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Form 10-Q for VSE CORP


31-Oct-2013

Quarterly Report


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

Executive Overview

We provide sustainment services for legacy systems and equipment and professional services to the U.S. Department of Defense ("DoD"), federal civilian agencies, the United States Postal Service ("USPS"), and other customers. Our operations consist primarily of supply chain management, vehicle and equipment maintenance and refurbishment, logistics, engineering, energy and environmental, IT solutions, health care IT, and consulting services performed on a contract basis. The majority of our contracts are with United States Government ("government") agencies and other government prime contractors. Our largest customer is the DoD, including agencies of the U.S. Army, Navy and Air Force.

Organization and Reporting Segments

Our business is managed under operating groups consisting of one or more divisions or wholly owned subsidiaries that perform our services. We have four reportable segments aligned with our management groups: 1) Supply Chain Management; 2) Federal; 3) International; and 4) IT, Energy and Management Consulting.

Supply Chain Management Group - Our Supply Chain Management Group provides sourcing, acquisition, scheduling, transportation, shipping, logistics, data management, and other services to assist our clients with supply chain management efforts. This group consists of our Wheeler Bros., Inc. ("WBI") subsidiary, acquired in June 2011. Significant current work efforts for this group include WBI's ongoing Managed Inventory Program ("MIP") for USPS and direct sales to other clients.

Federal Group - Our Federal Group provides engineering, technical, management, and integrated logistics support services to U.S. military branches, government agencies and other customers. These services include full life cycle engineering, logistics, maintenance, field support, and refurbishment services to extend and enhance the life of existing vehicles and equipment; comprehensive systems and software engineering, systems technical support, configuration management, obsolescence management, prototyping services, technology insertion programs, and technical documentation and data packages; and management and execution of government programs under large multiple award contracts. This group provides its services to the U.S. Army, Army Reserve, Marine Corps, and other customers. Significant efforts for this group include our U.S. Army Reserve vehicle and equipment refurbishment work and various vehicle and equipment maintenance and sustainment programs for U.S. Army commands.

International Group - Our International Group provides engineering, industrial, logistics, maintenance, information technology, fleet-wide ship and aircraft support, and foreign military sales services to U.S. military branches and government agencies, including the U.S. Navy, Air Force, Department of Treasury, Department of Justice, Bureau of Alcohol, Tobacco, Firearms and Explosives ("ATF"), and other customers. Significant work efforts for this group include ongoing assistance to the U.S. Navy in executing its Foreign Military Sales ("FMS") Program for surface ships sold, leased or granted to foreign countries, management of seized and forfeited general property programs ("Seized Asset Programs") for various law enforcement customers, and task orders under the U.S. Air Force Contract Field Teams ("CFT") Program.

IT, Energy and Management Consulting Group - Our IT, Energy and Management Consulting Group consists of our wholly owned subsidiaries Energetics Incorporated ("Energetics"), Akimeka, LLC ("Akimeka"), and G&B Solutions, Inc. ("G&B"). This group provides technical and consulting services primarily to various DoD and federal civilian government agencies, including the U.S. Departments of Defense, Energy, Homeland Security, Commerce, Interior, Labor, Agriculture and Housing and Urban Development; the Social Security Administration; the Pension Benefit Guaranty Corporation; the National Institutes of Health; customers in the military health system; and other government agencies and commercial clients. Energetics provides technical, policy, business, and management support in areas of energy modernization, clean and efficient energy, climate change mitigation, infrastructure protection, and measurement technology. Effective January 1, 2013, the businesses of Akimeka and G&B were combined, with integration expected to be substantially complete in late 2013. The combined Akimeka and G&B businesses offer solutions in fields that include medical logistics, medical command and control, e-health, information assurance, public safety, enterprise architecture development, information assurance/business continuity, program and portfolio management, network IT services, systems design and integration, quality assurance services, and product and process improvement services.

