Greetings, and welcome to VSE Corporation’s Second Quarter of 2022 Earnings Conference Call. [Operator Instructions] As a reminder, this conference is being recorded. I’d now like to hand over to your host, Mr. Noel Ryan of Investor Relations. Please go ahead.

Thank you. Welcome to VSE Corporation's Second Quarter 2022 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. With that, I would like to turn the call over to John Cuomo for his prepared remarks. John?

Thank you, Noel, and welcome to everyone joining us on the call today. Let's begin on Slide three of our conference call materials. VSE finished the first half of 2022 with two of the strongest revenue quarters in more than a decade, led by broad-based year-over-year growth in all segments, including Aviation, which reported record revenue in the second quarter. While the macro environment remains challenging, given continued supply chain disruptions, cost inflation and labor constraints, we continue to make steady progress on our customer-centric value proposition, highlighting the strength and resiliency of the VSE team and the demand for our products and services in the market. Our strong second quarter performance further highlights our successful implementation of recently awarded distribution and MRO programs together with our effective integration of recently acquired businesses. We executed on plan in the second quarter, delivering strong year-over-year growth in revenue and profitability. Total revenue increased by 38% year-over-year, adjusted EBITDA increased by 21% year-over-year and adjusted net income increased by 25% versus the prior year. We continue to advance our on-going business transformation, guided by three strategic initiatives that position us to drive long-term value creation for our shareholders. First, we are building sustainable revenue channels through new program execution, market share gain and product and capability expansion. Second, we remain focused on margin expansion and profitable growth as we drive scale with our recent and on-going investments, and improve our supply chain and operations through continuous improvement. And third, we are building on our strong legacy programs and our long-term customer relationships to optimize our core revenue channels with outstanding customer service and depth and breadth of product and service offerings. The company's second quarter results demonstrates substantial progress across these strategic initiatives as we continue to execute the next phase of…

Thanks, John. Now let's turn to Slides four and five of the conference call materials for an overview of our second quarter performance. VSE reported $241.7 million in revenue in the second quarter, an increase of 38% versus the prior year period. Second quarter revenue grew year-over-year in all three of our operating segments. Aviation generated $105 million of revenue, its highest quarter ever, driven by a combination of strong new program execution, share gains within the Business and General Aviation market and continued commercial and market recovery. Fleet segment growth was supported by commercial fleet and e-commerce fulfillment revenue. Federal & Defense growth was driven by growth in our U.S. Navy programs, partially offset by a U.S. Army contract completion. During the second quarter of 2022, we generated adjusted EBITDA of $22.9 million, an increase of 21% on a year-over-year basis. Adjusted EBITDA margin rate decreased to 9.5% in the second quarter as margin expansion across the Aviation segment offset margin compression within the Federal & Defense segment. Turning to Slide six. Aviation segment revenue of $105 million increased 121% year-over-year in the second quarter. Both our distribution and repair businesses grew on a year-over-year basis, up 177% and 37%, respectively. Distribution revenue, excluding $23.7 million of revenue contribution from our Global Parts acquisition, is approximately 150% above pre-pandemic levels as a result of recent new awards and strong program execution. Total MRO revenues are approximately 6% below pre-pandemic levels, and are led by Business and General Aviation repair, which is above pre-COVID levels, while Commercial repair is approximately 25% below pre-COVID levels. Consistent with recent market trends and our first quarter expectations, we anticipate moderate commercial MRO recovery in the second half of 2022 and continue to expect commercial MRO to recover to pre-pandemic levels by 2024. Looking…

[Operator Instructions] The first question comes from Ken Herbert of RBC Capital Markets.

Good morning, John and Steve. Nice quarter.

Good morning.

Hey John, on the Aviation business, it looks like you saw a bit of an inflection in the repair business in the quarter. It sounds like from the commentary that wasn't as much on the commercial side as it was on the business jet side. I know this tends to be the higher margin business. But can you just dig a little bit deeper into what you saw in the quarter on the repair side and if you're starting to comments sounded still a little cautious on the pace of the commercial repair recovery, but what are you seeing in that market and a little bit more on how the second half could look there?

