DLH Holdings Corp. Q2 FY2020 Earnings Call

Good day, and welcome to the DLH Holdings Corp. Fiscal 2020 Second Quarter Earnings Call. Please note, today's event is being recorded. I would now like to hand the conference over to Chris Witty, DLH Investor Relations Adviser. Please proceed, sir.

Thank you, Chris, and good morning, everyone. Welcome to our second quarter conference call. Of course, the world has changed quite drastically since we began 2020, but DLH has posted solid results in the face of these challenging economic times. If you turn to Slide 3, let me begin by providing a high-level overview of our financial performance and some color around the outlook for the rest of fiscal 2020. The company posted revenue of $54.8 million for the quarter, a new record since our restructuring, reflecting the positive contribution of the S3 acquisition as well as our organic growth across the company. While our second quarter is often strong from a top-line perspective, this year's performance was helped by additional demand for mail order prescriptions and other program services, reflecting the current COVID-19 environment. Operating income rose to $3.8 million in the second quarter, and we posted EBITDA of $5.6 million, also a new record. We generated $3.5 million of operating cash in the quarter and, as previously noted, paid down $3 million of our senior debt in January. Kathryn will discuss cash flow and our other debt position more in a moment. I'm also pleased to announce that during the quarter, the Veterans Affairs organization canceled its previously issued request for proposal for pharmacy services under our CMOP umbrella contract. As you may recall, this RFP included an additional requirement that the prime contractor would be a service-disabled, veteran-owned small business, which would have precluded us from continuing to perform as a prime contractor. After many months of consideration and analysis, the government determined that it would change the requirement and restart the solicitation process at a later date. While we do not yet know exactly how or when the revised procurement process will proceed, DLH does expect its current contracts for these services to be extended. This remains highly valued work to us, and we look forward to participating in the future process. As we adjust to the current economic conditions and the various repercussions from the onset of COVID-19, we are doing everything possible to safeguard the health of our employees and our customers, and our investors can find more information about this topic on our website or in our 8-K filings. I'll also be happy to address any of those specifically during the Q&A session. We see many opportunities to leverage our technology-enabled health care solutions and help bring relief to our country. If you look at Slide 4, we show our portfolio of national, mission-critical operations and the solutions that are well suited to the challenges of our time. Through the various agencies and markets that we serve, we're helping the U.S. attack the COVID-19 challenge and improve the lives of millions. As you can see on the slide, we are involved in a plethora of programs that help care for veterans, communicate health care strategies and emergency information, and assess medications as well as potential vaccines. I'm very proud of the work that we are doing in this arena, particularly during this volatile time in our nation's history. And we're proud of our people for their hard work and their commitment to DLH and the agencies that we serve. Turning to Slide 5, I want to shed some light on a few very specific examples of the work I just mentioned. DLH has many contracts in place across various agencies, including the National Institutes of Health, which is primarily to assess potential medications and compile data on drug efficacy. As part of the rapid mobilization to search for potential cures and vaccines related to COVID-19, we have pivoted our infectious disease activities to prioritize this pandemic. I'm sure that many of you have already read about the ongoing clinical trials for remdesivir, hydroxychloroquine and other synthetic medications that are in the news. Leveraging our clinical trials network and our strong in-house team, our preliminary analysis, which is sponsored by the National Institute of Allergy and Infectious Diseases, has shown that remdesivir does accelerate recovery for patients with advanced COVID-19. We think that this is obviously important work that will really demonstrate our ability to provide these kinds of services that will help us in the future. These analyses provide clear evidence that the efficacy of these therapies may literally mean the difference between life and death for millions of Americans and will continue to be in our portfolio. While we are not sure how the results of these studies will eventually impact the future of COVID-19, we are clearly in the right place to make a difference for our clients and our nation in future work. In addition, we've seen growing interest across the board for our technology-enabled solutions and well-known expertise in health-driven data analytics. We see incremental growth opportunities at the VA and across HHS, the DHA, Defense Health Agency, CDC and NIH. As seen from our current work on COVID-19, we have long-standing customer relationships with many NIH agencies, again, including the National Institute of Allergy and Infectious Diseases. We are well positioned to assist Dr. Fauci's organization across an array of initiatives. We're bidding on several contracts that leverage the company's leadership in this arena, including our telehealth solutions, program management, and big data analytics applications, and we expect rapid decision-making on some of these activities that are tied to the pandemic. The need for reliable and accurate research, testing, and analysis has never been greater than now. As our government and industry alike race to develop medical treatments and vaccines to battle this urgent public health catastrophe. Now turning to Slide 6, I'd like to remind our shareholders that DLH's InfiniByte Cloud solution is now available on the FedRAMP marketplace, the central portal for government cloud offerings. FedRAMP, which stands for the Federal Risk and Authorization Management Program, indicates that federal customers that DLH has undergone a security capabilities assessment and meets the enhanced security requirements of civilian agencies as well as the Department of Defense. We're now able to ensure the confidentiality, integrity, and security of health data in a very fast and reliable manner. InfiniByte Cloud, our secure cloud-based platform, offers agencies the data storage and access options that they need in a secure environment to provide the analytical tools to do their work. We believe that this platform-as-a-service marketplace will bolster our new business expansion in the secure data analytics market. Before turning the call over to Kathryn, I just want to wrap up by stating that DLH has proven once again to be a very strong and stable company during these volatile times. We continue to provide mission-critical services to a variety of well-funded government agencies, and the value of our diverse and technology-enabled platforms has never been more clear. This is very consistent with our strategy, and this translates to a steady, somewhat predictable outlook while many in our industry seem to struggle. Again, DLH has strong margins and strong cash flow, and we're strengthening our balance sheet by paying down our senior debt faster than required, with no repayments now required until 2022. Our borrowing capacity and tax benefits, along with low CapEx requirements, provide substantial liquidity to sustain the business as we look forward. We take the COVID-19 pandemic very seriously, but we also know that our operating model, our program portfolio, and industry expertise make us a somewhat unique provider of critical services during these times of need. While safeguarding our employees, we continue to work diligently with many core customers to help Americans navigate through this tragic turn of events and lead the way to a brighter tomorrow. There is always a way forward, and DLH is proud to improve the lives of millions of Americans. As FDR said, 'The only limit to our realization of tomorrow will be our doubts of today. Let us move forward with a strong and active faith.' So be strong and be well. With that, I'd now like to turn the call over to our Chief Financial Officer, Kathryn JohnBull.

