Magic Software Enterprises Ltd

NASDAQ:MGIC

Earnings Call Transcript 2023-Q2

[Operator]

Ladies and gentlemen, thank you for standing by. Welcome to the Magic Software Enterprises 2023 Second Quarter Financial Results Conference Call. Magic’s Second 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. [Operator Instructions] With us on the line today are Magic’s CEO, Mr. Guy Bernstein, Magic’s CFO, Mr. Asaf Berenstin, and Magic CTO, Mr. Yuval Lavi.

Before we start, I would 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 website.

I will now turn the call over to Mr. Asaf Berenstin, CFO of Magic Software. Please go ahead.

[Asaf Berenstin, Chief Financial Officer]

Thank you, Yoni and thank you everyone for joining us today as we report our second quarter 2023 financial results. During the call today, I will review highlights from our second quarter results and provide an overview of our achievements. We appreciate your continued support and look forward to sharing our progress with you. Revenues in the second quarter of 2023 increased to $137.6 million, up 0.4% from the second quarter of 2023 – of 2022. The currency headwind on revenues is significant compared to the second quarter of last year. On a constant currency basis, calculated based on average currency exchange rate for the 3 months ended June 30, 2022, revenues for the second quarter of 2023 would have increased by 4.4% to a record-breaking second quarter result of $143 million.

Even when compared to the previous quarter of this year on a constant currency basis, calculated based on average currency exchange rates for the 3 months ended March 31, 2023, our revenues in Q2 2023 would have been $1.8 million higher than the reported one, reaching $139.4 million. These results demonstrate the continued growing investments made by enterprises and organizations worldwide even during the COVID challenging macroeconomic climate, to leverage their digital technologies and cloud-based platforms, creating high demand for our innovative software solutions and services, which together with the outstanding execution by our teams led to another quarter of solid performance recorded across our businesses. We continue to see exciting opportunities and growth potential in the dynamic realm of cloud technology and managed services.

Since the first days of Magic Software, our D&A was to take complex IT processes and make them simple. Today, we put our focus on helping our clients to transition seamlessly to the cloud, enhance their software as a service capabilities and deliver exceptional value to our comprehensive suite of managed cloud services. We have made it our mission to assist businesses in overcoming the challenges associated with migrating to the cloud and achieving true SaaS excellence. We recognize that the cloud is not just a technology shift. It’s a transformative journey that demands expertise, dedication and innovation to which we bring industry-leading best practices, ensuring that our clients cloud deployment meet the highest standards of performance, scalability, security and reliabilities.

Our suit of energy cloud services, which includes services such as NOC-as-a-service, SOC-as-a-service, developed as-a-service, [indiscernible] as-a-service and much more are tailored to address critical aspects of cloud operations, empowering our clients to focus on their core competencies, while leading the management and optimization of the cloud environment to us. We converted our integration and application products to be fully cloud native. We created some new products like workspace and we are now starting to provide those products as managed cloud services, allowing our new and existing customers to move their businesses to the SaaS model while keeping their legacy systems and with minimal disturbance to their business.

The global cloud services market continues to experience rapid growth with businesses of all sizes recognizing the benefits of migrating to the cloud. The managed cloud services market, in particular, is projected to witness substantial expansion due to the increasing complexity of cloud environment and the need for specialized expertise. What sets Magic apart is our deep domain expertise, the customer-centric approach and a proven track record of delivering successful cloud transformation. Our teams of seasoned professionals is committed to understanding our clients unique needs and tailoring our services to drive tangible business outcomes.

Moving to our financials. In the second quarter of 2023, our revenues in North America amounted to $69.2 million, 4.1% and approximately $2.9 million lower than Q2 of 2022 and $3.4 million lower compared to Q1 of 2023 mainly due to cutbacks made by several clients in the U.S. and especially CVS Health, which decided to reduce expenses and put on hold IT investment decisions, resulting in a decrease of close to 250 of our U.S. specialists since the end of 2022, most of them around 150 specialists during the second quarter of 2023. Revenue from our Israeli operations amounted to $51.7 million up 1% compared to Q2 of 2022. The impact of the continued devaluation of the new Israeli shekel versus the U.S. dollar was material over our Israeli market revenue.

On a constant currency basis, calculated based on average currency exchange rates for the 3 months ended June 30, 2022. Revenues for the second quarter of 2022 of our Israeli operations would have increased by $5.4 million to $57.1 million, reflecting a year-over-year growth of 11.1%. This demonstrates strong performance in the region and reconfirmed our long-term strategic decision to focus on mature, stable and technology-driven sectors such as health care, defense, finance and the public sector, which compensated for the current slowdown we are experiencing in North America.

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 services 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 continue improving our shareholders value.

