Magic Software Enterprises Ltd (MGIC) 2020 Q3 法說會逐字稿

Ladies and gentlemen, welcome to Magic Software Enterprise 2020 Third Quarter Financial Results Conference Call. (Operator Instructions) As a reminder, this conference is being recorded.

Magic's quarterly earnings release was issued before the market opened this morning, and it has been posted on the company's website at www.magicsoftware.com. Representing Magic Software today are Magic CEO, Mr. Guy Bernstein; Magic CFO, Mr. Asaf Berenstin; and Magic VP of Technology and Innovation, 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 certain 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 Magic Software Investor Relations section of the website.

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

Thank you, operator, and thank you, everyone, for joining us today as we report our third quarter 2020 financial results. Magic continues to deliver strong execution across all our fronts as we advance our business globally, signing new business and increasing our revenue from existing customers.

During the third quarter, revenue grew by 11%, driven by our solid strategic performance to expand in Israel and in North America and leverage our existing customer relationships to upsell additional services. This quarter, we increased our revenue in Israel by 23% year-over-year, North America by 8% and Europe by 7%. These results were driven by the expansion of work for our existing customers and the addition of new ones during the quarter and demonstrate our ability to deliver our software solution and services to our existing customers and close new deals alongside our continued solid execution of our priorities of top line growth despite the continued global impact of the COVID-19 on business decision-making.

Overall, COVID-19 continues to leave only a small impact over our business results. As we prioritize our performance, we continue to work closely with our large customer base, supporting them in their daily challenges that they face. As markets are trying to normalize after the initial impact of COVID-19, we see that the current business disruption related to the pandemic pushes organization to embrace profound digital transformation to migrate from legacy systems to more than flexible, on-premise or cloud-based solutions as well as the need for meeting customers' expectations for digital and more personalized experience while improving the operational efficiency. This alone is driving future opportunities for Magic Software as our business is benefiting from these global trends that are driving our growth. Unlike during the first wave of COVID-19, with the second wave now hitting the main markets in which we operate, we experienced much less uncertainty from our customers and rarely come across customers taking sudden decision to stop or reduce project activity as we witnessed a solid demand for new projects and expansion of existing projects in much more normal fashion.

From Magic's point of view, our direct customer relations as well as our trusted adviser approach has been a beneficial aspect of our business model especially in this challenging business environment as we help our customers address their new and unique challenges. In return, this helps us secure our repeating revenues while increasing sales within our existing customer base, delivering additional services to enable our customers' growth and success. While there continues to be near-term uncertainty from COVID-19, we remain focused on execution.

And for the remainder of 2020, I'm pleased to say that deliverables to our existing customers remain on track. We will continue to grow where we have already landed and leverage our investments. We'll continue to see the growth in sales to our existing customers, which proved the viability of our position as a one-stop shop for the SMB market with enhanced products and services. Solid demand for our offerings with higher repeating revenue and a solid balance sheet positions us for success in this challenging environment. We continue to seek business growth organically and through M&A while we seek further opportunities to increase operating efficiencies and improve margins. We are confident that as a global economy -- as the global economy recovers, Magic Software will remain stronger and well positioned for the continued growth.

Turning now to our third quarter business performance. I will now review our non-GAAP results followed by comments on the balance sheet, cash flow and end with our outlook for the remaining of 2020.

Revenue in the third quarter of 2020 increased by 11% to $94.9 million compared to $85.8 million in the third quarter of 2019. Looking at the geographical breakdown of our revenues during the third quarter, North America accounted for 46% of total revenues; Israel, 42%; Europe, 8%; and APAC and the rest of the world accounted for 4% of our third quarter revenue. Most of our growth in absolute numbers during the third quarter was traditionally for North America and Israel, which continued to be our strongest territories. North America accounted for 30% of our growth in the third quarter, and Israel accounted for 65%. For the 9-month period, North America accounted for 41% of our growth in the third -- and Israel accounted for 55%.

Turning now to profitability. Our non-GAAP gross profit for the third quarter of 2020 was $30.7 million, up approximately 6% compared to $28.9 million in the third quarter of last year. Our non-GAAP gross margin for the third quarter of 2020 decreased from 33.7% in the third quarter of 2019 to 32.4% in the third quarter of 2020. The decrease in our gross margin is solely attributable to the change of our revenue mix related to our software solutions versus our professional services. The breakdown of our revenue mix for the 9-month period of 2020 was approximately 24% related to our software solutions and 76% related to our professional services, compared to 26% related to our software and 74% related to our professional services in 2019 as a whole, and 25% related to our software solution and 75% related to our professional services during the third quarter of 2019. The breakdown of our gross profit mix for the 9-month period of 2020 was approximately 50% related to our software solution and 50% related to our professional services, the same as in 2019 as a whole.

