Greetings, and welcome to the VSE Corporation First Quarter 2022 Earnings Conference Call. At this time all participants are in a listen-only mode. A question-and-answer session will follow the formal presentation. [Operator Instructions]. As a reminder, this conference is being recorded. I would now like to turn the call over to Noel Ryan of Investor Relations. Thank you. You may begin.

Thank you, operator. Welcome to VSE Corporation's First 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 materially from the 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 presentations 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'd like to turn the call over to John Cuomo for his prepared remarks.

Thank you, Noel and welcome to everyone joining us on the call today. We are off to a solid start to 2022 with the strongest revenue quarter for VSE in over 10 years, including revenue growth in all segments and the highest revenue on record for our Aviation segment. Not only was the first quarter a strong revenue quarter for the business but one where we delivered growth in adjusted EBITDA and profitability as well. We've started the year strong with a combination of new contract wins and execution excellence on existing legacy programs. Our business transformation continues as we make progress on our team, systems and processes. We're on track with our integration activity for both legacy VSE businesses and recent acquisitions, which will support our mission of creating scalable businesses able to capture more of their growing end markets. Three key strategic focus areas will enable us to deliver value for shareholders. First, we are building long-term, higher margin, sustainable revenue channels that capitalize on the strength of the VSE assets and enable us to support our customers in growing end markets. Second, we remain focused on growing profit as we drive scale with our recent and ongoing investments and improve our operations through continuous improvement. Third, we are building on our strong legacy customer relationships to strengthen core revenue channels with our industry-leading customer service and breadth of product and service offerings. The company's first quarter results demonstrate substantial progress across these strategic initiatives. I'll start by highlighting some of the progress in our Aviation segment. Our Aviation segment reported record first quarter results, highlighted by strong organic revenue growth across both our distribution and repair businesses. Distribution revenue has now exceeded pre-pandemic levels for the sixth consecutive quarter. While repair revenue continues to accelerate, supported by…

Thanks, John. Now let's turn to Slides 4 and 5 of the conference call materials for an overview of our first quarter performance. We reported $231.2 million in revenue in the first quarter, an increase of 40% versus the prior year period, our strongest revenue quarter in 10 years and revenue growth in all three of our operating segments. Aviation recorded its highest revenue quarter ever, driven by a combination of strong new program execution, share gains within the business and general aviation market and continued commercial end market recovery. Fleet segment growth was supported by commercial fleet and e-commerce fulfillment revenue. Federal & Defense segment growth was driven by inorganic contributions and new business awards, partially offset by the completion of a certain DoD contract in 2021. During the first quarter of 2022, we generated adjusted EBITDA of $22.2 million, an increase of 43% on a year-over-year basis. Adjusted EBITDA margin rate increased to 9.6% in the first quarter as margin expansion across both the Aviation and fleet segments offset margin compression within the Federal & Defense segment. Turning to Slide 6. Aviation segment revenue increased 110% year-over-year in the first quarter. Both our distribution and repair businesses grew on a year-over-year basis, up 172% and 22%, respectively. Distribution revenue excluding $22.5 million of revenue contribution from our Global Parts acquisition is approximately 118% above pre-pandemic levels as a result of recent new awards and strong program execution. Repair revenues remain approximately 20% below pre-pandemic levels, in line with the overall market. Consistent with recent market trends, we see a more moderate commercial MRO recovery in the second half of 2022 than originally anticipated, but continue to expect commercial MRO to recover the pre-pandemic levels by 2024. Throughout this year, we will continue to invest in new capabilities and…

Thank you. [Operator Instructions]. Our first question is coming from the line of Ken Herbert with RBC. Please proceed with your questions. Ken, were you able to check if you are on mute please. Ken are you there. Our next question is coming from the line of Austin Moeller with Canaccord. Please proceed with your questions.

Good morning John and Steve. Awesome quarter.

Thanks Austin, how are you?

Good. So my first question here, I understand the commercial fleet sales are lower margin. But does the exceptional demand for commercial trucking right now, just with all of the China lockdowns and port delays mean that the average margin on these products might start to go up soon?

