DLH Holdings Has A Path To More Upside

Summary

• Federal government contractor DLH has executed an impressive turnaround, with a multi-year history of revenue growth and margin expansion.
• Growth continues, including in a strong fiscal Q1 (December) quarter.
• Valuation is reasonably high, and federal government risk seems an issue.
• But DLH's key programs seem relatively well-positioned, and a continuation of the strategy should lead to more upside - as long as current trends hold.

Micro-cap government contractor DLH Holdings (NASDAQ:DLHC) has executed an impressive turnaround over the past few years:

Source: DLH Q4 earnings call presentation

That said, the market has noticed:

DLHC data by YCharts

And I wrote early last year that DLHC seemed to have priced in the turnaround - and then some. The 2016 acquisition of Danya added scale, and diversified the company away from a ~95% reliance on the Department of Veterans Affairs. But DLHC didn't look particularly cheap, particularly given still-heavy concentration and potential risk from the new Administration in D.C.

But fifteen months later, with DLHC at pretty much the same price, I'm more intrigued. DLH's business continues to improve, despite some concerns on the margin front. Existing programs seem relatively safe, and investments made of late should set the company up for further top line growth going forward. A strong fiscal Q1 report in February supports the case as well.

The question at the moment is whether DLHC is quite compelling enough to put money behind. But with the valuation relatively reasonable on a free cash flow basis, M&A optionality, and steady revenue growth, there's enough to at least give the stock a long look, and to expect that DLHC's upward trend will resume at some point.

Strong Results And The Bull Case

The case for DLHC, at its core, is that current trends are going to hold. Organic revenue in FY17 (ending September) rose 6.3%, per figures from the 10-K. The K cites increased spending on existing contract, and management has mentioned help from smaller, one-off deals, over the past few quarters.

Growth then accelerated to an impressive 15.7% (all organic, as the Danya deal has been lapped) in Q1. Per the Q1 call, there was a bit of one-time help, including the slippage of Head Start revenues from Q4 into Q1 and some new work with the CDC (Centers for Disease Control). But Q1 looks like a continuation of the performance over the past few years, which has resulted in a ~13% organic top-line CAGR over the five years before the quarter.

The broad performance is a validation of DLH's strategy as well. The company continues to target higher-margin opportunities, and gross margin expanded 150 bps in FY17 after a 290 bps expansion the year before. G&A did deleverage 50 bps last year, but it leveraged 190 bps in Q1. And some of the increase is coming as the company invests in tech and data applications, which in theory should set it up for more wins and expanded revenue within the existing contracts. Management has been very optimistic toward the pipeline on recent calls, though the budget impasse in D.C. has led to a bit of a slowdown in project acceptance.

While organic growth should continue, inorganic growth remains an option. DLH has made no secret of its desire for M&A, and in recent calls has said valuations are relatively reasonable for its targets. The company has $10 million in availability on its revolver, and while a transformative deal probably isn't on the table, there is room to make another material purchase.

So DLH should be able to keep grinding out growth going forward. As the company detailed in the K, defense contractors are focusing more on higher-margin military offerings, perhaps opening room for DLH to expand within the VA and in counseling programs for the DoD (Department of Defense). The efforts to move to more value-added projects - which help margins - clearly are working.

DLH has a 100% re-compete win rate over the past six-plus years, per CEO Zach Parker on the Q4 conference call, meaning the existing book of business should be protected. Those projects alone aren't going to post torrid growth, obviously, but DLH should be able to keep profits stable in the worst-case scenario, with upside optionality from winning new business and/or accretive M&A.

Depending on how an investor views the valuation here, that case is probably good enough to suggest a "heads, I win, tails, I don't lose much" argument here. And that appears to be broadly correct - because while there are risks here, they appear at worst much more manageable than an investor might think at the moment.

The Risks

The most obvious risk when it comes to DLHC is the company's concentration in terms of customers, and the potential impact of losing a key contract. 100% of revenue comes from the federal government, and DLH has shown no inclination to look toward the private sector. (Parker said on the Q2 FY16 call that the company would remain "within our lanes of the federal government space.")

The government exposure is amplified by the fact that nearly all of DLH's revenue comes from two customers. 62% of FY17 revenue came from the VA, a significant (but unspecified) portion of which comes from DLH's administration of the agency's mail-order pharmacy program (CMOP). Another 34% comes from HHS (Department of Health & Human Services), principally through Danya, which monitors providers under that agency's Head Start program.

Losing one of those programs would be a massive blow. But the company's re-compete history and strong relationship with the VA would seem to minimize the risk of such a loss with that agency. (VA-related revenue rose ~16% in FY17, based on figures from the 10-K; that growth seems likely to be organic, not acquired.) As far as Head Start goes, the program covers thousands of providers and Danya has a multi-year relationship, so a loss there, too, seems unlikely.

