# VSE CORP (VSEC) FY 2022 MD&A

Verbatim Item 7 Management's Discussion and Analysis from VSE CORP's 10-K for fiscal year 2022.

SEC filing source: https://www.sec.gov/Archives/edgar/data/102752/000010275223000012/vsec-20221231.htm
Accession: 0000102752-23-000012
Filing date: 2023-03-10
Report date: 2022-12-31
Extracted structurally from real Item 7 body heading to real Item 7A/8 boundary. Published MD&A gate trimmed front/tail over-capture.
Confidence: high

Company profile: /company/VSEC/
All MD&A years: /company/VSEC/mda/
Previous year: /company/VSEC/mda/fy2021/ (FY 2021)
Next year: /company/VSEC/mda/fy2023/ (FY 2023)

ITEM 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations

The following discussion and analysis should be read in conjunction with our consolidated statements and related notes included in Item 8. "Financial Statements and Supplementary Data" of this Annual Report on Form 10-K. The following generally discusses 2022 and 2021 items and year-to-year comparisons between 2022 and 2021. Discussions of 2020 items and year-to-year comparisons between 2021 and 2020 that are not included in this Form 10-K can be found under Item 7. "Management's Discussion and Analysis of Financial Condition and Results of Operations" in our Annual Report on Form 10-K for fiscal year ended December 31, 2021, filed with the SEC on March 11, 2022.

Business Overview

We are a diversified aftermarket products and services company providing repair services, parts distribution, logistics, supply chain management and consulting services for land, sea and air transportation assets to government and commercial markets. Our operations are conducted within three reportable segments aligned with our operating segments: Aviation, Fleet and Federal and Defense.

Business Trends

The following discussion provides a brief description of some of the key business factors impacting our results of operations detailed by segment.

Aviation Segment

Our Aviation segment has seen favorable results due to successful investments in growth initiatives, resulting in a 65% increase in annual revenue, totaling $408 million. The expansion of our distribution services was driven by new initiatives offering comprehensive “tip-to-tail” product-line solutions. Our repair business experienced growth from both the recovery of the commercial market and increased market share in the business and general aviation sector. These factors, combined with our growth initiatives, led to a 75% increase in distribution revenue and a 42% increase in repair revenue in 2022 compared to the prior period. In 2022, we secured key multi-year distribution deals for both domestic and new international markets. The new distribution initiatives are expected to bring in sustainable and recurring revenue with growth opportunities, contributing to future positive results. With continued growth in the distribution business and recovery in commercial markets, our focus is on investing in businesses and programs that will broaden our portfolio and reach new customers. The January 2023 acquisition of Precision Fuel Components expands our product offerings and customer base, offering strategic cross-selling opportunities and market share in niche B&GA related markets. The Aviation segment is expected to see continued growth due to progress on new initiatives, offering a favorable outlook for 2023.

Fleet Segment

Our Fleet segment continues to see growth in revenue from commercial fleet customers and e-commerce fulfillment, as the segment moves towards revenue diversification. Fleet is executing its revenue diversification strategy by acquiring new customers and expanding product options for the e-commerce fulfillment business. Commercial customer revenue continues to experience strong growth, increasing 42% in 2022 compared to the prior year. We anticipate continued growth as we extend our reach to meet the increasing demand from the commercial market. In 2022, commercial revenues were 40% of total Fleet segment revenue compared to 18% in 2020, demonstrating the continued success of our revenue diversification strategy. To support commercial revenue, Fleet opened a new distribution warehouse and e-commerce center of excellence in Olive Branch, MS (near Memphis, TN), in January 2023. The new facility, which doubles the existing warehouse space, enhances Fleet's geographical coverage and product offerings for customers. The launch of the new location will allow Fleet to keep up with the growing demand for e-commerce fulfillment. Additionally, we generated steady revenue from our support of the USPS delivery vehicle fleet through supplying parts and managing inventory, with revenue increasing 4% in 2022 compared to the prior year. We continue to monitor USPS vehicle procurement and are ready to support both new vehicles added to the fleet and existing vehicles still in service. Our experience and understanding of the USPS's needs strategically position us to remain a key partner. We are committed to remain agile and supporting the USPS during its vehicle transition. We expect continued growth within our commercial channels, coupled with stable contributions from USPS.

