Earnings Call Transcript - VSEC Q2 2020

Operator, Operator

Greetings. Welcome to the VSE Corporation Second Quarter 2020 Earnings Conference Call. At this time, all participants are in a listen-only mode. I will now turn the call over to Mr. Noel Ryan, Head of Investor Relations. Thank you. You may now begin.

Noel Ryan, Head of Investor Relations

Thank you. Welcome to VSE Corporation's second quarter 2020 results conference call. Leading the call today are our President and CEO, John Cuomo; and Chief Financial Officer, Tom Loftus. The presentation we are sharing today is on our website, and we encourage you to follow along accordingly. Today's discussion contains forward-looking statements about future business and financial expectations. Actual results may differ significantly from those projected in today's forward-looking statements due to various risks and uncertainties, including the risks described in our periodic reports filed with the SEC. Except as required by law, we undertake no obligation to update our forward-looking statements. We are using non-GAAP financial measures in our presentation. The appropriate GAAP financial reconciliations are incorporated into our presentation where available, which is posted on our website. All percentages in today's discussion refer to year-over-year progress, except as noted. At the conclusion of our prepared remarks, we will open for questions. With that, I would like to turn the call over to John Cuomo for his prepared remarks.

John Cuomo, President and CEO

Thank you, Noel. Welcome everyone and thank you for taking the time to join our call today. We are now halfway through the year that will long be known as one of great challenge and resilience. During a period of uncertain macroeconomic conditions and more specifically one in which commercial air traffic fell to historic lows, our team quickly adapted to rapidly evolving market dynamics with a series of targeted divestitures, cost reductions, and new business development initiatives. Despite the market conditions, VSE delivered $0.60 of adjusted EPS and strong free cash flow of $14.9 million, continuing to pay both our quarterly dividend and reduce debt within the quarter. Our VSE results-first culture led to our second quarter not only being about responding to the market during a global pandemic, but one where we exceeded our internal forecasts, seized new business opportunities, and continued to execute on our focused strategy. As expected, our second quarter results were impacted by the ongoing effects of the COVID-19 pandemic, particularly within our Aviation segment which reported a 31% year-over-year decline in revenue, excluding the impact of the prime turbines divestiture. This decline in commercial aviation activity was partially offset by comparatively stable demand from our government customers who on a combined basis represented about 75% of total revenue in the second quarter. Turning now to slide three of the conference call presentation. Before we move into a detailed review of our second quarter results, I'd like to begin with an update on our corporate strategy and specifically the actions taken to execute on this strategy since our last quarterly update. New business development remains the top priority across all of our operating segments. During the first half of 2020, our Federal & Defense Services Group reported $116 million in new awards, up from $32 million in the first half of 2019. This was driven by the successful expansion of our suite of capability offerings to both new and existing customers. During the first half of 2020, we increased our contract bidding activity by 30% compared to the first half of 2019, consistent with management's focus on building a growing pipeline of government contracts. Within our fleet segment, we reported a 67% year-over-year increase in commercial sales during the second quarter, driven by strong growth in our e-commerce business and new fleet commercial customer additions. Although our Aviation segment has been impacted by a decline in air travel, we've continued to take share