Over time, as we start to scale the business, we are still -- in that business, we haven't made any inorganic investments. We're making all organic investments. We have built an infrastructure, both people, systems, processes and facilities to support launching that commercial revenue channel. And through the end of this year, we still have investments to make. As we start to get into 2023 and beyond, you'll see us be able to scale that business to a different level and you'll see a little bit of margin improvement there in that sector. But I wouldn't expect anything in the near term.

Okay. That's helpful. And then for the Federal & Defense business bookings and backlog, can you discuss what countries or geographic regions for the allies were the largest portion of the bookings for the quarter?

Yes, I mean the largest portion is probably Egypt through our Navy program. That's probably the largest country. Steve, any other color that you think you want to give there?

Yes, I would just say the primary driver of the bookings increase is driven by the NAVSEA program, which supports many different countries. As John mentioned, Egypt is a big one, Bahrain, Iraq. Pretty -- we're seeing increased pickup in terms of award activity on that program, which we're pleased about. No new countries that we haven't previously announced though.

Okay, that's helpful. And then just one last question. So I understand the company's goal to achieve positive free cash flow this year. Do you think that inflection point happens next quarter or sort of in the second half of the year?

We haven't necessarily given the guidance. All we've mentioned is that we expect sequential improvement from here on out. I think what you see is that we made some investments early in the start of this year as it relates to preparing for 2022 sales. Also related to some of the distribution deals that we have previously announced. So I think we've gone with sequential guidance at this point and we look forward to being able to share more as the quarter comes out.

Okay, thanks for the color.

Thank you. Our next question is coming from the line of Ken Herbert with RBC. Please proceed with your questions.

Yes, hi. Good morning John and Steve. Sorry about the technical difficulties a few minutes ago. Nice quarter. Just wanted to start off on Aviation. As you look at the market and when we think about this business sequentially from the first to the second quarter and sort of the $10 million -- I'm sorry, from the fourth quarter to the first quarter, the $10 million increase. Can you break that down in terms of what you're seeing from distribution, I know we'll get that in -- obviously, with the filings, but not so much the growth but in terms of the activity levels and the margin contribution because I know you've talked about MRO in the past as sort of key for continued margin expansion in the segment, what were the trends you saw from the fourth to the first quarter and are you seeing that continue here into the second quarter?

Yes, thanks for the question. I think we've seen improvement from the fourth quarter to the first quarter both in distribution and in repair. And so you'll see when you kind of see the complete filings, but you'll see there's sequential growth in both sides of the business. And at the end of the day, as we mentioned, one of the key drivers from a margin rate improvement standpoint is the repair recovery from a revenue standpoint because it does drive higher incremental margins, just given the nature of the cost structure of the business. I think from a market trend standpoint, we will still continue to see positive improvements. But what we have communicated is that I think there's a slightly more moderate recovery within the repair space than what we had initially anticipated, which is in some ways, driving some of our assumptions as we look to the back half of this year in terms of when we think repair will recover and likely out into 2023 and 2024.

Yes. Okay. That's helpful. And with the recent distribution and other agreements you put in place, how much would you say of your business within aviation is sort of under long-term or recurring contracts versus sort of spot market or what I would call sort of point-of-sale or book and ship type businesses?

So our distribution business, I'd say at this point, we're probably close to 90% of the revenue is probably locked in under a long-term supply agreement. Obviously, the demand and the backlog is more of a transactional nature. So we have a lot of exclusive arrangements with suppliers. But then obviously, that doesn't necessarily mean you have firm backlog. The backlog obviously depends on the demand of the end user customer. But as far as consistency of revenue as we kind of break out our strategy, as we looked at this first phase of business transformation, a big part of that was to lock in our core programs and make sure that we've got a lot of longevity of kind of consistency in those revenue channels. So it was a big part of what we did to end the year and to start this year. So in distribution, we really have one program we're trying to get to finalize on a renewal and that puts all of the legacy programs in -- locked in for really long-term consistent revenue going forward.

