DLH - Noble Capital MarketsFeb 22, 2017 · revenue given DLH’s operational excellence, and the...

Feb 22, 2017

Defense

NCM

DLHC

Buy Initiation

Current Price

$5.27Target Price

$7.50

Market Capitalization 59.24M

Shares Outstanding 11.24M

Float 3.87M

Institutional Holdings 51.10%

12-month Low/High $3.09/$7.38

Average 90-day Volume 13

Fiscal Year End Sep 30

Revenues ($ MIL)

Period 2016A 2017E 2018EQ1 16.6A 26.1AQ2 16.9A 28.0EQ3 25.0A 32.0EQ4 27.1A 30.5E 85.6A 116.6E 123.0E

EPS ($)

Period 2016A 2017E 2018EQ1 (0.02)A 0.05AQ2 0.05A 0.09EQ3 0.11A 0.17EQ4 0.06A 0.14E 0.22A 0.43E 0.48E

DLHInitiation of DLH Holding Corp Coverage With Buy Rating

Unique Buy Opportunity. DLH represents a unique, and fundamentally undervalued, investment opportunity as a pure play government services provider focusing on critical areas of healthcare markets with federal agencies like the VA, DoD, HHS and CDC.

Organic Growth in Low Growth Sector. The niche within critical areas of the federal healthcare system provides meaningful growth drivers over both the near term and long term given projected healthcare spending trends. These trends, along with a history of operational excellence, enable the prospect of mid single digit organic growth, before potential new contract wins that could propel growth to double digits.

Clear Visibility and Reduced Risk. With a $233 million backlog and stability provided from two flagship contracts, DLH has a solid foundation and clear top line visibility, while bipartisan approval of many of the initiatives DLH provides support for reduces the risk profile of the contract base below that of the peer group.

Balance Sheet and Cash Flow Strength. DLH is well positioned with a healthy balance sheet to continue pursuing accretive acquisitions, and solid operating margins coupled with significant tax assets are drivers of meaningful levels of free cash flow.

Upside Potential. We are initiating a Buy rating with a twelve month price target of $7.50, representing a 40% premium over current share prices of $5.27. This target includes the company’s meaningful tax assets and represents an EV/EBITDA multiple of 10.0 times, in line with their peer group.

Equity ResearchMark Jordan, CFA, Senior Research Analyst, Government Services, Defense Technology (314) 687-1074 [email protected]

Ben Klieve, CFA, Associate Analyst (561) 997-8947 [email protected]

Noble Capital Markets, Inc.Trading: (561) 998-5489 Sales: (561) 998-5491 www.noblecapitalmarkets.com

Refer to the last two pages for Analyst Certification & Disclosures

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Summary of Investment Thesis/Valuation

We have initiated coverage on DLH with a Buy rating due to our belief that the company is uniquely positioned within the government services industry to deliver outsized organic growth while maintaining a lower risk profile than their peer group given the nature of their contract base. As a provider of services to the healthcare community, we believe DLH is poised to achieve long term growth in excess of peers given the expectation of long term increases in healthcare spending, particularly within the Department of Veterans Affairs, which comprises roughly 60% of revenues. Not only does the contract base provide the potential for outsized growth, it also reduces political risk innate within the government services sector due to the levels of bipartisan support for the initiatives DLH provides support. Management has a clear focus on value creation, which is seen in the financials, creating what we believe to be a meaningful potential for sustainable growth and profitability along with strong free cash flows.

We are establishing a twelve month price target of $7.50, representing a 40% upside from current market prices of $5.35. This target is based on projections for fiscal 2018, which calls for EBITDA of $10.2 million and a net debt position of $16.0 million, down from $18.9 million ending the first quarter of fiscal 2017. We also assume $1.05 of tax benefits that should shelter the company from meaningful cash taxes for at least five years. Finally, our target assumes an EV/EBITDA multiple of 10.0x, which is in line with industry peers.

Significant highlights are as follows:

Organic Growth Possibilities – Given historic and projected health spending trends within the VA, DoD and HHS, mid-single digit organic growth expectations are reasonable and in excess of their peer group.

Backlog and Pipeline – With a $233 million pipeline as of the first quarter of fiscal 2017 and a $500 million bid pipeline, DLH has both clear visibility of near term revenues and meaningful opportunities to drive long term growth to double digit levels.

