Vectrus (NYSE:VEC) Q3 2016 Results Earnings Conference Call November 9, 2016 8:00 AM ET
Michael Smith - Director of Investor Relations
Kenneth Hunzeker - Chief Executive Officer and President
Matthew Klein - Senior Vice President and Chief Financial Officer
Brian Ruttenbur - Drexel Hamilton, LLC
Bill Loomis - Stifel
Good day, and welcome to the Vectrus Incorporated Third Quarter 2016 Earnings Results Conference Call. Just a reminder, today’s call is being recorded.
For opening remarks and introductions I would now like to turn the conference over to Michael Smith, Director of Investor Relations and Corporate Development. Please go ahead, Sir.
Thank you, Debbie. Good morning everyone. Welcome to the Vectrus third 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 2. 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.
Thank you, Mike. Good morning everyone and thank you for joining us on the call. Today, we are reporting third quarter 2016 financial results.
Please turn to Slide 3. Revenue was $284 million compared to $299 million from last year mainly driven by the anticipated reduction of our contracts based in Afghanistan. Operating margin in the third quarter was 3.9%. Diluted earnings per share were $0.60. Year-to-date 2016 net cash provided by operating activities was $34 million. Our day sales outstanding or DSOs continue to be favorable and were 55 in the third quarter.
Our strong cash collections enable us to make voluntary debt payments totaling $8 million in the quarter. The $8 million of voluntary payments brings our year-to-date debt payments to $10 million. In total we have made $22 million of voluntary debt payments since September 2014 and reduced our total debt by 33%.
Please turn to Slide 4 where I will provide an operational update on Vectrus. As previously announced during the quarter we were notified that Vectrus was not selected as the Army's provider for the Kuwait based operations and security support services contract to Re-Compete or K-BOSSS 2.0. We along with all three other unsuccessful bidders protested the award decision to the Government Accountability Office or GAO.
On November 7, 2016 we were notified by the Department of the Army that was taking corrective action to resolve the protest. As part of the corrective action, the Army will amend the solicitation and clarify its requirement, request revised proposals from the existing offers based upon the amended solicitations and conduct discussions if necessary and issue a new award decision.
Through September 30, 2016 K-BOSSS contributed $323 million or approximately 36% of revenue. Additionally, the K-BOSSS contract currently runs through December 28, 2016 with an option to extend through March 28, 2017. We are pleased with the corrective action and look forward to working with the Army through the process.
Also during the quarter Vectrus announced we were not selected for the consolidated Army Prepositioned Stocks-5 or APS-5 contract which includes our current APS-5 Kuwait and APS-5 Qatar contracts. We filed the APS-5 protest on September 13, 2016. The GAO has up to 100 days to issue a written decision. Accordingly, we expect the GAO to issue a written decision no later than December 22, 2016 for the APS-5 award protest. We believe our protest has merit and we will continue to vigorously advocate for our superior proposal.
Through September 30, 2016 APS-5 Kuwait contributed $134 million or approximately 15% of revenue. The current protest on APS-5 contract makes assessing the future revenue streams somewhat difficult. However, on October 26, 2016 we received a contract modification of $46 million to extend the performance of the APS-5 Kuwait contract. The modification has an estimated completion date of February 28, 2017. Based on current information we believe it is likely, but not guaranteed that APS-5 Kuwait and K-BOSSS will contribute revenue through the first quarter of 2017.
We recently announced a reduction in force and realignment. The reduction resulted in the elimination of 64 positions at the Vectrus headquarters. Additionally, the realignment will complete the actions we initiated earlier this year by placing critical business functions closer to customers and programs. We will maintain our investment in the business development and other functions to drive revenue.
Our investment in the IT network service offerings continues and is not impacted by the aforementioned reductions in force. We have assembled and experienced team that aligns with significant market potential for the company and we expect full year contributions revenue in 2018. Regarding new business, we are taking great strides to improve our position. As a matter of fact we just concluded our 2016 leadership conference where the theme was "Winning in a Competitive Environment."
We brought in Vectrus leadership from all over the world in order to participate in this event. Everyone at Vectrus understands that retaining existing business and winning new work is our top priority. The business development realization actions taken earlier this year give me great confidence in our ability to win new awards. We currently have $1.5 billion of bids submitted awaiting potential awards. Additionally, we plan to submit proposals on over $7 billion of identified opportunities over the next 12 months all which are for new business.
