Vectrus' (VEC) CEO Ken Hunzeker on Q2 2016 Results - Earnings Call Transcript

| About: Vectrus (VEC)

Vectrus. (NYSE:VEC)

Q2 2016 Results Earnings Conference Call

August 10, 2016, 08:00 AM ET

Executives

Michael Smith - Director of Investor Relations

Ken Hunzeker - Chief Executive Officer and President

Matt Klein - Senior Vice President and Chief Financial Officer

Analysts

Bill Loomis - Stifel

Michael French - Drexel Hamilton

Operator

Good day, and welcome to the Vectrus Incorporated Second Quarter 2016 Earnings Conference Call. Today’s conference is being recorded. At this time, I would like to turn the conference over to Michael Smith, Director of Investor Relations and Corporate Development. Please go ahead, Sir.

Michael Smith

Thank you, Eric. Good morning everyone. Welcome to the Vectrus second quarter 2016 earnings conference call. Joining us today are Ken Hunzeker, Chief Executive Officer and President, and Matt Klein, Senior Vice President and Chief Financial Officer. Slides for today's presentation are available on our Investor Relations website, investors.vectrus.com.

Please turn to Slide two. During today's presentation, management will be making forward-looking statements pursuant to the Safe Harbor provisions of the federal securities laws. Please review our Safe Harbor statement in our press release for a description of some of the factors that may cause actual results to differ materially from the results contemplated by these forward-looking statements. We assume no obligation to update our forward-looking statements.

Also we will be making reference to non-GAAP financial measures during this call. We remind you that these non-GAAP financial measures are not a substitute for their comparable GAAP measures. You can find the non-GAAP reconciliations and other disclosures in our earnings release, and in our presentation slides which are publicly available on the Vectrus website at investors.vectrus.com.

At this time, I would like to turn the call over to Ken Hunzeker.

Ken Hunzeker

Thank you, Mike. Good morning everyone and thank you for joining us on the call. Today, we are reporting second quarter 2016 financial results. Before we get started, I would like to discuss a couple of items.

First, last month I visited our programs in the Middle East. I saw multiple customers met with the employees who conducted several town hall meetings. These trips always remind me of the tough and challenging environment our employees and service members endure in the region. They confirm for me that our mission is absolutely critical to the United States efforts overseas. As the active duty force structure is reduced, Vectrus will continue to be our government’s partner living, and working in very demanding and tough conditions. I’m exceptionally proud of our workforce.

The second item I would like to discuss is related to our Vectrus improvement projects also known as VIPS, which were the center piece of our operational excellence initiatives. As you may recall, VIPS are delivered, thoughtful and lean based approaches that are key component of how we support the customer in increased stakeholder value. There is true excitement within Vectrus to initiate and implement these projects and since initiating the VIP program, the number of submissions we are receiving from employees is increasing.

Importantly, the feedback we are getting from customers regarding VIPS has been overwhelmingly positive. I’d like to highlight one of our recent VIP of the winners to provide a sense of the results that they produced. This particular VIP on one of our IT programs implemented advanced automation of processes, optimized schedules and streamline staffing. The improvement project resulted in a 25% reduction in employee turnover and a significant cost savings to our customer.

Our VIP initiatives are creating significant value. We plan to issue a VIP of the re-award in October and look forward to sharing the story of results of the winning project with you later.

Please turn to slide three where I will discuss some of our second quarter highlights. Second quarter results were solid. Revenue was $308 million down slightly from last year. Our operating margin in the second quarter was 3.7%, up 20 basis points compared to the prior year.

Diluted earnings per share were $0.55, down a penny from last year. Our teams continued focus on cash collections resulted in a $20 million improvement in free cash flow compared to the prior year.

Our day sales outstanding or DSOs reached a company record of 52 days in the second quarter. Our strong cash collections enable us to make a voluntary debt payment of $2 million in the quarter. Additionally, I would like to note that subsequent to the end of the second quarter, we made another voluntary debt payment of $3 million. Including this amount we have made $17 million of voluntary debt payments since September of 2014 and reduced our total debt by 27%.