Yes. I mean we -- yes, Ken, we saw improvement and revenue increase in both the commercial and the Business and General Aviation repair businesses. So the recovery is happening, and we are still feeling very bullish about the future. I think that when we look at the year-over-year growth and how the other programs have executed as well, and when we look at the pipeline of new business opportunities that we have ahead of us and the issues around labor, we've definitely been a little more cautious in hiring and making sure that we're fully staffed to support the growth, growing a business and more than doubling the size of the business in the year, requires a lot of operational excellence as well. So we have definitely been a little bit more cautious on the SG&A side as well as the commercial MRO business. It has been slightly slower to recover, which is why we're more cautious on margins. Steve, do you want to share any more color on kind of the breakout of Commercial versus BG&A. I know we don't put too much detail. But...

Yes, we don't provide the split necessarily, but you are right, based on the commentary, Ken. We did see significant strength in B&GA. And I think generally speaking, we could see some of that pent-up demand coming through at the end of the first quarter that helped to translate into strong revenue generation for Business and General Aviation repair. I think we continue to see that commercial recovery, as John pointed out. But as you know, there's just some uncertainty generally in that market space, but we're pleased with the execution in the quarter.

Yes. No, it looks great. Is there anything that's giving you pause within the B&GA segment? Or are you seeing anything from your customers that may imply that the growth we've seen in that market could start to moderate?

No. I mean -- you and I had a few conversations. I tend to be a little more cautious than what you read in the market. That said, when we see the backlog and we see the customer activity, we continue to see pretty robust trends in that market.

Okay. Great. And just one final question. With Global Parts and then, of course, with the distribution agreements you've put in place, now that you're a few quarters or a year or so into some of these distribution agreements, any surprises on these? Anything around with the material you've acquired, that's either positive or negative? Or how are those performing relative to plan?

Yes. I mean, I appreciate the question. When we were exactly actually, Monday was a year anniversary of the Global Parts acquisition. That was a self-sourced deal at a low multiple. And when we look at the multiple in terms of how we -- how it performed compared to plan, it's tremendously exceeded our expectations. We're on track for a Q4 system integration and full integration of the business into our full distribution business, but it's performed above plan year-to-date. When we look at our Pratt & Whitney Canada agreement as well as a few of our other larger distribution agreements that we launched last year, I can't stress enough how proud I am of the team to be able to build out platforms that essentially doubled the size of our distribution business, while having market-leading distribution results and just amazing customer feedback in terms of how much we've improved, both operational performance as well as inventory availability. So far, everything is really performing above plan. And we came in with a thesis of where we -- there were some gaps in the market, and the market is really responding well to it.

That’s great. Alright, well thank you very much.

Thanks Ken.

Our next question comes from Michael Ciarmoli of Truist.

Hey good morning guys. Thanks for taking the questions. Nice results as well. John, maybe just to kind of go back to Ken's first question on Aviation, I think you kind of hinted at the margin dynamic talking about SG&A. But obviously, the second half implies a step down and you are getting that pickup in the MRO, which is higher margin. Is there anything else, kind of, any other moving pieces in the second half? Are you looking at just higher labor, any longer term times, anything that might also be impacting the margin in the second half? I'm assuming the MRO revenues don't take a step back here in 3Q and 4Q from where they were. Maybe you could just comment on the margin dynamic.

Sure. I mean at the end of the day, mix is what's going to drive the margin at this point. As we get into 2023 and beyond, you'll see SG&A as a percentage of sales, a big focus of that operational excellence and decreasing that. But right now, I think you're going to see mix drive kind of the margin. Steve, any color you want to add on that. But I would say -- let me add on the MRO side, we are not expecting a step down in the back half of the year.

Yes. No, I think, John, you highlighted mix dynamic there. And then we did reference during the first quarter that we continue to make investments in the business for growth. I think you can see with the second quarter results in terms of strong execution on the top line. We continue to see opportunities to grow organically. We'll make some investments to help generate that growth as we launch some of our new programs, which we previously announced in the first quarter. But besides the dynamics that John referred to, I don't think there's anything else necessarily to call out.

Okay. And on those investments, can we just think that you guys may be carrying extra costs while some of these organic investments get ramped up? Is that the right way to think about sort of how the margin will be impacted?

Absolutely. So you look at -- I'll give you a real -- so you look at a -- we signed our first authorized MRO capability to do avionics work, a 10-year agreement out of our facility in South Florida, which traditionally was an independent facility to get that business up and running. We've got the testing equipment. We've got -- bull inventory is not in SG&A, but we've got testing equipment, we've got labor. So when we look at the growth and the opportunities ahead, we don't want to pass on those opportunities by being overly cautious on the SG&A front. So like I said, we've been a little bit more aggressive in this market to make sure that we are able to staff and perform, that the value proposition is based on above-market performance. And to our end user customer, we want to make sure that we can continue to be there. Steve, any other color?