Federal and Defense Segment

In 2022, our Federal and Defense segment experienced revenue growth driven by strong performance in our Naval Sea Systems Command (NAVSEA) program in providing Foreign Military Sales (FMS), with the transfer of a U.S. Navy ship to Bahrain

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being a major contributor for the revenue increase. We experienced margin impacts from an unfavorable contract mix and recognized a loss on a non-Department of Defense contract with a foreign customer that was completed in 2022. To address these challenges, the Federal and Defense segment is reshaping its presence in the federal market by investing in business development. This includes a change in leadership and a focus on maintaining core operations while expanding our client base and capabilities. We aim to enhance our services and pursue new opportunities to support long-term growth for this segment.

Results of Operations

The following table summarizes our consolidated results of operations (in thousands):

[[GREPCENT_TABLE]]
[["","Years ended December 31,"],["","2022","","%","","2021","","%","","2020","","%"],["Revenues","$","949,762","","","100.0","","","$","750,853","","","100.0","","","$","661,659","","","100.0"],["Costs and operating expenses","894,631","","","94.2","","","729,333","","","97.1","","","606,896","","","91.7"],["Loss on sale of business entity and certain assets","\u2014","","","\u2014","","","\u2014","","","\u2014","","","(8,214)","","","(1.2)"],["Gain on sale of property","\u2014","","","\u2014","","","\u2014","","","\u2014","","","1,108","","","0.2"],["Goodwill and intangible asset impairment","\u2014","","","\u2014","","","\u2014","","","\u2014","","","(33,734)","","","(5.1)"],["Operating income","55,131","","","5.8","","","21,520","","","2.9","","","13,923","","","2.2"],["Interest expense, net","17,885","","","1.9","","","12,069","","","1.6","","","13,496","","","2.0"],["Income before income taxes","37,246","","","3.9","","","9,451","","","1.3","","","427","","","0.2"],["Provision for income taxes","9,187","","","1.0","","","1,485","","","0.2","","","5,598","","","0.8"],["Net income (loss)","$","28,059","","","2.9","","","$","7,966","","","1.1","","","$","(5,171)","","","(0.6)"]]
[[/GREPCENT_TABLE]]

Revenues. Revenues increased $198.9 million, or 26.5%, in 2022 compared to 2021 due to revenue growth in our Aviation segment of $160.3 million, our Fleet segment of $27.8 million and our Federal and Defense segment of $10.8 million. See "Segment Operating Results" below for further information by segment. See Note (3) to the consolidated financial statements for information regarding sales by type and customer type for each of our segments.

Costs and Operating Expenses. Costs and operating expenses increased $165 million, or 23%, in 2022 compared to 2021. Costs and operating expenses for our operating segments increase and decrease in conjunction with the level of business activity and revenues generated by each segment. See "Segment Operating Results" below for further information by segment.

Operating Income. Operating income increased $33.6 million, or 156%, in 2022 compared to 2021 attributable to increases of $50.8 million for our Aviation segment and $3.5 million for our Fleet segment, partially offset by a decrease of $20.7 million for our Federal and Defense segment. See "Segment Operating Results" below for further information by segment.

Interest Expense. Interest expense increased approximately $5.8 million or 48.2% in 2022 compared to 2021 primarily due to higher average interest rates on borrowings outstanding.

Provision for Income Taxes. The effective tax rate was 24.7% in 2022 compared 15.7% in 2021. The increase in our effective tax rate primarily resulted from book expense in connection with a decline in the fair market value of our corporate owned life insurance ("COLI") assets in 2022 vs. book income recorded in 2021. For tax purposes, current year COLI book expense was reversed resulting in an unfavorable adjustment to the effective tax rate as opposed to a favorable adjustment reported in 2021.