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Concentration of Revenues
(in thousands)

                          For the nine months ended September 30,
                        2013                           2012
Source of Revenue     Revenues             %         Revenues        %
USPS MIP            $     104,950            30      $  98,816        24
FMS Program                68,024            20         65,518        16
U.S. Army Reserve          45,383            13         56,141        14
Other                     130,931            37        189,420        46

Total Revenues $ 349,288 100 $ 409,895 100

Management Outlook

Our industry's business environment continues to present challenges to sustaining and growing our revenues and profits, resulting in revenue declines in the current year. We have seen declines in some of our DoD and IT revenues due to delays in government contract awards and funding, and to the expiration of programs without follow-on contract awards to continue the work. Although some parts of our business are experiencing declines, we are navigating our way through this challenging time with contributions from our key programs, success in winning work in new markets, and appropriate management action to reduce costs as necessary.

In response to our uncertain business environment, we have taken actions to reduce our indirect costs to achieve and retain balance with our current and projected workload. In April 2013, we made staff reductions and implemented plans for future actions that are expected to result in an estimated $6 million of reduced indirect labor and related costs in 2013. We will continue to assess the need for further reductions to remain competitive and profitable as we go forward.

We have several key programs centered on our legacy systems and equipment sustainment heritage. These programs include WBI's USPS MIP, our International Group's U.S. Navy FMS Program, and our Federal Group's U.S. Army Reserve vehicle refurbishment work, which together contribute more than half of our total revenues.

WBI's USPS MIP provides ongoing mission-critical support to the USPS, which provides us with a steady revenue and earnings source. This program does not rely on tax funded government spending, as it is primarily self-funded through collections of postage. This is our largest source of revenue and we have seen some modest growth in this program. Additionally, WBI's supply chain and inventory management competencies provide us opportunities to further diversify our customer base to new client markets. We are actively marketing these service offerings to new clients and are currently beginning to service other non-government vehicle fleets that have potential for further development.

We have a contract to develop a more fuel efficient repowered gasoline delivery vehicle that will provide increased fuel efficiency, enhanced environmental standards, and an extended service life for the USPS vehicle fleet using an engine designed by our WBI subsidiary specifically for the USPS vehicles. We were informed in September 2013 that USPS does not currently plan to move forward with the programmatic purchase of our newly designed repowered gasoline engines for its delivery vehicles. However, we plan to apply the resources used and supplier relationships cultivated through our repowered engine development effort toward offering the USPS standard engines and components on an as needed basis.

Our International Group's U.S. Navy FMS Program has been our second largest source of revenue in 2012 and 2013. This program does not rely on tax funded government spending as it is largely funded by foreign government clients. FMS Program revenues for these two years have been generated primarily from follow on technical services work with very little ship reactivation and transfer work. Our traditional mainstay of ship reactivation and transfer work continues to be deferred because the U.S. Congress has not passed the ship transfer legislation required to make excess U.S. Navy ships available to interested allies. Our contract supporting this work gives us potential contract coverage of up to $1.5 billion over a five-year period. This level of contract coverage, combined with the eligibility, upon approval, of multiple U.S. Navy ships for transfer to foreign government clients, is expected to present us with opportunity to restore revenue growth from this program if and when a Naval Vessel Transfer Act is passed. The reactivation, transfer, and follow-on technical support of these vessels is not affected by either sequestration or continuing resolution budget authority.

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FMS Program follow on technical services work has generated relatively consistent revenues. These services are provided to a number of foreign client countries. Work performed for the Egyptian Navy has represented the largest portion of our follow on technical services work. In July 2013, we evacuated our workforce from Egypt due to significant domestic and political unrest in that country. Support services for the Egyptian Navy have continued to be performed at other locations, but revenue levels associated with the Egyptian Navy support will be lower than during the time our workforce is located in Egypt. While we estimate a monthly decline in revenues of approximately $800 thousand due to the evacuation from Egypt, the level of Egyptian Navy work that will continue during this time may vary. The operating profit margin on this work is consistent with the reported profit margin of our International Group. We cannot predict if or when our workforce will be able to return to Egypt, or the longer range impact that the political situation in Egypt will have on our Egyptian Navy support program.

