All improvement: The Descartes Systems Group's CEO Discusses Q3 2014 Results

Executives

Edward J. Ryan – CEO

J. Scott Pagan – President & COO

Stephanie Ratza – CFO

Analysts

Gabriel Leung – Paradigm Capital

Michael Urlacher – GMP Securities

Richard Davis – Canaccord Genuity

Scott Penner – TD Securities

Pardeep Sangha – PI Financial

Thanos Moschopoulos – BMO Capital Markets

Ralph Garcia – Global Maxim

The Descartes Systems Group Inc. (DSGX) Q3 2014 Earnings Conference Call December 4, 2013 8:00 AM ET

Operator

Welcome to the Descartes quarterly results conference call. My name is John and I will be your operator for today’s call. At this time all participants are in a listen-only mode. Later we will conduct a question-and-answer session. (Operator instructions)

And please note that the conference is being recorded. And I will now turn the call over to your host, Scott Pagan. Scott, you may begin.

J. Scott Pagan

Thanks and good morning everyone. And joining me on the call today are Ed Ryan, CEO; and Stephanie Ratza, CFO. I trust that everyone has received a copy of our financial results press release that was issued earlier today. In addition, our quarterly report is now filed on SEDAR in Canada.

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 Descartes’ operating performance, financial results and condition, 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 SEC, the OSC, and other security commissions across Canada.

We provide forward-looking statements solely for the purpose of providing information about management’s current expectations and plans relating to the future. You are cautioned that such information may not be appropriate for other purposes. We do not 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 statements is based, except as is required by law. And with that let me turn the call over to Ed.

Edward J. Ryan

Good. Thanks Scott, and thanks to everyone who has reached out to us in the past week about the new role. On behalf of everyone here at Descartes we really appreciate your support. As most of you know, last week we announced the planned executive transition, where I became CEO, and Scott became president and chief operating officer. At the same time we announced Art’s retirement from Descartes in part to focus on stabilizing his health issues.

We know this transition will help get him healthier and wish him all the best moving forward. On behalf of everyone here at Descartes I would like to thank him for all of his help over the years. Just to give you some background on the transition process for those we may not have been able to speak with directly, this transition has been in the works for a number of years. About 4 to 5 years ago, Art and our board of directors along with Scott and myself put in place a succession plan that was to be executed over a number of years.

At that point Scott and I kicked off that plan by informally starting to manage a large part of the organization. About 2 to 2.5 years ago, we more formally took charge in the day-to-day operations of business. Art and our board planned for this as a logical next step in the evolution of Descartes. More recently over the past year and a half, Art and our board of directors asked us to establish better contact with a number of the analysts covering our company, as well as many of our major shareholders just so there wouldn’t be a big surprise in the day that these changes were announced.

Art played a big role in introducing us to everyone, and helping us to get comfortable talking to analysts and shareholders, and we really appreciated his support. All of this was done with an eye towards this day, so that we will be ready to lead our company and help take it to the next level. And I shouldn’t just make this about Scott and me there is a great team behind us. But planning for this transition over a number of years, we were able to build a strong management team that supports us, and was also ready for the transition.

Across the management team we have a ton of logistics experience, most of us have been in the business, you know, for somewhere between 5 and 25 years in this industry. We have lots of technology experience. Most of us have spent a large part of our careers working for technology companies and we have lots of Descartes experience. We have all been working together for over six years, and some of us for more like 10 to 12 years. Most of us grew up in this business together, and have become not just partners but friends.

We also have broader team of 800 plus employees around the world that remain focused on servicing our customers. Those of you who have been to our user group know that the biggest strength of our company is the fantastic people that we have, and the strong and persistent work ethics that they deliver each day to help our customers get results. It is great to know that we have a strong team behind us as we take this next step forward.

Scott and my previous roles encompassed operations, acquisitions and strategy. We are very focused on delivering results to our customers, as focused as we have been in delivering results to our shareholders. Scott and I have run Descartes operations to generate the superior financial results that you have seen over the past several years, and the results we are reporting to you today.

