The Descartes Systems Group Inc. (NASDAQ:DSGX) Q2 2024 Earnings Call Transcript

The Descartes Systems Group Inc. (NASDAQ:DSGX) Q2 2024 Earnings Call Transcript September 7, 2023

Operator: Good afternoon, ladies and gentlemen, and welcome to The Descartes Systems Group Quarterly Results Conference Call. At this time, all lines are in a listen-only mode. Following the presentation, we will conduct a question-and-answer session. [Operator Instructions]. This call is being recorded on Wednesday, September 6, 2023. I would now like to turn the conference over to Scott Pagan. Please go ahead.

Scott Pagan: Thanks and good afternoon, everyone. Joining me on the call today are Ed Ryan, CEO; and Allan Brett, CFO. I trust that everyone has received a copy of our financial results press release that was issued earlier today. Portions of today’s call, other than historical performance, include statements of forward-looking information within the meaning of applicable securities laws. These statements are made under the Safe Harbor provisions of those laws. These forward-looking statements include statements related to our assessment of the current and future impact of geopolitical and economic uncertainty on our business and financial condition; Descartes’ operating performance, financial results and condition; Descartes’ gross margins and any growth in those gross margins; cash flow and use of cash; business outlook; baseline revenues, baseline operating expenses and baseline calibration; anticipated and potential revenue losses and gains; anticipated recognition and expensing of specific revenues and expenses; potential acquisitions and acquisition strategy; cost reduction and integration initiatives; and other matters that may constitute forward-looking statements.

These forward-looking statements involve known and unknown risks, uncertainties, assumptions and other factors that may cause the actual results, performance or achievements of Descartes to differ materially from the anticipated results, performance or achievements implied by such forward-looking statements. These factors are outlined in the press release and in the section entitled certain factors that may affect future results in documents filed and furnished with the Securities and Exchange Commission, the Ontario Securities Commission and other securities commissions across Canada, including our management’s discussion and analysis filed today. We provide forward-looking statements solely for the purpose of providing information about management’s current expectations and plans relating to the future.

You’re cautioned that such information may not be appropriate for other purposes. We don’t undertake or accept any obligation or undertaking to release publicly any updates or revisions to any forward-looking statements to reflect any change in our expectations or any change in events, conditions, assumptions or circumstances on which any such statement is based, except as required by law. And with that, let me turn the call over to Ed.

Ed Ryan: Thanks, Scott, and welcome everyone to the call. We had an excellent first half of the year with record financial results this past quarter. We’re excited to go over those with you and give you some perspective about the business environment we see right now. But first, let me give you a roadmap for this call. I’ll start by hitting some highlights of last quarter and some aspects of how our business performed. I’ll then hand it over to Allan who will go over the Q2 financial results in more detail. I’ll then come back and provide an update on how we see the current business environment and how our business is calibrated as we enter Q3. And then we’ll open it up to the operator to coordinate the Q&A portion of the call.

So let’s get started by looking at the quarter that just ended July 31. Key metrics we monitor include revenues, profits, cash flow from operations and returns on our investments. For this past quarter, we again had record performance in each of those areas. Total revenues were up 17% from a year ago with service revenues up almost 20%. Net income and EPS were up 23% and 19%, respectively. Income from operations was up 17% while adjusted EBITDA was up 12%. And we generated $52 million in cash from operations representing 86% of adjusted EBITDA. At the end of the quarter, we had $227 million in cash and we were debt free with an undrawn $350 million line of credit. We remain well capitalized, cash generating, debt free and ready to continue to invest in our business.

We believe a company like ours is well positioned to continue to thrive in market conditions like these, because we’ve got good organic growth plus the experience and capital capacity to execute on acquisitions. We had a good quarter of organic growth in our core services revenues, so I want to highlight some of the drivers of that. The first is just real-time visibility. Just a refresher on this, a large part of shipping is people moving goods on other people’s assets, whether they be planes, trucks, rail or boats. There may also be intermediaries involved in arranging the shipments or making required filings, including freight brokers, third party logistics providers and customs brokers. With all those assets, modes of transportation, data sources, locations and parties involved, it can be challenging to know where a shipment is and knowing the location of a shipment and when that’s going to arrive is critical to serving your customer and running your business.

