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 <org value="ACORN:2039879603" idsrc="xmltag.org">United States Postal Service ("USPS"). Our operations consist primarily of supply chain management, equipment refurbishment, logistics, engineering, energy and environmental, IT solutions, health care IT, 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. 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 work efforts for this group included the U.S. Army Reserve vehicle refurbishment program and various vehicle and equipment maintenance and sustainment programs for U.S. Army commands. See Management Outlook for further discussion on the status of our  U.S. Army Reserve vehicle refurbishment and equipment 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 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 current 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 Department of Treasury and ATF seized and forfeited general property programs ("Seized Asset Programs"), and various 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.                                       - 16 -

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   Table of Contents  Concentration of Revenues (in thousands)                            For the six months ended June 30,                        2013                      2012 Source of Revenue    Revenues          %       Revenues        % USPS MIP            $    68,828         29     $  67,511        24 FMS Program              42,455         18        45,614        17 U.S. Army Reserve        39,032         16        34,775        13 Other                    87,904         37       127,758        46  Total Revenues     $   238,219        100     $ 275,658       100     Management Outlook  Our industry's business environment continues to present challenges to sustaining and growing our revenues and profits. Some parts of our business are experiencing declines, but we are navigating our way through this challenging time with steady performance in other parts of our business, some modest success in winning new work, and appropriate management action to reduce costs as necessary.  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. Conversely, a significant amount of our revenues have come from our larger programs that do not rely on tax funded government spending. Our USPS MIP and Treasury and ATF Seized Asset Programs are largely self-funded through collections of postage and asset auction proceeds, and our FMS Program is largely funded by foreign government clients.  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 that have provided steady performance in these challenging times.

Our USPS MIP provides ongoing mission-critical support to the USPS, which in turn provides us with a steady revenue and earnings source. We are actively marketing similar service offerings to other client targets.

  Follow on technical services work on our FMS Program 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 on our FMS Program. In July 2013, we evacuated our workforce from Egypt because of significant domestic and political unrest in that country. Some support services for the Egyptian Navy will continue to be performed at other locations, but revenue levels associated with the Egyptian Navy support will likely be lower than during the time our workforce is located in Egypt. While we estimate a potential 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 the International Group. We cannot predict when our workforce will be able to return to Egypt.  Our vehicle and equipment refurbishment program for the U.S. Army Reserve has also generated relatively consistent revenues. Our U.S. Army Reserve contract is being re-competed to transition the work from the General Services Administration ("GSA") to Army contracts. Our current U.S. Army Reserve contract expired July 20, 2013 prior to the award of successor follow-on contracts. Consequently, on July 22, 2013 we suspended operations for this work and placed our workforce of approximately 700 employees for this program on furlough. This program generated approximately $39 million of our revenue in the first six months of 2013. The operating profit margin on this work is consistent with the reported profit margin of the Federal Group. There is no guaranty that we will regain a substantial part of this U.S. Army Reserve vehicle refurbishment work. We expect the successor contracts to be awarded during the third quarter of 2013.                                      - 17 -

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   We have had some modest success in winning new work. In February of this year 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. These two awards support our confidence that our business development pipeline can contribute to winning additional new future work despite the government's continued delays in awarding contracts.  Our FMS Program revenues for the past two years have been generated primarily from follow on technical services work with very little ship reactivation and transfer work. Due to extended negotiations within the U.S. Congress, our traditional mainstay of ship reactivation and transfer work continues to be deferred. 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 for revenue growth from this program.  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. The repowered vehicle uses an engine designed by our WBI subsidiary specifically for the USPS vehicles. If USPS approves the engine and our effort successfully progresses to the production stage, we expect to generate an additional future revenue stream. We cannot determine with certainty if or when production will begin. WBI's supply chain and inventory management competencies also provide us opportunities to further diversify our customer base to other supply chain markets, including commercial work.  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 June 30, 2013, our employee count (without giving effect to the above-referenced furlough of employees) decreased to 2,125 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 and revenues for the six months ended June 30, 2013 and 2012, and funded contract backlog as of June 30, 2013 and 2012 is as follows:                               (in millions)                             2013        2012  Bookings                  $   248$ 266  Revenues                  $   238$ 276  Funded Contract Backlog   $   238$ 265     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.                                      - 18 -

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  Table of Contents   Revenue by Contract Type 

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

                               Six months ended June 30, Contract Type          2013          %         2012          % Cost-type            $  50,965        21     $  60,756        22 Time and materials      70,444        30        99,639        36 Fixed-price            116,810        49       115,263        42                      $ 238,219       100     $ 275,658       100   

WBI revenues are classified as fixed-price revenue.

