NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
NOTE 1
DESCRIPTION OF BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Description of Business and Basis of Presentation
Our Business
Vectrus, Inc. is a leading provider of services to the United States Government (U.S. government) worldwide. The Company operates as one segment and provides the following services and offerings: facility and base operations, supply chain and logistics services, information technology mission support, and engineering and digital integration services.
Vectrus was incorporated in the State of Indiana in February 2014. On September 27, 2014, Exelis Inc. (Exelis) completed the spin-off (the Spin-off) of Vectrus, and Vectrus became an independent, publicly traded company. References in these notes to "Vectrus", "we," "us," "our," "the Company" and "our Company" refer to Vectrus, Inc. References in these notes to "Exelis" or "Former Parent" refer to Exelis Inc., an Indiana corporation, and its consolidated subsidiaries (other than Vectrus). Exelis was acquired by a predecessor entity of L3Harris Technologies, Inc. in May 2015.
Equity Investments
In 2011, we entered into a joint venture agreement with Shaw Environmental & Infrastructure, Inc., which is now APTIM Federal Services LLC. Pursuant to the joint venture agreement, High Desert Support Services, LLC (HDSS) was established to pursue and perform work on the Ft. Irwin Installation Support Services Contract, which was awarded to HDSS in October 2012. In 2018, we entered into a joint venture agreement with J&J Maintenance. Pursuant to the joint venture agreement, J&J Facilities Support, LLC (J&J) was established to pursue and perform work on various U.S. government contracts. In 2020, we entered into a joint venture agreement with Kuwait Resources House for Human Resources Management and Services Company (KRH). Pursuant to the joint venture agreement, ServCore Resources and Services Solutions, LLC. (ServCore) was established to operate and manage labor and life support services outside of the continental United States at designated locations serviced by Vectrus and others around the world.
We account for our investments in HDSS, J&J, and ServCore under the equity method as we have the ability to exercise significant influence, but do not hold a controlling interest. We record our proportionate 40%, 50%, and 40% shares, respectively, of income or losses from HDSS, J&J, and ServCore in selling, general and administrative expenses in the Condensed Consolidated Statements of Income. Our investment in these joint ventures is recorded in other non-current assets in the Condensed Consolidated Balance Sheets.
When we receive cash distributions from our equity method investments, the cash distribution is compared to cumulative earnings and cumulative cash distributions. Cash distributions received are recorded as a return on investment in operating cash flows within the Condensed Consolidated Statements of Cash Flows to the extent cumulative cash distributions are less than cumulative earnings. Any cash distributions in excess of cumulative earnings are recorded as a return of investment in investing cash flows within the Condensed Consolidated Statements of Cash Flows. During the three months ended April 1, 2022, Vectrus received a $0.8 million distribution, representing a return on investment from our joint ventures. As of April 1, 2022 and December 31, 2021 our joint venture investment balance was $4.6 million and $5.4 million, respectively. Our proportionate share of income from the HDSS, J&J, and ServCore joint ventures was immaterial for the first quarters of 2022 and 2021.
Basis of Presentation
Our quarterly financial periods end on the Friday closest to the last day of the calendar quarter (April 1, 2022 for the first quarter of 2022 and April 2, 2021 for the first quarter of 2021), except for the last quarter of the fiscal year, which ends on December 31. For ease of presentation, the quarterly financial statements included herein are described as three months ended.
The unaudited interim Condensed Consolidated Financial Statements of Vectrus have been prepared pursuant to the rules and regulations of the U.S. Securities and Exchange Commission (SEC). Accordingly, certain information and note disclosures normally included in annual financial statements prepared in accordance with generally accepted accounting principles (GAAP) in the U.S. have been omitted. These unaudited interim Condensed Consolidated Financial Statements should be read in conjunction with our audited Consolidated Financial Statements and notes thereto included in our Annual Report on Form 10-K for the year ended December 31, 2021.
It is management’s opinion that these financial statements include all normal and recurring adjustments necessary for a fair presentation of the Company’s financial position and operating results. Revenue and net income for any interim period are not necessarily indicative of future or annual results.
NOTE 2
RECENT ACCOUNTING STANDARDS UPDATE
Accounting Standards Issued but Not Yet Effective
In October 2021, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) No. 2021-08, Business Combinations (Topic 805): Accounting for Contract Assets and Contract Liabilities from Contracts with Customers (ASU 2021-08). The amendment requires contract assets and contract liabilities acquired in a business combination to be recognized and measured in accordance with ASC 606, Revenue from Contracts with Customers, as if the acquirer had originated the contract. The amendment also provides certain practical expedients when applying the guidance. ASU No. 2021-08 is effective for interim and annual periods beginning after December 15, 2022, on a prospective basis, with early adoption permitted. The Company is currently evaluating the potential impact of ASU 2021-08 to its consolidated financial statements and expects to early adopt ASU 2021-08 during 2022 in conjunction with the proposed merger discussed below.
Accounting Standards That Were Adopted
In March 2020, the FASB issued ASU 2020-04, Reference Rate Reform (Topic 848): Facilitation of the Effects of Reference Rate Reform on Financial Reporting (ASU 2020-04). To ease the burden in accounting for reference rate reform on financial reporting, the ASU provides companies with optional expedients and exceptions for applying accounting guidance to contracts, hedging relationships and other transactions that reference the London Interbank Offered Rate (LIBOR) or another reference rate expected to be discontinued because of reference rate reform. The Company adopted the standard during the first quarter of 2022. It did not have a material impact on the Company's financial statements.