Lower Risk Profile – While revenue concentration would usually indicate greater risk, the significant penetration in the bipartisan supported VA and Head Start program provides lower political risk than their peer group. Furthermore, DLH has no meaningful revenues derived from either the politically contentious Affordable Care Act or unstable war related contracts.

Margins At Or Above Industry – Immediately following the integration of Danya, Gross Margins improved 400 to 500 basis points a range of 22% to 23%, while Adjusted EBITDA margins improved 300 basis points to roughly 8%. These are in line with their peer group, and further enhancements are possible from both organic revenue growth prospects and the further integration of Danya.

Healthy Balance Sheet Providing Flexibility – With a Net Debt/Forward EBITDA ratio of 2.0x, management maintains flexibility to seek accretive acquisitions.

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DLH DLHC | CURRENT PRICE $5.27 | Buy | 02/22/2017Mark Jordan [email protected] (314) 687-1074 | Ben Klieve, CFA [email protected] (561) 997-8947

Tax Assets and Free Cash Flow Generation – Tax assets of $1.05 per share will shelter cash taxes for at least five years, which combined with healthy margins and a reasonable debt level provide meaningful free cash flow generation potential.

Meaningfully Undervalued – At $5.35, shares are valued at an EV/EBITDA level of 7.0x and P/Adjusted Earnings basis of 11.0x, below industry peers of 10.1x and 14.3x, respectively.

Business Overview

DLH is a pure play government services provider with a primary focus on providing program management and technology solutions to healthcare process outsourcing for federal agencies like the VA, HHS, DoD and CDC, with the VA and HHS providing approximately 90% of revenues. The May, 2016 acquisition of Danya greatly expanded the scope of the business, particularly within the Department of Health and Human Services. A summary of DLH’s two flagship contracts and other business is as follows:

VA Consolidated Mail Outpatient Pharmacy (CMOP) – The CMOP program is legacy DLH’s flagship contract, filling 100% of the VA’s mail order prescriptions. With nearly 500,000 daily prescriptions being filled, DLH has been able to meet the ever increasing demand for these services throughout their seventeen year history on this contract. DLH has consistently provided superior results compared to their peers, winning the J.D. Power award for the highest overall satisfaction of all CMOP programs every year since 2010. We crudely estimate the CMOP program to be 35% of the company’s top linr, and, believe this will continue to be highly sticky revenue given DLH’s operational excellence, and the VA’s ability to efficiently control costs using DLH services. While modest scope expansion is possible, growth within the CMOP program is expected to primarily be derived from the increasing demand for pharmaceutical services from a growing and aging veteran population.

Head Start Program – Legacy Danya’s flagship contract is with the HHS’s Head Start program, providing monitoring services nationwide to ensure the efficient and effective delivery of critical healthcare and educational services. As a federally funded but regionally managed program, this system demands highly effective monitoring systems. We estimate the Head Start program to contribute roughly the same to the top line as the CMOP program at 35% of overall revenues. With the current five year contract continuing through 2020, this program again provides DLH with what we consider to be sticky revenue into the long term. While there is modest scope expansion possible, unlike the CMOP program there is not a visible catalyst for long term growth within this program.

Other Non-Flagship Programs – A series of smaller contracts with various government agencies comprises the remainder of DLH business. Management focuses on core competencies of program management and technology based solutions for healthcare delivery within the VA, DOD, HHS and CDC. Examples of services provided include logistics support for medical readiness of combat troops, physical/behaviorial health examination to support veteran transition to civilian life and advancing disease prevention methods. We believe much of this non-flagship business also has meaningful growth prospects and a lower than average risk profile

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given the steadily increasing need for healthcare solutions and government outsourcing. Most of the $500 bid pipeline is outside of the two flagship programs, with one bid outstanding being considered transformative, representing roughly $100 million to $125 million of the total pipeline. The remainder of the pipeline is a series of $30-$100 million contract bids, any of which could have a meaningful impact on the top and bottom line given DLH’s relatively small size.

Financial Overview

DLH maintains a strong balance sheet with a net debt position of $18.9 million relative to equity of $32.6 million and estimated fiscal 2017 EBITDA of $9.3 million. Net debt has been reduced by $13 million since the Danya acquisition nine months ago. With a healthy balance sheet, continued deleveraging is expected but management will have the flexibility to seek accretive acquisitions should opportunities arise.