Moving to operational costs. R&D expenses on a non-GAAP basis in the third quarter of 2020 totaled $3.1 million, same as in the respective quarter and compares to $2.8 million in the previous quarter. SG&A expenses on a non-GAAP basis in the third quarter of 2020 totaled $13.4 million compared to $14.1 million in the same quarter of last year and $11.4 million in the previous quarter. The increase in our SG&A expenses versus the second quarter of 2020 is attributable to cost-cutting measurements taken with respect to the COVID-19 business disruption during the second quarter. And as we move back to a more normalized business environment, we reduced savings to support our growth.

Our non-GAAP operating income for the third quarter of 2020 increased 21% to $14.2 million compared to $11.8 million in the same period last year. This reflects an operating margin of 14.9% for the third quarter of 2020 compared to 13.7% in the third quarter of 2019 and 14.1% in the second quarter of 2020.

Our non-GAAP tax expenses this quarter totaled $3 million compared to a tax expense of $1.4 million in the third quarter of 2019. Our effective tax rate for the 9-month period of 2020 was 18% compared to 19% recorded in 2019 as a whole. We expect our effective tax rate in 2020 to be in the range of 19% to 21%.

Our non-GAAP net income for the third quarter increased 17% to $9.5 million or $0.19 per fully diluted share compared to $8.1 million or $0.17 per fully diluted share in the same period last year.

Turning now to the balance sheet. As of September 30, 2020, cash and cash equivalents, short- and long-term bank deposits and marketable securities amounted to approximately $86 million compared to $92 million in the previous quarter. Our total financial debt as of September 30, 2020, amounted to $28.8 million compared to $25.3 million in the previous quarter.

From a cash flow perspective, we generated $13.3 million from operating activities in the third quarter, which were offset mostly by $8.6 million or $0.175 per share related to dividend distribution to shareholders with respect to the first half of 2020, $2.3 million related to dividend distribution to noncontrolling interest, and $10.8 million related to M&A activity. We continue to have high conversion from net profit to cash flow from operating activities. Third quarter represents 90% conversion, and the accumulated 9 -- last 9 months represents 103% conversion rate from net profit to adjusted operating cash flow.

In closing, I would like to turn now to our guidance for 2020. The global economy experienced significant disruption from COVID-19, and we have managed the pandemic effect for both our employees and our customers worldwide. That said, our business model has shown its resilience in a challenging environment. From an operational perspective, we are a software company which functionally allows us to reasonably work from home or from client side. As a result, we have a very high visibility of our revenue stream from existing customers. These factors give us confidence for the remainder of the year, and we are raising our 2020 full year revenue guidance, which we expect to be in the range of $358 million to $365 million on a constant currency basis, reflecting an annual growth rate of 9.9% to 11.5% year-over-year as compared to our prior range of $350 million to $360 million overall, increasing the midpoint of our guidance by 1.8%.

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

(Operator Instructions) The first question is from Tavy Rosner of Barclays.

First, I just wanted to touch on guidance. So your updated guidance kind of imply a flat Q4 in terms of revenue of roughly 4% year-over-year in Q4. So I'm just wondering if you guys are being conservative or if you're expecting some kind of slowdown in Q4 compared to Q3.

We are always conservative, but you need to remember that October, for example, there is the New Year's holiday season in Israel, which today account for over 40% of our revenue stream. And also in November, with the America -- with North America holiday season and Christmas also have some impact on the revenue. We always -- we hope that we will meet the higher end of our guidance, but I guess, yes -- but we remain conservative, by the way, as we were in the second quarter, where I think that -- everybody knew that we will update our guidance.

That's helpful. And then I just wanted to talk about your customers a little bit. So where do you see most of the demand coming from in terms of vertical? And conversely, which vertical are kind of pushing back in terms of budget during the corona time? Like what's driving most of the business at the moment?

I think that Magic is today very oriented to the health care sector, to the financial sector, to the defense sector. We are also oriented a little bit to the telecom sector, which a little bit impaired our results this year. We expected it to be much better and we saw a recovery, a slight recovery during the third quarter. So in the sense, we see a solid demand. I think that all of these sectors, the financial sector, the defense and the health care sector are the ones that were the minimum hit from the COVID-19. You need to remember that the financial district works and invests a lot of money in order to update the legacy system. We have tens of [common] people working on Israeli banks and Israeli insurance companies and credit card companies to update their legacy system. Same with start-up, every start-up in Israel that -- today, we see it and we feel it that every start-up in Israel that start to generate revenues and start to grow its business in everything that goes around the big data and cloud services, they know our name and they approach us. And with that, we managed also to grow our business. Same with the health care, CVS, the 2 Israeli biggest -- the largest health care providers are also in the midst of investments due to the COVID-19 and handling the winter, which also contributed to our business. So all of that are the drivers for the increase in our activity, and I'm sure that they will also continue in 2021.

That's helpful. And maybe a last one, if I may, on the M&A for you. You reiterated your commitment to future acquisitions. Have you guys seen anything relevant lately in the pipeline? And perhaps valuations are too high or there's a lot of competition for kind of trophy assets. Any color you could add?