Thank you, Zach, and good morning, everyone. Thanks for joining us. We're pleased to report another solid second quarter. Turning to Slide 7, we posted revenue for the three months ended March 31, 2020, of $54.8 million versus $33.8 million in the prior year second quarter. The revenue variance reflects the impact of our acquisition of S3 last June, approximately $18.7 million coming from that transaction, as well as strong growth across our other operations. Our second quarter results benefited from higher mail order demand from our VA programs, which more than offset some minor COVID-related reductions for programs requiring travel. Turning to Slide 8, income from operations rose to $3.8 million for the fiscal 2020 second quarter from $2.3 million last year, reflecting operating margins of 7% and 6.9%, respectively. The greater operating income reflected increased revenue with stronger margins even in the face of higher amortization of acquired intangibles from the S3 transaction. G&A rose to $6.3 million in the second quarter from $4.5 million last year, but declined as a percent of revenue to $11.4 million from $13.3 million in 2019. The decline as a percent of revenue was due to greater operating leverage and the timing of some business development activity. While it's always difficult to pin down the exact time frame, we do expect that business development expenses will be higher in quarters 3 and 4. We reported net income of approximately $2.1 million or $0.16 per diluted share versus $1.3 million or $0.10 a share last year. The company recorded a $0.9 million tax provision this second quarter versus $0.5 million in fiscal 2019, reflecting higher pretax net income. Interest expense was also $0.9 million in fiscal 2020 versus $0.5 million last year. The year-over-year increase in interest expense was due to higher outstanding debt balances in recognition of the S3 transaction. We continue to pay down debt as expeditiously as possible, as I'll review further in a moment. Turning to Slide 9, EBITDA for the three months ended March 31, 2020, was $5.6 million versus $2.9 million in the prior year period, reflecting the S3 acquisition and improved operating leverage. As a percent of sales, EBITDA rose to 10.2% this quarter versus 8.5% last year. A reconciliation of GAAP net income to EBITDA is in our earnings statement and in the back of this presentation. Slide 10 illustrates the progress we've made in reducing our senior debt since the transaction in 2019. We've continued our practice of using operating cash to pay down senior debt. As of today, we've paid down $19 million of senior debt, an additional $4 million since the end of the quarter and $19 million since the S3 acquisition in June of 2019. Our second quarter cash generation was impacted by the integration of the financial systems, but since that's complete, our outstanding receivable backlog has decreased with strong collections in April and early May, which is a great start to Q3 from a cash flow standpoint. Looking forward, we anticipate a debt balance of between $42 million and $45 million at fiscal year-end. Prepaying our debt not only strengthens the company's financial position, but it reduces our interest expense, improving our bottom line results. As Zach mentioned previously, we are well in a position where, as of today, no further debt repayments are required until September of 2022. This concludes my discussion of financial statements. With that, I would now like to turn the call over to our operator to open the call for questions.