Our Federal Group's vehicle and equipment refurbishment work for the U.S. Army Reserve has been our third largest source of revenue in 2012 and 2013. Our U.S. Army Reserve contract was re-competed to transition the work from a General Services Administration ("GSA") contract to three Army contracts. The GSA contract expired in July 2013 prior to the award of the Army successor follow-on awards. Consequently, we suspended operations for this work and placed our workforce of approximately 700 employees for this program on furlough. In August and September 2013, we won three new competitively awarded task orders on our existing Army contracts to resume the suspended work. While work on the new task orders will primarily be performed by our employees, it will be supplemented by small business subcontractor labor. We have reinstated the vast majority of our furloughed workforce on this program, and going forward the number of our employees plus subcontractor employees performing on this program is expected to approximate the number of employees furloughed when the work was suspended. The suspension of work on this program had a negative impact on our revenue, and our third quarter revenue from this program was approximately $6.4 million. This program generated approximately $78 million of revenue in 2012 and $39 million of revenue in the first six months of 2013. The interruption of this work had an adverse impact on the third quarter profitability of our Federal Group's operations.

We have had some success in winning new work. In February 2013, we were awarded a five-year $99 million contract to support the U.S. Coast Guard's FMS program, which further expands our presence in the FMS market place. In April 2013, we were awarded a four-year $24 million delivery order under our U.S. Navy FMS contract to provide technical assistance, supply chain management, and logistics support to upgrade and maintain Taiwan Maritime Defense Systems. In September 2013, we were awarded a five-year Indefinite Delivery/Indefinite Quantity (IDIQ) contract to support asset recovery services for the U.S. Department of Justice, and two five-year contracts with a combined value of $11.8 million to support the rebuild effort of transport and fuel dispensing semitrailers for the Marine Corps Logistics Command. These awards support our confidence that our business development pipeline can contribute to winning additional new future work despite challenges facing our government clients.

VSE has been the prime contractor for the U. S. Department of Treasury Executive Office for Asset Forfeiture (TEOAF) general property program since 2006. We received notice in September 2013 that the follow-on contract for this work was awarded to a competitor. We have protested this award to the U.S. Government Accountability Office ("GAO") and are continuing to perform work on this program until the final outcome of the protest is determined.

While our strategic direction toward expanding our Supply Chain Management services will lessen our reliance on employee services to generate profitable revenue streams, our employee labor continues to be an important part of our business operations. As of September 30, 2013, our employee count (including the above-referenced furlough and subsequent reinstatement of employees associated with our U. S. Army Reserve work) decreased to 1,870 as compared to 2,472 as of December 31, 2012.

Our cash flow remains strong and we continue to pay down our debt. This will position us to consider a variety of strategic and financial options to increase shareholder value.

Bookings and Funded Backlog

Our revenues depend on contract funding ("bookings"), and bookings generally occur when contract funding documentation is received. For our revenues that depend on bookings arising from the receipt of contract funding documentation, funded contract backlog is an indicator of potential future revenues. Revenues for WBI are driven by maintenance schedules and the rate and timing of parts failure on customer vehicles, and WBI bookings occur at the time of sale instead of the receipt of contract funding documentation. Accordingly, WBI does not generally have funded contract backlog and it is not an indicator of potential future revenues for WBI. A summary of our bookings

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and revenues for the nine months ended September 30, 2013 and 2012, and funded contract backlog as of September 30, 2013 and 2012 is as follows:

(in millions)

                           2013        2012
Bookings                  $   407      $ 437
Revenues                  $   349      $ 410
Funded Contract Backlog   $   268      $ 295

Critical Accounting Policies

Our consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States, which require us to make estimates and assumptions. There have been no changes in our critical accounting policies since December 31, 2012. Please refer to our 2012 Form 10-K for a full discussion of our critical accounting policies.

Revenue by Contract Type

Our revenues by contract type were as follows (in thousands):

                           Nine months ended September 30,
Contract Type           2013          %         2012          %
Cost-type            $   81,674        23     $  92,632        23
Time and materials       86,313        25       149,827        36
Fixed-price             181,301        52       167,436        41
                     $  349,288       100     $ 409,895       100

WBI revenues are classified as fixed-price revenue.