Our tax rate is also affected by discrete items that may occur in any given year but may not be consistent from year to year. In addition to state income taxes, certain federal and state tax credits and permanent book-tax differences such as foreign derived intangible income ("FDII") deduction, I.R.C. Section 162(m) executive compensation limitation and unrealized investment income or loss from our COLI plan caused differences between the statutory U.S. federal income tax rate and our effective tax rate.

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Segment Operating Results

Aviation Segment Results

The results of operations for our Aviation segment are as follows (in thousands):

[[GREPCENT_TABLE]]
[["","Years ended December 31,"],["","2022","","%","","2021","","%","","2020","","%"],["Revenues","$","408,112","","","100.0","","","$","247,852","","","100.0","","","$","165,070","","","100.0"],["Costs and operating expenses","371,696","","","91.1","","","262,225","","","105.8","","","159,743","","","96.8"],["Loss on sale of business entity and certain assets","\u2014","","","\u2014","","","\u2014","","","\u2014","","","(8,214)","","","(5.0)"],["Gain on sale of property","\u2014","","","\u2014","","","\u2014","","","\u2014","","","1,108","","","0.7"],["Goodwill and intangible asset impairment","\u2014","","","\u2014","","","\u2014","","","\u2014","","","(33,734)","","","(20.4)"],["Operating income (loss)","$","36,416","","","8.9","","","$","(14,373)","","","(5.8)","","","$","(35,513)","","","(21.5)"]]
[[/GREPCENT_TABLE]]

Revenues. Revenues increased $160 million, or 65%, in 2022 compared to 2021. Distribution revenue increased $129 million, or 75%, driven by contributions from recently initiated distribution contract wins and contributions from the acquisition of Global Parts (which occurred in the third quarter of the prior year). Repair revenue increased $32 million, or 42%, driven by improved demand in end markets as a result of market recovery and share gains with business and general aviation customers.

Costs and Operating Expenses. Costs and operating expenses increased $109 million, or 42%, in 2022 compared to 2021 primarily due to revenues increase as noted above and a $2.3 million non-cash charge to write down accounts receivable and inventory related to the Russian and Ukrainian markets, partially offset by a decrease in costs due to the absence of a $23.7 million inventory valuation reserve recognized in the prior year. Costs and operating expenses for this segment include expenses for amortization of intangible assets associated with acquisitions and allocated corporate costs. Expense for amortization of intangible assets was approximately $9.3 million and $8.7 million for 2022 and 2021, respectively. Expense for allocated corporate costs was approximately $12.9 million and $8.8 million for 2022 and 2021, respectively.

Operating Income. Operating income increased $50.8 million, or 353%, in 2022 compared to 2021 primarily due to contributions from new distribution programs, increases in higher margin repair revenue, and contributions from the Global Parts acquisition.

Fleet Segment Results

The results of operations for our Fleet segment are as follows (in thousands):

[[GREPCENT_TABLE]]
[["","Years ended December 31,"],["","2022","","%","","2021","","%","","2020","","%"],["Revenues","$","261,336","","","100.0","","","$","233,532","","","100.0","","","$","242,170","","","100.0"],["Costs and operating expenses","237,425","","","90.9","","","213,106","","","91.3","","","215,511","","","89.0"],["Operating income","$","23,911","","","9.1","","","$","20,426","","","8.7","","","$","26,659","","","11.0"]]
[[/GREPCENT_TABLE]]

Revenues. Revenues increased $27.8 million, or 12%, in 2022 compared to 2021. The increase was primarily from commercial customers of $31 million, or 42%, and other government customers of $7 million, or 5%. These increases were partially offset by a decrease in sales to DoD customers of $9 million, or 74%.

Costs and Operating Expenses. Costs and operating expenses increased $24.3 million, or 11%, primarily due to increased revenues. Costs and operating expenses for this segment include expense for amortization of intangible assets associated with acquisitions and allocated corporate costs. Expense for amortization of intangible assets was $6.4 million for 2022 and $7.1 million for 2021. Expense for allocated corporate costs was $7.5 million for 2022 and $8.5 million for 2021.

Operating Income. Operating income increased $3.5 million, or 17%, in 2022 compared to 2021, primarily due to a change in mix of products sold, including increased commercial fleet customer and e-commerce fulfillment sales as described above.

