Descartes Systems (DSG:TO) Strong Quarter; Bullish Outlook

For convenient sequential quarterly reference, here is a link to the post for the previous quarter.

The themes remain the same: Strong quarter despite worldwide recession, improving operational efficiency, and more accretive acquisitions planned for the future. Here are the Q2 2010 performance highlights:

• $18.6m in revenue, up 9% fiscally over Q2 2009, and 7% sequentially over Q1 2010
• GM at 68%, up from 64% fiscally, and down from 70% sequentially.
• Adjusted Net Income (EBITDA) at $5.2m, up 27% fiscally, and 11% sequentially. The EBITDA margin for the quarter was 28%, which exceeded consensus expectation.
  
• Pre-tax NI at $2.7m, up 35% over Q2 2009, and up 50% sequentially.
• NI of $0.8m or $0.02 EPS versus $1.4m or $0.03 EPS for Q2 2009, and $2.2m or $0.04 EPS for Q1 2010. Both of the comparative quarters benefited from income tax recovery.
• DSO was reported at 48 days, a 2 day decline fiscally, and a 1 day decline sequentially.
• $4.4m in cashflow for the quarter, exiting with $51.2m in cash and short-term investments.
  

The baseline revenue stream entering Q3 was disclosed on the conference call by management to be $17.7m with $13.7m in operating expenses, inferring a $4.0m or 23% margin.

Management indicated that H2 2010 should benefit from the current upswing in worldwide shipments as economic recovery takes hold. The company should benefit from the integration of both the Oceanwide and the Scancode acquisitions, and should see continued adoption of the 10+2 regulatory solution positively impact financial performance. The outlook is bullish.

Management re-iterated more forcefully its plan to become a global "federated" end-to-end platform for logisitics. By comparison, think of Salesforce.com's AppExchange for CRM. As the Company implements this strategy, investors should anticipate that Descartes will use some of its war chest of cash to make tuck-under acquisitions that will expand its capability as an end-to-end platform.

As a result, the company may look to expand capabilities in asset tracking, transaction management, accounting, workforce mobility, platform computing, and even cloud services via partnerships and acquisitions.

With a strong Q2 2010, a bullish H2 outlook from Management, and a plan to dominate through federation, investors are likely to continue to find the stock attractive. The share price has doubled in value since its lows in March.

Disclosure: I own shares of DSG

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.

Descartes Systems: In Dark Days The Sun Shines on DSG

Descartes Systems operates an unsexy SaaS messaging network for the worldwide supply chain that helps to lubricate the flow of goods across international borders by automating customs and regulatory filings associated with shipping. In addition, DSG provides logistics services for fleets, which has experienced increasing demand due to higher fuel and declining shipments.

Third Quarter was better than expected.

The Company was slightly below expectations in topline sales reporting $7.1 million versus my expectation of $7.3 million due to shipping headwinds. However EBITDA was higher than expected at $4.4 million versus my expectation of $4.1 million. I believe that this is due to greater demand for higher margin services during the quarter. Cashflow was reported at $5.9 million, substantially higher than our forecast of $4.9. This better than expected result was due partly to Days Sales Outstanding (DSO) declining from 53 days to 47 days versus our expectation that DSO would increase to 60 days due to the economic stress of its client base. Reported earnings were 64% higher than my forecast at $2.3 million versus $1.4 million. Part of this difference can be explain by lower than forecasted tax expenses. EPS was $0.04 and a penny higher than my expectations of $0.03 EPS. This Company is growing at a solid rate while many others are faltering.

Outlook Is Positive For Three Reasons.

1. Regulations will increase and make shipping more complex - With the announcement of the 10+2 regulation (aimed at improving product safety) in the US, DSG is well positioned to help its clients comply at minimal relative expense, while the US government continues to keep the supply chain lubricated. By 2011, European Union regulatory harmonization will boost demand again.
2. Worldwide Recession - Shippers will need to become more efficient to survive. Only 5% of all documentation is automated. More automation should be expected, and DSG is in a great position to benefit - especially in North America.
3. Volatility and Uncertainty - These two conditions benefit DSG the most because shippers will need to contend with increasingly complex orders and contracts that may be ammended by the second. This should benefit DSG in the near-term as the only way to deal with this is through automated messaging.

A Stock for the Times

Descartes Systems Group provides a boring but essential service to the Supply Chain. As conditions deteriorate, and volatility increases, while more regulations get enacted, Descartes Systems becomes more essential to Supply Chain.

The Company has no debt and $53.5 million in cash.

A Potential Consolidator

Descartes is in great position to use its balance sheet to accelerate its capture of more regulations worldwide for automation. Its acquisition of Dexx in Europe is an early foray. I expect more to come. I also believe that the Company can extend its messaging concept to other transactions in the value chain. Finally, DSG could leverage its balance sheet to evolve into an outsources fleet management system.

I do not own shares of Descartes Systems, nor do I receive any compensation from the Company, Management, or the Board.