In May, 2016, DLH utilized $32.5 million of debt to fund the $39 million acquisition of Danya. By December, 2016, at the end of the first quarter of fiscal 2017, debt had been reduced to a very reasonable $21.3 million. This debt is currently variable at LIBOR + 3%, and DLH maintains nearly $15 million of available credit under the existing facilities, with monthly principal payments due until maturity in May, 2021. Debt/Adjusted EBITDA levels of roughly 2.0x are well under covenants of 3.0x. We believe existing debt is at very affordable levels, and feel that access to additional debt should enable management to be opportunistic with regards to growth initiatives.

Important to our valuation is the presence of meaningful tax assets which we estimate at a current value of $1.05 per share derived from two sources. First, $11.4 million of deferred tax assets have been realized on the balance sheet, which we discount 20% to get a present value of $9 million, or $0.75 per diluted share. Second, nearly half of the $39 million Danya acquisition will be utilized to shelter income for up to 15 years. Assuming a statutory tax rate of 35%, with a 40% discount rate due to the long timeframe, we estimate a present value of roughly $4 million, or $0.30 per diluted share. We assume utilization of this asset through the remaining three quarters of fiscal 2017 with $0.88 per diluted share remaining at fiscal year end, which is included in our $7.50 price target.

Notable to DLH’s financial structure is a significant investment from Wynnefield Capital, who owns 42% of outstanding shares as of the end of fiscal 2016. A long time investor in DLH, Wynnefield also provided a bridge loan to help facilitate the Danya acquisition which was quickly retired. Wynnefield has consistently been proven to act in the best interests of DLH, and while their ownership is significant we maintain a favorable view of their partnership.

DLH is able to generate high quality earnings, with operating cash flows 1.75 times net income in fiscal 2016. With fiscal 2017 representing the first full year of the utilization of tax assets, this could improve even further. While the first quarter saw modest growth in working capital due to an increase in accounts receivable, existing working capital levels are expected to be maintained given the current contract base. While CapEx may be

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slightly higher than the long term run rate in 2017 due to ERP initiatives, minimal CapEx is expected in the long run, providing meaningful free cash flow levels.

Outlook for 2017 and 2018

Fiscal 2016 saw a steadily improving margin profile due to operational improvements and the integration of higher margin Danya business. On a September fiscal year, the company has reported results from the first quarter of fiscal 2017, which saw the continued integration of Danya business and enhanced margins on a year-over-year basis. The final top line impact of Danya is still to be determined as management determines the extent of lower margin awards. We look for mid single digit organic top line growth through fiscal 2018, and Adjusted EBITDA margins in excess of 8%. The development of an ERP system will lead to CapEx for fiscal 2017 of roughly $1.5 million, which is $1.0 million in excess of a normalized run rate. Beyond this expenditure, we do not expect any additional cash flow requirements through fiscal 2018, barring any significant new contract awards.

Management Overview

DLH has strong and experienced management, with what we believe to be a clear strategic vision based on value generation rather than growth for the sake of growth. A patient M&A strategy gives us confidence in their ability to create accretive inorganic growth, while a value oriented bid strategy gives us confidence in their pipeline generating high quality revenues in the future. A summary of management biographies is as follows:

Zachary Parker (President, CEO and Chairman of the Board) - Zach Parker is president, chief executive officer, and board director of DLH. Prior to joining DLH, Mr. Parker held positions with leading government services organizations within Northrop Grumman Corporation, VT Group, GE Government Services (now Lockheed Martin), and VSE Corporation. He has accomplished an outstanding track record for transitioning and profitably growing businesses having held positions including company president and executive VP for business development with the VT Group; Executive director, western region operations manager, and corporate account manager for Northrop Grumman (included Litton and PRC); and facility and program manager positions with GE and VSE Corporation.

Kathryn JohnBull (Chief Financial Officer) - Kathryn M. JohnBull joined DLH as Chief Financial Officer in 2012. From January 2008 to June 2012, Ms. JohnBull served as a senior financial executive with QinetiQ North America, a wholly-owned subsidiary of QinetiQ Group, PLC, a publicly- traded, U.K. - based provider of defense, technology and security services and solutions, including serving as the Senior Vice President/Chief Financial Officer of its Mission Solutions Group until February 2011 and subsequently as the Senior Vice President - Finance for QinetiQ North America's overall corporate operations. Prior to her tenure at QinetiQ, Ms. JohnBull served as the Operations Segment Chief Financial Officer of Maximus, Inc., a publicly-traded provider of business process outsourcing, consulting and systems solutions from August 2002 toDecember 2007. Ms. JohnBull has nearly 30 years of experience in finance and has been involved specifically in the defense and

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government services industries since 1988 working for organizations such as United Defense, BDM International, Inc. Maximus, Inc. and QinetiQ North America.

