Earnings Call Transcript - DLHC Q3 2024

Chris Witty, Investor Relations Advisor

Thank you and good morning, everyone. On the call with me today is Zach Parker, President and Chief Executive Officer, and Kathryn JohnBull, Chief Financial Officer. The company's earnings release and PowerPoint presentation are available on our website under the Investor page. I would now like to provide a brief Safe Harbor statement, which is also shown on slide three of the presentation. This call may include forward-looking statements that relate to the company's outlook for fiscal 2024 and beyond. These statements are subject to various risks and uncertainties, which could cause actual results and events to differ materially from such statements. Please refer to the risk factors contained in the company's annual report on Form 10-K and in our other filings with the Securities and Exchange Commission. We do not undertake any duty to update any forward-looking statements. On today's call, we will be referencing both GAAP and non-GAAP financial measures. A reconciliation of our non-GAAP results or reported GAAP results is included in the earnings release and in the investor presentation on DLH's website. President and CEO, Zach Parker will speak next, followed by CFO Kathryn JohnBull, after which we'll open it up for questions. With that, I now like to turn the call over to Zach. Please go ahead, Zach.

Zach Parker, President and CEO

Thank you, Chris, and good morning, everyone. Welcome to our third quarter conference call, as we remain on track for a solid year as we enter the last three months of Fiscal 2024. First, let me take a moment to thank our incredible workforce for their dedication and commitment to our ongoing success. Our sophisticated, highly credentialed staff continue to offer a broad array of high-technology services and solutions on behalf of our customers' vital missions. We would not be where we are today as a company if it weren't for these outstanding employees, and we appreciate what you do and what you stand for each and every day. Now, turning to Slide four, I will provide an overview of our financial results. We reported third quarter revenue of $100.7 million and EBITDA of $10.0 million, while generating operating cash flow of $4.6 million during the period. That translated to $14.9 million of cash flow year-to-date. This once again illustrates the company's ability to generate cash and to pay down debt, which now stands at $166.5 million. Kathryn will review this further in a moment. Overall, it was a solid quarter with no major surprises as we continue to position the company for the future, deleveraging our balance sheet, and investing in new business development activities for the future. Turning to Slide five, I'd like to give an update on our near-term outlook as we approach the end of fiscal '24. We're quite upbeat about the current award environment. We have several new business opportunities that we anticipate from across our core markets under government evaluation and/or anticipated requests for proposals. That hopefully should translate into award decisions in the near-term and potentially early in 2025. We believe the potential for new program wins in the future is high, which should bolster our top-line growth trajectory in the quarters to come. While third quarter revenue was negatively affected by the transition of some small business set-aside work, we see continued strong demand for our services in several of our core markets. The small business transition impact on Q3 sales offset the fact that many of our new key markets, such as public health and enterprise IT management programs, grew nicely year-over-year. We're optimistic that such trends will continue, given the overwhelming bipartisan support for the majority of our programs, combined with our strong agency relationships and the company's wider range of advanced solutions and digital transformation capabilities. As in the past, we expect our solutions and services will continue to hold broad bipartisan support in the quarters to come, regardless of changes in Congress or the White House. While one CMOP site already awarded is now set to transition soon, the other seven have been reset in terms of the bidding process, with funding on the current contract expected to be extended through at least October 31. The award timing of the other seven contracts remains uncertain, but we do anticipate the award process to be lengthy due to the complex nature of the critical services represented by these awards. In short, during the last quarter, the government restarted a new solicitation that allows new bidders to enter the competitive environment. These solicitations, however, still remain small disadvantaged veteran-owned businesses, and again, we will consider our participation given the changes to these procurements. Enhancing our highly credentialed workforce's presence and contributions as thought leaders is a significant element of our growth strategy. DLH expects to continue to hold leadership roles across the communities of practice, raising the company's profiles in the markets in which we bid for new work. In the past quarter alone, our experts and thought leaders have published and presented leading research in the fields of public health, readiness, and other technical services, demonstrating our company's innovative approaches to tackling some of the globe's most pressing challenges. Overall, we remain upbeat about the opportunities at our doorstep and the contract activity as the government's year-end comes to a close. We are proud of the breadth and depth of our offerings; our expanded capabilities are now more advanced than ever, and the highly credentialed nature of the company's workforce. Together, our people, our combined capabilities, our new and expanded processes, and past performance bring unmatched systems and solutions to the agencies we serve. With that, I'd now like to turn the call over to our Chief Financial Officer, Kathryn JohnBull. Kathryn?

