DLH Holdings Corp. 10-K

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Forward Looking and Cautionary Statements You should read the following discussion in conjunction with the consolidated financial statements and the notes to those statements included elsewhere in this Annual Report on Form 10-K for the year ended September 30, 2024. This discussion contains certain statements that are forward-looking within the meaning of the Private Securities Litigation Reform Act of 1995. Certain statements contained in this Management’s Discussion and Analysis are forward-looking statements that involve risks and uncertainties. In addition, any statements that refer to expectations, projections or other characterizations of future events or circumstances are forward-looking statements. The forward-looking statements are not historical facts, but rather are based on current expectations, estimates, assumptions and projections about our industry and business. Our actual results could differ materially from the results contemplated by these forward-looking statements. Business Overview: DLH Holdings Corp. ("DLH") delivers improved health and cyber readiness solutions for federal government customers through digital transformation, science research and development, and systems engineering and integration. We bring a unique combination of government sector experience, proven methodologies, and unwavering commitment to solve the complex problems faced by civilian and military customers alike, doing so by leveraging a robust capability set, including cyber technology, artificial intelligence, advanced analytics, cloud-based applications, and telehealth systems. We derive 98% of our revenue from agencies of the Federal government, providing services to several agencies including the HHS, VA, DoD, and DHS. The following table summarizes the revenues by customer for the years ended September 30, 2024 and 2023, respectively (in thousands): 2024 2023 Revenue Percent of total revenue Revenue Percent of total revenue Department of Health and Human Services $ 184,544 46.6 % $ 161,311 42.9 % Department of Veterans Affairs 139,945 35.3 % 138,862 37.0 % Department of Defense 64,128 16.2 % 70,325 18.7 % Customers with less than 10% share of total revenue 7,320 1.9 % 5,374 1.4 % Revenue $ 395,937 100.0 % $ 375,872 100.0 % Forward Looking Business Trends: Our mission is to expand our position as a trusted provider of technology-enabled healthcare and public health services, medical logistics, and readiness enhancement services to active duty personnel, veterans, and civilian populations and communities. Through our acquisition program, we have built a platform of technology-powered solutions to enable us to provide an array of innovative, high-value solutions in information technology, public health and digital transformation. We are focused on increasing organic growth across our addressable market and delivering robust cash flow. Our primary focus within the defense agency markets includes cyber security, military service members' and veterans' requirements for telehealth services, behavioral healthcare, medication therapy management, process management, clinical systems support, and healthcare delivery. Our primary focus within the civilian agency markets includes digital transformation, IT modernization, healthcare and social programs delivery and readiness. These include compliance monitoring on large scale programs, technology-enabled program management, consulting, and digital communications solutions ensuring that education, health, and social standards are being achieved within underserved and at-risk populations. We believe these business development priorities will position the Company to expand within top national priority programs and funded areas. Federal budget outlook for fiscal year 2025 : While Congress has not completed the final appropriation bills for the government’s 2025 fiscal year, the Company continues to believe that its key programs benefit from bipartisan support and does not expect a material impact on its current business 26 base from budget negotiations. If the appropriations bills are not timely enacted, government agencies operate under a continuing resolution ("CR"), which may negatively impact our business due to delays in new program starts, delays in contract award decisions, and other factors. On September 26, 2024, the President signed a continuing resolution (CR, H.R. 9747). The CR extends fiscal year 2025 funding for all 12 annual spending bills, including the Defense, Labor, Health and Human Services, and Education bills, through December 20, 2024. When a CR expires, unless appropriations bills have been passed by Congress and signed by the President, or a new CR is passed and signed into law, the government must cease operations, or shutdown, except in certain emergency situations or when the law authorizes continued activity. We are monitoring impact the new Presidential Administration will have on government funding negotiations as their legislative and political priorities . We continuously review our operations in an attempt to identify programs potentially at risk from CRs so that we can consider appropriate contingency plans. Historically, our customers’ missions have received bipartisan support from the legislative and executive branches of the federal government. However, we anticipate that the President-Elect and new Congress will seek to implement