VSE Corporation and Subsidiaries

Forward Looking Statements

This report contains statements that, to the extent they are not recitations of historical fact, constitute "forward looking statements" under federal securities laws. All such statements are intended to be subject to the safe harbor protection provided by applicable securities laws. For discussions identifying some important factors that could cause actual VSE Corporation (“VSE,” the “Company,” “us,” “our,” or “we”) results to differ materially from those anticipated in the forward looking statements contained in this report, see the discussions captioned “Business,” “Risk Factors,” “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and “Notes to Consolidated Financial Statements” containedconta ined in our Annual Report on Form 10-K for the fiscal year ended December 31, 2009 filed with the Securities and Exchange Commission (the “SEC”) on March 4, 2010.

Readers are cautioned not to place undue reliance on these forward looking statements, which reflect management’s analysis only as of the date hereof.  We undertake no obligation to revise publicly these forward looking statements to reflect events or circumstances that arise after the date hereof.  Readers should carefully review the risk factors described in our Annual Report on Form 10-K for the fiscal year ended December 31, 2009 and in the reports and other documents the Company files from time to time with the SEC, including this and other Quarterly Reports on Form 10-Q to be filed by us subsequent to our Annual Report on Form 10-K and any Current Reports on Form 8-K we file.

Item 1.    Financial Statements

 

Consolidated Financial Statements

The accompanying notes are an integral part of these financial statements.

 

Consolidated Financial Statements

The accompanying notes are an integral part of these financial statements.

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

JuneSeptember 30, 2010

Our business is focused on providing sustainment services for U.S. Department of Defense ("DoD") legacy systems and equipment and professional services to DoD and Federal Civilian agencies. Our operations consist primarily of logistics, engineering, equipment refurbishment, IT, construction management and consulting services performed on a contract basis. Substantially all of our contracts are with United States Government (“government”) agencies and other government prime contractors.

Our active divisions include GLOBAL Division (“GLOBAL”), Communications and Engineering Division (“CED”), Engineering and Logistics Division (“ELD”), Field Support Services Division (“FSS”), Fleet Maintenance Division (“FMD”), and Systems Engineering Division (“SED”). Our active subsidiaries are Energetics Incorporated (“Energetics”), Integrated Concepts and Research Corporation (“ICRC”), and G&B Solutions, Inc. (“G&B”), and, beginning August 19, 2010, our newly acquired subsidiary Akimeka, LLC (“Akimeka”).  

Our accompanying unaudited condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States for interim financial information and the instructions to Form 10-Q and Article 10 of Regulation S-X.  Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States for complete financial statements.  In our opinion, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included.  Operating results for the three- and six-monthsnine-months ended JuneSeptember 30, 2010 are not necessarily indicative of the results that may be expected for the fiscal year ending December 31, 2010.  For further information referr efer to the consolidated financial statements and footnotes thereto included in our Annual Report on Form 10-K for the fiscal year ended December 31, 2009.  

We haveDuring the first quarter of 2010, we elected to change the presentation of the accompanying Consolidated Statements of Income to report “operating income” instead of using “gross profit.”profit” terminology.  This change was only a wording change and did not impact any of the amounts previously reported in the accompanying consolidated statements of income for the three- and six-monthsnine-months ended JuneSeptember 30, 2009.  We also elected to reclassify our long-term lease obligations of $1.1 million at December 31, 2009 from other liabilities to long-term lease obligations to conform to the September 30, 2010 presentation.

Subsequent Events

There were no subsequent events that required recognition or disclosure.

Use of Estimates in the Preparation of Financial Statements

The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.  Estimates affecting the financial statements include accruals for contract disallowance reserves, self-insured health claims, earn-out obligations and estimated cost-to-complete on firm fixed-price contracts.

(2) Bank Notes Payable

We have a loan agreement with a group of banks that provides us several types of financing. This agreement was executed in August 2010 and replaced a previous loan agreement with the same banking group. The predecessor loan agreement consisted of revolving loans and letters of credit.  The current agreement consists of a term loan, revolving loans, and letters of credit. The current loan agreement has a three-year term that expires in August 2013.