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Federal and Defense Segment Results

The results of operations for our Federal and Defense segment are as follows (in thousands):

[[GREPCENT_TABLE]]
[["","Years ended December 31,"],["","2022","","%","","2021","","%","","2020","","%"],["Revenues","$","280,314","","","100.0","","","$","269,469","","","100.0","","","$","254,419","","","100.0"],["Costs and operating expenses","281,119","","","100.3","","","249,572","","","92.6","","","228,110","","","89.7"],["Operating (loss) income","$","(805)","","","(0.3)","","","$","19,897","","","7.4","","","$","26,309","","","10.3"]]
[[/GREPCENT_TABLE]]

Revenues. Revenues increased $11 million, or 4%, in 2022 compared to 2021 due to revenues from our Foreign Military Sales (FMS) program with the U.S. Navy, partially offset by declines in our U.S. Army work as a result of program completions.    

Costs and Operating Expenses. Costs and operating expenses increased $32 million, or 13%, in 2022 compared to 2021 due to increased revenue and a shift in our contract mix to a larger proportion of cost-plus contracts.

Operating (Loss) Income. Operating income decreased approximately $20.7 million, or 104%, in 2022 compared to 2021 primarily due to the completion of a U.S. Army program and a shift in our contract mix to a larger portion of cost-plus contracts, which generally provide lower profit margins compared to fixed-price and T&M contract types. Additionally, we recorded a $7.8 million loss in 2022 related to a specific fixed-price, non-DoD contract with a foreign customer. We have completed work on this contract in 2022.

Bookings and Funded Backlog

Our funded backlog represents the estimated remaining value of work to be performed under firm contracts. Bookings for our Aviation and Fleet segments occur at the time of sale. Accordingly, our Aviation and Fleet segments do not generally have funded contract backlog and backlog is not an indicator of their potential future revenues. Revenues for federal government contract work performed by our Federal and Defense segment depend on contract funding ("bookings”), and bookings generally occur when contract funding documentation is received. Funded contract backlog is an indicator of potential future revenue. While bookings and funded contract backlog generally result in revenue, we may occasionally have funded contract backlog that expires or is de-obligated upon contract completion and does not generate revenue.

Changes in funded backlog on contracts are sometimes unpredictable due to uncertainties associated with changing government program priorities and availability of funds, which is heavily dependent upon the congressional authorization and appropriation process. Delays in this process may temporarily diminish the availability of funds for ongoing and planned work.

In addition to funded backlog levels, we have contract ceiling amounts available for use on multiple award, indefinite delivery, indefinite quantity contracts (IDIQ) with DoD and federal civilian agencies. While these contracts increase the opportunities available for us to pursue future work, the actual amount of future work is indeterminate until task orders are placed on the contracts. Frequently, these task orders are competitively awarded. Additionally, these task orders must be funded by the procuring agencies before we can perform work and begin generating revenues. We do not include in backlog estimates of revenues to be derived from IDIQ contracts, but rather record backlog and bookings when task orders are awarded and funded on these contracts.

A summary of our bookings, revenues and funded contract backlog for our Federal and Defense segment is as follows (in millions):

[[GREPCENT_TABLE]]
[["","Year Ended December 31,"],["","2022","","2021","","2020"],["Bookings","$","294","","","$","314","","","$","270"],["Revenues","$","280","","","$","269","","","$","254"],["Funded Backlog","$","187","","","$","185","","","$","183"]]
[[/GREPCENT_TABLE]]

For the year ended December 31, 2022, Federal and Defense segment bookings decreased 6% year-over-year to $294 million, while total funded backlog increased 1% year-over-year to $187 million.

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Financial Condition

There has been no material adverse change in our financial condition in 2022. Our bank debt increased $2 million, and we had $160 million of unused bank loan commitments as of December 31, 2022. Changes to other asset and liability accounts were primarily due to our earnings; our level of business activity; the timing and level of inventory purchases to support new distribution programs, contract delivery schedules, and subcontractor and vendor payments required to perform our contract work; the timing of government contract funding awarded; and collections from our customers.