Obviously, there's also the risk that the programs themselves could be cut - or even disbanded. Indeed, I worried about the Head Start program a year ago, amid the transition in the White House. Conservatives long have criticized Head Start, and switching to block grants is a "perennial conservative education policy idea." Those block grants almost certainly would end Danya's federal contract; recapturing similar business at the state level would come at great expense and result almost certainly in some revenue erosion.

The news on this front looks a bit mixed at the moment, but net positive. (DLH management has described the political situation as "neutral to positive across the board," as Parker put it on the Q3 call; I'm not quite that optimistic but it's a reasonable description.) Head Start got a big increase in the recent budget deal. And conservative orthodoxy doesn't seem to be holding a lot of sway at the moment, particularly with rumors that Paul Ryan is headed for retirement.

But it's worth noting that Trump's budget originally had significant cuts to the Head Start program. The risk to that side of the business - which is probably at least a quarter of overall revenue, and given Danya's higher margin profile, potentially a greater share of profits - still exists.

The VA business looks to be in much better shape. Funding is increasing, and the department has support from both sides of the aisle. Privatization of the agency remains a goal of some on the right, but such a sweeping measure seems highly unlikely to pass. DLH also has a contract with the Navy to provide drug and alcohol counseling services, and expanded funding to fight opioid abuse in the U.S. could offer new opportunities for DLH in HHS and the VA.

Net/net, it would seem more likely that DLH's opportunities would expand rather than contract. And the loss of a contract seems reasonably unlikely. DLH's relationships with its two key agencies look strong enough for the company to continue its run.

That said, there does appear to be a concern relative to Danya. Pro forma figures from the FY16 10-K suggest that revenue actually declined year-over-year in FY17. That decline appears to have come from Danya, which generated $47 million in revenue in the year ending September 30, 2015 - but added just ~$41 million in FY16 and FY17, per the respective annual filings. Pro forma Adjusted EBITDA for FY15 was $9.53 million; the figure two years later was $9.3 million.

DLH hasn't publicly addressed any weakness there, and it's possible that a dip was expected: Danya sold itself for ~6x CY15 EBITDA, according to the acquisition presentation. And so far, growth in the legacy business has been good enough. Overall profit weakness can be explained somewhat by investments, including ~$1 million in tech-related spend and a ~$600K one-time bump in Q4 incentive comp. Even if Danya has been a bit weak of late, there's enough to see profit growth and EBITDA margin expansion going forward as those investments pay off and/or come off the books.

Valuation

The story here looks good at the moment, but valuation is more of a mixed bag. On an EV/EBITDA basis, DLHC is trading at 9.3x. (That multiple is based on Adjusted EBITDA, which backs out share-based comp; the company switched back to EBITDA after Q1.)

That seems reasonably cheap for the space. Booz Allen Hamilton (BAH) trades at about 12x March 2018 EBITDA. CACI International (CACI) is at about 11.5x FY18 numbers (ending June). Leidos (LDOS) and SAIC (SAIC) are in the same ballpark.

But DLHC's micro-cap nature and program concentration would seem to imply a lower multiple. And, again, DLH paid 6x for Danya, which implies either a phenomenal price or a peer-level multiple for the legacy business. Meanwhile, NCI Inc., another small government provider (albeit one with almost three times the revenue of DLHC) went private last year at 9.5x. 9x+ would seem to leave limited room for much in the way of multiple expansion.

Looked at another way, however, DLHC seems closer to cheap. Assuming $10 million in EBITDA this year - which implies a noted deceleration from the 57% growth posted in Q1 - normalized free cash flow is about $6.2 million. Net income is about $5.2 million (capex is much lower than D&A). Those figures suggest a 12x P/FCF multiple and a 14-15x P/E to FY18 results. And it's not as if leverage is driving those multiples; the ratio should be below 1.5x as of Q2 after a debt payment in January.

Relative to the overall growth of late, both multiples seem a bit light. At the least, even stable free cash flow suggests DLHC should be able to hold the $6 range, and maybe even grind out some equity upside with some deleveraging help and/or M&A. Double-digit EBITDA growth - even with no multiple expansion - drives mid-teen annual appreciation in the equity. And with a new win or two and/or another acquisition, there's room to see significant upside.

Again, there are risks, and a somewhat odd 8%+ gain on Friday and a recent ~12% rally from an eight-month low in late March eat up some of the potential gains. But there's still a nice case for DLHC in the low $6 range: the risks look reasonably priced in, but the upside very well might not be.

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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.