We are also responsible for acquisitions, for locating them, negotiating them, executing them and integrating them and that won’t change moving forward. And finally we worked with Art in developing and testing Descartes strategy, the same strategy that we are executing on today. Both Art and I have been in this industry over 20 years and have a lot of experience and history that we drew upon as we set our strategic course.

So let us talk about the strategy of the company. I would imagine that our shareholders want to make sure we plan on operating the same company that they invested in, so let us talk about that a little bit. We will be executing the same strategy because it is the strategy we played a big part in developing and executing over the past several years. If there is a change, is that you will see us more laser-focused on the transportation and logistics markets as we expand in the supply chain market.

You will not see us try and enter completely new verticals in the short term. These are huge markets, supply chain, logistics and transportation, and our vision can best be accomplished with intense focus on these markets. Our vision is to be the global logistics network for communities collaborating the logistics and supply chain processes and a platform for enterprises managing their own private logistics and supply chain processes.

To succeed we need to do a bunch of things. One, we need to continue to grow our network of authenticated connected parties that are essential to logistics, and serve as both an attraction to customers and a barrier to entry to our competitors. We need to continue to be viewed as the main experts in logistics and supply chain. We need to continue to be viewed as trusted and neutral and non-competitive to our customers. We need to continue to present customers and partners with a stable logistics and technology platform that can be relied on for the long term.

And of course, we need to continue to generate cash and have access to capital to facilitate acquisitions. And finally we need to continue to be viewed as the ideal steward for businesses and customers that join us via acquisition. We will also continue with the same financial growth strategy that is to say we will continue to be laser focused on profitable growth. We will continue to target 10% to 15% adjusted EBITDA per share growth per year, and we will do that through organic growth and acquisitions, just as we always have.

We run our operations with a focus on recurring and repeatable revenues as opposed to one-time sales. We want customers for life, not just one-time big deal revenue, to continue to run our operations in the high 25% to 30% range of adjusted EBITDA with a focus on cash generation. And we are going to use cash generated in our available debt and capital to buy businesses, to expand our networks geographical presence, expand our functional footprint and expand our community of network participants. Our execution to this strategy so far has led to record financial results, and we plan to continue to do more of the same moving forward.

Our business is in great shape. We have record revenues this past quarter of $38.8 million, which puts us at about $150 million run rate. We have record adjusted EBITDA of $11.4 million, which puts us at about a $45 million run rate. We have very good cash from operations, $9.2 million this past quarter, which is just a little over 80% of adjusted EBITDA. And we have great collections. We have 47 days DSO -- 47 day DSOs, and it is a great indication that our customers are happy.

These are the things that got us here. We plan on doing more of the same moving forward each day, and try to move a little bit faster and a little bit further. That is what we have been doing for the past nine years, and that is what we plan to do moving forward. Before I turn it over to Stephanie, I want to give thanks to the bunch of people that helped us get here, and I’m sure bunch of the people that will help us move forward in the future. First to our customers and partners, their support has been crucial to the growth of our network. They stuck with us in the bad times. They tell us what to build next, they tell us what to buy next, and the best ones partner with us in each of our next endeavors.

This is what we mean when we say customers for like. I like to thank our employees for their focus on servicing our customers, and their dedication to doing that everyday. And finally I like to thank our board of directors for their support through this transition process. Their planning has been invaluable to us as we moved through this process over the last 4 to 5 years.

With that I will turn it over to Stephanie for some comments on the financial results. Stephanie.

Stephanie Ratza

Great. Thanks Ed. My comments will focus on the Q3 fiscal 2014 quarter. We assume everyone has read the press release, so I will try not to repeat what is already in there. We also filed our shareholder report this morning on [Indiscernible] in Canada. Here are a few highlights for the quarter. We had record revenues with our recent success in home delivery being a big contributor this quarter. As well, we have seen increased network volumes contributing to the growth in our service revenues. This is unusual for Q3 as it reflects the increased seasonal shipment volume as retailers around the world get ready for their holiday season.

Adjusted EBITDA was strong and increasing as a percentage of revenues from the previous quarter, as we advanced on the integration of May acquisition of KSD. Our customers are happy, and you are seeing this in both the cash flow from operation being healthy, as well as our DSOs being lower compared to previous quarters.