Our visibility in transportation management solutions, which include MacroPoint, are increasingly important for our customers in this area. These solutions contributed to solid growth in the quarter for reasons including first, our solutions are better at tracking loads, customers pay based on the number of loads that are tracked by our solutions. So we’re aligned with our customers on doing what we can to connect as many carriers and intermediaries as possible to get location information on loads. We’ve launched new carrier self-connect tools that have helped our customers get even more location coverage across their network of carriers. We’ve also made investments in customer success personnel to help maximize the number of loads with full visibility.

The outcome has been a greater percentage of loads tracked, better data, happier customers and strong growth. Second issue is we’re winning more deals and seeing strong demand for visibility. The real-time visibility market is not without competitors. However, we’re having good success at securing new customers and welcoming back some old ones, because our commitment to tracking the success. We have a broader network that’s across more modes of transportation than our competitors and that’s being recognized by customers as they choose the visibility solution for the future. Our customers often take comfort in our reliability, and that we’re operating a business they know will be around to serve them for the long term. The third issue is visibility is embedded in more Descartes solutions.

Some customers come to us just for visibility, but others are using Descartes solutions and are looking to have visibility as an add-on to what they’re already doing. Each time we expand our solution set including by way of acquisition, we look for how we can embed visibility into the new solutions to provide an easier mechanism for our customers to track their loads. We believe that our best source of business is often our existing expansive and supportive customer base. So we’re making dedicated efforts to make visibility easier for those customers. Second big issue is routing, scheduling and mobile solutions and this contributed to our revenue success this quarter. These solutions are principally for when you’re managing your own fleet of vehicles rather than hiring space on other people’s vehicles.

We believe we’re the most experienced company in this market and have the premier routing and scheduling solutions to offer. Our customers in this area have faced recent challenges including rising labor costs, challenges in security data, rising fuel prices, and customer demands for accurate delivery windows. This is contributing to strong demand with new customer projects and existing customers retuning their solutions. We’ve also been innovative in this market, which has contributed to our market leadership. We’ve recently launched a new generation route planning solution that has been rolled out with customers. And we’ve made investments in our solutions through acquisitions with safety solutions from GroundCloud and final mile delivery tracking from Localz, all factors that contributed to good growth in this area.

The third area is global trade intelligence. Once again, we saw good growth in the global trade intelligence solutions in our business. Those solutions generally fall into three buckets. The first bucket is competitive intelligence. Our data mine solutions provide information on trade flows, historical classification of goods, and other logistics and supply chain intelligence. This information can be used to help make decisions about your own supply chain, but also to see how competitive you are with other companies supply chains. Recent attention on efficiency of supply chains has helped drive demand in this area. In addition, our data is front and center in many leading business publications as a source for data about logistics and supply chains, which has also been a good demand driver for us.

The second bucket is tariff and duty data to make intelligent shipping decisions. We provide up-to-date data about tariff and duty rates and rules around the world, which can be used by leading global trade management systems to help run international supply chains. We’ve seen an increased level of changes in tariffs and duties principally as a consequence of geopolitical tensions and trade disputes. This has changed the design of many supply chains and has increased the importance of having accurate and timely information like ours. The third bucket is compliance. These solutions help our customers make sure they’re not shipping things to people they shouldn’t be. This may be to specific people, to specific countries, to specific geographies, or in some cases specific goods being shipped.

These restrictions have expanded and increased in complexity, as the geopolitical tensions have increased, and trade disputes have emerged. In addition, governments in the larger economies, like the United States, have increased the resources dedicated to ensuring compliance and have levied substantial financial penalties on firms not taking compliance seriously. We’ve continued to see good demand for these compliance solutions as a result. The next area is e-commerce. This continues to be a growing market and part of our business. We’ve made investments into these solutions with additional leadership and also by way of acquisition with our purchase of XPS within the past year. The parcel market has seen some recent challenges with labor challenges at UPS, changing service preferences at the U.S. Postal Service and FedEx restructuring.