Liquidity and Capital Resources

Cash Flows

The following table summarizes our cash flows (in thousands):

[[GREPCENT_TABLE]]
[["","Year ended December 31,"],["","2022","","2021","","2020"],["Net cash provided by (used in) operating activities","$","8,051","","","$","(17,602)","","","$","35,761"],["Net cash (used in) provided by investing activities","(2,377)","","","(61,632)","","","20,219"],["Net cash (used in) provided by financing activities","(5,714)","","","79,374","","","(56,336)"],["Net (decrease) increase in cash and cash equivalents","$","(40)","","","$","140","","","$","(356)"]]
[[/GREPCENT_TABLE]]

Cash provided by operating activities was $8.1 million in 2022 compared to cash used in operating activities of $17.6 million in 2021. The change was primarily due to lower use of cash for inventory purchases and timing of vendor payments, partially offset by increased accounts receivable as a result of overall revenue growth and timing of collections.

Cash used in investing activities decreased $59.3 million in 2022 compared to 2021 primarily due to cash paid for acquisitions, net of cash acquired, of $53.3 million related to the acquisitions of our HSS and Global Parts subsidiaries in the prior year.

Cash used in financing activities was $5.7 million in 2022 as compared to cash provided by financing activities of $79.4 million in 2021. The change was primarily due to $52.0 million of proceeds received in the prior year related to our public underwritten offering of our common stock in February 2021 and overall lower net borrowings of our debt in 2022.

We paid cash dividends totaling approximately $5.1 million or $0.40 per share in 2022. Pursuant to our bank loan agreement, our payment of cash dividends is subject to annual restrictions. We have paid cash dividends each year since 1973.

Liquidity

Our internal sources of liquidity are primarily from operating activities, specifically from changes in our level of revenues and associated inventory, accounts receivable and accounts payable, and from profitability. Significant increases or decreases in revenues and inventory, accounts receivable and accounts payable can affect our liquidity. Our inventory and accounts payable levels can be affected by the timing of large opportunistic inventory purchases and by distributor agreement requirements. Our accounts receivable and accounts payable levels can be affected by changes in the level of contract work we perform, by the timing of large materials purchases and subcontractor efforts used in our contracts, and by delays in the award of contractual coverage and funding and payments. Government funding delays can cause delays in our ability to invoice for revenues earned, presenting a potential negative impact on our days sales outstanding. In addition to operating cash flows, other significant factors that affect our overall management of liquidity include capital expenditures; investments in expansion; improvement and maintenance of our operational and administrative facilities; and investments in the acquisition of businesses.

Our primary source of external financing is our loan agreement with a bank group and includes a term loan facility and a revolving loan facility, with an aggregate maximum borrowing capacity of $350 million. Under the loan agreement we may elect to increase the maximum availability of the term loan facility, the revolving loan facility, or a combination of both facilities, subject to customary lender commitment approvals. The aggregate limit of increases is $100 million.

On October 7, 2022, we entered into a fourth amendment to our loan agreement which, among other things, provides for the following: (i) an extension of the maturity date from July 23, 2024 to October 7, 2025; (ii) a reset of the aggregate principal amount of the term loan to $100.0 million; (iii) a modification to the amortization payments on the term loan from $3.75 million quarterly to $2.50 million quarterly; (iv) an increase in the maximum total leverage ratio from 4.25x to 4.50x, with such

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ratios decreasing thereafter as indicated in the table below; (v) a change in the benchmark rate from LIBOR to SOFR with a SOFR floor of 0.00%; and (vi) a corresponding change in pricing to account for the change from LIBOR to SOFR.

[[GREPCENT_TABLE]]
[["Testing Period","","Maximum Total Funded Debt to EBITDA Ratio"],["From the Fourth Amendment Effective Date through and including June 30, 2023","","4.50 to 1.00"],["From July 1, 2023 through and including December 31, 2023","","4.25 to 1.00"],["From January 24, 2024 through and including June 30, 2024","","4.00 to 1.00"],["From July 1, 2024 through and including September 30, 2024","","3.75 to 1.00"],["From October 1, 2024 and thereafter","","3.50 to 1.00"]]
[[/GREPCENT_TABLE]]

See Note (7) "Debt" to our Consolidated Financial Statements for information regarding our loan agreement.

