VSE Corp. VSEC 0.00%↑ offers aftermarket products distribution and services for aviation and fleet customers. VSE has a market cap of $1.3 billion and was founded in 1959.
Quality (3/5)
VSE’s 3-year CAGR for revenue is 9% and 10-year CAGR is 6%. We can see in the Koyfin history chart below that VSE has a poor track record for growth:
There are six straight years of revenue declines after the financial crisis. Back then, VSE was primarily serving the U.S. Department of Defense and many of its contracts expired. The company offered services like storing fireworks that were confiscated by the federal government. VSE no longer has the Federal business after divesting it in February 2024.
In 2015, VSE acquired four related businesses that provided MRO services (maintenance, repair, and overhaul) and parts supply, creating the Aviation segment. VSE’s other segment, Fleet, sells aftermarket parts for USPS trucks and other fleets of vehicles. I will focus on the Aviation segment since Fleet is under review for divestiture.
About 76% of revenue comes from the United States. VSE’s dividend yields 0.5% and has grown at a MSD-HSD rate. Financial leverage is currently 2.2X (total assets / total equity).
Visibility (3/5)
VSE signs distribution agreements with suppliers that have durations up to 15 years. This provides a predictable stream of revenue for the years to come. The company is mainly targeting aftermarket commercial aerospace where aircraft have set maintenance schedules. According to the 10-K, bookings for Aviation occur at the time sale, and therefore do not have funded contract backlog.
Is VSE simple, boring, and understandable? The business transformation creates uncertainty in the near-term, but the resulting company should be more focused and simple to understand. It appears management will sell or spin-off the Fleet segment, so the high customer concentration concern could go away (USPS is 19% of total revenue). VSE uses some non-GAAP adjustments related to conflicts in Europe, acquisitions, and restructuring, resulting in a NG/GAAP earnings ratio of 1.1X.
Management (3/5)
Management is led by CEO John Cuomo (since 2019), who was previously at Boeing Distribution Services after Boeing bought KLX. The CFO is Stephen Griffin (since 2020), who was at GE Aviation beforehand. So, leadership has a strong background in aftermarket aerospace.
Over the last decade, cumulative free cash flow (FCF) was $145M, while cash spent on acquisitions was $580M. It is disappointing to see negative net cash flow. In addition, I calculate ROIC to be ~10%, a slim margin above my estimated cost of capital for VSE.
Management’s incentives include Revenue, Adjusted Operating Profit, Adjusted Free Cash Flow, and a Subjective category. It would be preferable to see organic growth, GAAP operating profit, and ROIC included in the incentives.
Stock-based compensation (SBC) is 1% of total revenue. While SBC is low, management has diluted shareholders through stock offerings over the last decade, with the share count increasing from 11 million to 15 million today.
According to the latest proxy, insiders own 14.6% of shares out. The main owner is Calvin Koonce, who owns 11.8% of shares out. Koonce is not the Cubs baseball player, but instead, a managing director at the RIA firm Montgomery Investment Management. Koonce served as a director for 32 years until he announced his retirement earlier this year.
Demand Creation (3/5)
I think VSE is beginning to demonstrate some demand creation ability with its differentiated MRO and distribution model. However, it appears most demand is dependent on global air travel and OEM aircraft production, which could be out of VSE’s control.
Recently, VSE announced distribution wins for Pratt & Whitney Canada, Honeywell, and Triumph.
The idea is that American Airlines, for example, has to buy many replacement parts from many different suppliers for its aircraft. VSE is saying, ‘we will make that easy for you, get all the OEM parts from us.’
With <$1 billion in annual sales, VSE does not have a size and scale advantage today, but as management states, it is “ready to scale”. VSE competes against larger distributors and, I suppose, the OEMs themselves. Aftermarket is typically a high margin, high cash flow business for OEMs, so we have seen those companies focus more on it. Boeing is one example, with Boeing Global Services (BGS) reporting $19 billion in revenue in 2023, up from $16 billion in 2021. BGS had an EBIT margin of 17% in 2023, making it the only profitable segment for Boeing.
There could be high switching costs, especially for these exclusive distribution agreements, where customers would not be able to find product elsewhere. Plus, VSE could bundle and sell additional products as customers are driven to it for the exclusive items.
“We're expanding our customer and supplier base accelerating our market diversification and key is differentiation. You're going to hear a lot about differentiation this morning. Differentiation is what will continue to drive embeddedness with our customers and suppliers and more important to shareholders over time is the margin improvement. That is what allows us to continue to expand margins. I've done it in the past, taking a commoditized distribution business that was in the low teens operating margin and for a large number of years, drive that business at basically 20% operating margin. And the key to that was differentiation.” (VSEC: 2023 Analyst/Investor VSE Corporation Transcript, 2023-11-14)
I could see a future where VSE becomes a one-stop shop for buying replacement OEM parts and can expand globally to reach its customers wherever they are.
Valuation & Pricing (3/5)
Attached below is my discounted cash flow analysis (DCF):
Feel free to download the spreadsheet and enter in your own assumptions. I set revenue to grow 20% as air travel continues to grow off the pandemic, leading to a strong commercial aerospace market. Many larger aftermarket companies are seeing double-digit growth in 2024 (Transdigm, Collins). EBIT margin expands to 12.5% from 10.2% today. That might be low, especially if management divests the Fleet segment. Aviation had EBIT margin of 13% in 2023 after posting an operating loss in 2021. Fleet margin is around 10%.
