Descartes Systems: Premium Valuation For A Premium Player

In January, I concluded to not shop for shares of Descartes Systems (NASDAQ:DSGX) at the time. This came after the company has seen solid growth in 2022, despite choppier markets and more challenging market conditions. Trading around 40 times earnings, appeal was hard to find, even as I generally applaud the roll-up strategy of the business.

Certainly as a reversal in e-commerce growth was seen, including tougher comparables, I found that valuation far too demanding to see any appeal just yet.

The Business

Descartes is a Canadian provider of logistics solutions, which has seen solid growth through a continued bolt-on acquisition strategy. The company has announced dozens of deals over the past years, resulting in steady growth and added skills to be exported to other areas of the business.

Solutions offered include services offered to carriers, shippers, intermediates and others stakeholders, typically requiring intensive communication relating to reporting, compliance and taxes to facilitate global and e-commerce trade. Big logistics companies and many small and medium-sized enterprises are key customer groups of the business.

Pre-pandemic, Descartes posted an 18% increase in 2019 sales to $326 million, but moreover the business was very profitable, posting GAAP operating profits of $52 million, and net earnings of $37 million, equal to $0.45 per share. With shares trading around the $50 mark early in 2020, operations were valued at 15 times sales and over a hundred times (GAAP) earnings, very demanding multiples.

Shares rallied to a high around the $90 mark in 2021 amidst a general upbeat outlook for the economy and certainly the e-commerce sector. Shares fell to the $60 mark in the summer of 2022 amidst a setback in markets at large, but ever since shares have made up a lot of lost ground, trading near their post-2021 highs at $78 here.

During the pandemic year 2020, sales rose in a relatively modest fashion with sales up 7%, as sales growth accelerated to 22% in 2021. For the year 2021, revenues came in at $425 million as earnings (adjusted for amortization charges) rose to $1.60 per share, all while the company maintained a solid net cash position.

With the company posting double-digit percentage sales growth during the quarters of 2022, despite a challenging external environment, shares were doing quite alright as they traded in the low $70s in February. Based on a realistic earnings number around $1.70 per share and net cash position of $3 per share, forward multiples expanded to 40 times earnings again (after dipping last summer). This was a too demanding multiple to see a compelling risk reward, all while the company was awarded a roughly $6 billion market valuation.

More Deals

Since I voiced a constructive, but cautious view on the back of this valuation at $70 in late January, shares have gained some ground as they have moved up towards the $80 mark, now trading at $78 and change.

By mid-February, Descartes announced a somewhat more substantial deal than the typical bolt-on acquisition. Descartes has reached a deal to acquire GroundCloud in a $138 million deal, with earn-outs having the potential to increase the deal tag to $218 million.

GroundCloud provides last-mile logistics automation, combining operations, safety and compliance in an integrated platform. Unfortunately, no financial details other than the purchase price, have been announced. This makes it hard to judge the impact of the deal, as the price tag comes in at 2-4% of the own enterprise valuation, depending on if you include the (full) earn-out, or not.

On the first day of March, Descartes posted a solid 11% increase in fourth quarter sales to $125 million, as full year earnings were up 14% to $485 million. Quarterly GAAP earnings were up by twelve cents to $0.34 per share, with full year reported earnings up to $1.18 per share. Adding back $60 million in amortization charges to the GAAP earnings number of $102 million, earnings come in just a few pennies short from the $2 per share number based on an 84 million share count.

With net cash of $276 million, the company can easily pay for the GroundCloud deal and has more financial capacity to pursue bolt-on deals, as it can take on quite some debt as well of course given the solid underlying profitability of the firm.

The company did exactly that as it announced its next bolt-on deal in April, although that the latest acquisition was truly a bolt-on deal with Australian-based Localz adding a mere $6 million in revenues to Descartes.

Similar Stretched Valuation

Despite the fact that Descartes ended the fourth quarter on a reasonably strong note, I continue to proceed with caution here. With earnings power coming in just short of $2 per share (after adding back amortization charges, valuation multiples remain quite demanding at around 40 times earnings here. This makes me extremely cautious, as signs of global trade softening potentially has an impact as well.

The GroundCloud deal is a bit more expensive and probably should have an outsized revenue contribution, based on the assumption that Descartes is buying the business at a discount to its own valuation, but unfortunately the company did not provide more color on the fourth quarter earnings release, nor provided an outlook for the year.

Given all this, I conclude to keep a close eye on the business, but I am proceeding with caution here.

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