Magic Software Enterprises Ltd

NASDAQ:MGIC

Earnings Call Analysis

Magic Software Q4 2023: Revenue Dips Amid Global Headwinds

In Q4 2023, Magic Software's revenue fell by 14.7% to $125.5 million year-over-year. However, constant currency figures suggest an 11.2% decrease to $130.6 million. Challenges included the Israeli shekel devaluation impacting revenues by $5.6 million and a demand drop from key U.S. customers, which saw a reduction of 600 U.S. specialists. Despite an overall tough macroeconomic environment, the non-GAAP operating margin improved by 140 basis points to 14.1% from the previous year. In contrast, Israeli operations saw a 9.5% increase in revenue, indicating a strong performance in the local market.

Recovering Momentum and a Positive Outlook for 2024

In the fiscal year 2023, the company, with a diverse portfolio encompassing high tech (25%), defense (10%), finance (15%), and public sector (5%), navigated significant currency headwinds and issues in the U.S. to deliver a resilient performance. While revenues declined by 5.6% to $535.1 million, the gross margin improved by 120 basis points to 29.6%. The company managed to mitigate some of the revenue declines with increased profitability, reflecting a strong emphasis on efficient operations despite external pressures.

Strengthening Profitability Amidst Challenges

Against the backdrop of headwinds, the company enhanced gross margins to 30.8% in Q4 2023 from 29.3% the previous year and achieved a gross profit mix of 42% from software solutions (with a robust 64% margin). Even as non-GAAP operating income dipped slightly to $71.8 million, the operating margin showed strength, increasing to 13.4% from 13.1% in 2022. Non-GAAP net income fell by 6.5% to $48.4 million, evidencing resilient yet pressured profitability metrics amid higher financial costs from increased debt levels and interest rates.

Liquidity and Cash Flows: A Testament to Fiscal Prudence

The company maintained healthy liquidity with cash and cash equivalents at around $107 million and reduced its total financial debt from $88 million to $81 million. The cash flow from operating activities for 2023 underlined operational efficacy, growing by 29% to $77.9 million, which demonstrates a robust cash conversion cycle that is critical for sustaining operations and growth initiatives.

Guidance for Growth: A Look Ahead

Looking to 2024, the company sets forth a revenue guidance of $540 million to $550 million, suggesting an optimistic return to normalized growth rates, with expectations of 7.5% to 9.5% in annual growth. This outlook is built upon stabilizing U.S. markets, recovery from the Israeli conflict's impact, and sustained performance across key sectors like finance, high-tech, and defense that underscore the company's resilient business model.

Earnings Call Transcript 2023-Q4

[Operator]

Ladies and gentlemen, thank you for standing by. Welcome to the Magic Software Enterprises' 2023 Fourth Quarter and Full Year Financial Results Conference Call.

Magic's fourth 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 Bernstein; and Magic's 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 Bernstein, 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 fourth quarter 2023 financial results. During the call today, I will review highlights from our fourth quarter results and provide an overview of our outlook.

Revenue in the fourth quarter of 2023 decreased to $125.5 million, down approximately 14.7% from the fourth quarter of 2022. As we already mentioned in the past calls, during the year, the effect of the currency fluctuations on our revenues over the course of the year was and still is significant compared to the corresponding quarter of last year. On a constant currency basis, calculated based on the average currency exchange rates for the 3 months ended December 31, 2022, revenues for the fourth quarter of 2023 would have decreased by approximately 11.2% compared to the fourth quarter of 2022 to $130.6 million, $5 million more higher than our reported revenue figure for the quarter.

As we described in the third quarter results conference call on November 14, the reduction in our third and fourth quarter revenues was caused primarily by 2 factors: One, the currency headwind caused by the significant devaluation of the Israeli shekel relative to the U.S. dollar in 2023, reaching 9.7% for the year and 9.3% for the fourth quarter, which has hurt our Israeli shekel-denominated operation by $5.6 million for the fourth quarter and $22.9 million for the year. And second, a substantial and unexpected decline in demand for our professional services from several of our important U.S.-based blue-chip customers, which without any advanced notification and due to internal reasons unrelated to our software services decided during the second half of the third quarter in going forward to immediately suspend significant part 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 noted a significant post third quarter event. The outbreak of Israel 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 1,700 Israeli employees. We keep on sending with [indiscernible] and wish our employees who are fighting in the entire Israeli Armed Forces, continued success at eliminating the terrorist organization that planned and conducted the brutal murder of 1,400 Israeli civilians and continues to hold 134 Israeli hostages.