Okay, very helpful. And then just finally, as you think about sort of the capital structure and we think about capital allocation, two questions here. First, is there any sort of near-term risk around floating or fixed rate on the debt and is that anything that you might be able to address this year? And then second, as we just look at leverage in the aggregate, how do we think about that moving through the year as ideally the cash flow profile starts to improve?

Yes. Good questions. So I think there obviously is risk as we are in a floating rate structure from our debt standpoint. So I think what we have internally assumed is that we would expect the back half of this year to continue to be at levels from an interest rate expense similar to where we're at right now. Even though we expect the free cash flow to drive down the balances, we do anticipate rates to continue to rise which will drive an offset to that reduction. And then in terms of the capital structure long term, we continue to evaluate options. I think you know last year, we did an amend and extend for 18 months of our existing facility, really so that we could support the recovery within our businesses and get to a stabilized level of new performance because we're such a different business than where we were about three years ago. We really want to be in a sound footing when we go to have conversations about what we want our capital structure to look like long term. So I'd say it remains something that we'll look at over the course of this year and evaluate whether or not there's something to move differently in terms of the capital structure, whether it be this year or early next year.

Okay, perfect. Thanks Steve -- thanks for the color.

Thank you.

Thank you. Our next question is coming from the line of Michael Ciarmoli with Truist. Please proceed with your questions.

Hey, good morning guys. Nice results. Just before I wanted to get into aviation, just on the federal and defense, you took the charge this quarter calling out, I guess, the nature of that fixed-price contract. But I guess as you look about within the current mix of contracts and dealing with the inflation environment, do you expect more pressure on some of your existing fixed-price contracts, do you have to wait for those to renew to kind of deal with the current, whether it's labor or raw materials, I guess I'm just trying to figure out how much risk is in that federal segment from a contracting standpoint?

Oh, it's a good question. I know I'd say there's very, very little risk. At the end of the day, we've been talking -- I've been in the business for about three years now. And the first phase of it was to kind of clean up the legacy assets and get our value proposition in each of the three business segments aligned and start pushing this business forward. And the federal business has been -- it's the slowest business just because of the market to get it back on track. So we made the decision this quarter when we look at kind of exiting legacy contracts that were noncore. This was pretty much the end of it and I think the business now from here is you could expect this kind of as the floor. And now it's looking at the assets inside the portfolio to see what's core and noncore as you move forward. But I wouldn't expect anything else on any risk on fixed-price contracts going forward.

Okay. How does that -- if let's say you signed a fixed-price contract six months ago where the inflationary environment was dramatically different. I mean is that how are you protected on a contract like that six months ago, I mean is that just -- did you have more open negotiations with the customers or I'm just trying to understand...?

So when you look at our -- when you look at the three business segments, our aviation business and our fleet business are highly transactional. So we have a lot of -- a strong ability to very quickly change price. The very few contracts we have in those two segments that are long term. There are pricing escalation abilities within the contract to raise prices when we need to raise prices. Within the federal business, the way that the contracts were most -- right now, our contract mix and, unfortunately, you see in the margins is a little bit more cost plus or cost reimbursable heavy right now. The fixed price work that we do have, though, is more task order-based. So it's more of a short-term booking and we have a lot of confidence in how we're booking there. So we don't really have any long-term kind of fixed-price contracts right now or there's any open risk as we move forward.

Got it. Perfect. Then just switching to Aviation, can you call out what specifically changed with the repair business, you said it's tracking a little bit below your expectations versus what you called out last quarter, what are you seeing in the marketplace?

Yes. I mean we anticipated the commercial MRO side of the business to be very close to pre-pandemic recovery by the end of the year. It's just -- it's like a slower slope up. Every month, we obviously track our inputs on a daily basis. But when we look at the trend on a monthly basis, we are continuing to see input improvement in the MRO shops month-over-month as we move forward. It's just not at the level of robust activity from the airlines that we had anticipated. So we look at kind of that pre-pandemic recovery in that segment really being pushed out to 2023 and not happening in the back end of 2022 as anticipated. So it's more of a market recovery. But we feel the business is performing well. You can see this margin improvement as we have discussed as the business starts to scale. It's just a slightly slower recovery in the market than we initially had anticipated.

