Description

Executive Summary

VSE Corp provides aftermarket parts and MRO services across a variety of end-markets. VSE’s business is relatively unexciting (stable and low-ish growth); however, the company has been in the midst of a transformation plan under new management that should result in a faster growing, larger and higher quality business over time.

Natty813 did a great job in his/her February 2021 write-up of VSE. Eighteen months later, we’ve had the opportunity to observe and assess the new management teams’ progress. Below we provide an overview of key achievements and shortcomings below and outline our view of the long-term opportunity. In short, while revenue growth has been impressive, EBITDA has disappointed and free cash flow has been anemic, causing the stock to be down slightly since Natty’s post. However, these results do not tell the full story. As part of the company’s turnaround, significant long-term investments were required to support and grow the business. The need for these investments was extremely poorly/barely communicated, resulting in unexpected margins compression and limited free cash flow generation. These investments are now beginning to dissipate, which should ultimately reveal a much more profitable and cash flow generating business in the coming years.

VSE currently trades at 7.8x 2023e EBITDA and a 13% equity free cash flow. On a sum-of-the-parts basis, we estimate fair value to be $70 per share over three years, implying or 92% upside/24% IRR/1.9x MOIC from current levels.

Business Overview

VSE Corporation is a diversified, 100% aftermarket provider of repair, parts distribution, logistics, consulting and supply chain management services for land, sea, and air transportation assets. VSE's products and services help preserve and elongate the life of its customers' assets through routine maintenance and upkeep, as well as unforeseen repair.

VSE operates across three business segments:

Aviation (42% of 2022e revenue, 48% of 2022e EBITDA)

The Aviation segment was assembled over time via acquisition and comprises two sub-segments: distribution and repair. The distribution business (87% of segment revenue) sells OEM aftermarket avionics, flight control, ignition, fuel control and other parts across 1m SKUs, often on an exclusive basis. The repair business (23% of segment revenue) operates two facilities that fix components including pneumatics, fuel, and engine accessories but NOT air frames or engines, typically on a scheduled basis.

Aviation customers include commercial airlines, regional airlines, cargo transporters, other MRO integrators and providers, corporate and private aircraft owners, and fixed-base operators ("FBOs").

Fleet (28% of 2022e revenue, 36% of 2022e EBITDA)

The Fleet business (“Wheeler Fleet Solutions”) provides aftermarket parts and inventory management solutions for medium and heavy-duty trucks (primarily class 4-8), with an emphasis on “step vans” and other delivery vehicles.

The Fleet segment’s main customer is the USPS (57% of segment sales), which it supplies on a JIT basis by stocking inventory within USPS repair facilities. Wheeler is the dominant supplier of aftermarket parts to the USPS (approximately 75% share), of which many are private label. While the USPS business is a low to no growth business, the relationship is very sticky given systems and operational integrations. The Fleet segment also increasingly serves other commercial fleets (for example, those managed by Frito Lay or Aramark) through e-commerce channels or on a direct basis.

Wheeler does not provide engine or transmission parts and as such, is somewhat insulated from a shift towards more EV fleets.

Federal & Defense (30% of 2022e revenue, 16% of 2022e EBITDA)

The Federal & Defense (or “FDS”) segment is the company’s original business line. FDS provides refurbishment, supply chain management and IT and other consulting services to all areas of the Department of Defense (Navy, Army and Air Force). Approximately 43% of contracts are cost plus, 26% fixed price and 21% time and materials.

35% of segment revenue is related to the Navy’s ("FMS Program"), a contract that was extended to September 2022.

Key Thesis Points

Under the Radar, Obscure Company

For most of its history, VSE operated under the radar with limited investor interaction. Despite going public in 1983, the company did not host its first earnings call until Q4 2019, only recently began attending industry conferences and still does not provide detailed earnings guidance. VSE’s industry group is also misclassified on Bloomberg (listed under “Industrial Wholesale and Rental”), causing it to be omitted from distribution and/or aerospace screens. Finally, VSE is somewhat illiquid, trading just over $1m per day.  

