[/GREPCENT_TABLE]] Revenues. Revenues increased $191.0 million, or 29%, in 2023 compared to 2022 due to revenue growth in our Aviation segment of $135.9 million and our Fleet segment of $55.1 million. See "Segment Operating Results" section below for further discussion of revenues by segment. Costs and Operating Expenses. Costs and operating expenses increased $156.6 million, or 25%, in 2023 compared to 2022. Costs and operating expenses for our operating segments increase and decrease in conjunction with the level of business -20- Table of Contents activity and revenues generated by each segment. See "Segment Operating Results" section below for further discussion of costs and operating expenses by segment. Operating Income. Operating income increased $34.4 million, or 64%, in 2023 compared to 2022 attributable to increases of $34.8 million for our Aviation segment and $7.3 million for our Fleet segment. See "Segment Operating Results" section below for further discussion of operating income by segment. The operating income increase attributable to our segments was partially offset by an increase in corporate costs, including acquisition and integration costs incurred during the current period. Interest Expense. Interest expense increased approximately $13.2 million, or 74% in 2023 compared to 2022 primarily due to an increase in our debt facility borrowings and higher average interest rates on borrowings outstanding. Provision for Income Taxes. The effective tax rate for continued operations was 24.2% in 2023 compared to 25.3% in 2022. The decrease in our effective tax rate primarily resulted from book income in connection with an increase in the fair market value of our corporate owned life insurance ("COLI") plan assets in 2023 versus book expense recorded in 2022. For tax purposes, current year COLI book income was nontaxable income resulting in a reduction to our effective tax rate as opposed to 2022 nondeductible COLI loss that increased our effective tax rate. Our tax rate is also affected by discrete items that may occur in any given year but may not be consistent from year to year. In addition to state income taxes, certain federal and state tax credits and permanent book-tax differences such as foreign derived intangible income ("FDII") deduction, I.R.C. Section 162(m) executive compensation limitation and unrealized investment income or loss from our COLI plan caused differences between the statutory U.S. federal income tax rate and our effective tax rate. Segment Operating Results Aviation Segment Results The results of operations for our Aviation segment were as follows (in thousands): [[GREPCENT_TABLE]] [["","Years ended December 31,"],["","2023","","2022","","Change ($)","","Change (%)"],["Revenues","$","544,020","","","$","408,112","","","$","135,908","","","33","%"],["Costs and operating expenses","472,852","","","371,696","","","101,156","","","27","%"],["Operating income","$","71,168","","","$","36,416","","","$","34,752","","","95","%"]] [[/GREPCENT_TABLE]] Revenues. Revenues increased $135.9 million, or 33%, in 2023 compared to 2022. Distribution revenue increased $86.2 million, or 29%, driven by strong program execution on new and existing distribution contracts and contributions from the acquisition of Desser Aerospace (which occurred in July 2023). Repair revenue increased $49.8 million, or 46%, driven by an expansion of repair capabilities, improved end market demand, and share gains with commercial and B&GA customers. Costs and Operating Expenses. Costs and operating expenses increased $101.2 million, or 27%, in 2023 compared to 2022 primarily due to increased revenues as discussed above. 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 increased $2.4 million in 2023 to $11.7 million from $9.3 million in 2022 driven by newly acquired intangibles in connection with acquisitions completed in the current year. Expense for allocated corporate costs was $12.9 million for 2023 and 2022, respectively. Operating Income. Operating income increased $34.8 million, or 95%, in 2023 compared to 2022 primarily due to revenue growth and a favorable shift in sales mix and pricing. -21- Table of Contents Fleet Segment Results The results of operations for our Fleet segment were as follows (in thousands): [[GREPCENT_TABLE]] [["","Years ended December 31,"],["","2023","","2022","","Change ($)","","Change (%)"],["Revenues","$","316,468","","","$","261,336","","","$","55,132","","","21","%"],["Costs and operating expenses","285,211","","","237,425","","","47,786","","","20","%"],["Operating income","$","31,257","","","$","23,911","","","$","7,346","","","31","%"]] [[/GREPCENT_TABLE]] Revenues. Revenues increased $55.1 million, or 21%, in 2023 compared to 2022. The increase was primarily from commercial customers of $46.7 million, or 45%, and other government customers (primarily USPS) of $11.5 million, or 7%. 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. These increases were partially offset by a decrease in sales to DoD customers of $3 million, or 94%. Costs and Operating Expenses. Costs and operating expenses increased $47.8 million, or 20%, primarily due to increased revenues. In addition, costs and operating expenses for this segment included expense for amortization of intangible assets associated with acquisitions and allocated corporate costs. Expense for amortization of intangible assets decreased $3.8 million in 2023 to $2.6 million from $6.4 million in 2022 driven by intangibles becoming fully amortized during the current year. Expense for allocated corporate costs was $7.8 million for 2023 and $7.5 million for 2022. Operating Income. Operating income increased $7.3 million, or 31%, in 2023 compared to 2022, primarily driven by increased revenues, a change in mix of products sold, and decreased amortization expense. Financial Condition There has been no material adverse change in our financial condition in 2023. Our outstanding borrowings under our term loan and revolving facility increased $144 million, and we had $216 million of unused commitments under the credit agreement as of December 31, 2023. In July 2023, we completed an underwritten public offering of 2,846,250 shares of the Company's common stock, generating proceeds of $129.1 million in connection with the offering, net of issuance costs. Changes to other asset and liability accounts were primarily due to our earnings; our level of business activity; the timing and level