I am proud to announce that during the second quarter, Vectrus successfully underwent an ISO 20000 [technical difficulty] for compliance and effectiveness. Additionally, Vectrus completed the standard CMMI Appraisal method for process improvement. Vectrus is currently appraised for development at Maturity level 3 and plans to work towards achieving the increased appraisal levels.

These two served cases demonstrate the Vectrus IT commitment to industry leading standards that strengthen our ability to deliver imaginative, compliant and affordable solutions to our customers.

Additionally, subsequent to the second quarter, we received a two year recertification of ISO 90001. To become ISO 90001 certified, an organization was demonstrated quality management system with the ability to consistently meet statutory, regulatory and customer requirements.

These internationally recognized credentials are important as they ensure we maintain competitive qualifications in support of our current programs and new business pursuits.

Please turn to slide four where I will provide an operational and update on Vectrus. First, on 15th July, 2016 there was an attempted coup in Turkey. During this event, Turkey’s officials stopped all flight in and out of Incirlik Airbase. Vectrus provides the full spectrum, day to day base operations and maintenance services Incirlik airbase as part of our Turkey, Spain base maintenance contract. I’m happy to report that none of our employees were injured during this event.

During this uncertain time our employees delivered exceptional support to our customer facing restricted base access, no commercial power, work days exceeding 20 hours a day in some cases, our teams were able to continue the mission without interruption.

Key leadership Incirlik Airbase recognize our employees contributions and thank them for their efforts during this event. In my view, this is remark of a demonstration of how Vectrus remains true to its mission and consistent works towards its vision of being the customer’s first choice and most trusted partner.

Regarding our major re-competes, our largest re-compete on a revenue basis is the K-BOSSS program. We continue to operate under a $329 million modification of the contract, which runs through December 28, 2016. Every day we operate the K-BOSSS contract, we look for ways to improve our already exceptional performance and the value that we bring to the customer.

K-BOSSS has the largest U.S. military footprint in the Middle East and we have seen increased activity associated with this contract. Rapid response to varying customer requirements is a core strength of Vectrus. We believe the current off-tempo [ph] in the Middle East allows Vectrus to demonstrate quickly without fail in order to meet the complex and challenging needs of our customer.

Turning to our re-compete on APS-5 Kuwait and Qatar, we continue to operate under extensions for both contracts which have the potential to run through February of 2017. As we noted in the past, the contracts will be combined and awarded under the EAGLE indefinite delivery, indefinite quantity or IDIQ contract.

Eagle is a very competitive contract vehicle and we believe the consolidation of our prior contracts make this program even more compelling to competitors. Although our past performance in APS-5 has not been the same as K-BOSSS or Maxwell, we have made tremendous progress on APS-5 since our initial work and we look forward to demonstrating our unique solutions and VIPS on a new contract. It is currently our best estimate that both K-BOSSS and APS-5 will be awarded in the latter part of third quarter.

Regarding our Maxwell Base Operations Support program, during the second quarter Vectrus was awarded a three month modification that extends into August, subsequent to the second quarter, Vectrus was awarded a second three month option that extends till November 2016.

Our past performance on Maxwell remains strong and these option periods provide an opportunity for Vectrus to continue our excellent performance and increase our track record of success for this customer. Hopefully, we will have some additional clarity on our recompetes by the time we report our third quarter 2016 results in November.

Turning to our IT and network services business, we have successfully recruited some of the best and brightest individuals in the industry that reached full capacity in our Reston Virginia office. This talented team is working hard to deliver unique and differentiated solutions to customers.

Our team plans to leverage our existing past performance, customer relationships, global footprint and solid financial position to effectively compete with our peers in this market. We are already seeing solid progress by our Reston based team expect our efforts to produce results over the next 18 months.

