Black Friday has come and gone and those who slept in not only missed the $400 big screen TVs, they also missed a 181 point rally in the Dow. While Friday’s post Thanksgiving day rally was impressive, the action does little to repair the damage that has been mounting since the first of November. Economic concerns have begun to mount and while some take solace in the fact that the majority of investor sentiment may be turning negative, there are still significant structural issues that must be addressed before the economy can truly be categorized as healthy. The rally, therefore, may give traders a welcome gift in the form of higher prices to unload underperforming assets and quite possibly some attractive entry points for short positions.
Many stocks posted impressive gains including Deltek Inc (PROJ) which has only been public a few weeks. Pricing at $18.00 on November first, the market was quick to knock the stock down sending it nearly 15% lower in the first 3 weeks of trading. Friday, the stock caught a bid rising $1.60 to finally close at the IPO price but the volume was light at only 35,600 shares. A light volume rally like this to an area that is likely to prove resistance may in fact offer a great short entry if one can secure a borrow on the shares.
There is little fundamental information out on the company at this time, but reading through the prospectus was an educational experience. The firm focuses on offering project management software and consulting to companies who… (you guessed it)… manage projects. The customer list is actually quite impressive with 90 or the 100 leading federal information technology contractors and 76% of the top 500 architectural and engineering firms using services provided by Deltek. The company believes that its specialized product offering allows it to compete due to the level of detail necessary for many of its clients projects. With customers contracting with federal agencies for specific projects, tracking expense items, timetables and quality of work is very important.
While it was easy to become impressed with the level of detail available in the software Deltek produces, I was struck by the significant amount of debt the company is carrying, especially considering how unpredictable the revenue stream is, and how dependent on the economic cycle the business model is. Furthermore, with the majority of the debt revolving on a variable interest rate, the firm seems very much at risk and the factors surrounding that risk are completely out of management’s control. As a point of reference, net income was reduced by nearly 50% in the first 6 months of 2007 due to interest expense. It seems that our economy is at an interesting crossroad where weakening economic conditions may cause somewhat lower interest rates (but Deltek’s revenue would likely drop significantly), or an stabilizing economy would be met with much higher rates as the Fed attempts to rescue the purchasing power of the dollar and ward off inflation (which would mean significantly higher interest expense for Deltek).
While the company has had strong growth the last 2 years, it has not significantly outpaced many other growth names that have been brought to market. Yet the stock is priced at a hefty multiple when looking at the last 4 quarters of income. While the market is obviously willing to pay higher multiples for strong growth stories, there are also discounts that should be applied when higher levels of risk or uncertainty are involved. The debt adds to the company’s risk especially when one considers that the stipulations on the credit line do not allow the company to enter any other debt agreements. This limits the firms access to additional capital if needed. Furthermore, the uncertainty surrounding the economic state in the US (95% of the company’s customers are based in the United States) adds to uncertainty and should be reflected in a lower multiple.
The conclusion is that an unstable revenue base and an economic environment create risk for higher multiple growth names. While my fund has a very small position taken on the IPO, I have reduced my exposure to this name as much as possible and will consider taking a short position in the coming weeks as the stock has rallied to offer an attractive entry point near the IPO price. The float is very thin and price fluctuations are obviously wide so please use caution if shorting this name. Still over the next several months, I see the risks in this name far outweighing the possible reward.
Disclosure: Author has long position in PROJ