Not including the $20 million term loan mentioned above, the maximum amount of credit available to us at Junefrom the banking group for revolving loans and letters of credit as of September 30, 2010 was $50 million and the loan agreement has a provision whereby we may elect to increase thethis maximum credit availability to a total of $75 million. The maturity date of the loan agreement is August 26, 2011.  From time

We had approximately $4.9$5.0 million of letters of credit outstanding as of September 30, 2010 and approximately $4.8 million of letters of credit outstanding as of June 30, 2010 and December 31, 2009, respectively.2009. We had no revolving loan amounts outstanding as of JuneSeptember 30, 2010 andor December 31, 2009. Interest expense incurred on revolving loan borrowings was approximately $35$7 thousand and $67$74 thousand for the three- and six-monthnine-month periods ended JuneSeptember 30, 2010, and approximately $19$15 thousand and $73$88 thousand for the three- and six-monthnine-month periods ended JuneSeptember 30, 2009, respectively.

The loan agreement contains collateral requirements that secure our assets, restrictive covenants, a limit on annual dividends, and other affirmative and negative covenants. Under the terms of the loan agreement, we have agreed to maintain a $600 thousand compensating balance with one of the banks. As of JuneSeptember 30, 2010 we have not been notified by the banks, nor are we aware, of any defaults under the loan agreement. We were in compliance with the covenants as of September 30, 2010.

 

(3) Stock-based Compensation

Restricted Stock

In January of every year since 2007, we have notified certain employees that they are eligible to receive awards under the 2006 Restricted Stock Plan based on our financial performance for the respective calendar years. On March 2, 2010, the employees eligible for the restricted stock awards based on the financial performance of 2007, 2008, and 2009 received 16,123 shares of our common stock.  

We also have awarded shares of restricted stock to our non-employee Directors under the 2006 Restricted Stock Plan. On January 2, 2010, the non-employee Directors received a total of 4,900 shares of our common stock.

The compensation expense related to all restricted stock awards discussed above and included in contract costs was approximately $204$436 thousand and $699 thousand$1.1 million for the three- and six-monthnine-month periods ended JuneSeptember 30, 2010, respectively, and approximately $346$162 thousand and $881 thousand$1.0 million for the three- and six-monthnine-month periods ended JuneSeptember 30, 2009, respectively.

The stock-based compensation amount of approximately $392$830 thousand and $625$787 thousand shown on the accompanying statements of cash flows for the sixnine months ended JuneSeptember 30, 2010 and 2009, respectively, is based on the compensation expense included in contract costs reduced by the tax withholding associated with the awards issued during the applicable periods.

(4) Earnings Per Share

Diluted EPS has been computed in a manner consistent with that of basic earnings per share while giving effect to all potentially dilutive common shares that were outstanding during each period.  Potentially dilutive common shares represent incremental common shares issuable upon exercise of stock options. There were no common shares issuable upon the exercise of stock options that could potentially dilute EPS in the future that were not included in the computation of diluted EPS because to do so would have been anti-dilutive for the three- and six-monthnine-month periods ended JuneSeptember 30, 2010 and 2009.

(5) Commitments and Contingencies

We have, in the normal course of business, certain claims against us and against other parties and we may be subject to various governmental investigations.  In our opinion, the resolution of these claims and investigations will not have a material adverse effect on our results of operations or financial position. However, the results of any legal proceedings cannot be predicted with certainty.

(6) Business Segments and Customer Information

Business Segments

Management of our business operations is conducted under four reportable operating segments: the Federal Group, the International Group, the IT, Energy and Management Consulting Group, and the Infrastructure Group.  These segments operate under separate management teams and financial information is produced for each segment.  The various divisions within the Federal Group and the International Group and the twothree subsidiaries within the IT, Energy and Management Consulting Group are operating segments as defined by the accounting standard for segment reporting and meet the aggregation of operating segments criteria.  We evaluate segment performance based on consolidated revenues and profits or losses from operating income.operations.