NOTE 3
PROPOSED MERGER WITH VERTEX AEROSPACE
On March 7, 2022, the Company, including its newly incorporated subsidiaries Andor Merger Sub LLC (Merger Sub LLC) and Andor Merger Sub Inc. (Merger Sub Inc.), and Vertex Aerospace Services Holding Corp. (Vertex), entered into an agreement and plan of merger (the Merger Agreement) proposing that Merger Sub Inc. merge with and into Vertex (the First Merger), and immediately thereafter, Vertex, as the surviving company of the First Merger, merge with and into Merger Sub LLC (the Second Merger), with Merger Sub LLC surviving the Second Merger as a direct, wholly owned subsidiary of the Company (the Proposed Transaction).
The Proposed Transaction is structured so that the existing stockholders of Vertex will own approximately 62.25% of the issued and outstanding Company common shares following the consummation of the Proposed Transaction, and the existing shareholders of the Company will own approximately 37.75%.
The consummation of the Proposed Transaction is subject to the satisfaction of certain conditions, including, among others, the expiration or termination of antitrust waiting periods and receipt of certain other regulatory approvals, absence of injunctions or restraints prohibiting consummation of the Proposed Transaction, the Vectrus shareholder approval being obtained, the shares issued to Vertex being approved for listing on the New York Stock Exchange and the execution and delivery of a shareholder rights and registration rights agreements. The obligation of each party to consummate the Proposed Transaction is also conditioned on the other party’s representations and warranties being true and correct, the other party having performed in all material respects its obligations under the Merger Agreement, and the absence of any material adverse effect after the date of the Merger Agreement.
The Merger Agreement provides certain termination rights for both the Company and Vertex, and further provides that a termination fee equal to $16.6 million will be payable by the Company to Vertex upon termination of the Merger Agreement under certain circumstances, including, among others, (i) as a result of the termination of the Merger Agreement by the Company to accept a Parent Superior Proposal (as defined in the Merger Agreement), (ii) the Company having Willfully Breached (as defined in the Merger Agreement) any of its obligations under the no solicitation provisions of the Merger Agreement, or (iii) the Board having changed its recommendation to shareholders.
NOTE 4
REVENUE
Performance Obligations
A performance obligation is a promise in a contract to transfer a distinct good or service to the customer and is the unit of account for revenue in ASC Topic 606. A contract’s transaction price is allocated to each distinct performance obligation and recognized as revenue when, or as, the performance obligation is satisfied. To determine the proper revenue recognition method, consideration is given as to whether a single contract should be accounted for as more than one performance obligation. For most of our contracts, the customer contracts with us to perform an integrated set of tasks and deliverables as a single service solution, whereby each service is not separately identifiable from other promises in the contract and therefore is not distinct. As a result, when this integrated set of tasks exists, the contract is accounted for as one performance obligation. The vast majority of our contracts have a single performance obligation. Unexercised contract options and indefinite delivery and indefinite quantity (IDIQ) contracts are considered to be separate performance obligations when the option or IDIQ task
order is exercised or awarded.
Contracts are often modified to account for changes in contract specifications and requirements. If the modification either creates new enforceable rights and obligations or changes the existing enforceable rights and obligations, the modification will be treated as a separate contract. Our contract modifications, except for those to exercise option years, have historically not been distinct from the existing contract and have been accounted for as if they were part of that existing contract.
The Company's performance obligations are satisfied over time as services are provided throughout the contract term. We recognize revenue over time using the input method (e.g., costs incurred to date relative to total estimated costs at completion) to measure progress. Our over time recognition is reinforced by the fact that our customers simultaneously receive and consume the benefits of our services as they are performed. For most U.S. government contracts, this continuous transfer of control to the customer is supported by clauses in the contract that allow the customer to unilaterally terminate the contract for convenience, pay us for costs incurred plus a reasonable profit and take control of any work in process. This continuous transfer of control requires that we track progress towards completion of performance obligations in order to measure and recognize revenue.
The Company's contracts are multi-year contracts and typically include an initial period of one year or less with annual one-year or less option periods. The number of option periods varies by contract, and there is no guarantee that an option period will be exercised. The right to exercise an option period is at the sole discretion of the U.S. government when we are the prime contractor or of the prime contractor when we are a subcontractor. We expect to recognize a substantial portion of our performance obligations as revenue within the next 12 months. However, the U.S. government or the prime contractor may cancel any contract at any time through a termination for convenience or for cause. Substantially all of our contracts have terms that would permit us to recover all or a portion of our incurred costs and fees for work performed in the event of a termination for convenience.
Remaining performance obligations as of April 1, 2022 and December 31, 2021 are presented in the following table:
| | | | | | | | | | | | | | |
| | |
| | April 1, | | December 31, |
| (In millions) | | 2022 | | 2021 |
| Performance Obligations | | $ | 1,288 | | | $ | 1,398 | |
We expect to recognize approximately 64% of the remaining performance obligations as of April 1, 2022 as revenue in 2022 and the remaining 36% during 2023.
Contract Estimates
Accounting for contracts and programs involves the use of various techniques to estimate total contract revenue and costs. For contracts, we estimate the profit on a contract as the difference between the total estimated revenue and expected costs to complete a contract and recognize that profit over the life of the contract.
