VSE's Second Quarter: Company Continues to Grow

| About: VSE Corporation (VSEC)

In a recent article, we noted that VSE Corporation (NASDAQ:VSEC) has been growing nicely over the last 5 years. On an annualized basis, revenue growth is 49%, net income growth is 63%, and diluted EPS growth is 58%. It is instructive to examine the company's funded backlog. As noted in the company's Form 10-K, the "funded backlog for government contracts represents a measure of the Company's potential future revenues and is defined as the total value of contracts that has been appropriated and funded by the procuring agencies, less the amount of revenues that have already been recognized on such contracts." Funded backlog grew from 83M in 2003 to 408M in 2007.

This is a low-margin business due to very high contract costs. In 2005, 2006, and 2007 gross margins were 3.7%, 3.5%, and 3.6%, respectively, operating margins were 3.6%, 3.4%, and 3.5%, respectively, and net margins were 2.2%, 2.1%, and 2.2%, respectively.

As measured by return on equity, management has been quite effective. Return on equity was 18% in 2004, 27% in 2005, 26% in 2006, and 37% in 2007.

The results of the first quarter of 2008 continued to show strong performance with revenue growth of 56%, net income growth of 32%, diluted EPS growth of 27%. Funded backlog, which was 408M at December 31, 2007, rose to 570M. Gross margin for the quarter was 3.3%, operating margin was 3.1%, and net margin was 1.9%.

Several interesting pieces of news were reported during the last three months. Energetics Incorporated, a subsidiary of VSE Corp., was awarded a new three-year, $7.2 million contract from the U.S. Department of Energy to provide a range of services to help advance the adoption of energy-saving technologies. Energetics also received a five-year contract award for $85 million which it will share with joint venture partner New West Technologies to provide support services for all Department of Energy research and development programs in energy efficiency and renewable energy.

VSE was awarded a subcontract as part of the winning team selected to support the Night Vision and Electronic Sensors Directorate. The new prime contract has a contract ceiling of approximately $487 million, and VSE will be eligible to compete for tasks under the new award. In addition, VSE was selected for one of several prime contracts awarded to support the United States Air Force Contract Field Teams [CFT] Program. The CFT Program awards have a maximum ceiling of approximately $10.12 billion and are designed to provide rapid deployment and long-term support services for a variety of Air Force requirements to maintain, repair and modernize equipment and systems.

As a multiple award, indefinite delivery/indefinite quantity contract, actual VSE revenues under the contract cannot be predicted. However, the award provides VSE with the opportunity to compete for work which may contribute to future revenue growth. Finally, the Board of Directors increased the cash dividend by 12.5% to an annual payout rate of $.18 per share, and Calvin S. Koonce, a Director, purchased 37,974 shares of common stock.

The company has just reported the results for the second quarter of 2008. On a year-over-year basis, revenue grew 58%, net income grew 34%, diluted EPS grew 32%. Funded backlog, which was 570M at March 31, 2008, is now 674M. Gross margin for the first half of the year was 3.3%, operating margin was 3.1%, and net margin was 1.9%.

The company has a market cap of 210.3M corresponding to a stock price of 41.51. With a trailing-twelve-month EPS of 3.19, the PE now stands at 13.

In order to value the company, we will look at owner earnings [OE] which is similar to free cash flow but which excludes the effect of working capital. It is defined as net income plus depreciation and amortization less capital expenditures. Some analysts will only subtract maintenance capex, thereby including growth capex in owner earnings. We will take the more conservative approach and subtract out total capex.

On a trailing-twelve-month basis, owner earnings is 10.5M. With 1.5M in cash and no long-term debt, the company has an enterprise value of 208.8M and therefore is trading at an EV/OE multiple of 19.9. A DCF calculation, using an 11% discount rate, a 5-year growth period, and no terminal growth shows that the current price is based on the assumption of 20% growth. While the company may well be able to achieve this, the current price leaves little margin of safety.

I will look to pick up more shares when the EV/OE multiple pulls back to around 16-17. At 16, the company would be priced for 14% growth and the corresponding stock price is 33.43. At 17, company would be priced for 16% growth and the corresponding stock price is 35.50. A purchase in the range $33 to $35 looks like a good investment.

Stock position: Long.