Turning to the status of new business, we currently have over $1 million of proposal for new business submitted and are awaiting more. Additionally, we're trying to submit proposals along with $7 million of identified opportunities over the next 12 months, all of which are new business. I'd like to point out that these numbers do not include potential highly IDIQ contracts.

Our new business pipeline has been impacted by various factors, while we have been submitted proposals, we have reported about $1 billion of bids awaiting award for several quarters now with no recent award announcements. This means there are been some unsuccessful bids.

We believe there's always an opportunity to get better and that continues improvement is essential part of our culture. Based on some recent organizational change, our teams are now better aligned staff and resource in order to improve probability or [ph] win new opportunities.

Regarding the $411 million truly based me in this contract, on 26th June, 2016 the U.S. Court of Appeal for the Federal Circuit ruled in favor of our day's subsidiary and issued the decision that reverse the decision of the Court Federal Claims.

Since then, however two of the protesters have filed petitions for a rehearing with the full-court. We remain confident that our position is strong.

Now I’d like to turn the call over to Matt and he will go through our financial results and provide details regarding our updated 2016 guidance, then we will open the call for questions.

Matt Klein

Thank you, Ken. Good morning, everyone. Please turn to Slide five. Today, I will be discussing our financial results for the three and six months ended July 1, 2016.

I'd like to start with the second quarter financial results reflected in the chart at the top of slide five. For the second quarter funded orders were $304 million, down $29 million compared to the same period of 2015. This change is primarily driven by timing of contract modifications. Our funded book-to-bill ratio was 1.0 times in the quarter.

In the second quarter revenue was $308 million, down less than 1% or $2 million compared to the same period of 2015. This change was primarily driven by a $31 million decrease in revenue from our Afghanistan, U.S. and European programs and partially offset by an increase from our Middle East programs of $29 million when compared to the second quarter of 2015.

Operating income was $11 million or 3.7% operating margin in the second quarter of 2016, $500,000 or 20 basis point improvement compared to the second quarter of 2015.

Net cumulative catch-ups added $300,000 to operating income in the second quarter compared to a negative impact of $1.2 million in the second quarter of 2015. Cumulative catch-ups are a natural part of our business and are driven by changes in contract terms, program performance, customer scope changes, and changes to estimates in the reported period.

These changes can be positive or negative depending on the dynamics of a program, and we're pleased with the net favorable results this quarter. Importantly, during the quarter, we witnessed an increase in interest expense related to the fees incurred for the renegotiation of the credit agreement covenants.

Interest expense in the second quarter of 2016 was $1.7 million versus $1.4 million in the prior year period. Diluted earnings per share for the second quarter were $0.55, compared to $0.56 per share in the second quarter of 2015.

It is important to note EPS was negatively impacted by the credit agreement amendment and equity expense acceleration. Both items totalled approximately $400,000 in the quarter.

Now I'd like to turn your attention to the year to-date 2016 financial results shown on the lower half of side five. Our funded orders were $909 million, an increase of $433 million compared to the same period in 2015, primarily due to timing funded award and contract extensions.

Year to-date 2016 revenue was $619 million, an increase of $48 million or up 8% when compared to the same period of 2015. The increase was driven by our growth on our Middle East programs of $85 million and partially offset by the decline in revenue from our Afghanistan, U.S. and European programs of $37 million.

Operating income was $23 million year to-date in the second quarter of 2016 or 3.7% operating margin, which is $2.9 million or 20 basis points favourable when compared to the same period in 2015.

Year to-date 2016 diluted earnings per share were $1.16 compared to a $1.02 per share in the prior period. Year to-date 2016 we generated $19 million of free cash flow, which is an improvement of $19.9 million when compared to the prior period.

Continuous improvement in the collections process helped us reach a company record 52 day sales – day sales outstanding during the quarter. For our current mix of contracts 52 days is a superior performance. However, we do not expect to sustain this level as we grow our business and start up new contracts. We believe a more sustainable DSO is in the low 60s range.

