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Industrials

Business Services

DLH Holdings Corp.

On August 22nd, Noble Capital Markets hosted CEO Zach Parker and CFO Kathryn JohnBull for a web-based NDR with institutional investors. Highlights of the meeting included:
Organic Growth Delivering 
Significant Organic Growth Becoming A Trend.&nbsp;The past five quarters have seen organic growth averaging nearly 17%, attributable to both new awards and expanding services on existing contracts. While these levels are likely unsustainable into the long term, given DLH&#8217;s positioning in the federal healthcare space that is driven largely by demographic trends, we expect organic growth to continue to be in excess of government services peers.&nbsp;
Some Uncertainty Surrounding the VA CMOP Program.&nbsp;The VA is considering adopting the &#8220;Rule of Two&#8221; provision for the CMOP program, which would could restrict competition of Prime positioning to veteran owned businesses. There are a number of possible outcomes which are still uncertain, as is the timing of developments. It is important to note that while the program is meaningful from a top line perspective, which we estimate to be roughly one third of the overall business, it is by nature lower margin work. Based on margin structure of the business before the Danya acquisition, we believe the business is a low single digit operating margin producer, and a low to mid single digit producer on an EBITDA basis. While we certainly hope for DLH to maintain a sizable position on this program, should the scope of its work meaningfully decrease we do not believe this would be as significant from an EBITDA basis as it would be on a revenue basis. As such, a meaningful decrease in scope would not fundamentally alter our value proposition.
Strong Visibility from Head Start&nbsp;Program.&nbsp;Seasonally high activity&nbsp;in the Head Start program helped drive fiscal third quarter revenues to a meaningful beat of&nbsp;$36.1 million in revenue relative to our estimate of&nbsp;$32 million. Fortunately stability from this program will offset uncertainty from the CMOP program, as recompete risk is expected to be nominal for at least a couple of years. While fourth quarter revenue will likely be modestly down from the particularly strong third quarter, we believe this program will provide the company with a solid platform to grow on in 2019.
<div>Revenue Outlook. We believe fourth quarter revenue will benefit from service expansion on existing contract vehicles during this past quarter, and we estimate growth on a year-over-year basis to be close to double digits. Looking into fiscal 2019, we think mid to high single digit revenue growth can be delivered with meaningful potential for a revenue beat should the pipeline deliver.&nbsp;</div>
<div> </div>
<div>Inorganic Growth Potential</div>
Balance Sheet Transformation.&nbsp;Following the Danya acquisition in 2016, DLH&#8217;s net debt levels reached its high-water mark at nearly $24 million, but has fallen to $7 million in the eight quarters since. Current levels represent .7 times TTM EBITDA, and .6 times on a forward basis. Given this nominal debt position and signficant free cash flow generation potential, we believe DLH is well positioned to make an acquisition at any time. We expect the debt capacity to be roughly 4.5 trailing EBITDA or 3.5 forward EBITDA to safely receive reasonable borrowing terms. Using the Danya acquisition multiple and margin profile, we believe DLH could conservatively acquire an $80 million revenue business and remain within while remaining within these debt levels.
A Three Fold Acquisition Vetting Process.&nbsp;We believe the acquisition of Danya was a home run, and this success gives us confidence in management&#8217;s ability to further capitalize on the industry&#8217;s active&nbsp;M&amp;A environment. Currently, the government services industry is a fractured space undergoing an aggressive period of consolidation. This environment provides DLH with ample opportunities for accretive inorganic growth. Given the fractured market, management can take a patient&nbsp; approach when considering targets that pass the three fold vetting process. First and foremost, DLH intends to stay in their lane only considering targets whose operations fall within their core competencies in the government health services and IT space while also adding differentiated capabilities. Second, the newly acquired work must have a healthy funding tail that provides sufficient budget visibility for the target&#8217;s existing contract vehicles. Third, DLH assesses the degree of re-compete risk that they would experience with the newly acquired work.&nbsp; 
Moving Up the Value Chain.&nbsp;An acquisition that meets the standards outlined above would coincide with the company&#8217;s strategic focus on pursuing high value work.&nbsp;We expect the next move to be a continuation of the progress achieved in the Danya acquisition, in that Danya brought new tech enabled capabilities, expanded the customer base and enhanced legacy DLH margins. Where historical gross margins on legacy work have been constrained to the mid-teen level, newly acquired work has brought in gross margins of over 20% and we expect any further acquisitions to do the same. Given the success of the Danya transaction, we have confidence in management&#8217;s approach to M&amp;A activity.&nbsp;
Near Term Buyers, Long Time Takeover Target? While a $130 million business today, we believe within two to three years DLH could be a $250 business through both organic and inorganic initiatives. Should this growth be met, and margin structures continue to be in line with the larger government services peers, we believe DLH could represent an attractive takeover target for peers looking to gain exposure in the attractive federal healthcare space. 
GAAP Figures Mute Strong Growth.&nbsp;On a GAAP basis, profitability growth has not matched top line growth. However, after adjusting for non cash taxes and acquisition related expenses, Adjusted EPS growth has closely followed the strong performance on the top line, as seen below in Figure 1.
<img decoding="async" src="https://www.noblelinx.com/x/research/images/reports/DLHCGrowthVisual.JPG" /> 
 
Investment Thesis
DLH&#8217;s current organic growth momentum combined with its inorganic growth potential drives our positive outlook and Outperform rating. We believe DLH represents a unique microcap investment in the government services space that is gaining ground on larger peers, and is positioned to accelerate their improvement with an accretive acquisition. We reiterate our $8.25 price target and find that DLH is meaningfully discounted on a forward looking P/FCF, and an EV/Adjusted EBITDA basis. Our price target of $8.25 represents a P/FCF of 11.0x and an&nbsp;EV/Adjusted EBITDA multiple of 8.9x based on our 2019 forward looking estimates. See Figure 2 below for our free cash flow estimates.&nbsp;
 <img decoding="async" src="https://www.noblelinx.com/x/research/images/reports/DLHCFCFVisual.JPG" />

DLH Holdings Corp. (DLHC)

Moving Up the Value Chain

Fundamental Analysis:

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Post Call Commentary: Ready to Pounce (DLHC)

Better Than Expected Third Quarter Results (DLHC)

Post Call Update (DLHC)

Releases 2Q23 Results (DLHC)

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