Contract estimates are based on various assumptions to project the outcome of future events. These assumptions include labor productivity and availability; the complexity of the services being performed; the cost and availability of materials; the performance of subcontractors; and negotiations with the customer on contract modifications. When the estimates of total costs to be incurred on a contract exceed total estimates of the transaction price, a provision for the entire loss is determined at a contract level and is recognized in the period in which the loss was determined.
The impact of adjustments in contract estimates on our operating income can be reflected in either revenue or cost of revenue. Cumulative catch-up adjustments for the three months ended April 1, 2022 and April 2, 2021 increased operating income by $0.6 million and decreased operating income by $1.3 million, respectively.
For the three months ended April 1, 2022 and April 2, 2021, the cumulative catch-up adjustments to operating income increased revenue by $0.6 million and decreased revenue by $1.9 million, respectively.
Revenue by Category
Generally, the sales price elements for our contracts are cost-plus, cost-reimbursable or firm-fixed-price. We commonly have elements of cost-plus, cost-reimbursable and firm-fixed-price contracts on a single contract. On a cost-plus type contract, we are paid our allowable incurred costs plus a profit, which can be fixed or variable depending on the contract’s fee arrangement, up to funding levels predetermined by our customers. On cost-plus type contracts, we do not bear the risks of unexpected cost overruns, provided that we do not incur costs that exceed the predetermined funded amounts. Most of our cost-plus contracts also contain a firm-fixed price element. Cost-plus type contracts with award and incentive fee provisions are our primary variable contract fee arrangement. Award fees provide for a fee based on actual performance relative to contractually specified performance criteria. Incentive fees provide for a fee based on the relationship between total allowable and target cost. On most of our contracts, a cost-reimbursable element captures consumable materials required for the contract. Typically, these costs do not bear fees.
On a firm-fixed-price type contract, we agree to perform the contractual statement of work for a predetermined contract price. A firm-fixed-price type contract typically offers higher profit margin potential than a cost-plus type contract, which is commensurate with the greater levels of risk we assume on a firm-fixed-price type contract. Although a firm-fixed-price type contract generally permits us to retain profits if the total actual contract costs are less than the estimated contract costs, we bear the risk that increased or unexpected costs may reduce our profit or cause us to sustain losses on the contract. Although the overall scope of work required under the contract may not change, profit may be adjusted as experience is gained and as efficiencies are realized or costs are incurred.
The following tables present our revenue disaggregated by several categories. Revenue by contract type for the three months ended April 1, 2022 and April 2, 2021 is as follows:
| | | | | | | | | | | | | | | | | | | | | | | | | | |
| | Three Months Ended | | |
| | April 1, | | April 2, | | % | | | | | | |
| (In thousands) | | 2022 | | 2021 | | Change | | | | | | |
| Cost-plus and cost-reimbursable | | $ | 311,094 | | | $ | 290,230 | | | 7.2 | % | | | | | | |
| Firm-fixed-price | | 128,004 | | | 128,757 | | | (0.6) | % | | | | | | |
| Time and material | | 17,373 | | | 15,017 | | | 15.7 | % | | | | | | |
| Total revenue | | $ | 456,471 | | | $ | 434,004 | | | | | | | | | |
Revenue by geographic region in which the contract is performed for the three months ended April 1, 2022 and April 2, 2021 is as follows:
| | | | | | | | | | | | | | | | | | | | | | | | | | |
| | Three Months Ended | | |
| | April 1, | | April 2, | | % | | | | | | |
| (In thousands) | | 2022 | | 2021 | | Change | | | | | | |
| Middle East | | $ | 235,754 | | | $ | 240,013 | | | (1.8) | % | | | | | | |
| United States | | 167,980 | | | 149,811 | | | 12.1 | % | | | | | | |
| Europe | | 36,531 | | | 40,623 | | | (10.1) | % | | | | | | |
| Asia | | 16,206 | | | 3,557 | | | 355.6 | % | | | | | | |
| Total revenue | | $ | 456,471 | | | $ | 434,004 | | | | | | | | | |
Revenue by contract relationship for the three months ended April 1, 2022 and April 2, 2021 is as follows:
| | | | | | | | | | | | | | | | | | | | | | | | | | |
| | Three Months Ended | | |
| | April 1, | | April 2, | | % | | | | | | |
| (In thousands) | | 2022 | | 2021 | | Change | | | | | | |
| Prime contractor | | $ | 427,093 | | | $ | 403,262 | | | 5.9 | % | | | | | | |
| Subcontractor | | 29,378 | | | 30,742 | | | (4.4) | % | | | | | | |
| Total revenue | | $ | 456,471 | | | $ | 434,004 | | | | | | | | | |
Revenue by customer for the three months ended April 1, 2022 and April 2, 2021 is as follows:
| | | | | | | | | | | | | | | | | | | | | | | | | | |
| | Three Months Ended | | |
| | April 1, | | April 2, | | % | | | | | | |
| (In thousands) | | 2022 | | 2021 | | Change | | | | | | |
| Army | | $ | 280,113 | | | $ | 257,349 | | | 8.8 | % | | | | | | |
| Air Force | | 61,474 | | | 78,170 | | | (21.4) | % | | | | | | |
| Navy | | 75,217 | | | 56,427 | | | 33.3 | % | | | | | | |
| Other | | 39,667 | | | 42,058 | | | (5.7) | % | | | | | | |
| Total revenue | | $ | 456,471 | | | $ | 434,004 | | | | | | | | | |
Contract Balances
The timing of revenue recognition, billings, and cash collections results in billed and unbilled accounts receivable (contract assets) and customer advances and deposits (contract liabilities) on the Condensed Consolidated Balance Sheets. Amounts are billed as work progresses in accordance with agreed-upon contractual terms at periodic intervals (e.g., biweekly or monthly). Generally, billing occurs subsequent to revenue recognition, resulting in contract assets. However, we may
receive advances or deposits from our customers, before revenue is recognized, resulting in contract liabilities. These advance billings and payments are not considered significant financing components because they are frequently intended to fund current operating expenses under the contract. These assets and liabilities are reported on the Condensed Consolidated Balance Sheets on a contract-by-contract basis at the end of each reporting period.