I think you hit it all.

Thanks, Mike.

Just one other one as well. Just -- you mentioned the B&GA, the backlog, the activity. I guess we're now in a technical recession here, and there's always been a pretty tight correlation to corporate profits with biz jet activity. I mean how are you looking at the trends longer term? I mean do you have that much backlog and visibility in that specific segment?

No. I mean it's an aftermarket business. So you're correct. There's not a tremendous backlog of visibility. We look at the after trends. The trends are continuing to perform the way that the year has started to perform. When we look at 2023, and we look at the back end of 2022, I'm a little bit more cautious than the double-digit growth rates that you see out of the market. I do not think that we will see the, like, let's say, the 2008 business in general Aviation kind of boom and bust market. That said, I do think that a level of caution in the forecast as we look at 2023 plus. Steve, do you have anything else there?

I think you hit it.

Thanks guys. [Indiscernible]

Thank you. The next question comes from Louie DiPalma of William Blair.

John and Steve, good morning.

Hey Louie, how are you?

Good morning Louie.

Your Aviation revenue growth, John and Steve, continues to be robust. Was your new Honeywell Avionics contract that you announced in April? Was that the key driver for revenue growth in Aviation this quarter?

Louie, actually, that program that we announced in the first quarter really won't start to generate revenue until maybe late this year but probably more early next year. So it doesn't necessarily contribute to the strong results this quarter. I think what we would attribute the strong results this quarter too is really excellent implementation of the new programs, as well as success within the Global Parts business. We continue to see that the teams are operating at a very high level of efficiency in terms of managing our product as well as at the same time finding new solutions for customers. So we're very pleased with the implementation of those programs as well as optimizing the legacy programs that exist within VSE Aviation beforehand.

Great. Stephen, what were some of those, I guess, new programs that were the key revenue drivers in Aviation? .

I would point back to the three large programs that we announced last year, one being the Pratt & Whitney Canada engine accessories deal, the second one being the Pratt & Whitney Canada auxiliary power unit deal and then the last being the Triumph actuation program. All of those programs now are at full implementation. And then that, combined with the Global Parts integration and helping to drive some commercial synergies in terms of sales opportunities and sales leads, I think that helped to contribute to the strength on the top line.

Great. And when those programs are at -- I mean full implementation, does that mean that like growth is somewhat capped for those programs? Or should there be like continued growth in future quarters and years from the Pratt & Whitney Canada engine accessory parts and the other programs that you mentioned?

Yes. I mean once they're fully ramped, you're not going to see the growth rates that you're seeing today. You'll see us grow with the market. You'll see us have the ability to grow, both in terms of price and volume. And then there's additions and some add-ons as we kind of gain share of wallet, kind of intend gentle sales around those core programs. So there is a growth strategy beyond the full implementation. It just won't be at the same pace that you see the implementation growth rate.

Thanks, John. And John, I think you referenced how the pipeline is very large. And Steve talked about how there is some caution related to staffing. Right now, are you turning down certain deals or even deferring certain partnerships until the staffing environment improves?

No, I wouldn't say staffing is holding us back. Again, we've been a little bit more aggressive, both in our Fleet business and in our Aviation business to support the growth that we have in front of us and the growth that we see even further ahead. We are looking at capacity. During COVID, we created centers of excellence that will help us drive scale in all of our businesses. I wouldn't -- we've got a few that we're still working on, getting that scale ready to handle the future. But I wouldn't say we're turning down business, but I'd say that we are watching capacity to make sure that we can handle the growth not just today, but in 2023 and beyond.

That makes sense. And one final one. How is the Southwest program progressing? Southwest this morning announced that it expects reduced deliveries for its Boeing 737 MAX for this year. Would that have any impact on how your program with Southwest ramps?

It does. We purposely did not put a large forecast and didn't put a big forecast out in the market on that program for the near term. Although we anticipate about 250-or-so aircraft that will retire during the life of that program. We don't believe that this is going to be the robust year. You need new aircraft deliveries to support aircraft retirements, and there's just a level of uncertainty out there in terms of delivery. So we -- our forecast is extremely conservative for 2022, and even relatively speaking, for 2023, on the program until we know that deliveries are going to come in, that will allow them to retire those aircraft. So no change to any of our forecast. But again, a level of conservatism around how we look at that program.