Kathryn JohnBull, Chief Financial Officer

Thank you, Zach, and good morning, everyone. We're pleased to report our third quarter results for fiscal 2024. Turning to Slide 7, I'd like to provide a high-level overview of some key financial metrics for the three months ended June 30, 2024. We reported revenue of $100.7 million in the third quarter versus $102.2 million in the prior year period, reflecting growth across several priority markets, offset by the conversion of some programs to small business set-aside contracts. We continue to see expansion within our public health and enterprise IT management businesses and are excited by the level of opportunities presented within the current bid environment, as Zach discussed. We reported EBITDA of $10 million for the third quarter versus $11.4 million last year, and the company has generated operating cash of $14.9 million year-to-date. Our EBITDA was lower than last year, largely due to a higher-than-normal contribution from non-labor pass-through revenue, which inherently carries lower margins. Now, if you'd turn to Slide 8, I'll provide an update regarding our deployment of the company's cash to reduce debt, strengthen the balance sheet, and lower interest expense. We paid off approximately $4.3 million of our higher interest floating-rate debt during the quarter, ending the period with $166.5 million of total debt outstanding. Due to updated forecasts and working capital changes, we now anticipate that our debt will be reduced to between $157 million and $160 million at the end of Q4, slightly higher than prior projections, but still leaving us on track to start fiscal 2025 with a debt leverage ratio below 3.5x. We will continue utilizing the favorable tax attributes of our acquisitions, along with stock compensation plans, to minimize cash income tax payments going forward. In addition, if interest rates come down as anticipated, we will utilize that excess cash to accelerate our debt reduction next year. This concludes my discussion of the financial statements. With that, I would now like to turn the call over to our operator to open for questions.

Operator, Operator

We will now begin the question-and-answer session. Our first question comes from Joe Gomes with Noble Capital Markets. Please go ahead.

Josh Villanueva, Analyst

This is Josh Villanueva for Joe. Hi. So, you know, my first question is revenue kind of came in lower than we expected. Can you guys just kind of provide just a little bit more color on that kind of soft business award runoff? It seems to have a larger impact than I think we expected. How much more of it should we expect and kind of, how is that kind of recompete process as a subcontractor looking for those?

Zach Parker, President and CEO

Yes. No, great question, Josh. And we're happy to provide that added color. I think it's very important to have that context of what we've seen this quarter and what we see coming down the pipeline. First of all, we still remain really, really strong with our ability to compete in terms of our win rate for our existing business, right? And so our capabilities to retain work from a competitive standpoint still remain strong. That's not what's driving this. As you may recall, we do have a fair amount of business, booking on business that we've retained for a better part of a year and a half that was awarded to us previously as a small business set aside, at least in terms of the companies that came, the contracts that came to us through acquisitions. While we pay no value for those in our acquisition for those small business set aside contracts, some of them have continued to extend and are starting to roll off now. We had some of our work that has either come to an end and we cannot bid it and would not bid it as a small business set aside. And there's still some addition that we expect in the coming quarters. Those are sans the CMOP. Obviously, we gave separate commentary there as well. Now having said that, we anticipate that the government's commitment to small business set asides will have some varying impact on some legacy contracts, and we'll be certainly keeping you advised. We are working with our customers to try to continue to maintain those in an unrestricted environment and we will keep you posted on that. But we do see probably a quarter or two of some meaningful, cleanup, what we call a reset of our strong capabilities contracts where the government has committed to going small business set aside. Some of those we're going to bid and be a subcontract partner where we might be able to retain up to 49 percent. But some of those we're just allowing to run off because they were non-strategic. So we'll give you some added color on that near term as well in terms of sizing. But again, we anticipate several of those to run out between Q3, Q4, and maybe a trickle into Q1.

Kathryn JohnBull, Chief Financial Officer

Yes, I think as Zach indicated in his comments, this is not unexpected. As we've talked about a number of times, the business is built roughly 85% on recurring business that just rolls forward through the term of the contract. And then there's some part of the business that comes to us via acquisitions that we understand at the time we do the deal it's not strategic to the business and/or, as Zach indicated in the current quarter, some we knew the acquired company had won as a small business and wouldn't be eligible in the re-compete to be the prime. Nothing about that surprises us. That's why we bubble around at approximately 100 million, and we're going to have some variability period-to-period. The real change in trajectory is going to be when a major event happens, such as a big contract award, which we talk about frequently and we're happy to share more about on this call, and/or a disruptive event like the transition of CMOP, which we also will cover in more detail. I think that was part of your question, Josh.

