TH - Target Hospitality: Growth And Financial Strength On The Back Of A Single Relationship

2023-12-06 07:04:37 ET

Summary

• Target Hospitality Corp. provides hospitality services to the energy industry and the US government, focusing on the needs of unaccompanied minors.
• The company has shown high revenue growth, improved margins, and reduced debt while trading at very low multiples, showing all the signs of a potential homerun.
• The company's relationship with nonprofit Endeavors is a key driver of its financial success, but there is political risk associated with this particular organization.

My first contact with Target Hospitality Corp. (TH) as a potential investment was just last week as one of the highlighted names in Joel Greenblatt's webpage, a site that I personally have found useful as a screener of names for deeper due diligence.

I am giving the company a neutral rating because of the highly discreet nature of potential future outcomes that hinge around a single risk, that in my opinion, has not been adequately addressed by other authors nor by analysts in the Q&A sections of earning calls.

The company as its name implies, provides integrated hospitality services to the energy industry and to the US government to solve the humanitarian needs derived from the immigration dynamics into the country, focusing in particular on the needs of unaccompanied minors.

A quick glance at the financials of the company shows very high levels of revenue growth, improving margins and sharply reduced levels of debt, all of that while currently trading under 4 times FV/EBITDA.

Definitely worth going into a deeper due diligence, and that is what I've been doing for the last few days. First, I went into a deeper analysis of the financials and by using zero growth, an 11% discount rate (my personal hurdle rate in the current rate environment) and an exit multiple of 10 times the price to NOPAT, I concluded that this company could easily be trading 50% above current levels.

After that, I went through their latest 10-K and the last 17 earning call transcripts to have a more detailed understanding of the drivers of its amazing financial results. And it became obvious that most, if not all, of the positive developments hinge around the contracts that the company has been fulfilling as the subcontractor of the deals that its non-profit partner Endeavors , has been winning in the last couple of years.

By looking at TTM figures you can see that roughly 73% of the company's revenues are coming from the fulfilment of government contracts and those contracts have adjusted gross margins that are more than twice the levels they achieve with their energy clients. It's important to highlight that the company had a government business before establishing its relationship with Endeavors, but at this point, those projects should be less than 20% of the revenues of the Government segment.

With all of that, is that I think that the detailed analysis of the financials of the company is much less important than making a careful assessment of the risks and opportunities around their relationship with this nonprofit organization as the outcomes are very discreet in nature, and that is the objective of this article.

THE RELATIONSHIP WITH ENDEAVORS

The formalized relationship with Endeavors was initially informed by TH on March 29, 2021 , with the objective of providing a suite of support services for up to 4,000 individuals, including displaced persons, nonprofit employees, and related personnel. The partnership was later expanded with an announcement made on July 6, 2022 , including enhanced amenities, comprehensive support services and customized infrastructure solutions for approximately 6,400 displaced persons, nonprofit employees, and related personnel, representing a 60% population increase from the initial contract. Finally announcing, concurrently with the results for the 3rd quarter of 2022 , that their relationship with Endeavors turned into an " Exclusive 11-year partnership with nonprofit partner to continue jointly providing services solely for the expanded humanitarian community, previously announced on July 6, 2022, ("Expanded Humanitarian Community") "

Both of those contracts have been awarded on an annual basis with options of renewal by the government, and since late 2022 and early 2023, the efforts of management and the nonprofit have centered on making this a multiyear contract. On March 10, 2023, they announced that " a key milestone was achieved through the establishment of the required contracting vehicle the government utilizes to facilitate multi-year contract awards and consists of a 5-year base term with a 5-year option period".

After that, on May 17 the company announced the execution of a 6-month extension option to facilitate the closing process. And during the 2nd quarter earnings call management informed of an increased requirement by the government to support their humanitarian efforts raising the need to a total of up to 10,000 individuals through 3 different contracts (the 10,000 figure includes the 6,400 beds that TH is providing at this point). At the same time management indicated that they were bidding for all 3 contracts by sealing an additional partnership, this time with another established government service provider to be able to fulfil the whole requirement (It's unclear if the new partnership also depends on Endeavors as the direct contractor)

And finally with their latest earning release, management " announced [the] contract award for the Influx Care Facility ("ICF") located at Target's Pecos Children's Center ("PCC") community, solidifying its critical humanitarian mission, jointly with Target's existing non-profit partner. "

This is the 5-year contract (with a potential extension) that they were working towards, and even though this is clearly a positive development, it's important to keep in mind that while this is a program that is designed as long-term in nature by the current administration, its subject to yearly appropriations and that is why I think there is a material political risk with a potential election of a Republican president next year, and that is where I will focus on the next section of the article.