through new business wins, positioning us to perform better than our industry peers despite near-term softness in demand. As we look to the second half of 2020, we are already seeing results from our business development efforts as evidenced by the recently announced distribution agreement with Honeywell. We have already engaged in supporting our business in general aviation customers with products from that distribution agreement in the month of July. Together with new business development, we also remain focused on rightsizing our business and cost structure in the current demand environment. As disclosed last quarter, we expect to remove approximately $13 million in annualized costs mainly within the Aviation segment by the end of the third quarter of 2020. We expect to realize approximately $6 million in cost benefit reduction in the back half of 2020 from these actions. Further, during the second quarter, we progressed with our plan to integrate our Aviation business units and reduce our go-to-market entities from seven to two, including market-leading business units that serve both distribution and MRO services. As part of this program, we consolidated work into centers of excellence and closed or are in the process of exiting three facilities. Consistent with our strategic focus on higher margin business with greater barriers to entry, we continue to rightsize our asset portfolio while divesting of non-core assets. During the second quarter, we completed the sale of assets related to CT Aerospace, a provider of engine acquisition and leasing spare and insurable part inventories. Importantly, we sold these assets for the full book value. Looking ahead, our Aviation go-to-market strategy will concentrate on higher growth components and engine accessory MRO and parts distribution to support the Commercial and Business and General Aviation markets. Finally, we remain highly focused on maintaining balance sheet discipline while continuing to pay our quarterly dividend and preserve capital to help fund high return growth opportunities. Given the low capital intensity of our business, we consistently achieve high free cash flow conversion. During the second quarter, we generated $14.9 million in free cash flow, up from a negative $2.7 million in the prior year period. This year-over-year growth in free cash flow generation resulted in more than $13 million in debt reduction during the quarter, bringing our net debt to the lowest level in nearly two years. Moving to slide four, VSE reported total revenue of $168.7 million, down 10.8% year-over-year. Revenue from core commercial customers is down 32% year-over-year to $40.2 million, primarily due to the softness in our Aviation segment. Revenue from our Federal & Defense customers was relatively flat, down 1% year-over-year to $128.6 million for the quarter. We ended the quarter with total adjusted net income of $6.6 million or $0.60 for adjusted diluted share and with total adjusted EBITDA of $17.2 million, down 27.1% year-over-year. For the business as a whole, commercial customer revenue is recovering at a healthy rate versus June levels. We currently anticipate sequential quarter-over-quarter growth in the aviation segment revenue and earnings during the third quarter of 2020, as compared to the second quarter. We continue to make strong progress with respect to new business development wins across each of our reporting segments, positioning us to leverage our share again as an offset to what we expect will be gradual multi-year recovery in the Aviation aftermarket. I am pleased with our second quarter results, particularly given the macroeconomic challenges facing the Aviation industry. While we have significant work ahead of us, we have repositioned the company as a leaner and more scalable business than it was 12 months ago, positioning us to win in higher margin markets over the long term. We expect to be both profitable and free cash flow positive for the full year 2020. With that, I turn the call over to our CFO, Tom Loftus, to discuss our second quarter financial performance in more detail.