Our first question today will come from Ken Herbert with Canaccord.

I hope everybody is well during these challenging times. I just wanted to first ask, historically, Kathryn, you've seen a nice step-up in gross margins from the first half to the second half of the fiscal year. I'm wondering, with the different mix now in S3, how should we think about gross margins into the third and fourth quarter?

Yes, I believe we will maintain a similar performance to the second quarter, possibly with minor improvements. As you pointed out, we are expecting a stronger contribution from the VA program due to increased volume, although it has a lower gross margin rate within our business. However, we anticipate that contributions from the acquired business will continue to rise as we build on the contracts that Zach mentioned. Therefore, we are still aiming for a gross margin in the range of 21% to 23%. This quarter, we achieved a gross margin of 21.6%. For our planning, I expect something close to that, around 22%, for the rest of the year.

Okay, that's helpful. Yes, and great news on the CMOP and the change in contract structure. I have two questions about that. First, when do you expect the formal recompete process to start under the revised structure? Second, regarding your other VA work, there has been some discussion about whether the other contract streams would adopt the proposed CMOP structure. Now that they have backed away from that, I assume you don't expect any changes in the other streams as a risk of a set-aside?

Sure. Yes. Let's start with your second question regarding what's in the pipeline. We've been really very actively focused on that work, which we believe is not subject to set-aside. There are certain opportunities, of course, where we're going to lean in on a couple of set-aside projects where they make sense for us strategically to add additional capabilities. So it will continue to be a part of our new business pipeline. Every indication is that we see really strong prime opportunities in the future for DLH. With regard to the schedule on the new solicitation or revised solicitation, it's still difficult to tell. It's really too early to tell. There have been some changes, of course, in their organization, and they're looking at what to do with the new solicitation. Quite frankly, like many other acquisition shops, they are focused on COVID-19 efforts to support our veterans. We suspect that with what's going on in the pandemic, it will probably delay things. Therefore, we're seeing no impact through the remainder of this fiscal year. Best estimates would suggest we would continue through a fair amount of next fiscal year as well.

That's great. Just finally, if I could. In light of everything with COVID-19, you've clearly got a very well-positioned portfolio now with the addition of S3. Can you provide any metrics around quote activity or pipeline opportunities that you're seeing in light of the pandemic? I appreciate it's still early and there's just a lot going on in different directions. But anything you can comment on just the bid and activity levels in response without thinking about firm business maybe. But how are you seeing this opportunity evolve?

Sure. So there are a couple of ways in which we've been engaged. First and foremost, whenever there's something that's time-sensitive, they often require companies like ourselves to pivot our resources from existing projects to devote our resources accordingly. A substantial amount of the work we have done has been on that basis. We have folks under the guidance of our Chief Scientist and others really reallocating some of our epidemiologists and purposefully focusing our clinical trials and labs on the current priorities. So that's been the first part of it. At the same time, we've had about a dozen bids, largely for the CDC and NIH. Some may be from other countries looking for support that we are also evaluating. But as you might imagine, some of these are small, quick-turn bids. We've won a few already, and they represent relatively straightforward opportunities. As conditions start to stabilize, and we gain clarity on the therapeutics and vaccines, the government can begin to reassess how to gather data from those trials and studies and progress into Phase IIs and IIIs. As we've seen with previous pandemics, the landscape will evolve with some short-term, immediate needs followed by more sustainable activities later. We'll have greater insight over the next quarter regarding these quick-turn projects, and we'll be able to discuss more about what the future may hold. This situation is certainly a virus that won't disappear completely anytime soon. We've been doing work on other legacy viruses, including HIV, and exploring their impacts on chronic diseases, as indicated in our presentation. There will be numerous studies going forward, focusing on vulnerable populations, including seniors and those in underserved areas, particularly within minority communities. We believe that once we get through this initial phase, we'll be well-positioned for further support.

Our next question will come from Chris Bliska of NOBLE Capital.

Congratulations on a great quarter. I have two questions. VA revenues are up 12.6% year-over-year. Can you give a breakdown of what drove that and the sustainability of that increase, please?