Other Obligations and Commitments

See Note (7) "Debt" to our Consolidated Financial Statements for information regarding our long-term debt obligations. We estimate cash requirements for interest payments on our bank loan debt to be approximately $20.6 million for 2023, $19.8 million for 2024 and $16.2 million for 2025. The estimates do not take into account future drawdowns and repayments on the debt or changes in the variable interest rate, and actual interest may be different. The estimates included variable rate interest obligations estimated based on rates as of December 31, 2022. The interest payments are estimated through the maturity date of our term loan. Interest payments under our revolver loans have been excluded because a reasonable estimate of timing and amount of cash out flows cannot be determined.

See Note (12) "Leases" to our Consolidated Financial Statements for information pertaining to future minimum lease payments relating to our operating and lease obligations.

Inflation and Pricing

Our Aviation and Fleet segments have experienced broad-based inflationary impacts consistent with overall trends in the aerospace and industrial distribution market, due primarily to increased materials, labor and services costs. The effect of these increased costs on total company net income has been mitigated with improved efficiency in our underlying business through productivity improvements and pass-through price increases. Our Federal and Defense segment has limited inflation risk as most of our contracts provide for estimates of future labor costs to be escalated for any option periods, while the non-labor costs in our contracts are typically reimbursable at cost. Given broader inflation in the economy, we are monitoring the risk inflation presents to active and future contracts.

Off-Balance Sheet Arrangements

We do not have any off-balance sheet arrangements that have, or are reasonably likely to have, a current or future material effect on our financial condition, changes in financial condition, revenue or expenses, results of operations, liquidity, capital expenditures or capital resources.

Critical Accounting Policies, Estimates and Judgments

Our consolidated financial statements are prepared in accordance with United States generally accepted accounting principles ("U.S. GAAP"), which require us to make estimates and assumptions. Certain critical accounting policies affect the more significant accounts, particularly those that involve judgments, estimates and assumptions used in the preparation of our consolidated financial statements. The development and selection of these critical accounting policies have been determined by our management. Due to the significant judgment involved in selecting certain of the assumptions used in these policies, it is possible that different parties could choose different assumptions and reach different conclusions. We consider our policies relating to the following matters to be critical accounting policies.

Revenue Recognition

We account for revenue in accordance with ASC 606. The unit of account in ASC 606 is a performance obligation. At the inception of each contract with a customer, we determine our performance obligations under the contract and the contract's transaction price. A performance obligation is a promise in a contract to transfer a distinct good or service to the customer and

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is defined as the unit of account. A contract’s transaction price is allocated to each distinct performance obligation and recognized as revenue when the performance obligation is satisfied. The majority of our contracts have a single performance obligation as the promise to transfer the respective goods or services is not separately identifiable from other promises in the contracts and is, therefore, not distinct. For product sales, each product sold to a customer typically represents a distinct performance obligation. Our performance obligations are satisfied over time as work progresses or at a point in time based on transfer of control of products and services to our customers.

Contract modifications are routine in the performance of our contracts. Contracts are often modified to account for changes in contract specifications or requirements. In most instances, contract modifications are for goods or services that are not distinct, and therefore are accounted for as part of the existing contract.

Substantially all Fleet segment revenues from the sale of vehicle parts to customers are recognized at the point in time of the transfer of control to the customer. Sales returns and allowances for vehicle parts are not significant.

Our Aviation segment revenues result from the sale of aircraft parts and performance of MRO services. Our Aviation segment recognizes revenues for the sale of aircraft parts at a point in time when control is transferred to the customer, which usually occurs when the parts are shipped. Our Aviation segment recognizes revenues for MRO services over time as the services are transferred to the customer. MRO services revenue recognized is measured based on the cost-to-cost input method, as costs incurred reflect the work completed, and therefore the services transferred to date. Sales returns and allowances are not significant.