Kevin Wilson (President of DLH Solutions) - Kevin Wilson was appointed as the President of our subsidiary DLH Solutions in October 2008, previously serving as the Director of DLH Solutions from June 2007 through September 2008. From January 2004 to June 2007, Mr. Wilson served as the Director of Strategic Alliances of government services provider SAIC, Inc., where he was responsible for business development in the domestic and foreign defense markets. From March 1997 to January 2004, Mr. Wilson was the Program Manager for a multiyear defense services contract with Endress Hauser Systems & Gauging. Mr. Wilson also worked at Tracer Research Corporation from January 1990 to March 1997, where he was Project Manager for the United States Air Force, Air Combat Command professional services contract. Mr. Wilson holds a B.S. in Business Marketing from Northwest Missouri State University.

Helene Fisher (President of Danya International, LLC) - Prior to joining DLH Danya, Ms. Fisher held leadership positions with MAXIMUS Federal Services including responsibility for operations and program performance of a major initiative for the U.S. Department of Health and Human Services and several Federal civilian agencies. Prior to joining MAXIMUS, she led large-scale program delivery efforts for the U.S. Departments of Homeland Security, Justice, and State as well as electronic health record programs. Previously, Ms. Fisher spent 17 years with Lockheed Martin in various program management, systems engineering, information technology, customer relationship, business area management, and business development roles. Ms. Fisher holds Project Management Professional and Information Technology Infrastructure Library certifications. She is a United States Army Signal Corp Veteran. She earned a Bachelor of Science degree in Mathematics/Computer Science from Prairie View A&M University, and a Master of Arts degree in Computer Information and Resources from Webster University.

Valuation Overview

We have established a twelve month price target of $7.50 per share, based on our fiscal 2018 estimates. This target represents 40% upside from current values of $5.27. This valuation makes the following assumptions:

Fiscal 2018 Adjusted EBITDA of $10.2 million, representing an 8.3% margin, in line with post-Danya results and fiscal 2017 expectations.

A net debt position ending fiscal 2018 of $16.0 million, representing a modest decrease from the $18.7 million at the end of the first quarter of fiscal 2017

Tax assets estimated at a present value of $1.05 per share, which are expected to shelter meaningful cash tax payments for at least five years. Of the $1.05 per share of assets, approximately $0.75 per share are reflected in deferred tax assets on the balance sheet with an additional $0.30 per share assumed via tax deductibility from the Danya acquisition.

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An EV/EBITDA multiple of 10.0x, representing the average of the government services peer group. This target also reflects a 15.6x P/Adjusted Earnings ratio, which is in line with the industry average when excluding outliers.

For a comparative analysis of the peer group and relative valuations, please see Figure 1 below:

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Company Profile

DLH Holdings Corp. is a pure play government services provider of professional healthcare and social services to various government agencies, with concentrations in the Department of Veterans Affairs, Department of Health and Human Services and Department of Defense. Their 1,400 nationwide employees provide a range of healthcare services, program management and delivery services to support many government programs, including Head Start and the VA CMOP program.

Valuation Summary

We are initiating a $7.50 twelve month price target for DLH, which represents an EV/EBITDA multiple of 10.0 times. We assume fiscal 2018 Adjusted EBITDA of $10.2 million, and a modest reduction in net debt from $18.8 million as of the first quarter of fiscal 2017 to $16.0 million ending fiscal 2018. We also consider the impact of the estimated $1.05 present value of tax assets, which should shelter DLH from meaningful cash taxes for at least five years.

Risks to investment include: Revenue concentration within the VA CMOP and Head Start program; presence of a single large shareholder; Integration risk of the May, 2016 acquisition of Danya; Government regulations; Delays and/or cuts to Federal budgets.

