Description

TL;DR Debt to equity transfer on significant debt reduction over the next few years unlocking substantial valuation discount to public and private peers with proven, aligned management team and highly defensive recurring revenue

Risk price: $8.85 (5 x 2024E EBITDA, trough multiple last ten years)

Reward price: $28.00 (10x EV/2024 EBITDA, 8.5% FCF Yield to Equity, 1-5x discount to public/private comps)

Reward/risk ratio: 6.0x

Background

DLH Holdings (NDAQ: DLHC) is a government services contractor that has been transformed under current management.  The company was a small, mismanaged government service business in 2010 when the current management, led by CEO Zach Parker, took over the company following a recapitalization effort led by small-cap investor Wynnefield Partners.  Kathryn Johnbull, the current CFO, joined shortly after the recapitalization effort.  The company was an overlevered penny-stock at the time of the recapitalization and appointment of new management.

Under current leadership, the company has pursued a disciplined acquisition strategy targeting government programs that expand the scope of work DLH can pursue.  DLHC has a multi-year track record of organic and inorganic growth.  The company has grown contracted revenue by high-single digits over the past 10 years and executed on several acquisitions that diversified revenue, offered tax benefits through the depreciation of acquired assets and were accretive to earnings.  With acquisitions, the company has grown in the high-teens range.  DLHC funds acquisitions with attractively priced debt and does not dilute shareholders through the issuance of equity.  Management is aligned with equity investors, with insiders owning >40% of the company. 

Notably the company was a beneficiary of COVID related work.  In the fall of 2021, they announced multiple awards for FEMA related work staffing nurses in Alaska that ultimately totaled more than $125mm in revenue and $12.5mm in operating income to the company.  This caused the stock to crest $20/share.  As these contracts rolled off, the stock drifted to where it is today in the $10-$12/share range. 

History of M&A

The company is a disciplined acquirer of assets that diversify the end-market exposure of the company, add technical capabilities, make financial sense and possess long-term, durable bipartisan contracts with departments in the US government.  The company structures these acquisitions as asset purchases, allowing them to amortize the intangibles and limit cash taxes over an aggressive debt paydown schedule.  The acquisitions are typically funded exclusively with debt that the company works on paying down quickly, with a track record of outperforming the debt paydown schedule laid out at the time of acquisition.  Assets routinely trade in private equity in the 9-13x EBITDA range given the durable, long-term nature of the contracts and government counterparty risk. 

• Social and Scientific Systems (SSS) – acquired in August of 2019 for $70mm in total consideration, 11x EBITDA pre-synergies and tax benefits, 8.5x EBITDA post-synergies and tax savings, 1.1x fwd. revenue multiple.  $346mm in backlog at the time of closing largely in the HHS segment of the government, $65mm in revenue, significantly expanded public health exposure for DLHC.  Pro-forma leverage of 3.5x post the acquisition, delevered to ~2x within one year before making the next acquisition of IBA.
• Irving Burton Associates (IBA) – acquired in October of 2020 for $32mm in total consideration, 9.3x EBITDA pre-synergies and tax benefits, 7.7x EBITDA post synergies and tax savings, 1.2x fwd. revenue.  $140mm in backlog at the time of closing largely in the DoD segment of the government, $25mm in revenue, introducing DLHC’s presence in that department.  Pro-forma leverage of 3.1x post the acquisition, delevered to 0.5x within two years before making the next acquisition of GRSi.

• Grove Resource Solutions (GRSi) – acquired in December of 2022 for $185mm in total consideration including $178mm in cash and $7mm in equity to GRSi’s founder.  Purchase price of 10x EBITDA pre-synergies and tax benefits, 8.5x post-synergies and tax benefits, 1.3x fwd. revenue multiple.  Adds significant exposure to HHS and DoD, as well as prime exposure to Omnibus 3 and Omnibus 4, a $10bn procurement contract of the US Government.  $550mm in backlog at the time of closing, $140mm in revenue, 300bps margin accretive to core DLHC business as well as better organic growth characteristics (low-teens growth for GRSi versus mid-to-high single digits for DLHC).  Pro-forma leverage of 3.8x with a debt paydown schedule indicating leverage to <2x by YE2024.  The company is focused primarily on leveraging tech capabilities within the US government, so DLHC can pair their strong healthcare background with technology capabilities of GRSi to win new contracts.  Given the interest rate risk on the debt pro-forma for the deal, the company executed a $112mm floating-to-fixed interest rate swap at 8.4%.  The remainder of the debt load is floating. 

