Greetings. Welcome to the VSE Corporation Third Quarter 2021 Earnings Conference Call. [Operator Instructions] Please note this conference is being recorded. I will now turn the conference over to your host, Noel Ryan, you may begin.

Thank you, operator. Welcome to VSC Corporation's third quarter 2021 results conference call. Leading the call today are our President and CEO, John Cuomo; and Chief Financial Officer, Steve Griffin. 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 where noted. At the conclusion of our prepared remarks, we will open the line for questions. And with that, I would like to turn the call over to John Cuomo for his prepared remarks.

Thank you, Noel. Welcome, everyone, and thank you for taking the time to join our call today. Let's begin on Slide 3 of our conference call materials. VSE had a strong third quarter, representing the highest quarterly revenue run rate since the fourth quarter of 2016. Excluding nonrecurring items, total revenue for the quarter increased by 27% year-over-year, supported by total year-over-year growth across all three reporting segments. Adjusted EBITDA for the quarter increased by 19% year-over-year, while adjusted net income increased by 42% versus the prior year period. We continued to execute on our aftermarket distribution and MRO strategies during the third quarter, while positioning the business to generate above-market revenue growth in higher-margin verticals that leverage our unique value proposition through new contract wins, long-term program extensions, new program execution, the addition of new MRO capabilities, growth in our e-commerce platforms and contributions from recently completed acquisitions. VSE has created a strong recurring base of business, which will drive continued growth and margin expansion opportunities for our business into the future. Specifically, within our aviation segment, revenue increased more than 100% year-over-year to a record $73.1 million, driven by new program execution and contributions from the global parts acquisition. Aviation has now posted five consecutive quarters of sequential revenue improvement, driven by both organic and inorganic growth, while both aviation adjusted EBITDA and adjusted EBITDA margins have trended materially higher versus prior quarter and prior year levels, consistent with our focus on higher-value margin-enhancing opportunities. Third quarter aviation distribution revenue was nearly 190% above the prior year and more than 90% above the second quarter 2021, due mainly to organic share gains within the business and general aviation market, an area of significant long-term opportunity for the company and the positive impacts of our global parts acquisition. While…

Thanks, John. We'll now turn to Slides 4 and 5 of the conference call materials for an overview of our third quarter performance. We reported $200.6 million in revenue in the third quarter, an increase of 27% from the prior year period, excluding the impact of a nonrecurring pandemic related PPE order in our fleet segment in the third quarter of 2020. On an adjusted basis, revenue increased across all three reporting segments on a year-over-year basis in the third quarter. Our aviation segment grew for the fifth straight quarter. The 102% year-over-year growth was driven by a combination of new program wins, share gains and contributions from our global parts acquisition completed in July 2021. The federal segment growth was driven by a combination of organic and inorganic wins and the fleet segment growth was spurred by commercial fleet and e-commerce fulfillment revenue as well as slightly higher USPS revenue. We generated adjusted EBITDA of $20.4 million in the third quarter, an increase of 19% on a year-over-year basis. Our adjusted EBITDA margin rate was just under 11%, as we saw the aviation segment continue to improve profitability, both on a year-over-year basis and sequentially. Operating cash flow, less total capital expenditures was $21 million in the third quarter. Turning to Slide 6. Aviation segment revenue increased more than 100% year-over-year in the third quarter and was up 54% versus the second quarter of 2021. Both our distribution and repair businesses grew on a year-over-year basis, with distribution outperforming repair, primarily driven by improved end market demand and new contract wins. Distribution revenue, excluding the global parts acquisition is back above pre-pandemic levels, while our repair business has been slower to recover. We anticipate a further repair recovery throughout next year, particularly as we expand our integrated solutions across…

[Operator Instructions] And our first question is from Ken Herbert with RBC Capital Markets. Please proceed with your questions.

John, I first just wanted to ask, on the aviation segment on the top line, can you provide any more color on maybe some of the mix of business jet versus - I know you talked a lot about the growth in the distribution versus MRO. But within the distribution side, in particular, as we think about the business jet side relative to commercial transport or geographically, any more ways to parse out that very strong growth within the aviation segment would be helpful?

Yes, sure. We don't break out the revenue by market channel. But when I first came on board two years ago, I kind of shared that the business was about 50% business general aviation, 50% commercial. The business has definitely skewed more business in general aviation, specifically on the distribution side over the last 12 months. So the global parts acquisition and the contributions from that business are all business in general aviation, that they do not support commercial customers. And then our engine accessories program and the revenue and earnings supported from the ramp-up of that program or contributions from the ramp-up of that program are all business in general aviation associated as well. So as we get to the back end of 2021, we're seeing the distribution business skew heavily towards BG&A versus commercial. On the repair side, it's still a similar mix that we've consistently had in the past.

