Michael J. Smith - Director of Investor Relations Kenneth W. Hunzeker - President, Chief Executive Officer & Director Matthew M. Klein - Chief Financial Officer & Senior Vice President.

Brian W. Ruttenbur - CRT Capital Group LLC Bill R. Loomis - Stifel, Nicolaus & Co., Inc..

Good day and welcome to the Vectrus, Incorporated Fourth Quarter Fiscal 2014 Earnings Conference Call. Today's conference is being recorded. At this time, I would like to turn the conference over to Mike Smith. Please go ahead, sir..

Thank you, Eric. Good morning, everyone. Welcome to the Vectrus fourth quarter earnings conference call. Joining us today are Ken Hunzeker, Chief Executive Officer and President; and Matt Klein, Senior Vice President and Chief Financial Officer. Slides from today's presentation are available on our Investor Relations website, investors.vectrus.com.

Please turn to slide two. During today's presentation, management will be making forward-looking statements pursuant to the Safe Harbor provisions of the federal securities laws.

Please review our Safe Harbor statement in our press release for a description of some of the factors that may cause actual results to differ materially from the results contemplated by these forward-looking statements. We assume no obligation to update our forward-looking statements.

Also, we will be making reference to non-GAAP financial measures during this call. We remind you that these non-GAAP financial measures are not a substitute for their comparable GAAP measures.

You can find the non-GAAP reconciliations and other disclosures in our earnings release and in our presentation slides, which are publicly available on the Vectrus website at investors.vectrus.com. And, at this time, I'd like to turn the call over to Ken Hunzeker..

Our procurement cycle is a long one, and these changes will take time. But I can guarantee you that increasing our margins has all of our attention. Leveraging our operational excellence and continuous improvement programs is critical to our plan.

The new contracts we are phasing in this year are mainly fixed price with five to seven years of runway, which gives us sufficient time to execute our stated margin targets on these contracts. On a positive note, the core business is expected to grow, replacing the Afghanistan revenue declines. Please turn to slide six.

We expect revenue from programs based in Afghanistan to continue to decline. In 2014, we finished with $270 million in revenue, down nearly 50% compared to 2013. Afghanistan program revenue in 2015 continues to come down, as it's expected to contribute approximately $160 million.

We're pleased to announce that, in 2015, our core business with the new wins is expected to grow approximately 10% compared to 2014. This expected growth aligns with our strategy. Air Force customer concentration moved from 5% in 2013 to 13% in total 2015 revenue. Navy concentration moved from 0% in 2013 to 2% in 2015.

And we're becoming less concentrated in Army-based programs, moving from 92% in 2013 to approximately 85% in 2015. Also, 2015 geographic presence is broadening with U.S. and Europe expanding by 5% and 7%, respectively, when compared to 2013. We still have some work to do but we're making good progress to our stated objectives.

As we move through the early stages of being a publicly-traded company, we're beginning to see success in our strategy of broadening our customer base and diversifying our geographic footprint. Now, I'd like to turn the call over to Matt. And he will go through the details of the fourth quarter, full year performance and provide 2015 guidance.

Then, we'll open the line up for your questions..

Thank you, Ken. Good morning, everyone. Please turn to slide seven. Today, I'll start with the review of the financial results for the fourth quarter and full year 2014. Then I'll provide guidance for 2015.

The financial results of Vectrus noted on slide seven includes the Tethered Aerostat Radar System, TARS program, and separation costs required to become a standalone company. The TARS program was retained by Exelis as part of the spin. The separation costs are non-recurring costs to the business.

I'll address the financial results on an adjusted basis which we believe better reflect the ongoing business trends. You can reference the appendix of this presentation for the reconciliation of our adjusted results to GAAP. Please turn to slide eight. For the fourth quarter, adjusted funded orders were $178 million.

Orders were slightly up compared to the fourth quarter of 2013 which is a reflection of timing of funded awards in our base business. Adjusted revenue for the quarter was $286 million. Afghanistan contracts contributed $51 million in the quarter and were down $43 million compared to the prior year's quarter.