Got it. Got it. And then last one for me, and I'll jump back in the queue. On those margins, it sounds like from your kind of directional guidance, we're going to get set down margins from here. Is that a function. I mean I know you called out the organic investments and obviously, the slower ramp in repair, but it's just -- I mean, it still seems like you're going to start to get some leverage on some of these new contracts and more volume. Is there -- I guess I'm just trying to figure out from this 11.6% level, talking 10% to 11% the remainder of the year seems like it could be a bigger step down. I mean I know you're going to get the year-over-year expansion versus obviously what you did in 2021. But anything else color you could provide on some of that margin pressure?

Steve, do you want to go...

Yes, I was just going to mention. So as it relates to some of the newer programs that we mentioned, we continue to make these organic investments as you referenced. I do want to make sure that it's clear. Those won't necessarily turn into revenue this year, right. So these were new repair activities that we're investing in, in that business. They don't necessarily turn into revenue within a month. Like a distribution deal, you can turn around quite quickly. These are businesses that we are going to have to make investments in, in terms of technical talent to make sure that we're prepared and we really anticipate revenue to begin in 2023 hence, why was we talked about the margin rate of the business. We want to make these investments because we know what drives long-term growth of the business, but it won't drive short-term improvement in margins. In that sense some of the assumptions we've given around that margin 10% to 11% for the year.

You go ahead.

I wanted to -- I was going to add, so it's primarily staffing and adding that technical labor.

Exactly. So when you look at it, so we feel -- when we look at our product margins and our service margins, those are performing very much in line with our plans, and we're really pleased to see where those margin -- that margin performance is. When we look at our SG&A as a percentage of sales, it's higher than maybe -- I think maybe -- you had maybe had modeled. And let me explain why. We really want to be well positioned, as you could see the growth on a year-over-year basis, we need to be able to manage that growth. A huge part of our value proposition in the market is how we perform from a customer excellence perspective. And a big part of that is making sure that we're staffed appropriately. I know you're at the conference for Aviation this week, and you get a lot of pressure on labor. We are really, we believe, better positioned than most in the market from a labor perspective. And we just want to make sure that we're not being too thin on the labor side. As the recovery starts to happen and people are going to struggle with technical talent, we want to make sure that we're really fully staffed. And so the SG&A right now is a little heavier relative to sales. And then just over time, it will scale naturally. And we feel very confident in our mid- and longer-term margin expansion plan. We just, again, want to be a little cautious in the near term based on the pressures that you see in the market.

Got it, makes sense. Thanks guys. I will jump back in the queue.

Thank you. Our next question is coming from the line of Louie DiPalma with William Blair. Please proceed with your questions.

John, Stephen, and Noel. Good afternoon -- good morning actually. What drove the sharp increase in revenue from your fleet e-commerce fulfillment channel on a sequential basis and are we still in the early innings of growth there, are we part of like a multiyear growth cycle or should that exceedingly higher revenue growth, like taper off significantly over the next several quarters?

No, it's a great question. Two years ago or so, we launched kind of this commercial revenue channel. And we kind of go to market as a true kind of classic commercial distributor. We have our own e-commerce platform. We have what we call e-commerce fulfillment, where we're supporting products through other platforms as well. And then we have our just-in-time program. And the market is really responding well to our offerings. So we do believe we're only in the early innings of the growth here. You'll continue to expect growth. At some point in the back end of this year, we're going to move that business onto a new ERP platform, and we'll kind of communicate ahead of time. You might see just a one month kind of level off a little bit as we kind of that transition, and that will get us ready for 2023. But we believe we're in the early innings of really building something special and being able to continue to diversify that customer base within the fleet business. So really proud of what the team has done and what they've been able to deliver.

Thanks John. And for Stephen, you provided guidance for the fleet EBITDA margin, and you mentioned further investment to support the rapid growth I believe for this year and next year. Do you though expect -- I think you said a 12% to 13% margin, should that be the long-term trough for the fleet margin or should like future investments pull that down further?