As of April 1, 2022 and December 31, 2021, we had contract assets of $235.3 million and $240.0 million, respectively. Contract assets primarily consist of unbilled receivables which represent rights to consideration for work completed but not billed as of the reporting date. The balance of unbilled receivables consists of costs and fees that are: (i) billable immediately; (ii) billable on contract completion; or (iii) billable upon other specified events, such as the resolution of a request for equitable adjustment. Refer to Note 5, "Receivables" for additional information regarding the composition of our receivable balances. As of both April 1, 2022 and December 31, 2021, our contract liabilities were insignificant. NOTE 5
RECEIVABLES
Receivables were comprised of the following:
| | | | | | | | | | | | | | |
| | | | |
| (In thousands) | | April 1, 2022 | | December 31, 2021 |
| Billed receivables | | $ | 136,287 | | | $ | 104,074 | |
| Unbilled receivables (contract assets) | | 235,341 | | | 239,979 | |
| Other | | 5,943 | | | 4,552 | |
| Total receivables | | $ | 377,571 | | | $ | 348,605 | |
As of April 1, 2022 and December 31, 2021, substantially all billed receivables are due from the U.S. government, either directly as prime contractor to the U.S. government or as subcontractor to another prime contractor to the U.S. government. Because the Company's billed receivables are with the U.S. government, the Company does not believe it has a material credit risk exposure.
Unbilled receivables are contract assets that represent revenue recognized on long-term contracts in excess of amounts billed as of the balance sheet date. We expect to bill customers for the majority of the April 1, 2022 contract assets during 2022. Changes in the balance of receivables are primarily due to the timing differences between our performance and customers' payments.
NOTE 6
GOODWILL AND INTANGIBLE ASSETS
As of April 1, 2022 and December 31, 2021 the carrying amount of goodwill was $321.7 million.
The Company tests goodwill for impairment on the first day of the Company's fourth fiscal quarter each year, or more frequently should circumstances change or events occur that would more likely than not reduce the fair value of a reporting unit below its carrying amount.
Identifiable intangible assets consist of the following:
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| | April 1, 2022 | | December 31, 2021 |
| (In thousands) | | Gross Carrying Amount | | Accumulated Amortization | | Net Carrying Amount | | Gross Carrying Amount | | Accumulated Amortization | | Net Carrying Amount |
| Contract backlogs and recompetes | | $ | 77,300 | | | $ | (16,868) | | | $ | 60,432 | | | $ | 77,300 | | | $ | (14,988) | | | $ | 62,312 | |
| Customer contracts | | 7,200 | | | (3,932) | | | 3,268 | | | 7,200 | | | (3,572) | | | 3,628 | |
| Trade names and other | | 1,249 | | | (668) | | | 581 | | | 1,249 | | | (607) | | | 642 | |
| Balance | | $ | 85,749 | | | $ | (21,468) | | | $ | 64,281 | | | $ | 85,749 | | | $ | (19,167) | | | $ | 66,582 | |
Identifiable intangible asset amortization expense was $2.3 million and $2.5 million for the three months ended April 1, 2022 and April 2, 2021, respectively. As of April 1, 2022, the remaining average intangible asset amortization period was 9.2 years.
Future estimated amortization expense is as follows (in thousands):
| | | | | | | | | | | | | | |
| Period | | | | Amortization |
| 2022 (remainder of the year) | | $ | 6,365 | |
| 2023 | | $ | 8,486 | |
| 2024 | | $ | 7,379 | |
| 2025 | | $ | 6,582 | |
| 2026 | | $ | 6,112 | |
| After 2026 | | $ | 29,357 | |
NOTE 7
DEBT
Senior Secured Credit Facilities
Term Loan and Revolver. In September 2014, we and our wholly-owned subsidiary, Vectrus Systems Corporation (VSC), entered into a credit agreement. The credit agreement was subsequently amended on December 24, 2020 and January 24, 2022 and is collectively referred to as the Amended Agreement. The credit agreement consists of a term loan (Amended Term Loan) and a $270.0 million revolving credit facility (Amended Revolver) as of April 1, 2022.
The Amendment Agreement includes an accordion feature that allows the Company to draw up to an additional $100.0 million, subject to the lender's consent on the same terms and conditions as the existing commitments. The Amendment Agreement also permits the Company to borrow up to $75.0 million in unsecured debt as long as the aggregated sum of both the unsecured debt and the accordion does not exceed $100.0 million.