 
 

Our segment information for the three- and six-monthnine-month periods ended JuneSeptember 30, 2010 and 2009 is as follows (in thousands):

VSE CORPORATION AND SUBSIDIARIES

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

JuneSeptember 30, 2010

Customer Information

Our revenue by customer is as follows (in thousands):

(7) Acquisition

(8) Goodwill

Changes in goodwill for the sixnine months ended JuneSeptember 30, 2010 are as follows (in thousands):

Under the terms of the ICRC and G&B acquisitions, additional consideration is due to the sellers if certain financial performance targets are achieved.  G&B achieved certain financial performance targets for the second earn-out period ended on March 31, 2010. This resulted in a $1.4 million earn-out, which was recorded as goodwill during the first quarter of 2010 and paid to the sellersellers in May 2010. ICRC achieved certain financial performance targets for the third earn-out period ended on December 31, 2009. Additional goodwill of approximately $445 thousand was recorded as of December 31, 2009 and paid to the sellersellers in March 2010.

(11) Fair Value Measurements

The accounting standard for fair value measurements defines fair value, and establishes a market-based framework or hierarchy for measuring fair value.  The standard is applicable whenever assets and liabilities are measured at fair value. The unaudited consolidated balance sheets include various financial instruments (primarily cash and cash equivalents, receivables, accounts payable, deferred supplemental compensation plan, deferred compensation and contingent consideration under the Akimeka acquisition).

The fair value hierarchy established in the standard prioritizes the inputs used in valuation techniques into three levels as follows:

Level 1 – Observable inputs – quoted prices in active markets for identical assets and liabilities;

Level 2 – Observable inputs other than the quoted prices in active markets for identical assets and liabilities – includes quoted prices for similar instruments,  quoted  prices  for identical or similar instruments in inactive markets, and amounts derived from valuation models where all significant inputs are observable in active markets; and

Level 3 – Unobservable inputs – includes amounts derived from valuation models where one or more significant inputs are unobservable and require us to develop relevant assumptions.

Included in otherThe following table summarizes the financial assets and liabilities measured at fair value on a recurring basis as of JuneSeptember 30, 2010, and the level they fall within the fair value hierarchy (in thousands):

Changes in other currentthe fair value of the Non-COLI assets held in the deferred supplemental compensation plan, as well as changes in the related deferred compensation obligation, are recorded as selling, general and other long-term assets as of December 31, 2009 is approximately $3.5 million and $4.8 million, respectively, of investments we hold in a trust related to a non-qualified benefit plan.  administrative expenses.

We determined the fair value of these assetsthe earn-out obligation related to the Akimeka acquisition by using a valuation model which included the Level 1 methodology.  We haveevaluation of all possible outcomes and the application of an offsetting deferred compensation liability for this plan.  As such, we do not have earnings volatility as a resultappropriate discount rate.  At the end of fluctuations ineach reporting period, the fair value of the plan’s investments.contingent consideration is re-measured and any changes are recorded as selling, general and administrative expenses. There was no change in the fair value of the earn-out obligation between the acquisition date and September 30, 2010.

(9)(12) Recent Accounting Pronouncements

arrangements entered into or materially modified after the adoption date.  We are currently assessing the potential effecthave determined the adoption of this new guidance will not have if any,a material impact on our financial statements.

           and Results of Operations

Executive Overview

Our business is focused on providing sustainment services for U.S. Department of Defense ("DoD") legacy systems and equipment and professional services to DoD and Federal Civilian agencies. Our operations consist primarily of logistics, engineering, equipment refurbishment, IT, construction management and consulting services performed on a contract basis. Substantially all of our contracts are with United States Government (“government”) agencies and other government prime contractors.

Our business is managed under operating groups. Our Federal Group operations are conducted by our Communications and Engineering Division ("CED"), Engineering and Logistics Division ("ELD"), Field Support Services Division (“FSS”), and Systems Engineering Division ("SED"). Our International Group operations are conducted by our GLOBAL Division ("GLOBAL") and Fleet Maintenance Division ("FMD"). Our IT, Energy and Management Consulting Group operations are conducted by our wholly owned subsidiaries Energetics Incorporated ("Energetics") and, G&B Solutions, Inc. (“G&B”), and, beginning August 19, 2010, our newly acquired wholly owned subsidiary Akimeka, LLC (“Akimeka”). Our Infrastructure Group operations are conducted by our wholly owned subsidiary Integrated Concepts and Research Corporation (“(R 20;ICRC”).