We have historically not provided timing on expected awards as various factors make this task extremely difficult to predict. However, in order to potentially help provide some visibility as it stands currently, we respect to hear the results of about $1 billion of bids in the next 6 to 9 months. Also after a prolonged protest period the Danish subsidiary owned by Vectrus is currently in discussions with the Air Force regarding commencement of the Thule Base Maintenance Contract next year.
We are looking forward to providing the Air Force customer with an affordable and robust solution while adding this new work to our backlog and recognizing the associated revenue. While we are still in discussion with our customer regarding commencement of the contract we believe any potential revenue streams associated with this contract would be in the second half of 2017.
In October, we announced a joint venture to pursue the US Army's Logistics Civil Augmentation Program 5 or LOGCAP V contract vehicle. LOGCAP V has an estimated ceiling value of $150 billion and is meant to provide contingency support to augment the Army force structures. From 2007 through 2015 approximately $19 billion has been obligated to three vendors under the LOGCAP IV program. Order in our LOGCAP IV ends on April 02, 2017 and we will likely receive additional information regarding the expected timing of the award at the Industry Day next week.
Since late 2014 we have talked numerous times and at length about our three re-competes. The remaining re-competes of the three to be awarded is our Maxwell Base operations support program. We are currently operating under an option period that extends into November 2016.
The Maxwell re-compete is a low price technically acceptable or LPTA bid. We have strong past performance on Maxwell and have also proven that we can succeed on LPTA procurements. As a matter of fact our Thule, Turkey Spain base maintenance contracts in addition to our most recent ASCAP [indiscernible] quarter win were awarded on an LPTA basis. We know how to bid lean and we also know how to execute under those requirements. We expect award on Maxwell to be made in the first quarter of 2017.
Outside of Maxwell and looking ahead, given the heavy volume of re-competes we have experienced recently, we expect 2017 to be much lower year of re-compete volume with no one contract making up 5% or more of our 2016 revenue midpoint.
I would like to point out that we reached the upper end of our previously communicated 2016 voluntary debt payment range of $8 million to $10 million ahead of schedule. We have made great progress in paying down our debt, reducing total debt by 33% [ph] since September 2014 and as of September 30, 2016 we had total debt of $94 million representing a 1.76 debt-to-EBITDA leverage ratio.
In April 2016 we amended our credit agreement which resulted in more favorable covenants. Regardless of how the K-BOSSS 2.0 and APS-5 contracts are solved I am confident in our ability to meet our financial obligations.
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 and our current view of 2017, then we will open the call up for questions.
Thank you, Ken and good morning everyone. Please turn to Slide 5. Today I will be discussing our financial results for the three and nine months ended September 30, 2016. The tables at the top of Page 5 and 6 reflect the generally accepted accounting principles or GAAP financial results for Vectrus. The tables at the bottom of Page 5 and six reflect the adjustments made to operating income and diluted earnings per share in the prior year period only, which excludes operation costs required to become a stand-alone public company and one-time favorable settlements of cash liabilities.
I will address the financial results related to income measures on an adjusted basis which we believe better reflect the ongoing business trends. You can reference the appendix of this presentation for the reconciliation of our adjusted result to GAAP.
For the third quarter funded orders were $77 million down $367 million compared to the same period of 2015. This change is primarily driven by a partial year funding increment on our K-BOSSS contract as this contract approaches the end of it contractual period of performance.
In the third quarter revenue was $284 million down $15 million or 5% compared to the same period of 2015. This change was primarily driven by $26 million decrease in revenue from Afghanistan programs and a $12 million decrease in revenue from our U.S. and European programs partially offset by an increase in revenue from Middle East programs of $23 million when compared to the third quarter of 2015.
Operating income was $11.2 million or 3.9% operating margin in the third quarter of 2016, $600,000 or 5% lower compared to the third quarter 2015 adjusted operating income. The change is primarily driven by the year-over-year decrease in revenue. Diluted earnings per share for the third quarter were $0.60 compared to adjusted diluted earnings per share of $0.65 in the third quarter of 2015.
This is primarily driven by the year-over-year decrease in revenue, higher shares outstanding and offset partially by lower interest expense. Interest expense decreased for the three months ended September 30, 2016 when compared to the three months ended September 25, 2015 due to a lower long-term debt balance.
Please turn to Slide 6. Now I'd like to turn your attention to the year-to-date 2016 financial results. Our funded orders were $986 million an increase of $66 million compared to the same period in 2015, primarily due to timing of funded awards and contract extensions. Year-to-date 2016 revenue was $902 million an increase of $33 million or up 3.8% when compared to the same period of 2015. The increase was driven by the growth on our Middle East programs of $108 million which is partially offset by the decline in revenue from our Afghanistan programs of $52 million and U.S. and European programs of $23 million.
