TMCnet News
VSE CORP - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations(Edgar Glimpses Via Acquire Media NewsEdge) Executive Overview We provide sustainment services for legacy systems and equipment and professional and technical services to the United States Government (the "government"), including the United States Department of Defense ("DoD"), the United States Postal Service ("USPS"), and federal civilian agencies, and to other customers. Our largest customers are the DoD and the USPS. Our operations consist primarily of vehicle fleet parts, supply chain management, ship and aircraft maintenance, vehicle and equipment maintenance and refurbishment, logistics, engineering, energy and environmental, IT solutions, health care IT, and consulting services performed on a contract basis. Organization and Reporting Segments Our operations are conducted within four reportable segments aligned with our management groups: 1) Supply Chain Management; 2) International; 3) Federal; 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 wholly owned subsidiary Wheeler Bros., Inc. ("WBI"). Significant current work efforts for this group include WBI's ongoing Managed Inventory Program ("MIP") that supplies vehicle parts for the USPS truck fleet and commercial clients. International Group - Our International Group provides engineering, industrial, logistics, maintenance, information technology, fleet-wide ship and aircraft support, aircraft sustainment and maintenance, facility operations, storage and disposal support for seized and forfeited general property programs, and foreign military sales services to the U.S. military branches, government agencies, and other customers. This group provides its services to the U.S. Navy, Air Force, Department of Justice, Bureau of Alcohol, Tobacco, Firearms and Explosives ("ATF"), and other customers. Significant work efforts for this group include 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 seized and forfeited general property programs ("Seized Asset Programs"). 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 current work efforts for this group include our ongoing U.S. Army Reserve vehicle refurbishment program and various vehicle and equipment maintenance and sustainment programs for U.S. Army commands. IT, Energy and Management Consulting Group - Our IT, Energy and Management Consulting Group consists of our wholly owned subsidiaries Energetics Incorporated ("Energetics") and Akimeka, LLC ("Akimeka"). This group provides technical and consulting services primarily to various DoD and federal civilian agencies, including the United States Departments of 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. Akimeka offers 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 --------------------------------------------------------------------------------- Table of Contents Concentration of Revenues (in thousands) For the six months ended June 30, 2014 2013 Source of Revenue Revenues % Revenues % USPS MIP $ 78,963 35 $ 68,828 29 FMS Program 42,534 19 42,455 18 U.S. Army Reserve 29,330 13 39,032 16 Other 76,544 33 87,904 37 Total Revenues $ 227,371 100 $ 238,219 100 Management Outlook As challenges in our legacy markets continue to adversely impact our revenues, we are responding by adapting our vehicle, ship, and aircraft sustainment, service life extension, and logistics competencies to the needs of adjacent markets. Our success in extending these competencies to new markets, especially with respect to our supply chain services, has given us a clear direction for our future. Our initiatives for future growth are focused on extending our key sustainment and logistics competencies to these more promising markets, while we continue to defend and maintain our presence in our chosen legacy markets. We are committed to providing value to our clients by assisting them in extending the service life and enhancing the performance of their existing physical assets as an attractive alternative to costly replacement. Our key service offerings include managed inventory services centered on vehicle fleet sustainment offered by our Supply Chain Management Group. WBI's USPS MIP provides ongoing mission-critical supply chain support to the USPS, which provides us with a steady revenue and earnings source. This program does not rely on appropriated government spending, as it is primarily self-funded through revenues generated by USPS business operations. This is our largest revenue source and we have seen growth in this program. Additionally, WBI's managed inventory competency is being successfully marketed to commercial clients operating large vehicle fleets. Success in WBI's offerings to both traditional and commercial markets has encouraged us to focus our strategic direction on this part of our business and direct financial and management resources toward such efforts. We have experienced declines in our DoD and other federal civilian agency revenues due to a curtailment of government spending for certain programs and services, changes in government spending priorities and increased competition for fewer opportunities. In response to uncertainty in our legacy business environment, we have aggressively balanced our cost structure with our workload. We will continue cost balancing efforts to remain competitive