DSG:CC - Descartes Systems: Expensive Gem

2023-03-21 15:37:58 ET

Summary

• The company has built a great track record of profitable growth over the past decade.
• Multiple smaller acquisitions supported the growth trajectory.
• A highly experienced management team is in charge.
• Despite a strong balance sheet that provides firepower for further inorganic growth, the valuation remains full.

[Please note that all currency references are to U.S. dollars except if indicated otherwise.]

Descartes Systems G roup ( DSGX ) ( DSG:CA ) provides software and services to the logistics and supply chain industry. The company was founded in 1981, is headquartered in Waterloo, Canada, and is listed on the Nasdaq and Toronto Stock exchanges.

Descartes has performed well over the past decade by building and expanding a platform of software solutions for the global supply chain industry. An experienced management team should be able to continue executing the growth-by-acquisition strategy in a large and fragmented industry. However, the growth strategy comes with risks while the valuation leaves no room for error.

Connecting the supply chain operators

Descartes operates the largest neutral shipping network in the world and provides software that organizes operations of and facilitates connections between the various parties involved in the global supply chain and logistics network. These parties include carriers (ocean, air, truck, rail), shippers (retailers, manufacturers, distributors), intermediaries (custom brokers, freight brokers, forwarders), and government agencies (customs, regulators).

The solutions offered by the company include business-to-business connectivity, transportation management, e-commerce shipment and fulfillment, global trade intelligence, broker and forwarder enterprise systems, and customs and regulatory compliance. The systems offered by Descartes serve 25,000 customers in the logistics chains and enable the tracking of 575 million shipments every year.

Prominent customers include American Airlines, Hapag-Lloyd, FedEx, Kuehne+Nagel, The Home Depot, Toyota, Coca-Cola, and Fresenius. The indicated customer retention rate is around 95%.

Descartes operates globally with clients based in 160 countries. Revenue in the 2023 financial year (ended 31 January) was $486 million, with a net profit of $102 million. Revenues are mostly derived from subscription fees for the use of the software and products (“software-as-a-service” model). Other revenues come from consulting, implementation, and training activities related to the products and services.

Customers paying in U.S. dollars provided the bulk of the revenues in 2023 (69%), followed by the Euro (11%), Canadian dollar (7%), and British Pound (7%) with the balance in other currencies.

The company faces competition from various entities including developers of supply chain network solutions (for example Manhattan Associates), enterprise resource planning software vendors (SAP and Oracle), messaging networks (OpenText GXS), cargo booking portals (Unisys Corporation), custom compliance and forwarder back-office solutions (WiseTech), trade intelligence platforms (S&P Global), and eCommerce shipping and fulfillment providers (Stamps.com).

Rapid and profitable growth…fuelled by acquisitions

Descartes has grown rapidly over the past decade, mostly through acquisitions. Acquisitions are normally smaller in size (average of $40 million per transaction) and are focused on complementary technologies that could also be offered to existing customers.

Since 2015, the company has completed 28 acquisitions for a total outlay of about $1.1 billion. Acquisitions are mostly financed with cash on hand, using an existing credit facility, or the occasional issue of shares.

As a proportion of annual revenues, the acquisitions averaged 41% over the past decade. However, this has slowed down to 20% over the past three fiscal years after a bumper period in 2019.

Recent acquisitions include XPS which helps e-commerce shippers connect to e-commerce platforms; GroundCloud provides final mile logistics automation and video telematics for driving event verification; NetCHB provides customs filing solutions in the U.S.; while Foxtrot offers machine-learning mobile route planning solutions.

While the pace of acquisitions slowed somewhat in recent years, the pace of profit growth has accelerated (see table). Importantly from an investor perspective, the per share net profit and cash flow growth also accelerated and grew at a faster rate than revenues – this indicates that management succeeded in extracting value and synergies from the acquisitions. Improving profit margins carry the same message.

Descartes is actively exploring further acquisitions and can access a revolving credit facility of $500 million for further acquisitions. In addition, in 2022 the company filed a base shelf prospectus which allows for the issue of an unlimited number of common shares, preferred shares, or debt securities.