Description

The company now is diversified to end customer within the government from both a program and department perspective.  DLH targets programs that are bipartisan in orientation, limiting risk to political cuts, with a focus on fast growing parts of the federal budget: healthcare and technology.  The company has historically grown organically in the mid-to-high single digits range, with the acquisition of GRSi boosting organic growth.  Notable exposure is below:

• Department of Health and Human Services (41% of 2023E revenue) – largely diversified among programs within this department.  The largest program is the Office of Head Start monitoring program, which was recently renewed in August of 2020 for a five-year term.  This program provides monitoring and auditing of the nationwide Head Start program and its 2000+ grantees.  The HHS segment will see the most significant revenue growth YoY in 2023 driven by the GRSi acquisition.  Other contracts within this segment include studies related to the impact of the opioid and HIV crisis, pandemic preparedness and nutrition research.
• Department of Veteran Affairs (37% of 2023E revenue) – the company’s primary contract with the VA is the administration of the pharmacy benefit manager program for the department (CMOP Medical Logistics).  The company has administered the PBM business for over 20 years.  Notably, this contract has been on sole-sourced one-year bridges since November of 2016 driven by the desire of the government to diversify this program to small businesses if possible.  The program is broken down into seven geographic regions, with DLH being prime on all seven.  Given the complexity of the program and synergies from operating all seven locations holistically, it is unlikely a small business would be able to gain share in this market despite protests dating back to April of 2021.  Performance metrics from DLHC have been outstanding, further validating the sole-sourced nature of this contract.  Past the PBM work, the company administers several studies in coordination to the VA, including work analyzing traumatic brain injury, COVID related research, and precision oncology.
• Department of Defense (19% of 2023E revenue) – DLH’s exposure within the DoD is primarily related to the healthcare delivery to military personnel.  The company’s exposure is diversified among multiple contracts that are bipartisan in nature.  GRSi is also significantly exposed to the DoD, with revenue doubling within DLHC pro-forma for the acquisition. 

Through the additional scale of acquisitions and diversity of government contracts, DLHC now offers a superior EBITDA margin profile to government service peers (BAH, CACI, ICF, SAIC, LDOS) at 11.8% in 2023E versus comps in the 8-11% range.  The company offers a best-in-class organic and inorganic growth profile of high-single digits / high-teens versus comps 3-8%. 

Valuation

The company’s valuation is below.  The primary metric to value these assets is EV/EBITDA given the leverage profile and lack of capex (maintenance capex of $0.5-$1mm/year).  Free cash flow given is after capex, cash interest, cash taxes, and movements in working capital.  No further contract wins are included in revenue assumptions for the model.

The larger government service peers are the most appropriate comps from an end market perspective, including BAH, CACI, ICF, SAIC, LDOS.  However, they are significantly larger in size, which makes them less relevant.  Private market comps have traded in the 9-13x EBITDA range depending on backlog and growth characteristics.

The significant FCF generation of the DLHC business allows for equity appreciation over time.  The company’s debt paydown schedule is notably conservative.  Based on the capex, D&A, cash interest and cash taxes schedule by my model, below if the debt schedule:

The company has a strong track record of outperforming their own guidance on debt paydown in both the SSS and IBA acquisitions. 

Rolling forward the current 6.5x EBITDA multiple to 2025E EBITDA, for example, yields a $20 stock price (6.5 x 2025E EBITDA of $60.1mm – YE2025 Debt of $110mm).  Using a 10x multiple, a discount to peers, yields a $35 stock price on 2025 EBITDA. 