The absence of our Israeli employees who were drafted for active military services since the beginning of the war on October 7, together with the decline in demand for our software services from several of our important U.S.-based blue-chip customers and the continued challenging macroeconomic environment of high interest rates, persistent inflation and reduced capital spending, have caused us to report significantly lower revenues for the fourth quarter and for the second half compared to the same period last year.

Having said that, I would like to highlight that our fourth quarter revenues have reached the higher end of our fourth quarter revenue guidance target.

Despite all of those difficulties working against us, we continue to plow forward with our worldwide dedication and confident that we can continue to execute on sales of our world-class suite of product and 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 and 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 teams and our adherence to our cost structure enabled us to improve our profitability despite the lower revenue.

In the fourth quarter of 2023, our non-GAAP operating margin held strong at approximately 14.1% of our revenue, 80 basis points higher compared to the margin during the first half of 2023 and 140 basis points higher compared to the corresponding period last year. This shows the enhanced scalability and the sensibility of our business model and our ability to maintain and even improve 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 in the future.

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 continue to see excellent execution by our teams. Setting aside the fact that slower 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 realm 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 maintenance [indiscernible]. 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 a 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.

Like many others, we recognize that the cloud is not just 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 higher standards of performance 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 operations and client business continue and time business continuity, empowering our trying to focus on their core competencies, while leaving the management and optimization of the cloud and IT system environment to us. 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 with double-digit CAGR during -- due to the increasing complexity of cloud environment and the need for specialized expertise. As of today, Magic has over 300 logos consuming its managed cloud services. What sets 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 3 major cloud platforms, AWS, GCP and Azure, and are well positioned to provide our customers with optimal solutions tailored to their unique needs.

Our strategic focus centers on being industry leaders in artificial intelligence, AI and generative AI. This strategic alignment allows us to cater to a diverse clientele, ranging from digital native technology companies to traditional enterprises. By harnessing the power of AI and generative AI, we aim to empower businesses to enhance efficiency and competitiveness in their respective domains.

Proceeding to address our fourth quarter financials. In the fourth quarter of 2023, our revenues in North America amounted to $51.3 million, which is approximately $30.4 million or 37% lower compared to the fourth quarter of 2022 and $7.2 million or 12% lower compared to the third quarter of 2023, mainly due to additional CapEx made by several clients in the U.S. among with some of our largest customers during the second half of the third quarter, which decided to reduce expenses and put on hold IT investment decision resulting in a decrease of close to 600 of our U.S. specialists compared to the respective quarter last year.

Revenue from our Israeli operation amounted to $54.3 million, up by 9.5% compared to $49.6 million reported in the fourth quarter in 2022. The impact of the continued devaluation of the new Israeli shekel versus the U.S. dollar was a material factor in reducing the increase of our dollar reported Israeli market revenue. On a constant currency basis, calculated based on the average currency exchange rate for the 3 months ended December 31, 2022, revenues for the fourth quarter of 2023 of our Israeli operation would have increased by additional $5.6 million to $59.9 million overall, reflecting a year-over-year growth of 20.8% in [indiscernible] 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 accounts for 20% of our business, high tech, which accounts for 25%, defense 10%, finance 15% and the public sector of 5%, which allowed us to partially compensate for the current slowdown we experienced in North America.

Turning now to profitability. Despite the significant currency headwind and the problems with our U.S.-based revenues during the second half of 2023, we were nevertheless able to increase our gross margin for the fourth quarter of 2023 by 150 basis points to 30.8% of revenue or $38.6 million compared to 29.3% in the corresponding quarter of 2022, in which it was $43.2 million.

The breakdown of our revenue mix for the year of 2023 was approximately 19% related to our software solutions with a gross margin of approximately 64% and 81% related to our positional services with a gross margin of approximately 21%. In 2022, approximately 17% of our revenues was attributable to our Software Solutions segment, with a gross margin of approximately 64%, same as this year and 83% related to our Professional Services with a gross margin of approximately 21%, again, same as this year.