While the base business grew by $12 million, this demonstrates that our existing non-Afghanistan contracts are stabilizing and will provide a strong revenue base for 2015. Fourth quarter adjusted operating income was $8.6 million or 3% operating margin, which is $17.2 million or 520 basis points down when compared to the same period of 2013.

Afghanistan contracts contributed $3.2 million in the quarter and were down $16.8 million compared to the prior year. This unfavorable variance is due to lower service level requirements on Afghanistan contracts and was expected as we reshape our contract portfolio.

The adjusted diluted earnings per share for the quarter was $0.33 per share compared to $1.58 per share in the fourth quarter of 2013, largely due to the mix of the business and to an increase of our fourth quarter effective tax rate to 49.5% related to one-time catch-up items that I will discuss in more detail later. Please turn to slide nine.

Now, I'll turn to the financial results of the full year 2014. 2014 adjusted funded orders declined by $363 million from 2013 due to lower service requirements on Afghanistan and Middle East contracts. $1.3 billion in orders represents a year-to-date book to bill of 1.1 times, consistent with our 2014 guidance expectation of exceeding one.

Adjusted revenue for 2014 was $1,172 million, which is $303 million lower than prior year. Afghanistan programs finished the year at $270 million, down $243 million due to U.S. troop withdrawals. Middle East programs were down $86 million as a result of base closures as the U.S.

government consolidated contracting activity and reduced maintenance requirements in Tethered. These impacts were partially offset by an increased level of effort for domestic construction projects and full year revenue on our Navy FSET contract. 2014 adjusted operating income was $50 million or 4.3% operating margin, down by $79 million.

Programs based in Afghanistan contributed $24 million, down $67.1 million compared to the prior year. The 4.3% adjusted operating margin falls within our prior expectations. Adjusted diluted earnings per share for the full year 2014 was $2.80 per share compared to $7.92 per share when compared to 2013.

Free cash flow through year-to-date December was $39.1 million, which is stronger than originally expected due to solid funding on our contracts and a proactive collection process. Cash balance was $42.8 million at year-end.

The free cash flow results benefited from earlier than anticipated collections, which will have an impact on 2015, which I'll discuss in a minute. The effective tax rate for 2014 was 38.2%, an increase of 250 basis points from prior guidance.

The increase is attributed to discrete items, including non-deductible spin cost and one-time impact of a change in our state deferred tax rate applied through our deferred tax liabilities as our mix of programs changes adding a greater domestic footprint. We anticipate the 2015 effective rate will move back to 36%. Please turn to slide 10.

For the year ending December 31, 2014, the total backlog was $2.9 billion with approximately $800 million funded. During the quarter, we recorded the ACE-IT and Turkey/Spain Base Maintenance contract in backlog. The year-to-date total backlog excludes the Thule contract.

Although in February 2015 the GAO denied the protest filed by three unsuccessful competitors, at least one of them has filed a subsequent protest with the Court of Federal Claims. We are moving forward with the phase-in as directed by the customer. And we expect to add Thule to backlog in the first quarter of 2015.

Total backlog represents firm orders and potential options on multi-year contracts, excluding IDIQ contracts. The 2014 backlog adjusted to include the Thule contract award would represent $3.3 billion. Please turn to slide 11. Regarding 2015, we expect the top line to stabilize. Our core business is expected to grow 10% compared to 2014.

The 2015 guidance assumptions include an estimated 65% of revenue attributed to existing business, 21% attributed to re-competes, and 14% to Afghanistan contracts. We have incorporated the newly awarded contracts into our 2015 guidance.

However, due to the uncertainty around 2015 potential awards and the inevitable protests delaying the procurement cycle, we have not included revenue from new business associated with any proposals submitted and pending award.

Re-competes are our focus this year at several of our programs, K-BOSSS being our largest by revenue, and their contractual periods of performance. If the procurement cycle remains on schedule, which is hard to predict, then these contracts will award in the latter part of 2015.

