Greetings, and welcome to the VSE Corporation Third Quarter 2022 Earnings Call. At this time, all participants are in listen-only mode. A brief question-and-answer session will follow the formal presentation. If anyone should require operator assistance during the conference, please press star then 0 on your telephone keypad. As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Noel Ryan. Thank you, sir. You may begin.

Thank you. Welcome to VSE Corporation's Third 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. And with that, I would like to turn the call over to John Cuomo for his prepared remarks.

Thank you, Noel. Welcome to everyone joining us on the call today. As detailed in our third quarter earnings release, our business transformation continues to gain momentum. Recent new business wins and strategic progress across each of our business segments have contributed to continued profitable growth during a period of broader market volatility. Let's now turn to Slide 3 of our conference call material. During the third quarter, revenue, net income, adjusted EBITDA and free cash flow each increased materially on a year-over-year basis, driven by a combination of new business wins, program execution and improved demand across our key commercial end markets. Total revenues of $242.5 million increased 21% year-over-year, driven by growth across all 3 segments. In the third quarter, both the Aviation and Fleet segment recorded their highest year-to-date revenue in company history. Third quarter adjusted EBITDA of $24 million was up 12% versus the prior year, driven by contributions from both our Aviation and Fleet segment. Our Aviation segment had another outstanding quarter with revenue of $102 million, up 40% and adjusted EBITDA up 86% in the third quarter. This segment's strong performance was supported by balanced growth across both commercial and business and general Aviation customers and both our distribution and MRO revenue channels. Revenue in our Fleet segment increased 7% in the third quarter, driven by growth with commercial and e-commerce fulfilment customers. Commercial Fleet revenue increased 23% on a year-over-year basis and now represents 39% of total Fleet segment revenue. Fleet segment adjusted EBITDA increased 13% on a year-on-year basis in the third quarter. The EBITDA improvement benefited from commercial Fleet growth, along with steady contributions from the U.S. Postal Service. During the quarter, Federal and Defense segment revenue increased 12% year-over-year, driven by growth within the foreign military sales program with the…

Thanks, John. Let's now turn to Slides 5 and 6 of the conference call materials for an overview of our third quarter performance. We reported third quarter revenue of $242.5 million, an increase of 21% versus the prior year period, driven by growth in all 3 of our operating segments. Aviation recorded another strong quarter with over $100 million in revenue, driven by the successful implementation of new programs, share of wallet expansion and continued end market recovery in both Business and General Aviation and commercial end markets. Fleet segment growth was supported by commercial fleet and e-commerce fulfillment revenue, together with modestly higher contributions from the U.S. Postal Service. Federal and Defense segment growth was driven by the U.S. Navy programs, specifically for military sales in support of ongoing aftermarket services. During the third quarter, we generated adjusted EBITDA of $24 million, an increase of 12% on a year-over-year basis. Consolidated adjusted EBITDA margin rate decreased 80 basis points to 9.9% as margin expansion across both the Aviation and Fleet segments was offset by margin compression within the Federal and Defense segment. Turning to Slide 7. Aviation segment revenue of $102.6 million increased 40% year-over-year in the third quarter. Both our distribution and MRO businesses grew on a year-over-year basis, up 35% and 55%, respectively. Distribution continues to operate above pre-pandemic levels, while commercial MRO remains 10% below pre-pandemic levels. Aviation adjusted EBITDA increased by more than 86% year-over-year, while adjusted EBITDA margin increased by 326 basis points year-over-year to 13.2%. Margin expansion was driven by achieving scale on new programs, improved MRO results and disciplined price and cost management across our mix of offerings. Within the Aviation segment, we maintain our assumption of year-over-year revenue growth as we look to the fourth quarter. The newly announced distribution deals…

Thank you. We will now be conducting a question and answer session. [Operator Instructions] The first question we have is from Kenneth Herbert from RBC Capital Markets.

Good morning John, How are you?

Good morning John.

Good move obviously in the Aviation segment. My first question, you've nudged up the guidance there for the full year EBITDA. I just wondered if you can provide a little bit more detail on where you're seeing the incremental upside? And then specifically, how are you handling inflation when you think about increased costs from your suppliers on the distribution side or increased cost on the MRO side? Are you able to pass most of that through? It sounds like it, but just help us better understand the moving pieces within inflation.