Tom Loftus, Chief Financial Officer

Thanks, John. Turning to slide 5, our second quarter revenue of $168.7 million decreased 10.8% year-over-year, primarily driven by decreases in our Aviation and Federal & Defense segments. For the trailing 12 months, our revenue was up $30.7 million or 4.3%. As illustrated on slide 6 and 7, our total adjusted EBITDA was $17.2 million, down 27% year-over-year in Q2 and our trailing 12-months adjusted EBITDA was approximately $88 million, up 5% year-over-year. In the face of the global pandemic, our Aviation segment was adversely impacted by lower revenue passenger miles, which resulted in lower demand for aftermarket parts supply as well as MRO support. Additionally, revenue from our Federal & Defense segment decreased due to the completion of a contract with the Department of Defense in January 2020. Our Fleet segment benefited from $19.5 million of revenue from a non-recurrent order for COVID-related PPE supplies from a government customer. Despite the challenges we've experienced this quarter, we expect to be both adjusted net income and free cash flow positive for the full year 2020. Now, I will discuss each of the three operating segments starting with slide 8. Excluding the sale of Prime Turbines, Aviation segment revenue declined 31% year-over-year to $32.2 million in the second quarter. Our operating income decreased approximately $39.6 million for the second quarter of 2020 compared to the same period of the prior year. The primary components of the decrease were $33.7 million of non-cash impairment charges, a $678,000 loss on the sale of CT Aerospace assets, and a decline in revenue and profits precipitated by the pandemic. Adjusted EBITDA decreased to $1.2 million in the second quarter of 2020. Turning to slide 9, revenue from our fleet segment increased 32.4% year-over-year to $71.2 million in the second quarter, while operating income decreased approximately 8% year-over-year to $7 million. This segment continues to successfully execute on its customer diversification strategy with commercial revenue growing $3.4 million or 67% in the second quarter on a year-over-year basis. Fleet segment adjusted EBITDA decreased $7.7 million year-over-year in the second quarter to $9.6 million. Revenues of $19.5 million from a non-recurring PPE order from a government customer had an adverse impact on margin. Excluding the one-time order, adjusted EBITDA margin was 18.6 for the quarter. On slide 10, Federal & Defense segment revenue declined 18.7% year-over-year to $65.3 million in Q2 2020. But operating income increased 33% year-over-year to $6.8 million. Adjusted EBITDA for this segment increased 29% year-over-year in the second quarter to $7.5 million. In the second quarter, total Federal & Defense segment bookings decreased 37.5% year-over-year to $45 million, while total funded backlog declined 36.4% year-over-year to $171 million. The decline in funded backlog was attributable to the expiration of a large army contract in January and delays in new business awards. The company continues to focus on revitalizing this business with an emphasis on growing backlog and developing the channel of new customer activity in the current year. The third quarter is off to a strong start with the recent announcement of $42 million in new bookings so far in July. Turning to slide 11, as of June 30, 2020, we had $184 million in cash and unused commitments available under our $350 million revolving credit facility that matures in January 2023. Our existing credit facility includes a $100 million accordion provision. We ended the quarter with total net debt outstanding of $260 million against $88 million trailing 12-months adjusted EBITDA. As John highlighted earlier, despite the current economic environment, we remain highly focused on liquidity conservation and debt reduction for 2020. Lastly, on June 29th, we successfully amended our existing loan agreement with our bank group. Under the terms of the amended loan agreement, the amendment provides financial covenant flexibility, which will allow us to successfully operate through the current economic environment. Importantly, these amendments were not required. We made the decision to amend the agreement to ensure a healthy cushion and conservative approach to debt during these uncertain times. With that, I'll turn it back over to John.

John Cuomo, President and CEO

Thank you, Tom. In closing, I'd like to thank our investors and employees for their ongoing support of VSE. During periods of great uncertainty, strong businesses find a way to capitalize on market inefficiencies while creating new opportunities for profitable growth. Against the market adversities, I am proud of what the VSE teams accomplished during the first half of this year. We are well-positioned to manage through challenging times with our balanced customer product and service portfolio, solid vision for long-term growth, and a strong balance sheet. We are confident in our ability to emerge from the current crisis even stronger, more profitable, and better positioned in our markets. Operator, we are now ready for the question and answer portion of our call.

Operator, Operator

Thank you. At this time, we will be conducting a question-and-answer session. Our first question comes from the line of Michael Ciarmoli with SunTrust. Please state your question.

Michael Ciarmoli, Analyst

Hey, good morning, guys. Nice results here given the current operating environment. John, just on Aviation, maybe can you give us an update on what the trends sort of looked like. It seems like across the industry April might have benefited a little bit from a backlog of repair work. What did you see into May and June, and do you think that sort of weakens before it gets better just given the reduced flying hours and utilization of the Fleet?

John Cuomo, President and CEO

Thanks, Mike. Let me break it out by MRO and distribution. If we look at MRO, we definitely benefited from some backlog in our MRO businesses in April. So we had a definite little benefit upfront there. If you look at business in general aviation, our MRO position is there, May and early June really represented a bottom for us; although we're far from pre-COVID revenue levels, the end of June and July recovery trends appear to be holding. For the commercial MRO, just as we had more backlog in April to start the decline, we do see that recovery coming a little slower, but we were looking at kind of the bottom there being June, July and we're starting to see inputs increase towards the end of July, which will bode for a stronger recovery in the month of August. From our distribution business, we have a really short book to ship, so virtually all the revenues are somewhat organic in that quarter. So for that business, there was no benefit of backlog in April, and we are seeing consistent improvement in the month of June and July in that business as well.