Our operations are conducted within four reportable segments aligned with our management groups: 1) Federal; 2) International; 3) IT, Energy and Management Consulting; and 4) Infrastructure.

    

Our cost plus incentive fee contract to support this program ended September 30, 2010 and the Department of Treasury awarded us a seven-month interim contract for approximately $25.9 million to continue providing services under whichthe program. The interim contract will allow the customer additional time to make an award decision on a successor contract. Additionally, we were awarded through our GLOBAL division a 10-year IDIQ contract in September 2010 with the Department of Justice, Bureau of Alcohol, Tobacco, Firearms, and Explosives (ATF) to provide similar services. The ATF contract represents a recompete win under a separate competition of the ATF portion of the Treasury Seized Asset Program. The interim contract and the ATF contract do not have the incentive fee forterms that have resulted in earnings fluctuations on this contract is awarded, and to the potential for changesprogram in the cost targets as work requirements vary, the full amountpast and we do not expect such fluctuations associated with this program in future periods.

The decline in the “Other” linecategory in the table above include: 1) revenuesis primarily attributable to a decline in our Federal Group from legacy sustainment equipment refurbishment services performed by our ELD divisionsubcontractor work on CED task orders and from work performed by our FSS and SED divisions on programs other than the RCV Modernization Program; 2) revenues in our FMD division from services provided on engineering and technical services task orders and from work performed on the CFT Program; and 3) revenues from various contracts performed in our IT, Energy and Management Consulting Group.orders.

Management Outlook

We believe that our near term outlook has not changed appreciably from our recent prior filings withWhile market conditions and certain contract activity are causing us to experience a decline in revenue in the SEC. Wecurrent year, we continue to sharpen our focus on strategic efforts to improve our profit margins at a time when we are experiencing an anticipatedprofitability. A decline in our revenues. Our over-arching strategy of transitioning from low-to-no profit margin subcontract work while also moving to more promising Federal markets is having the desired effect of increasing profit margins.  The intended result is an increased percentage of work performed by our employees while performing a larger percentagesubcontractors that generated much of our revenue growth in prior years is the primary reason for the decrease in revenue. During the time that subcontractor work in growing Federal markets.  These efforts have resulted in improved profit margins in each of the first two quarters of 2010.

We also know there are risks and uncertainties related to our business. Government spending priorities may continue to change significantly.and there is significant pressure on government budgets. The current administration is redefining “inherently governmental work.”  As a consequence, the governmentwork” and is implementing a strategy of “in-sourcing” to move work from federal contractors into the government. Accordingly, the flow of work to federal contractors may be significantly impacted. We believe that most of our service offerings are not targeted by these federal cutbacks. Federal budget reductions will be aimed more towards large capital expenditure projects that may present additional opportunities related to our legacy sustainment offerings. The government is also striving for budget efficiencies from better IT infrastructure and information management , another area for which we are well positioned.

Revenues in our industry depend on contract funding (“bookings”) and funded contract backlog is an indicator of potential future revenues. A summary of our bookings and revenues for the sixnine months ended JuneSeptember 30, 2010 and 2009, and funded contract backlog as of JuneSeptember 30, 2010 and 2009 is as follows:

Recent Accounting Pronouncements

Critical Accounting Policies

Our revenues by contract type were as follows (in thousands):

A significant portion of our time and materials revenues are from CED R2 Program task orders under which revenues result primarily from the pass through of subcontractor support services. These revenues have a lower profit margin than revenues generated by work performed by our employees.

