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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, 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. Beginning in 2015, we will be consolidating our International and Federal groups into a single management group and one reportable segment. 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. -15--------------------------------------------------------------------------------- Table of Contents Concentration of Revenues (in thousands) For the nine months ended September 30, 2014 2013 Source of Revenue Revenues % Revenues % USPS MIP $ 121,322 37 $ 104,950 30 FMS Program 71,662 22 68,024 20 U.S. Army Reserve 39,624 12 45,383 13 Other 96,512 29 130,931 37 Total Revenues $ 329,120 100 $ 349,288 100 Management Outlook We are responding to ongoing challenges in our legacy markets by taking active measures to adjust our cost structure and operating model to better meet the needs of these markets and by adapting our competencies and service offerings to new adjacent markets. A curtailment of government spending for certain programs and services, changes in government spending priorities, and increased competition for fewer opportunities has led to declines in our DoD and other federal civilian agency revenues. In response, we have chosen to adjust our operating model by eliminating certain management positions and reducing other costs that have supported these activities; we will continue to consolidate our International Group and Federal Group during the fourth quarter of 2014 and report their results as a single operating group beginning in 2015. Under this program, we have incurred approximately $400 thousand in severance costs in the current third quarter and expect to provide an estimated $4 million in savings on an annual basis beginning in the fourth quarter of 2014. 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 U.S. Navy FMS Program, and our military vehicle and equipment refurbishment work. As challenges in our legacy markets continue to adversely affect our revenues, we are adapting competencies in our vehicle, ship, and aircraft sustainment, service life extension, and logistics 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 and optimizing their investment in existing physical assets by assisting them in extending service life and enhancing performance 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 continue to see growth in this program in 2014. Additionally, WBI's managed inventory competency is being marketed to commercial clients operating large vehicle fleets. WBI's operating performance has increased the likelihood that certain earn-out thresholds in our acquisition agreement will be met. Accordingly, we have recorded charges related to this earn-out obligation, which reduced the operating income by approximately $2 million for the third quarter and $2.8 million for the first nine months of 2014. 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. Our 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 legislation required for the transfer of naval vessels to allied navies. Historically, supporting the U.S. Navy in reactivating, transferring and providing 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. -16--------------------------------------------------------------------------------- Table of Contents Without the benefit of revenues from vessel transfers, follow on technical support work has generated the majority of revenues under our FMS Program. These services are provided to several 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 $25 million of revenue for the first nine months 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. We believe that our long term relationship with the Egyptian Navy remains strong, and as a result, we anticipate to benefit if the political situation in Egypt stabilizes and U.S. and Egyptian relations improve. We cannot, however, predict how the Egyptian political situation will unfold or the long range affect it will have on our Egyptian Navy support program. Our vehicle and equipment refurbishment work for the U.S. Army Reserve is our third largest source of revenue. The U.S. Army Reserve has been adversely affected by DoD and Department of the Army budget reductions. Also, beginning in August 2013, contractual coverage for our work on this program was transitioned from a previous contract to multiple task orders on our existing Army contracts with different contractual terms. This resulted in a reduction in revenues and lower profit margins on this program compared to previous years. This program generated approximately $40 million of revenue for the first nine months of 2014 and approximately $60 million of revenue for a full year in 2013. Contractual coverage on a portion of the work on our current task orders expired in August 2014, and revenue will be lower going forward. Revenue for this program was approximately $2.7 million for September 2014. Contractual coverage on our current task orders has been extended for varying periods of time at lower levels, and it remains uncertain how much of this work will be re-competed, continued or extended. Our work as the prime contractor for the U.S. Department of Treasury Executive Office for Asset Forfeiture general property program ended 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 nine months of 2014 and approximately $36 million of revenue for a full year in 2013. We have consistently reduced our bank debt, which we believe positions us to consider several options to increase stockholder value. Bookings and Funded Backlog Much of our revenue depends on contract funding ("bookings"), and bookings generally occur when contract funding documentation is received. For our revenue that depends on bookings arising from the receipt of contract funding documentation, funded contract backlog is an indicator of potential future revenue. While bookings and funded contract backlog generally result in revenue, 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 affected by maintenance schedules and the rate and timing of parts failure on customer vehicles. 