The challenge for companies that grow mainly by acquisitions is firstly to find the rights targets and then to extract synergies that can be accretive to the bottom-line profits. The second challenge is that the acquisitions need to become larger as the business grows which increases the risk that a large mistake will be made.

Descartes – comparing well with the industry leaders

Descartes is a profitable entity with attractive profit margins although the return on capital is low. But the low return on capital is somewhat explained by the many acquisitions that contributed to a large intangible asset base on the balance sheet which, in turn, depresses the return on capital.

Compared to a peer group Descartes compares well on the EBITDA margin, but the return on invested capital is below par. Revenue growth and earnings per share growth were higher than the peer average but comparable to Constellation Software over the past five years.

Finally, Descartes, Manhattan, and Constellation performed very well in terms of stock price performance with annual gains in excess of 20% over the past five years. These returns align with the high levels of profit growth and profitability.

A fortress balance sheet supported by ample cash flow

The company had shareholders' equity of $1.1 billion by the end of January 2023, zero debt, and cash of $276 million. Acquisitions made in the early part of 2023 would have consumed some of the cash but the balance sheet remains healthy.

In addition, the company generates significant cash flow, and given the asset-light business model, incurs limited capital expenditures. This leaves ample free cash flow that can be used for debt reduction, acquisitions, share buybacks, or dividend payments.

Over the past five years, the company generated $657 million in free cash flow while acquisitions amounted to $614 million, taking up the bulk of the available cash flow. The company does not pay a dividend and has not been an active buyer of its own shares in the market although it currently has regulatory approval to buy up to 7.4 million shares.

An experienced C-team

Edward J. Ryan is the Chief Executive Officer, a position he has held since 2013. He joined Descartes in 2000 when his previous employer E-Transport Incorporated was acquired by Descartes. Before he was appointed CEO, he was the corporation’s Chief Commercial Officer with oversight of sales, marketing, and customer success.

The Chief Operating Officer is J. Scott Pagan; he joined in May 2000 and was appointed to his current role in 2013. The Chief Financial Officer is Allan Brett who was appointed in 2014 and the Executive VP of Information Services, Raimond Diederik joined in 1998. Another key executive is Ed Gardner who is responsible for the development and execution of the acquisition strategy – he joined in 2003.

Executives earn a base salary, benefits, short-term incentives, and long-term incentives. Short-term incentives are based on the achievement of annual revenue, EBITDA, and cash flow targets. Long-term incentives are based on the share price performance of Descartes relative to a peer group over a 3-year period. In the 2022 fiscal year, the CEO earned $5.9 million with the incentive awards making up 91% of his total reward.

The members of the board and senior executives together hold less than 2% of the total issued shares. Major institutional shareholders are T. Rowe Price with 14.0% of the common shares and Jarislowsky Fraser holding 5.5%.

Sound recent results

The company recently reported solid results for the fourth quarter and year ending 31 January 2023. For the full year, revenues increased by 14% to $486 million and with expanding profit margins, net income was up by 18%. Fully diluted earnings per share was also up by 18%. Cash flow from operations increased by 9% and free cash flow by a similar margin.

Consensus estimates indicate a revenue growth of 14% for the 2024 fiscal year and earnings per share growth of 24%.

Nothing cheap here

Given the stock’s current price and consensus estimates for the next 12 months, the company is valued on an EV/EBITDA ratio of 24.5 times and a price-to-cash flow ratio of 29.9 times.

The operations of the selected peers overlap to some extent with the verticals in which Descartes operates. However, the peers represent a mixed bag of slow-growing large companies and fast-growing smaller companies. Compared to the average of the top-tier, slow-growth peer group, Descartes looks overvalued. When compared to the smaller, fast-growing peers, such as Constellation Software or Manhattan Associates, the valuation looks more reasonable, although still expensive.

Bottom line … nice business but too expensive

There is much to like about Descartes – management has developed the business through complementary, small, low-risk acquisitions in niche markets, and in the process created a profitable entity with strong cash flows. But the valuation is just too rich for our taste.

By Deon Vernooy, CFA, for TSI Wealth Network

For further details see: