The current market is characterized by a lot of uncertainty in regard to technology stocks, as most of them witnessed selloffs over the past couple of weeks. Investors are looking for long-term value picks and fundamentally solid companies, but an important question is - are these fundamentally strong tech stocks available at reasonable valuations? An interesting case study for analysis is logistics tech solutions provider, Descartes Systems Group Inc. (DSGX, Financial).
Why this particular stock? Descartes is among the top mid-cap tech companies that has consistently grown in terms of revenue and profitability over the years. After reaching new highs in October, the stock, like many other technology companies, underwent a correction and is back to March levels. At this stage, it is important to determine whether now is a good time to buy.
A good third quarter with new customers and the acquisition of PinPoint
Descartes third-quarter 2019 results were decent as revenue grew 13% from the prior-year quarter to $70 million. Earnings before interest, taxes, depreciation and amortization were $24 million, which is about 34% of the top line.
The company managed to acquire some key customers, including Merchants Foodservice, the12th-largest foodservice distributor in the U.S., and the mobile tire-fitting company Tyres On The Drive. Management also continued its strategy of completing key strategic acquisitions by buying Toronto-based logistics technologies and workforce solutions provider PinPoint.
Fundamentals are strong, but has the multiple expansion gone a bit too far?
There are very few growth stocks with the kind of fundamental solidity Descartes has. The company has an 8 out of 10 profitability and growth score and a 7 out of 10 financial strength rating from GuruFocus, which is phenomenal. To top it off, the company's business predictability rank is a perfect five stars, which implies it has provided more than 12% annualized return to its investors.
The company’s business is running at an operating margin of 15.94% and a net margin of 10.92%, which are phenomenal when compared to industry peers. The return on equity of 5.77% is on the lower side, but the company has used no leverage in financing its operations. The debt-to-equity ratio is 0.11 and the debt-to-EBITDA ratio outperforms industry peers. The low leverage has also resulted in the beta of the stock being as low as 1.05, which suggests it is less volatile than its competitors.
Valuations, however, are a completely different story. As illustrated in the chart above, over the last five years, the stock's growth trajectory has been a dream for growth investors. However, the first glimpse of reality came earlier this month when the share price fell below $30. Despite the fall, the stock continues to trade at an EV-to-Revenue multiple close to 9 and a price-earnings ratio of 83.52, which is unreal. In the chart, we see a 49% appreciation in the EV-to-Revenue multiple and a 28% appreciation in the EV-to-EBITDA multiple over five years, which is largely responsible for the stock price doubling over this period.
Descartes' only direct competitor that is public is Amber Road (AMBR, Financial). It is hardly one-tenth the size of Descartes and is a loss-making company, so a comparison of valuation multiples is not fair. If we look at the software solutions industry as a whole, however, these trading multiples are very much on the high side.
Conclusion
There are several good reasons why investors should stay away from Descartes despite the recent correction. While there is no doubt the company is fundamentally strong and the management team is doing a good job of attracting large clients and making key acquisitions, the multiple expansion has been unreal. Despite the recent correction and the strong quarterly numbers, it is unlikely the stock will be able to maintain its growth trajectory. There has also been no real insider buying or any recent guru trades, which is not really a positive sign, especially at current levels. Like many other tech stocks today, Descartes is a wait-and-see case. Investors need to be patient and wait for the company to reach a more reasonable valuation.
Disclosure: No positions.Â
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