Descartes Systems – Growing Along (NASDAQ:DSGX)

Descartes Systems (NASDAQ:DSGX) is an e-commerce facilitator which benefits from its roll-up strategy, providing a growth impetus on the back of the secular growth play which the company is. After all, while the near-term outlook for e-commerce is held back by tough comparables amidst reopened economies and economic concerns, long-term drivers for the continued rise of e-commerce remain largely intact.

I looked at the name late in 2020 when I concluded that valuations were a bit too rich for me to get involved, despite this arguably attractive positioning. The same applies now even as valuations have come down, as higher interest rates and diminished growth prospects make it hard to justify the current premium valuation.

Former Take

Descartes is a Canadian provider of SaaS solutions in logistics-intensive industries, operating a “total growth” model which is based on organic growth and bolt-on dealmaking. Besides total growth, the company focuses heavily on growing the recurring revenue base, as the network effect benefits from more routes, customers, countries etc. Descartes has been focusing on bolt-on transactions with some 24 deals announced between 2014 and 2020 at a combined cost of some $800 million, with typical purchases ranging in the tens of millions. This is exemplary of the “roll-up” strategy as it adds incremental capabilities and services, not causing potential for major operational turmoil, while these qualities can be exported to the rest of the business.

These network solutions include carriers, shippers, intermediaries and governments, among others. All these stakeholders require extensive communication to let actual products flow, meet reporting and compliance requirements and to provide information. These solutions are used by leading names in the industry, including airlines, but also traditional logistics names like XPO, UPS, FedEx, DSV and K+N, as well as consumer names like Home Depot and Wayfair, among many others.

Amidst the outbreak of the pandemic, Descartes posted an 18% increase in sales for the year 2019 to $326 million, with growth driven by the focus of organic growth and dealmaking. GAAP operating earnings rose 26% to $52 million, with net earnings coming in at $37 million, equal to $0.45 per share. With shares trading at $55 at the time, it was needless to say that valuations were sky-high at some 100 times GAAP earnings and around 15 times annualised sales.

These were far too ambitious valuations in my eyes to see any appeal, despite the big impetus of the pandemic to e-commerce at large, and its suppliers and beneficiaries, like Descartes.

$60 – $90 – $60

With shares trading at $60 late in 2020, they rallied to a high of $90 late in 2021, but amidst the pullback in many e-commerce names, shares have sold off to $60 again here, marking zero returns in nearly two years’ time.

Early in 2021, the 2020 results showed modest growth despite the pandemic. Revenues rose 7% to $349 million as GAAP operating profits rose to $71 million, even after a $56 million amortization charge. GAAP earnings came in at $0.61 per share, but realistically come in half a dollar higher if we adjust for amortization charges, for a realistic $1.10 per share number. This reduced multiples a great deal, certainly if we account for a $133 million net cash balance.

During the boom year 2021, the company has seen continuation of growth with revenues up 22% to $425 million. GAAP earnings improved to exactly a dollar, and if we account for amortization of intangible assets, realistic earnings trend at $1.60 per share. In the meantime, net cash balances have improved to $213 million, equal to about $2.50 per share. Based on the current valuation at $60, the unleveraged business trades at still a hefty 35 times realistic earnings multiple, as the sales multiple has fallen to roughly 11 times here.

On the first day of June, the company posted first quarter results for what the company calls its 2023 fiscal year, really corresponding to the calendar year 2022. Revenues were up 17% to $116 million as I peg the realistic earnings numbers around $0.40 per share here. The 86 million shares now trade at $59, for an equity valuation of just over $5.0 billion, and around $4.8 billion after accounting for a net cash balance of $212 million.

To provide some impetus to the growth this year, Descartes has been resorting to bolt-on dealmaking again. In April, Descartes announced a $4 million deal for Foxtrot, a provider of machine learning mobile route execution solutions. In June, a slightly larger deal was announced as the company reached a deal to acquire XPS Technologies in a deal valued at $65 million, with potential earn-outs topping this number to $75 million. No revenue numbers have been communicated, but with the deal, Descartes gets a hold of cloud-based multi-carrier parcel shipping solutions.

And Now?

Working with a 10% growth assumption for this year, I see revenues at around $475 million, with perhaps a bit of risk to that outlook. Realistic earnings are likely seen around $1.60 per share, as I expect some headwinds to the bottom line here. Hence, valuations remains quite stretched at around 35 times here, as the business is hugely profitable already, all while end markets will likely grow at a much slower pace and higher interest rates are not favorable for highly valued companies.

Hence, I am much more constructive on Descartes as I was late in 2020, and while the intermediate growth in sales and earnings has been beneficial, valuations remain demanding in perhaps a more unforgiven market.

While management believes the shares are cheap, with a huge 7 million share buyback program being announced early in June, I am perhaps a bit more reserved here, not seeing a reason to become immediately involved here despite the recent voice of optimism displayed by management.