VSE CORP – 10-Q – 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") and Federal Civilian agencies, including the United States Postal Service ("USPS"). Our operations consist primarily of logistics, engineering, equipment refurbishment, supply chain management, IT solutions, health care IT, construction management and consulting services performed on a contract basis. Substantially all of our contracts are with United States Government ("government") agencies and other government prime contractors.

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 five reportable segments aligned with our management groups: 1) Federal; 2) International; 3) IT, Energy and Management Consulting; 4) Infrastructure; and 5) Supply Chain Management.

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 programs under large multiple award contracts. This group provides its services to the U.S. Army, Army Reserve, Marine Corps, and other customers. Significant current and recent work efforts for this group include task orders completed under our U.S. Army CECOM Rapid Response ("R2") contract, which expired in 2011, our ongoing U. S. Army Reserve vehicle refurbishment program, and our Driver's Vision Enhancer-Family of Systems ("DVE-FOS") program.

International Group - Our International Group provides engineering, industrial, logistics, maintenance, information technology, fleet-wide ship and aircraft support, and foreign military sales services to the U.S. military branches, government agencies, and other customers. These services include program management, engineering, technical support, logistics services, and follow-on technical support for ship reactivations and transfers; field engineering, ship repair and modernization, ship systems installations, ordnance engineering, facility operations, war reserve materials management, and IT systems integration; aircraft sustainment and maintenance services; and management, maintenance, storage and disposal support for seized and forfeited general property programs. This group provides its services to the U.S. Navy, Air Force, Department of Treasury, Department of Justice, Bureau of Alcohol, Tobacco, Firearms and Explosives ("ATF"), and other customers. Significant current and recent 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, various task orders under the U.S. Air Force Contract Field Teams ("CFT") Program, and management of Department of Treasury and ATF seized and forfeited general property programs ("Seized Asset Programs").

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IT, Energy and Management Consulting Group - Our IT, Energy and Management Consulting Group provides technical and consulting services primarily to various DoD and civilian government agencies. The group consists of our wholly owned subsidiaries: Energetics Incorporated ("Energetics"), G&B Solutions, Inc. ("G&B"), and Akimeka, LLC ("Akimeka"). Energetics provides technical, policy, business, and management support in areas of clean and efficient energy, climate change mitigation, infrastructure protection, measurement technology, and global health. G&B provides 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. Akimeka offers solutions in fields that include medical logistics, medical command and control, e-health, information assurance, and public safety. This group provides its services to the U.S. Departments of Defense, Energy, Homeland Security, Commerce, Interior, Labor, Agriculture, 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.

Infrastructure Group - Our Infrastructure Group is engaged principally in providing engineering and transportation infrastructure services and construction management services primarily to Federal Civilian agencies. This group consists of our subsidiary Integrated Concepts and Research Corporation ("ICRC") . ICRC provides project design, planning and integration management, environmental planning, construction management, building renovation, and other technical services. ICRC's largest contract is with the U.S. Department of Transportation Maritime Administration for services performed on the Port of Anchorage Intermodal Expansion Project in Alaska (the "PIEP"). ICRC also provides services to various DoD and Federal Civilian departments and agencies, and to other customers.

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

                            Concentration of Revenues                                  (in thousands)                       For the three months ended March 31,                                        2012                    2011 Source of Revenue                    Revenues        %       Revenues        % USPS MIP                             $  34,198        24     $       -         - FMS Program                             21,888        15        26,168        17 U.S. Army Reserve                       15,398        11        16,883        11 Treasury/ATF Seized Asset Programs       7,939         6        10,545         7 R2 and R2-3G Programs                    4,593         3        34,929        23 Other                                   60,325        41        62,719        42                                      $ 144,341       100       151,244       100     Management Outlook 

Our company and our industry are facing a challenging operating environment that is constraining revenue levels. While it appears that conditions will continue to be challenging through most of 2012, we believe we have made progress through our diversification efforts to enhance our prospects for future revenue and income.

Operating environment challenges are centered on federal government budgeting and spending priorities, initiatives, and processes. Federal budgets are strained, government spending priorities are changing, and there is an increasing government emphasis on oversight activities at the expense of contract administration efforts. These conditions are affecting the timeliness of awards and the funding of new and existing contracts in our markets, impacting the flow of work to federal contractors, causing increased competition in the federal marketplace, and resulting in a sharp increase in protests of government contract awards.