The breakdown of our gross profit mix for the year was approximately 42% related to our Software Solutions and 58% related to our Professional Services compared to 39% and 61% in the same period last year.

Our non-GAAP operating income for the fourth quarter of 2023 fell on an absolute basis while increasing on a percentage basis compared to the corresponding period of 2022. It was $17.7 million compared to $18.7 million in the same period last year. This reflects an operating margin of 14.1% for the quarter compared to 12.7% in the fourth quarter of 2022. On a constant currency basis, calculated based on average currency exchange rates for the 3 month period ended December 31, 2022, non-GAAP operating income for the fourth quarter of 2023 would have decreased by 2.8% to $18.2 million for the quarter.

Financial expenses, during the quarter, we had financial debt interest expenses of $1.5 million related to our $81 million financial debt compared to $0.7 million of interest expenses recorded in the same period last year related to a total financial debt of $51 million. The increase in our financial expenses mainly resulted from the increase in our overall debt in 2023, and in our interest rate level as the majority of our debt bears variable interest rates, which has been subject to higher interest rate in 2023 compared to the same period last year.

Net income attributable to noncontrolling interest, Other 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 noncontrolling interest increased to $1.5 million compared to $1.6 million for the same period last year.

Our non-GAAP net income for the fourth quarter decreased by 24% to $11.6 million or $0.23 per fully diluted share compared to $13.4 million or $0.27 per fully diluted share in the same period last year, which was a product of the reduction in our operating income, an increase in financial expenses resulting from increased level of debt and increased bank interest rate.

Turning now to the full year results for the 12 months that ended December 31, 2023. 2023 revenues decreased to $535.1 million, down approximately 5.6% from $568.8 million in 2022. As we already mentioned, during the year, the effect of the currency fluctuation in our revenues over the course of the year was significant compared to the corresponding year. On a constant currency basis, calculated based on the average currency exchange rate for the 12 months ended December 31, 2022, revenues for 2023 would have decreased by approximately 1.6% to $557.9 million compared to 2022, $22.8 million higher than our reported revenue figure for the year.

Turning now to profitability. Despite the significant currency headwinds, and the problems with our U.S.-based revenues during the second half of 2023, we were nevertheless able to increase our gross margin for the year by 120 basis points to 29.6% of revenue or $158.4 million compared to 28.4% in 2022, in which it was $160.8 million. Our non-GAAP operating income for the year fell on an absolute basis while increasing on a percentage basis compared to the corresponding period of 2022. It was $71.8 million compared to $74.5 million in the same period last year. This reflects an operating margin of 13.4% for the quarter -- for the year compared to 13.1% in 2022.

On a constant currency basis, calculated based on average currency exchange rates for the 12-month period ended December 31, 2022, non-GAAP operating income for the year would have reached to $74.5 million, same as last year. Our non-GAAP net income for the year decreased by 6.5% to $48.4 million or $0.99 per fully diluted share compared to $51.7 million or $1.05 per fully diluted share in 2022, which was a part of the reduction in our operating income and increased financial expenses resulting from an increased level of debt and increased bank interest.

Turning now to the balance sheet. As of December 31, 2023, our cash and cash equivalents and short-term bank deposits amounted to approximately $107 million, same as of September 30, 2023. Our total financial debt as of December 31, 2023, amounted to $81 million compared to $88 million as of the end of the previous quarter. Our cash flow from operating activities was $12.4 million during the fourth quarter of 2023 compared to $12.5 million in the same period of 2022. Our cash flow from operating activities for the year increased 29% to $77.9 million compared to $60 million, excluding payments of deferred and contingent consideration related to acquisitions recorded under cash flow from operating activities.

In closing, I would like to turn to our annual revenue guidance for 2024. As we stated on our third quarter earnings call, as of the third quarter, our business activity in North America experienced a significant slowdown side-by-side to the outbreak of Israeli war against the terrorist organization Hamas, which, among other things, has led to drafting into active military service of approximately 200 of our 1,700 Israeli employees. We acknowledge that while short-term conditions are not ideal, we are nevertheless optimistic that in 2024, once the major part of the war in Israel would also be behind us, we expect to return to our normalized historical growth rates in the midterm.