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 WBI's potential future revenues. A summary of our bookings and revenue for the nine months ended September 30, 2014 and 2013, and funded contract backlog as of September 30, 2014 and 2013 is as follows: (in millions) 2014 2013 Bookings $ 292 $ 407 Revenues $ 329 $ 349 Funded Contract Backlog $ 194 $ 268 -17--------------------------------------------------------------------------------- Table of Contents 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 our consolidated financial statements. Critical Accounting Policies Our consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States, which require us to make estimates and assumptions. There have been no changes in our critical accounting policies since December 31, 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): Nine months ended September 30, Contract Type 2014 % 2013 % Fixed-price (1) $ 196,415 60 $ 181,301 52 Cost-type 101,516 31 81,674 23 Time and materials 31,189 9 86,313 25 $ 329,120 100 $ 349,288 100 (1) WBI's revenues are classified as fixed-price revenue. Results of Operations Our results of operations are as follows (in thousands): Three months Nine months Change ended September 30, ended September 30, Three Nine 2014 2013 2014 2013 Months Months Revenues $ 101,749 $ 111,069 $ 329,120 $ 349,288 $ (9,320 ) $ (20,168 ) Contract costs 93,388 101,026 297,480 315,364 (7,638 ) (17,884 ) Selling, general and administrative expenses 1,178 583 2,397 1,821 595 576 Operating income 7,183 9,460 29,243 32,103 (2,277 ) (2,860 ) Interest expense, net 871 1,395 3,158 4,453 (524 ) (1,295 ) Income before income taxes 6,312 8,065 26,085 27,650 (1,753 ) (1,565 ) Provision for income taxes 2,425 2,738 9,985 10,089 (313 ) (104 ) Income from continuing operations 3,887 5,327 16,100 17,561 (1,440 ) (1,461 ) Loss from discontinued operations (4 ) (1 ) (898 ) (115 ) (3 ) (783 ) Net income $ 3,883 5,326 $ 15,202 $ 17,446 $ (1,443 ) $ (2,244 ) Our revenues decreased approximately $9 million, or 8%, for the third quarter of 2014, and approximately $20 million, or 6%, for the first nine 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. -18--------------------------------------------------------------------------------- Table of Contents 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 $8 million, or 8%, for the third quarter of 2014, and approximately $18 million, or 6%, for the first nine months of 2014, as compared to the same periods of 2013. In addition to a reduction in contract costs associated with the decrease in revenues, cost balancing initiatives implemented in 2013 and 2014 to reduce our indirect costs have 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. Selling, general and administrative expenses consist primarily of costs and expenses that are not chargeable or reimbursable on our operating unit contracts. These costs increased by approximately $595 thousand for the third quarter and approximately $576 thousand for the first nine months of 2014, as compared to the same periods of 2013, due to severance payments and to legal, consulting and professional services fees associated with the implementation of changes to our operating model and strategic planning efforts. Our operating income decreased approximately $2 million, or 24%, for the quarter ended September 30, 2014, and approximately $3 million, or 9%, for the first nine months of 2014, as compared to the same periods 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 $524 thousand, or 38%, for the quarter ended September 30, 2014, and approximately $1.3 million, or 29%, for the first nine 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 capital leases in the first nine months of both 2014 and 2013 is approximately $1.3 million. Interest expense declined in 2014 as compared to the prior year due to lower levels of bank borrowing. Our effective income tax rate was 38.3% for the first nine months of 2014 as compared to 36.5% 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 Nine months Change ended September 30, ended September 30, Three Nine 2014 2013 2014 2013 Months Months Revenues $ 44,542 $ 39,665 $ 127,478 $ 114,260 $ 4,877 $ 13,218 Contract costs 38,311 32,085 105,693 93,484 6,226 12,209 Selling, general and administrative expenses 36 274 72 341 (238 ) (269 ) Operating income $ 6,195 $ 7,306 $ 21,713 $ 20,435 $ (1,111 ) $ 1,278 Profit percentage 13.9 % 18.4 % 17.0 % 17.9 % Revenues for our Supply Chain Management Group increased approximately $4.9 million, or 12%, for the third quarter of 2014 as compared to the same period for the prior year. Revenues increased approximately $13.2 million, or 12%, for the nine months ended September 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 $6.2 million for the third quarter and approximately $16.4 million for the nine months ended September 30, 2014. Contract costs increased approximately $6.2 million, or 19%, for the quarter and approximately $12.2 million, or 13%, for the nine months. The increases resulted primarily from increases in WBI's USPS