Magic Software Enterprises Ltd. (NASDAQ:MGIC) Q1 2023 Earnings Call Transcript May 18, 2023

Magic Software Enterprises Ltd. misses on earnings expectations. Reported EPS is $0.26 EPS, expectations were $0.28.

Operator: Welcome to Magic Software Enterprises 2023 First Financial Results Conference Call. At this time, all participants are in a listen-only mode. A brief question-and-answer session will follow the formal presentation. As a reminder, this conference is being recorded. With us on the line today are Magic’s CEO, Mr. Guy Bernstein; Magic’s CFO, Mr. Asaf Berenstin; and Magic VP of Technology and Innovation, Mr. Yuval Lavi. Magic first quarter 2023 earnings release was issued before the market opened this morning and it has been posted on the company’s website at www.magicsoftware.com. Before we start, I’d like to remind everyone that this conference call may contain projections or other forward-looking statements. The Safe Harbor provision provided in the press release issued today also applies to the content of this call.

Magic expressly disclaims any obligation to update or revise any of these forward-looking statements whether because of future events, new information, a change in its views or expectations or otherwise. Also during the course of today’s call, management will refer to non-GAAP financial measures, a reconciliation schedule showing GAAP versus non-GAAP results has been provided in the press release issued before the market opened this morning. A replay of this call will be available after the call on our Investor Relations section of the company’s website. I will now turn the call over to Mr. Asaf Bernstein, CFO of Magic Software. Please go ahead.

Asaf Berenstin: Thank you, operator, and thank you, everyone, for joining us today as we report our first quarter 2023 financial results. During the call today, I will review highlights from our first quarter results and provide an overview of our achievements. We appreciate your continued support and look forward to sharing our progress with you. Our hard work and dedication contributed to our solid performance in the first quarter of 2023 as we report approximately 3% year-over-year growth in revenues, reaching first quarter all-time high $142.4 million and operating income of $18.4 million. These results demonstrate the growing investments made by enterprises and organizations worldwide even during COVID challenging macroeconomic climate to leverage the digital technologies and cloud-based platforms creating high demand for innovative software solutions and services, which together with the outstanding execution by our teams led to another quarter of solid performance recorded across our business.

Our top line reported growth in Q1 of 2023 was solely driven by our North American operation, which grew by 4% year-over-year to $72.6 million, while revenues reported with respect to our operations in Israel remain flat at $53.3 million. On a constant currency basis, our revenues in the Israeli market grew by 10% year-over-year, which represents in real terms, an all-time high of $58.8 million when calculated based on average currency exchange rates for the three months ended on March 31st, 2022. The strong growth of our operation in Israel — in the Israeli market, particularly in light of the current macroeconomic conditions, reconfirms our long-term strategic decision to focus on mature, stable and technology-driven sectors such as healthcare, defense, finance and the public sector, which compensated the recent slowdown, which we are currently experiencing in the high-tech and telecom sectors, mainly in North America and to some extent also in Israel.

Despite seeing some ongoing caution during recent months in the high-tech sector, we are still witnessing a healthy demand and maintaining a solid pipeline to deliver continued growth during 2023, as our customers increasingly engage us as a preferred partner for innovative digital transformation initiatives, and as such, we continue to fortify our position as a leading software solution and an IT service global vendor. We have a well-established track record of growth, profitability and high cash generation. And the Magic team worldwide is committed to executing our strategy to deliver growth and to continue improving our shareholders’ value. On the M&A front, despite the rising interest rate environment, we continue to believe that M&A remains an important part of our growth strategy, and as such, we continue to explore though with an increased level of caution, new opportunities in the fields that we operate in as well as in fields that we target and identify growth opportunities as we have in the past.

Moving to the financials and starting with the geographical breakdown of our revenues, during the first quarter of 2023, North America accounted for 51% of our total revenues, Israel 37%, Europe 9%, and APAC and the rest of the world accounted for 3% of our first quarter revenue. Our revenues in North America reached $72.6 million, up 3.9% compared to $69.9 million in the same period last year. Revenues in Israel reached $53.3 million as in the same period last year. On a constant currency basis, our revenues in the Israeli market grew by 10% year-over-year, which as I have already mentioned represented in real terms an all-time high of $58.8 million compared to $53.3 million in the same period last year. Turning now to profitability. Despite the significant currency headwind, we were able to deliver growth in our gross profit as well as in our gross margin, as our non-GAAP gross profit for the first quarter of 2023 reached $40.2 million, up approximately 3.1% compared to $38.9 million in the same period last year.

