Magic Software Enterprises Ltd

NASDAQ:MGIC

Earnings Call Analysis

Earnings Call Transcript 2023-Q3

[Operator]

Ladies and gentlemen, thank you for standing by. Welcome to the Magic Software Enterprises 2023 Third Quarter Financial Results Conference Call. Magic's third 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 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 projections or other forward-looking statements may be provided on this conference call. 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 the Investor Relations section of the company's website.

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

[Asaf Berenstin, executive]

Thank you, operator, and thank you, everyone, for joining us today as we report our third quarter 2023 financial results. During the call today, I will review the highlights from our third quarter results and provide an overview of our outlook. Revenue in the third quarter of 2023 decreased to $129.5 million, down approximately 10% from the third quarter of 2022. As we already mentioned, during the conference call for the second quarter results of operations, the effect of the currency fluctuations on our revenues over the course of the year is significant compared to the corresponding quarters of last year. On a constant currency basis, calculated based on average currency exchange rates for the 3 months ended September 30, 2022, revenues for the third quarter of 2023 would have decreased by approximately 6% and compared to the third quarter of 2022 to $135.3 million, $5.9 million higher than our reported revenue figure for the quarter.

As we described in the preannouncement of our third quarter results on November 8, the reduction in our third quarter revenues was caused primarily by 2 factors. One, currency headwinds caused by significant deterioration of the new Israeli shekel relative to the U.S. dollar in 2023, which has helped our Israeli shekel denominated operation by $6.3 million for the third quarter compared to the same period last year. And two, a substantial and unexpected decline in demand for our software services from several of our important U.S.-based customers carrying low gross margins which without any advanced notification and due to internal results unrelated to our software services decided to immediately suspend significant parts of their active time and material-based projects.

Behind the results also lies the ongoing challenging macroeconomic climate, which did not help our ability to overcome the primary adverse factors that weigh against us. We also note a significant post third quarter event. The outbreak of the Israeli war against the terrorist organization Hamas, which, among other things, has currently led to the drafting to active military service of approximately 200 out of our 1,500 Israeli employees. We stand with Israel in its fight and wish our employees while fighting and the entire Israeli armed forces success at eliminating the terrorist organization that planned and conducted the brutal merger of 1,400 Israeli civilians and continues to hold 240 Israel and foreign hostages.

The absence of our Israeli employees who were drafted for active military service since the beginning of the world on October 7, together with the decline in demand for our software services from several of our more important U.S.-based customers and the continued challenging macroeconomic environment of high interest rates, persistent inflation and reduced capital spending have caused us to anticipate significantly lower revenues for the fourth quarter in the range of $115 million to $125 million. We preannounced our third quarter results on November 8 immediately after the effects of all of the foregoing factors became clear to us. And in order to prevent multiple updates to our investors, while the effect of such factors was being carefully analyzed by us. Once the effect of all of these factors was clear, we immediately updated our investors.

I would highlight that we have provided a wider than normal range given that many of the factors are outside of our control. But that said, we have taken a very conservative approach and feel very comfortable with this guidance range. Despite all of those difficulties working against us, we continue to plow forward with our worldwide dedication and confidence that we can continue to execute on sales of our world-class suite of products and in providing related services. Our AI low-code, no-code and services offerings are critical as customers continue to automate and digitize their systems and products. And while some of our customers are facing macro companies -- company-specific challenges, we believe we have the right set of offerings to address our clients' needs. We have seen even in this challenging environment that outstanding execution by our team and our adherence to our cost structure enable to maintain our profitability despite the lower revenue.

In the third quarter of 2023, our non-GAAP operating margin held strong at approximately 13.3% of our revenue, 10 basis points higher compared to the margin during the first half of 2023 and 20 basis points higher compared to the corresponding period last year. This slowdown the inherent scalability -- this shows the inherent scalability and defensibility of our business model and our ability to maintain our operating margin, whether our revenues rise or fall. We believe that our ability to maintain the profitability of our operations will keep our balance sheet strong and will enable us to invest to drive revenue growth as soon as the opportunity presents itself.

As we look at our business, we see that we continue to leverage our digital technologies and cloud-based platforms to create strong demand for our innovative software solution and services. We similarly continued to see excellent execution by our teams. Setting aside the factors that slowdown our revenues in North America, which were beyond our control, we experienced another quarter of solid performance recorded across all other parts of our business. We continue to see exciting opportunities and growth potential in the dynamic form of cloud technology and managed services. Since the first days of Magic Software, we have been characterized by our ability to take complex IT processes and make them simple.

Today, we put our focus on helping our clients to transition seamlessly to the cloud enhanced 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 deployments meet the highest standards of performance, scalability, security and reliability.

Our suite of managed cloud services, which includes services such as NOC as a Service, SOC as a service, DevOps as a service, FinOps as a service and much more are tailored to address critical aspect of cloud operation empowering our clients to focus on their core competence while leaving the management and optimization of the cloud environment to us. Our integration and application products are fully cloud-native and we are now starting to provide those products and manage cloud services, allowing our new and existing customers to move their businesses to the SaaS model while keeping their legacy systems and with minimum disturbances to their business. The global cloud services market continues to experience rapid growth with businesses of all sizes recognizing the benefit of migrating to the cloud. The managed cloud service market, in particular, is projected to witness substantial expansion due to the increasing complexity of cloud environment and the need for specialized expertise.