MIP revenues. Contract costs include fair value adjustments in the accrued earn-out obligation associated with our acquisition of WBI. The adjustment to the earn-out obligation increased contract costs approximately $2 million for the quarter ended September 30, 2014 and decreased contract costs approximately $50 thousand for the same period of the prior year. The adjustment to the earn-out obligation increased contract costs approximately $2.8 million for the nine months ended September 30, 2014 and increased contract costs approximately $108 thousand for the same period of the prior year. -19--------------------------------------------------------------------------------- Table of Contents Operating income decreased approximately $1.1 million, or 15%, for the quarter and increased approximately $1.3 million, or 6.3%, for the nine months. Changes in operating income resulted primarily from the increases in USPS MIP revenues and the fair value adjustments in the accrued earn-out obligation associated with our acquisition of WBI. The changes in profit percentage resulted primarily from differences in earn-out obligation adjustments. International Group Results The results of operations for our International Group are as follows (in thousands): Three months Nine months Change ended September 30, ended September 30, Three Nine 2014 2013 2014 2013 Months Months Revenues $ 24,718 $ 35,428 $ 86,228 $ 107,057 $ (10,710 ) $ (20,829 ) Contract costs 24,112 33,143 82,240 101,328 (9,031 ) (19,088 ) Selling, general and administrative expenses 315 - 549 278 315 271 Operating income $ 291 $ 2,285 $ 3,439 $ 5,451 $ (1,994 ) $ (2,012 ) Profit percentage 1.2 % 6.4 % 4.0 % 5.1 % Revenues for our International Group decreased approximately $10.7 million, or 30%, for the third quarter, and decreased approximately $20.8 million, or 19%, for the nine months ended September 30, 2014, as compared to the same periods for the prior year. Contract costs decreased approximately $9 million, or 27%, for the third quarter, and decreased approximately $19 million, or 19%, for the nine months ended September 30, 2014, as compared to the same periods for the prior year. The decreases in revenues resulted primarily from decreases of approximately $7.8 million for the third quarter and approximately $17.9 million for the nine 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 $2 million, or 87%, for the third quarter, and decreased approximately $2 million, or 37%, for the nine months ended September 30, 2014, as compared to the same periods for the prior year. Changes in operating income resulted primarily from decreases in profits of approximately $873 thousand for the quarter and approximately $1.9 million for the nine months attributable to the revenue declines associated with the completion of our U.S. Treasury Seized Assets Program in March 2014, a decrease in award fee income associated with our FMS Program in the third quarter due to the timing of the award fee contractual notification, 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 and not in the third quarter. -20--------------------------------------------------------------------------------- Table of Contents Federal Group Results The results of operations for our Federal Group are as follows (in thousands): Three months Nine months Change ended September 30, ended September 30, Three Nine 2014 2013 2014 2013 Months Months Revenues $ 17,197 $ 17,043 $ 68,889 $ 71,430 $ 154 $ (2,541 ) Contract costs 17,507 19,310 67,916 70,037 (1,803 ) (2,121 ) Selling, general and administrative expenses 86 36 153 55 50 98 Operating income $ (396 ) $ (2,303 ) $ 820 $ 1,338 $ 1,907 $ (518 ) Profit percentage (2.3 )% (13.5 )% 1.2 % 1.9 % Revenues for our Federal Group increased approximately $154 thousand, or 1%, for the third quarter, and decreased approximately $2.5 million, or 4%, for the nine months ended September 30, 2014, as compared to the same periods for the prior year. Contract costs decreased approximately $1.8 million, or 9%, for the third quarter, and decreased approximately $2.1 million, or 3%, for the nine months ended September 30, 2014, as compared to the same periods for the prior year. Changes in revenues and contract costs were affected by changes in levels of our Army Reserve vehicle refurbishment work, a nonrecurring military parts order of approximately $4.3 million in 2013, the timing of material deliverables on a task order for an international customer, and decreases in other work. Our Army Reserve vehicle refurbishment work decreased as a result of the transition of contractual coverage in the third quarter of 2013, including an interruption of work for approximately two months, and generally lower levels of work subsequent to such transition. Revenues for this program increased approximately $3.9 million for the third quarter of 2014 as compared to the same period of 2013 when the interruption of work occurred. Revenues for this program decreased approximately $5.8 million for the nine months ended September 30, 2014 compared to the same period of 2013. Additionally, contractual coverage on a portion of the work on our current task orders expired in the third quarter of 2014. Revenues from the material deliverables on the international task order decreased approximately $2.8 million for the third quarter of 2014 as compared to the third quarter of 2013 and increased by $4.7 million for the nine months ended September 30, 2014 as compared to the same period of 2013. The decreases in contract costs are primarily attributable to the lower level of work associated with our decreases