Our strong cash collections enable us to voluntarily pay down $2 million of debt in the second quarter of 2016. Our debt as of July 1, 2016 was $105 million, representing a total debt to trailing 12 months consolidated EBITDA ratio of 2.0 times. Also of note, subsequent to the second quarter on July 28, Vectrus paid $3 million additional voluntary debt payments, bringing the total payments to $5 million for the year.

Please turn to slide six. For the second quarter, total backlog was $2.3 billion. Total backlog represents firm orders and potential options on multi-year contracts, which excludes the ceiling values of IDIQ contract vehicle awards. Our funded backlog was $975 million. We expect total backlog levels to increase once re-compete contracts are awarded and new business pursuits are won.

Please turn to slide seven. As a result of our improved visibility and outlook for the remainder of the year, we are increasing the previously communicated ranges for revenue, diluted EPS and free cash flow for 2016.

We increase the ranges for revenue to $1.18 billion to $1.2 billion, from $1.15 billion to $1.19 billion. The new midpoint for 2016 revenue is $1.19 billion. We increase the estimated range for diluted earnings per share to $2.07 to $2.32. The new midpoint for diluted earnings per share is $2.20.

We also increase the range of free cash flow. We now estimate free cash flow to range from $28 million to $32 million with a midpoint of $30 million. We are maintaining the range of operating margins at 3.6% to 3.9%, with a midpoint of 3.75%.

Debt management remains a focus in 2016. Given the $5 million of voluntary debt payments made so far this year and our strong free cash flow, we increase the lower end of our anticipated voluntary payment range and now expect payments of $8 million to $10 million. This should bring our debt leverage ratio to below two times EBITDA by the end of 2016.

Depreciation and amortization is expected to be $2 million in 2016, a change from $4.1 million as previously reported due to recent contract closures. Interest expense is forecasted at $5.8 million. We currently estimate a 36.7% tax rate for the full year.

Now, I'd like to turn the call over for questions.

Question-and-Answer Session

Operator

Thank you. [Operator Instructions] And we'll take our first question from Bill Loomis with Stifel.

Bill Loomis

Thank you. Good morning.

Ken Hunzeker

Hi, Bill.

Bill Loomis

Just looking at the backlog, it looks like the backlog was down sequentially almost a couple hundred million, but yet 1.0 book-to-bill, was there any time of revaluation or anything in the backlog?

Ken Hunzeker

No. What we're seeing is really the backlog come down as we earn the revenue in this quarter and what we're really waiting for as the recompetes to be rewarded as we said in the prepared remarks. We expect those announcements really by end of the third quarter, early fourth quarter latest. Once that happened, backlog levels will bump up again.

So, the funding is strong on our current contracts. We reported $975 million of funded orders. What that really does is, it gives us visibility to our cash collections in the next 60 to 90 days or so.

Bill Loomis

Okay. So, just be clear, the 307 million in orders you had and wins you had in a quarter that didn't add into backlog?

Matt Klein

That was funded backlog. That does not add into total backlog. The way we report, our backlog is in two chunks. Total backlog of $2.3 billion includes unfunded elements. And the reason why we do that is, it's really kind of a better reflection of revenue streams going out into the future.

Funding for us is not in jeopardy per say. As far as – I'm sorry, the option for us is they're partially funded. They're not in jeopardy of realizing the full option year because of the way our contracts works. So, funding really is visibility in our cash flows.

The shorter our funding, the lower our funding, the tighter our cash collections will be. And so really the way to look at it $2.3 billion is our revenue streams in the next couple of years, 975,000 of funded orders really gives us an idea of how the next couple of quarters will play out and how our collections will result [ph].

Bill Loomis

Okay. So the 975 is not a part of the $2.3 billion?

Matt Klein

975 is part of the $2.3 billion.

Bill Loomis

So the 300 million in awards did go into the $2.3 billion calculation?

Matt Klein

It goes into the funded chunk of it, breaks out the $2.3 billion, correct.