Moving to geographical background of our revenues, during the second quarter of 2023, in North America accounted for 50% of total revenues; Israel, 38%; Europe, 9%; and APAC and the rest of the world accounted for 3% of our second quarter revenues.

Turning now to profitability. Despite the significant currency headwinds, we were able to deliver growth in our gross profit as well as in gross margins as our non-GAAP gross profit for the second quarter of 2023 reached $41.6 million, up approximately 9.3% compared to $38.2 million in the same period last year. Our non-GAAP gross margin for the second quarter of 2023 increased by 240 basis points from 27.9% to 30.3% in the second quarter of 2023. The breakdown of our revenue mix for the 6-month period of 2023 was approximately 18.4% related to our software solutions with a gross margin of approximately 63.1% and 81.6% related to our professional services with a gross margin of approximately 21.6%.

While in the first half of 2022 approximately 80% of our revenues were attributable to our Software Solutions segment with a gross margin of approximately 64% and 82% related to our professional services with a gross margin of approximately 20%. The breakdown of our gross profit mix for the 6-month period of 2023 was approximately 40% related to our software solution and 60% related to our professional services compared to 41% and 59% in the same period last year. Our non-GAAP operating income for the second quarter of 2023 increased by approximately 4% to $18.4 million compared to $17.8 million in the same period last year. This reflects an operating margin of 13.4% for the quarter compared to 13% in the second quarter of 2022.

On a constant currency basis, calculated based on average currency exchange rate for the 3-month period ended June 30, 2022, non-GAAP operating income for the second quarter would have increased by approximately 7% and to a second quarter record-breaking result of $19.1 million. Financial expenses met, during the quarter, we had financial debt interest expenses of $1.2 million resulted from $89.6 million financial debt compared to $0.4 million recorded in the same period last year for a total financial debt of $56.5 million. As our overall debt continued to grow in 2023 and as the majority of our debt bears variable interest rate we still expect interest excesses to rise compared to last year.

Net income attributable to non-controlling interest as our business combination model has often relied on keeping former shareholders in acquired entities as minority stakeholders in addition to their managerial role in such entities we are allocating a portion of our net income to those minority shareholders. Net income attributable to non-controlling interest increased to $1.8 million compared to $1.6 million in the same period last year. Our non-GAAP tax expense this quarter totaled $2.9 million compared to a tax expense of $3.9 million in the second quarter of 2022. Our effective tax rate for the first half of 2023 was approximately 17% compared to 20% recorded in the same period last year. Our non-GAAP net income for the second quarter increased 15.4% to $13.5 million or $0.28 per fully diluted share compared to $11.7 million or $0.24 per fully diluted share in the same period last year.

Turning now to the balance sheet. As of June 30, 2023, cash and cash equivalent and short-term bank deposit amounted to approximately $106 million compared to $106.4 million in the previous quarter. Our total financial debt as of June 30, 2023, amounted to $89.6 million compared to $67.4 million in the previous quarter. During the second quarter, Magic paid shareholders $14.7 million with respect to its 2022 second half semiannual dividend distribution as well as $12.3 million towards settlement of liabilities related to acquisitions, which we acquired in prior years. Our cash flow from operating activities reached $23.9 million during the second quarter of 2023 compared to $5.6 million in the same period last year.

In our press release issued today, we announced that Magic Board of Directors has declared the semiannual cash dividend in an amount of $32.7 per share or in the aggregate amount of approximately $16.1 million reflecting approximately 75% of our net income for the first half of 2023. The dividend will be paid on September 13, 2023 to shareholders of record as of August 30, 2022.

In closing, I would like to turn to our guidance for 2023. Our revenue guidance update considers the following two main factors: One, the impact of foreign exchange headwinds and mainly the continued devaluation of the new Israeli shekel versus the U.S. dollar; and two, the slowdown of our operation in North America market. With respect to the exchange tetravalent, we continue witnessing a significant weakness of the new Israeli shekel versus the U.S. dollar, which began during the second half of 2022 and has been continuously deteriorating ever since.

The impact on our yearly revenue guidance for the previous guidance from the previous guidance reported in my amounts to approximately $6 million. With respect to the slowdown we have experienced during the first half of 2022 in the North American market and in particular, the reduced level of our workforce at CVS Health, though we start seeing first signs of improvement, we are still below our original expectations and as such, decided to reduce the forecasted revenue level until the end of the year. The impact on our annual guidance amounts to approximately $9 million. As a result, we have updated our revenue guidance from the range of $585 million to $593 million to a new range of $570 million to $580 million. We anticipate that Q3 will be higher than Q2 revenues by 3.5% to 4%.

In summary, we remain committed to executing our strategy, leveraging our strength and delivering sustainable growth and value for our shareholders. Our business model enables us to navigate the current macroeconomic environment with added stability. Today, over 85% of our revenue comes from existing clients, giving us stability and highly visible source of cash from operations. Our confidence in the market’s need for digital transformation and in our ability to address it remains high. We can confidently continue to execute our strategy to deliver growth and generate cash.