Our Federal and Defense segment revenues result from professional and technical services, which we perform for customers on a contract basis. Revenue is recognized for performance obligations over time as we transfer the services to the customer. The three primary types of contracts used are cost-type, fixed-price and time and materials. Revenues result from work performed on these contracts by our employees and our subcontractors and from costs for materials and other work-related costs allowed under our contracts.

Revenues on cost-type contracts are recorded as contract allowable costs are incurred and fees are earned. Variable consideration is included in the estimated transaction price, to the extent that it is probable that a significant reversal will not occur, when there is a basis to reasonably estimate the amount of the fee. These estimates are based on historical award experience, anticipated performance and our best judgment based on current facts and circumstances.

Revenues on fixed-price contracts are recorded as work is performed over the period. We generally recognize revenue using the time-elapsed output method for our fixed-price service offering performance obligations. For certain deliverable-based fixed-price performance obligations, revenue is recognized over time using costs incurred to date relative to total estimated costs at completion. For such contracts, we estimate total costs at the inception of the contract based on our assumptions of the cost elements required to complete the associated tasks of the contract and assess the effects of the risks on our estimates of total costs to complete the contract. Our cost estimates are based on assumptions that include the complexity of the work, our employee labor costs, the cost of materials and the performance of our subcontractors. These cost estimates are subject to change as we perform under the contract and as a result, the timing of revenues and amount of profit on a contract may change as there are changes in estimated costs to complete the contract. Such adjustments are recognized on a cumulative catch-up basis in the period we identify the changes.

Revenues for time and materials contracts are recorded based on the amount for which we have the right to invoice our customers, because the amount directly reflects the value of our work performed for the customer. Revenues are recorded on the basis of contract allowable labor hours worked multiplied by the contract defined billing rates, plus the direct costs and indirect cost burdens associated with materials and subcontract work used in performance on the contract. Generally, profits on time and materials contracts result from the difference between the cost of services performed and the contract defined billing rates for these services.

Revenues related to work performed on government contracts at risk, which is work performed at the customer's request prior to the government formalizing funding, is not recognized until it can be reliably estimated, and its realization is probable.

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Inventory Valuation

Inventories are stated at the lower of cost or net realizable value using the first-in, first-out ("FIFO") method. Inventories for our Fleet segment consist primarily of vehicle replacement parts, and also include related purchasing, storage and handling costs. Inventories for our Aviation segment consist primarily of aftermarket parts for distribution, and general aviation engine accessories and parts, and also include related purchasing, overhaul labor, storage and handling costs. We periodically evaluate the carrying value of inventory, giving consideration to factors such as its physical condition, sales patterns and expected future demand in order to estimate the amount necessary to write down any slow moving, obsolete or damaged inventory. These estimates could vary significantly from actual amounts based upon future economic conditions, customer inventory levels or competitive factors that were not foreseen or did not exist when the estimated write-downs were made.

Business Combinations

We account for business combinations under the acquisition method of accounting. The purchase price of each business acquired is allocated to the tangible and intangible assets acquired and the liabilities assumed based on information regarding their respective fair values on the date of acquisition. Any excess of the purchase price over the fair value of the separately identifiable assets acquired and liabilities assumed is allocated to goodwill. Determining the fair value of assets acquired and liabilities assumed requires management's judgment and often involves the use of significant estimates and assumptions, including assumptions with respect to future cash inflows and outflows, discount rates, and market multiples, among other items. We determine the fair values of intangible assets acquired generally in consultation with third-party valuation advisors. The valuation of assets acquired and liabilities assumed requires a number of judgments and is subject to revision as additional information about the fair values becomes available. We will recognize any adjustments to provisional amounts that are identified during the period not to exceed twelve months from the acquisition date (the "measurement period") in which the adjustments are determined. Acquisition costs are expensed as incurred. The results of operations of businesses acquired are included in the consolidated financial statements from their dates of acquisition.