Okay. That's helpful. And it looks like incremental adjusted EBITDA margins were sort of low to mid-teens in the quarter. How do we think about the opportunity of some of the new contract wins ramp? And what should the progression of the EBITDA margins within the aviation segment look like through the rest of this year and perhaps into 2022?

Yes, sure, Ken. So the adjusted EBITDA margin for the quarter in the business was 10%, up 3 - over 3 points versus the prior year and up 1.5 points versus the prior quarter. So what we've communicated is you should expect sequential growth from the business as we continue to experience the recovery in the new program introductions. We've historically communicated that we expect to be mid-teens, which is where this business had been historically and that all the new program wins would fit in with that. So in line with sort of historic communications around the EBITDA margin rate. So I think what you should expect as we transition to '22, is continued improvement in the EBITDA margin rate of the aviation segment as the business recovers. All at the end of the day, subject to are the recovery in the repair business, which we've talked about as being an incredibly important indicator as to how we'll get back to that mid-teens rate.

Okay. That's helpful. And just one final question. I know you made the comment, John, that you weren't seeing any real significant disruptions yet from supply chain or cost inflation. But I'm curious, are there any areas of concern with your OEM partners when I think about the distribution business and are you seeing any potential impact on their supply chains? And/or any steps you're having to take to maybe mitigate risk down the road from your - on the distribution side?

Yes. I know, it's a great question. And just to kind of clarify my comments, we are seeing both inflation and labor as well as in some areas of our - in costs in some areas of our business. We have actions in place that we've been taking over the last 12 months to mitigate the risk that we see and how it could negatively impact the business. And what we've done specifically is you've seen us put a lot of working capital to use in terms of inventory and making sure that my assumption having been in distribution for the last 20-plus years is that we're going to see lead times continue to push out, specifically as we see recovery in the markets like commercial aerospace, and you're going to see more compression there. So we've been a little bit more aggressive on inventory purchases to be well prepared to manage that and actually, hopefully, a little bit opportunistic as well. The other thing I'd say is we have a very - in our aviation business, we have a very proprietary park heavy content without a lot of long-term fixed-price contracts, it's a little bit more transactional in nature. So it does allow us to push that cost directly to the customer, similar to our fleet business. So the fleet business is where we've seen probably the most inflationary and supply chain pressure on product, but we've been able to really manage that with pushing that cost, both logistics and price down to the customer. It's unique times right now, and we're looking at it both in terms of how do we mitigate risk as well as how do we create opportunities for the business with the inventory that we have to capitalize on both new customer relationships because we're solving problems and to expand margins where we can.

Our next question is from Michael Ciarmoli with Truist. Please proceed with your question.

Nice results. Steve, maybe just clarity. Can you give the organic growth rate in aviation? I mean, you had, I guess, global parts 2 months should we assume maybe $8 million to $10 million of revenue contribution from those guys?

Yes. So it's - the global parts business contributed $13 million worth of revenue in the quarter. It was just a little over two months in terms of total contribution. The organic growth rate, so if you were to compare sort of sequential growth 2Q to 3Q aviation, excluding the global business, it was up about 26% from a revenue standpoint. So growth, excluding global and obviously, good results from the global team as well.

And was all that the parts, obviously, all distribution? Or did some of that flow into repair?

The majority of it - repair is immaterial within that number of $13 million.

So was there anything different? I mean, if I look, I think you called out on the slides, distribution up 187% year-over-year. It looks like if you had a $13 million contribution, I mean, that's a pretty big step down from 2Q June. I think you did 28.5% in distribution-was there anything in the core business? I mean, ex global parts, it would seem like that distribution revenue is down significantly?

No. No. I don't think that I would say that. Distribution was $54 million in the quarter. So $13 million contribution from the.

Okay. Got it. Got it. $54 million in the quarter. Okay. Got it. Yes. So distribution revenue up 187%. Okay. Yes, got it. Got it. That makes sense. Okay. And then just on the - maybe back to Ken's question on supply chain and raw materials. Looking at the inventory, pretty significant build this quarter and investment in inventory--how much was for some of the new contracts ramping up these new programs. And I think, John, you just said you're starting to look at extending lead time. So presumably, you're building some buffer there. I mean how do we think about the inventory levels going forward?