and profitable as we go forward. Despite these challenges to our revenue base, we have key programs in our legacy markets continuing to provide a substantial portion of our business. These programs include our International Group's U.S. Navy FMS Program, and our Federal Group's military vehicle and equipment refurbishment work. Our International Group's U.S. Navy FMS Program is our second largest source of revenue. This program does not rely on appropriated government spending as it is largely funded by foreign government clients. FMS Program revenues for the past few years have been impeded by protracted delays in passing the legislation required for the transfer of naval vessels to allied navies. Historically, supporting the U.S. Navy in reactivating, transferring and providing the follow-on technical support to receiving navies constituted the majority of our FMS business. Our current contract supporting this work gives us potential contract coverage of up to $1.5 billion over a five-year period that began in January 2012. This level of contract coverage, combined with the eligibility, upon approval, of a large backlog of U.S. Navy ships for transfer to foreign government clients, presents us with an opportunity to return to prior FMS revenue levels when a Naval Vessel Transfer Act is passed by Congress. Follow on technical support work under our FMS Program has generated relatively consistent revenues. These services are provided to a number of foreign client countries, the largest of which is the Egyptian Navy. In July 2013, we evacuated our workforce from Egypt due to significant domestic and political unrest in that country. We continued performing support services for the Egyptian Navy at other locations, but our revenue from this support under these circumstances is lower than when our workforce is located in Egypt. In March and April 2014 we began reinstating some of our workforce in Egypt at lower than our previous staffing levels. Our Egyptian Navy support services generated approximately $18 million of revenue for the first half of 2014 and approximately $48 million of revenue for a full year in 2013. Operating profit margin on this work is consistent with the reported profit margin of our International Group. Our long-term relationship with the Egyptian Navy remains strong and will only grow stronger as U.S. and Egyptian relations improve. We cannot predict the longer range impact that the political situation in Egypt will have on our Egyptian Navy support program. - 17 --------------------------------------------------------------------------------- Table of Contents Our Federal Group's vehicle and equipment refurbishment work for the U.S. Army Reserve is our third largest source of revenue. Our contract for this work was re-competed in July 2013 to transition the work from a General Services Administration ("GSA") contract to multiple Army contracts. In August and September 2013, we were awarded three new task orders on our existing Army contracts to continue work on this program for another year. Contractual terms under those task orders have resulted in lower profit margins for us on this program compared to our previous contractual arrangements. This program generated approximately $29 million of revenue for the first half of 2014 and approximately $60 million of revenue for a full year in 2013. The U.S. Army Reserve is not insulated from DoD and Department of the Army budget reductions. Currently, it remains uncertain how much of this work will be re-competed, continued or extended upon expiration of our current task orders. Our work as the prime contractor for the U.S. Department of Treasury Executive Office for Asset Forfeiture general property program came to an end in 2014, and substantially all of our work on this program was completed as of March 2014. This program generated approximately $9 million of revenue for the first half of 2014 and approximately $36 million of revenue for a full year in 2013. We have consistently reduced our bank debt and that positions us to consider a variety of options to increase stockholder value. Bookings and Funded Backlog Much of our revenues depends 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. While bookings and funded contract backlog generally result in revenues, occasionally we will have funded contract backlog that expires or is de-obligated upon contract completion and does not generate revenue. WBI's revenues 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, 2014 and 2013, and funded contract backlog as of June 30, 2014 and 2013 is as follows: (in millions) 2014 2013 Bookings $ 173 $ 248 Revenues $ 227 $ 238 Funded Contract Backlog $ 178 $ 238 Recently Issued Accounting Pronouncements In May 2014, the Financial Accounting Standards Board ("FASB") issued Accounting Standards Update ("ASU") No. 2014-09, Revenue from Contracts with Customers, which outlines a single comprehensive model for entities to use in accounting for revenue arising from contracts with customers and supersedes most current revenue recognition guidance, including industry-specific guidance. The ASU is based on the principle that an entity should recognize revenue to depict the transfer of goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. The ASU also requires additional disclosure about the nature, amount, timing and uncertainty of revenue and cash flows arising from customer contracts, including significant judgments and changes in judgments and assets recognized from costs incurred to fulfill a contract. The ASU will become effective for us on January 1, 2017. We currently are assessing the impact that this standard will have on its consolidated financial statements. - 18 --------------------------------------------------------------------------------- Table of Contents 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, 2013. Please refer to our 2013 Form 10-K for a full discussion of our critical accounting policies. Revenue by Contract Type Our revenues by contract type were as follows (in thousands): Six months ended June 30, Contract Type 2014 % 2013 % Fixed-price (1) $ 131,064 58 $ 116,810 49 Cost-type 75,751 33 50,965 21 Time and materials 20,556 9 70,444 30 $ 227,371 100 $ 238,219 100 (1) WBI's revenue is classified as fixed-price revenue. Results of Operations Our results of operations are as follows (in thousands): Three months Six months Change ended June 30, ended June 30, Three Six 2014 2013 2014 2013 Months Months Revenues $ 107,962 $ 119,062 $ 227,371 $ 238,219 $ (11,100 ) $ (10,848 ) Contract costs 96,481 105,555 204,092 214,338 (9,074 ) (10,246 ) Selling, general and administrative expenses 778 806 1,219 1,238 (28 ) (19 ) Operating Income 10,703 12,701 22,060 22,643 (1,998 ) (583 ) Interest expense, net 1,090 1,481 2,287 3,058 (391 ) (771 ) Income before income taxes 9,613 11,220 19,773 19,585 (1,607 ) (188 ) Provision for income taxes 3,669 4,257 7,560 7,351 (588 ) 209 Income from continuing operations 5,944 6,963 12,213 12,234 (1,019 ) (21 ) Loss from discontinued operations (279 ) (101 ) (894 ) (114 ) (178 ) (780 ) Net Income $ 5,665 $ 6,862 $ 11,319 $ 12,120 $ (1,197 ) $ (801 ) Our revenues decreased approximately $11 million, or 9%, for the second quarter of 2014, and approximately $11 million, or 5%, for the first six months of 2014, as compared to the same periods of 2013. Revenues of our Supply Chain Management Group increased and revenues of our International, Federal, and IT, Energy and Management Consulting Groups decreased compared to the prior year. Contract costs consist primarily of direct costs including labor, inventory, material, and supplies used in the performance of our work and delivery of our products, and indirect costs associated with these direct costs. These costs will generally increase or decrease in conjunction with our level of work or products sold and associated revenues. Our contract costs decreased approximately $9 million, or 9%, for the second quarter of 2014, and approximately $10 million, or 5%, for the first six months of 2014, as compared to the same periods of 2013. Reductions to our indirect costs initiated in the second quarter of 2013 contributed to the decrease in contract costs in 2014 as compared to 2013. Contract costs from our Supply Chain Management Group increased and contract costs from our International, Federal, and IT, Energy and Management Consulting Groups decreased compared to the prior year. - 19 --------------------------------------------------------------------------------- Table of Contents 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 associated with contract protests and other matters. Our operating income decreased approximately $2 million, or 16% for the quarter ended June 30, 2014, and approximately $583 thousand, or 3%, for the first six months of 2014, as compared to the same periods of 2013. Operating income from our Supply Chain Management Group increased and operating income from our International, Federal and IT, Energy and Management Consulting Groups decreased compared to the same period of 2013. Changes in revenues, costs and expenses, and income are further discussed in the summaries of our segment results that follow. Interest expense decreased approximately $391 thousand, or 26%, for the quarter ended June 30, 2014, and approximately $771 thousand, or 25%, for the first six months of 2014, as compared to the same periods of 2013 due to reductions in our level of borrowing as we pay down our bank loan. Interest expense also includes interest associated with capitalized construction costs related to our executive and administrative headquarters facility lease. The amount of interest expense associated with this capital lease in the first six months of 2014 was approximately $841 thousand, as compared to $865 thousand for the same period of 2013. Our effective income tax rate was 38.2% for the first six months of 2014 as compared to 37.5% for the same period of 2013. Our tax rate is affected by discrete items that may occur in any given year, but may not be consistent from year to year. In addition to state income taxes, certain tax credits and other items can impact the difference between our statutory tax rates and our effective tax rate. Federal tax credits that lowered our 2013 effective tax rates expired at the end of 2013 and did not benefit our 2014 effective tax rate. 