However, our share in the market continues to increase as we work with partners to find the most efficient way for our customers to get their deliveries made. So good acquisition and organic contribution in the quarter. We’re very happy with how the business performed in the quarter and in particular with the organic growth the business was able to produce, a few comments on our two most recent acquisition additions. The first is on GroundCloud. We combined with GroundCloud in February. GroundCloud is particularly strong in safety and compliance solutions that help identify safety incidents faced by drivers and provide responsive and targeted video training on challenges drivers face. They also help companies manage delivery obligations as they have subcontractors to other delivery brands, such as FedEx. This was one of our larger acquisitions.

And when we first combined, we indicated we anticipated some impact overall on our adjusted EBITDA margin, which we saw in Q1. We’ve made good progress on integration and actually saw a slight uptick in aggregate adjusted EBITDA margin this quarter, so we’re hoping that bodes well for the future. Finally, FedEx has recently announced that it may increase the number of shipments that will move to the independent contractor network. So we saw some good initial improved demand for that. Second acquisition is Localz. This business provides final mile visibility on deliveries. So if you’re used to watching your Uber driver or food delivery vehicle come down the street to your house, Localz technology replicates that experience for delivery of other goods.

This was a key investment in our routing, scheduling and mobile space, something our own customers need and they seek to provide a better delivery experience for their own customers. This investment was critical to some of our new customers trusting their fleet management to Descartes. Let me just summarize as I hand it over to Allan to give full financial details on the quarter. We had record financial results. The business performed well. And we believe that’s a good reflection of the value that our customers continue to get from our solutions and the hard work that our team continues to put in for our customers. We ended the quarter with $227 million in cash, $350 million in available credit, and a market opportunity where we continue to grow the business for our customers both organically and through acquisitions.

We remain focused on profitable growth so that we can continue to ensure our customers have a secure, stable and growing technology partner that can help them with their challenges well into the future. Many thanks to all the Descartes team members for everything they’ve done to contribute to a great quarter and continue to have our business in an enviable position for future success. I’ll turn the call over to Allan to go through our Q2 financial results in more detail.

Allan Brett: Thanks, Ed. As indicated, I’m going to walk you through our financial highlights for our second quarter, which ended on July 31. We are pleased to report record quarterly revenue of 143.4 million this quarter, an increase of 17% from revenue of 123.0 million in Q2 last year. While revenue from new acquisitions, including the GroundCloud acquisition completed earlier in the year, as Ed just mentioned, contributed nicely to this growth, similarly to the first quarter and really the last several years, growth in revenue from new and existing customers from our existing solutions was the main driver in growth this quarter when compared to last year. Looking further at our numbers, our revenue mix in the quarter continued to be very strong with services revenue increasing 19% to 130.7 million or 91% of total revenue compared to 109.4 million or 89% of total revenue in the same quarter last year.

Services revenue was also up nicely sequentially increasing just over 5% from the first quarter of this year, as we continue to help our customers expand with new services and additional volumes. Removing the impact of recent acquisitions, on a like-for-like basis, we would estimate that our growth in services revenue from new and existing customers would have been just over 9% for the quarter when compared to the same quarter last year, similarly to the results we saw in Q1 this year. License revenue came in at 1.4 million or just 1% of revenue in the quarter, down from license revenue of 3.3 million in the second quarter last year, as we had a couple of larger than normal license deals closed in the second quarter last year while professional services and other revenue came in at 11.3 million or 8% of revenue, up approximately 10% from revenue of 10.3 million in Q2 last year.

This was mainly as a result of recent acquisitions, including GroundCloud. Gross margin for the second quarter was 76% of revenue for the quarter, pretty consistent with gross margins we realized both in the first quarter of this year and the second quarter last year. Operating expenses increased by approximately 19% in the second quarter over the same period last year, and this was primarily related to the impact of recent acquisitions, including GroundCloud but also from additional labor-related costs as we continue to invest in various areas of our business to prepare for future growth. So as a result of both revenue growth offset slightly by our planned cost increases in the business, we continue to see strong adjusted EBITDA growth of 12% to a record 60.6 million, up from 54.0 million in Q2 last year.