Results of Operations

The results of operations are as follows (in thousands):

                              Three months                 Nine months                    Change
                          ended September 30,          ended September 30,          Three         Nine
                           2013          2012           2013          2012         Months        Months
Revenues                $  111,069     $ 134,237     $  349,288     $ 409,895     $ (23,168 )   $ (60,607 )
Contract costs             101,026       117,798        315,364       366,485       (16,772 )     (51,121 )
Selling, general and
administrative
expenses                       583         1,147          1,821         3,073          (564 )      (1,252 )
Impairment of
goodwill and
intangible assets                -         1,025              -         1,025        (1,025 )      (1,025 )
Operating Income             9,460        14,267         32,103        39,312        (4,807 )      (7,209 )
Interest expense, net        1,395         2,033          4,453         5,380          (638 )        (927 )
Income before income
taxes                        8,065        12,234         27,650        33,932        (4,169 )      (6,282 )
Provision for income
taxes                        2,738         4,748         10,089        13,046        (2,010 )      (2,957 )
Income from
continuing operations        5,327         7,486         17,561        20,886        (2,159 )      (3,325 )
Loss from
discontinued
operations                      (1 )      (1,522 )         (115 )      (1,959 )       1,521         1,844
Net Income              $    5,326     $   5,964     $   17,446     $  18,927     $    (638 )   $  (1,481 )

Our revenues decreased approximately $23 million, or 17%, for the quarter ended September 30, 2013, and approximately $61 million, or 15%, for the first nine months of 2013, as compared to the same periods of 2012. Revenues of our Supply Chain Management Group increased while revenues of our Federal, International, and IT, Energy and Management Consulting Groups declined varying degrees.

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Our operating income decreased approximately $4.8 million, or 34% for the quarter ended September 30, 2013, and decreased approximately $7.2 million, or 18%, for the first nine months of 2013, as compared to the same periods of 2012. Operating income from our Supply Chain Management and International Groups increased, while operating income from our Federal and IT, Energy and Management Consulting Groups declined.

Changes in revenues and operating income are further discussed in the summaries of our segment results that follow.

Selling, general and administrative expenses consist primarily of costs and expenses that are not chargeable or reimbursable on our operating unit contracts. These expenses include legal costs primarily associated with contract protests and costs associated with underutilized leased facilities. Year-over-year changes for these expenses are primarily due to legal costs and settlements.

Interest expense includes interest associated with capital leases for our executive and administrative headquarters office building in 2013 and 2012 and for our WBI facilities in 2012. Interest expense on capital lease payments for our new executive and administrative headquarters office building began in May 2012 and is ongoing. Interest expense on capital lease payments for our WBI facilities includes expense from January 2012 through November 2012 when we purchased the facilities. The amount of interest expense associated with capital leases in the first nine months of both 2013 and 2012 is approximately $1.3 million. Interest expense declined in 2013 as compared to the prior year due to lower levels of bank borrowing.

Our effective income tax rates for the nine months ended September 30, 2013 and 2012 were 36.5% and 38.4%, respectively.

Supply Chain Management Group Results

The results of operations for our Supply Chain Management Group are as follows
(in thousands):

                          Three months                 Nine months                  Change
                      ended September 30,          ended September 30,         Three       Nine
                       2013           2012          2013          2012        Months      Months

Revenues            $    36,597     $ 32,074     $  106,319     $ 100,607     $ 4,523     $ 5,712

Operating Income    $     7,306     $  5,990     $   20,311     $  17,751     $ 1,316     $ 2,560
Profit percentage          20.0 %       18.7 %         19.1 %        17.6 %

Revenues for our Supply Chain Management Group increased approximately $4.5 million or 14%, for the quarter ended September 30, 2013 as compared to the same period for the prior year. Revenues increased approximately $5.7 million or 6%, for the nine months ended September 30, 2013 as compared to the same period for the prior year. The increases in revenues resulted primarily from growth in sales to our USPS client.

Operating income for our Supply Chain Management Group increased approximately $1.3 million, or 22% for the quarter and approximately $2.6 million or 14%, for the nine months ended September 30, 2013 as compared to the same periods for the prior year. The increases in operating income are attributable to the revenue increases, improved operating efficiencies, and to differences in fair value adjustments in the accrued earn-out obligation associated with our acquisition of WBI. The adjustment to the earn-out obligation decreased operating income by $108 thousand and $610 thousand for the nine-month period ended September 30, 2013 and 2012, respectively.