The Amended Term Loan amortizes in an amount equal to $2.6 million for the fiscal quarters ending July 1, 2022 through September 30, 2023, with the balance of $37.2 million due on November 15, 2023. Amounts borrowed under the Amended Term Loan that are repaid or prepaid may not be re-borrowed. Any unpaid amounts must be repaid by the maturity dates. As of April 1, 2022, the balance outstanding under the Amended Term Loan was $52.8 million.
The Amended Revolver is available for working capital, capital expenditures and other general corporate purposes. There were $67.0 million of outstanding borrowings under the Amended Revolver at April 1, 2022. Up to $25.0 million of the Amended Revolver is available for the issuance of letters of credit. As of April 1, 2022, there were two letters of credit outstanding in the aggregate amount of $2.7 million which reduced our borrowing availability under the Amended Revolver to $200.3 million. At December 31, 2021, there were $50.0 million of outstanding borrowings under the Amended Revolver. The Amended Revolver will mature and the commitments thereunder will terminate on November 15, 2023.
The aggregate scheduled maturities of the Amended Term Loan and Amended Revolver as of April 1, 2022, are as follows:
| | | | | | | | |
| (In thousands) | | Payments due |
| | |
| 2022 (remainder of the year) | | $ | 7,800 | |
| 2023 | | 112,000 | |
| | |
| | |
| Total | | $ | 119,800 | |
Guarantees and Collateral. The indebtedness and other obligations under the Amended Agreement are unconditionally guaranteed jointly and severally on a senior secured basis by us and certain of our restricted subsidiaries and are secured, subject to permitted liens and other exceptions, by a first-priority lien on substantially all of our tangible assets and those of each domestic guarantor.
Voluntary Prepayments. We may voluntarily prepay the Amended Term Loan in whole or in part at any time without premium or penalty, subject to the payment of customary breakage costs under certain conditions. Voluntary prepayments of the Amended Term Loan will be applied to the remaining installments thereof as directed by us. We may reduce commitments under the Amended Revolver in whole or in part at any time without premium or penalty.
Covenants. The Amended Agreement contain customary covenants, including covenants that, under certain circumstances and subject to certain qualifications and exceptions: limit or restrict our ability to incur additional indebtedness; merge, dissolve, liquidate or consolidate; make acquisitions, investments, advances or loans; dispose of or transfer assets; pay dividends; redeem or repurchase certain debt; and enter into certain restrictive agreements.
In addition, we are required to comply with (a) a maximum ratio of total consolidated indebtedness to consolidated earnings before interest, tax, depreciation and amortization (EBITDA) of 3.00 to 1.00 (3.50 to 1.00 for the 12 months following a qualified acquisition), and (b) a minimum ratio of consolidated EBITDA to consolidated interest expense (net of cash interest
income) of 4.50 to 1.00. As of April 1, 2022, we had a ratio of total consolidated indebtedness to EBITDA of 1.40 to 1.00 and a ratio of consolidated EBITDA to consolidated interest expense of 12.32 to 1.00. We were in compliance with all covenants related to the Amended Credit Facilities as of April 1, 2022.
Interest Rates and Fees. Outstanding borrowings under the Amended Agreement accrue interest, at our option, at a per annum rate of (i) SOFR plus the applicable margin, which ranges from 1.85% to 2.60% depending on the leverage ratio, or (ii) a base rate plus the applicable margin, which ranges from 0.75% to 1.50% depending on the leverage ratio. The interest rate under the Amended Credit Facilities at April 1, 2022 was 2.41%. We pay a commitment fee on the undrawn portion of the Amended Revolver ranging from 0.30% to 0.45%, depending on the leverage ratio.
Carrying Value and Fair Value. As of April 1, 2022 and December 31, 2021, the fair value of the Amended Credit Facilities approximated the carrying value because the debt bears interest at a floating rate of interest. The fair value is based on observable inputs of interest rates that are currently available to us for debt with similar terms and maturities for non-public debt.
NOTE 8
DERIVATIVE INSTRUMENTS
During the periods covered by this report, we have made no changes to our policies or strategies for the use of derivative instruments and there has been no change in our related accounting methods. For our derivative instruments, which are designated as cash flow hedges, gains and losses are initially reported as a component of accumulated other comprehensive loss and subsequently recognized in earnings with the corresponding hedged item.
Interest Rate Derivative Instruments
Our interest rate swaps are designated and qualify as effective cash flow hedges. The contracts, with expiration dates through November 2022 and notional amounts totaling $39.8 million at April 1, 2022, are recorded at fair value.
The following table summarizes the amount at fair value and location of the derivative instruments in our balance sheet for our interest rate hedges in the Condensed Consolidated Balance Sheets as of April 1, 2022:
| | | | | | | | | | | | | | |
| (In thousands) | | Fair Value |
| | Balance sheet caption | | Amount |
| | | | |
| Interest rate swap designated as cash flow hedge | | Other accrued liabilities | | $ | 227 | |
| | | | |
| | | | |
The following table summarizes the amount at fair value and location of the derivative instruments used for our interest rate hedges in the Condensed Consolidated Balance Sheets as of December 31, 2021:
| | | | | | | | | | | | | | |
| (In thousands) | | Fair Value |
| | Balance sheet caption | | Amount |
| Interest rate swap designated as cash flow hedge | | Other accrued liabilities | | $ | 666 | |
| | | | |
We regularly assess the creditworthiness of the counterparty. As of April 1, 2022, the counterparty to the interest rate swaps had performed in accordance with its contractual obligations. Both the counterparty credit risk and our credit risk were considered in the fair value determination.