Bill Loomis

Now I understand. So, if we look at the total, you burned off your revenue in the quarter, which was about roughly 300 million – 308 million. You had awards of about the same which replace that in backlog, so I'm just wondering why backlog went down sequentially?

Matt Klein

No. I think we're talking past through each other. So, the way it would work is, let's start from the second or the first quarter. We had $2.5 billion, okay. So we burn $300 million of revenues, so that would bring that down to $2.2 billion. We received another $100 million of contract expansion, nothing to do with funding at this point. So that gets us to the $2.3 billion, okay. Part of that $2.3 billion in any given quarter is funded or unfunded. So the $300 million that we've realized in the quarter really breaks out that $2.3 billion.

Bill Loomis

Okay. So, what would be the 300 and awards you had in the quarter and funded awards? What would be the amount that would have gone into total backlog included the unfunded part of your $300 million?

Matt Klein

Right. So, we saw an extension on our [Indiscernible] program that added to our total backlog. Does that helps?

Bill Loomis

Yes. I need to get – I'm confused on this, so I'll talk to you offline on that one.

Matt Klein

Okay.

Bill Loomis

And then on the – pipeline went from $6 billion to $7 billion, what was the – was it a series of smaller awards or was it a big one that boosted that sequentially that you're eyeing?

Ken Hunzeker

Bill, this is Ken. It's really a combination of both. As we expand what capabilities we have in the IT Networks business. As I looked at the pipeline and we look at it going forward. The IAM [ph] log has stayed pretty much standard and hasn't increased that much, but because we're expanding in the IT Networks business that's where we see most of the expansion on our pipeline.

Bill Loomis

Okay. So that's series of like $100 million type jobs or a lot smaller jobs, I'm just trying to understand the concentration on that sequential increase?

Ken Hunzeker

Yes. We have – today our current pipeline is made up of some larger contracts. I will say the AFCAP contract vehicle we're seeing a lot of activities and those are lower volume, but it’s a mix. I think as we mature the IT Solutions just start to see those coming in smaller increments, as far as TCVs.

But our pipeline is made up of such roughly maybe you know 5 to 10 pursuits in a given quarters. But the IT Networks has really shown better mix going forward to small and large contracts.

Bill Loomis

Okay. And then just on the 400,000 in cost you had with the credit negotiation at the acceleration. That was a pre-tax number, so it would be – I'm calculating about $0.02 per share after tax?

Matt Klein

Yes. We're on the same page. That's a pre-tax number.

Ken Hunzeker

That's exactly right.

Bill Loomis

Okay. And then, just one, last one on the Thule contract. So what is the – how could this play out and over what time frame now they've file these two other petitions?

Ken Hunzeker

Well, quite candidly we're waiting for the government response and in one case we've been asked for our response for preparing that. And then as it goes to a decision of whether or not it's heard by the entire federal court than that carries it forward. If that doesn't take place and the only next option would than be to basically go to the Supreme Court which really hasn't done much in the past.

So we're really waiting to see if there is another – if the third competitor actually files, we only have two right now than see with the Court's decision ongoing forward. But quite candidly if this all comes to play I think we'll know by the end of September, early October how this all will play out in the future.

Matt Klein

Yes. The likelihood of seeing revenue streams, if the awards -- re-awarded to Vectrus this year is probably expiring, but we sure we would like to get this decision behind us and get a full run rate next year.

Bill Loomis

Okay, great. Thank you.

Ken Hunzeker

Thank you, Bill.

Operator

And our next question is from Michael French with Drexel Hamilton.

Ken Hunzeker

Good morning, Mike.

Michael French

Hi. Good morning, gentlemen. Congratulations on the strong results.

Matt Klein

Thank you, Mike.

Michael French

Yes. Ken, I'd like to ask you the follow-up on -- actually couple of Turkey. So you mentioned, guys working 20 hours, feel sorry for them working that hard under those conditions. But the financial question is, does that result in any uptick for you guys if there is more work being done there. Was that just a temporary situation?