As a percentage of revenue, adjusted EBITDA came in at 42.3% of revenue, down from 43.9% of revenue in Q2 last year. And as mentioned in Q1, this is once again primarily related to the acquisition of GroundCloud earlier in the year as it came into Descartes with much lower EBITDA ratios than the rest of our business. We should note that our adjusted EBITDA ratio as a percentage of revenue did increase slightly in Q2 when compared to Q1 of this year, as we’ve already started to work at improving the profitability on the GroundCloud business consistent with our plans as Ed mentioned earlier. As a result of the above, net income under GAAP came in at 28.1 million or $0.32 per diluted common share in the second quarter, an increase of 23% from net income of 22.9 million or $0.27 per diluted common share in the second quarter last year.

If we look at our operating results for the first half of the year, the trends stay the same. Revenue came in at 280.0 million, an increase of 17% from revenue of 239.4 million in the first six months last year. For the six months year-to-date, adjusted EBITDA came in at 118.3 million or 42.3% of revenue, up just over 12% from 105.2 million or 43.9% of revenue last year. Net income for the six-month year-to-date period increased 25% coming in at 57.5 million or $0.66 per diluted common share compared to 46.0 million or $0.53 per diluted common share in the first half of last year, again, with higher operating profits being partially offset by higher tax expense. With these strong operating results and continued strong accounts receivable collections, cash flow generated from operations came in at 52.0 million or 86% of adjusted EBITDA in the second quarter, an increase of 12% from operating cash flow of 46.4 million or also 86% of adjusted EBITDA in the same quarter last year.

For the six months year-to-date, operating cash flow has been 100.9 million or 85% of our adjusted EBITDA, up 11% from 90.8 million in the first half of last year. And we should mention as always going forward, we expect to continue to see strong cash flow conversion and generally expect cash from operations to be between 80% to 90% of our adjusted EBITDA in the periods ahead, subject any unusual fluctuations or future changes and contingent consideration payments that we’ll discuss later as I comment on our outlook for the second half of the year. So overall, we’re once again pleased with our operating results in the quarter as strong organic growth and solid performance from our recent acquisitions resulted in 17% growth in revenue and a 12% increase in adjusted EBITDA for the quarter.

If we turn our attention to the balance sheet, our cash balances totaled 227 million at the end of July, an increase of approximately 45 million from the end of the first quarter in April. While we generated 52 million in cash flow from operations, we also used 6 million of our existing cash balances to complete an earn-out or contingent consideration payment on a past acquisition, while also adding 2 million in capital additions during the quarter. As a result, we currently have our 227 million of cash as well as a $350 million line of credit available under our credit facility available to deploy towards future acquisitions. So we continue to be well capitalized to allow us to consider all opportunities in our market consistent with our business plan.

As we turn our attention to the second half of fiscal 2024, we should note the following. After incurring approximately 3.4 million in capital additions in the first half of the year, we expect to incur approximately 2 million to 3 million in additional capital additions for the balance of the year. At this point, we currently expect the second half of the year we’ll use approximately 22.8 million of our cash to pay additional contingent consideration payments on two acquisitions. While the entire 22.8 million estimated contingent consideration to be paid is now accrued for on our balance sheet, 12.7 million of this balance relates to the portion of the earn-out arrangements that were accrued for at the time of the acquisition and will be reflected in cash flow from financing activities while the remaining balance of approximately 10 million will be reflected in cash flow from operating activities when paid as a result of these acquisitions have been better than our initial expectations.