Net interest rate derivative losses of $0.2 million and $0.3 million were recognized in interest expense, net, in our Condensed Consolidated Statements of Income during the first three months of 2022 and 2021, respectively. We expect $0.2 million of existing interest rate swap losses reported in accumulated other comprehensive loss as of April 1, 2022 to be recognized in earnings within the next 12 months.
Foreign Currency Derivative Instruments
The Company had no outstanding foreign currency forward contracts at April 1, 2022 and outstanding forward contracts with a current liability value of less than $0.1 million at December 31, 2021.
Net foreign currency derivative gains and losses recognized in selling, general and administrative expenses during the first three months of 2022 and 2021 were immaterial.
NOTE 9
LEASES
We determine whether an arrangement contains a lease at inception. We have operating leases for office space, apartments, vehicles, and machinery and equipment. Our operating leases have lease terms of less than one year to ten years.
We do not separate lease components from non-lease components (e.g., common area maintenance, property taxes and insurance) but account for both components in a contract as a single lease component.
The components of lease expense are as follows:
| | | | | | | | | | | | | | | | | | |
| | Three Months Ended | | |
| (In thousands) | | April 1, 2022 | | April 2, 2021 | | | | |
| | | | | | | | |
| Operating lease expense | | $ | 3,673 | | | $ | 1,825 | | | | | |
| Variable lease expense | | 130 | | | 203 | | | | | |
| Short-term lease expense | | 13,669 | | | 13,448 | | | | | |
| Total lease expense | | $ | 17,472 | | | $ | 15,476 | | | | | |
Supplemental balance sheet information related to our operating leases is as follows:
| | | | | | | | | | | | | | |
| | | | |
| | | | |
| (In thousands) | | April 1, 2022 | | December 31, 2021 |
| Right-of-use assets | | $ | 42,074 | | | $ | 43,651 | |
| | | | |
| Current lease liabilities (recorded in Other accrued liabilities) | | $ | 11,979 | | | $ | 11,983 | |
| Long-term lease liabilities (recorded in Operating lease liability) | | 33,167 | | | 34,536 | |
| Total operating lease liabilities | | $ | 45,146 | | | $ | 46,519 | |
Additional right-of-use assets of $1.9 million were recognized as non-cash asset additions that resulted from new operating lease liabilities during the first three months of 2022.
The weighted average remaining lease term and discount rate for our operating leases at April 1, 2022 was 5.2 years and 3.7%, respectively.
Maturities of lease liabilities at April 1, 2022 were as follows:
| | | | | | | | |
| (In thousands) | | Payments due |
| | |
| 2022 (remainder of the year) | | $ | 9,842 | |
| 2023 | | 13,121 | |
| 2024 | | 8,607 | |
| 2025 | | 4,565 | |
| 2026 | | 3,889 | |
| After 2026 | | 10,480 | |
| Total minimum lease payments | | 50,504 | |
| Less: Imputed interest | | (5,358) | |
| Total operating lease liabilities | | $ | 45,146 | |
| | |
| | |
NOTE 10
COMMITMENTS AND CONTINGENCIES
General
From time to time, we are involved in legal proceedings that are incidental to the operation of our business. Some of these proceedings seek remedies relating to employment matters, matters in connection with our contracts and matters arising under laws relating to the protection of the environment. Additionally, U.S. government customers periodically advise the Company of claims and penalties concerning certain potential disallowed costs. When such findings are presented, Vectrus and the U.S. government representatives engage in discussions to enable Vectrus to evaluate the merits of these claims as well as to assess the amounts being claimed. Where appropriate, provisions are made to reflect probable losses related to the matters raised by the U.S. government representatives. Such assessments, along with any assessments regarding provisions for legal proceedings, are reviewed on a quarterly basis for sufficiency based on the most recent information available to us. We have estimated and accrued $9.8 million and $9.6 million as of April 1, 2022 and December 31, 2021, respectively, in "Other accrued liabilities" in the Condensed Consolidated Balance Sheets for legal proceedings and for claims with respect to our U.S. government contracts as discussed below, including years where the U.S. government has not completed its incurred cost audits. Although the ultimate outcome of any legal matter or claim cannot be predicted with certainty, based on present information, including our assessment of the merits of the particular claim, we do not expect that any asserted or unasserted legal or contractual claims or proceedings, individually or in the aggregate, including the lawsuit discussed below, will have a material adverse effect on our cash flow, results of operations or financial condition.
U.S. Government Contracts, Investigations and Claims
We have U.S. government contracts that are funded incrementally on a year-to-year basis. Changes in U.S. government policies, priorities or funding levels through agency or program budget reductions by the U.S. Congress or executive agencies could have a material adverse effect on our financial condition or results of operations. Furthermore, our contracts with the U.S. government may be terminated or suspended by the U.S. government at any time, with or without cause. Such contract suspensions or terminations could result in unreimbursable expenses or charges or otherwise adversely affect our financial condition and results of operations.
