Company Notes Series (#12): Descartes Systems Group

Editor’s note: This is the latest edition in the “Company Notes Series”, where we periodically share our notes on companies we’ve studied in the recent past but currently have no vested interest in (we may invest in or sell shares in the companies mentioned at any time). The notes are raw and not updated, and the “as of” date for the data is given at the start of the notes. The first 11 editions in the series can be found here, here, here, here, here, here, here,  here,  here, here, and here. Please share your thoughts on the series through the “Contact Us” page; your feedback will determine if we continue with it. Thanks in advance!

Start of notes for Descartes Systems Group

Data as of 2023-02-21

Background

  • Founded in 1981
  • Listed in 1999, dual listing on NASDAQ (NASDAQ: DSGX) and Toronto Stock Exchange (TSX: DSG)
  • Headquartered in Ontario, Canada
  • Over 1500 employees
  • Reports financials in the US$

Business

  • The problem Descartes is trying to solve:
    • We believe logistics-intensive organizations are seeking to reduce operating costs, differentiate themselves, improve margins, and better serve customers. Global trade and transportation processes are often manual and complex to manage. This is a consequence of the growing number of business partners participating in companies’ global supply chains and a lack of standardized business processes.
    • Additionally, global sourcing, logistics outsourcing, imposition of additional customs and regulatory requirements and the increased rate of change in day-to-day business requirements are adding to the overall complexities that companies face in planning and executing in their supply chains. Whether a shipment is delayed at the border, a customer changes an order or a breakdown occurs on the road, there are increasingly more issues that can significantly impact the execution of fulfillment schedules and associated costs.
    • The rise of e-commerce has heightened these challenges for many suppliers with end-customers increasingly demanding narrower order-tofulfillment periods, lower prices and greater flexibility in scheduling and rescheduling deliveries. End customers also want real-time updates on delivery status, adding considerable burden to supply chain management as process efficiency is balanced with affordable service.
    • In this market, the movement and sharing of data between parties involved in the logistics process is equally important to the physical movement of goods. Manual, fragmented and distributed logistics solutions are often proving inadequate to address the needs of operators. Connecting manufacturers and suppliers to carriers on an individual, one-off basis is too costly, complex and risky for organizations dealing with many trading partners. Further, many of these solutions do not provide the flexibility required to efficiently accommodate varied processes for organizations to remain competitive. We believe this presents an opportunity for logistics technology providers to unite this highly fragmented community and help customers improve efficiencies in their operations.”
  • Provides software for logistics and supply chain management business processes; helps customers to streamline their logistics processes and save costs. Customers use Descartes’ software “route, schedule, track and measure delivery resources; plan, allocate and execute shipments; rate, audit and pay transportation invoices; access and analyze global trade data; research and perform trade tariff and duty calculations; file customs and security documents for imports and exports; and complete numerous other logistics processes by participating in a large, collaborative multi-modal logistics community.” In other words, Descartes help customers manage their end-to-end shipment, including researching global trade information, booking of shipment, tracking of shipment, regulatory compliance filings, settlement of audit etc. Descartes offers many software applications that are modular and interoperable.
  • The company has historically lost, over a 1-year period, 4% to 6% of aggregate annualised recurring revenue 
  • Customers include logistics companies (3P logistics providers, freight forwarders, and custom brokers), transportation companies (air/land/ocean), and distribution-intensive companies where logistics is critical in their own product or service offering (direct-to-consumer e-commerce companies for example); these customers include Delta Air, CMA CGM, FedEx, DHL, Home Depot, WayFair, Coca-Cola, Toyota, Fresenius. 
  • Has a mostly SaaS model subscription model but also has a few clients on perpetual licenses – worth noting that some of the revenue earned by Descartes from its software is tied to volume of shipments being processed.
  • Descartes’ tailwinds: Can benefit from the rise of e-commerce and greater demand for logistics
  • Created a Global Logistics Network (GLN) – a state-of-the-art messaging network – of trading partners that customers can use. This GLN is the moat behind Descartes as it is the foundation of the company’s technology platform that manages the real-time flow of data and documents that tracks and control the movement of inventory, assets, and people. Customers can use the GLN to access and collaborate with a wide range of trading partners.
  • In first 9 months of 2022, USA was 63% of total revenue, EMEA 26%, Canada 7%, and Asia Pac 4% 

Sales strategy

  • Sales in North America and Europe are through direct sales
  • Use channel partners in APAC, India, LATAM, and Africa. Channel partners include distributors, alliance partners, and value-added resellers
  • Has a “United by Design” alliance with numerous companies so that Descarte’s software is interoperable with numerous other service providers (this is another moat in my view) 

Customer Stats

  • 25,000+ customers worldwide, from 160+ countries
  • On an annual basis, Descartes now tracks >575 million shipments in real time and processes >18.6 billion messages

Growth strategy

  • Acquisitions are a key factor in Descartes’ historical growth (see “Financial Results” below); the acquisition strategy is focused on “complementary technologies, industry consolidation and close adjacencies across logistics”
  • Made 31 acquisitions for a total sum of $1.04 billion since 2014. This is more than its total free cash flow generated, so it funded some acquisitions through secondary public offerings in July 2014 (in FY2015) and June 2019 (in FY2020). But Descartes has recently been building back its cash position; as of October 2022, it has net cash of US$229 million (cash minus capital leases)
  • Likely will accelerate acquisitions again?