Operating income was $34.3 million or 3.8% operating margin year-to-date in the third quarter of 2016 which is $2.2 million or 100 basis points favorable when compared to the adjusted operating margin for the same period in 2015. This is due to increased revenue and operating margin performance year-to-date 2016. Year-to-date 2016 diluted earnings per share were $1.76 compared to adjusted diluted earnings per share of $1.69 in the third quarter of 2015. This is primarily due to increased revenue and operating income offset by a slight increase in the tax rate.
Net cash provided by operating activities was $33.5 million year-to-date which was an improvement of $23.5 million versus the same period in 2015. We closed out the quarter with 55 days sales outstanding which is a reflection of our team's focus on billings and collections. For our current mix of contracts 55 days is the peer 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.
Please turn to Slide 7. From a capital allocation standpoint our major goal and focus when we first spun off two years ago was to manage our debt profile, making sure we were below our debt covenants. As you can see by the graph we have successfully reduced our leverage profile. Over the past two years we have reduced our total debt by $47 million or 33%.
Additionally, over this period for each dollar of mandatory payments we have made an almost equivalent voluntary payment. In total we have made $22 million of voluntary payments and $24.5 million of mandatory payments. So far in 2016 we have voluntarily paid down a total of $10 million of debt in addition to $10.5 million of mandatory payments.
As of September 30, 2016 debt was $93.5 million which represents a debt to trailing 12-month consolidated EBITDA leverage ratio of 1.76 times. We are tracking well below our covenant level of 3.25 times in 2016. In 2017 our debt to trailing 12-month consolidated EBITDA leverage ratio covenant level drops to 3.0 times and reduces to 2.75 times in 2018. Until we get more certainty around future revenue streams from APS-5 and K-BOSSS debt management will continue to be a focus as we manage the leverage ratios below the levels outlined in the credit agreements.
Please turn to Slide 8. For the third quarter total backlog was $2.1 billion. Total backlog represents firm orders and potential options on multiyear contracts and includes both funded and unfunded contract values. Total backlog excludes the ceiling values of IDIQcontract vehicle awards.
Our funded backlog for the third quarter was $768 million. Our total backlog levels have declined year-over-year which is a reflection of shorter increments on contract values associated with APS-5 and K-BOSSS. As they approach the end of their contractual periods of performance. Importantly, once we receive the notice to proceed on the Thule-based maintenance contract from the Air Force we will add this contract to backlog.
Please turn to Slide 9. Turning to 2016 guidance, we narrow the range for revenue to $1.19 billion to $1.2 billion from $1.18 billion to $1.2 billion. The new midpoint for 2016 revenue is $1.195 billion. We are tightening the range for operating margin at 3.6% to 3.8%. As a result the new midpoint for operating margin is 3.7%. The operating margin range now assumes a severance charge in the fourth quarter, resulting from the actions announced on October 18. We expect to record severance of approximately $2 million in the fourth quarter with the majority charge to SG&A.
We anticipate a portion of the severance expenditures to be recoverable following the rules highlighted in the Federal acquisition regulations. Overall, we anticipate the net charge to the income statement to be around $500,000 which is included in our full-year guidance. We changed the estimated range for diluted earnings per share to $2.12 to $2.28. The midpoint for diluted earnings per share is maintained at $2.20 due to higher net income associated with the increase in revenue midpoint.
Net cash provided by operating activities will range from $30 million to $34 million with the midpoint of $32 million. Depreciation and amortization is expected to be $2 million in 2016. Interest expense is forecasted at $5.8 million and we currently estimate 36% tax rate for the full year.
Before turning the call over for questions, I would like to discuss some important elements related 2017. The outcome of K-BOSSS and APS-5 will likely have topline considerations in 2017. At this time we do not have complete information on 2017, but we do have some important elements on each contract that may give insight into next year.
First related to K-BOSSS, we are on contract to provide full performance through December 28, 2016 with an option to extend through March 28, 2017. Earlier Ken discussed the Army's notice of corrective action. In light of that development it seems more likely although not a guarantee to see the government exercise the option to extend through March or beyond.
Second, related to APS-5 we are on contract to provide full performance through February 28, 2017. We also know that the GAO's written decision is due by December 22, 2016 and the APS-5 solicitation has three months transition plan. It would not be unreasonable although not a guarantee to see the extension beyond our current performance periods. With the scenarios described above revenue on K-BOSSS and APS-5 contracts may continue through March 2017.