Could EBIT margin really expand to 20%? I suppose that would be possible if Fleet is gone and management focuses on Aviation. VSE would likely have to win more distribution and achieve global scale.
My base case will assume Fleet stays, which results in an estimate value per share of $68. My positive scenario would be to divest Fleet and have a focused aftermarket aerospace company led by an experienced aftermarket team. Take out the $300M of Fleet revenue and then, through expanded distribution agreements, revenue grows again, and EBIT margins eventually expand near 20%. That would result in the stock being undervalued today.
For pricing, VSEC is just above the median in terms of P/E NTM at 22X. Its EBIT margin, ROIC, debt, and revenue growth are all near the median, so VSEC appears to be appropriately priced at the moment. Many of these companies are ~$1 billion market cap with very little analyst following, so the NTM estimates might not be entirely useful.
Compared to itself, VSEC has typically received a market multiple. With the SPY ETF at 22X right now, that is also leading me to think VSEC is reasonably priced.
Combining my valuation and pricing, I get a target buy-below price of $81 which is $1 above the current price of $80. The Mark score is a little low for my liking and I typically do not buy such small companies. However, as an owner of HEICO stock, and acknowledging the differences in the business models, I think this is an attractive end market and I could see VSEC becoming a higher scoring stock in the future if they complete their business transformation. It will definitely go on the watchlist.
Risks
My top risk is increased competition from PMA suppliers, especially after the HEICO / Wencor combination. Management makes the case for why VSE should be a more attractive business partner than HEICO with its PMA sales:
“You also think about how OEMs today are being threatened by potential PMA entrants in many parts of their portfolio. And where they really need to help us understanding what is driving that PMA competition. And I can tell you, it's usually not price. Availability and performance are much bigger issues than price when it comes to PMA competition. We understand these dynamics, and they need help crafting strategies that prevent PMA competition in the first place or if it's already there, helped win it back. This is what our product line managers do with our OEM partners. They work with them to build and expand and protect OEM brand value and ultimately extend the life of the products that we're supporting.” (VSEC: 2023 Analyst/Investor VSE Corporation Transcript, 2023-11-14)
The second risk is the low interest coverage and negative free cash flow. EBIT was only covering interest 2.8X in 2023 and 3X in 2022. FCF has been negative in 2021, 2022, and 2023. VSE had to issue $130 million of stock in 2023 and $52 million in 2021. I am worried about company failure (I set a 5% failure rate in my DCF) or continued dilution of owners to keep it afloat.
Next, the risk of product failures. I like HEICO because it does not make parts, for example, for the engine, that could potentially cause catastrophic failures. This does not seem to be the case for VSE.
“VSE announced today that it has entered into an asset purchase and perpetual license agreement with Honeywell International Inc. (“Honeywell”) to exclusively manufacture and support certain of Honeywell’s fuel control systems on four key engine platforms through its VSE Aviation business.”
‘Fuel control systems on key engine platforms’ sounds like something that could go badly wrong and cause customers to lose trust in VSE if they do happen to fail.
Customer concentration is another risk. If management keeps the Fleet business, then one would have to worry about 19% of revenue going to one customer, the USPS. You could argue that the USPS is a steady customer that will make it payments and grow steadily over time.
Lastly, there is risk that a recession could cause a slowdown in global travel.
“We are subject to macroeconomic cycles, and when recessions occur, we may experience reduced orders, payment delays, supply chain disruptions or other factors as a result of the economic challenges faced by our customers, prospective customers and suppliers. Further, the aviation industry has historically, from time to time, been subject to downward cycles which reduce the overall demand for jet engine and aircraft component replacement parts and repair and overhaul services, and such downward cycles result in lower sales and greater credit risk. Demand for commercial air travel can be influenced by airline industry profitability, world trade policies, government-to-government relations, terrorism, disease outbreaks, environmental constraints imposed upon aircraft operations, technological changes, price, and other competitive factors.” - 2023 10-K
To conclude, VSE Corp. scores a 15/25 in my latest review of the company. See where it stacks up with the other companies I follow, now on Tableau!
Thank you for reading! Please share your thoughts below. This was my first time looking at this company, so if you have more knowledge about VSE, I would like to hear it!
Disclosure:
I do not own VSEC stock. Please see my holdings disclosure located in the Google Sheets link.
Any views or opinions are my own. I do not represent a firm. I am not giving financial advice. The stocks that I write about could increase in value, lose value, or stay the same value. Investing involves risk and losses can occur. Some stocks I write about may not be appropriate for you and you should consult a professional investment advisor. Data presented is from sources I believe to be reliable. The opinions and commentary presented reflect my best judgement at this time and may include “forward-looking statements”, all of which are subject to change at any time without obligation to update them. Actual future results may be different than my expectations.
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Will be intriguing to keep an eye on this company to see if it can scale properly and become a Heico or Transdigm going forward. Thanks for posting and keep up the great research!