After incurring amortization costs of 30.2 million in the first half of the year, we expect the amortization expense will be approximately 29.8 million for the second half of the year, with this figure being subject to adjustment for foreign exchange changes and future acquisitions. Our income tax rate for the second quarter came in at approximately 27% of pre-tax income, which is right around our blended statutory tax rate. Looking into the second half of the year, we currently expect our tax rate will continue to be in the range of 25% to 30% of our pre-tax income, or somewhere either side of our statutory blended rate. However, as always, we should state that our tax rate may fluctuate quarter-to-quarter from one-time items that may arise as we operate internationally across multiple countries.

And finally, after incurring stock-based compensation expense of 7.4 million in the first half of this year, we currently expect stock compensation will be approximately 9.3 million for the balance of the year, subject to any forfeitures of stock options or shared units. And with that, I’ll turn it back over to Ed to wrap up with some closing comments as well as our baseline calibration for Q3.

Ed Ryan: Great. Thanks, Allan. With Q3 a month in, we remain confident in our business but cautious about the broader economic circumstances and various statistics and commentary relating to the supply chain logistics markets. On the broader economic front, this continued high interest rates, pervasive conflict in Ukraine, labor availability challenges and various recessionary pressures and economic discussions. In the supply chain and logistics market, here’s a few things we’re noting. First is shipping volumes. Shipping volumes across various modes of transportation are below their pandemic highs and more closely tracking pre-pandemic trends. In addition, there are some current challenges such as the reduced flow through the Panama Canal caused by low water levels that could impact shipping alternatives.

The second is retailer inventories. This higher level of retailer inventories potentially impacting fall replenishment cycles, inventories aren’t decreasing, implying retailers are matching demand with replenishment and potentially carrying more safety stock. The third is consumer demand. There’s uncertain consumer demand coming into this peak buying season, in particular it’s uncertain how spending habits will split between durable goods and services and experiences. Overall, U.S. consumer spending is still high, but there’s caution as we approach the holiday season. The fourth is some capacity left the market. The U.S. truck market has seen some capacity come out of the market with the recent bankruptcy of Yellow. The market continues to adjust the post pandemic volumes and it’s possible more capacity will leave.

In air, we’re seeing capacity adjustments with less reliance on pure air freighters. With additional trade restrictions, there continues to be new restrictions announced principally relating to the war in Ukraine and in connection with burgeoning trade tensions between the U.S. and China. Some new restrictions have been announced with respect to investment in and trade in chip manufacturing, AI and quantum technologies. These restrictions can be positive for our global trade intelligence business, but can also impact freight volumes. There’s also labor challenges. Labor negotiations have created challenges for UPS, West Coast ports and Yellow and may impact other unionized supply chain players. Next are some logistics participants planning for a muted peak season.

General commentary from logistics participants is bracing for lower volumes in the second half of the year with some companies taking proactive cost reduction activities. This is illustrative of the pervasive sentiment of caution. And then finally, distribution of parcel volumes among larger players is uncertain. As I mentioned earlier, UPS has some labor challenges which may have resulted in some parcel buying cautiously being redirected to other players. FedEx has publicly indicated it will be moving more parcel volume to its ground division with independent contractors and away from its Express division using employees. The U.S. Postal Service has implemented various new service adjustments as it seeks to compete and Amazon has announced its reentering the parcel delivery business.

All of this combines to provide a very competitive environment with uncertainty as to how the volumes will shake out among the various providers. So those are some of the things we’re hearing from our customers and seeing in our business, things that also inform our calibration for the quarter. Our business is designed to be predictable and consistent. We believe that stability and reliability are valuable to our customers, employees and our broader stakeholders. To deliver this consistency, we continue to operate from the following principles. Our long-term plan is for our business to grow adjusted EBITDA 10% to 15% annually. We grow through a combination of organic growth and acquisitions. We take a neutral party approach to building and operated solutions on our global logistics network.