their budget priorities, which may impact our customers’ projects and budgets. Industry consolidation among federal government contractors: There has been active consolidation and a strong increase in merger and acquisition activity among federal government contractors over the past few years that we expect to continue, fueled by public companies leveraging strong balance sheets. Companies often look to acquisitions that augment core capabilities, contracts, customers, market differentiators, stability, cost synergies, and higher margin and revenue streams. Potential impact of federal contractual set-aside laws and regulations: The Federal government has an overall goal of 23% of prime contracts flowing through small businesses. As previously reported, various agencies within the federal government have policies that support small business goals, including the adoption of the “Rule of Two” by the VA, which provides that the agency shall award contracts by restricting competition for the contract to service-disabled or other veteran-owned businesses. To restrict competition pursuant to this rule, the contracting officer must reasonably expect that at least two of these businesses, which are capable of delivering the services, will submit offers and that the award can be made at a fair and reasonable price that offers best value to the U.S, When two qualifying small businesses cannot be identified, the VA may proceed to award contracts following a full and open bid process. The Company believes that its past performance in this market and track record of success provide a competitive advantage. However, the effect of set-aside provisions may limit our ability to compete for prime contractor positions on programs that we recompete or that we have targeted for growth. In these cases, the Company may elect to join a team with an eligible contractor as prime for specific pursuits that align with our core markets and corporate growth strategy. During the fiscal year ended September 30, 2024, we generated revenues of approximately $140.0 million from our set of contracts in support of the VA's Consolidated Mail Outpatient Pharmacy ("CMOP") program. As previously reported, the VA has been soliciting proposals for new contracts covering this work with a preference for a Service-Disabled Veteran Owned Small Business, or SDVOSB, to perform as the prime contractor. During the 2024 fiscal year, the VA awarded one contract to a SDVOSB that was not affiliated with DLH. Should awards for the locations for which we have submitted a proposal be offered to a partner of DLH, we expect to continue to perform a significant amount of those contracts' volume of business as a subcontractor. While the acquisition process is being conducted, DLH continues to operate as the prime contractor for all CMOP locations other than the Chelmsford location. For more information concerning the status of this procurement effort, see Item 1. Business – Major Contracts . 27 Results of Operations Fiscal Year Ended September 30, 2024 as Compared to Fiscal Year Ended September 30, 2023 The following table summarizes, for the years indicated, consolidated statements of operations data expressed (in thousands except for per share amounts, and as percentages of revenue): Year Ended September 30, 2024 2023 Change Revenue $ 395,937 100.0 % $ 375,872 100.0 % $ 20,065 Cost of operations Contract costs 317,026 80.1 % 296,016 78.8 % 21,010 General and administrative costs 36,959 9.3 % 37,795 10.1 % (836) Impairment loss of long-lived asset — — % 7,673 2.0 % (7,673) Corporate development costs — — % 1,735 0.5 % (1,735) Depreciation and amortization 17,052 4.3 % 15,562 4.1 % 1,490 Total operating costs 371,037 93.7 % 358,781 95.5 % 12,256 Income from operations 24,900 6.3 % 17,091 4.5 % 7,809 Interest expense 17,153 4.3 % 16,271 4.3 % 882 Income before provision for income tax (benefit) expense 7,747 2.0 % 820 0.2 % 6,927 Provision for income tax expense (benefit) 350 0.1 % (641) (0.2) % 991 Net income $ 7,397 1.9 % $ 1,461 0.4 % $ 5,936 Net income per share - basic $ 0.52 $ 0.11 $ 0.41 Net income per share - diluted $ 0.51 $ 0.10 $ 0.41 Revenue For the year ended September 30, 2024 revenue was $395.9 million, an increase of $20.1 million or 5.3% over the prior year period. The increase in revenue is principally due to the December 2022 acquisition. Cost of Operations Contract costs primarily include the costs associated with providing services to our customers. These costs are generally comprised of direct labor and associated fringe benefit costs, subcontract cost, other direct costs, and the related management and infrastructure costs. For the year ended September 30, 2024, the contract costs increased as compared to the prior fiscal year by $21.0 million to approximately $317.0 million primarily due to the increase in revenue volume. Non-labor costs, which consist primarily of subcontract and other direct costs and inherently carry a lower margin, increased as a percentage of revenue in fiscal 2024 as compared to the prior fiscal year. General and administrative costs are for employees and third parties not directly providing services to our customers, including but not limited to executive management, bid and proposal, accounting, and human resources. These costs decreased as compared to the prior fiscal year by $0.8 million to approximately $37.0 million as the company achieved operating leverage following the December 2022 