Yes. I mean I'll give you sort of the financial answers as it relates to cash flow. So we feel good about the inventory position that we're in today. As you know, we are continuing to stock for inventory associated with the new Pratt & Whitney Canada deal, which we announced previously would be $56 million of inventory purchases. So we are stocking as part of the build-out of that program. In the quarter, we generated $21 million worth of free cash flow. Obviously, we used quite a bit to start the year. So we feel good, I think, in terms of the investment level in the business. And by the end of the year, we've communicated, we'll be free cash flow negative, but sort of on a trajectory to have a year-over-year improvement, obviously. As it relates to the inventory levels, John, in terms of stocking and lead times, maybe I'll let you handle that.

Yes. I'd say, Mike, that nothing that we're going to do will take us off of our plan to be free cash flow positive next year. So without knowing if some great new opportunity comes out in the market that may shift that. But based on our current organic plans, yes, we will invest further, but it won't change our 2022 free cash flow forecast.

And on the pricing environment, I mean, John, you've been through a couple of cycles here. I mean, do you think pricing could add a couple of points either to growth or margin? I mean, you've probably got a good amount of inventory that probably can be dialed up in terms of value right now. How do we think about maybe some incremental tailwind to top line and maybe margin contribution, assuming customers out there need to get their aircraft off the ground and probably going to pay for whatever they can get their hands on. I mean, do you think that's a bit of a tailwind?

I think right now in the commercial space, there's still - the recovery is still - it's slow and steady. And I believe that there's still a large amount of inventory in the marketplace though I think there'll be pricing power and shift in prices sometime in 2022? Absolutely. But I would say on the commercial side, we're not seeing that yet. And on the business and general aviation side, we're really not seeing as many supply chain issues out there, I think, and that's why I was pretty transparent in the earlier statements about no impact to our business for the remainder of the year. I'd say maybe where there's some opportunity would be in the fleet business where we can potentially expand our margins there.

And we've been talking about, I think, supply chain relative to aviation. You just brought up fleet, thinking about kind of light trucks in the markets you serve there and everything we're hearing on broader auto? I mean, supply chain inventories, lead times, anything jumping out on that side of the business?

Yes. I mean - so remember, our commercial business in that market was very small. And you can see our commercial growth and the whole '21 and '22 is all about that customer diversification strategy for that business. And really building a business that's less reliant on one single customer. And I'm very proud and pleased to how the team is performing in that diversification strategy. So it's not like we have a ton of long-term contracts on the commercial space where we're short inventory. So I'd say we've been very opportunistic with our relationships to overstock and products and actually build new customer relationships because we're solving some problems. But you are absolutely correct that we are seeing more supply chain issues and cost inflation, logistics issues on that segment than the other two.

And our next question is from Louis De Palma with William Blair. Please proceed with your question.

Good morning, John, Stephen. Noel. For John, is the main reason that the repair business has been slower to recover than your distribution business because the mix of repair is more skewed towards commercial, whereas distribution is more skewed towards business aviation and business aviation has just recovered much faster. Is that the simple reason? Or is there something else?

We do have repair capabilities in our business and general aviation segment, and they are recovering quite well, and they're very close to, if not above pre-pandemic levels. Our commercial MRO business is still below pre-pandemic levels, and the recovery is slow and steady, but it's slow and steady.

And as it relates to your fleet business, you discussed a sequential EBITDA margin improvement. Are we at a point in which the fleet EBITDA stabilizes as your commercial subsegment experiences rapid growth and your USPS business achieves? Some slight stabilization or maybe a modest decline. Have we reached a point of overall EBITDA stabilization for fleet?

I'd say we're close, but I don't want to say that we're exactly there yet where you can say this is the bottom, and now you can expect steady improvements. We are committed, and we feel very confident that we can get the business to return to mid-teens operating margins. We are continuing to invest to support our commercial fleet business in the back half of 2021, we stood up a center of excellence to support our e-commerce initiatives around that business. We continue to invest to make sure that we are building centers of excellence. We have an ERP system conversion that will go in, in early 2022. So I'd say that the reason that summarize that in one customer, which is the USPS. Our goal is to keep the USPS as flat to slightly down as possible. The contribution margin from that customer is strong. And if that number is slightly off, you may see a slight bounce in the operating income until we get to levels that are stabilized over the next 12 months. So I'd say we're close, but not exactly there yet. Steve, any color you want to add?

No, I think that adequately covers it.

Great. And one final one. On Monday, one of your larger competitors, Amentum announced that it is acquiring PAE. Would you view PAE as one of your closest comps for your Federal division?