Our 2015 guidance contemplates the timing of these awards, and we do not think there will be a material change to our range at this time. The new wins are expected to generate approximately $150 million of partial year revenue in 2015. As these programs are fully phased in, we expect them to generate over $200 million of annualized revenue.

We will likely experience margin pressures as Afghanistan-based programs continue to decline and we complete the phase-ins on our three contracts. Phase-ins are the most critical time of a contract and, if performed well, set the programs up for long-term success.

Accordingly, we have dedicated the resources and attention necessary for successful phase-ins. A component of delivering both top-line growth and margin improvement is our commitment to operational excellence.

We will accomplish these improvements through a combination of ongoing Lean initiatives and process improvements, coupled with the development of innovative approaches to program performance on both current and new-bid programs. The new business pipeline is strong, with over $1 billion of proposals submitted, pending potential award.

As we mentioned before, debt management will be a focus in 2015. We have approximately $11 million of mandatory payments due and anticipate making additional accelerated payments in the range of $5 million to $10 million. Equity-based compensation expense includes the impact of Founders' Grants.

The 2015 impact of these equity awards is expected to be $2.4 million. Interest expense is forecasted to be $6 million. And the effective tax rate is expected to be 36%. Please turn to slide 12. For 2015, we are forecasting revenue from $1.1 billion to $1.2 billion, including approximately $150 million attributed to the newly awarded contracts.

We expect to start recognizing revenue from the new contracts in the second half of 2015. Adjusted operating margins are estimated to range from 3.2% to 3.6%, adjusted for minimal spin costs in 2015. For operational visibility purposes, adjusted operating margins, less nonrecurring Founders' Grants, will range from approximately 3.5% to 3.8%.

Free cash flow is estimated to range from $15 million to $19 million, which takes into account the impact of the favorable 2014 free cash flow results of $12 million from early collections. Adding back the favorable 2014 cash collections, our 2015 free cash flow conversion to net income exceeds 100%, which is typical for our business.

The guidance for adjusted diluted earnings per share is estimated from $1.76 to $2.23 per share. With that, I would like to turn the call over to Ken for final remarks..

Thank you, Matt. When I think about Vectrus and where we are, I see a company in transition with a lot of history with work in Iraq and Afghanistan. I see a company that has a vision to diversify its geographic and customer base and has shown the ability with new wins to start this process.

I see a company that is focused on growth with core business growing 10% this year. I see a business that has seen pressures on margins, but with tools and focus to turn this around with a commitment from its leadership to get back to 4% in 2016.

I see a company that had a backlog of $2.2 billion two quarters ago that is projecting $3.3 billion with the on-boarding of the latest win. I see and continue to visit first-hand a dedicated workforce that is on vector to the future with the mission to be a trusted partner of choice, which is Vectrus. Our future is bright.

I'm blessed to serve with this group of professionals whose goal is to deliver superior results every day. Thank you for your questions, interest and attention today. Now, I'd like to turn the call over for questions..

Thank you. And we'll take our first question from Brian Ruttenbur with CRT Capital..

Yes. Thank you very much. A couple questions. First of all, good quarter. The first question I have is about your Afghanistan business longer term. You talk about where it's going to be in 2015.

Where do you anticipate it longer term at a stabilized rate of $50 million a year or is there any kind of visibility beyond 2015?.

Brian, this is Ken. That's a great question because we're paying a lot of attention to what the discussion between obviously our two governments. President Ghani is coming into meet in the White House next week to figure out the way ahead as where that's going.

What we have modeled in our plan is exactly what's been announced by the administration and when talking to our customer on the ground on the three contracts we have there specifically and what the changes are. And we've stayed tuned into that. That's what Matt and I put the forecast going forward..

Yeah. I think when we project our Afghanistan revenue in 2015 at $160 million that's in line to what we've discussed, even back in September. So, we're still seeing additional reductions. I think if you see any upside going into the future, you might see an elongation of our revenue stream past 2016.

But we're still anticipating those revenue streams to come down slightly..