As such, we anticipate 2024 revenues to be in the range between $540 million and $550 million based on current currency exchange rate. This guidance for 2024, when measured against our annualized 2023 fourth quarter revenue on a going-forward basis reflects an annual growth of 7.5% to 9.5%.

Magic has a well-established track record of growth, profitability and high cash generation. Across the globe, our dedicated team is resolutely focused on executing our strategic vision to not only restore but [indiscernible] our previous highs, thereby ensuring sustained growth and the continual enhancement of shareholders' value.

I would like to thank our clients and shareholders for their continued support and trust and we look forward to continue to deliver results on your behalf.

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

[Operator]

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

[Chris Reimer, analyst]

Congratulations on the strong results. I was wondering if you could provide any color on the outlook and maybe some of the contributing factors in arriving at your revenues range?

[Asaf Berenstin, executive]

Basically, if we separate between the U.S. market, the North American market and the Israeli market, in the Israeli market, we saw in 2023 compared to 2022, a continued strong momentum. By the way, despite the events that we are currently experiencing in Israel and the fact that we had all through the quarter a significant amount of employees drafted to the Israeli Airforce against Hamas, I think that's what drove our revenue significantly higher was -- first of all, the fact that we are operating in strong sectors like finance -- like the finance sector and the high-tech sector and the -- and of course, the defense sector, which because of the events in Israel had to accelerate projects, deliverable and even increase the level of operation that we had with them prior to be happenings in Israel.

With that, I would say that when we show guidance for growth in next year between 7.5% to 9.5%, still I think that the second half is expected to be significant higher than in the first half. If I need to assume, I would assume that 20% to 25% of the growth will happen during the first half, and the rest will happen during the second half of 2024.

[Chris Reimer, analyst]

Got it. And how would you describe the environment in the U.S. versus the last 2 quarters? Have you seen any change?

[Guy Bernstein, executive]

I think we saw that things have calmed down a bit. So we don't face any more cuts. And two, we're trying to -- it's a bit -- we don't want to tend to sound too optimistic, but we start to see new hirings. But yes, it's on a small scale. Therefore, we prefer to be conservative.

[Operator]

The next question is from Maggie Nolan of William Blair.

[Margaret Nolan, analyst]

Thank you for all the detail. Can you talk about talent management and your utilization and margin targets for 2024, given the changes in the client base as well as the draft in Israel?

[Asaf Berenstin, executive]

I think that currently -- and again, looking forward next year, as we said in the midterm to return to our regular pace of operation growth level, I think that our gross margins should remain relatively stable at around 29%. As I mentioned during the call, gross margin from the software side of the organization is always -- if you look back for 3, 5, 7 years back, you see that it is around 64%. Our gross margin from our professional services is between 21% or 22%. Also going forward, I think that those margins are pretty stable going forward.

The shift sometimes on a weighted average gross margin is, as in this year, goes because of the changes because of the mix between those 2 operations because of the fact that the level of our professional services went down significantly in the U.S. market, lowering our lower part of the margin business, we managed to experience higher margins on average. Again, looking back, I think that the 13% operating margin is what we are currently always aiming to be around at that level.

[Margaret Nolan, analyst]

And with respect to your revenue guidance for the year, what are the foreign currency assumptions baked into that guidance?

[Asaf Berenstin, executive]

As I mentioned on the call, we take the current -- we don't try to anticipate the fluctuation of the currency. Otherwise, we would have been in other parts of business, not in IT. We use the current level of -- the current level of current exchange -- the current exchange rate.

[Margaret Nolan, analyst]

And on a year-over-year basis, what is roughly the impact using the current level?

[Asaf Berenstin, executive]

Basically, the average in 2023 was around 3.69. The current exchange rate is 3.65. That's so I don't -- so currently, there shouldn't be any significant difference, except for Q4, where the average rate was around 3.8. And today, we are at 3.65. So again, on the Israeli side of our operation, 40% of our revenues today that should pick up our profit a little bit.

[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 thank you, everyone, for joining the call. We hope to bring good news in the near future, and thanks for joining us.

[Operator]

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