of inventory purchases to support new distribution programs, and vendor payments required to perform our work; and collections from our customers. Liquidity and Capital Resources Cash Flows The following table summarizes our cash flows (in thousands): [[GREPCENT_TABLE]] [["","Year ended December 31,"],["","2023","","2022"],["Net cash (used in) provided by operating activities","$","(21,829)","","","$","8,051"],["Net cash used in investing activities","(235,690)","","","(2,377)"],["Net cash provided by (used in) financing activities","264,971","","","(5,714)"],["Net increase (decrease) in cash and cash equivalents","$","7,452","","","$","(40)"]] [[/GREPCENT_TABLE]] Cash used in operating activities was $21.8 million in 2023 compared to cash provided by operating activities of $8.1 million in 2022. The change was primarily due to greater use of cash for inventory purchases. Cash used in investing activities increased $233.3 million in 2023 compared to 2022 primarily due to cash paid for acquisitions, net of cash acquired, of $218.6 million in connection with acquisitions during the current period as discussed in Note (2) "Acquisitions" to the consolidated financial statements. -22- Table of Contents Cash provided by financing activities was $265.0 million in 2023 compared to cash used in financing activities of $5.7 million in 2022. The change was primarily due to the receipt of $129.1 million in proceeds related to our public underwritten offering of our common stock in July 2023 and overall higher proceeds from net borrowings of our debt during the current period primarily related to the increase in our term loan facility borrowings to fund cash paid for acquisitions. We paid cash dividends totaling approximately $5.4 million, or $0.40 per share, in 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. 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; investments in expansion; improvement and maintenance of our operational and administrative facilities; and investments in the acquisition of businesses. Our primary source of external financing is 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 under our revolving facility 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. 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; (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 Group Inc. [[GREPCENT_TABLE]] [["Testing Period","","Maximum Total Funded Debt to EBITDA Ratio"],["June 30, 2023 through and including September 30, 2023","","5.00 to 1.00"],["December 31, 2023 through and including June 30, 2024","","4.75 to 1.00"],["September 30, 2024","","4.50 to 1.00"],["December 31, 2024 through and including March 31, 2025","","4.25 to 1.00"],["June 30, 2025","","4.00 to 1.00"],["September 30, 2025 and thereafter","","3.75 to 1.00"]] [[/GREPCENT_TABLE]] On December 28, 2023, we entered into a sixth amendment to our credit agreement which, among other things, provided for the following: (i) an increase in the aggregate principal amount of the term loan from $177.5 million to $300 million and an extension of the maturity date of the term loan by one year to October 7, 2026; (ii) a modification to the amortization payments on the term loan from $5.0 million quarterly to $7.5 million quarterly, commencing with the first quarterly amortization payment due on April 1, 2024; and (iii) an extension of the maturity date of the revolving credit facility by one year to October 7, 2026. As a result of the amendment, the capacity under the revolving facility remained unchanged and we have increased availability under the revolving facility by approximately $122.0 million. 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. -23- Table of Contents Other Obligations and Commitments See Note (7) "Debt" to our Consolidated Financial Statements for information regarding our long-term debt obligations. We estimate cash requirements for interest payments on our debt facilities to be approximately $32.1 million for 2024, $28.7 million for 2025, and $23.0 million for 2026. The estimates do not take into account future draw downs and repayments on the debt or changes in the variable interest rate, and actual interest may be different. The estimates included variable rate interest obligations estimated based on rates as of December 31, 2023. The interest payments are estimated through the maturity date of our term loan. Interest payments under our revolving facility have been excluded because a reasonable estimate of timing and amount of cash out flows cannot be determined. See Note (12) "Leases" to our Consolidated Financial Statements for information pertaining to future minimum lease payments relating to our operating lease obligations. Inflation and Pricing Our Aviation and Fleet segments have experienced broad-based inflationary impacts consistent with overall trends in the aerospace and industrial distribution market, due primarily to increased materials, labor, and services costs. The effect of these increased costs on total company net income has been mitigated with improved efficiency in our underlying business through productivity improvements and pass-through price increases. Given broader inflation in the economy, we are monitoring the risk inflation presents to active and future contracts. 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. 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. The development and selection of these critical accounting policies have been determined by our management. Due to the significant judgment involved in selecting certain of the assumptions used in these policies, it is possible that different parties could choose different assumptions and reach different conclusions. We consider our policies relating to the following matters to be critical accounting policies. Revenue Recognition We account for revenue in accordance with ASC 606. The unit of account in ASC 606 is a performance obligation. At the inception of each contract with a customer, we determine our performance obligations under the contract and the contract's transaction price. A performance obligation is a promise in a contract to transfer a distinct good or service to the customer and is defined as the unit of account. A contract’s transaction price is allocated to each distinct performance obligation and recognized as revenue when the performance obligation is satisfied. The majority of our contracts have a single performance obligation to transfer goods