Josh Villanueva, Analyst

Yes. And so that's kind of a good segue as well because you mentioned obviously the CMOP contracts as well. Can you kind of just give me a little bit more color? Like, do you guys have any indication of how the VA is really moving along with these contracts? What's your guys' confidence level in kind of re-competing for the CMOP contracts that you want to re-compete for?

Zach Parker, President and CEO

Yes, That's a great question again. We've kept the community abreast with the VA's attention for some time. And just for a recap, our current contracts ended in 2016, November of 2016. Since then, the VA has had three or four attempts to try to get them awarded and competing and then revising the competition strategy or acquisition strategy and revising it again. Of the bids that have been submitted, they were submitted in the early part of '23. Of those eight bids, only one, the Chelmsford one, the smaller of all of them has been awarded to date. It has morphed about every other year since then. In May, the VA came up with a modification that reopened the competition to any new bidders, service-disabled veteran-owned small businesses. So it's like a restart of all except Chelmsford. Those proposals, none of those proposals have been submitted by any of the competitors yet. The best estimate is that by the end of August, or maybe the first part of September, the government will have received all of those proposals. We have pivoted as the government's modifications have pivoted regarding our approach. For those we are still engaged with a small business partner, we do have a good probability of a win. But I do want to be clear that they have moved the nature of the work with their solicitations, as well as with the most recent modifications to clearly signal what they're looking for, which is the equivalent of a temporary staffing company, small, and in this case limiting to SDVOSBs. Previously, we have built the business both by organically winning 17 of those contracts and executing performance excellence, leading to J.D. Power awards for the VA for 10 consecutive years. With the current solicitation, the focus has shifted to staffing rather than performance metrics. In short, our appetite for the current versions is not the same. When you move to that kind of environment, it becomes almost a low-cost shootout. While I won't go into any details because this is still competition sensitive, the transition that the new contracting folks at the VA have made makes it a different type of acquisition. We're not excited about that, but we do have strong qualifications that we think differentiate us in particular areas and locations, and we're leaning into those.

Josh Villanueva, Analyst

Yes. Thank you for the color on that. And just kind of looking at your income statement, I noticed that your gross margin was down about 200 basis points in the last year and really about 300 basis points sequentially. Can you guys just kind of describe what's really driving that decrease?

Kathryn JohnBull, Chief Financial Officer

Yes, Josh, that's really a function of, as we mentioned, in this particular quarter, the contribution of lower margin pass-through costs was more significant than it was in the prior period. Those types of costs inherently generate tighter margins, and therefore it's going to deliver an aggregate lower gross margin.

Operator, Operator

Our next question comes from Brian Kinstlinger with Alliance Global. Please go ahead.

Brian Kinstlinger, Analyst

When you look at the $100 million in quarterly revenue you just reported, can you quantify how much of that revenue is related to small business contracts?

Zach Parker, President and CEO

Let's see. The revenue reported for the quarter. We'll probably need to come back to you to give you a specific number.

Kathryn JohnBull, Chief Financial Officer

Yes, it's not a material portion of the total $100 million. To the point, most of those items that we anticipated would convert are largely behind us. Not completely, but largely.

Zach Parker, President and CEO

Excluding CMOP.

Kathryn JohnBull, Chief Financial Officer

Excluding CMOP. No, but two flavors of small business. The flavor that was inherently pent-up that an acquired company previously wanted as a small business. By the way, it's not the acquisition that caused them to be ineligible to re-compete for that work. They had already outgrown the small business status prior to the acquisition. So there's that layer. Then, as Zach said, there's, of course, things that are not presently small business, like CMOP, that are moving to that kind of vehicle. That's a different layer.

Zach Parker, President and CEO

And I want to tell you that, Brian, the other added color on that is we've anticipated, as did the customer, that several of these would have been decided probably two to three quarters prior. The government seems to be pretty slow in getting some of these award decisions. Much like CMOP, this kind of works to our favor in some regards. In some cases, when we diligence the deal, some of these award decisions that were going to small business were slated for earlier in 2023, and they just started to hit this past quarter. So good news, bad news, I guess, in that regard.

Brian Kinstlinger, Analyst

To be clear, when you say insufficient, Kathryn, you're saying less than 5% of revenue. That's what I think is insignificant, even smaller, is actual small business contracts.

Kathryn JohnBull, Chief Financial Officer

That's a fair way to think about it.