Departments and agencies of the U.S. government have the authority to investigate various transactions and operations of the Company, and the results of such investigations may lead to administrative, civil or criminal proceedings, the ultimate outcome of which could be fines, penalties, repayments or compensatory or treble damages. U.S. government regulations provide that certain findings against a contractor may lead to suspension or debarment from future U.S. government contracts or the loss of export privileges for a company or an operating division or subdivision. Suspension or debarment could have a material adverse effect on the Company because of its reliance on U.S. government contracts.
U.S. government agencies, including the Defense Contract Audit Agency (DCAA), the Defense Contract Management Agency (DCMA) and others, routinely audit and review our performance on U.S. government contracts, indirect rates and pricing practices, and compliance with applicable contracting and procurement laws, regulations and standards. Accordingly, costs billed or billable to U.S. government customers are subject to potential adjustment upon audit by such agencies. The U.S. government agencies also review the adequacy of our compliance with U.S. government standards for our business systems, including our accounting, earned value management, estimating, materials management and accounting, purchasing, and property management systems.
As a result of final indirect rate negotiations between the U.S. government and our Former Parent, we may be subject to adjustments to costs previously allocated by our Former Parent to our business, which was formerly Exelis’ Mission Systems Business, from 2007 through 2014. We are in discussions with our Former Parent and the U.S. government regarding these cost adjustments from 2007 through 2014 and believe that our potential cumulative liability for these years is insignificant. Between June 2019 and March 2021, the U.S. government provided us with three Contracting Officers Final Decisions (COFD) for the years from 2007 through 2014 related to Former Parent costs. We filed appeals of the COFDs with the Armed Services Board of Contract Appeals (ASBCA), which have been consolidated. The ASBCA has granted Vectrus’ and the U.S. government’s joint requests to stay proceedings in the appeal, most recently through May 23, 2022, to enable ongoing discussions regarding the matter between the parties. The U.S. government subsequently offered a settlement to reduce the costs to an insignificant amount to address errors and costs related to contracts novated to our Former Parent, which we are currently reviewing. We believe we are fully indemnified under our Distribution Agreement with our Former Parent and have notified our Former Parent of our appeal of the U.S. government's decision in this matter.
COVID-19 Pandemic
On March 11, 2020, the World Health Organization designated the outbreak of COVID-19 as a global pandemic. Governments and businesses around the world have taken unprecedented actions to mitigate the spread of COVID-19, including, but not limited to, shelter-in-place orders, quarantines, significant restrictions on travel, social distancing guidelines, and restrictions on employees going to work. Uncertainty with respect to the economic impacts of the pandemic has introduced significant volatility in the financial markets. The Company has observed, and continues to experience, some
disruptions on its operations due to government and supply chain delays related to the global pandemic. While the extent to which COVID-19 ultimately impacts the Company’s future results will depend on future developments, the pandemic and associated economic impacts, particularly with respect to newly issued vaccine mandates for government contractors and subcontractors, could result in a material impact to the Company’s future financial condition, results of operations and cash flows.
Contractual Commitment
On September 30, 2021, the Company signed a forward-starting agreement for warehouse space in support of its contractual obligations under a task order issued under the Logistics Civil Augmentation Program (LOGCAP) V support services contract in support of the U.S. Military. The agreement commencement date, which is anticipated in the second quarter 2022, is subject to the completion of certain documents and the receipt of related government regulatory and other third-party approvals. The term of the agreement consists of eight one-year extension options and one additional six-month option period, consistent with our LOGCAP V contract with the U.S. Military. The annual obligations are $20 million per year, subject to a market adjustment beginning in the sixth year, and additional obligations for certain operating expenses.
NOTE 11
STOCK-BASED COMPENSATION
The Company maintains an equity incentive plan, the 2014 Omnibus Incentive Plan, as amended and restated effective as of May 13, 2016 (the 2014 Omnibus Plan), to govern awards granted to Vectrus employees and directors, including nonqualified stock options (NQOs), restricted stock units (RSUs), total shareholder return (TSR) awards and other awards. We account for NQOs and stock-settled RSUs as equity-based compensation awards. TSR awards, described below, and cash-settled RSUs are accounted for as liability-based compensation awards.
Stock-based compensation expense and the associated tax benefits impacting our Condensed Consolidated Statements of Income were as follows:
| | | | | | | | | | | | | | | | | | |
| | Three Months Ended | | |
| (In thousands) | | April 1, 2022 | | April 2, 2021 | | | | |
| Compensation costs for equity-based awards | | $ | 3,100 | | | $ | 1,983 | | | | | |
| Compensation costs for liability-based awards | | (542) | | | 639 | | | | | |
| Total compensation costs, pre-tax | | $ | 2,558 | | | $ | 2,622 | | | | | |
| Future tax benefit | | $ | 555 | | | $ | 569 | | | | | |
Liability-based awards are revalued at the end of each reporting period to reflect changes in fair value.
As of April 1, 2022, total unrecognized compensation costs related to equity-based awards and liability-based awards were $9.3 million and $2.6 million, respectively, which are expected to be recognized ratably over a weighted average period of 2.25 years and 2.36 years, respectively.