Cash from ops is greater than 80% of adjusted EBITDA in the quarter, and 92% on a year-to-year basis. Over the past seven years, we have 31% compounded annual growth rate in cash from ops. Here’s a few other things to note. As Ed mentioned, one of our key operating metrics we monitor is the growth in our adjusted EBITDA per share. We target between 10% to 15% annual growth. This quarter is 13% over a year ago and we are on track for 15% annualized.

Net income includes $0.8 million of acquisition and restructuring related expenses related to the KSD acquisition, and $4.6 million of amortization of intangibles acquired in part of the previous acquisition. With the restructuring activities, we ended the quarter with 822 employees, down 8 employees from the prior quarter. From a capital perspective, as of October we had working capital greater than $60 million. We had $49.3 million in cash, $17.2 million of debt drawn with an additional $32.8 million that we can draw upon for future acquisitions.

We had 62.8 million shares issued and outstanding, and our total weighted average on a fully diluted basis was 64.3 million. Looking forward at the final quarter of the year and beyond, we note the following. We expect to incur approximately $0.2 million in restructuring costs in the Q4 relating to KSD and other previously announced restructuring activities. We expect to incur approximately $2 million in retirement charges in connection with our recent executive transition. We may incur up to $0.3 million of incremental tax planning in Q4.

These costs are not reflected in our baseline expense calibration, as we are not certain whether they will be incurred in Q4 or in Q1. We expect to incur approximately $1 million in capital expenditures in Q4. We expect some acquisition costs in Q4, but difficult to estimate at this time. As Ed mentioned, we have got a robust pipeline.

We don’t expect any material changes to the amortization profile that we have shared with you previously, but it remains subject to FX fluctuations. Stock based compensation will be in the range of $0.5 million to $0.7 million subject to forfeitures of stock options.

Thank you to all our employees for their efforts in generating these record results. Over to you Ed.

Edward J. Ryan

Great, thanks Step. Let us talk about the state of the business moving forward. As you probably are aware the company is in very good shape, and we are well positioned to continue to deliver superior financial results. We have a well calibrated operation heading into Q4. Calibration right now is at $36.5 million in visible, recurring, contracted revenues, what we would refer to as our baseline revenues. We have $27.9 million in baseline operating expenses, which leaves us $8.6 million of baseline calibration headed into Q4. To be clear, this is how much we will make if we sell nothing more this quarter.

This calibration reflects 23.6% of baseline revenues, and assumes a 0.79 Canadian dollar, and 1.33 euro. The company is well capitalized. As Stephanie mentioned, we had $49.3 million in cash at the end of Q3. We are generating almost $10 million in cash each quarter, and we have a $50 million acquisition line of credit, of which we have used $17.2 million thus far to date.

We have a very strong acquisition pipeline. Acquisitions, if you have been following us over the years remain a core part of us continuing to grow our business, and strengthen the platform for the community that we are building. We have historically done 2 to 4 acquisitions per year. Earlier this year we did one of the larger acquisitions we have done, KSD in Scandinavia was a $30 million plus acquisition. This has strengthened our position in the customs filing market in the European sphere.

Our acquisition pipeline remained strong. We run our operation so we can pick the acquisitions that are right for us, and we based it on a handful of things, the geographic fit and our ability to expand in the new geographies, the functional or solution fit and our ability to expand our solution footprint for our customers, the community of network participants that we add with each new acquisition, and most importantly based on sound financial metrics.

We have had a lot of anchors over the years call us cheap. We think of it more as smart, but either way we have a way of looking at businesses that has been successful for us, and we don’t deviate from those standards and we will continue to do that -- we don’t plan on continuing to do that going forward. Most importantly, we have a number of great business opportunities in front of us.

We have the retail and delivery market that we have been in for the last several years. It has been a real boost for us. We have an ideal solution to help retailers tackle the army channel of marketing problems that they face today, and we have had some great success in this market recently. In the last couple of months you have seen press releases on wins at Sears and Restoration Hardware, and a big expansion at [John Lewis] partners over in Europe, and there has been many others that we haven’t announced that are great news for our business.

