DCGO - DocGo: Growth Significantly Exceeded My Expectations

2023-11-30 07:51:26 ET

Summary

• I believe DCGO remains undervalued and has strong growth prospects.
• Recent results show significant revenue growth and an increase in FY23 revenue guidance.
• Despite concerns about contract rejection, DCGO has a strong relationship with the New York City government and is well-positioned to address the issue.

Overview

My recommendation for DocGo (DCGO) is a buy rating, as I believe the current valuation is not reflecting the business growth and margin expansion outlook. Growth has significantly outperformed my expectations, and I believe DCGO should be able to continue this momentum as new projects ramp up and margins expand accordingly. Note that I previously gave a buy rating for DCGO because I believed the secular tailwinds for virtual care were strong and would continue to drive demand for DCGO services. Given the enormous addressable market, DCGO should be able to grow for a very long time, increasing profitability.

Recent results & updates

The last time I wrote about DCGO was at the start of 2023, and the stock price went in the direction I expected, surpassing my target price of $8.63 (the stock reached a high of $10.82). The stock then fell sharply from August to September due to the rejection of contracts by the New York City comptroller . I believe this situation has provided investors with another attractive opportunity to buy the stock again.

In the recent quarter, DCGO reported 3Q23 revenue of $186.6 million and adjusted EBITDA of $16.7 million. This was a significant quarter as revenue grew 78.9%, driven by the ramp-up of new projects and comps against a normalized base (DCGO previously faced a tough comp base due to COVID-related revenue). Growth was driven across all segments, with the mobile health segment growing 81.7% and transportation revenues growing 70.6%. However, gross margins declined by 220bps to 29.5%. The decline in gross margin should not ring any alarm bells, as it is driven by the surge in new projects that are still ramping up. I expect gross margin to expand and normalize gradually as the contract progresses. Management is also projecting sequential improvements in gross margin, so this should not weigh on the stock valuation.

The strong 3Q23 performance pushed management to raise their FY23 revenue guidance, now expecting a range of $615 million to $625 million, up from the prior $540 million to $550 million, which is well ahead of my previous model estimates of $493 million (13% growth vs. management guidance of 40% to 42% growth). I believe the guidance is highly reliable, given that DCGO has strong visibility into its project pipeline. In fact, I would argue that DCGO could beat this revised guidance if the new projects in 3Q23 ramp up faster than expected and if DCGO maintains its growth momentum into 4Q23 (winning more projects).

"The contracts that we are winning and negotiating and have in the pipeline with the insurers have the potential to be very large as we scale them." From: 3Q2023 earnings call

The increase in revenue guidance was also accompanied by a revision in EBITDA guidance. Management now expects FY23 adjusted EBITDA to be in the range of $50 million to $55 million. While this is a lower margin than I had expected previously, I think the FY23 EBITDA expectation is not on a normalized basis. That is to say, if all the projects were to be ramped up to normalized levels, margins would be higher. Moreover, management continues to expect cost savings initiatives that will drive gross margin improvement in the coming quarters, which should further support margin recovery. Management reiteration of the 4Q25 margins target of 40% gross and 20% adjusted EBITDA supports my view.

Cycling back to growth outlook. I think the growth potential remains very attractive for DCGO, and the momentum for acquiring and expanding contracts remains strong. Within the health systems, DCGO achieved notable success in the quarter for medical transport, securing contracts for three years with Main Line Health and five years with South Central NHS. Execution on previously won contracts is going smoothly, as seen from the successful rollout and operation of the New York City Health & Hospital contract . In my opinion, existing contracts can continue to expand and drive revenue as well. An example of an existing contract that is ramping up and generating substantial revenue is the one with the New York City Department of Housing Preservation and Development [HPD]. In the call, management highlighted that there was a launch of four new sites recently. This further supports my view that the current EBITDA margin is depressed optically due to contracts not ramping up to their full potential yet.

All in all, I believe DCGO performance since I last wrote was great with accelerating revenue growth due to the HPD contract and strong operating leverage that should help the business achieve its 4Q25 margin targets. I believe the stock can do well at these levels if the company can keep executing on its near-term projects, grow its pipeline to show its multi-year growth trajectory.

My main worry is the possibility of unforeseen events, such as the audits being conducted by the New York comptroller. In summary, the New York City comptroller has refused to approve DCGO's $432 million contract with the city's HPD department to offer a wide range of services to immigrant populations. Reasons for this include the New York attorney general's recent investigation into possible improper behaviour towards migrants seeking asylum and DCGO's handling of the project, which involves services outside of DCGO's core competencies such as shelter and security. The outcome is debatable, but in my opinion, DCGO enjoys a cordial relationship with the New York City and State governments, having signed contracts with various departments throughout both. I think there is a lot of pressure on local officials to find a solution because of how sensitive and widely discussed the migrant situation in New York City is, and DCGO is in a prime position to address it. Finding a replacement vendor that can support the project financially is challenging, and if DCGO were to suddenly stop providing services, the situation would only worsen, so I expect them to win the contract in the end.

Valuation and risk

According to my updated model, DCGO is valued at $14 in FY24, representing a 146% increase. The increase in target price is due to the better growth outlook, driven by stronger than expected FY23 growth, a ramp-up of new contracts won in 3Q23 through FY24, and the potential for new contracts to win given the current momentum. While I have revised my EBITDA margin expectation down in FY23, it is not to reflect deteriorating unit economics; rather, it is to reflect the new projects won. Margins should expand significantly, due to operating leverage, towards the management 4Q25 target for a 20% adj. EBITDA margin. I believe the current multiple is heavily weighed down due to the contract incident, pushing the valuation down to 7.2x forward EBITDA. While I believe DCGO should trade back to 13.5x forward EBIDTA (its historical average) given the stronger business position today, I think a conservative multiple to assume is that it trades back to the mid-point (~11x) of where it is today vs. average.

The bear case (risk) for DCGO is that the DCGO eventually lost the contract, and the city decides to conduct an audit across all of DCGO's existing contracts, elevating the risk of more contract loss. This could significantly weigh on the stock sentiment as the growth and margin expansion outlook becomes very uncertain.

Summary

My view of DCGO remains optimistic. The company has demonstrated remarkable growth surpassing my expectations, with strong revenue projections and a robust pipeline. The stock's fluctuation due to contract rejection by the New York City comptroller offers an attractive buying opportunity, considering DCGO's potential to secure the contract eventually. The recent quarter showcased substantial revenue growth, albeit with a temporary decline in gross margins due to new project ramp-ups. However, I anticipate margin normalization as contracts progress. Management's upward revision of revenue guidance for FY23 and continued cost-saving initiatives support this belief.

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