The following table provides a summary of the activities for NQOs and RSUs for the three months ended April 1, 2022:
| | | | | | | | | | | | | | | | | | | | | | | | | | |
| | NQOs | | RSUs |
| (In thousands, except per share data) | | Shares | | Weighted Average Exercise Price Per Share | | Shares | | Weighted Average Grant Date Fair Value Per Share |
| Outstanding at January 1, 2022 | | 59 | | | $ | 23.19 | | | 245 | | | $ | 51.18 | |
| Granted | | — | | | $ | — | | | 208 | | | $ | 36.09 | |
| Exercised | | — | | | $ | — | | | — | | | $ | — | |
| Vested | | — | | | $ | — | | | (101) | | | $ | 45.90 | |
| | | | | | | | |
| | | | | | | | |
| Forfeited or expired | | — | | | $ | — | | | (10) | | | $ | 43.13 | |
| Outstanding at April 1, 2022 | | 59 | | | $ | 23.19 | | | 342 | | | $ | 43.44 | |
For employee RSUs, one-third of the award vests on each of the three anniversary dates following the grant date. Director RSUs are granted on the date of an annual meeting of shareholders and vest on the business day immediately prior to the next annual meeting. The fair value of each RSU grant was determined based on the closing price of Vectrus common stock on the date of grant. Stock compensation expense will be recognized ratably over the vesting period of the awards.
Total Shareholder Return Awards
TSR awards are performance-based cash awards that are subject to a three-year performance period. Any payments earned are made in cash following completion of the performance period according to the achievement of specified performance goals. During the three months ended April 1, 2022, we granted TSR awards with an outstanding aggregate target TSR value of $2.8 million. The fair value of TSR awards is measured quarterly and is based on the Company’s performance relative to the performance of the Aerospace and Defense Companies in the S&P 1500 Index. Depending on the Company’s performance during the three-year performance period, payments can range from 0% to 200% of the target value.
NOTE 12
INCOME TAXES
Effective Tax Rate
Income tax expense during interim periods is based on an estimated annual effective income tax rate, plus discrete items that may occur in any given interim periods. The computation of the estimated effective income tax rate at each interim period requires certain estimates and judgment including, but not limited to, forecasted operating income for the year, projections of the income earned and taxed in various jurisdictions, newly enacted tax rate and legislative changes, permanent and temporary differences, and the likelihood of recovering deferred tax assets generated in the current year.
For the three months ended April 1, 2022 and April 2, 2021, we recorded an income tax provision of $0.7 million and $2.6 million, representing effective income tax rates of 19.7% and 17.5%, respectively. The effective income tax rates vary from the federal statutory rate of 21.0% due to state and foreign taxes, required tax income exclusions, nondeductible expenses, available deductions not reflected in book income, and income tax credits.
Uncertain Tax Provisions
As of April 1, 2022 and December 31, 2021, unrecognized tax benefits from uncertain tax positions were $9.5 million and $9.3 million, respectively. The increase in the uncertain tax positions was principally the result of the additional Foreign Derived Intangible Income (FDII) deduction as the Company reserves a portion of the FDII benefit claimed or expected to be claimed on its income tax return filings.
NOTE 13
EARNINGS PER SHARE
Basic earnings per share (EPS) is computed by dividing net income by the weighted average number of common shares outstanding for the period. Diluted EPS reflects potential dilution that could occur if securities to issue common stock were exercised or converted into common stock. Diluted EPS includes the dilutive effect of stock-based compensation outstanding after application of the treasury stock method.
| | | | | | | | | | | | | | | | | | |
| | | | | | | | |
| | Three Months Ended | | |
| | April 1, | | April 2, | | | | |
| (In thousands, except per share data) | | 2022 | | 2021 | | | | |
| Net income | | $ | 2,855 | | | $ | 12,048 | | | | | |
| | | | | | | | |
| Weighted average common shares outstanding | | 11,759 | | | 11,648 | | | | | |
| Add: Dilutive impact of stock options | | 27 | | | 43 | | | | | |
| Add: Dilutive impact of restricted stock units | | 116 | | | 136 | | | | | |
| Diluted weighted average common shares outstanding | | 11,902 | | | 11,827 | | | | | |
| | | | | | | | |
| Earnings per share | | | | | | | | |
| Basic | | $ | 0.24 | | | $ | 1.03 | | | | | |
| Diluted | | $ | 0.24 | | | $ | 1.02 | | | | | |
The following table summarizes the weighted average of anti-dilutive securities excluded from the diluted earnings per share calculation.
| | | | | | | | | | | | | | | | | | |
| | Three Months Ended | | |
| | April 1, | | April 2, | | | | |
| (In thousands) | | 2022 | | 2021 | | | | |
| | | | | | | | |
| Anti-dilutive restricted stock units | | 5 | | | 1 | | | | | |
| | | | | | | | |
NOTE 14
DEFERRED EMPLOYEE COMPENSATION
During the first quarter of 2021, the Company established a non-qualified deferred compensation plan under which participants are eligible to defer a portion of their compensation on a tax deferred basis. The assets in the plan are held in a Rabbi trust. Plan investments and obligations were recorded in other non-current assets and other non-current liabilities, respectively, in the consolidated balance sheets, representing the fair value related to the deferred compensation plan. Adjustments to the fair value of the plan investments and obligations are recorded in selling, general, and administrative expenses. The plan assets and liabilities were $0.8 million and $0.5 million as of April 1, 2022 and December 31, 2021, respectively.
NOTE 15
MULTI-EMPLOYER PENSION PLAN
Certain Company employees who perform work on contracts within the continental United States participate in a multiemployer pension plan of which the Company is not the sponsor. Expense recognized for this plan was $0.2 million for the three months ended April 1, 2022 and the three months ended April 2, 2021.