10+2 and Descartes Systems (DSG-TSX)

Earlier this week Descartes Systems (DSG-TSX) announced that it has launched an electronic service for the new Importer Security Filing (ISF)10+2 customs filings regulations for the United States.

The 10+2 customs filing rule (10 data elements and 2 messages) is designed to help identify actual cargo movements and improve the accuracy of cargo descriptions. Expanded ISF descriptions are part of Department of Homeland Security’s (DHS) strategy to better assess and identify high-risk shipments to prevent terrorist weapons and materials from entering the United States. As well, the new descriptions help regulators trace product inputs to root manufacturers for product safety recalls (remember lead paint and toys?). The 10 data elements are:

Manufacturer (or supplier) name and address
Seller (or owner) name and address
Buyer (or owner) name and address
Ship-to name and address
Container stuffing location
Consolidator (stuffer) name and address
Importer of record number/foreign trade zone applicant identification number
Consignee number(s)
Country of origin, and
Commodity Harmonized Tariff Schedule number

Initially, the service is expected to be rolled-out to Descartes' current 4000 customers, and then bundled with current electronic services for new potential customers. Currently only 5% of documentation worldwide is handled electronically. As more Governments layer more regulation on the movement of goods, and as margins compress with a declining world economy, more shippers will be forced to switch from manual customs filing processes to electronic processes. As complexity increases, so do the costs of manual input. Increased regulation such as the 10+2 becomes increasingly positive for electronic messaging vendors such as Descartes Systems, especially in a weakened economy. Although 10+2 is a fairly major regulation, there are dozens more to be enacted over the next two years including EU harmonization. At one point soon, it may become impossible to manage shipping documentation manually.

As adoption of the service increases by its client base throughout the year, DSG revenue should increase by between $1.5 million and $2.5 million for FY2010 (C2010) and $0.01 incremental EPS or a 5% positive impact on forecasted earnings of between $0.20 and $0.23 EPS. By FY2011, the EPS impact should double to 10%.

However, the more interesting possibilities for Descartes Systems lie in bundling. As Descartes layers more electronic documentation services onto its distributed platform, it can offer compelling service bundling options for potential new clients that are difficult to compete with on pricing and scope . The bundling options would be similar to how cable companies bundle channel packages, internet access, and phone services to consumers.

In North America, the launch of the electronic 10+2 customs filing service could be a tipping point for Descartes Systems because it establishes a base for aggressive service bundling. If management executes effectively, then bundling strategies could have substantially more significant impact on performance than $0.01 EPS improvement in FY2010. Investors should be aware of this potential.

There is still a lot of gross margin leverage with this SaaS Company. Descartes Systems is well positioned to take advantage of some of the utility/cloud computing opportunities that are emerging, which should have a positive impact on network costs. Similarly, with a highly evolved and expansive normalized data taxonomy, it is well positioned to federate data flows with like-minded partners and extend its reach throughout the supply chain from point of procurement to point of sale. Such data integration could result in transaction based revenue sharing with gross margins nearing 100%.

Investor should take note of the launch of DSG's 10+2 custom filing service, because three years from now, it may be looked back upon as a key service launch in the evolution of the Company.

I do not own shares in Descartes Systems.

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