in revenues. Operating income increased by approximately $1.9 million, or 83%, for the third quarter, and decreased approximately $518 thousand, or 39%, for the nine months ended September 30, 2014, as compared to the same periods for the prior year. Changes in operating income and profit percentages resulted primarily from the changes in revenues associated with our 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 Nine months Change ended September 30, ended September 30, Three Nine 2014 2013 2014 2013 Months Months Revenues $ 15,292 $ 18,933 $ 46,525 $ 56,541 $ (3,641 ) $ (10,016 ) Contract costs 13,415 16,407 41,330 50,217 (2,992 ) (8,887 ) Selling, general and administrative expenses 11 51 44 118 (40 ) (74 ) Operating income $ 1,866 $ 2,475 $ 5,151 $ 6,206 $ (609 ) $ (1,055 ) Profit percentage 12.2 % 13.1 % 11.1 % 11.0 % Revenues for our IT, Energy and Management Consulting Group decreased approximately $3.6 million, or 19%, for the third quarter, and decreased approximately $10 million, or 18%, for the nine months ended September 30, 2014, as compared to the same periods for the prior year. Contract costs decreased approximately $3 million, or 18%, for the third quarter, and decreased approximately $8.9 million, or 18%, for the nine months ended September 30, 2014, as compared to the same periods for the prior year. Revenues and contract costs decreased primarily due to a decline in services ordered by clients on continuing contracts and the expiration of a contract in the fourth quarter of 2013. Revenue on the expired contract was approximately $2.5 million for the third quarter of 2013 and $7.3 million for the nine months ended September 30, 2013. -21--------------------------------------------------------------------------------- Table of Contents Operating income decreased by approximately $609 thousand, or 25%, for the third quarter, and decreased approximately $1.1 million, or 17%, for the nine months ended September 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, which were partially offset by 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 nine 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 $108 thousand during the first nine months of 2014. Cash provided by operating activities increased approximately $76 thousand in the first nine months of 2014 as compared to the first nine months of 2013. The change is primarily attributable to an increase of approximately $5.1 million in depreciation and amortization and other non-cash operating activities, a decrease of approximately $2.8 million due to changes in the levels of operating assets and liabilities, and a decrease of approximately $2.2 million 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. Cash used in investing activities decreased approximately $534 thousand in the first nine months of 2014 as compared to the first nine months of 2013. Cash used in investing activities consisted of purchases of property and equipment. Cash used in financing activities decreased approximately $719 thousand in the first nine months of 2014 as compared to the first nine months of 2013. Cash used in financing activities consisted primarily of repayments on our bank loan, earn-out obligation payments, and dividends. We used approximately $1.5 million in cash to pay dividends of $0.28 per share during the first nine 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 affect 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. -22--------------------------------------------------------------------------------- Table of Contents 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. We may also make earn-out obligation payments in years subsequent to an acquisition. 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 September 30, 2014 are $6.3 million in 2014 and $25 million in 2015. The amount of our term loan borrowings outstanding as of September 30, 2014 was approximately $31.3 million. The maximum amount of credit available to us from the banking group for revolving loans and letters of credit as of September 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 $26 million in revolving loan amounts outstanding and no letters of credit outstanding as of September 30, 2014. During the first nine months of 2014, the highest outstanding revolving loan amount was $36.4 million and the lowest was $10.9 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 September 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 September 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 2.05%. 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 September 30, 2014. Current Maximum Ratio Actual Ratio Total Funded Debt/EBITDA Ratio 2.50 to 1 1.01 to 1 Minimum Ratio Actual Ratio Fixed Charge Coverage Ratio 1.20 to 1 1.36 to 1 Minimum Ratio Actual Ratio Asset Coverage Ratio 1.00 to 1 1.78 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 will remain in effect until the projects are completed by the small business prime contractors. -23--------------------------------------------------------------------------------- Table of Contents As of September 30, 2014, two of the bonded projects had not yet been completed and the aggregate bonded amount on these projects was approximately $4 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 of approximately $898 thousand, net of tax, which is included in loss from discontinued operations for the nine months ended September 30, 2014 primarily related to these claims and disputes. We expect all remaining bonded projects to be completed in early 2015. 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 |