About a month and a half ago, we held our Retail & Home Delivery Summit over in the UK. We had over 100 retailers in the room and around Europe learning how Descartes can help them take this next big step. Some massive industry attention on this, and there is tons of smart minds at Descartes thinking about how to do it better. Today most retailers are realizing that they need to get into same day, next day delivery to compete with the Amazons and Googles of the world. And once they make that decision, they quickly realize that Descartes is someone they need to partner with to help efficiently manage this transition.

We also have a customs filing business and you heard us talk about this over the years. It has been a big part of the growth in our business. Regulations compelled supply chain participants, basically forwarders, carriers, third-party logistics companies to generate trans management process, submit and report electronic information to governments around the world. This is a global endorsement -- government endorsement of the strategic path that Descartes is on.

We believe we are the most advanced player globally in this arena, and we continue to expand what we do for our customers. Recently we completed development for the Japanese and Israeli security filing initiatives, and delivered enhancements for the recent eManifest’s regulations in Canada. We also worked on the latest AES enhancements in the United States. Since the KSD acquisition, we are seeing a lot more momentum in Europe as well, and the pickup in customer activity for larger importers and forwarders. They won a multicountry European solution and hopefully someday a global solution.

We are building a vision where our customers can use one supplier to manage this entire process globally, and our customers are enthusiastically following. And finally the Descartes community, if you were down at user group, we launched the Descartes community down there and got probably 300, 400 new participants on it at the show on the first day of launch.

It is a platform for Descartes customers and maybe even for non-Descartes customers to collaborate about supply chain processes. We noticed that frequently, you know, one customer had a set of data that they need to share with another that they are working on the same shipment for a big retailer or manufacturer, and the Descartes community is the place that they can do that quickly and efficiently.

It is evolving. It is going to become a broader logistics community that our customers wanted to become, and we are paying close attention to what they want to do next as we roll out the first set of features on the network. They are coming up with bigger and better ideas, and those are the next things that we are going to be building into the community.

And finally in closing, Scott and I are both well known to our employees, our customers and partners based on the work we have done with Descartes over the last 14 years. We have also met many shareholders and analysts over the past few years. We appreciate the opportunity to have a clear and frank dialogue with our stakeholders about the shared investment. We will be acceptable to that, and we like to start that dialogue right now by opening the call up to Q&A. So, operator if you could open the call.

Question-and-Answer Session

Operator

Thank you. (Operator instructions) And our first question is from Gabriel Leung from Paradigm Capital.

Gabriel Leung - Paradigm Capital

Thanks a lot and congrats Ed and Scott on the promotion. A couple of things, just want to focus a little bit about your deployment capacity right now. I think historically you guys have been running at, you know, full utilization in terms of your deployment teams, Ed any thoughts or Scott any thoughts around increasing your capacity just to help potentially accelerate the top line growth of the company?

Edward J. Ryan

Yes, it is actually something we have been doing over the past probably 6 to 8 months. As we started to get bigger and get more products in, and bigger customers that wanted more people on the site, we have been growing our professional services group to accommodate them. You know, we like to have a backlog, but we don’t want it to be too long. We don’t want to have to tell a customer they have to wait months to start getting a product installed. So, we have been doing that and I suspect that will continue.

Gabriel Leung - Paradigm Capital

And I presume that is going to potentially hold back your ability to bump up sort of the target EBITDA margin range from the current 25% to 30%, but at the same time it is going to help accelerate revenue growth, is that the way to think about it?

Edward J. Ryan

Yes, I mean, we are going to probably continue to operate in that 25% to 30% range. I don’t know that the pro-services is a big enough chunk of our revenue to make a noticeable difference. But yes -- as we I think said in the past, when we get up to that 30% range, we feel like we should be investing back in the business to build more product and help grow our revenue for the future.

Gabriel Leung - Paradigm Capital

All right. That is helpful. On the community platform, it is good to hear about the 300 plus signups, but how should we think about the roadmap in terms of, you know, services being deployed into that community portal. You know, I think, [Indiscernible] I think the initial thing was really more around collaboration and whatnot. But how do you see some of the milestones we should be watching for in terms of services being dropped into this portal?