Catalysts

The company has won multiple large ID/IQ contracts in the past 18 months.  These contracts represent gates to trim the field of potential contract awardees to qualified bidders.  The speed of the government awarding these contracts is predictably slow, although historically these get awarded in real dollar amounts 18 months post the announcement of the ID/IQ process.  Notably, Omnibus 3 is rolling off, with the $10bn Omnibus 4 awards coming out in the next 1-2 quarters.  These contracts will likely result in quantifiable awards in the next twelve months, which should be highly accretive to equity value given they are not in the model and the debt/cap of the company. Below is the list of the recent wins of DLHC (* denotes ID/IQ wins that have not yet been awarded into quantifiable contracts, i.e. upside to the model):

8/2/2023

$85mm 5 year contract with 4 other awardees with unit of NIH

https://investors.dlhcorp.com/news-releases/news-release-details/dlh-expand-digital-transformation-services-national-heart-lung

5/15/2023

$18.6mm National Institute of Aging 1 year contract with 4 1-year extensions

https://investors.dlhcorp.com/news-releases/news-release-details/dlh-expands-its-digital-transformation-services-national

4/17/2023

$14.6mm contract for Naval Information war center - 1 year contract with 4 1-year extensions

https://investors.dlhcorp.com/news-releases/news-release-details/dlh-continue-providing-enterprise-integration-and-cyber

2/28/2023

*$1.7bn cap award from NCI for 5 years, 8 parties in total

https://investors.dlhcorp.com/news-releases/news-release-details/dlh-deliver-leading-edge-enterprise-and-specialized-information

10/6/2022

*ID/IQ $650mm for 5 year ceiling right to bid contract, nothing declared yet

https://investors.dlhcorp.com/news-releases/news-release-details/dlh-pioneer-medical-and-healthcare-technology-innovations

7/11/2022

*ID/IQ $320mm for 5 year ceiling right to bid contract, nothing declared yet

https://investors.dlhcorp.com/news-releases/news-release-details/dlh-awarded-nih-cancer-epidemiology-and-genetics-contract

6/2/2022

NIH $13mm renewal 1-year, with 4 1-year options attached

https://investors.dlhcorp.com/news-releases/news-release-details/dlh-wins-renewal-national-institute-health-contract-statistical

5/25/2022

*ID/IQ $10bn upward ceiling right to bid contract, nothing declared yet

https://investors.dlhcorp.com/news-releases/news-release-details/dlh-awarded-dha-omnibus-iv-military-medical-research-and

Further catalyst in index inclusion, given the company sits out of all major indexes, as well as wall street coverage and institutional interest assuming the stock improves in trading liquidity as the stock price goes up. 

Management

Zach Parker – CEO since 2010; 6.0% stock ownership including options

• 19 years at Northrup Gruman
• 7 years GE Government Services
• BA California State, Northridge

Kathryn Johnbull – CFO since 2012; 4.4% stock ownership including options

• SVP of Finance of QinetiQ North America, government contractor
• Operations CFO of MAXIMUS, BPO
• CPA at BDM and Arthur Anderson
• Summa cum laude University of Tulsa

Wynnefield owns 26.6% of the stock, and controls one board seat. 

Risks

• CMOP contract working on 1-year contract extensions due to bid protests, as discussed in the Department of Veteran Affairs section above
• Significant leverage for a microcap company, debt/cap of 54% and net-debt/pro-forma EBITDA of 3.7x
• Limited trading liquidity
• Significant ownership by insiders – Wynnefield has publicly expressed a desire to get to 25% ownership as % of shares outstanding from 26.6% today
• Government shutdown / incompetence – delays payment to government services contractors like DLHC, credit risk downgrade, delays bid process for new contracts
• Interest rate sensitivity - $83mm of the $195mm in total debt is floating rate at SOFR+4.2%
• Recompete risk on existing contracts coming up for renewal

Catalyst

• Further contract wins (see above)
• Index inclusion
• M&A