Michael Ciarmoli, Analyst

Got it. And then even on there from like, if I were to look at an inventory standpoint, inventory for you guys up, sequentially on the distribution side, I guess specifically what are you seeing in sort of, I guess the product velocity out there in the marketplace. Do you think there is going to be a lot of destocking that happens for some of your customers across the commercial biz jet general aviation, and do you think it's going to be a little bit harder to move that inventory and convert it to cash?

John Cuomo, President and CEO

A couple of things. First, when it comes to the inventory we have on hand, we did a significant amount of rescheduling in the quarter, pushing as much work out into 2021 beyond as possible. Obviously, there is some with the manufacturers that we have some commitments, so we did receive a significant amount of inventory in the quarter based on trends that were trending much higher in Q1. The good thing here in this business is that most of our inventory is very heavily OEM proprietary part-centric and it's not products that customers traditionally stock heavily. What that means is they are not sitting on a lot of inventory regardless of the trend and we should recover faster and have much less of the destocking risk than many of our competitors or other suppliers out there.

Michael Ciarmoli, Analyst

Got it. And then just some shifting quickly to Federal, you guys talked about the new bookings, the new wins here in July, and it sounded like you're getting out there more into the marketplace. I think the number you threw out, your bidding activity was up 30%. Focusing on our pipeline, what else aside from maybe blanketing the market with more bidding activity, what else is kind of helping you win this business? Can you talk maybe about your value proposition or what else is attracting customers to you guys?

John Cuomo, President and CEO

Yeah. So it's a business that the former leadership really focused on creating these three segment aftermarket businesses; it's a business that suffered a little bit with the lack of investment. So when we look at kind of the phase strategy over the next three years, Phase one was revitalizing the team; we have such tremendous core competencies in technical engineering, maintenance, repair, and overhaul and other types of capabilities inside the team, and making sure that we were getting those capabilities out in the marketplace. So candidly, the first phase of it was all about just taking these operations work and the sustainment work and making sure we're bidding more to win more. The second phase of it is now extending those value propositions. Specifically, you'll see us focus over the next six to nine months on the supply chain capability and doing a much deeper dive. We restructured that team in the quarter, brought on a new leader in that team, and you will see us that will be a core focus of ours. On the maintenance and sustainment programs, we were traditionally more on kind of the army and the naval vessel type work, and we launched greater initiatives to focus on that aircraft sustainment work for Air Force and for other armed forces that are flying aircraft. We had one win earlier in the year and that Naval program went live officially in the month of July in Jacksonville.

Michael Ciarmoli, Analyst

Got it. Perfect. I understand that you won’t be providing guidance, but you did mention some positive trends as the year wraps up. Can you share any additional insights regarding revenue? I assume that Fleet will experience a drop due to the one-time order, but is there anything else you can tell us about Q3 or Q4 in terms of growth or profitability?

John Cuomo, President and CEO

I mean, what we've consistently said is that if you break out the segments, the Federal Group was kind of a shrink to grow and kind of a build — keep the core and revitalize that business this year. That business is performing to our internal plan and they continue to achieve our internal plan and we expect that to continue throughout the back half of the year. From a fleet perspective, we had a strong quarter in terms of commercial demand as we focus on diversifying that customer base, but that quarter was really strong with our e-commerce customers and a little bit less strong with our just-in-time customers, so we didn't have the ability to get in front of customers and focus on that growth. We are seeing better performance in that commercial side of the business. The non-e-commerce side has started to improve in the third quarter. From an Aviation perspective, I think we're breaking this out one quarter at a time right now, and we are comfortable to say that you will see sequential quarter-over-quarter both revenue and earnings growth Q3 over Q2, which I think I'm not sure if everybody else is saying that in the market at this point, but we feel comfortable with that guidance.

Michael Ciarmoli, Analyst

Got it. That's helpful. I'll jump back in the queue guys, thanks.

John Cuomo, President and CEO

Okay. Thanks, Mike.