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 2014 2013 2014 2013 Months Months Revenues $ 42,313 $ 36,891 $ 82,936 $ 74,594 $ 5,422 $ 8,342 Contract costs 34,579 29,897 67,382 61,398 4,682 5,984 Selling, general and administrative expenses 37 20 36 67 17 (31 ) Operating Income $ 7,697 $ 6,974 $ 15,518 $ 13,129 $ 723 $ 2,389 Profit percentage 18.2 % 18.9 % 18.7 % 17.6 % Revenues for our Supply Chain Management Group increased approximately $5.4 million, or 15%, for the second quarter of 2014 as compared to the same period for the prior year. Revenues increased approximately $8.3 million, or 11%, for the six months ended June 30, 2014 as compared to the same period for the prior year. The increases resulted primarily from an increase in WBI's USPS MIP revenue of approximately $5.6 million for the quarter and approximately $10.1 million for the six months. The increases were partially offset by declines in sales of parts to DoD clients. Contract costs increased approximately $4.7 million, or 16%, for the quarter and approximately $6 million, or 10%, for the six months. Operating income increased approximately $723 thousand, or 10%, for the quarter and approximately $2.4 million, or 18%, for the six months. Contract costs and operating income increases resulted primarily from the increase in USPS MIP revenue. Operating income for this segment for 2014 and 2013 was impacted by fair value adjustments in the accrued earn-out obligation associated with our acquisition of WBI. The adjustment to the earn-out obligation decreased operating income approximately $613 thousand for the quarter ended June 30, 2014 and increased operating income approximately $219 thousand for the same period of the prior year. The adjustment to the earn-out obligation decreased operating income approximately $787 thousand for the six months ended June 30, 2014 and decreased operating income approximately $58 thousand for the same period of the prior year. The changes in profit percentage resulted from the USPS MIP revenue increase and a decrease in lower margin sales to DoD, and from differences in earn-out obligation adjustments. - 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 2014 2013 2014 2013 Months Months Revenues $ 26,794 $ 36,239 $ 61,510 $ 71,629 $ (9,445 ) $ (10,119 ) Contract costs 25,846 34,551 58,128 68,185 (8,705 ) (10,057 )Selling, general and administrative expenses 189 215 234 278 (26 ) (44 ) Operating Income $ 759 $ 1,473 $ 3,148 $ 3,166 $ (714 ) $ (18 ) Profit percentage 2.8 % 4.1 % 5.1 % 4.4 % Revenues for our International Group decreased approximately $9.4 million, or 26%, for the second quarter, and decreased approximately $10.1 million, or 14%, for the six months ended June 30, 2014, as compared to the same periods for the prior year. Contract costs decreased approximately $8.7 million, or 25%, for the second quarter, and decreased approximately $10 million, or 15%, for the six months ended June 30, 2014, as compared to the same periods for the prior year. The decreases in revenues resulted primarily from decreases of approximately $8.4 million for the quarter and approximately $9 million for the six months associated with the completion of our U.S. Treasury Seized Assets Program in March 2014. The decreases in contract costs are primarily attributable to the lower level of work associated with our decreases in revenues. Operating income decreased by approximately $714 thousand, or 48%, for the second quarter, and decreased approximately $18 thousand, or 1%, for the six months ended June 30, 2014, as compared to the same periods for the prior year. Changes in operating income resulted primarily from decreases in profits of approximately $1.3 million for the quarter and approximately $840 thousand for the six months attributable to the revenue declines associated with the completion of our U.S. Treasury Seized Assets Program in March 2014, offset by an increase in award fee income associated with our FMS Program in the second quarter and from the elimination of losses on our CFT Program work. Profit margins in this group can vary due to fluctuations in contract activity and the timing of contract award fees associated with our FMS Program. Award fee evaluations on this program occur three times per year. We recognize award fee revenue and income in the period we receive contractual notification of the award, and we typically receive such notification in the first, second, and fourth quarters each year. Because we had not received contractual notification for the award fee that is typically recognized in the second quarter of 2013 until after June 30, 2013, this award fee revenue and income was recognized in the third quarter of 2013. In 2014, we received timely notification and award fee revenue and income was recognized in the second quarter of 2014. 