Bullish Outlook For VSE Corp Still Intact Despite Recent Challenges

Key takeaways

• VSE Corp. (VSEC) trades at a mid single-digit multiple as the recent expiration of a key government contract and general decline in revenue over the past several years due to the winding down of military involvement in Iraq and Afghanistan caused investors to question the long term growth outlook.


• However, work quickly resumed on this key contract after the award of three new task orders. Moreover, operating income is higher despite significantly less revenue due to a shift to more profitable contract work.


• Furthermore, the growing free cash flow (yield of 19%) is expected to pay down acquisition-related debt at an accelerated pace and provides greater flexibility to reward shareholders through further dividend increases or another transformative acquisition.

Company overview

VSEC provides sustainment services for Department of Defense legacy systems and equipment as well as professional services to the DoD and federal civilian agencies. VSEC operates through the following four wholly-owned subsidiaries:

The supply chain management group provides sourcing, acquisition, scheduling, transportation, shipping, logistics, data management and other services. A contract to supply vehicle parts through the Managed Inventory Program to the U.S. Postal Service is the largest source of revenue.

The federal group provides legacy equipment sustainment, engineering, technical, management, integrated logistics support and IT services to the DoD and other government agencies.

The international group provides engineering, industrial, logistics and foreign military sales services to the U.S. military and other government agencies.

The IT, energy and management consulting group provides technical and consulting services to civilian government agencies.

Volatile results mask positive underlying trend

While the past several years have been challenging, the best days are clearly ahead even if investors are still focused on the past. For example, the winding down of U.S. military involvement in Iraq and Afghanistan as well as the expiration of a large U.S. Army contract in 2011 (CECOM Rapid Response) are primary responsible for the revenue decline in 2011 as shown in the chart below. However management said in the 2012 10-K that most of the declines in programs that experienced revenue losses have "run their course".

However, the focus should be on the bottom line rather than the top given that ttm operating income is higher than the 2010 level despite significantly lower revenue. There are three primary drivers for this margin expansion. First, fixed-priced contracts continue to account for a growing portion of revenue (e.g. 52% YTD compared to 7% in 2010). Second, VSEC shifted away from lower margin pass-through work (e.g. revenue from subcontracting and materials declined to 49% of revenue in 2012 from 69% in 2010 - PDF alert). Third, a workforce reduction in April 2013 is expected to provide ~$6 million in cost savings.

The significant growth in free cash flow (with a 19% yield on a ttm basis) shown in the chart below is actually understated as VSEC spent ~$9 million to move its corporate headquarters* and $9 million to purchase office, warehouse and distribution facilities that support the growing supply chain management group last year.

More recently, in the mrq revenue declined 17% to $111 million while operating income declined 34% to $9.5 million as strong performance from the supply chain management group was more than offset by weaker performance in the other three groups. The expiration in July 2013 of a contract for vehicle and equipment refurbishment work for the U.S. Army Reserve (the third largest source of revenue) was largely responsible for the revenue decline. However, in August and September 2013, VSEC won three new competitively awarded task orders to resume work on this contract.

While the foreign military sales program in the international group (the second largest source of revenue) provides relative stability** as it does not rely on tax funded government spending, there is significant positive optionality if Congress passes the Naval Vessel Transfer Act, which would allow for ship reactivation and transfer work (to make excess U.S. Navy ships available to allies) with potential contract coverage up to $1.5 billion over a five-year period.

VSEC continues to win more contracts ($99 million U.S. Coast Guard contract, $24 million contract to support Taiwan Maritime Defense efforts, $12 million contract to support the Marine Corps Logistics Command), which resulted in a funded contract backlog of $268 million.

*This was a necessary move as the building was scheduled to be demolished so staying put and saving the $9 million was obviously not an option.

**Revenue for Egyptian Navy support declined by ~$0.8 million per month after the workforce was evacuated in July 2013 due to political unrest, although support services continue to be performed at other locations.

Great progress but more can be done by doing less

VSEC made a great acquisition in June 2011 in Wheeler Brothers, which established the supply chain management group that is more than punching above its weight (see Valuation section below) and provides significant expansion opportunity such as servicing non-government vehicle fleets. Although this $180 million acquisition resulted in the increased debt load shown in the chart below, the growing cash flow (aided by the expected decline in capex) is being used to repay this debt.

In December 2012, VSEC decided to sell its construction management services subsidiary Integrated Concepts and Research (after a U.S. Transportation Department contract expired earlier than anticipated) and combined the operations of its Akimeka and G&B Solutions subsidiaries, which should result in greater efficiencies and a stronger competitive position.

While management mentioned the possibility of further acquisitions given the greater financial flexibility, a less risky approach (and potentially more rewarding from a shareholder perspective) may be to grow organically. While this would require pivoting from the growth through acquisitions strategy, VSEC is prepared for this change given its valuable asset mix (e.g. improving financials, diverse group of subsidiaries, strong management). This would allow for accelerated debt reduction rather than force management to effectively "start over" (e.g. debt increases again and needs to be paid down).

The excess cash flow could then be used to continue the consistent dividend increases. For example, the annual dividend steadily rose from $0.175 in 2008 to $0.36 currently (most recently increased 12.5%). While the annual dividend that can be paid is limited to $0.60 by the bank loan agreement, there is still sufficient runway until this limit is reached.

However, even if management decides on another acquisition, this would not materially affect the investment thesis given the excellent long term track record by management.

Valuation

The mid single-digit multiple is attractive on an absolute basis and compared to its peers (although EGL is the closer peer after CACI acquired Six3). Moreover, as previously mentioned EBITDA is depressed due to the interruption of the Army Reserve contract, which should result in a rebound in EBITDA as work has since been resumed.

This temporary revenue decline results in the supply chain management group acting as the primary valuation driver. For example, as shown in the charts below, this group accounted for only 30% of revenue YTD and 61% of operating income. Once growth resumes at the other three groups, the implied discount for each should gradually be removed and result in an overall higher multiple.

Risks

The following are the primary risks to the investment thesis, in order of importance:

• The loss of a contract to a competitor (e.g. in September 2013 it lost a follow-on contract for the Treasury Department Asset Forfeiture general property program to a competitor) or the expiration of a contract (e.g. at the end of 2012 a contract to provide mechanical maintenance services for Mine Resistance Ambush Protected vehicles and systems expired) would negatively affect results. This risk is mitigated to some extent as a significant amount of revenue is from larger programs that do not rely on tax funded government spending or new procurements.


• A small number of large contracts accounts for a majority of revenue. The managed inventory program, foreign military sales program and equipment refurbishment program accounted for 30%, 20% and 13%, respectively, of revenue YTD.


• Lower federal government spending (especially due to sequestration) would negatively affect results due to fewer contract awards while competition could increase as more companies compete for fewer contract dollars.

Conclusion

The target price is based on a 1x turn increase in the EBITDA multiple, which is conservative given that the EBITDA used is based on ttm and assumes no rebound.

The 200 DMA right below the current price provides a natural place for a tight stop loss. The time frame is 12-24 months.

Source: Bullish Outlook For VSE Corp Still Intact Despite Recent Challenges

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. (More...)

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