Zach Parker, President and CEO

Well, there's still those things that are in our current book of business I think you're referring to. I'd say there's still some risk in that book, right, in a couple of areas. Largely attributed to two things. Number one, across the industry, all of our folks are seeing in January of this year, the White House and OMB issued a directive to all federal agencies to go through the “rule of two process” for a number of these IDIQ, multiple award contracts, and consider setting aside some of that work for small businesses. While there are no enabling regulations that have been issued by and introduced into the federal regulations, some agencies take it as guidance, particularly since OMB did not provide the usual exclusion language that agency contracting officers can use. We’ve seen some of that happen to some of our competitors over the last six months. We have not been hit by that yet, but we have been in close discussions with some of our customers that they're considering it. We do have some of that quantified. We've framed it as some erosion risk for us sometime in 2025. The good news is we've seen indications that the government is going to be releasing some of these RFPs, so we can organically grow our way out of a little bit of that transition. As we indicated, we have some things we have very high win probabilities for. We'd like those to have been awarded by now or at least solicited by now, but we're still hearing good things and seeing good behaviors from the customers that those should be coming in at a timely manner to help us offset that small business erosion.

Brian Kinstlinger, Analyst

That's a great transition to my next question. You've highlighted some large pending adjudications that you believe could help drive this return to growth. I know it's not something typically you provide, but I think it would be helpful for investors if you could quantify the total proposals outstanding that are pending adjudication.

Zach Parker, President and CEO

Yes. We periodically do provide our pipeline and some metrics around that, so we'll make sure we do get that to you shortly. In short, I can tell you, though, that we have north of two dozen opportunities that could materially affect the strong growth by mid-FY'25, with good anticipated organic win probability, it should help us exit 25 in an outstanding position relative to the erosion, including small business erosion, that we anticipate. Some of those, I will say that as Kathryn and I diligence that quite a bit, there's a mix of work that is in our digital transformation and cybersecurity arena that is typically a lot higher margin than some of the work in our systems engineering and logistics. That mix will have an effect, depending upon which ones come out first. It will either dilute or expand our gross margins in those contracts and, of course, ultimately impacting our EBITDA. We're monitoring that pretty closely just because now we're capable of bidding much larger contracts, north of $100 million over five years and with high-tech qualifications. We'd like to see those come out at a similar timeline as some of the lower margin work, but still very strategic. We'll keep you posted on that. We'll give you that color pretty soon with regard to our pipeline. But some of those, again, as I said, we'll try to add more color than just the numbers and kind of give you an idea of what's in our DTC, our digital transformation and the higher health research and technology arena.

Brian Kinstlinger, Analyst

Last question I've got is following up on a question I asked last quarter. Can you talk about the progress you're making on increasing your proposal submission engine? This seems more important than ever, obviously, given the roll-offs you're experiencing.

Zach Parker, President and CEO

Yes. That's probably the area I'm most excited about, my friend. I'll tell you, I think we have briefed the community, especially the shareholders, about a year or so ago that we're making some major changes, major improvements into elevating both our ability to go after large contracts and to do so with high win probability. There were several key factors to this process, which we had walked through in our shareholder call. Our ability to drive winning value propositions and technology solutions has elevated substantially, which is needed. We were generally operating with entities in the $60 million, $70 million, $80 million range as an operating unit. Now we're looking at larger deals. We've augmented them now, revamped our full approach to business development, expanding it with the capabilities we have in hand. You've probably seen some press releases regarding some caliber of expertise that we've brought in with our cybersecurity, data analytics, data fusion, AI, and ML capabilities. While we had performance capability and were able to execute with the customer, we didn't have that on the bench. It didn't exist with any of the acquisitions. These now strongly complement the more strategic shaping assets that we had along. A number of bids before didn’t have the value of our strategic advisory capabilities. We’ve seen substantial improvement in our process for positioning and building the type of intimacy needed to have a real strong win rate. We are really optimistic about that. We've got teams that are as good as, if not better than, most organizations in our industry just because we’ve come from those organizations. We’re excited about the elevation in terms of size and about the positioning to elevate our win probabilities and value propositions.

Operator, Operator

It appears there are no further questions in the queue. This concludes our question-and-answer session. I would like to turn the conference back over to Mr. Parker for any closing remarks.

Zach Parker, President and CEO

I'd like to thank you all again for your participation and your continued interest in the very probative conversation. It's really important to set the expectations around what we see in the coming quarters. At the same time, we really want to lean into looking at the longer trajectory from a forecasting perspective. We're really optimistic that despite the small business set-aside impacts to some of our work that is becoming less differentiating. We're excited about the quality of the new business pipeline and our ability to prosecute it. We'll come out of this upcoming period much stronger as we go forward. Thank you again, and we'll continue to keep you posted. The next time we get together will be around the election time period, and we'll give a little more color around that as we approach Q4 and Q1. Thank you all and have a blessed day. Bye for now.

Operator, Operator

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