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 2014 2013 2014 2013 Months Months Revenues $ 23,137 $ 26,817 $ 51,692 $ 54,388 $ (3,680 ) $ (2,696 ) Contract costs 22,194 24,301 50,409 50,728 (2,107 ) (319 ) Selling, general and administrative expenses 56 6 67 19 50 48 Operating Income $ 887 $ 2,510 $ 1,216 $ 3,641 $ (1,623 ) $ (2,425 ) Profit percentage 3.8 % 9.4 % 2.4 % 6.7 % Revenues for our Federal Group decreased approximately $3.7 million, or 14%, for the second quarter, and decreased approximately $2.7 million, or 5%, for the six months ended June 30, 2014, as compared to the same periods for the prior year. Contract costs decreased approximately $2.1 million, or 9%, for the second quarter, and decreased approximately $319 thousand, or 1%, for the six months ended June 30, 2014, as compared to the same periods for the prior year. The decreases in revenues resulted primarily from decreases of approximately $3.6 million for the quarter and approximately $9.8 million for the six months associated with our Army Reserve vehicle refurbishment work, and from decreases in other work. An increase in revenues from a task order that included non- - 21 --------------------------------------------------------------------------------- Table of Contents recurring levels of material deliverables in the first quarter of 2014 partially offset our six-month revenue decrease by approximately $7.5 million. The decreases in contract costs are primarily attributable to the lower level of work associated with our decreases in revenues. Operating income decreased by approximately $1.6 million, or 65%, for the second quarter, and decreased approximately $2.4 million, or 67%, for the six months ended June 30, 2014, as compared to the same periods for the prior year. Operating income and profit percentage decreases resulted primarily due to a decrease in profits associated with the decline in Army Reserve work. 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 Six months Change ended June 30, ended June 30, Three Six 2014 2013 2014 2013 Months Months Revenues $ 15,718 $ 19,115 $ 31,233 $ 37,608 $ (3,397 ) $ (6,375 ) Contract costs 13,870 16,594 27,915 33,810 (2,724 ) (5,895 ) Selling, general and administrative expenses 16 29 33 67 (13 ) (34 ) Operating Income $ 1,832 $ 2,492 $ 3,285 $ 3,731 $ (660 ) $ (446 ) Profit percentage 11.7 % 13.0 % 10.5 % 9.9 % Revenues for our IT, Energy and Management Consulting Group decreased approximately $3.4 million, or 18%, for the second quarter, and decreased approximately $6.4 million, or 17%, for the six months ended June 30, 2014, as compared to the same periods for the prior year. Contract costs decreased approximately $2.7 million, or 16%, for the second quarter, and decreased approximately $5.9 million, or 17%, for the six months ended June 30, 2014, as compared to the same periods for the prior year. The revenue and contract cost decreases resulted primarily from a reduction in services performed due to contract expirations and a decline in services ordered by clients on continuing contracts. Operating income decreased by approximately $660 thousand, or 26%, for the second quarter, and decreased approximately $446 thousand, or 12%, for the six months ended June 30, 2014, as compared to the same periods for the prior year. Operating income decreases resulted primarily from the decreases in revenues and lower profit margins associated with new contracts that replaced predecessor contracts. For the six months ended June 30, 2014, we experienced operating profit percentage improvement resulting from the indirect cost reductions and efficiencies associated with combining our Akimeka and G&B subsidiaries. Financial Condition Our financial condition did not change materially in the first six months of 2014. 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 increased approximately $82 thousand during the first six months of 2014. Cash provided by operating activities increased approximately $1.8 million in the first six months of 2014 as compared to the first six months of 2013. The change is primarily attributable to an increase of approximately $2.2 million due to changes in the levels of operating assets and liabilities, an increase of approximately $328 thousand in depreciation and amortization and other non-cash operating activities, and a decrease of approximately $801 thousand in cash provided by net income. Our largest operating assets are our accounts receivable and inventories. Our largest operating liabilities are our accounts payable and accrued expenses. 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 obligations. Accordingly, our levels of accounts receivable and accounts payable may fluctuate depending on the timing of services ordered, government funding delays, the timing of billings received from subcontractors and materials vendors, and the timing of payments received for services. Such timing differences have the potential to cause significant increases and decreases in our accounts receivable and accounts payable in short time periods. Our levels of inventories and accrued expenses tend to vary in accordance with our levels of revenues and services performed. - 22 --------------------------------------------------------------------------------- Table of Contents Cash used in investing activities decreased approximately $661 thousand in the first six months of 2014 as compared to the first six months of 2013. Cash used in investing activities consisted of purchases of property and equipment. Cash used in financing activities increased approximately $1.1 million in the first six months of 2014 as compared to the first six months of 2013. Cash used in financing activities consisted primarily of repayments on our bank loan and dividends. We used approximately $963 thousand in cash to pay dividends of $0.18 per share during the first six months of 2014. 