Specific circumstances that present challenges to our revenue in 2012 include a slower than usual ramp up of our FMS Program activity on the follow-on contract due to a lengthy award and protest process (which is now completed); and a reduction in our overseas equipment servicing opportunities as U.S. military involvement in Southwest Asia winds down.

We believe we are positioned to withstand these market condition challenges in the longer term. We believe that potential future opportunities include an expansion of our vehicle and equipment refurbishment program to additional U.S. Army Reserve locations, the U.S. Army, and other clients; an increase in our FMS Program work as ship reactivations and transfers are approved; and an expansion of our Supply Chain Management services to DoD clients and other customers, including commercial clients.

We also believe that our acquisition of WBI in June 2011 positioned us to improve our revenues and profit margins, diversify our product offerings and customer base, and improve the balance between our services to DoD and Federal Civilian agencies. WBI gives us a well established supply chain management capability, which when combined with our existing client relationships, is expected to provide potential for future revenue growth in the DoD market. Conversely, WBI's relationship with the USPS, combined with our existing capabilities, also presents opportunities to leverage our legacy vehicle life extension services to a new client. These synergies are already producing results. We have delivered a vehicle for evaluation under our contract with the USPS to develop a more fuel efficient repowered gasoline delivery vehicle. If we successfully move this effort to the production stage, we will generate an additional future revenue stream. Our acquisition of WBI's supply chain and inventory management competencies is also expected to provide us opportunities to further diversify our customer base to other markets, including commercial work.

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Although the inclusion of WBI in our operations and 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 March 31, 2012, our employee count increased to 2,525 as compared to 2,516 as of December 31, 2011.

Bookings and Funded Backlog

Revenues in our industry depend on contract funding ("bookings"), and funded contract backlog is an indicator of potential future revenues. A summary of our bookings and revenues for the three months ended March 31, 2012 and 2011, and funded contract backlog as of March 31, 2012 and 2011 is as follows:

                              (in millions)                             2012        2011  Bookings                  $   168      $ 107  Revenues                  $   144      $ 151  Funded Contract Backlog   $   307      $ 357    

Recently Adopted Accounting Guidance

On January 1, 2012, we adopted an update issued by the Financial Accounting Standards Board ("FASB") to existing guidance on the presentation of comprehensive income. This update requires the presentation of the components of net income and other comprehensive income either income either in a single continuous statement or in two separate but consecutive statements. Net income and other comprehensive income has been presented in two separate but consecutive statements for the current reporting period and prior comparative period in our condensed consolidated financial statements.

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, 2011. Please refer to our Annual Report on Form 10-K for the year ended December 31, 2011 filed with the SEC on March 7, 2012 for a full discussion of our critical accounting policies.

Revenue by Contract Type

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

                                     Three Months                                    ended March 31, Contract Type          2012          %         2011          % Cost-type            $  31,556        22     $  44,866        30 Time and materials      47,818        33        86,390        57 Fixed-price             64,967        45        19,988        13                      $ 144,341       100     $ 151,244       100   

A significant portion of our time and materials revenues in 2011 were from our R2 contract, which expired in January 2011. WBI's revenues are classified as fixed-price revenue. Accordingly, the percentages of work performed by contract type will differ in 2012 as compared to 2011.

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Results of Operations

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

                                                                   Three Months                                                                  ended March 31,                                                  2012          2011         Change           % Revenues                                       $ 144,341     $ 151,244     $  (6,903 )          (5 ) Contract costs                                   131,443       143,514       (12,071 )          (8 ) Selling, general and administrative expenses         555           821          (266 )         (32 ) Operating Income                                  12,343         6,909         5,434            79 Interest expense, net                              1,532           144         1,388           964 Income before income taxes                        10,811         6,765         4,046            60 Provision for income taxes                         4,143         2,593         1,550            60 Net Income                                     $   6,668     $   4,172     $   2,496            60   

Our revenues decreased approximately $7 million, or 5%, for the quarter ended March 31, 2012, as compared to the same period of 2011, primarily due to the expiration of work on our R2 Program. Revenues in our Federal, International, IT, Energy and Management Consulting, and Infrastructure Groups declined. These declines were largely offset by the inclusion of revenues from our Supply Chain Management Group, established in June 2011, in our operating results for 2012.