As of today, Magic has over 200 logos consuming its managed cloud services. What Magic apart is its deep domain expertise, a customer-centric approach and a proven track record of delivering successful cloud transformation. Our team of seasoned professional leverage their expertise across the the 3 major cloud platforms, AWS, GCP and Azure, and we are well-positioned to provide our customers with the optimal solutions tailored to their unique needs. Proceeding to address our third quarter financials. In the third quarter of 2023, our revenue in North America amounted to $58.5 million, approximately $19.2 million or 25% lower than the Q3 of 2022 and $11 million or 15% lower compared to the second quarter of 2023, mainly due to additional CapEx made by several clients in the U.S., among with some of our largest customers, we decided to reduce expenses and put on hold IT investment decisions, resulting in a decrease of close to 500 of our U.S. specialists compared to the respective quarter last year.

Revenue from our Israeli operation amounted to $54 million, up by 2% compared to $53.1 million reported on Q3 of 2022. The impact of continued devaluation of the new Eilishekel versus the U.S. dollar was a material factor in reducing our dollar reported Israeli market revenue. On a constant currency basis, revenues for the third quarter of 2023 of our Israeli operation would have increased by $7.2 million year-over-year to $60.3 million, reflecting a year-over-year growth of 13.6% in real terms. This demonstrates our strong performance in the region and reconfirms our long-term strategic decision to focus on mature, stable and technology-driven sectors such as health care, which account to 25% of our revenue; Defense, which accounts for 10%; finance 20%; and the public sector, which accounts for 5% and which allowed us to partially compensate for the current slowdown we experienced in North America.

Turning now to profitability. Despite a significant currency headwind and the problems with our U.S.-based revenue in Q3 we were nevertheless able to increase our gross margin for the third quarter of 2023 by 130 basis points to 29.4% of revenues or $38.1 million compared to 28.1% in the same corresponding quarter of 2022, in which it was $40.5 million. The breakdown of our revenue mix for the first 9 months of 2023 was approximately 19% related to our software solutions with a gross margin of approximately 64% and 81% related to our professional services with a gross margin of approximately 21%. In the first 9 months of 2022, approximately 17% of our revenues were attributable to our Software Solutions segment with gross margin of approximately 64% and 83% related to our professional services with a gross margin of approximately 20%.

The breakdown of our gross profit mix for the 9-month period since the start of 2023 was approximately 41% related to our software solutions and 59% related to our professional services, compared to 40% and 60% in the same period last year. Our non-GAAP operating income for the third quarter of 2023 fell on an absolute basis while remaining relatively the same on a percentage basis compared to the corresponding period of 2022. It was $17.2 million compared to $18.9 million in the same period last year. This reflects an operating margin of 13.3% for the quarter compared to 13.1% in the third quarter of 2022. On a constant currency basis, calculated based on an average currency exchange rate for the 3 months period ended September 30, 2022, non-GAAP operating income for the third quarter of 2023 would have decreased by 5% to $17.9 million.

Financial expenses. During the quarter, we had financial debt interest expenses of $1.7 million related to our $87 million financial debt compared to $0.6 million interest expenses recorded in the same quarter last year related to a total financial debt of $60 million. As our overall debt grew in 2023 and as the majority of our debt bearing variable interest rate, which has been subject to higher interest rates in 2023 compared to the same period last year, we expect interest expenses to continue to rise in the fourth quarter compared to the corresponding quarter of last year.

Net income attributable to noncontrolling 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 these minority shareholders. Net income attributable to noncontrolling interest increased to $2 million compared to $1.5 million for the same period last year. Our non-GAAP net income for the third quarter decreased by 24% or $10.4 million or $0.21 per fully diluted share compared to $13.7 million or $0.28 per fully diluted share in the same period last year, which was a product of the reduction in the operating income and increase in financial expenses resulting from the increased level of debt and the increase in bank interest rates.

Turning now to the balance sheet. As of September 30, 2023, cash and cash equivalent and short-term bank deposits amounted to approximately $107 million compared to $106 million as of June 2022. Our total financial debt as of September 30, 2023, amounted to $88 million compared to $90 million as of the end of the previous quarter. During the third quarter of 2023, Magic paid its shareholders a semiannual cash dividend of $0.327 per share or approximately $16.1 million, reflecting approximately 75% of our net income for the first half of 2023, which we paid on September 13, 2023, to shareholders of record as of August 30, 2023. We furthermore paid $3 million in Q3 2023 towards payment of financial debt. Our cash flow from operating activities was $22.9 million during the third quarter of 2023 compared to $21.9 million in the same period of 2022.