Great. Thanks. I’ll jump back in the queue.

Thanks Louie.

The next question comes from Austin Moeller of Canaccord.

Good morning, John and Steve, nice quarter.

Thank you. Good morning.

So my first question here, just in the fleet business, the performance on the USPS contract was relatively strong. Do you now expect that USPS may perform better than anticipated going forward, just given the diverse vehicle fleet and potential extension of use on the Northrop LLVs if we see like the Oshkosh vehicles get pushed to the right?

Yes. I think that we are anticipating the LMVs to be more of a longer-term play for the postal service based on the communication that you see that's in the public domain as well as the same that we do. But based on both delivery of new vehicles and being a longer delivery cycle, the mix of fleet that's going to -- that the USPS will have when they're complete with their fleet transition in probably 8 to 10 years from now, which will include some commercial off-the-shelf vehicles as well as the inability for them to get vehicles today. We do anticipate the LLD being extended. And that's obviously -- we have a very strong market share on that vehicle. We also are seeing market share gains on other vehicle types within the USPS fleet, for two reasons. Number one, they're starting to age out. And as they start to age out, we're seeing revenue by vehicle types start to grow as well as we start to understand how the customer uses the vehicles. we're starting to be able to penetrate with additional products as well. So yes, it was a very strong quarter for the USPS.

Thank you. The next question comes from Sir Jeff Van Sinderen of B. Riley.

Good morning everyone. Let me add my congratulations as well. Just a follow-up on the B&GA MRO segment. It looks like you're building pretty good momentum there, taking market share. What's your latest thinking on what inning we're in relevant to taking more market share there in that segment?

In the businesses generally -- so let me just talk at a high level about MRO share gains. So MRO share gain is from when we kind of launched a capability or win a new program until you see revenue execution is about 12 months. It could even be as high as 18 months before you see these programs wrap. It's a little different than a distribution program where we have to get the capability and the testing and the like up and running. We still see a long runway ahead for both distribution share gains as well as MRO share gains, in both Commercial and in Business and General Aviation. Just want to share the difference though when we announced kind of a win in the MRO space in terms of revenue realization versus a win in the distribution, the space as a quicker in terms of revenue realization. But we still see a tremendous upside in both BG&A and commercial MRO capability expansion.

Okay. Great. And then I know you touched on being more aggressive on labor. Just wanted to circle back to that. Are there any changes for better or worse and kind of the latest that you're seeing in terms of labor availability, labor rates, any change there?

I would say there's no material change or difference from kind of what we've seen in the prior quarters. Part of what we're building is building a culture. And it may sound a little corny, but building a culture of winning team where people want to be on the team. And I believe that if you look at some of our growth segments like our Aviation and our Fleet segment, we actually have lower turnover than most of the market has experienced in the recent times.

Okay, good. And then any update on supply chain, how you're seeing availability evolve? And then maybe just update on how you're handling price increases in the near term.

Yes, I'll talk about pricing first, then we'll talk about supply chain. I mean from a pricing perspective, we're an aftermarket business. We do not have a lot of long-term fixed price contracts, and that does give us the ability to amend price and change and adjust price pretty quickly to end user customers. As we look at supply chain, we look at supply chain and two, it's kind of like a seesaw. You look at the risk and then you look at the opportunities that can come out of those risks. So when you look at our working capital usage, we are really making sure we've got sufficient inventories on the shelf to support both the current demand as well as the future demand that we anticipate. Somebody earlier mentioned kind of are we in a recession or not based on the metrics, we look at our business as one that has opportunity set during recessions as people try to extend the life of assets, specifically transportation assets. The repair spend typically goes up and you see maintenance repair and overhaul and distribution businesses performed quite well. So we are positioning ourselves pretty strong in terms of our inventory position to support both 2023 -- the back end of 2023 as well as -- the back end of 2022 as well as 2023.

Okay, great. Thanks for taking my questions, and best of luck.

Thank you.

Thank you.

Next, we have a follow-up from Ken Herbert of RBC Capital Market.

John or Steve. Thanks for taking the follow up. Just quickly, the positive free cash flow guide for the year implies a pretty nice recovery in the back half. You've had a nice improvement sequentially in cash from the first to the second quarter. How should we think about the cadence there? Are you the cash flow positive in the third quarter? And how much of it is dependent upon the fourth quarter?