Our operating income increased approximately $5.4 million, or 79% for the quarter ended March 31, 2012, as compared to the same period of 2011. The primary reason for the increase was the inclusion of operating income from our Supply Chain Management Group in our operating results for 2012. Operating income in our IT, Energy and Management Consulting Group increased and operating income in each of our other groups declined.

Changes in revenues and 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 decreased for the quarter ended March 31, 2012 as compared to the same period of 2011 due to costs associated with our acquisition of WBI in June 2011.

Our effective income tax rate for the quarters ended March 31, 2012 and 2011 was 38.3%.

   Federal Group Results  

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

                         Three Months                        ended March 31,                       2012         2011        Change         %  Revenues            $ 30,755     $ 66,348     $ (35,593 )     (54 )  Operating Income    $  1,410     $  2,544     $  (1,134 )     (45 ) Profit percentage        4.6 %        3.8 %   

Revenues for our Federal Group decreased approximately $36 million or 54%, for the quarter ended March 31, 2012 as compared to the same period for the prior year. The decrease in revenues for this segment resulted primarily from a decrease in revenues of approximately $33 million associated with our expired R2 contract. The remaining decline was due to a decline in services ordered on other contracts, including our U. S. Army Reserve vehicle refurbishment and DVE-FOS programs.

Operating income for our Federal Group decreased approximately $1.1 million, or 45% for the quarter ended March 31, 2012, as compared to the same period for the prior year. The decline in operating income is primarily due to the decline in revenue on the U. S. Army Reserve vehicle refurbishment and DVE-FOS programs.

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International Group Results

  The results of operations for our International Group are as follows (in thousands):                          Three Months                        ended March 31,                       2012         2011        Change        %  Revenues            $ 45,764     $ 51,710     $ (5,946 )     (11 )  Operating Income    $  1,516     $  1,916     $   (400 )     (21 ) Profit percentage        3.3 %        3.7 %   

Revenues for our International Group decreased approximately $6 million, or 11%, for the quarter ended March 31, 2012, as compared to the same period for the prior year. The decrease in revenues resulted primarily from a decline of approximately $4.3 million in revenues associated with our FMS Program services and a decline of approximately $2 million in revenues associated with our Seized Asset Programs.

Operating income for our International Group decreased approximately $400 thousand, or 21%, for the quarter ended March 31, 2012 as compared to the same period for the prior year. Reduced profits associated with the decreased revenue level were partially offset by the elimination of losses on our CFT Program work in 2012. Profit margins in this group can vary due to fluctuations in contract activity the timing of contract award fees associated with our FMS Program.

IT, Energy and Management Consulting Group Results

The results of operations for our IT, Energy and Management Consulting Group are as follows (in thousands):

                         Three Months                        ended March 31,                       2012         2011        Change       %  Revenues            $ 25,738     $ 27,363     $ (1,625 )     (6 )  Operating Income    $  3,081     $  2,344     $    737       31 Profit percentage       12.0 %        8.6 %   

Revenues for our IT, Energy and Management Consulting Group decreased approximately $1.6 million, or 6% for the quarter ended March 31, 2012, as compared to the same period for the prior year. The decrease in revenues was due primarily to a general decline in services ordered by clients.

Operating income for this segment increased approximately $737 thousand, or 31%, for the quarter ended March 31, 2012, as compared to the same period for the prior year. The increase is primarily attributable to a $964 thousand reduction in an accrued earn-out obligation associated with our acquisition of Akimeka.

Infrastructure Group Results

  The results of operations for our Infrastructure Group are as follows (in thousands):                                Three Months                              ended March 31,                             2012         2011        Change        %  Revenues                  $   4,354     $ 5,823     $ (1,469 )      (25 )  Operating (Loss)/Income   $    (150 )   $   232     $   (382 )     (165 ) Profit percentage              -3.4 %       4.0 %                                            20

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Revenues for our Infrastructure Group decreased approximately $1.5 million, or 25%, for the quarter ended March 31, 2012, as compared to the same period for the prior year, due primarily to a reduction in services ordered on the Port of Anchorage Intermodal Expansion Project ("PIEP"). This segment incurred a loss of approximately $150 thousand for the quarter ended March 31, 2012, as compared to earning operating income of $232 thousand for the same period of the prior year, primarily due to the decline in revenues.

