VSE Corporation (NASDAQ:VSEC) is a government contractor, primarily in the defense arena. They have little debt and generate good free cash flow. The current debt they have relates to the acquisition of Akimeka (see below) and should be paid off in 3 years. They financed $11M of the $33M purchase price. They have used that cash to make acquisitions. In the past few years, those acquisitions included ICRC, an infrastructure contractor, G & B, a female-owned IT contractor with services to the Social Security Administration among others, and Akimeka, IT services to the Military Health System, primarily.
This analysis primarily comes from VSE’s filed 10-K.
As war operations in Iraq and Afghanistan have wound down, VSE’s revenue (and stock price) has dropped correspondingly. The market may have overreacted. Currently, the market is pricing in net income declines. Stable net income (0% growth) values VSE at $45.60 at a 10% discount rate. The market is pricing in a decline due to the revenue decline and due to government budget and spending uncertainties. Though revenue may decline, VSE should be able to hold the line on net income in 2011 for a number of reasons.
First, in 2010, revenue was down because of less subcontract low margin work, but net income did not drop as much because they are doing more work themselves at a higher margin. This trend should continue. Second, VSE took a $4M reserve on a contract (see p. 27 of the 10-K) where the contract had not been approved by the government but most likely will be. If $4M was added to net income, it shows a good trend. Third, the acquisitions appear to be accretive. VSE had earnout provisions on both its Akimeka and its G & B acquisitions. If Akimeka met certain goals, VSE would have to pay Akimeka $11M more.
They accrued $8M at 12/31/10, present value. I calculated that they are anticipating paying $9.5M (ignoring present value), which means Akimeka is going to meet 80% of the goal. This seems like a positive acquisition. Akimeka produced $6.5M of operating income the year prior to the acquisition. If G & B met certain goals, they would have to pay $1.4M annually for three years. They have paid the first 2 years and expect to pay the third year. Fourth, they paid $800k in transaction expenses in 2010 as part of the Akimeka acquisition. These will not recur.
Some factors working against VSE include the suspension of $20M of revenue related to Egyptian operations. Also, there is substantial government budget uncertainty and a pressure to cut costs. Akimeka and G & B are attempts by VSE to diversify into other government services, but still, all revenue relates to the federal government. Finally, ICRC, which VSE purchased in June 2007 for $11.6M, did not produce any net income for VSE in 2010. Up to this point, it was not a good use of free cash flow.
Some other positive trends include insiders purchasing a small amount of shares (.3%) and retaining restricted stock they were awarded, only selling the portion required to pay the tax. G & B was one of five subcontractors and four subcontractors on two $2.5B Social Security contracts. It is unclear how much of this revenue G & B will receive.
As an aside, the increase in other liabilities is primarily due to a change in accounting rules. The earnout provision used to be recorded when paid (to goodwill), but now, it is recorded as a liability when the company is purchased. Thus, the company’s liabilities are higher under the new standards. It is money VSE will probably have to pay, but only if the company they buy hits earnings targets.
In summary, I believe there is $4.8M of expense that will not recur. Along with Akimeka accretion, I believe VSE should at least be able to hold the line in net income and more realistically, probably grow earnings 2-3%. I ran a discounted cash flow analysis on VSE at moneychimp.com. Assumptions:
- Growth next 5- 0%
- Growth after- 0%
- Discount rate- 10%
- Valuation- $45.60.
Basically, if VSE can just hold the line, discounted cash flow would say they are worth $45.60. VSE appears to be a good value buy at its current price.
Disclosure: I am long VSEC.