We haven't necessarily given the long-term guidance for the business yet. I think towards the back half of this year, we'll be able to provide more color for you as you look to the long-term multiyear transformation. But I'd say in and around this range is probably the right place to be. And the reason why I say that is, this year, as John mentioned, we're going to continue to make investments, and those are going to help us deliver the next round of scale because the business, as you can see, is continuing to rapidly grow which in some level, we're going to have to make investments in terms of our infrastructure to make sure that we're able to support that growth. And what you haven't necessarily completed all that modeling to be able to share with you sort of what the long-term guidance looks like in terms of that business's margin rate. But it's in and around this space. I'll go back to sort of the commentary that John used at the very beginning. We're looking at growing adjusted EBITDA of this business. The margin rate itself is obviously very important to us, but we're also trying to think about building a long-term business that's very sustainable while we go through this mix shift with the other USPS customer within the segment. And so our focus right now remains on growing EBITDA dollars, and that's where we're going to continue to drive as we go through this transformation.

Okay. So should the EBITDA dollar should that continue to grow from here?

That's -- when it comes to long-term guidance as to how to think about the business is performing, that's exactly what we're driving for.

Sounds good. And final one, back to John, can you talk about your ability to gain market share in the aviation repair business? You recently announced the Honeywell repair partnership in last quarter, the Boeing 737 partnership, if you execute on those contracts, do those showcase VSE aviations repair abilities and should that lead to other partnerships on the repair side?

Absolutely. I think that -- so we're trying, again, to build out -- when you look at the aviation business, it will be the long-term kind of strategic vision is for the business to be very balanced between commercial and business and general aviation and MRO work and pure distribution work. And what you're seeing from the business in the first kind of year and half, two years that I've been with the business, we had a tremendous growth in the distribution business and brought on a lot of great new programs. What you're seeing this year is us start to scale the MRO business. So we're bringing on board this program that we announced this week with Honeywell is supporting legacy as well as next-generation aircraft, mostly avionic work, and that will take us probably to the end of this year to get that new test cell and that authorized repair center up and running. But then we have a lot of those very long-term consistent revenue stream. What that will do is not only bring new customers to us, and those customer approvals will then give us opportunities to use our other repair capabilities to sell to those customers, but also highlight our ability to be a very OEM-centric business, and that we'll do and I know how to show this week or already starting to have dialogue with other OEMs to say this is how we really can represent you well in the market. Specifically, during these times of really tough labor when we have the ability to move a little quicker than they can for -- to build out those MRO capabilities to support these OEMs. So very excited about kind of the future potential for that MRO business as well as the distribution business.

That's helpful. And where is that Honeywell repair center going to be located?

It will be in our South Florida, in our Miami, our Miramar aviation headquarters. So that's where most of our commercial hydraulic pneumatic avionic repair is. Kansas is where we do more of our business in general aviation work. And in Cincinnati, it's more kind of low tech, like interiors and things like that.

And is the Boeing 737 teardown work, is that also going to be done in Florida or is that in Texas or somewhere else?

That work is -- it's a partnership with the airline, and we have a third party that will do actually the physical teardown. We're not actually tearing down the aircraft. And then what we're doing once the aircraft is kind of torn apart, then we're moving that material to our facility, either in Miami or in Phoenix in our distribution facilities to help distribute that product. And if there's repair needs, then that product will come into our shop or into another shop to get repaired before it gets sold out to the market.

That makes sense. Thanks John. Thanks everyone.

Thank you. Our next question is coming from the line of Jeff Van Sinderen with B. Riley. Please proceed with your questions.

Hi, good morning everyone. So I wanted to circle back for a second if we could do the commercial MRO market. Just a point of clarification there. I know you mentioned that you see the recovery running slightly slower than anticipated. I'm just wondering, what do you attribute that slower rate of recovery to versus prior expectations?

Steve, do you want to jump -- I mean -- so at a high level, I mean, at the end of the day, the market is just recovering a little slower or softer than we had anticipated. My personal perspective is I think you've got a lot of labor and fuel pressure at the airline. And any maintenance that can be deferred, they're taking advantage of those opportunities and deferred maintenance. So again, we're continuing to see consistent improvement in inputs month-over-month in our commercial MRO shop, but it's slightly less robust than we had initially anticipated. But you'll continue to see these and let's close the gap on that 2019 kind of data point.