Results of Operations

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

                               Three months                 Six months                     Change                             ended June 30,              ended June 30,            Three           Six                           2013          2012          2013          2012          Months         Months Revenues                $ 119,062$ 135,671$ 238,219$ 275,658$  (16,609 )$  (37,439 ) Contract costs            105,555       121,741       214,338       248,687        (16,186 )      (34,349 ) Selling, general and  administrative expenses                      806         1,378         1,238         1,926           (572 )         (688 ) Operating Income           12,701        12,552        22,643        25,045            149         (2,402 )

Interest expense, net 1,481 1,829 3,058 3,347

           (348 )         (289 ) Income before income taxes                      11,220        10,723        19,585        21,698            497         (2,113 ) Provision for income taxes                       4,257         4,092         7,351         8,298            165           (947 ) Income from continuing operations       6,963         6,631        12,234        13,400

           332         (1,166 ) Loss from discontinued operations                   (101 )        (336 )        (114 )        (437 )          235            323 Net Income              $   6,862$   6,295$  12,120$  12,963$      567$     (843 )    Our revenues decreased approximately $17 million, or 12%, for the quarter ended June 30, 2013, and approximately $37 million, or 14%, for the first six 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.  Our operating income increased approximately $149 thousand, or 1% for the quarter ended June 30, 2013, and decreased approximately $2.4 million, or 10%, for the first six 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 compared to the same period of 2012.  

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.

  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 six months of 2013 is approximately $865 thousand, as compared to $648 thousand in the same period of the prior year.                                      - 19 -

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Our effective income tax rates for the six months ended June 30, 2013 and 2012 were 37.5% and 38.2%, respectively.

Supply Chain Management Group Results

  The results of operations for our Supply Chain Management Group are as follows (in thousands):                          Three months               Six months                 Change                        ended June 30,            ended June 30,          Three        Six                       2013         2012         2013         2012       Months      Months  Revenues            $ 34,957$ 33,701$ 69,722$ 68,533$ 1,256$ 1,189  Operating Income    $  6,993$  5,357$ 13,005$ 11,761$ 1,636$ 1,244 Profit percentage       20.0 %       15.9 %       18.7 %       17.2 %    Revenues for our Supply Chain Management Group increased approximately $1.3 million or 4%, for the quarter ended June 30, 2013 as compared to the same period for the prior year. Revenues increased approximately $1.2 million or 2%, for the six months ended June 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 $1.6 million, or 31% for the quarter ended June 30, 2013, as compared to the same period for the prior year. Operating income increased approximately $1.2 million or 11%, for the six months ended June 30, 2013 as compared to the same period for the prior year. The increases in operating income are primarily attributable to differences in fair value adjustments in the accrued earn-out obligation associated with our acquisition of WBI and to the increases in revenues. The adjustment to the earn-out obligation increased operating income approximately $219 thousand for the quarter ended June 30, 2013 and decreased operating income approximately $806 thousand for the same period of the prior year. The adjustment to the earn-out obligation decreased operating income approximately $58 thousand for the six months ended June 30, 2013 and decreased operating income approximately $1.2 million for the same period of the prior year.  Federal Group Results  The results of operations for our Federal Group are as follows (in thousands):                          Three months               Six months                    Change                        ended June 30,            ended June 30,           Three          Six                       2013         2012         2013         2012        Months         Months  Revenues            $ 28,751$ 35,670$ 59,260$ 69,323$  (6,919 )$  (10,063 )

Operating Income $ 2,491$ 2,907$ 3,765$ 4,669 $

  (416 )   $     (904 ) Profit percentage        8.7 %        8.1 %        6.4 %        6.7 %    Revenues for our Federal Group decreased approximately $6.9 million or 19%, for the quarter ended June 30, 2013 as compared to the same period for the prior year. Revenues decreased approximately $10.1 million or 15%, for the six months ended June 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, which reduced revenues by approximately $5.8 million for the three-month period ended June 30, 2013 and $11.6 million for the six-month period ended June 30, 2013. The revenue decreases from this project and revenue declines in other programs were partially offset by an increase in revenues from the U.S. Army Reserve vehicle refurbishment program of approximately $4.3 million for the six months.  Operating income for our Federal Group decreased approximately $416 thousand, or 14% for the quarter ended June 30, 2013, as compared to the same period for the prior year. Operating income decreased approximately $904 thousand or 19%, for the six months ended June 30, 2013 as compared to the same period for the prior year. The declines in operating income are primarily due to the revenue declines.                                      - 20 - --------------------------------------------------------------------------------   Table of Contents International Group Results  The results of operations for our International Group are as follows (in thousands):                          Three months               Six months                    Change                        ended June 30,            ended June 30,           Three          Six                       2013         2012         2013         2012        Months         Months  Revenues            $ 36,239$ 42,281$ 71,629$ 88,045$  (6,042 )$  (16,416 )