Financial Results

  • Fiscal year ends on 31 Jan
  • Revenue compounded at 15.7% per year (FY2010 – FY2022)
  • FCF compounded at 22%
  • FCF ex WC (working capital) margin has grown from 22% to 36%, aided by some WC change. But even excluding WC changes, FCF has compounded at 20.7%
  • Cash conversion is 231% of net income. Cash conversion ratio is super high for two reasons: (1) Net income impacted by amortisation of intangible assets which is not a cash expense but quite significant on the income statement; (2) Some SBC
  • FCF per share has compounded at 16.5% (FY2010 – FY2022) which accounts for the dilution from the two secondary offerings made in the period
  • Company is now net cash positive at US$229M
  • There is some dilution from SBC (stock-based compensation) but it is minimal and well-controlled (weighted average diluted share count up 3.6% from FY2010 to FY2022)

FY2023 Q3 Results

  • New financial year starts on 1 Feb
  • Q3 FY23 revenues were up 12% but down QoQ due to forex to US$121.5 million
  • 91% of revenue is service revenue and 8% is professional fees
  • License only makes up 1%
  • CFO was US$50.9 million, up 18%, and 42% of revenue
  • Year-to-date revenue was up 16% and CFO up 8%
  • Has US$237 million in cash and US$350 million of credit facilities (which can be expanded to US$500 million upon lenders’ approval), so there’s ability to leverage up the balance sheet which could be good for shareholders

Management

  • CEO Edward J. Ryan (54). Been CEO since November 2013, was previously Chief Commercial Officer (2011-2013). Joined Descartes in 2000. 
  • President and COO J. Scott Pagan (49). Been COO since November 2013. Joined Descartes in 2000.
  • CFO Allan Brett (55). Been CFO since May 2014. Joined Descartes as CFO
  • Hard to tell exactly how many shares are owned by them because the data reported is only for market-value of shares held, and market value of “in the money” of unexercised but vested options held by them. But nonetheless, as of 29 April 2022, based on a share price of C$80.14 (the weighted-average price for the 5 days prior to 29 April 2022) – price is C$101.29 as of 21 Feb 2023 – the value of Descartes shares controlled by Ryan, Pagan, and Soctt, is US$34.0 million, US$35.0 million, and US$14.0 million, respectively. That is a decent amount of skin in the game.

Compensation of Management

  • Compensation consists of 3 components: (1) Base salary and benefits, (2) Short-term incentives, and (3) Long-term incentives.
  • Base salary for FY2022 was US$500,000 for Ryan, US$350,000 for Pagan, and US$350,000 for Brett.
  • Short-term incentive for FY2022 was a maximum of US$750,000 for Ryan, US$446,250 for Pagan, and US$367,500 for Brett. Short-term incentive for FY2022 was based on Descartes’ adjusted EBITDA, revenue, and OCF as % of adjusted EBITDA. Descartes had to meet targets in FY2022 of 10% growth in adjusted EBITDA (actual was 31%), 9% growth in revenue (actual was 22%), and OCF as % of adjusted EBITDA of 80-50% (actual was 95%). All 3 executives were paid short-term incentives of the maximum amount stated. 
  • Long-term incentive for FY2022 consists of:
    • PSU grants which vest at the end of a three-year performance period
    • RSU grants which vest over a period of three fiscal years; and
    • stock options that vest over a period of three fiscal years. 
  • The actual PSU to be received by the executives ranges from 0% to 200% of the granted target PSUs and depends on the total shareholder return of Descartes relative to a Comparator Group over a 3-year period. If Descartes is less than the 30th percentile, the actual PSU distributed will be 0%; if Descartes is in the the 90% percentile or higher, the actual PSU distributed will be 200%. On the date of the grant, the target PSUs were worth US$2 million; the RSUs were worth US$1.4 million, and the stock options were worth US$0.6 million. The Comparator Group includes Enghouse Systems, Kinaxis, Wisetech Global, Aspen Technology, Ebix QAD, and more.
  • Sensible compensation structure, since it emphasises long-term stock price return. Dollar-amounts are reasonable (though on the high-side) since the total compensation of each executive in FY2022 is still a single-digit percentage of net income and FCF.

Valuation

  • US$6.4 billion market cap (as of 21 February 2023) and trailing FCF of US$182 million
  • ~35 PFCF ratio 
  • EV of US$6.1 billion, so EV-to-FCF of 34
  • Doesn’t pay a dividend nor does it buyback shares, so no cash is being returned to shareholders yet
  • But there are good capital allocators at the helm so far, judging from growth of business through acquisitions
  • Pricey given that all the cash flows need to be reinvested back to drive growth in the form of acquisitions

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