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 our dividend each year since 2004. Liquidity Our internal sources of liquidity are primarily from operating activities, specifically from changes in our 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 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. In March 2013, we purchased a building to support our Federal Group operations for approximately $1 million. From time to time, we may also invest in the acquisition of other companies. Our external financing consists of a loan agreement with a bank group that provides for a term loan, revolving loans, and letters of credit. The loan agreement expires June 2016. The term loan requires quarterly installment payments. Our scheduled term loan payments after June 30, 2014 are $12.5 million in 2014 and $34.4 million in 2015. The amount of our term loan borrowings outstanding as of June 30, 2014 was approximately $46.9 million. The maximum amount of credit available to us from the banking group for revolving loans and letters of credit as of June 30, 2014 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 $20.5 million in revolving loan amounts outstanding and no letters of credit outstanding as of June 30, 2014. During the first six months of 2014, the highest outstanding revolving loan amount was $36.4 million and the lowest was $15.4 million. The timing of 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 June 30, 2014, the LIBOR base margin is 1.75% and the base rate base margin is 0.0%. The base margins may increase or decrease in increments as our Total Funded Debt/EBITDA Ratio increases or decreases. We had interest rate hedges on a portion of our outstanding borrowings that expired June 30, 2014. After June 30, 2014, we have had no interest rate hedges on our outstanding borrowings. As of June 30, 2014, interest rates on portions of our outstanding debt range from 1.9% to 3.25%, and the effective interest rate on our aggregate outstanding debt was 2.07%. - 23 --------------------------------------------------------------------------------- Table of Contents The loan agreement contains collateral requirements by which we pledge our assets as security, restrictive covenants, and other affirmative and negative covenants, conditions and limitations. Restrictive covenants include a limit on annual dividends, a maximum Total Funded Debt/EBITDA Ratio, a minimum Fixed Charge Coverage Ratio, and a minimum Asset Coverage Ratio. We were in compliance with the financial covenants and other loan agreement terms and conditions at June 30, 2014. Current Maximum Ratio Actual Ratio Total Funded Debt/EBITDA Ratio 2.50 to 1 1.17 to 1 Minimum Ratio Actual Ratio Fixed Charge Coverage Ratio 1.20 to 1 1.39 to 1 Minimum Ratio Actual Ratio Asset Coverage Ratio 1.00 to 1 1.46 to 1 We currently do not use public debt security financing. Indemnity Obligations Prior to ceasing operations in December 2012, our subsidiary ICRC participated in an arrangement to provide performance and payment bonding services for certain small business prime contractors associated with ICRC's construction management business. Under the arrangement, ICRC received subcontractor work from the small business prime contractors in exchange for indemnifying the surety company in respect of the performance and payment bonds it provided for the small business prime contractors. In October 2012, the surety company, at ICRC's request, ceased issuing bonds for the small business prime contractors, and in December 2012, ICRC ceased performing all work on construction projects when it discontinued its construction management operations. Bonds issued prior to December 2012 for construction projects that are not yet completed by the small business prime contractors remain in effect until the projects are completed by the small business prime contractors. As of June 30, 2014, three of the bonded projects had not yet been completed and the aggregate bonded amount on these projects was approximately $4.9 million. There have been claims and disputes made by subcontractors associated with the bonded projects. Under the Miller Act (40 U.S.C. Section 3131 to 3134), a subcontractor or material supplier may bring an action against a bond up to one year after the day on which the last of the labor was performed or material was supplied. We have recorded an expense related to these claims and disputes of approximately $894 thousand, net of tax, which is included in loss from discontinued operations for the six months ended June 30, 2014. We expect all remaining bonded projects to be completed in 2014. 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 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. Disclosures About Market Risk Interest Rates Our bank loans provide available borrowing to us at variable interest rates. Accordingly, interest rate changes can potentially put us at risk for a material adverse impact on earnings and cash flows. To mitigate the risks associated with interest rate movements, we previously employed interest rate hedges to fix the rate on a portion of our outstanding borrowings for various periods of time. The resulting fixed rates gave us protection against interest rate increases during the time that our borrowing was at higher levels. The last of our interest rate hedges expired on June 30, 2014. - 24 --------------------------------------------------------------------------------- Table of Contents VSE CORPORATION AND SUBSIDIARIES |