Operating Income $ 1,473$ 1,319$ 3,166$ 2,835 $

                         Three months               Six months                    Change                        ended June 30,            ended June 30,           Three          Six                       2013         2012         2013         2012        Months         Months  Revenues            $ 19,115$ 24,019$ 37,608$ 49,757$  (4,904 )$  (12,149 )

  (375 )   $   (2,217 ) Profit percentage       13.0 %       11.9 %        9.9 %       12.0 %    Revenues for our IT, Energy and Management Consulting Group decreased approximately $4.9 million, or 20% for the quarter ended June 30, 2013, as compared to the same period for the prior year. Revenues decreased approximately $12.1 million or 24%, for the six months ended June 30, 2013 as compared to the same period for the prior year. The decreases in revenues were due primarily to a decrease in services performed due to contract expirations and a decline in services ordered by clients on continuing contracts.  Operating income for this segment decreased approximately $375 thousand, or 13%, for the quarter ended June 30, 2013, as compared to the same period for the prior year. Operating income decreased approximately $2.2 million or 37%, for the six months ended June 30, 2013 as compared to the same period for the prior year. The decreases in operating income are primarily attributable to a decrease in profits associated with the revenue declines and to additions to prior year operating income from reductions in the accrued earn-out obligation associated with our acquisition of Akimeka. Additions to prior year operating income due to reductions of our accrued earn-out obligation for Akimeka were approximately $967 thousand for the second quarter and $1.9 million for the six months. If the impact of the earn-out adjustments on prior year operating income were disregarded, this Group would show a year over year improvement in profit percentage for both the three- and six-month periods, based on cost efficiencies associated with combining the businesses of Akimeka and G&B.                                      - 21 -

  Our financial condition did not change materially in the first six months of 2013. 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.   

  Cash provided by operating activities increased approximately $2 million in the first six months of 2013 as compared to the same period of 2012. The change is attributable to a decrease of approximately $2.1 million in other non-cash operating activities, a decrease of approximately $843 thousand in cash provided by net income, and an increase of approximately $4.9 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.  Cash used in investing activities decreased approximately $13.3 million in the first six months of 2013 as compared to the same period of 2012. This was primarily due to non-recurring capital expenditure requirements of about $8 million associated with the move of our corporate headquarters offices in May 2012.  Cash used in financing activities increased approximately $16.5 million in the first six months of 2013 as compared to the same period of 2012. This difference was primarily due to an increase in repayments of our bank borrowing.  We paid quarterly cash dividends of $0.16 per share during the first six months of 2013. 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, and have increased the dividend each year since 2004.  

  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 can cause delays in our ability to invoice for revenues earned, presenting a potential 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. From time to time, we may also invest in the acquisition of other companies.                                       - 22 - --------------------------------------------------------------------------------   Table of Contents Our external financing consists of a loan agreement with a group of banks. This loan agreement expires in June 2016 and consists of a term loan, revolving loans, and letters of credit.  The term loan requires quarterly installment payments. Our scheduled term loan payments after June 30, 2013 are $12.5 million in 2013, $25.0 million in 2014, and $34.4 million in 2015. The amount of our term loan borrowings outstanding as of June 30, 2013 was approximately $71.9 million.  The maximum amount of credit available to us from the banking group for revolving loans and letters of credit as of June 30, 2013 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 $46.9 million in revolving loan amounts outstanding and $573 thousand of letters of credit outstanding as of June 30, 2013. During 2013, the highest outstanding revolving loan amount was $54.5 million and the lowest was $39.0 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 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 June 30, 2013, the LIBOR base margin is 2.00% and the base rate base margin is 0.25%. 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 June 30, 2013, interest rates on portions of our outstanding debt ranged from 2.19% to 3.62%, and the effective interest rate on our aggregate outstanding debt was 3.03%.  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, a minimum Fixed Charge Coverage Ratio, and a minimum Asset Coverage Ratio, which increases over time. We were in compliance with required ratios and other terms and conditions at June 30, 2013.                                 Current Maximum Ratio Actual Ratio 

                                Minimum Ratio Actual Ratio 

                         Minimum Ratio Actual Ratio 

  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 and warehouse 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.                                      - 23 -

  Table of Contents  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, we use interest rate hedges to fix the rate on a portion of our outstanding borrowings for various periods of time. The resulting fixed rates on this portion of our debt are higher than the variable rates and have increased our net effective rate, but have given us protection 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 paid an effective rate on the hedged term debt of 0.56% plus our base margin from July 2011 through June 2012, and we pay 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 June 30, 2013 is $63.4 million.                                      - 24 -

                        VSE CORPORATION AND SUBSIDIARIES