Our non-GAAP gross margin for the first quarter of 2023 increased by 10 basis points from 28.1% in the first quarter of 2022 to 28.2% in the first quarter of 2023. On a constant currency basis, our gross margin would have gained additional 30 basis points, an amount to 28.4%. The breakdown of our revenue mix for the first quarter of 2023 was approximately 18% related to our software solutions, with a gross margin of approximately 65% and 82% related to our professional services with a gross margin of approximately 20%. While in the first quarter of 2022, approximately 19% of our revenues were attributable to our software solutions segment, with a gross margin of approximately 64% and 81% related to our professional services with gross margin of approximately 20%.

The breakdown of our gross profit mix for the quarter was approximately 42% related to our software solutions and 58% related to our professional services compared to 43% and 57% in the same period of last year. Our non-GAAP operating income for the first quarter of 2023 decreased by 3.4% to $18.5 million compared to $19.1 million in the same period last year. This reflects an operating margin of 13% for the quarter compared to 13.8% in the first quarter of 2022 and 13.1% in 2022 as a whole. On a constant currency basis, calculated based on average currency exchange rates for the three months ended on March 31st, 2022, non-GAAP operating income for the first quarter of 2023 would have increased by approximately 3% to the first quarter record breaking $19.6 million.

Financial expenses, during the quarter, we had a financial debt interest expenses of $0.8 million, resulted from our $67 million financial debt compared to $0.2 million recorded in the same period last year for a total financial debt of $60 million. As the majority of our debt, there is variable interest and interest rates are still expected to rise, we expect our interest expenses to continue growing. Net income attributable to non-controlling interest as our business combination model has often relied on keeping former shareholders in acquired entities as minority shareholders in addition to their managerial role in such entities, we are allocating a portion of our net income to these minority shareholders. Net income attributable to non-controlling interest amounted this quarter to $1.7 million compared to $1.5 million in the same period last year.

Our non-GAAP tax expenses this quarter totaled $3.1 million compared to a tax expense of $3.6 million in the first quarter of 2022. Our effective tax rate for the quarter was approximately 18% compared to 20% recorded in the same period last year. Our non-GAAP net income attributed to Magic shareholders for the first quarter decreased 3.2% to $12.6 million or $0.26 per fully diluted share compared to $13 million or $0.26 per fully diluted share in the same period last year. Turning now to the balance sheet, as of March 31st, cash and cash equivalents and short-term bank deposit amounted to approximately $106.4 million compared to $87 million in the previous quarter. Our total financial debt as of March 31st amounted to $67.4 million compared to $51.2 million in the previous quarter.

Our cash flow from operating activities reached $18.8 million during the first quarter of 2023 compared to $12.8 million in the same period last year. In closing, I would like to turn to our guidance for 2023. We are reiterating our 2023 full year revenue guidance of $585 million to $593 million, reflecting annual growth of 3.2% to 4.6%. We believe that this growth takes into consideration anticipated organic growth, the current macroeconomic environment, and the current devaluation of foreign currency exchanges versus average rates in 2022. In summary, we remain committed to executing our strategy, leveraging our strength and delivering sustainable growth and value for our shareholders. I would like to thank our clients and shareholders for their continued support and trust and we look forward to delivering even greater success throughout the remainder of 2023.

With that, I will now turn the call over to the operator for questions.

Q&A Session

Operator: Thank you. Ladies and gentlemen, at this time we will begin the question-and-answer session. The first question is from Chris Reimer of Barclays. Please go ahead.

Chris Reimer: Yeah, hi, thanks for taking my questions. I was wondering if you could give some more color on the diversification that — your strategy of diversifying revenues verticals that you mentioned and if there’s anything in particular where you’re seeing a slight change and basically where you see the growth coming from this year.

Asaf Berenstin: So I think it’s a very unique year this year because of what happened with the economy and the market and the interest rate. We definitely see some customer being cautious in the States. For now outside of the States, especially in Israel, we don’t see that, so we pushed quite hard on the Israeli market in order to compensate for some of the business reduction in the State. But all-in-all, we feel quite comfortable because we are working with big corporate so we know how to plan it.

