Descartes' Neutral Network Facilitates Shipping Throughout the Global Supply Chain

Senior Equity Analyst

Dan Romanoff

Descartes operates the largest neutral shipping network in the world, connecting 200,000 shippers, manufacturers, suppliers, retailers, and government agencies and enabling the sharing of tens of billions of shipping-related transactions each year. The firm also offers a broad portfolio of solutions that solve a variety of challenges in the shipping industry.

Descartes' Global Logistics Network is a more modern approach to electronic data interchange, or EDI, that ties together the disparate software systems of many connected parties. In doing so, the platform modernizes the model, which consists of a variety of different data formats that were not necessarily compatible. The GLN also provides deeper intelligence than EDI was capable of. This is especially important as shipping regulations become increasingly complex in a global supply chain that was stretched beyond its limits in 2021.

With so many connected parties on the network, Descartes has a captive audience for its software portfolio. Over time, the firm has developed solid positions in niche markets, mainly for customs and regulatory compliance. We also view both trade management and the broker and forwarder enterprise systems as better positioned competitively, with routing, mobile, and telematics operating in a more competitive niche. E-commerce also became an important pillar of the business because of covid lockdowns. While the network and software modules are sticky separately, we think they are stronger together, as the firm enjoys strong retention rates of approximately 95%.

Descartes relies on acquisitions to expand its software portfolio and help drive growth. The firm typically does multiple acquisitions annually for between $50 million and $150 million in aggregate. Management is focused on areas that fill holes across the portfolio and introduces functionality that customers request, and is disciplined in its approach. We think acquisitions drive approximately half of the company’s growth, and we expect several small deals each year. We see acquisition opportunities as abundant in this highly fragmented $15 billion market.

Business Strategy & Outlook

We assign a narrow moat rating to Descartes, driven by high customer switching costs and a network effect that have historically enabled the company to generate returns on invested capital in excess of its cost of capital. We believe it is more likely than not that excess returns will continue for the next 10 years. We note the company is acquisitive and therefore has a sizable goodwill balance that depresses ROICs.

Switching costs for software are often driven by several factors, in our view. The more critical the function and the more touch points across an organization a software vendor has, the higher the switching costs. There is also the direct time and expense of implementing a new software package for the customer while maintaining the existing platform and retraining employees on a new system. Additionally, there is operational risk of changing software vendors, including business process reengineering, loss of data during the changeover, and overall project execution. A major implementation is likely to involve a system integrator and can take in excess of a year in bad cases. Lastly, lost productivity is likely to be an issue as customers move up a learning curve on the new system along with the distraction of users involved in the function where the change is occurring.

Retention metrics typically help inform investors on both the presence and the durability of a moat. These come in two flavors: gross, which describes what percentage of the customer base remains customers after a given period, and net, which highlights what percentage of customer spending is retained by the software provider after a given period. We believe Descartes’ customer retention is approximately 95%, which we consider to be excellent and provides quantitative evidence for a narrow moat. It seems unlikely that Descartes’ customers—entities directly involved in moving goods—will be inclined to switch software platforms that help them move goods more efficiently. Further, we think the large network, combined with the various related software modules, represents a compelling logistics solution for users, making the integrated platform that much stickier.

Descartes provides the largest neutral network for connecting manufacturers, suppliers, shippers, logistics providers, and retailers. The network connects users and their back-end software systems to allow for direct communication of important shipping information, such as container contents, departure time, shipping nodes along the way, and scheduled delivery time. Different transportation modes (truck, train, air, sea) have different needs and must comply with regulations that can vary widely by country. Further, as far as users are concerned, they must connect to one platform, rather than individually to each trading partner a la early electronic data interchange connections.

We believe this network attracts and retains users because of both its size and its neutrality. Descartes’ Global Logistics Network boasts thousands of customers and approximately 200,000 connected parties in more than 160 countries that send about 20 billion transactions over the network annually. The fact that so many users are already on the GLN helps attract new users who know their shipping partners also use it.

Having alternate suppliers and shippers is critical to manufacturers, as inventory management tends to be just-in-time and manufacturing lean. A broad and connected network makes finding second sources or alternate transportation routes essential to avoid disruption. The breadth of Descartes’ network was on display during the coronavirus pandemic, which idled manufacturing facilities in China and forced the supply chain to be both creative and flexible. We also think neutrality is important for connected parties. This ensures that larger shippers are not favored over smaller shippers and that no party is forced to use a competitor’s software system. It also gives suppliers and manufacturers confidence that they are getting the best possible service at pricing they are most comfortable with. 

Shipping needs have evolved as the supply chain has become global and customer expectations have been reset by the Amazon experience. A modern approach to shipping requires visibility, intelligence, and advanced capabilities. Descartes delivers in this regard, with a wide variety of add-on software modules to tackle specific shipping challenges. Beyond the GLN, the company’s software includes customs and regulatory compliance; transportation management; routing, mobile, and telematics; and broker and forwarder enterprise systems. We think the most critical software modules involve customs, broker and forwarder, and routing. Combined, we believe these three areas make up the vast majority of software-related revenue beyond the core GLN. Among its software offerings, the company is best positioned in customs and regulatory compliance, where it is a leader, in our view.

We believe Descartes’ software solutions solve real-world challenges experienced by users on the network. For example, the trend toward unilateral trade agreements between the United States and other countries increases complexity for companies around the world from a customs and taxation perspective. An easy way to ensure or maintain compliance is through the GLN and its customs software, so we see customers as having to rely more on Descartes. Another popular module, routing, mobile, and telematics, helps retailers with delivery fleets improve truck usage and better plan routes. Descartes has helped customers such as Home Depot save more than $10 million annually just on its delivery planning and execution. Further, the solution allows Home Depot’s customers to schedule specific date and time delivery windows, so everybody is better off.

The market for supply chain software is highly fragmented. The major enterprise resource planning providers, such as SAP, Oracle, and Infor, have supply chain modules that are regularly used, but by definition none of these include neutral networks. While we do not view Descartes as a clear leader in any of the niche software categories it serves, we think it is generally considered among several leaders at least in customs and transportation management and is a trusted partner providing software solutions that solve a problem that the ERP systems might not, or may be unnecessarily large for the needs of smaller companies. The company is one of the largest independent supply chain management software vendors. Lastly, SAP, the largest supply chain software provider, has partnered with Descartes for years to help offer a neutral communication network and the widest possible network of trading partners to its suppliers.

Narrow

Economic Moat

Descartes Systems Group

The Descartes Systems Group, Inc. provides on-demand, software-as-a-service solutions focused on improving the productivity, performance and security of logistics-intensive businesses. It uses modular, software-as-a-service solutions to route, schedule, track and measure delivery resources; plan, allocate and execute shipments; rate, audit and pay transportation invoices; access global trade data; file customs and security documents for imports and exports; and complete numerous other logistics processes by participating in the world's largest, collaborative multimodal logistics community. The company was founded on May 22, 1981 and is headquartered in Waterloo, Canada.

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The Descartes Systems Group, Inc. engages in the provision of on-demand, software-as-a-service solutions focused on improving the productivity, performance and security of logistics-intensive businesses. It uses modular, software-as-a-service solutions to route, schedule, track and measure delivery resources; plan, allocate and execute shipments; rate, audit and pay transportation invoices; access global trade data; file customs and security documents for imports and exports; and complete numerous other logistics processes by participating in the world's largest, collaborative multimodal logistics community. The company was founded on May 22, 1981 and is headquartered in Waterloo, Canada.

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