Our customer has experienced delays in funding and defining the scope of work on the PIEP, which have contributed to our decreased revenue levels for this segment. Our customer has funded the cost of certain work we performed on this project, but has not funded fees normally associated with this work pending resolution of environmental and technical issues impacting the work. Accordingly, we have not recognized fees for most of the work on this project performed in some periods prior to our first quarter of 2012. We are currently in discussions with our customer regarding resolution of the fee issue. If the fees on this work are funded, we could recognize additional revenue and operating income of between $1.8 million and $2.3 million.

Supply Chain Management Group Results

  The results of operations for our Supply Chain Management Group are as follows (in thousands):                           Three Months                         ended March 31,                         2012          2011       Change       %  Revenues            $     37,730      $   -     $ 37,730       -  Operating Income    $      6,756      $   -     $  6,756       - Profit percentage           17.9 %        - %   

This group was established and began contributing to our operating results upon our acquisition of WBI in June 2011. Financial performance comparisons to prior year results will not be meaningful until the third quarter of 2012.

Financial Condition

Our financial condition did not change materially in the first quarter of 2012. Changes to asset and liability accounts were due primarily to our earnings, our level of business activity, contract delivery schedules, subcontractor and vendor payments required to perform our work, and the timing of associated billings to and collections from our customers.

Liquidity and Capital Resources

Cash Flows

Cash and cash equivalents decreased approximately $83 thousand during the first quarter of 2012.

Cash provided by operating activities in the first quarter of 2012 was approximately $6.7 million, as compared to cash used in operating activities of approximately $307 thousand in the first quarter of 2011. The change is primarily attributable to an increase of approximately $3.2 million from an increase in depreciation and amortization and other non-cash operating activities, an increase of approximately $2.5 million in cash provided by net income, and an increase of approximately $1.3 million due to changes in the levels of working capital components. Of these working capital components, our largest asset is our accounts receivable and our largest liability is our accounts payable. A significant portion of our accounts receivable and accounts payable result from the use of subcontractors to perform work on our contracts and from the purchase of materials to fulfill our contract requirements. Accordingly, our levels of accounts receivable and accounts payable may fluctuate depending on the timing of the government services ordered, government funding delays, the timing of billings received from subcontractors and materials vendors, and the timing of payments received from government customers in payment of these services. Such timing differences have the potential to cause significant increases and decreases in our accounts receivable and accounts payable in short time periods.

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Net cash used in investing activities increased approximately $12.4 million in the first quarter of 2012 as compared to the same period of 2011. This was primarily due to non-recurring capital expenditure requirements of about $8 million necessitated by the move of our corporate headquarters offices scheduled for May 2012.

Net cash provided by financing activities in the first quarter of 2012 was approximately $6.8 million, as compared to cash used in financing activities of approximately $2 million in the first quarter of 2011. This was primarily due to bank borrowing to finance our increased capital expenditures.

We paid quarterly cash dividends of $0.07 per share during the first quarter of 2012. Pursuant to our bank loan agreement, our payment of cash dividends is subject to annual rate 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 the level of revenues and associated accounts receivable and accounts payable, and from profitability. Significant increases or decreases in revenues and accounts receivable and accounts payable can impact our liquidity. Our accounts receivable and accounts payable levels can be affected by changes in the level of the work we perform, by the timing of large materials purchases and subcontractor efforts used in our contracts, and by government delays in the award of contractual coverage and funding and payments. Government funding delays have caused delays in our ability to invoice for revenues earned, resulting in a negative impact on our days sales outstanding.

We also purchase property and equipment and invest in expansion, improvement, and maintenance of our operational and administrative facilities. In the first quarter of 2012, we made approximately $8 million in capital investments and $960 thousand in prepaid maintenance and support agreements related to the move of our corporate headquarters offices scheduled for May 2012. From time to time, we may also invest in the acquisition of other companies. Our acquisition of WBI in 2011 required a significant use of our cash.