We don’t favor any particular party. We run our business for all supply chain participants, connecting shippers, carriers, logistics, service providers and customs authorities. When we over perform, we try to invest that over performance back into our business. We focus on recurring revenues and establishing relationships with customers for life. And we thrive on operating a predictable business that allows us forward visibility to our revenues and investment paybacks. In our Q2 report, we provided a comprehensive description of baseline revenues, baseline calibration, and there are limitations. As of August 1, 2023, using a foreign exchange rate of $0.75 to the Canadian dollar, $1.10 to the euro and $1.28 to the Great Britain pound, we estimate that our baseline revenues for the third quarter of 2024 are approximately $124 million and our baseline operating expenses are approximately $78 million.

We consider this to be our baseline adjusted EBITDA calibration of approximately $46 million for the third quarter of 2024 or approximately 37% of our baseline revenues as at August 1, 2023. We continue to expect the adjusted EBITDA operating margin range of 40% to 45%, our margins vary in that range given such things as foreign exchange movements and the impact of acquisitions as we integrate them into our business. Last quarter, GroundCloud impacted our margin while we started the integration work to bring it up to our desired Descartes contribution levels. The integration activities have gone well, we’ve already seen some margin improvement in Q2, and we’re planning for some additional margin improvement going forward, absent any other acquisition activity.

We’ve got lots of exciting things planned in our business. It remains an uncertain broader economic and supply chain environment. But we believe our proven track record of execution, solid capital structure and customer focus will serve us well. Thanks, everyone, for joining us on the call today. As always, we’re available to talk to you about our business in whatever manner is most convenient for you. And with that, operator, I’ll turn it over to you for questions.

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Q&A Session

Operator: Thank you. Ladies and gentlemen, we will now conduct a question-and-answer session. [Operator Instructions]. Your first question comes from the line of Matt Pfau from William Blair. Your line is now open.

Matt Pfau: Great. Thanks, guys. I wanted to follow up on some of the comments you made about potential headwinds in the back half of the year here. How should we think about those in terms of the potential impact on your business? Part of your business is transaction based but it’s not as simple as just being tied to shipping volume. So how do we think through the potential puts and takes there in terms of the impact on your revenue?

Ed Ryan: Well, as we’ve been talking about for a year or two now, we have a lot of things going very well in our business. And maybe it will be going better if at some point in the future, transportation transactions went down. We don’t know what the future is going to bring. We’re just running the business, looking at what’s going on in the market and going hey, there’s some uncertainty out there. So we’ll see what happens. As you’ve seen in the past, transportation transactions have gone down and still performed very well. We do that because we sell a lot of software outside of that 60% of our recurring revenues outside of transaction-based volume. And even in the transaction space, we tend to be picking up more volume over the course of a quarter or a year because our customers are doing more business with us and as a result we end up doing pretty well even in the face of the industry having a lackluster time.

So we’ll see what happens. I don’t know what’s going to happen in the rest of the year. We’ve heard different things, the same stuff you probably read in the paper. We’ll see what happens, but we like our chances either way.

Matt Pfau: Great. And just wanted to follow up on MacroPoint. You called out that that’s been an area of strength and performing well in a trucking environment that was oversupplied. How does trucking capacity coming out of the system potentially impact that? Is that anything material to think about?

Ed Ryan: That’s interesting. That’s actually one of the areas I think about when I made the comment a minute ago. MacroPoint continues to grow in a relatively flat truck environment, because it continues to pick up more and more customers and more volume from our competitors. I went over that in some of the prepared comments on the call today. But MacroPoint’s a big beneficiary of that as people realize the importance of having a network and they value that over a flashy application, because we can track more loads, more and more customers are settling with Descartes because they’re saying, hey, that’s what’s most important. My ability to put in 100 loads and be able to track high 80s, low 90s percentage of those loads is much more important than the visibility application I’m using myself. Most of the time, they’re not even using an application to look at these things.

Matt Pfau: Great. Thanks guys for taking my questions. I appreciate it.

Ed Ryan: Thanks, Matt.

Operator: Your next question comes from the line of Paul Treiber from RBC. Your line is now open.

Paul Treiber: Thanks very much. Good afternoon. Just a question on the earn-outs. I don’t recall in the past you having this degree of earn-outs. What’s changed now over the last several acquisitions that are leading to these earn-outs versus acquisitions in the past?