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Federal Group Results

The results of operations for our Federal Group are as follows (in thousands):

                          Three months                 Nine months                    Change
                      ended September 30,          ended September 30,          Three         Nine
                       2013           2012          2013          2012         Months        Months

Revenues            $   20,111      $ 38,099     $   79,371     $ 107,422     $ (17,988 )   $ (28,051 )

Operating Income    $   (2,303 )    $  3,228     $    1,462     $   7,897     $  (5,531 )   $  (6,435 )
Profit percentage        (11.5 )%        8.5 %          1.8 %         7.4 %

Revenues for our Federal Group decreased approximately $18 million or 47%, for the quarter ended September 30, 2013 as compared to the same period for the prior year. Revenues decreased approximately $28 million or 26%, for the nine months ended September 30, 2013 as compared to the same period for the prior year. The decreases in revenues are primarily due to the expiration of a contract at the end of 2012 to provide mechanical maintenance services for Mine Resistance Ambush Protected ("MRAP") vehicles and systems in Kuwait and to the interruption of vehicle and equipment refurbishment work for the U.S. Army Reserve in the third quarter of 2013. The expiration of the MRAP contract reduced revenues by approximately $5.3 million for the quarter and $16.8 million for the nine months ended September 30, 2013. The reduction in revenues for our vehicle and equipment refurbishment work for the U.S. Army Reserve was approximately $14.9 million for the quarter and $10.7 million for the nine months ended September 30, 2013.

Our Federal Group had an operating loss of approximately $2.3 million for the quarter ended September 30, 2013, as compared to operating income of approximately $3.2 million for the same period of the prior year. Operating income decreased approximately $6.4 million or 81%, for the nine months ended September 30, 2013 as compared to the same period for the prior year. The loss for the quarter and the operating decline for the nine months are primarily due to the continuation of fixed infrastructure costs associated with our U.S. Army Reserve program during the time that work was suspended, and to the expiration of the MRAP contract.

International Group Results

The results of operations for our International Group are as follows (in
thousands):

                          Three months                 Nine months                    Change
                      ended September 30,          ended September 30,         Three         Nine
                       2013           2012          2013          2012         Months       Months

Revenues            $    35,428     $ 39,778     $  107,057     $ 127,823     $ (4,350 )   $ (20,766 )

Operating Income    $     2,285     $  1,317     $    5,451     $   4,152     $    968     $   1,299
Profit percentage           6.4 %        3.3 %          5.1 %         3.2 %

Revenues for our International Group decreased approximately $4.4 million, or 11%, for the quarter ended September 30, 2013, as compared to the same period for the prior year. Revenues decreased approximately $20.8 million or 16%, for the nine months ended September 30, 2013 as compared to the same period for the prior year. The decreases in revenues resulted primarily from a decline in pass-through work provided on engineering and technical services task orders of approximately $4.4 million for the quarter and approximately $15.6 million for the nine months, and to lesser declines in revenues from our CFT Program services. These declines were partially offset by increases in revenues on our FMS and Seized Asset Programs.

Operating income for our International Group increased approximately $968 thousand, or 74%, for the quarter ended September 30, 2013, as compared to the same period for the prior year. Operating income increased approximately $1.3 million or 31%, for the nine months ended September 30, 2013 as compared to the same period for the prior year. The year over year changes in operating income were due to a charge of approximately $1 million associated with the lease of warehouse facilities for our Seized Asset Programs that was recognized in the third quarter of the prior year, a loss of $750 thousand associated with a work share agreement with a subcontractor that we recognized

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in the second quarter of the prior year, an increase in operating income associated with the increased revenues on our Seized Asset Programs, and the timing of award fee recognition on our FMS Program. Award fee evaluations on our FMS Program occur three times per year. We recognize award fee revenue and income in the period we receive contractual notification of the award, and we typically receive such notification in the first, second, and fourth quarters each year. Because we had not received contractual notification for the award fee that is typically recognized in the second quarter until after June 30, 2013, this award fee revenue and income was recognized in the third quarter of . . .
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