Operator, Operator

Our next question comes from the line of Joshua Sullivan with The Benchmark. Please proceed with your question.

Joshua Sullivan, Analyst

Hey, good morning John, nice quarter here.

John Cuomo, President and CEO

Thanks, Joshua.

Joshua Sullivan, Analyst

In the Aviation segment, can you discuss the competitive landscape? Are you noticing any competitors facing difficulties, and are you gaining market share from them at this time?

John Cuomo, President and CEO

Yeah, I mean, if I kind of break out the Aviation segment into distribution and MRO, I think that from a distribution perspective, we are seeing more opportunities. We're seeing some of our competitors who play in the distribution market but are on pure play aftermarket distribution businesses, focusing on their core, whether that be an OEM or other type of core business, and that's creating some opportunities for us. We're also seeing new business opportunities where some of the traditional aftermarket players are in a financial position to invest organically in their businesses. So from a market share perspective, that's where we see the Aviation distribution business right now. From the MRO perspective, the market is going to be a little slower to recover there on the commercial side. Where we see the biggest opportunity is there are still a segment of really fragmented smaller MRO shops, and there is a little bit of CARES Act support that will extend through the end of September to support some of those businesses. But we are seeing a decrease in technical talent at some of those businesses, which is creating some opportunity for us as well as that rotable parts trading business that exists in those businesses, again a little bit of a change in investment strategy, which has created some opportunity for us as well.

Joshua Sullivan, Analyst

And then, just on the fleet segment, some impressive year-over-year growth there; it sounds like it was tough on the commercial side. It sounds like it was really driven by the e-commerce offering. Any particular product trends within that that's driving that growth or just what is driving the e-commerce uptick here?

John Cuomo, President and CEO

No, it's really just solid execution by the fleet team on the internal strategy. We're not going down that brick-and-mortar route — our play in the commercial space there will be predominantly around that e-commerce and what we call e-commerce fulfillment strategy as well as that just-in-time strategy, so we saw a stronger focus on e-commerce in the quarter. We believe predominantly because people weren't physically getting out and we do think there is a little bit of benefit from how COVID is going to help shift consumers' thoughts around e-commerce, and we benefited from that.

Joshua Sullivan, Analyst

Got it. And then just on the post office, some of the funding mechanics that are going on there. How are you feeling about that right now in this new leadership, and does that change your outlook at all for how you're exposed there?

John Cuomo, President and CEO

We're happy to see the funding that's coming through as expected. I mean, we're seeing more of a commercial approach right from the onset with the new leader. We're seeing slightly lower demand of maintenance activity as costs are controlled and cost pressures are controlled. The benefit that we see is that our relationship with the USPS is very commercial in nature. It's a full just-in-time program; we manage about 70% of part content on the 231,000 vehicles that are in the supply chain, and effectively, it's on a consignment program where the USPS doesn't have any on-hand inventory. So we believe that we're ahead of the curve where the new Postmaster General wants to take that program into more of a commercial business, and we do see some potential opportunities for expansion in other types of partnership opportunities with the Postal Service as he moves forward with that transformation.

Joshua Sullivan, Analyst

And just one last one on Aviation. With your exposure to pipeline replacement parts and as we think about how airlines are thinking about A, B, C, and D checks, any noticeable trends you can comment on that right now?

John Cuomo, President and CEO

I think that a couple of things; I think where we kind of we're not large in our markets yet today. We have strong positions from a market perspective but not from a market share perspective. So we try to break down kind of what we see in terms of demand and then how it actually relates to our business. We think our businesses are down 60% plus, and we're outperforming those because of share of wallet expansion and our existing customers. What I mentioned earlier on the part sales industry is that we're a little better capitalized to support that part of the business compared to the smaller, more fragmented players out there. We do see ourselves in a very well-positioned state, and kind of the same logic applies to the MRO side, where we feel like our scale and financial strength to support the business through COVID, where some of the smaller competitors do not, is really going to position us best to come out of this faster. We're very aggressively focusing on that capability expansion. So the way that we're building our business model is to assume that there is a plateau at some point in this recovery that we've seen through the bottom, and how do we still grow in that plateau. And that has to come with share of wallet expansion and capability and product expansion. So it's kind of the way that we're approaching the strategy.