Thule is expected to contribute no more than a half of year revenue in 2017. As a reminder, the original award is expected to contribute approximately $60 million of annualized revenue. We expect to experience a continued decline in Afghanistan revenue of approximately $40 million year-over-year.
As discussed previously we implement a reduction in force at the Vectrus headquarters. The annualized savings associated with the 64 personnel actions taken in October is approximately $8 million. The cost savings initiatives will be partially offset by continued investment in our business development team. We believe the actions we have taken to maintain a competitive SG&A without impacting performance or ability to win future contracts.
As we have discussed in prior conference calls, an element to improve our long-term margin profile was the expectation that re-compete contracts would have more contractual levers, mainly fixed-price elements, which would allow us to exercise a continuous improvement program in order to increase margins over time. The outcome of APS-5 and K-BOSSS 2.0 will be essential in gaining clarity around profit margins in 2017.
Full-year net cash provided by operating activities is expected to be slightly above 100% net income conversion. The net working capital position on both APS-5 and K-BOSSS is currently close to zero. Therefore we do not anticipate a positive cash benefit in those programs if those programs conclude.
Mandatory debt payments for the credit agreement in 2017 are $16 million. We will provide more information related to 2017 during our fourth quarter full-year conference call in March.
Now, I'd like to turn the call over for questions.
Thank you. [Operator Instructions] We'll go first today to Brian Ruttenbur with Drexel Hamilton.
Yes, thank you very much. Couple of questions on the backlog first of all 2.1 billion from 2.3 billion last quarter was that all because of K-BOSSS dropping I know you've mentioned something about funded dropping 77 million from K-BOSSS, but could you elaborate a little bit?
Sure, so the $2.3 billion that we realized in the second quarter as we earn revenue that comes down with that earned revenue and then any contract value that we see in the quarter adds to that. So the simple math is $2.3 billion in the second quarter, $284 million of revenue in this quarter and then we had about $50 million of additional contract value added to the third quarter and that contract already comes from ASCAP about $20 million of our ASCAP tasks order win in additional work on several of our contracts.
Okay, thank you very much. That's helpful and then just as a follow on, Maxwell Air Force Base LPTA is that what it's always been or under your previous or the current contracts said better was it an LPTA contract?
Well, this is Ken. Obviously, it was full and open in the past and it was done on best value. But if you look at the buying behavior of the Air Force Education Training Command Base in San Antonio they've been going through the LPTA cost structure on their base operations. So on all the work that's associated with that is still on the LPTA basis.
Brian, I would also highlight that our Thule contract and our Turkey Spain contract are Air Force contracts, both LPTA. So we have experience, recent experience with winning with this customer in this contract type.
Okay and then last question is just on K-BOSSS. You were very confident in the past on winning it given that there is a brand new chance for you guys in a rebid, do you feel as confident as you were before say six months ago, what do you feel about the chances of rebidding this contract?
Well, Brian, just I got t tell you this, our past performance here as we've talked about is exceptional. It continues to be best value. I think we really don't know exactly what the competition this will look like until we actually see what the government comes back with. But what I do know is that we will take advantage of all the things that we've done in the past as far as operational excellence, bidding lean, understanding the customer's requirements and things along those lines. And based on understanding the mission as well as anybody can, I know we will put in a phenomenal solution for this thing and I'm very confident that hopefully we can win this going forward. Matt, anything to add?
Yes and what we're looking for in our solicitation is a fair valuation. We found some anomalies that we were concerned about and we raised that to the GAO. The procuring agency agreed and agreed to amend some of the requirements. So we feel like that's the best outcome and given a fair solicitation our solutions will be valued and we'll be competitive.
Okay, thank you.
[Operator Instructions] We'll go next to Bill Loomis with Stifel.
Hi thanks, good morning. Just on the cash flow guidance so just to be clear, you said 100% cash from operations after working capital will be about 100% net income in 2017 is that accurate?
Right, typically in this business we've always said that we track to 100% conversion. There are some non-cash items like equity grants that we should see some additional cash, but what we wanted to make sure was understood is APS-5 and K-BOSSS are very efficient today. And if they continue to the end of the year we would not expect any benefit next year, though these programs conclude.
Okay, so it's just the conversion this year at least cash guidance is about 130%, but what's going to change next year, are you just being conservative with 100?