POLITICAL RISK

I will be getting into subjects that I understand might be politically sensitive and regarding that, I want to point out that I am not an American citizen and live outside of the US, so I have zero intention of initiating a political debate here.

My objective is to simply point out how some recent developments (whether real or perceived) in my opinion make a potential Republican administration a risk for the evolution of the services provided by TH as the subcontractor of the nonprofit organization Endeavors, especially in the current tribal political landscape.

Some authors have mentioned the risk of a Republican administration regarding a tougher approach to illegal immigration, and even though that might reduce the need for humanitarian assistance I don't think that the issue can be fully resolved. And it's important to mention that TH is currently serving the needs of unaccompanied children and my understanding is that minors by law have extra protections and cannot be so easily deported. So that need should still be there to a significant degree.

The risk that seems more material relates to Endeavors and the origin of the contracts that currently are being fulfilled by TH.

To be fair it's important to recognize that Endeavors receives a solid score from Charity Navigator getting 3 out of four stars, meaning that according to their system " If this organization aligns with your passions and values, you can give with confidence. ". So, it seems to be a serious and well-regarded organization.

But despite that, the original contract that started the partnership between TH and Endeavors seems to be at the center of a political conflict. This is the case because apparently a former deputy assistant director at ICE who served on President Joe Biden's transition team, took a job at Endeavors and was the one who brokered the initial deal that was awarded on a non-compete basis. And keep in mind the dates, President Biden was sworn in on January 20 and two months later the contract was awarded.

There are many articles that mention this situation ( a , b , c , d ) and even if there was no impropriety in the process, those articles seem to indicate that there is a clear negative perception by the Republican representatives regarding these contracts. And in fact, Endeavors is criticized also for the handling of $17 million by a Republican committee . Each one of the readers can form their own opinion regarding this whole situation, you can think this is a whole lot of nothing or that is a clear case of a conflict of interests, but regarding the political risks for the continuation of this program by Endeavors, the only thing that matters is the perception of the governing administration.

I do not have the slightest idea who is going to win the next presidential election, but I know that both Biden and the Republic candidate (apparently Trump) have real chances.

In case President Biden is re-elected I think that everything points towards TH being a great investment as the status quo is more than enough to justify a position. And as management has repeatedly pointed out they are currently exploring different opportunities in other industries.

In the other case (Republican administration) the situation is much less clear. The worst-case scenario is that they can serve this contract for at least two years (until 3rd quarter of 2025) as the next appropriation will happen in the last year of President Biden. Under this worst-case scenario, I get to a 37% downside from current levels using the same set of assumptions that I detailed in the fourth paragraph.

I would not say that it's certain that the contract would be reassigned under a different administration or even that they are able to do so on their first appropriations cycle if they intend to. The need of care for unaccompanied minors will probably still be there, and it would be risky to reassign this contract without a reliable alternative solution already in place.

The company could and most certainly will try to lobby a new Republican administration into continuing the provision of this contract. One of the company's board members, Pamela Hughes Patenaude , is a former deputy secretary of the Department of Housing and Urban Development ((HUD)) under President Trump, and TH recently announced two new "Strategic Government Affairs" hires. So those lobbying efforts are most likely to be pursued and could potentially be successful.

CONCLUSION

There are many other drivers and risks that I could have focused on in this already long article; like a more detailed look at their business with energy clients, the potential of new businesses with other areas of government or other private industries, or the fact the Brad Archer decided to step down as the CEO to then change its mind a couple of months later during 2022. But all that pales in comparison to the materiality of this single relationship. It's true that the range of outcomes is not totally symmetric, and the average of the different potential outcomes is probably positive. But the level of underlying uncertainty makes it an investment that is not particularly well suited for my investment approach and that is why I decided to pass on this one, clearly recognizing that one of the outcomes is a potential home run.

But that's just my perspective, and it's entirely possible that it could work for some of you.

Best of luck with your investments and hope the article was informative and useful in your personal due diligence of the name.

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