Edward J. Ryan

Yes, so what we have done so far is create a platform where everyone can join and communicate with each other. And then we also took a number of the core products that our customers use primarily the back office freight forwarding systems and brokerage systems, and allowed people to communicate in those systems. So, you know, if I’m a freight forwarder working on a big retailer or manufacturer on a shipment for them, and that manufacturer has a outport agent over in Asia that I have to work with as a 3PL to actually coordinate the shipping move. By opening up the community platform to both participants, we put them in a situation where they can start to exchange that data.

These are things that two months ago had to be phone called and faxes, they are emails and routine and a pretty inefficient process. And our hope is in this first stages, the community is going to allow that collaboration to save our customers a whole bunch of time and money.

At the same time, and if you were in the room when this happened, as soon as the customers see this ability, they start thinking of all the things they can do with it. And they start coming up with new ideas for us to build enhancements into this system. So we are very actively looking into them right now and trying to figure out what we should do next, what new applications we should bring into the community, and should they be existing applications of ours, or should we actually build new functionality in it. And I think, you know, in the coming months you are going to see a combination of both to start to address some of the, if I could say, cool things that customers want to do in this that hopefully save their companies time and money.

Gabriel Leung - Paradigm Capital

And maybe one last question just on the M&A front, if I look at sort of the pillars of the company, so I think MRM compliance, transportation management and I guess the GLN. You know, where do you see that you need to prioritize on the M&A, is it add another pillar, or is to enhance one of the existing ones, or maybe talk about where you feel there is a deficiency where you may need to bulk up on them -- with M&A, and that is it from me, thanks?

Edward J. Ryan

Thanks Gab. Yes, no, listen we are going to do more of the same with acquisitions. We are always trying -- we look at each company that comes in, whether we find them or they find us, and actually interestingly enough, more and more are finding us because they think that we are going to be a good home for their baby.

You know, we are trying to expand the geographic footprint of our network. We are trying to expand the functional footprint, or we are looking at potential acquisition as someone, where we say, hey, we can take those customers and we told them about all the products we have, we can really help to grow this business a lot faster than it was growing on its own.

And I think we will continue to do more of the same. You know, we can’t control who is available in the market for sale. But there is a lot of people out there right now, and we’re trying to be pretty judicious about those decisions. And if someone comes along that we think would be a great new pillar on the market or in our market, we will take a very serious look at it and make the decision when the time comes.

Operator

Our next question is from Mike Urlacher from GMP. Please go ahead.

Michael Urlacher - GMP Securities

Good morning. Thanks for hosting the call Ed and Scott. I wonder if you could maybe just describe qualitatively what you see in terms of the retail customers, or logistics providers to retailers in terms of their interest level and what they get out of optimizing their home delivery systems?

Edward J. Ryan

Sure. Yes, it has been a big boom for us in the past couple of years. A lot of the biggest deals that we are getting right now are exactly what you just mentioned, big retailers. We are the service providers that are looking to deal with the omnichannel marketing problem that they have. You know, all these retailers were accustomed to selling things in their store only. And all of sudden Google and Amazon and eBay came along, and now -- I got to change things. People are coming into my store, and they are buying from Amazon while they are in my store looking at the product, and that is frustrating to a retailer.

When they make that decision that hey, I got to be very good at offering a website where people can order from me and my store. They need to be in a position where they can manage the same day and next day delivery process for the items that are too big to walk out of the store with. We have been doing that for years. We were the first ones to do it, and over the years we have become the best at it.

We took a big departure from our competitors about eight or nine years ago in building, you know, what we call nonstop optimization tools. Everyone else, including ourself back nine years ago was what we call daily batch of planning. You plan once a day, somewhere between midnight and three in the morning for the next day’s deliveries. You know, if you are going stuff today on the fly and you do same-day and next day delivery, you need to be making those decisions all day long. So when the next customer comes on to the website and says that he wants to buy, you can find the most optimal time to deliver him, and give him the tightest time window that saves you money, and is very convenient for the customer.

And Descartes has those solutions right now, and our competitors don’t and it has been great for our business, and I suspect it is going to continue for some time to come.