Our external financing consists of a loan agreement entered into in June 2011 with a group of banks to fund our WBI acquisition and provide working capital for our continuing operations. This loan agreement, which expires in June 2016, consists of a term loan, revolving loans, and letters of credit.

The term loan requires payments in quarterly installments based on an accelerating amortization schedule, with 15% of the original $125 million principal amount due in each of the first two years, 20% due in each of years three and four, and 30% due in year five. The amount of term loan borrowings outstanding as of March 31, 2012 is approximately $106 million.

The maximum amount of credit available to us from the banking group for revolving loans and letters of credit as of March 31, 2012 was $125 million and under the loan agreement we may elect to increase this maximum availability up to $175 million. We may borrow and repay the revolving loan borrowings as our cash flows require or permit. We pay an unused commitment fee and fees on letters of credit that are issued. We had approximately $65 million in revolving loan amounts outstanding and $5 million of letters of credit outstanding as of March 31, 2012. During 2012, the highest outstanding revolving loan amount was $74 million and the lowest was $51 million. The timing of certain payments made and collections received associated with our subcontractor and materials requirements and other operating expenses can cause fluctuations in our outstanding revolving loan amounts. Delays in government funding of our work performed can also cause additional borrowing requirements.

We pay interest on the term loan borrowings and revolving loan borrowings at LIBOR plus a base margin or at a base rate (typically the prime rate) plus a base margin. As of March 31, 2012, the LIBOR base margin is 2.25% and the base rate base margin is 0.5%. The base margins increase or decrease in steps as our Total Funded Debt/EBITDA Ratio increases or decreases. We have employed interest rate hedges on a portion of our outstanding borrowings. After taking into account the impact of hedging instruments, as of March 31, 2012, interest rates on portions of our outstanding debt ranged from 2.49% to 3.75%, and the effective interest rate on our aggregate outstanding debt was 2.86%.

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The loan agreement contains collateral requirements that secure our assets, restrictive covenants, other affirmative and negative covenants, and subjects us to certain conditions and limitations. Restrictive covenants include a maximum Total Funded Debt/EBITDA Ratio, which decreases over time, and a minimum Fixed Charge Coverage Ratio. We were in compliance with required ratios and other loan agreement terms and conditions at March 31, 2012.

                                        Current Maximum Ratio Actual Ratio         Total Funded Debt/EBITDA Ratio       3.25 to 1        3.05 to 1                                              Minimum Ratio Actual Ratio               Fixed Charge Coverage Ratio   1.20 to 1    1.55 to 1   

We currently do not use public debt security financing.

Inflation and Pricing

Most of our contracts provide for estimates of future labor costs to be escalated for any option periods, while the non-labor costs in our contracts are normally considered reimbursable at cost. Our property and equipment consists principally of computer systems equipment, furniture and fixtures, shop equipment, and land and improvements. We do not expect the overall impact of inflation on replacement costs of our property and equipment to be material to our future results of operations or financial condition.

  Disclosures About Market Risk  Interest Rates 

Our bank loans provide available borrowing to us at variable 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, in July 2011 we employed interest rate hedges to fix the rate on a portion of our outstanding borrowings for various periods of time. While the immediate result of fixing these rates is an increase in the net effective rate as compared to the effective interest rate on our aggregate outstanding debt prior to July 2011, the fixed rates protect us against interest rate increases.

In July 2011, we entered into a three-year amortizing LIBOR interest rate swap on our term loan with a notional amount of $101 million. The swap amount amortizes as the term loan amortizes, with reductions in the swap amount occurring on the same dates and for approximately the same amounts as term loan principal repayments. With the swap in place, we will pay an effective rate on the hedged term debt of 0.56% plus our base margin from July 2011 through June 2012, and an effective rate of 1.615% plus our base margin from July 2012 through June 2014. The amount of swapped term loan debt outstanding as of March 31, 2012 is $86.9 million.

In July 2011, we entered into a two-year LIBOR interest rate swap on the revolving loan debt with a notional amount of $40 million. The swap amount declines to $20 million in June 2012, and expires in June 2013. With the swap in place, we will pay an effective rate on the hedged term debt of 0.7775% plus our base margin during the two years.

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                          VSE CORPORATION AND SUBSIDIARIES