I mean they're definitely a comp and definitely a competitor. They play a little bit more on the technical side than we do - we've got a balance of MRO services work as well as technical and consulting work in our federal and defense portfolio. So they skew more on the right side than the left side, but they are absolutely - we look at them as a comp and a competitor.

And our next question is from Austin Moeller with Canaccord. Please proceed with your question.

Good morning, John. My first question here is just on the federal and defense segment. The 23% increase in funded backlog. There's clearly been a strategy here to sort of move the - from cost-plus to firm fixed-price contracts. Have you indicated what the margin differential is on that or at least ballpark it between the two types of contracts as you change the mix more from one to the other?

We haven't. But what I will say, what we have shared is, the business has historically performed in the low single-digit margin rate as a total segment. And we've shared that the business will perform at high single digits, hopefully pushing to a double-digit margin rate. So with that, I think you can kind of finish the math on kind of the mix. So it is - we are definitely moving into higher-margin verticals, both in our consulting and services business as well as more technical MRO and distribution work.

Yes. And just for you to know, Austin. So like going back to 2018, 2019, the level of fixed price work done in the business was low 20% of total of the overall federal and defense segment. Last year, it was 54% this year, we're somewhere in the midst of like high 30s. This quarter was around 38%, and last quarter, it was 47%. So the shift towards the fixed-price contract has been a significant driver of the overall margin improvement that you've seen in that segment over the last 24 months.

Okay. Good. Yes, that's very helpful. Now just on the aviation segment, you've obviously seen the recent news that the U.S. has reopened international travel to Europe. Have you already started seeing an uptick in demand for MRO work on wide-body aircraft or other commercial aircraft because of that? Or do you anticipate that soon?

We have not. We have not seen - I was just over in New York this last week at the MRO Europe show. There is definitely a different level of enthusiasm about that market. But that enthusiasm right now is in energy and not necessarily backlog. So we've seen relatively consistent month-over-month improvements in inputs in our commercial MRO space, but we haven't seen a real kind of bump on the heavy - on the component of repair side with regard to wide-body based on the recent announcement. We do expect it will again, materially impact positively 2022, but I haven't seen it yet.

Okay. Great. And on the aviation segment, on the business jet side, there's been a lot of news about business jet OEM build rates being materially higher and demand rising. And so if you look at business jet travel rates in terms of traffic, it's 15% to 20% higher than either 2020 levels or 2019 level. So obviously, you guys are very bullish on the business and general aviation market. So do you think this is sort of a temporary trend? Or do you think there's been a long-term structural change in the market?

I think it's been a long-term structural change. I think it's a great question because I've obviously been in this market for about 25 years. And there was a little bit of - you saw like a pop in the market and then it would kind of settle down. And it was never a real market. We're seeing this as a - you've got new players in the market like wheels up. You've got used aircraft and parked aircraft at the lowest levels historically. You've got people like Netjets and the like that are pretty much at capacity in terms of access to aircraft. So we expect this to be a continued trend, and we see our tip to tail approach in terms of both MRO capabilities and distribution products to be something that is a long-term sustaining revenue and margin opportunity for the business.

Awesome. Well, that definitely sounds very exciting. So I'll pass it back and congrats on the quarter, guys.

And our next question is from Jeff Van Sinderen with B. Riley. Please proceed with your question.

A bunch of my granular questions were answered. So we'll take a crack at a multipart broader one, and maybe you can provide some thoughts. I believe previously, the expectation was for 40% of EBITDA to fall in first half and 60% in second half. Wondering if that's changed and if so, kind of what weighting you're contemplating now? And then also, would you anticipate that revenues will grow sequentially overall from Q3 to Q4 this year? And then any thought or color on EBITDA margins that might be feasible for Q4?

Sure. So Jeff, good to hear from you. We're not going to give guidance on the fourth quarter, so I can't answer the - I know originally at the start of the year back and I think it was February or January, we communicated an expectation around a 40-60 split. I can't necessarily give you that answer without just giving you the fourth quarter. I think, but what I would say is we're pleased by the performance within the aviation segment. So you've seen a strong revenue and EBITDA recovery. We've internally modeled an expectation around that business sequentially recovering. So I'd say it's in line with our expectations, and we're pleased with sort of that trend, and that was going to be the biggest driver of what we expected to be a stronger back half of the year. We've seen strong results from our FDS business. Back at the beginning of the year, we communicated that on a year-over-year basis, 2020 versus 2021, the EBITDA margin rate would be a bit of a headwind. Now last year, we were north of 11% EBITDA margin rate. I think on a year-to-date basis, we're just above 10%. So we've seen some contracts move from fixed price to cost-plus within that portfolio. And so as a result, we're kind of sticking to our guidance around year-over-year, a bit of pressure. But overall, we're pleased with the business's performance. As it relates to sort of planning for the fourth quarter, we haven't given specific guidance, but other than to say, we still - I think John answered the fleet question already. I think the FDS business is continuing to go task order by task order to identify where those opportunities are to take on some of that risk for the fixed price work. So I'd say you should you model out the full year and compare it to last year, and you can get a sense for where we're at now and what you think the fourth quarter might be. Aviation, as I mentioned, you should expect us to continue to drive from a recovery standpoint, all predicated upon some level of recovery within the repair business.