As part of the agreement to acquire certain subsidiaries, we may be obligated to pay contingent consideration should the acquired entity meet certain earnings objectives subsequent to the date of acquisition. As of the acquisition date, contingent consideration is recorded at fair value as determined through the use of a probability-based scenario analysis approach. Under this approach, a set of potential future subsidiary earnings is estimated based on various revenue growth rate assumptions for each scenario. A probability of likelihood is then assigned to each potential future earnings estimate and the resultant contingent consideration is calculated and discounted using a weighted average discount rate. The fair value is measured each reporting period subsequent to the acquisition date and any changes are recorded within cost and operating expenses within our consolidated statement of income. Changes in either the revenue growth rates, related earnings or the discount rate could result in a material change to the amount of the contingent consideration accrued.

Goodwill and Intangible Assets

Goodwill is subject to a review for impairment at least annually. We perform an annual review of goodwill for impairment during the fourth quarter and whenever events or other changes in circumstances indicate that the carrying value may not be fully recoverable. The goodwill impairment test is performed at the reporting unit level. We estimate and compare the fair value of each reporting unit to its respective carrying value including goodwill. If the fair value is less than the carrying value, the amount of impairment expense is equal to the difference between the reporting unit’s fair value and the reporting unit’s carrying value. Determining the fair value of a reporting unit requires the exercise of significant management judgments and the use of estimates and assumptions. We estimate the fair value of our reporting units using a weighting of fair values derived from the income approach and market approach. Under the income approach, we calculate the fair value of a reporting unit based on the present value of estimated future cash flows. Cash flow projections are based on our estimates of revenue growth rates and operating margins, taking into consideration industry and market conditions. The discount rate used is based on a weighted average cost of capital adjusted for the relevant risk associated with the characteristics of the business and the projected cash flows. Under the market approach, we estimate the fair value of a reporting unit based on multiples of earnings derived from observable market data of comparable public companies. We evaluate companies within our industry that have operations with observable and comparable economic characteristics and are similar in nature, scope and size to the reporting unit being compared. We analyze historical acquisitions in our industry to estimate a control premium that we incorporate into the fair value estimate of a reporting unit under the market approach. The carrying value of each reporting unit includes the assets and liabilities employed in its operations and goodwill. There are no significant allocations of amounts held at the Corporate level to the reporting units.

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The results of our annual goodwill impairment tests in fiscal 2022 and 2021, respectively, indicated that the estimated fair value of each reporting unit exceeded its carrying value. There were no impairment charges recorded in the years ended December 31, 2022 and 2021.

In the second quarter of 2020, due to the significant decline in our market capitalization as well as an overall stock market decline amid market volatility as a result of the COVID-19 pandemic, we performed an interim impairment test utilizing a quantitative assessment approach. Based on the assessment, our VSE Aviation reporting unit was determined to be impaired and a $30.9 million impairment charge was recognized. Based on our annual goodwill impairment test performed in the fourth quarter of 2020, for which a qualitative assessment approach was utilized, it was determined that it was more likely than not that the fair value of our reporting units exceeded their carrying value, and no additional impairment was recognized.

Intangible assets with finite lives are amortized using the method that best reflects how their economic benefits are utilized or, if a pattern of economic benefits cannot be reliably determined, on a straight-line basis over their estimated useful lives. Intangible assets with finite lives are assessed for impairment whenever events or changes in circumstances indicate that the carrying value may not be recoverable.

Income Taxes

Income taxes are accounted for under the asset and liability method. Under the asset and liability method, deferred tax assets and liabilities are recognized for the estimated future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax basis. This method also requires the recognition of future tax benefits, such as net operating loss and capital loss carryforwards, to the extent that realization of such benefits is more likely than not. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date.

The carrying value of net deferred tax assets is based on assumptions regarding our ability to generate sufficient future taxable income to utilize these deferred tax assets within the carryback or carryforward periods provided for in the tax law for each applicable tax jurisdiction. Deferred tax assets are evaluated quarterly to determine if valuation allowances are required or should be adjusted.

Recently Issued Accounting Pronouncements

For a description of recently announced accounting standards, including the expected dates of adoption and estimated effects, if any, on our consolidated financial statements, see "Nature of Business and Significant Accounting Policies-Recently Issued Accounting Pronouncements" in Note (1) to our Consolidated Financial Statements included below in Item 8.