Description

Deltek Systems, Inc. (DLTK) develops, markets, and supports software for professional services organizations and project-oriented businesses. Sales for the twelve months through September 30,2001 were $95.5 million or $6.24 per diluted share. DLTK currently trades at about 5.00 per share on the NASDAQ National market. My estimate of intrinsic value is $9.82 per share.

I believe Deltek has a franchise, in the Buffett sense, for a portion of their business. Although there are many providers of job-cost and project related software, DLTK dominates the government contracting services organization cost accounting segment of this market. The requirements of government contract cost accounting are arcane enough and narrow enough that a damaging attack on DLTK seems unlikely. DLTK's technical command of the intricacies of government contract cost accounting is near total.

On the other hand, DLTK sells into a broader market than government contractors. DLTK's CFO gave a rough estimate that 40% of their revenues come from companies that do significant government contracting. Among non-government contracting customers, I don't detect any particular franchise, except the need of existing customers to buy support from Deltek. Deltek's penetration in some of these areas is still strong, however: In April 2000 release of the Engineering News-Record's (ENR's) Top 500 Design Firms, 72% of the firms are Deltek customers, 94% of these using two or more Deltek products, according to an October 11, 2000 Deltek press release.

Competitors of which I am aware in the government contracting segment include CCAS, Portera GC, Lawson Software, J.D. Edwards and more general accounting software packages. Of these, only CCAS and Portera GC (both privately held) emphasize the government contractor market.

Deltek's sales growth has stagnated and profits have been off considerably the last two years. I attribute the sales problems to three causes: 1) general IT investment decline, 2) increased US Government emphasis on GSA Schedule procurement (a method that can eliminate the need for a fully compliant cost accounting system) and 3) post Y2K lull. Profits are also reduced by Delteks's efforts to expand their product line into front office software. Sales problems 1 and 3 should pass with time. Regarding sales problem 2, I have only anecdotal evidence of recent increases in government contract awards using cost reimbursable payment approaches. Cost reimbursable contracts require awardees to have a cost accounting system compliant with federal cost accounting standards. These are the systems Deltek offers.

My calculation of the asset value of DLTK is $9.32 per share. By asset value, I mean the cost of reproduction of the company as described by Greenwald et al in "Value Investing - From Graham to Buffett and Beyond". On an earning power basis, after normalizing EBIT to $15 million per year (from a trailing twelve month's $5.9 million), and making adjustments as described in the same book, I calculate a valuation of $10.32 per share. Averaging these two values, I get an intrinsic value of $9.82 per share. Normally I would demand a 40% discount from this value, buying at $5.89 or less per share. For franchises with growth potential I don't demand a discount. I would count 40% of DLTK's value as being franchise value (since 40% of revenue is from government contractors) and thus only demand the 40% discount on the other 60% of intrinsic value, yielding a maximum purchase price of 7.46 per share.

DLTK has no debt. Price/book is 1.5. Price to tangible book is 2.5. DLTK is trading at 12.4 times EBIT for the trailing 4 quarters, 5.5 times my estimate of trailing free cash flow, and 77% of trailing sales. Trailing free cash flow return on ending equity is 28%.

The company has retired common shares from an average of 17.7 million shares in 1999 to 15.2 million shares as of September 30, 2001.

Other possible negatives:

- Management has a history of trying to expand outside its area of franchise.
- Deltek's revenues come mostly from software license fees and from services in support of the products. The license fee fraction of revenues has declined steadily from 36% in 1995 to 26% in the first nine months of 2001.
- Average trading volume of only 21,000 shares. Market cap $76 million.

Disclosure: I indirectly own shares of DLTK. I worked as CFO for 18 years for a software development government contracting firm that used Deltek's System 1 and Costpoint products.

Catalyst

The only catalysts I see are the very low price relative to value, and a possible sales turnaround. But then I seldom see catalysts.