Unsurprisingly, this has limited “active ownership” of the company and resulted in limited sell-side coverage, with all four of the (higher quality) analysts initiating within the past 12-18 months. This dynamic has resulted in an overlooked security at a discounted valuation at a time where the company is going through significant managerial and strategic change.

Solid New Management Team Driving Cultural & Operational Change

Over the past three years, VSE has undergone dramatic managerial change, replacing its long-term CEO (11-year tenure) and CFO (18-year tenure), Chairman and the Presidents of two of its divisions (Aviation and Federal & Defense). VSE’s new management team has extremely impressive backgrounds in aerospace, particularly for a company of its size: CEO John Cuomo previously ran and grew a publicly traded aero parts distribution business (B/E Aerospace/KLX) for over a decade before selling to Boeing ($4bn TEV, 15.7x EBITDA) while Steve Griffin CFO was previously at GE Aviation (CFO of Engine Services). Cuomo has described VSE as an “old house with good bones” and has laid out a strategy of greatly expanding the Aviation business, stabilizing, and then growing the Fleet business and rationalizing and growing the FDS business.

Since new management joined, they have largely delivered on this plan. The company has divested lower margin, non-core assets (Prime Turbines and CT Aerospace in February and June 2020, respectively), cut overhead (estimated $10m during COVID) while making a concerted effort towards winning new business and acquiring assets. Recent notable business wins include Triumph landing gear ($20m annual revenue), Pratt & Whitney engine accessories ($65m annual revenue) and a used serviceable materials (“USM”) deal with Southwest set to launch in early 2023 (revenue potential undisclosed). The company also acquired Global Parts Group – a parts distributor for business and general aviation aircraft - for ~$38m or a low-single-digit EBITDA multiple on a normalized basis.

On the Fleet side, management has pursued new customer groups outside of the USPS, growing this business by over 4x from $20m to nearly $90m of revenue by leveraging the company’s existing IT and distribution infrastructure to better service this segment of the market that is generally poorly served by existing distributors due to its “tweener” nature (i.e., nether auto or large truck).

This more assertive management team is in direct contrast to prior leadership, which lacked expansion aspirations and did little to organically grow the business. VSE’s progress towards a higher margin and stronger growth profile has been somewhat masked by the impact of COVID and significant operational investment to support new wins (discussed more below), but we believe it’s more invigorated strategic direction and higher earnings power should become apparent to the market over time.

Long Growth Runway Remaining

Aviation distribution/repair is a highly fragmented, multi-billion-dollar industry. While the large aircraft manufacturers (Boeing, Airbus) have a significant presence, parts suppliers often prefer to deal with independent players with better customer support such as VSE. During COVID, service issues have become more pronounced, leading to sticky share gains by VSE, as evidenced by its distribution business operating at >140% of pre-COVID levels.

Over time, we expect VSE to win additional market share and be a consolidator in the space, consistent with management’s prior experience. We estimate that by exit year 2025, Aviation will comprise nearly 60% of EBITDA versus just 20% in 2018. As the company’s highest multiple segment, growth in the Aviation business should result in a compounding of value of time.

Depressed Earnings Base Understates Progress

Valuing VSE on near-term earnings fails to give credit for the full run-rate of recent business wins (namely Pratt & Whitney engine) and the Global Parts acquisition, which collectively contribute $9m incremental EBITDA on a run-rate basis or 22% relative to 2022 estimates. The Pratt & Whitney contract will take several years to ramp ($12m of revenue in 2021, growing to $65m by 2024) while Global Parts is somewhat of a turnaround, with the potential to improve margins from mid-single-digit to mid-teens over time through sharper pricing and improved procurement.

Further, while VSE’s aviation distribution sub-segment has recovered nicely, its repair business remains depressed as repair typically lags as it is tied to flight activity, whereas distribution tends to precede and prepare for flight activity. We estimate the repair business is currently break-even as management has maintained full staffing levels in anticipation of winning market share from competitors that cut costs during COVID. A recovery to pre-COVID levels of repair business would add $4m of EBITDA or 10% upside from 2022 levels.