acquisition. In the 2023 fiscal year there were two costs that did not recur in fiscal 2024 which impacted the Company’s operating income and net income. These costs consisted of an impairment loss of a long-lived asset of $7.7 million and corporate development costs of $1.7 million. The impairment charge resulted from the consolidation of under utilized real estate assets. The corporate development costs were incurred to complete the December 2022 acquisition and include legal counsel, financial due diligence, customer market analysis and representation and warranty insurance premiums. For the year ended September 30, 2024, depreciation and amortization costs were $0.6 million and $16.5 million, respectively, as compared to $0.8 million and $14.8 million for the year ended September 30, 2023, respectively, an aggregate increase of $1.5 million which is primary due to the December 2022 acquisition. 28 Interest Expense Interest expense includes items such as interest expense and amortization of deferred financing costs on debt obligations. For the year ended September 30, 2024, interest expense was $17.2 million compared to interest expense of $16.3 million in the prior year, an increase of approximately $0.9 million over the prior year period. The increase in interest expense was primarily due to the increase in debt associated with the December 2022 acquisition. Provision for Income Taxes Provision for Income taxes for the fiscal year ended September 30, 2024 was a tax expense of $0.4 million, an increase of approximately $1.0 million from the prior fiscal year. The increase was primarily due to the impairment of real estate assets in fiscal 2023 that did not impact fiscal 2024. The effective tax rate was a positive 4.5% for the fiscal year ending September 30, 2024 and a negative 72.2% for the fiscal year ending September 30, 2023. Non-GAAP Financial Measures The Company is presenting additional non-GAAP measures regarding its financial performance for years ended September 30, 2024 and 2023. The measures presented are Earnings Before Interest Taxes Depreciation and Amortization (“EBITDA”), and Adjusted EBITDA. In calculating Adjusted EBITDA, we have added the corporate development costs associated with completing the December 2022 acquisition to our results for fiscal year 2023 and removed the impairment loss on certain real estate assets. These resulting measures present the annual financial performance compared to results delivered in the prior year period. Definitions of these additional non-GAAP measures are set forth below. We have prepared these additional non-GAAP measures to eliminate the impact of items that we do not consider indicative of ongoing operating performance due to their inherently unusual or extraordinary nature. These non-GAAP measures of performance are used by management to conduct and evaluate its business during its review of operating results for the periods presented. Management and the Company's Board utilize these non-GAAP measures to make decisions about the use of the Company's resources, analyze performance between periods, develop internal projections and measure management performance. We believe that these non-GAAP measures are useful to investors in evaluating the Company's ongoing operating and financial results and understanding how such results compare with the Company's historical performance. These supplemental performance measurements may vary from and may not be comparable to similarly titled measures by other companies in our industry. EBITDA and Adjusted EBITDA are not recognized measurements under accounting principles generally accepted in the United States, or GAAP, and when analyzing our performance investors should (i) evaluate each adjustment in our reconciliation to the nearest GAAP financial measures and (ii) use the aforementioned non-GAAP measures in addition to, and not as an alternative to, revenue, operating income, or net income, as measures of operating results, each as defined under GAAP. We have defined these non-GAAP measures as follows: "EBITDA" represents net income before income taxes, interest, depreciation and amortization. “Adjusted EBITDA” represents net income before income taxes, interest, depreciation and amortization and the corporate costs associated with completing the acquisition and the impairment loss on the right of use asset. Reconciliation of GAAP net income to EBITDA and Adjusted EBITDA, non-GAAP measures (in thousands): 29 Year Ended September 30, 2024 2023 Change Net income $ 7,397 $ 1,461 $ 5,936 Interest expense, net $ 17,153 $ 16,271 882 Provision for income tax expense (benefit) 350 (641) 991 Depreciation and amortization 17,052 15,562 1,490 EBITDA $ 41,952 32,653 $ 9,299 Impairment loss of long-lived asset (a) — 7,673 (7,673) Corporate development costs (b) — 1,735 (1,735) Adjusted EBITDA $ 41,952 42,061 $ (109) (a): Represents impairment loss of certain long-lived real estate assets associated with a reduction of the fair value of an asset prompted by a triggering event. During the fourth quarter of fiscal 2023, DLH reduced its leased office space requirement by consolidating underutilized premises as part of an ongoing facility rationalization effort, to accurately reflect the operational needs of the business. As a result, the Company has determined that its Right of Use Assets experienced a reduction in fair value below its associated carrying value and recorded a $7.7 million loss