We think this increase is sustainable. There are a couple of factors at play right now. One is there has been organic increases in demand and support for the VA from a pharmaceutical standpoint. Additionally, as Kathryn alluded to in March, we started to see some impacts from COVID-19 as well. It is a challenging work environment, and there is some volatility in our workforce to effectively meet those demands. However, we do believe this indicates sustainable growth for some time to come, certainly over the next several quarters. We will have a clearer picture of where that may plateau as the fiscal year progresses. We clearly see this growth mode continuing overall. Kathryn, anything to add to that?

I think that's exactly right. The effects of COVID are indeed widespread. One of the significant impacts for the VA is that, due to social distancing measures within medical treatment facilities and military hospitals, they are redirecting work to CMOP instead of fulfilling it within those facilities. This change minimizes traffic through those places, and I don't anticipate this adjustment curtailing anytime soon. Therefore, we expect it to be sustainable, and I believe this is a very cost-effective approach to managing business.

I think you touched on this in response to an earlier question. But specific to S3, the revenue increase of $1.4 million. I think you indicated previously that you thought you'd see some impact from COVID. So is any of the $1.4 million increase due specifically to new work related to the virus?

No. That is really attributed to the timing of certain studies that were already in play before the onset of the COVID situation. As Zach mentioned, right now, the COVID support is primarily triage work. It involves reallocating current resources on active contracts to focus on immediate COVID-related support. We expect sustainable incremental efforts from COVID to be in the form of small pinpoint activities for the remainder of this fiscal year, but the comprehensive, long-term analysis of COVID's impact on chronic diseases and other long-term studies is likely 18 to 24 months away, as our government customers are prioritizing immediate responses.

Zach, Kathryn, your performance has been admirable. Thank you very much for all the hard work you and your employees have contributed.

Very well. Thank you.

Thanks for your support.

I'm interested in understanding your position and philosophy towards debt and cash. Certainly, your rapid debt repayment is comforting, but many management teams are now allowing cash to accumulate on their balance sheets, as cash in hand is often viewed as better than a promise. Can you provide your thoughts on this as you project a year-end debt balance down to $42 million or $45 million, versus maintaining it at the $55 million level while accumulating cash?

Sure. Thanks for the question. We generate strong operating cash flow, which I expect to sustain my operating needs moving forward. I don't expect to enter a net borrowing mode. If I did have a gross cash need, I have access to a $25 million revolver, which I think I've utilized maybe three times during our financial system transition. Currently, it sits at a zero balance, so I have considerable borrowing capacity. I don't feel particularly compelled to accumulate cash because we have reliable access to cash necessary to fund operations. I have heard various views on hoarding cash and utilizing lines of credit, but I believe, given the visibility into durable revenue and demand for our services, we can responsibly continue focusing on debt reduction while managing operations through this challenging time.

And I would echo your observation that many of our peers are assessing the advantages and disadvantages relative to cash flow amidst this unique environment. Given the conditions we currently face, many peer companies are struggling simply to remain operational. We are classified as an essential organization, which makes a significant difference. Anticipating these circumstances, it would have benefited our peers to adopt more cautious strategies regarding cash management, as Kathryn has pointed out. We have already set some effective strategies in place and look to continue considering both organic and acquisition opportunities in the coming years.

Regarding the $25 million revolver, which has a zero draw on it currently. Could you give us an idea of which banks are involved and the maturity date of that revolver?

Yes. It is linked with my term credit from the banking consortium led by First National Bank that supported our S3 acquisition. As part of securing that financing, we committed to term debt along with the revolver, both of which have a maturity date in June of 2024.

We have no more questions in queue at this time, and this will conclude our question-and-answer session. I would now like to turn the conference back over to Mr. Parker for any closing remarks.

Thank you. We really appreciate all of your continued support and interest in the company. As you may be aware, I think last time we spoke, we had introduced a couple of investor conferences that were coming up. As is consistent with our company experience, we are now operating in a highly telecommuting mode, encouraging all of our employees to respect social distancing guidelines nationwide. As a result, one or two of those investor conferences have been canceled, and another is deferred. We look for an opportunity to provide additional color around the business. If these conferences remain postponed, we may consider arranging a town hall or roadshow conference to address the questions you've raised today and discuss our pipeline's maturity in the near term. Stay tuned for updates, and again, we thank you for your support. Stay safe, be blessed, and we'll talk soon. Bye for now.

The conference has now concluded. Thank you very much for attending today's presentation. You may now disconnect.