Chris Reimer: Great. Okay, yeah.

Asaf Berenstin: Just adding that in terms of the business we see of course the growth coming from our clients that basically are moving their core systems to the cloud. We see a significant improvement and increase in our cloud consumption operation. We see significant increase on our cyber security consulting. We provide hardening services for our clients. We provide a penetration test. We provide a NOC services. We provide CSO-as-a-service, SOC-as-a-service to our clients. I think that just from the migration of what we expect to continue and see as migration of core systems into the cloud is probably the main growth engine for the company.

Guy Bernstein: And a lot about the managed services as opposed to professional services. Moving into a managed cloud service offering.

Chris Reimer: Okay. Thanks. That’s really helpful. And just one more. How comfortable are you with current staffing levels? And are you finding attrition rates maybe declining or is there some — is there any change or easing in related to employee acquisition?

Asaf Berenstin: I think that today we see that due to the current market situation, attritions rate have significantly decreased. Of course, the most talented people are still being looked after and quoted. And their level of salary and their ambition to stay is always something that is very challenging, but on the average, we see people that are hanging onto their seats, so this became more comfortable. We see the salaries being pretty much stabilized and all of the increases that we experienced in 2022 and in 2021 post-COVID were already behind us. I think that our hit rate in recruiting new employees has also been improved. So in the past, we had to look for much more employees and the competition was much higher in order to succeed and recruit people and now today it’s a bit more easier.

Guy Bernstein: And also think that when we are looking into bring juniors in a way that they will grow inside the organization as opposed to bringing champions that it’s much harder to compete on.

Chris Reimer: Great. That’s great color, guys. Thank you. That’s it from me.

Operator: The next question is from Maggie Nolan of William Blair. Please go ahead.

Maggie Nolan: Hi. How are you? I’m hoping you can give us a little bit more clarity on how you expect revenue to come in for the year on a quarterly basis. And it was great to see you reiterate the full year.

Asaf Berenstin: Nolan, it’s a little bit difficult during this kind of call to provide something that we won’t — that we don’t share on the global side and on our PR, but I can say that, of course, we have, as I said, we have 50% of our business in the US. And second quarter is a regular quarter, full day billable days, no change, no special events post to the Israeli — post to the Israeli market where we have the pass over and we have the Independence Day which are holiday that holiday season that our employees are — where — it’s already happened. We’re on vacation days. So if in Q1, we had like 65 billable days in the Israeli market, it goes down next quarter to 59.5. Overall, I would say that, that should bite or normally bites our — our revenue level by around 3.5% for Q2 versus Q1.

Maggie Nolan: That’s really helpful. Thank you. And then what opportunity do you think there is from potential increases in enterprise spending on AI for your business? And then how also do you intend to leverage it within your own business models?

Guy Bernstein: We are, again, I’m not sure I fully understood the question about the AI, but we are looking into implement quite a lot of AI into our technologies in specific fields, okay. We’re looking now for some cooperation or joint ventures around the predictive and other trends in this market. But the challenge again with AI, we want to come with a defined solution and not just with a general statement of, we’re doing AI, again most of this market. So we’re trying to come and see how we plug it into our product and not to our solution. Putting aside all the other consultancy that we have that are doing also a AI consultancy. Okay. So it’s kind of from two level, AI consultancy, data science and stuff like that and bringing AI into our products.

Maggie Nolan: Perfect. Thank you.

Operator: There are no further questions at this time. There is an additional question from Mike Silver of Kingston Capital. Please go ahead. Mike Silver?

Mike Silver: Hi. Is there anything you could share about future acquisitions?

Asaf Berenstin: We do have two or three potential acquisitions. Again, we trying to play safe here. We made the negotiations from our side way harder because we think the market allows it to us. We don’t see yet as we would call it reduction in multiples of prices, but I’m sure it will come. I don’t know how it will be that significant, but for sure it will come. So for the time being, we are trying to close with the one we have in the pipe at better terms.

Mike Silver: Thank you.

Operator: There are no further questions at this time. Mr. Bernstein, would you like to make your concluding statement?

Asaf Berenstin: Yes. So thank you very much for joining our call and we sure hope to bring you some more good news in the next call. Thank you very much.

Operator: Thank you. This concludes Magic Software Enterprises Ltd 2023 First Quarter Results Conference Call. Thank you for your participation. You may go ahead and disconnect.