Michael Urlacher - GMP Securities

Thank you, and can you describe, I mean, I hate to use strong words, but is there a kind of heightened interest or a frenzy among the retailers for this, or how do you describe that?

Edward J. Ryan

I hope it becomes a frenzy. I don’t know if I would quite call it that yet, but increasingly there are a number of large retailers that are realizing they had to do this. And I don’t know that we are the first thing they think of when they have to do it, but we are probably the second or third because somewhere along the line of deciding, we got to do a good job of delivering it to customers that buy off of our website. They quickly go, how am I going to do that efficiently because there is two ways to do it.

You can buy way too many trucks, and satisfy all your customers and spend a lot of money, or you can do it efficiently using a system like ours for a fraction of the price. And as soon as they get into that process and start thinking about it, I think they realize they need to have a solution to do this, and increasingly as we get more and more retailers, it is becoming kind of common knowledge in that business. Just like in our business with logistics providers and transportation providers, they all know each other, they all talk about what they are doing, and eventually the word gets out. I think the same thing is happening in the retail channel, and I don’t know if I could call it frenzy yet, but it certainly has been something that is good for our business.

Michael Urlacher - GMP Securities

Okay, thank you, and maybe just to offer a bit of context, how big a contributor to revenue would you say this is now, and could be say in two years from now?

Edward J. Ryan

It is significant now. I mean it is not all of our revenue by any stretch, but it is certainly in that routing business, which is maybe a third of our business. It has been the big growth factor. And I suspect it is going to continue like that for some time.

Michael Urlacher - GMP Securities

Okay, thank you.

Operator

Our next question is from Richard Davis from Canaccord. Please go ahead.

Richard Davis - Canaccord Genuity

Hi, thanks very much. So you guys deserve a lot of credit for being able to kind of grow through a tough period over the last 10 years, but we are seeing around your space, there is kind of a -- it feels like we are at the foothills of -- in my opinion, a multi-year upgrade cycle in supply chain. So kind of three questions off of that point, would be one, are you seeing this yet, it sounds just probably to some degree. Two, what gaps do you have to make sure you participate in this cycle and three, why would this -- why would you think this could or could not lead you to a, you know, in my opinion a 200 basis points to 300 basis points acceleration in your organic growth rate as things go, because when I look at you landing kind of periodically larger deals that over time adds to your growth rate over time. So just kind of -- just trying to frame -- frame where we are in this cycle. Thanks.

Edward J. Ryan

Yes, I appreciate your support. Yes, while we do think -- I haven’t thought of it as a step of a foothill yet, but yes, something like that. We do believe it is a big opportunity for us. As more and more retailers and manufacturers realize that there is a lot of money to be saved in operating their business more efficiently through the use of, you know, efficient logistics and supply chain products, you know, we want to be the first name that they think of when it comes to that.

You know, we do a lot of that right now and there are certain other areas where we think we can continue to expand our footprint. We want to have everything that someone wants in our logistics technology platforms someday. And we’re not all the way there yet by any stretch. But we do a lot of the things that they want, and I do think that is a big opportunity for us, and if they look out across our competitors, you know, I like to position them, because I think, you know, we have done it the smart way, right.

All of our stuff is recurring, revenue businesses. Everything is SaaS based, and our customers pass by the transaction, and you know, when our sales rep sells something it is not, thanks for your business. I will see you later. It is thanks for your business. I will see you tomorrow. And see you tomorrow means making sure that that product works, and finding out what they want to do next because oftentimes, you know, people buy our transportation management system. Well, it is just logical that you would buy our supply chain visibility system at some point after that.

And our guys going in, they install that transportation management system, make sure it is working, make sure they are happy with it, and then start talking about what else they could do. And, you know, we have a lot of the products that would fall into that what else can you do category, and we hope to get a lot more of them in the future either by building them ourselves or by buying them through acquisitions.

Richard Davis - Canaccord Genuity

Right, that is helpful. I appreciate it. Thanks.

Edward J. Ryan

Thank you, Richard.

Operator

Our next question is from Scott Penner from TD Securities.