or services. Our performance obligations are satisfied over time as work progresses or at a point in time based on transfer of control of products and services to our customers. Our Aviation segment revenues result from the sale of aircraft parts and the performance of MRO services. Our Aviation segment recognizes revenues for the sale of aircraft parts at a point in time when control is transferred to the customer, which usually occurs when the parts are shipped. Our Aviation segment recognizes revenues for MRO services over time as the services are transferred to the customer. MRO services revenue recognition is measured based on the cost-to-cost input method, as costs incurred reflect the work completed, and therefore, the services transferred to date. Sales returns and allowances are not significant. Substantially all Fleet segment revenues from the sale of vehicle parts to customers are recognized at the point in time of the transfer of control to the customer. Sales returns and allowances for vehicle parts are not significant. -24- Table of Contents Inventory Valuation Inventories are stated at the lower of cost or net realizable value using the first-in, first-out ("FIFO") method. Inventories for our Aviation segment consist primarily of aftermarket parts for distribution, and general aviation engine accessories and parts, and also include related purchasing, overhaul labor, storage and handling costs. Inventories for our Fleet segment consist primarily of vehicle replacement parts, and also include related purchasing, storage and handling costs. We periodically evaluate the carrying value of inventory, considering factors such as its physical condition, sales patterns and expected future demand in order to estimate the amount necessary to write down any slow moving, obsolete or damaged inventory. These estimates could vary significantly from actual amounts based on future economic conditions, customer inventory levels or competitive factors that were not foreseen or did not exist when the estimated write-downs were made. Business Combinations We account for business combinations under the acquisition method of accounting. The purchase price of each business acquired is allocated to the tangible and intangible assets acquired and the liabilities assumed based on information regarding their respective fair values on the date of acquisition. Any excess of the purchase price over the fair value of the separately identifiable assets acquired and liabilities assumed is allocated to goodwill. Determining the fair value of assets acquired and liabilities assumed requires management's judgment and often involves the use of significant estimates and assumptions, including assumptions with respect to future cash inflows and outflows, discount rates, and market multiples, among other items. We determine the fair values of intangible assets acquired generally in consultation with third-party valuation advisors. The valuation of assets acquired and liabilities assumed requires a number of judgments and is subject to revision as additional information about the fair values becomes available. We will recognize any adjustments to provisional amounts that are identified during the period not to exceed twelve months from the acquisition date (the "measurement period") in which the adjustments are determined. Acquisition costs are expensed as incurred. The results of operations of businesses acquired are included in the consolidated financial statements from their dates of acquisition. Valuation of Goodwill and Intangible Assets Goodwill represents the excess of fair value of consideration paid for an acquisition over the fair value of the net assets acquired and liabilities assumed as of the acquisition date. We recognize purchased intangible assets in connection with our business acquisitions at fair value on the acquisition date. We evaluate goodwill for our reporting units for impairment at least annually on the first day of the fourth quarter, or whenever events or other changes in circumstances indicate that the carrying value may not be fully recoverable. We estimate and compare the fair value of each reporting unit to its respective carrying value including goodwill. We estimate the fair value of our reporting units using a weighting of fair values derived from the income approach and market approach. The analysis relies on significant judgements and assumptions about expected future cash flows, weighted-average cost of capital, discount rates, expected long-term growth rates, and financial measures derived from observable market data of comparable public companies. Based on the annual goodwill impairment test performed during the fourth quarter of 2023, we determined that each reporting unit's fair value significantly exceeded its carrying value. Intangible assets with finite lives are amortized using the method that best reflects how their economic benefits are utilized or, if a pattern of economic benefits cannot be reliably determined, on a straight-line basis over their estimated useful lives. Intangible assets with finite lives are assessed for impairment whenever events or changes in circumstances indicate that the carrying value may not be recoverable. Accounting for Income Taxes Income taxes are accounted for under the asset and liability method. Under the asset and liability method, deferred tax assets and liabilities are recognized for the estimated future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax basis. This method also requires the recognition of future tax benefits, such as net operating loss and capital loss carryforwards, to the extent that realization of such benefits is more likely than not. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. The carrying value of net deferred tax assets is based on assumptions regarding our ability to generate sufficient future taxable income to utilize these deferred tax assets within the carryback or carryforward periods provided for in the tax law for each applicable tax jurisdiction. Deferred tax assets are evaluated quarterly to determine if valuation allowances are required or should be adjusted. -25- Table of Contents Recent Accounting Pronouncements See "Nature of Business and Summary of Significant Accounting Policies—Recent Accounting Pronouncements" in Note (1) to our Consolidated Financial Statements included below in Item 8 of this annual report on Form 10-K for additional information.