Okay. And then as a follow-up to that, and I know - I understand it's early. But kind of looking forward to 2022, since it's only a couple of months out. Any thoughts on sort of organically being able to grow EBITDA faster than sales? Any thoughts around that?

Yes. I mean, I think the places where you're going to see the most leverage opportunity is a place like aviation, where we've made significant investments into the business. And we've talked about this versus our competitors, we didn't necessarily take out as much cost as we want to be able to grow as the overall market recovered. So you should expect us to be able to drive leverage and hence, therefore, drive overall EBITDA margin improvement as we head into next year. Within the Federal and Defense segment in the fleet segment, we haven't necessarily given guidance. But as John mentioned, within fleet, we've got sort of two dynamics. One is the mix shift towards commercial, which we've communicated as lower margin, but also there's an opportunity there from a scaling perspective as well as we've made investments both in sales force as well as new facilities to support that growth. So there's that in two different dynamics, one hurting one helping as we continue to look into that next year.

And our next question is from Chris McGinnis with Sidoti & Company. Please proceed with your question.

I just had a question around the new five-year contract you just recently announced. Can you just talk about the difference, I guess, from the prior contract, what you added to it and then maybe how much of a - maybe a margin profile difference there might be associated with that?

Yes. Chris, I mean, so I think you hope you guys have seen the level of transparency since I've been on board, and Steve has been on board that we try to have both on our disclosures as well as on these calls. Obviously, with the exception of areas that we think we'll competitively harm us. What we did with that contract specifically is, this is a legacy VSE contract been here earlier than myself, our Head of Aviation and Steve, and we saw a tremendous opportunity to not only drive the long-term revenue and margin from that program. But also, there's a little opportunity to take advantage of a situation in the market where we can get more favorable terms. So what I would say is that it's as good or better than it was before. And as each contract on the legacy side of the business is getting close to expiration. We have a really sophisticated and strong team in place that's able to drive higher value out of those programs than we have in the past. So I'd like to kind of keep it more qualitative and quantitative right now on that program.

[Operator Instructions] Our next question is from Michael Cerioli with Truist. Please proceed with your question.

John, just on the topic of labor. I know you're not going to kind of give the color you were going to give. But as we look at this federal contract or vaccination deadline of December 8, I mean, how do you think about your employee base there? I don't know if you can share anything in terms of which employees are vaccinated in terms of percentage? And then any specific labor tightness you're seeing on - within the aviation side of your business that we should be aware of?

Sure. We are not immune from the macroeconomic conditions. We're not immune from impacts that face all businesses. Our - we do operate in three very distinct segments from an operating perspective. So the mandate impacts our federal and defense team only, and we're working through that now. So we're not in a position where we're able to share the data or what the outcome will be until probably Q4. We are working to mitigate it. What I would say is more than anything we're trying to really get our - this is we're trying to get all of you engaged on not just the quantitative measures and the proof points and the improvements we've made in the business, but the culture and the business that we're driving and the value that we're adding in the marketplace that people want to work here. So yes, we are seeing some attrition. And yes, it's an area of stress. But on the flip side, we are taking advantage of the attrition from other businesses, and we're able to really attract top talent that are excited to be part of a nimble, agile entrepreneurial business that's going to scale and build something pretty powerful in the market for customers. So it's a balance of one day pulling your hair out and the next day feeling enthusiastic about what we're building. But it is definitely interesting times on the labor front, something that's definitely - we talk about supply chain, that have been through multiple cycles. This is definitely unique. But right now, we've got it under control for the federal and defense team, and we'll continue to keep you guys updated if anything changes.

And we have reached the end of the question-and-answer session. I'll now turn the call over to CEO, John Cuomo, for closing remarks.

Great. Thanks, everybody, for the time today. I appreciate your continued interest in VSE, and look forward to speaking with you when we report our fourth quarter earnings. Have a great day.

And this concludes today's conference, and you may disconnect your lines at this time. Thank you for your participation.