Joshua Sullivan, Analyst

Got it. Nice quarter. And again, thank you for the time.

John Cuomo, President and CEO

Thanks, Josh.

Tom Loftus, Chief Financial Officer

Thanks, Josh.

Operator, Operator

Our next question comes from the line of Michael Ciarmoli with SunTrust. Please proceed with your question.

Michael Ciarmoli, Analyst

Hey. Thanks for taking the follow-up guys. John, just can you disclose what percentage of the Postal Service was in the quarter?

John Cuomo, President and CEO

I don't know if you have that handy. We don't traditionally disclose the specific customer's contribution in the quarter; you'll see kind of the federal breakdown, and that's part of the federal space, but they continue to be our largest customer.

Michael Ciarmoli, Analyst

Got it. And then, you had that nice distribution announcement with Honeywell, and I know you've had a pretty long lengthy relationship there. It sounds like this is a two-year exclusive. Can you just give a little bit more color on that? Did you win this competitively? Are there any upfront inventory requirements? And then, sort of, what can we expect from a revenue standpoint? I know it seems like a portion of those offerings are a little bit more discretionary in nature and maybe tied to sat-comm and connectivity, which I'm not really sure if there's going to be a lot of spending there, but maybe just a little more color on that deal?

John Cuomo, President and CEO

Sure. The relationship with Honeywell has been very strong since I joined VSE about a year ago. I previously had a solid relationship with them dating back to 2008, so I'm pleased to continue our partnership. This particular contract is not a result of competition; rather, it represents an expansion of our existing relationship. The deal is valued at approximately $20 million over its duration, and we have already realized immediate revenue in July. Although this revenue is discretionary and relates to platforms in the general aviation market with planned upgrades for 2020 and 2021, we anticipate it will not be a consistent revenue stream throughout the period. However, we expect it to grow, and we have already surpassed our internal revenue forecast for July as we launch this initiative. In terms of inventory, we expect it to increase through probably three or four purchases during the term.

Michael Ciarmoli, Analyst

Okay. Last one, and this probably pertains to a little bit more to your commercial MRO. But as we think about the wave of retirements that are coming here, what's likely going to be a pretty big increase in used and serviceable material. How are you guys thinking about that? Obviously, you don't traffic much in the parts trading. But is there an opportunity to participate from an accessory repair standpoint, if products are coming off old planes? Just trying to think about this, is it more of a risk? Is it an opportunity, or is it just really a net neutral for you guys?

John Cuomo, President and CEO

Yeah, I mean, it's probably net neutral for us. I mean you're less than 5% of our parts are probably – there's some USM application out there from a competitive perspective. But I mean, that's me, even rounding up, it's such a small portion of where we would see an impact in the business. From an MRO perspective, we do see consistent opportunities out there, even from some of the routable pools where the 8130 tag needs to be refreshed in our team's ability to do that through our FAA certified shop. So we see some opportunities, but I would say on par, it's probably net neutral.

Michael Ciarmoli, Analyst

Okay. Cool. Thanks guys.

Tom Loftus, Chief Financial Officer

Hey, Mike, to follow up on your question about USPS, we revealed in the 10-K that USPS represents approximately 22% of our total revenue for 2019. Excluding that one-time order, it remains consistent with that figure from last year.

Michael Ciarmoli, Analyst

Okay, perfect. Thank you.

John Cuomo, President and CEO

Thanks, Mike.

Operator, Operator

Great. Thank you. Thanks everybody for your time and interest today. We appreciate your support of VSE. Stay safe and we look forward to connecting with you on our next quarterly call. Have a great day. This concludes today's teleconference. You may now disconnect your lines at this time. Thank you for your participation and have a wonderful day.