In closing, I would like to turn now to our guidance for the fourth quarter of 2023. As we stated in our earnings pre-announcement issued on November 8, our updated revenue guidance for Q4 2023 estimate that our revenue will be in the range of $115 million to $125 million for that quarter. That reflects the confluence of adverse factors that I identified towards the start of this call. The deterioration of the new Israeli shekel against the U.S. dollar, which we estimate will have an adverse impact on revenues also in the fourth quarter. The difficulties experienced by some of our largest North American customers, which carry relatively low margins, the absence of a significant portion of our Israeli workforce, which has been called to duty in the Israeli war against Hamas enhance the general challenging macroeconomic conditions, which weigh against capital spending by our clients.

In summary, we acknowledge that while short-term conditions are not ideal, we are nevertheless optimistic that in 2024, once the major part of the world and behind that and our Israeli customers return to full operation, they will resume to engage us to an increasing degree as a preferred partner for innovative digital transformation initiatives, and we expect to return to our normalized historical growth rate in the midterm. As such, we will be able to continue to fortify our position as the leading software solutions and IT service global vendor. We have a well-established track record of growth, profitability and a high cash generation and the Magic team worldwide is committed to executing our strategy to deliver growth and continue improving our shareholders' value. I would like to thank our clients and shareholders for their continued support and past, and we look forward to continue to deliver results on your behalf.

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

[Operator]

[Operator Instructions] The first question is from Maggie Nolan of William Blair.

[Unknown Analyst]

This is Jesse on for Maggie. We hope everyone is safe in Israel, but could you remind us of the makeup of your delivery in other countries and your ability to transfer work to other locations?

[Asaf Berenstin, executive]

If you heard my short brief, as I said, currently, except for the 200 people that are currently being drafted -- actively drafted, basically, we have good work and good business relationships still going on with our clients. Most of our clients are large financial institutions or customers working in the defense sector, which are in the health care sector, which were not much influenced by the -- what is going on now in Israel. The fact that we are losing 200 people doing time and material work. Of course, this is something that we can't compensate. And in most aspects, we can't necessarily move to other locations. .

[Unknown Analyst]

Understood. And then for my follow-up, is there anything incremental you can share about the cancellations and would you be able to elaborate on demand in your other sectors outside those cancellations?

[Guy Bernstein, executive]

Yes. I think that what we've seen in North America, we updated at the end of last quarter that we saw some slowdown, and we spoke to some of the big customers that were cutting some employees. Towards, let's say, end of this quarter, we saw a significant reduction in force by some of the customers. It was across the board. So I cannot identify a specific customer, although we still work with all of them, they -- some of them decided to cut some of their projects while continuing with the project they still continue with us. All in all, was really unexpected then on top of the call that we had with them before that. But we will make the relevant adjustments and we'll bring the business back to speed.

[Operator]

The next question is from Chris Reimer of Barclays.

[Chris Reimer, analyst]

Last quarter, I believe you did note the decrease in specialists, particularly for CVS Health. Now when you mentioned these issues today, has that customer maintained the same level? Or have you seen further decline at that customer? And just also, how can we look at margins given the issues that you've brought up earlier in your comments?

[Guy Bernstein, executive]

Okay. So as for the specific customer, I think the main hit -- or let's say, the significant hit came from this customer, while we talked to this customer last time. We understood that they are going for some kind of cutoff. And later on, they decided to go deeper. In terms of the margin, I don't think it's going to affect the margins percentage-wise. It may even get -- we may even get better margins because of this -- of the rebate policies of most of them, so we can improve the margins on the percentage side. In absolute numbers, we will probably feel a small hit on the numbers. But again, I think, we are doing whatever is needed in order to overcome this.

[Chris Reimer, analyst]

Got it. And regarding the managed cloud services vertical, can you give us an idea of what what percentage of your business is there? Or how should we look at that progressing going forward?

[Guy Bernstein, executive]

When you talk about percentage of the business from the total business or from the -- from the total...

[Asaf Berenstin, executive]

I will comment on that. First of all, we need to understand that in terms of cloud services, we separated between cloud consumption and managed services. On the cloud consumption side, we are currently running at a run rate of around $60 million growth in terms of the cloud consumption. We are working mainly with Azure and with AWS, and we are now establishing a much deeper relationship also with GCP. So we expect these revenues to continue to rise. Those amounts which I mentioned, we don't present them at growth. We present them at net. So we, of course, offset the cost that we pay to those vendors for such services.

So it has a much, much minimum impact over the total revenues that we create currently profit range between 7% to 10% on cloud consumption. On cloud services, this is part of the services that you see that we provide. And as you see and as I reported, we experienced around 13% average growth in real terms in the Israeli market, significant portion of it comes from projects that we provide to 200 different logos today on managed services on different aspects of managed services and cloud.

[Operator]

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

[Guy Bernstein, executive]

Yes. So I know that this quarter was not the best quarter for us. We take the time, and I believe that within the next 2 quarters, we will bring the business back to speed. Of course, there are some unknowns with the war that is going on now in Israel. But assuming we -- this is the status that we are facing now and it will not get worse, then I believe that in the next 2 quarters will bring the business up to speed to growth again. And just to remind you, as our investors from -- for the last probably 14 years, we've taken the business from quarter-by-quarter. And every time we succeeded in bringing good news to our investors, and we hope that we'll bring that sooner rather than later to you guys.

So thank you for joining, and thank you for the patience.

[Operator]

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