It's a good question. What we've iterated here is that you should expect sequential free cash flow improvement from here. So I think that would intuitively imply some level of positive free cash flow for the third quarter. But we reiterate sort of our guidance that barring any major organic investments that might be strategic, we expect free cash flow to be positive for the year. And it's candidly and it's kind of similar to what you saw last year, when we do see this kind of being somewhat of a dynamic as we move forward where stocking of inventory towards the year-end, that then could lead to payables that head out in the first quarter, in the second quarter is a dynamic that might play in the industries that we're in. So you do tend to see more of a second half focus around cash flow, but we reiterate that guide.

Okay. That's great. And Steve, good job on -- as well some of the hedging. It looks like you did about half of the debt. Is there plans to do -- to cover sort of the other half of the debt or anything else you can provide on the hedging strategy and how we think about the potential risk there in terms of rates?

Yes. So first, we did hedge about half the debt. I do think that we'll be able to provide further updates for you in the second half of this year because we'll be getting together in the fourth quarter for our Analyst Day, and I might be able to provide a bit more guidance when we get to that discussion. Right now, we feel very comfortable, obviously, with that 50% hedge, especially as we generate stronger free cash flow in the second half of the year. As it relates to interest rate risk, I mean, I think you should expect interest rate in terms of how it affects our P&L to be pretty close to where we're at in the third quarter. We do anticipate obviously higher interest rate on the remainder portion of the debt that's not hedged. But we do also expect that positive free cash flow to reduce our debt balance and therefore, improve our interest expense. But net-net, I think you can expect there in the fourth quarter to be in line with what we saw thereabouts in the second quarter.

Excellent. Perfect. Thank you.

Thanks, Ken.

Next, we have a follow-up from Michael Ciarmoli of Truist.

Hey thanks guys. Steve, just housekeeping. I may have missed it. The $2.3 million or so charge for Russia and Ukraine, what specifically was the write-down there related to?

Yes, we had a bit of outstanding receivables. And as well, we had some inventory that we had purchased that is specific for that. There is a small slice of the business in general, the ag market that is tied to Russia. And given some of the recent news as well as obviously some of the sanctions, we felt it was most appropriate to take a reserve on those two items. I would say with both items, there is no further risk on either one of them.

Okay, got it. And then just, I guess, looking at that second half free cash flow, accounts receivable up pretty significantly. Do we get a working capital tailwind, obviously, supply chain and inventory investment. But anything going on with receivables or just thinking about working capital second half?

Yes, I think we expect to see some elements of a tailwind from a working capital standpoint. Now I would caution that with the amount of growth that you're seeing within our business, we do expect working capital from accounts receivable to grow just by the nature of the business. I would say there's -- from a collectability standpoint, nothing to be concerned about. So I think as you look to the second half of the year, you'll see a bit more of the EBITDA contribution of the business fall down as well as a little bit of a working capital benefit.

Got it. Perfect. Thanks guys.

Thanks, Mike.

Next, we have a follow-up from Austin Moeller of Canaccord Ingenuity. Thank you.

Thanks for taking my questions. You sort of touched on this in a prior question, but if we do see a slowdown in business jet activity into next year, do you think that, that might be offset by that greater pent-up demand that hasn't been realized yet from commercial aircraft MRO?

Yes. I think we continue to look at diversity of the businesses within the businesses, so to speak. So when we look inside of that bit made a lot of sense, when we look inside of business and general aviation, I think that we are touching all different types of aircraft, all different types of users, all different types of parts of the airplane on a tip-to-tail approach, and that we continue to see opportunities to kind of grow share of wallet. So if we see kind of a slower growth rate next year, first, there will be opportunities for share of wallet gain within our existing customers to kind of combat that. Second, absolutely, we expect the commercial business and the -- both the share gain and the other opportunity sets in front of us to help counterbalance any kind of concerns we have in business in general aviation.

Okay. Great. Thanks for the detail John.

Ladies and gentlemen, we have reached the end of the question-and-answer session. I would now turn the call over to Mr. John Cuomo, President and CEO, for his closing remarks.

Thanks, everybody, for joining our call today. We look forward to seeing many of you at our Investor Day that we'll announce shortly. That will be in the late third quarter, early fourth quarter, and if not on our third quarter earnings call. Thanks again for the support. Have a great day.

Thank you. This concludes today's conference. Thank you for your participation, and you may now disconnect your lines.