Yes, I'll start with the inflation piece and I'll let Steve talk about the EBITDA guidance. The -- with regard to inflation, we are in a predominantly transactional business. Being 100% aftermarket focused. So we do have the ability, for the most part, to push price down to the end-user customer as we see price increases. So we are not seeing the inflationary pressure on material costs impact our margins. Obviously, labor has a slight play there, but we're not seeing the material costs on -- have that negative impact. Steve, do you want to address the margin improvement?

Yes. I think the second half of this year in terms of improvements versus what we initially anticipated, I think the business in general aviation business has remained quite robust and that's helped improve our expectations for the business. The second half of it is an improved MRO recovery, and that's both on the business and general aviation side and on the commercial side. So we've talked a lot about sort of expecting what we expect throughout the year for commercial recovery. We're now at about 10% below pre-COVID levels in our commercial repair business, which has improved versus the second quarter and continues to pace in line with the overall market recovery and then our business in general aviation repair businesses continued to accelerate in terms of investments we placed through those businesses. And all of that, I think, has contributed to the expectations change.

That's great. And if I could, in the Fleet business with the opening of the Center of Excellence in Tennessee in Memphis, how can that contribute or what's the potential opportunity for revenue increase from that? Or should we think about that more as you come out of the investments as more accretive to margins?

Both, but it will be revenue first. Steve, do you want to give a little color?

Yes, sure. So Ken, if you look at the run rate for our commercial business within fleet right now, I'd say, let's call it roughly $100 million commercial business at this point. We think that as we look towards next year, this can contribute up to potentially $50 million of incremental revenue, which is an important step for us as we think about building our business. And obviously, it's going to take us some time to ramp the facility, ramp our capabilities, and we expect that this will be an important pivot point as we think about the overall diversification of our revenue from the United States Postal Service and Commercial. As it relates to the margins, we've made reference to this earlier, but we will see some margin dilutive effects driven by the investments we're making to build the facility and ramp it up as well as the fact that the commercial revenues do come with a lower margin rate. However, we are very bullish on this opportunity for the diversification effect it has as well as our opportunity to grow long-term EBITDA dollars.

That's great. And can you quantify or at least help us bracket the potential margin impact or sequentially, how we think about the first quarter of 2023 relative to how you should come out of this year in the fleet segment?

I don't think we're ready yet to give the specific guidance. I think it's going to take us some time to really get our arms around the ramp in the production in terms of hiring of new individuals and exactly how it's going to translate into revenue. We've tried to give our best estimate at this point, which is to say that we expect it to be dilutive in the first quarter. And at this point, I don't think we're able to provide any specific range.

Alright. Hey, nice quarter.

The next question we have is from Michael Ciarmoli from Truist Securities.

Hey, thanks for taking the questions, John, Steve. Nice results. John, can you just give us a little bit of color on aviation. I mean it sounds like trends are pretty favorable, but revenue is down a bit sequentially. Did anything -- any noticeable changes in demand? Anything different from the customers just from 2Q to 3Q? Or any color you could provide on the sequential downtick in revenues.

Yes. No, just a little bit of seasonality. We're going through an integration with our Global Parts business, so a little slightly slower sales there. But nothing -- I wouldn't say anything material. On the commercial side of the business, we are seeing very consistent month-over-month, just nice gradual improvement and inputs in our MRO business and in bookings on our distribution business. Business in general aviation tends to be a little bit more driven by activity is very engine focused. So a little bit more cyclical in nature there. But nothing -- I would say nothing special in the quarter, a few onetime orders, but not --

Got it. Got it. And then just -- I think you called out the agreement with Lufthansa and now having the ability with the Southwest deal. It seems like you've got a natural sort of sales channel there. Can you just give us an update on what's happening? And I guess, looking at the headlines this morning, it sounds like Southwest is getting their jets at a slower pace. I want to know if there's -- if that's impacting sort of your expectation with that program to get access to that material on those older planes?

Yes, there's not 250 aircraft. We had -- I think we were a little bit more conservative in our internal forecasting than with the initial proposal was because we just assume things are going to get pushed out more than they're going to get pulled in. But I think we feel very comfortable with the inventory pipeline that's coming in, and we'll put ourselves in a position partnering with Southwest to be the largest used service material supplier for 737, 700s and 800s as those aircraft start to get -- continue to get torn down. But we're seeing nice activity across different geographies supporting that product.