Finally, VSE has made significant IT, sales and infrastructure investments to support the growth of its commercial fleet business, which has generated impressive revenue growth but has yet to achieve operating leverage with margins declined by 700bps over the past three years. As a result, while the fleet business has grown revenue by 16%, EBITDA has fallen by over 30%. While a portion of this is attributable to a negative mix shift towards lower margin and often OEM commercial products, the majority is due to investments made to scale the business. Management provided limited disclosure on the need for and scope of these investments, which are necessary but largely one-time in nature, leading to investor disappointment and confusion. Disclosure is beginning to improve and over time, we expect this investment to taper off and margins to approach historical levels.

Importantly, all of this future growth and recovery across both divisions requires little incremental capital, which should lead to improving ROIC and ROA levels over time.

On the negative side, we assume minimal recovery in the FDS business as it faces severe inflation pressure from fixed price contracts and assume the large US Navy contract does not renew, a ~$3m EBITDA drag. The FDS business has been a disappointment within the broader turnaround plan (which management acknowledges), though it is likely reaching a trough.

Potential to Close Conglomerate/Complexity Discount

VSE is an assemblage of three somewhat similar but ultimately unrelated businesses. These businesses possess differing growth potential, predictability and capital needs and thus warrant divergent trading multiples. VSE currently trades towards the lowest multiple of its three divisions (Federal & Defense), which is a common attribute of conglomerates. Our expectation is that the company will eventually exit the more volatile, lower margin and highly competitive Federal & Defense business to become a pure-play distribution and repair business serving the aerospace and fleet markets, which should result in a re-rating of VSE shares.

Eventual M&A Target

In recent years, the aerospace distribution/repair industry has experienced significant M&A activity, including by Boeing (KLXI/16x EBITDA) as well as private equity firms such as Warburg Pincus (Wencor), Carlyle (StandardAero, Signature Aviation) and Platinum Equity (Wesco/14x EBITDA). PE firms are attracted to the distribution/repair industry given its favorable cash flow dynamics, strong long-term industry backdrop and roll-up potential due to fragmented industry structure. As VSE’s business is simplified, we believe it could be an attractive acquisition target.

Valuation & Returns

Given its disparate collection of business, we value VSE on a sum-of-the-parts basis using what we view as “normalized” earnings (as discussed above) which we expect to be achieved by 2025. We apply a 9.5x EBITDA multiple to the Aviation business (a 20% premium to AAR - the closest public peer - which we view as in inferior business given lower margins, lower returns and greater exposure to labor-sensitive competition), a 9.5x multiple to the Fleet business (a 30% discount to industrial and auto distributors WW Grainger, MSC, Genuine Parts, Applied Industrial Technologies and Dorman given significant exposure to the challenged USPS) and a 5.5x EBITDA multiple to the FDS segment, in-line with historical public peer and take-private valuations.

In aggregate, we arrive at a fair value of $70 per share or 92% upside/24% IRR/1.9x MOIC from current levels, as shown below.

Risks

1. VSE has significant customer concentration, with approximately 16% of total revenue is derived from the USPS. The USPS is beginning a multi-year fleet refreshment program that will entail replacing the vast majority of the existing truck fleet (including 20% electric units). New non and EV trucks will require less maintenance spend, which creates a headwind for VSE’s fleet division.

2. Minimum inventory requirements associated with new business wins in the Aviation division consume significant capital as VSE must establish a pool of inventory at the onset of a contract. This has been particularly pronounced in 2021/2022 given the pace of new wins, greatly suppressing EBITDA. A recession will dampen demand for these products, a scenario which management may not have fully underwrote when taking on the business.

3. Strong growth within the Aviation division to some extent may have benefited from re-stocking by airlines coming out of COVID. While management maintains this has been a small contributor to growth, a reversion to the mean is possible within the Aviation distribution business as demand patterns normalize.

4. VSE is nearly 4x levered and operates in a cyclical industry, giving the company limited breathing room for downturns.

Catalyst

1. Fall 2022 investor day should provide three-year growth plan, greater clarity on recent investments

2. Continued operational execution on existing business, new business and acquired business

3. Debt reduction/improved cash flow generation

4. Divestiture of FDS segment