What we realized this year is really some inefficiencies that we had in historical periods. We've created a VIP which is a Vectrus Improvement Project. Our team is focused on what we could to improve our accrued receivables and our turns once we submit an invoice. And as you've seen in our DSO over the last couple of quarters we've been highly successful and we couldn’t be happier and I want to thank our teams for further success.
But with that performance that's a one-time up tick right. So you get efficient on your balance sheet you realize that this year we're happy to have that cash infusion and you can we've paid down our debt in advance so $10 million of voluntary payments. And also if you look at the balance sheet we have about $53 million of cash in a bank account. So we're performing optimally right now, but we can expect that to continue into 2017 because we've already realized that efficiency this year.
Okay, and then after you spend a lot of time I'm sure looking at scenarios of the last couple months, so what would you think if let's say you are unsuccessful on the second time on K-BOSSS and then on that APS-5 protest and they could completely go away. What kind of structure should we be thinking about in that type of scenario?
I mean Ken SG&A dropped by the revenue amount or is it going to be detrimental to margins or can you – is there some cost savings over the gross margin on those programs being lower that can result in the same or maybe a little better margins if the remaining programs are higher gross margin?
So let's me start with our view on costs. So we took a first step in considering our SG&A position as we go into next year. What we've always said is we proactively look at our cost structure and we can adapt very quickly and I think our actions on October 18 reflect that. We also have to be cognizant that we can't impair our ability to bid new contracts. So we're making sure that our investment and beauty is strong and is sustained.
The other thing that we think about is we're still performing on APS-5 and K-BOSSS. We are on contract on APS till February and K-BOSSS through December. So some personal and some wrong requirement that's built into our SG&A is required to run those programs. So my point being is, we've made some adjustments, we expect those adjustments to save about $8 million annualized. And then as we know more, as we close out the fourth quarter and if things change we think we can make some other adjustments and another considerations. So we have to be cognizant. And really kind of our culture is we have to make sure we perform. We can't sacrifice our performance in managing our cost.
Going back to your questions on margins, I believe that we have enough levers that we can adjust our cost structure. We shouldn’t see significant margin erosion related to SG&A. But as far as setting specific SG&A targets, there's too many variables that are in play that I just, I can't commit to right now.
When you say no margin degradation, are you talking about if those two programs go away from you that you'd be able to hold margins, is that what you are saying?
Our anticipation, we're in business to make money and increase shareholder value. So we would take the appropriate steps and I'm not saying it is pro rata to manage our SG&A to make sure that we're competitive without sacrificing our business development to investment, but also trying to maintain margins. I still believe this company should be able to realize 4% normalized margin or not quite there.
We would have closed this quarter. We were counting on certain levers like the recomplete contracts re-awarding, having some contractual elements to a fixed price element that we could implement our bps program and realize improved margins over time because this is delayed and the real question is when, when can we realize some increased margin? So we'll just have to wait and see. We're happy that we're having a fearless station on K-BOSSS. We can re-win that then that gives us more options.
Okay and just quick one. I was just talking about martins being good enough in the third quarter, it looks like you had some nice positive EAC adjustments. Are those one time or do you think you could see some more of those over the next year?
There is always the possibility that we can realize that in the future. The one thing I would caution if you watched our tunes and catch up in the 10-Q, those changes. Those net changes can be positive and negative. And there are a lot of factors that go into why they are positive or negative and a lot of it is timing of when you realize costs and when you realize extensions.
This quarter we had a positive catch-up of $1.1 million. That contributed to our performance. As we look to the fourth quarter, you noticed we tightened our margin range. We're not expecting that kind of an uptick in the fourth quarter although we still have a couple of them. Two more months to close out and so we have to wait and see and if we do we'd be happy no two moments the closeouts will have to wait see and if we do would be happy to report that.
Okay, thank you.
[Operator Instructions] With no other questions at this time, I'll turn the conference back to Ken Hunzeker for closing remarks.
Thank you for joining us on the call today. Vectrus has a strong reputation of supporting this customer's missions with a legacy dating back to 1945. We've had our fair share of obstacles over the years and in each situation we found ways to overcome these challenges. Looking forward, we will continue to support our customer's missions with exceptional value, performance and the ethical standards that have come to be expected from Vectrus.
Finally, on November 11, 2017 we observed veteran's day. It is our national day of remembrance honoring the men and women who have served and are serving in the defense of our country. On behalf of the entire Vectrus workforce, I'd like to thank each veteran for your sacrifices and your service to our great nation and for those service members currently keeping the world safe, thank you for continuing commitment to his great country.
Ladies and gentlemen, thank you for your participation. This does conclude today's conference. You may now disconnect.