Okay. Got it. And then just to maybe tie the same. You mentioned the Memphis facility and potentially investing in working capital, but you've got these range of other deals that you've also announced. Are there going to be -- some of them are extensions, some of them are new, but should we think about any potential start-up costs or additional working capital investment, investment inventory that might also be a little bit of a drag on cash even as we enter into 2023.

Yes. I'll let Steve address it. The return on the fleet investments is very quick because that inventory does turn and getting that inventory in and seeing the revenue generation from it within the next 2 or 3 quarters is going to happen. Steve, do you want to give a little color on kind of investments and what that looks like?

Yes, sure. As you know, Michael, there's some elements of it that are new programs, some that are extensions. I'd say in the aggregate, if you look at all the announcements, including the Memphis facility, there's probably about $60 million of working in capital investment that we'll make into our business over the coming 6 months or so and probably about $10 million of CapEx next year as part of all the growth that we're experiencing. I'd say of the $60 million in working capital, there's maybe up to 1/3 of it that could be in the fourth quarter depending upon how things play out. I know we mentioned this earlier, but we're going to look to strategically -- potentially bring on inventory to support customers, support the partnerships with the OEMs, especially and then see if there are revenue opportunities. But there's some element of uncertainty to that as we play through the remainder of this year. But as we think towards next year, there's definitely investment as I referenced, and then we expect, as John mentioned, for it to begin to turn into revenue shortly thereafter.

Got you. Last one, I'll get out of the way here. On Memphis, I think you mentioned $50 million of revenue once everything is up and running and operational, you're not saying that's $50 million of revenue in 2023. You're saying sort of on a full run rate once that facility is mature and going full tilt it will generate $50 million?

No, we're saying $50 million in 2023. I mean it will obviously ramp up through the year. Yes. I mean so just to give you a feel of what's happening today, we're capacity constrained. So we can’t add SKUs. So I talked about the SKU expansion at that facility. We can’t add SKUs to support our e-commerce fulfilment customers or through our own e-commerce site at this point in time. So we are ready. We've done the work, and the team just needs a facility and the infrastructure to go execute on the plan. So that's what I was saying, the return is pretty quick on the investment there.

Got it. Okay. So then you're comfortable with us modeling -- so we're going to see kind of upper teens, 20% revenue growth in fleet next year with that $50 million?

Yes, I mean there's obviously the offsetting -- yes, there's the offset to that, which is the U.S. Postal Service, which we anticipate to be -- haven't get -- let me put it this way. We haven't given guidance on that for the full year next year. But there's some -- likely some declines there as we continue to articulate. And then what we tried to articulate is that we expect to see some margin dilution. And as I mentioned, it's going to take us -- certainly, the first quarter will see a bigger impact on margins, but it's going to take us some time to progressively get back as it relates to kind of getting the full ramp rate and there's a mix shift dynamic on the commercial revenue channel versus the U.S. Postal Service.

The next question we have is from Austin Moeller from Canaccord.

Good morning, John and Steve. Great quarter here. So my first question, within aviation that -- we're seeing on the commercial side, is that largely being driven by airlines now coming to you with some of the deferred maintenance that they put off?

Yes, I think it's a little bit of deferred maintenance. I think it's -- the revenue RPKs continue to improve compared to 2019 levels as well. So I think it's just probably a balanced demand improvement across our commercial airline customers. And again, we continue to see that consistent kind of improvement both in distribution and in MRO on the commercial side.

Great. And then just on the fleet segment, are we seeing margin improvement in any of the commercial sales? Or is it primarily just the higher USPS revenue in the mix?

I'd say we're beginning to see some improvements on the commercial side, but it still remains dilutive to the overall mix of the business. So to your point, there's an element of improvements with the United States Postal Service being up about 6% to 7%. But then there's also some improvements on the commercial side, but I would say it still remains dilutive.

Okay. And then when we think about the multiple new contract wins that were just announced, within 2023, I know you sort of said phase-in in the first half, but should we think about that as like late Q1, early Q2? What's sort of the timing there on that phasing in?

Yes, I'd say it's going to phase in over that time period. So it's not going to be fully affected for the first quarter. If you look at the aviation deals that we've announced, I'd say, we're looking at maybe, call it, $10 million to $12 million of incremental revenue for next year with opportunities for us to continue to support more customers, depending upon the timing of the transition and inventory transitions and the like. But over that time period, 2Q is probably a fair approximation, but we'll share more updates when we get to the fourth quarter call and we actually get through some of the implementation phases in the next couple of months.