And so if -- let's just say they are deferring some maintenance. I mean, would you anticipate sort of a catch-up period at some point in the future where all of a sudden, there's a lot of deferred maintenance that starts to hit and benefits your business?

It's a good question. At this point, I wouldn't say that. I think you're just going to see a nice gradual increase. We may see the market heat up and kind of that trajectory kind of go more directly up rather than on a nice incremental month-over-month improvement. But at this point, we're not forecasting it that way.

Okay. Fair enough. And then on Honeywell, the contribution from that, just wondering when that's likely to be running at peak levels and then, I guess, as you think about other potential wins there, how much more capacity do you have to take on more work of that nature?

Yes. So a good question. So on the Honeywell side, when you look at our new MRO capability, I'd say really 8 to 10 months before because we build out the capability. We get new test cells in. We obviously do some pilot programs to make sure things are working before we really start going to market. So you won't really see the real contribution until 2023 on that program. From a capacity perspective, we have a tremendous amount of capacity for growth. So during COVID, we did a site consolidation and build centers of excellence. So our MRO center of excellence in South Florida has the ability to at least double the size of the business within the existing footprint. So we are very well positioned as we win new awards to quickly bring them on board and to scale this business.

Okay. Great. And then one final one, if I could squeeze it in, just wondering around all the activity with the war in Ukraine, if you're seeing an increase in, I don't know, requests for bid in your Federal and Defense segment, any changes there that you're noticing that might result in incremental contract wins?

There's a lot of initial discussions, specifically kind of NATO country. We have some of our team over in New York right now, having some discussions with some customers. I'd say that there's initial discussions at this point. We don't have any firm orders supporting any of that work yet. We will report if and when any of that materializes in an actual order.

Yes, Jeff, I was just going to say, just to cover sort of the impact across the other two segments because I think it is relevant. Obviously, no real impact on the fleet segment because it's quite domestic. I'd say our Aviation business, a real upside. If we look at what the potential is. There's maybe $2 million of sales in that region last year just to give you a reference in terms of the type of an impact it might have on our business this year.

Okay, thanks a lot.

Thank you. [Operator Instructions]. Our next question is coming from the line of Michael Ciarmoli with Truist. Please proceed with your questions.

Hey, thanks for taking the follow-up guys. Just on -- I appreciate the directional guidance here for the remainder of the year. But Steve, the Global Parts, I think you said it was a $22.5 million contribution this quarter. I think I had it at a similar run rate in the fourth quarter of last year, is that correct, was it in that kind of $21 million, $22 million range?

Let me actually get it for you. We disclosed it last quarter. So last quarter was about -- just under $19 million and this quarter, you can see it's under $22 million.

Yes. No, I guess I was getting at as we think about the remainder of the year, that was pretty good sequential aviation growth. And I think we're looking at a lot of the industry and the companies on a sequential basis. Are those kind of the -- that's the right trajectory to kind of think about aviation on a go-forward basis. I mean there's obviously a lot of moving parts with materials, labor, price. But if we continue to see traffic grow, the market remain healthy, I mean, it's something in that mid- to high single-digit organic sequential kind of the way to think about aviation?

I would think about the business maybe twofold because remember, we've got the commercial side of our business and the business and general aviation side of our business. I would say the sequential improvements we expect to continue for the commercial side of the business. I think at some point you are going to start to see the business in general aviation side start to slow somewhat, just given the market it's quite strong and quite robust right now. And I think at some point, you'd have to expect that it's going to level off at some point. So total business will -- we haven't necessarily given sequential guidance, but we've given the assumptions on year-over-year, and I think you can kind of get a good understanding of what we're thinking about for the year. But there's a difference between commercial and business and general aviation.

Okay, got it, helpful. Thanks guys.

Thank you. There are no further questions at this time. I'd now like to turn the call back over to John Cuomo for any closing comments.

Thanks, everybody, for joining the call today. I appreciate your continued support of VSE. Wish you all a great day.

This does conclude today's teleconference. We appreciate your participation. You may disconnect your lines at this time. Enjoy the rest of your day.