of fair value. (b): Represents corporate development costs we incurred to complete the December 2022 transaction. These costs primarily include legal counsel, financial due diligence, customer market analysis and representation and warranty insurance premiums. Liquidity and Capital Management Cash is approximately $0.3 million and $0.2 million for the period ended September 30, 2024 and 2023 respectively. Credit facility availability was approximately $32.5 million and $32.0 million for the period ended September 30, 2024 and 2023, respectively. A summary of the change in cash is presented below for the years ended September 30, 2024 and 2023 (in thousands): Year Ended September 30, 2024 2023 Net cash provided by operating activities $ 27,366 $ 31,033 Net cash used in investing activities (836) (181,197) Net cash (used in) provided by financing activities (26,403) 150,151 Net change in cash $ 127 $ (13) 30 Cash flows from operations totaled approximately $27.4 million and $31.0 million for the years ended September 30, 2024 and 2023, respectively. The decrease in cash from operations was principally due to a decrease in current liabilities, specifically lease liabilities. We used $0.8 million and $181.2 million of cash in investing activities during fiscal years 2024 and 2023, respectively. The cash utilized was predominantly due capital expenditures and the December 2022 acquisition in fiscal years 2024 and 2023, respectively. Cash used in financing activities during the fiscal year ended September 30, 2024 was approximately $26.4 million and cash provided by financing activities during the fiscal year ended September 30, 2023 was $150.2 million, respectively. The cash used in financial activities during the fiscal year ended September 30, 2024, was primarily due to the early repayment of principal on our secured term loan. The activity in the fiscal year ended September 30, 2023 was primarily due to finance the December 2022 acquisition. Sources of Cash As of September 30, 2024, our immediate sources of liquidity include cash of approximately $0.3 million, accounts receivable, and access to our secured revolving line of credit. This credit facility provides us with access of up to $32.5 million subject to certain conditions including eligible accounts receivable. As of September 30, 2024, we had unused borrowing capacity of $18.1 million. The Company's present operating liabilities are largely predictable and consist of vendor and payroll related obligations. We believe that our current investment and financing obligations are adequately covered by cash generated from profitable operations and that planned operating cash flow should be sufficient to support our operations for twelve months from the date of issuance of these consolidated financial statements. Credit Facilities A summary of our credit facilities as of September 30, 2024 is as follows (in millions): Lender Arrangement Loan Balance Interest * Maturity Date First National Bank of Pennsylvania Secured term loan (a) $ 142.5 SOFR1 + 4.1% December 8, 2027 First National Bank of Pennsylvania Secured revolving line of credit (b) $ 12.1 SOFR1 + 4.1% December 8, 2027 1 Secured Overnight Financing Rate ("SOFR") as of September 30, 2024 was 5.2%. On January 31, 2023, we executed an additional floating-to-fixed interest rate swap with FNB; the notional amount as of September 30, 2024 is $80.0 million, it matures in January 2026, and the fixed rate is 4.1%. As a result of entering interest rate swap agreements, for the twelve months ended September 30, 2024, interest expense has been decreased by approximately $1.3 million. (a) Represents the principal amounts payable on our secured term loan, which is secured by liens on substantially all of the assets of the Company. The principal of the secured term loan is payable in quarterly installments with the remaining balance due on December 8, 2027. (b) As of September 30, 2024 the secured revolving line of credit had a borrowing base of $32.5 million. The Company accessed funds from the secured revolving line of credit during the year, and had $12.1 million outstanding balance at September 30, 2024. The secured term loan and secured revolving line of credit are secured by liens on substantially all of the assets of the Company. The provisions of the secured term loan and secured revolving line of credit, including financial covenants, as amended, are fully described in Note 8 to the consolidated financial statements. 31 Contractual Obligations as of September 30, 2024 Payments Due By Period Next 12 2-3 4-5 More than 5 (Amounts in thousands) Total Months Years Years Years Debt obligations $ 154,558 $ 12,058 $ 42,750 $ 99,750 $ — Facility operating leases 18,538 3,536 6,011 5,203 3,788 Contractual obligations $ 173,096 $ 15,594 $ 48,761 $ 104,953 $ 3,788 Critical Accounting Policies and Estimates Use of Estimates The preparation of financial statements in conformity with accounting principles generally accepted in the U.S. requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Significant estimates include valuation of goodwill and intangible assets, and stock-based compensation. In addition, the Company estimates overhead charges and allocates such charges throughout the year. Actual results could differ from those estimates. Revenue Recognition We recognize revenue over time when there is a continuous transfer of control to our customer. For our U.S. government contracts, this