Okay. Very good. Can you talk maybe, Matt, I don't know if it's Matt or Ken on this one, but on your ramp of three new contracts and the costs associated with those ramps? And you should benefit, I guess, in 2016 from some tailwinds from not having those ramps.

Is that correct?.

Yeah. So, what's impacting 2015 is, as you've been watching, as we won these awards in the fall of last year, we've had a couple programs protest, which has delayed the on-boarding of the contracts. We're through that critical phase.

So, there is some cost associated with defending that, so that puts some pressure on our fourth quarter operating margin. And also the timing of those contracts.

As they phase in the second half of this year, we kind of run out of room to kind of make sure everything is operational, the foundation is set and to kind of work the operational efficiencies that we expect to achieve. So, we do expect 2016 to see some improvement on those programs.

So, unfortunately, in 2015, we've dropped below our normalized guidance of 4% to 5%, but we are working actively to get back to 4% by 2016..

And it's primarily these three new contracts ramping that is the drag on the – at least on the core. I understand the Afghanistan dropping and the Founders' Grants, but it's these three new contracts ramping.

Is that correct?.

Yeah. The plan was that and the plan still is, is Afghanistan transitions out and it contributes more to our overall operating margins. We did new programs, which we're very happy that we won those awards and we're on-boarding those. They can replace some of that margin, so that's an element.

And then the re-competes that we talked about will also give us some new leverage going forward that is more incentive-laced, a little bit more fixed price-based that we think that margins will improve over time. So, those two elements; the new business and the re-compete structure – contractual structure, will help improve our margins..

Okay. And then final question is on debt repayment. You're talking about $16 million to $21 million of debt repayment. What you have to repay is $11 million, but you're sitting on almost $43 million of cash.

Is there any incentive to accelerate that even further?.

Yeah. So, we took a very conservative, deliberate approach in our first quarter. We are developing policies and working closely with our board and what to do with the additional cash and capital allocation decisions. This year, as we've announced before, we want to focus on our debt management and we're doing that.

We expect to accelerate that debt payment to give us some more flexibility. If the opportunity arises and we improve on our working capital collections, we would contemplate additional debt payments, but we would have to work that through our board as well..

Okay. Thank you..

Thanks, Brian..

At this time, we have one question remaining in the queue. We'll take our next question from Bill Loomis with Stifel..

Hi. Thanks. Good morning. Just looking at the margins again. So, am I doing apples-to-apples, 7% operating margin you have on the chart for Afghanistan contracts, that's kind of an all-in operating margin. So when I take that out, I get the rest of the business at about 2.8% and 2015 at the midpoint.

Is that about right?.

Yeah. That's about right, Bill..

And then you got the Founders' Grant which adds, what, 20 basis points, 30 basis points, bring it up to 3.0%, 3.1%?.

Yeah. I want to clarify one thing on the Founders' Grant. I described it as non-recurring. So, we have $2.4 million in 2015 related to Founders' Grants. We have a couple more years of debt payment or Founders' Grants expense. And it comes into about $800,000 in 2016 and $600,000 in 2017 and then it no longer appears in our cost structure..

Okay. And I'm sorry.

What was the 2015 number for that?.

2015 was $2.4 million. So, we had $1.2 million accelerated in the fourth quarter of 2014, $2.4 million in 2015, $800,000 in 2016 and $600,000 in 2017 and then we're done..

Okay. Okay. So, just looking at the three contracts starting up, you said it's going to pressure. So, we'll go from, call it, 3% adjusted without Afghanistan up to 4% in 2016 at the low end of your long-term target range.

But let's say you didn't have those three contracts starting up, what would be that adjusted margin in 2015? Would it be already in that 4% to 5% long-term range?.

Yeah. So we're counting on our base programs coming up for re-compete having different levers to improve our operating margin. But the existing contracts are in that 3% range, and we have some opportunities to improve that. I mean 2014 was a busy year for us.

We're making some additional cost-saving initiatives in 2015 that we should see some improvements, which will help margins. But the core business is really at 3% now with significant re-competes coming up in 2015, which will likely play out in 2016, which will give us additional levers..

