Description

INVESTMENT THESIS

Deltek (Ticker: PROJ) is a small, high-quality software company that is a market leader in its niche.  Deltek makes packaged enterprise resource planning ("ERP") software, a product with high switching costs and strong pricing power; consequently, Deltek generates after tax ROTIC north of 100% and ROIC in the 35-45% range.  The company is currently facing cyclically low demand for new licenses from its A&E business, but can likely resume and sustain revenue growth of 8-10% going forward as end markets stabilize.  This top-line growth, coupled with continued margin expansion, support annual FCF growth north of 15% before any use of cash for buybacks or M&A.   Coupled with reinvestment in small tuck-in acquisitions and modest buybacks, Deltek should compound FCF per share at 18-20% per year over the next business cycle.

At the current price of about $7.00/share, Deltek trades for 14x the cyclically weak 2009E EPS, and only 8.5x 2009E FCF/sh (excluding working capital benefit in 2009, 11.5x 2009E FCF/sh).  Taking into account the prospects for 18-20% value creation per year and the defensive nature of the sticky maintenance revenue stream, we think a 16x multiple to normalized EPS is reasonable (this multiple implies 14x normalized FCF/sh, 9x normalized EBITDA, and ~5x 2010E maintenance revenues). This analysis derives a value per share of $13.50 in 2012E, or 93% upside (annual IRR of 25% over three years). Peak upside could be 150% or more under a scenario of stronger growth in end markets or a potential takeout of the company by strategic buyers.  Downside seems muted as applying a 10x multiple to normalized FCF from maintenance only implies a value of $7 per share, which is where you can buy the stock today.

BACKGROUND

Deltek sells ERP systems to project-based businesses. The company has two types of customers - Professional Services and Government Contractors.  Professional Services customers include aerospace and infrastructure contractors and engineering and architectural firms, while Government Contractors is compromised of defense contractors and general providers for the government. Deltek's customers, which are project-oriented, rather than product-oriented, typically require functionality that differs from the needs of users of traditional manufacturing-oriented ERP systems.  Examples of unique requirements include  accounting and reporting for time and resource usage, costs and savings / EVM delivered for the client , and compliance for audit purposes by the government.

The company was founded in 1983, went public in 1997, was taken private by New Mountain Capital (PE) in 2005, and then went public again in May 2007.  New Mountain still owns ~60% ownership and has 3 board seats.  In May of 2009, New Mountain signaled its commitment to Deltek by fully participating in a right offering (which was 100% subscribed by shareholders). The CEO, Kevin Parker, came on board in June 2005 and previously was the CFO of PeopleSoft before the Oracle takeout. The CFO, Mark Wabschall joined in May 2006 from WebMethods.  He recently announced that he was resigning for personal reasons, and the company has publicly stated that his departure is not related in any way to professional misconduct.  Wabschall is staying as a consultant until Deltek finds a replacement.

MARKET OVERVIEW

The overall market for project-based ERP applications is about $18b (according to IDC), comprised of $14.5b of custom-built applications (largely internal solutions) and $3.5b of packaged applications (Deltek's business). Packaged applications have been growing at 9-12% annually, taking share from custom-made applications, which have been expanding at 6% annually. 

The Government Contractors and A&E segments comprise about $1.2b of the $18b ERP applications market.  Deltek is by far the largest vendor of packaged ERP applications for the Government Contractors and A&E segments, with about 25% share of the total market for Government Contractors and 30% for A&E. Within these verticals, the vast majority of competition for Deltek's ERP applications comes from internal solutions based on Microsoft Excel or patches around Microsoft Project, as most end users in these verticals are small companies. With respect to large end users (those with >1000 employees), which comprise the minority of the market, Deltek competes with generic ERP systems (i.e. Oracle, SAP, and Lawson).

BUSINESS MODEL

Deltek's value proposition to an end user is comprised of a combination of low implementation cost as compared to traditional ERP systems (Oracle and SAP), scalability not attainable through internal solutions and support for relevant system updates (crucial for auditing purposes, particularly in the Government Contractors segment).  The result is quicker ROI versus alternatives and a platform that can support the user over many years. Once Deltek wins a customer it generally holds on to it for a long period of time, as renewal rates are above 90% and 75% of incremental new module sales come from existing customers.  Deltek's business is therefore extremely sticky, due to the nature of the ERP application's critical role in delivering and evaluating the customer's main offering (project execution).

Pricing is on a per seat basis for the basic package, with extra charges for additional modules. Typical new license deals range from ~$50K - $75K and Deltek initially charges the customer about 16.5% of license fees for the first year's maintenance (which is billed quarterly).  Thereafter, the company commands strong pricing power, typically increasing prices 1-2% every quarter.  As a result, Deltek generates about 1/3 of its total sales from maintenance, which have very high margins and consequently constitute the vast majority of overall FCF. 

The business has minimal capital intensity with capex historically running at about 2-3% of revenues. Deltek also has a conservative balance sheet; the company will have about $60mm of net debt as of year end 2009 (0.9x Debt/EBITDA, 10.6x EBITDA/Interest).

COMPETITIVE ADVANTAGES AND THREATS

As a software company, the key competitive threat for Deltek is in potential displacement of technology and pricing war with larger ERP vendors.  However, unlike many technology companies, Deltek benefits from three important competitive advantages that protect investors from rapid and unexpected impairment of capital: brand, stickiness of the product and structure of competitive landscape.

Over the last 25 years Deltek built a brand as the gold standard in the government contractor and A&E segments.   When potential new customers evaluate ERP solutions, they typically seek a vendor that provides peace-of-mind on an ongoing basis in term of compliance with the changing environment in which the contractor operates. With an install based of 12,000 customers, Deltek has the largest installed base by far in its market.  New customers will therefore typically find it easier to choose Deltek as the 'safe and proven' bet within their industry. 

Deltek mostly targets organizations with 100-150 end users.  These businesses are too small to fit well with Oracle's or SAP's ERP systems (which require large upfront capital deployments and very costly investments in IT professionals that develop tailored solutions over the ERP system to meet the customer's specific requirements). At the same time, these businesses are generally large enough that an internal solution (i.e. Excel) will not afford the scalability and functionality required for their projects.  Deltek therefore operates in space within the ERP competitive landscape that is too small for Oracle and SAP to compete in, and where Deltek has built an initial lead that offers it an edge versus new entrants when it sells into new customers.   Microsoft, with its Project  ERP solution for mid-size companies, appears to be still far behind in terms of functionality and installed base (which for government contractors and A&E clients appears to be less than 10% the size of Deltek's install base).

None of Deltek's competitive advantages are irreplaceable or impossible to duplicable.  However, a new entrant into the market will require several years to develop the necessary functionality and brand to displace Deltek. Furthermore, since 75% of Deltek's growth comes from existing customers and given that the product is hard to displace, competition affects the company mostly on the margin, at least in the short to medium term.  Consequently, the rate of change in Deltek's competitive standing will be relatively slow as compared to a typical software company.  Such change will not likely occur over the coming business cycle since most of the growth in new customers still comes from displacement of internal IT solutions.  However, should growth slow down and competition intensify materially, investors will have enough time to react given the above dynamics.

RISKS

-Competition from larger ERP providers like Oracle and SAP or Microsoft Project

-Sustained/further weakness from end market/ prolonged recovery to "normal"

-Eventual exit of New Mountain Capital

-Use of cash - could invested in lower ROIC acquisitions rather than in Deltek's business or returned to shareholders

-CFO transition

Catalyst

-Return to normal demand in end markets

-Increased coverage by wall street

-Possible increase in share buybacks