Ken Hunzeker

Well, as you know, that contract and the work that is taking place in Turkey has been modelled [ph] several times based upon an increased activity at the base. So, we actually have that in our numbers for this year and it's already reflected. What we're seeing right now is a very small surge, really not that impactful on our revenue income, but what's incredible is that our employees have really performed exceptionally during this period. You couldn't get them to go home. They were all about the mission. They were all about getting everything taken care of and the passion that they showed was really recognized by the customer.

And so, I think it really showed the Vectrus is up to the task and can basically execute under any conditions. And so, it really was – if you can make a good new story out of something that was in a very trying time, that's what the good news was.

Michael French

Okay. Thank you. And perhaps a more difficult question. I'd like to ask you sort of you've taken the political situation there and how stable this is as a piece of business for you guys?

Ken Hunzeker

I will tell you, my personal opinion here is that when it comes to national interest President Erdogan is really a realist. And when you look at their partnership with NATO and that relationship, they very much value that. And so, I think that our relationship as a nation will continue with Turkey. I've talked to Turkey's officials in the past. They loved their relationship with NATO and the United States.

So I think that bond is strong. And I think as long as we have a common enemy which we do, which is ISIS or Daesh, we will continue to be partners as that going forward. So, I think that relationship will stand the test of what the internal struggles within Turkey that are taking place now.

Michael French

Okay. Very well. And shifting gears on the new contracts at IT Networks, the mix of large and small, I was wondering if you can provide more color. Some of these contracts we saw of the – from the facility in Reston. And do these contracts are talking about do they differ from previous contracts in any material way, their size, margin, structure, scope of work, any other color you could add there would be helpful?

Matt Klein

That's great question, Mike. So, when you think about the IT Networks in many cases, not lot of people recognize that was really one of our business platforms in the past based on when we work with Exelis. So that fact that we've actually come out and told everybody that we want to build out the office and we want to do that. We're actually getting into partnership with some of our peers in the group and we're actually bidding contracts with them now and working those kind of opportunities. But it also alerts our customer base that we're player here and based upon the number of folks that we've hired and they've identified future opportunities going forward, its really give us a refresh on our look on our pipeline. That's the biggest change, is its that refresh, a new set of eyes and how we want work it, but the talents that we've been able to hire in the last six months.

Ken Hunzeker

Yes, so the near term of our pipeline looks very untraditional over the contracts we are performing on now ASIC being the most relevant. As we move through the year, you know next 12 to 18 to 24 months, that pipeline will strengthen, will have the intent is to be on some IDIQ contracts, so as I discussed earlier those values will be and smaller increments though hopefully a larger number of past quarters.

And the idea here is obviously we have 20 plus contracts in our current portfolio we will like to have less contract concentration in any one contract. So looking forward in the next three to five years, if we could have 50 contracts and no contract makes up the K-BOSSS [ph] type buying of 30% would be ideal.

Going back to your question on profitability. Yes, we are hopeful that this investment gives us some more margin improvement. We think there is some opportunities to where we are today roughly as an organization at the 3.7% versus what we think our peers are earning you know in 7%, 8%, 9% range. So we feel like we have an opportunity to take some business away, improve our margins but you know not out price ourselves in this initiative.

Michael French

Okay. Very good. Thank you and good luck.

Ken Hunzeker

Thanks Mike.

Operator

[Operator Instructions] And with no questions in the queue, I’ll turn the call back to Mr. Hunzeker for any additional remarks.

Ken Hunzeker

Thanks Eric. Thank you for joining us on the call today. First half of 2016 has seen great performance by our team. Our execution and improved visibility have allowed us to increase our 2016 revenue, diluted earnings per share and free cash flow guidance. We continue to execute on these three pillars of our strong long term strategy that is, include and which has continued to execute the three pillars enhancing a solid foundation, balancing our portfolio and providing more value. We thank you for your interest and look forward to updating you on our progress next quarter.

Operator

This concludes today’s call. Thank you for your participation. You may now disconnect.

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