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GENERAL DISCLAIMERSAll statements or opinions contained herein that include the words "we", "us", or "our" are solely the responsibility of Noble Capital Markets, Inc. ("Noble") and do not necessarily reflect statements or opinions expressed by any person or party affiliated with the company mentioned in this report. Any opinions expressed herein are subject to change without notice. All information provided herein is based on public and non-public information believed to be accurate and reliable, but is not necessarily complete and cannot be guaranteed. No judgment is hereby expressed or should be implied as to the suitability of any security described herein for any specific investor or any specific investment portfolio. The decision to undertake any investment regarding the security mentioned herein should be made by each reader of this publication based on its own appraisal of the implications and risks of such decision.

This publication is intended for information purposes only and shall not constitute an offer to buy/sell or the solicitation of an offer to buy/sell any security mentioned in this report, nor shall there be any sale of the security herein in any state or domicile in which said offer, solicitation or sale would be unlawful prior to registration or qualification under the securities laws of any such state or domicile. This publication and all information, comments, statements or opinions contained or expressed herein are applicable only as of the date of this publication and subject to change without prior notice. Past performance is not indicative of future results.

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IMPORTANT DISCLOSURESThis publication is confidential for the information of the addressee only and may not be reproduced in whole or in part, copies circulated, or discussed to another party, without the written consent of Noble Capital Markets, Inc. ("Noble"). Noble seeks to update its research as appropriate, but may be unable to do so based upon various regulatory constraints. Research reports are not published at regular intervals; publication times and dates are based upon the analyst's judgement. Noble professionals including traders, salespeople and investment bankers may provide written or oral market commentary, or discuss trading strategies to Noble clients and the Noble proprietary trading desk that reflect opinions that are contrary to the opinions expressed in this research report.

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Company Specific DisclosuresThe following disclosures relate to relationships between Noble and the company (the "Company") covered by the Noble Research Division and referred to in this research report. The Company has attended Noble investor conference(s) in the last 12 months.

Noble intends to seek compensation for investment banking services and non-investment banking services (securities and non-securities related) within the next 3 months. Noble is not a market maker in the Company.

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WARNINGThis report is intended to provide general securities advice, and does not purport to make any recommendation that any securities transaction is appropriate for any recipient particular investment objectives, financial situation or particular needs. Prior to making any investment decision, recipients should assess, or seek advice from their advisors, on whether any relevant part of this report is appropriate to their individual circumstances. If a recipient was referred to Noble Capital Markets, Inc. by an investment advisor, that advisor may receive a benefit in respect of transactions effected on the recipients behalf, details of which will be available on request in regard to a transaction that involves a personalized securities recommendation. Additional risks associated with the security mentioned in this report that might impede achievement of the target can be found in its initial report issued by Noble Capital Markets, Inc.. This report may not be reproduced, distributed or published for any purpose unless authorized by Noble Capital Markets, Inc..

U.S. CLIENTSFor purposes of distribution in the United States, this report is prepared for persons who can be defined as "Institutional Investors" under U.S. regulations. Any U.S. person receiving this report and wishing to effect a transaction in any security discussed herein, must do so through a U.S. registered broker or dealer. Noble Capital Markets, Inc. is a U.S. registered broker dealer.

RESEARCH ANALYST CERTIFICATIONIndependence Of ViewAll views expressed in this report accurately reflect my personal views about the subject securities or issuers.

Receipt of CompensationNo part of my compensation was, is, or will be directly or indirectly related to any specific recommendations or views expressed in the public appearance and/or research report.

Ownership and Material Conflicts of InterestNeither I nor anybody in my household has a financial interest in the securities of the subject company or any other company mentioned in this report.

> NOBLE RATING DEFINITIONS % OF STOCKS COVERED % OF IB CLIENTS

BUY: potential return is >15% above the current price 57% 39%

HOLD: potential return is -15% to 15% of the current price 30% 5%

SELL: potential return is >15% below the current price 0% 0%

Additional information is available upon request. Any recipient of this report that wishes further information regarding the subject company or the disclosure information mentioned herein, should contact Noble Capital Markets, Inc. by mail or phone.

Noble Capital Markets, Inc.225 NE Mizner Blvd. Suite 150Boca Raton, FL 33432561-994-1191

Noble Capital Markets, Inc. is a FINRA registered broker/dealer.Member - SPIC (Securities Investor Protection Corporation)

Report ID: 9734

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DLH - Noble Capital MarketsFeb 22, 2017 · revenue given DLH’s operational excellence, and the...

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