This is Ken. It's really a transition year for Vectrus regarding the margins. And you see that with the onboarding of the three contracts and then basically the reset on the six contracts that we have coming up for re-compete..

Okay. And in terms of the cost reductions, you said it doesn't sound like there was going to be a lot in 2015.

Is most of that you already did in 2014, prior to the spin-off?.

No. So let me walk you back. On the 10-K, we reported SG&A. I'll start with SG&A. SG&A of $80 million roughly. In that $80 million, there's $13 million of spin cost, so you normalize that out to $67 million. We had a voluntary reduction plan executed last year. So we expect to realize additional savings into 2015. It's already implemented.

And we've done a very nice job of managing our standalone costs as a public company. So, overall, when you look at that $67 million SG&A benchmark for 2014, we expect to save about 8% to 10% in our G&A. Those are our targets. All the while balancing the requirement to phase in these contracts.

Many of our contracts require G&A support to make sure that they're starting out on the right foundation. So we're being very cautious to not to overreact to make sure those programs get off on the right foot. And then we'll make decisions later in the year, if we need to..

Okay. And then the re-competes, I know you already have them, obviously, so there is no start-up.

But are you going to have an investment period early on in those contracts that will depress margins, because it doesn't sound like it if they're going to help boost your margin to 4%?.

Typically re-competes do not have an investment, because we're already on the contract. You get the benefit of that, correct..

Okay. And then just to be clear on other opportunities outside of those re-competes. How are you seeing it now? Because I heard you have some that are right now LPTA that you see going more towards best value. So if we take out these re-competes, which are going more to fixed price, will help you boost your margins, as you said.

Look at everything else, your new business and the pipeline.

Can you just tell me, again, where you see the pricing on those in terms of are they mostly fixed price and are they mostly LPTA? Any color there?.

Yeah, Bill. Specifically, when you look at the mix that's coming in, as I said earlier, you're seeing some LPTA moving over to best value. And it all depends upon the nature of the work and where the customer is, is whether this could be a fixed price or a cost plus.

As I look at the pipeline going forward, it is a really healthy mix of combination of both because you really want to have some cost plus, which is some of the traditional contracts we've had, but we're looking for more opportunities on the fixed price and best value.

So that's really the lens that I've had the team look at as going forward is to see what we can look at in that arena..

Yeah. Just to give you some color, too, ACE-IT was best value, so we won on a best-value contract. And the other two contracts, Thule and Turkey/Spain, had some sort of hybrid of LPTA. So we're competing with both dynamics, and we're winning in both.

Clearly, I think we align well with best value, so the more contracts that go best value the better because our performance is so strong, especially on contracts that we already have in our contract portfolio..

Okay.

So excluding the three that you've won stuff and excluding your re-competes, would you characterize that mix of some fixed price and costs and LPTA best value in your 4% to 5% range, or are they below that?.

Yeah.

As far as the pipeline?.

Yes..

Yeah.

If I could generally look at the pipeline excluding your re-competes coming up, are they in that 4% to 5% long-term range?.

Directionally, yes. But here is where we have to balance. You have to balance the price to win. And in our contracts what we're seeing is enough levers that give us opportunities to normalize our costs, achieve efficiencies through our operational excellence programs and then some of our contracts have cost sharing parameters.

So, if we can reduce cost as we go through the contract, the government, our customer, shares in that savings and we also share in that savings. So the dynamics of the contracts are getting much more incentive-laced. So, yes, I mean, I would expect at a minimum that we'd be in those 4% to 5% going forward..

Absolutely..

Okay. Great. Thank you..

Thanks, Bill..

Thanks, Bill..

It appears there are no further questions at this time. Mr. Hunzeker, I'd like to turn the conference back to you for any additional or closing remarks..

Well, thank you for joining us on the call today. As we discussed during our prepared remarks, we're excited to be a new company. The recent wins align directly to our strategy and help mitigate the declining Afghanistan revenue base. And we look forward to a successful 2015. Again, thank you to all our employees..

This concludes today's call. Thank you for your participation..