The next question we have is from Michael Louie DiPalma from William Blair.

Congrats on the launch of the new Memphis facility. I was wondering how great of a capacity increase is the new facility versus your existing facility?

About 100% increase from our existing footprint.

Great. And related to this facility, what types of new features does it have from a technology standpoint to increase productivity and ultimately margins?

Yes. I mean we're going live in the site with the new warehouse management system and a new ERP system. So we're going live in the next few weeks with that new system. We will move in 2023 to more of a robotic warehousing system. We will not do that on the launch because we want to get the site up and running and make sure the ERP and the WMS are talking to each other well. But as we get to the back end of 2023, we will start to implement some more robotic warehousing that's in the queue and in the pipeline to help drive productivity improvements as well as order accuracy.

And are you going to shut down the existing facility? Or will you operate both simultaneously?

No. So our existing facility in Pennsylvania, just outside of Pittsburgh, that will maintain -- remain as the distribution center and corporate headquarters for the fleet business. And essentially, the commercial traditional distribution sales and the USPS sales will still be supported out of that facility. Memphis will solely support e-commerce, direct and e-commerce fulfilment through our fulfilment partners.

Awesome. And switching to aviation, you announced an expansion of your Pratt & Whitney Canada partnership to the Asia Pacific and you also announced a distribution agreement, I believe, with Honeywell for their JetWave tail-mounted antenna for the Middle East. Do you already have the infrastructure to support distribution in Asia and the Middle East? Or is this an incremental cost? And also can you describe like overall, the international opportunity for your distribution business as right now, I believe it's primarily domestic but --

Yes. I mean, Louie, from a strategic perspective, we're definitely highly domestic. We have a team in Europe and have plans, other plans in 2023 to continue to grow there. But the opportunity with Pratt & Witney Canada to support Southeast Asia is a great opportunity. We'll be supporting out of both Brisbane and Singapore. We do have existing infrastructure in Singapore to support that. We will work with the third-party logistics initially in Brisbane, -- so we don't need -- it's not a tremendous amount of cost and start-up costs to get that program up and running. And then for the Honeywell JetWave program, that will be support out of our existing infrastructure as well. So there's not a lot of upfront cost. But we do see a lot of cross-selling opportunities as we bring on new customers in these regions that we're not supporting today, specifically in the business and general aviation market.

Great. And one final one. What impact does the expansion of your NAVSEA program contracts have on the renewal of the long-term contract?

So the expansion is essentially to support our Egypt customer. So the foreign military sales program that we have with NAVSEA is a U.S.-based program, but we do support for military through it. And our customers through Egypt essentially wants to get the scope of their work completed. So we increase the ceiling was increased on that program, and that's predominantly to support Egypt. We are anticipating an award for the complete recompete and renewal in early 2023.

Okay. And in the slides, you mentioned how a portion of, I think, the Bahrain frigate is non-recurring. Will that contract -- will there be growth in 2023 over 2022? Or is most of the non-recurring revenue in 2022 such that there's a headwind for --

There is. So a ship transfer -- when the U.S. does a ship transfer, we have a strong ability to have access to that through our NAVSEA contract, and it's a great opportunity for us to support that program. Those are not consistent programs, they're one-off programs. They are large programs and large in revenue and non-repeatable. So the NAVSEA program will not -- will have a lower revenue in 2023, much more in line with the consistent revenue we've had in prior years.

Okay. And I think in your 10-K, it said I think for the past few years, it's been around a $100 million run rate.

We haven't finished the forecast yet for that program, but I'd say in that range is how you should be looking at it.

And how much in revenue was it generating in 2022?

We haven't necessarily shared it, but I'd say the Bahrain ship transfer in the quarter specifically was up about 86%. That helped -- that drove the majority of the 86% increase within the NAVSEA program, and NAVSEA is about 1/3 of the business, so that should help give us some approximation.

[Operator Instructions] The next question we have is from Joshua Sullivan from the Benchmark Company.

Just on the new Memphis facility, great location for the organic business. But curious how much of the decision was aimed at capturing maybe larger fleet customers that may operate in the area? I guess, was choosing the location opportunistic? Or are there larger potential customers who might have had some input, which might be driving that $50 million goal?