I would like to thank our clients and our shareholders for their continued support and trust, and we look forward to deliver greater success throughout the remainder of 2023.

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

[Operator]

[Operator Instructions] The first question is from Chris Reimer of Barclays. Please go ahead.

[Chris Reimer, Barclays]

Hi guys. Thanks for taking my questions. First off, can you give any color about what contributed to the margin expansion? Would that have just derived from the reduction of the North American-related employees, or was something else going into that? Any color on that would be helpful.

[Asaf Berenstin, Chief Financial Officer]

Yes. In major aspects, mainly the reduction of our operations with CVS, which carried a much lower gross margins than our other professional service projects that we do, with CVS because of the magnitude of overall relationship in our business, we have something between 10% to 12% gross margin. And as you can see, our average gross margin is around 28%, 28.5%. So, once that went down, it impacted our gross margin for the quarter.

[Chris Reimer, Barclays]

Okay. And you mentioned seeing some signs of improvement, can you give any color on that as it leads into the pipeline for maybe next year? And maybe if you could just comment on what kind of projects are you seeing being done now maybe in lieu of something else?

[Yuval Lavi, Chief Technology Officer]

Yes. Hi, this is Yuval. We see, again, the digital transformation and cloud and movement to the cloud all over, even in some places, we see CVS in the future going into more digital transformation and this is what to reassure us that we are on the right track as far as looking to provide the cloud transformation to our customers.

[Asaf Berenstin, Chief Financial Officer]

In terms of our prospects during the first six months of the year, we did see a significant reduction of new business coming from the U.S. in several sectors that we operate in. If it’s in the telecom, of course, in the healthcare, as I mentioned, but also for cloud consumption and from high-tech companies, by the end of the second quarter and let’s say, all through the month of July, we see clients coming back. We see pipeline recuperate. So, we believe that this is not something that only represents July, but something that we feel is a window of going back to improvement rather than one thing.

[Chris Reimer, Barclays]

Great. Thanks. That’s really helpful. And that’s it for me.

[Operator]

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

[Maggie Nolan, William Blair]

Thank you. Can you talk a little bit about the kind of percentage of revenue coming from your managed cloud services versus other services that you offer and how you expect that to be developing over time?

[Asaf Berenstin, Chief Financial Officer]

First of all, I need to put out that if we look at the cloud consumption, for example, and today, we sell something around $60 million in – approximately $60 million, give or take, in cloud consumption, but we don’t show it on a gross. We show it on the net and this is under a gross margin that can run from 4% – around 4% or 5%. So, despite the fact that we sell what we see as a significant amount of revenue from cloud consumption services, this is not something that is highly reflected on our top line. Nevertheless, it of course brings other type of businesses and services, as I mentioned, and SOC-as-a-service.

[Yuval Lavi, Chief Technology Officer]

NOC-as-a-service, FinOps, all other managed services. Also, we can see that our – I think more than 50% of our ongoing offerings that are in the market are asking for managed cloud services. Regardless to the type of cloud services, but they wanted as a managed cloud service and not the perpetual or not is on-premise. So, we see it more and more. I think it’s hard to say cut and the absolute numbers that are being here and there because there is the shift that we see in some places, but also increased. So, from putting the line, it’s hard at the moment for me at least.

[Maggie Nolan, William Blair]

Got it. No, that’s helpful. Thank you. And then on the demand side of things, can you talk a little bit about what level of these are cancellations? Is the spend that you expect will materialize in the future at some point? And then what do you think it takes for your customers to get comfortable kind of loosening up their budgets and spending again?

[Guy Bernstein, Chief Executive Officer]

I think we need to differentiate here between the U.S. market and the rest of the world. In the U.S., we saw that customers started to squeeze their budget at the beginning of the year to end down dramatically towards mid-second quarter. And now we start to see again that they start to hire again, but we prefer to be cautious here because we don’t know where it goes. In the Israeli market, for example, nothing happened. It’s like the market with all the mass in the country, still the business is rather good. But again, we prefer to be cautious because there is some kind of uncertainty, political uncertainty that affected at the beginning and now it’s like we see that the businesses are growing again. So, this is where we stand.

[Maggie Nolan, William Blair]

Got it. Thank you for the update.

[Operator]

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

[Guy Bernstein, Chief Executive Officer]

Yes. So, thank you everyone for joining another call of Magic Software. We definitely intend to bring you more good news in the next quarters. Thank you very much.

[Operator]

Thank you. This concludes the Magic Software Enterprises Ltd. 2023 second quarter results conference call. Thank you for your participation. You may go ahead and disconnect.