TheOur results of operations are as follows (in thousands):

Our revenues decreased approximately $43$50 million, or 17%19%, for the three months ended JuneSeptember 30, 2010, as compared to the same period of 2009. Revenues decreased approximately $55$105 million, or 11%14%, for the sixnine months ended JuneSeptember 30, 2010, as compared to the same period of 2009. Revenues in our Federal International, and InfrastructureInternational Groups declined while revenues increased in our IT, Energy and Management Consulting Groupand Infrastructure Groups increased during these periods.

Our operating income decreased approximately $536$657 thousand, or approximately 5% for the three months ended JuneSeptember 30, 2010, as compared to the same period of 2009. Operating income increased approximately $671$14 thousand or approximately 4% for the sixnine months ended JuneSeptember 30, 2010, as compared to the same period of 2009. Operating income in our FederalIT, Energy and Management Consulting Group declinedincreased while operating income increased in each of our other operating groups declined during these periods.

Changes in revenues and income are further discussed in the summaries of our group results that follow.

Our effective income tax ratesrate for the sixnine months ended JuneSeptember 30, 2010 and 2009 were 38.1% and 38.6%, respectively. The decrease in the effective tax rate is the result of the reversal of a valuation allowance of approximately $51 thousand during the first quarter of 2010.was 38.4%.

The results of operations for our Federal Group are as follows (in thousands):

Revenues for our Federal Group decreased approximately $23$39 million and $46$85 million, or 15%27% and 19%, for the three- and six-monthnine-month periods ended JuneSeptember 30, 2010 as compared to the same periods for the prior year. The decreases in revenues for this segment resulted primarily from a decrease in CED revenues associated with work performed under our R2 contract of approximately $27$42 million and $59$101 million, for the three- and six-monthnine-month periods, respectively. Revenues associated with our ELD division equipment refurbishment services also declined approximately $5$6 million and $7$13 million for the three- and six-monthnine-month periods, respectively. The declines in revenues in this group were partially offset by revenue increases of approximately $6$5 million and $13$19 million for the three- and six-monthnine-month periods, respectively, associated with our FSS Division work on vehicles and equipment overseas and by revenue increases of approximately $4 million and $7$11 million for the three- and six-monthnine- month periods, respectively, associated with our SED Division engineering and design work.

Operating income for our Federal Group decreased approximately $363$453 thousand and $77$530 thousand, or 6%7% and %1,3%, respectively, for the three- six-monthand nine-month periods ended JuneSeptember 30, 2010, as compared to the same periods for the prior year. The decreaseschanges in operating income for these periods are primarily due to: decreases in profits of approximately $632 thousand$3.5 million and $582 thousand$4.3 million, respectively, associated with the decline in CED revenues from our R2 Program; decreases in profits of approximately $1.5$2.2 million and $2.8$5.0 million, respectively, associated with the decline in revenues on our ELD equipment refurbishment services; increases in profits of approximately $900$989 thousand and $2.1$3.1 million, respectively, on our FSS division work attributable to the increased revenues in this division; and increases in profits of approximately $900 thousand$1.2 millio n and $1.3$2.4 million, respectively, on our SED division work. Profit margins in this group are increasing as revenues from our low margin subcontractor work on the R2 Program decline and revenues generated by our direct labor become a larger percentage of our overall revenues.

Revenues for our International Group decreased approximately $20$24 million and $15$39 million, respectively, or 28%27% and 11%17%, for the three- and six-monthnine-month periods ended JuneSeptember 30, 2010, as compared to the same periods for the prior year. The decrease in revenues resulted primarily from a decline of approximately $22$36 million and $35$71 million, respectively, in revenues for these periods primarily from FMD servicespass-through work provided on engineering and technical services task orders.orders under the R2 contract. The revenue declines were partially offset by revenue increases on our GLOBAL Division services of approximately $9.5 million and $23.4 million, for the three- and nine-month periods, respectively; revenue increases on the CFT Program of approximately $1.4$1.7 million and $3.7$5.4 million for the three- and six-monthnine-month periods, respectively,respectively; and revenue increasesincrea ses on the Treasury Seized Asset Program of approximately $247$599 thousand and $2.2$2.8 million for the three- and six-monthnine-month periods, respectively, and revenue increases on our GLOBAL Division services of approximately $13 million.respectively.