No, it actually wasn't based on that. It's really based on the ability to get e-commerce parts out as late as possible. That business is obviously highly transactional. We want to be able to take orders as late in the day as possible and get them out for same-day shipment. We also want to be in a city that has a reasonable cost of labor and reasonable lease rates on warehouse facilities and put us in a position where we've got the existing infrastructure in a city like that, and Memphis just happened to check all those boxes. But we did look at a number of locations.

Got it. Got it. And then on the aviation side, what are your needs to hire technicians to continue the growth? Or maybe how much excess capacity do you have built into the current infrastructure before you need to expand?

I'd say in distribution, we still have -- we have built capacity to continue to expand, and we do expect to be able to scale that business a little faster. I would say when we look at the MRO businesses as they start to recover close to pre-pandemic levels, we are in a position where we don't need to add dollar for dollar of SG&A, but we'll definitely need technicians to do the work.

The next question we have is from Jeff Van Sinderen from B. Riley Securities.

The next question we have is from Jeffrey Van Sinderen from B. Riley Securities. Let me add my congratulations on continued strong overall metrics. Just wanted to follow up regarding the $350 million in contracts you announced wondering if there's anything notable there relevant to margins?

Steve, do you want to address that?

Yes. No, I think we maintain our longer-term projections of that business being a mid-teens margin rate business. I don't think that the deals that we've announced would change that in terms of our expectations.

Okay. Great. And then I think you mentioned some of the considerations around the new Memphis facility and why you picked that. Just wondering if you can touch on labor for that facility, how you're working around that. And then, I guess, generally, what you're seeing most recently overall on the labor front?

Yes. I mean, we're starting to see a little bit of stabilization, I'd say, in terms of labor. We are -- we do have our leadership team for the Memphis facility hired and onboard and we're going through a recruiting process essentially right now to get ourselves ramped up for a Q1 start. But we've retained -- the local area has been great and provided a tremendous amount of great support for us. And we do feel very comfortable that we're going to be able to staff the location.

Okay. Great. And then just wondering, any update you can provide in terms of your acquisition pipeline, maybe the latest that you're seeing there?

Yes. I mean, M&A pipeline still looks strong, and we’ve shared mostly in the aviation business. Obviously, now with our announcement on the fleet business you could see why that wasn’t the focus area, we’ve got a tremendous organic pipeline there. So we're continuing to look at both MRO and distribution businesses. And pipeline is looking strong. The markets are a little I'd say, slower in terms of deal flow than probably anticipated, but we still remain very focused on growing both organically and inorganically. And as the right deal comes forward, expect us to move forward if it meets all the criteria that we can --

All right. I'll take the rest offline. Best of luck in Q4.

The next question we have is a follow-up from Michael Ciarmoli of Truist Securities.

I guess, John, just maybe the one negative here in the quarter. The federal EBITDA margins looked like a multi-year, maybe even an all-time low. I mean, is anything -- are these just still bad contracts flowing through? I mean I realize there are a lot of cost plus. I mean, are the --

No. So Mike, the biggest driver of that is actually the bridge contract for the NAVSEA program. So essentially, when that bridge contract came through last year at $100 million and now the $80 million addition, the contract immediately flips to a cost reimbursable program at a lower margin. Now over time, you can work to move task orders to fixed price and work on a margin improvement plan. With a new contract essentially coming out in early 2023, it is a very difficult time to get contracting officers to go through that process. So we are in a position right now where we're essentially -- where almost that entire program has moved from a balanced program of fixed price and cost reimbursable to essentially all cost reimbursable. That's the biggest driver of it.

I guess I'm still surprised. I mean, that's really low for a cost plus. And presumably, you can pass through all of your inflation. So it's just -- I mean, is it just -- is it a low fee? Is it just not a great contract? I mean it just seems hard --

It's an outstanding contract. If you look at a lot of these low-cost technically acceptable bids out in the market, they traditionally have a very low risk, but they're essentially -- you're seeing many of them well below 5% operating margin. That's where those contracts tend to trade. This one does perform better than that. But it is -- again, without the ability to move, to [ask owners] to fixed price, its put some margin pressure on that segment for sure.

Thank you, sir. At this stage, there are no further questions, I would like to turn the floor back over to John Cuomo, President and CEO, for closing comments.

Thanks for attending our third quarter call today, and look forward to speaking with you in early 2023 to talk about the full year and our outlook for 2023. Have a great rest of your day.

Thank you, sir. Ladies and gentlemen, that then concludes today's conference. Thank you for joining us. You may now disconnect your lines.