continuous transfer of control to the customer is supported by clauses in the contract that allow the U.S. government to unilaterally terminate the contract for convenience, pay us for costs incurred plus a reasonable profit and take control of any work in process. When control is transferred over time, revenue is recognized based on the extent of progress towards completion of the performance obligation. For service contracts, we satisfy our performance obligations as services are rendered. We use cost-based input and time-based output methods to measure progress. For time-and-materials contracts, revenue is recognized to the extent of billable rates times hours delivered plus materials and other reimbursable costs incurred. Revenue for cost-reimbursable contracts is recorded as reimbursable costs are incurred, including an estimated share of the applicable contractual fees earned. For firm-fixed-price contracts, the consideration received for our performance is set at a predetermined price. Revenue for our firm-fixed-price contracts is recognized over time using a straight-line measure of progress. Contract costs are expensed as incurred. Estimated losses are recognized when identified. Refer to Note 5 of the accompanying notes to our consolidated financial statements contained elsewhere in this Annual Report on Form 10-K for discussion relative to the Company's revenue recognition in accordance with ASC-606. Long-lived Assets Our long-lived assets include equipment and improvements, right-of-use assets, intangible assets, and goodwill. The Company continues to review its long-lived assets for possible impairment or loss of value at least annually or more frequently upon the occurrence of an event or when circumstances indicate that a reporting unit’s carrying amount is greater than its fair value. Equipment and improvements are stated at cost, less accumulated depreciation and amortization. Depreciation and amortization are provided using the straight-line method over the estimated useful asset lives (3 years to 7 years) and the shorter of the initial lease term or estimated useful life for leasehold improvements. Costs incurred to place the asset in service are capitalized and costs incurred after implementation are expensed. Amortization expense is recorded when the software is placed in service on a straight-line basis over the estimated useful life of the software. Right-of-use assets are measured at the present value of future minimum lease payments, including all probable renewals, plus lease payments made to the lessor before or at lease commencement and indirect costs, less incentives received. Our right-of-use assets include long-term leases for facilities and equipment and are amortized over their respective lease terms. Intangible assets are originally recorded at fair value and amortized on a straight-line basis over their assessed useful lives. The assessed useful lives of the assets are 10 years. 32 Goodwill The Company continues to review its goodwill for possible impairment or loss of value at least annually or more frequently upon the occurrence of an event or when circumstances indicate that a reporting unit’s carrying amount is greater than its fair value. At September 30, 2024, we performed an internal goodwill impairment evaluation with a qualitative assessment of factors to determine whether it was necessary to perform the goodwill impairment test. Based on the results of the work performed, the Company has concluded that no impairment loss was warranted at September 30, 2024, as no change in business conditions occurred which would have a material adverse effect on the valuation of goodwill. Provision for Income Taxes The Company accounts for income taxes in accordance with the liability method, whereby deferred tax assets and liabilities are determined based on the difference between the financial statement and tax bases of assets and liabilities, using enacted tax rates in effect for the year in which the differences are expected to reverse. Deferred tax assets are reflected on the consolidated balance sheet when it is determined that it is more likely than not that the asset will be realized. This guidance also requires that deferred tax assets be reduced by a valuation allowance if it is more likely than not that some or all of the deferred tax assets will not be realized. Stock-based Equity Compensation The Company uses the fair value-based method for stock-based equity compensation. Options issued are designated as either an incentive stock or a non-statutory stock option. No option may be granted with a term of more than 10 years from the date of grant. Option awards may depend on the achievement of certain performance measures determined by the Compensation Committee of our Board. Shares issued upon option exercise are newly issued common shares. All awards to employees and non-employees are recorded at fair value on the date of the grant and expensed over the period of vesting. The Company uses a Monte Carlo method to estimate the fair value of each stock option at the date of grant. Any consideration paid by the option holders to purchase shares is credited to capital stock. New Accounting Pronouncements A discussion of recently issued accounting pronouncements is described in Note 3 of the accompanying notes to our consolidated financial statements contained elsewhere in this Annual Report, and we incorporate such discussion by reference.