Yes. I will answer that, Asaf. Yes, we do have a lot of transaction in the pipe. Most of them are rather very small companies. As you know, we don't work through bankers. Most of the businesses we acquire are coming via our businesses, the branches around the world. And therefore, they are way more conservative in the way we do it because we are talking about companies that we know, companies that we compete with. But the disadvantage is that most of them are rather small. So this is how we do it. Still, we are looking for the one which is like a game changer. Apparently, prices are pretty high but we're still looking.

The next question is from Maggie Nolan of William Blair.

Congrats on the strong quarter. I'm sensing some kind of preliminary optimism on 2021. Can you maybe give us some preliminary thoughts just based on the conversations you've had with clients around what they're seeing in terms of their budgets for 2021 and how that may translate into your outlook for both software and services?

So I would...

Okay. Go ahead, Guy. Sorry.

Yes. So I would probably say that in the sectors we work in, like the health care is definitely -- they all have like lots of plans for 2021 about the financial sector. They always have plans and they always invest. So we're trying to expand as much as we can within the existing customers and, of course, to gain some more new logos. So all in all, currently, they all are pretty positive about 2021. Yet to be seen, we are not sure where this all pandemic is going to.

I do have a follow-up. So for this quarter, the September quarter, can you give us a little more detail on the new client additions and kind of the breakout of the growth coming from new clients versus your existing client base?

I think it would be probably rather tough to give you like a list of clients because, as you know, Magic is working. The deals -- most of the deals are rather small deals in the range of like a few tens to a few hundred thousand dollars. And therefore, there is no significant client that is making a strong impact in the quarter. So it's probably between a few tens of clients. We definitely see the expansion in the health care and in the financing sector.

The next question is from Kevin Dede of H.C. Wainwright.

So Asaf, you touched on telecom and a resurgence there. I suspect that you were alluding to Sprint/T-Mobile. Can you give us a little more color? How is that going? Are they sort of full throttle yet? Do you expect them to go maybe full throttle in the next stage of their integration next year? And do you think Magic will be more involved?

We hope to be more involved. I can tell you that starting from the second half or mostly in the third quarter of the 2019, T-Mobile basically stopped everything because of this merger with Sprint. We do see improvement, but it's far, far from where we were in previous year. I think in previous years, I think that the 5G, once it will start driving in more investment in the telecom industry, we will also benefit and ride on that. But currently, it's very small. It became a smaller business for us. We managed to also adjust our cost relatively to that. If you look at on our OpEx, on our sales and G&A expenses versus last year, the entire deduction of around $800,000 comes from the telecom sector that shrink significantly from where we were in prior years. So to your question, we don't see -- we see a slight improvement but not where we were in prior years.

I'm glad you mentioned the SG&A, Asaf. It was up almost $2 million from the June quarter. Is that just because of sales mix and increase in sales or...

It was not -- 25% of that -- roughly 30% of that is from the -- going back to normalized activity. All other refers to some legal stuff, insurance, D&O that prices went up from last year, where our premium was around $50,000. Today, it's close to $300,000. So we got some hit on the insurance and legal, some customers that -- clients that we thought are not making payments on time. So we made some -- we had to do some bad debt provision of around $0.6 million. And bonuses -- when the business does well, sales people are getting -- again paid for. So this is also part of the increase. So I would say 50% comes from the -- going back to normalized business and improvement of our financial results and 50% legal insurance and bad debt.

All right. So do you think this is sort of a new run rate? Or so does it settle back down somewhere closer to first half levels?

In terms of what? In terms of the OpEx expenses?

G&A. Yes, G&A, yes, just for the December quarter.

Yes. I don't -- I think that it would even reduce for the Q4. Again, I don't -- we said that we are conservative. I don't -- we don't give any guidance on that, but I think that this is pretty much the level, yes, to your question.

Okay. All right. Can you give us the same sort of color on CVS, too? I mean I know both you and Guy mentioned health care. And I'm wondering if that's sort of the bucket that you tossed the CVS deal into?

We see -- the health care, we also -- we have a very strong operation in Israel on the health care sector. But yes, CVS today accounts for around 10% of our top line. We do -- again, on the profit side, it is not that profitable because there is rebate on CVS and stuff like that. But still, we managed to bring, in absolute numbers, increased level of business. So it pays out also to us and to the clients.

Okay. So is that sort of more normalized now, too? Is that a fair way to look at it?

We hope that it will continue to grow.

Okay, okay. I think that's the better way to phrase it. Is -- I think the operator mentioned that Yuval is on. Is he on the call?

Yes.

Okay. Could you give us a little more insight on the next generation of xpa and the integration of PowWow? How is that going? Have you run beta? Have any of your customers looked at it? What sort of insight can you give us and how you think it emerges in sort of the competitive world?

We're in the midst of kind of the R&D effort. We are -- prepared the 2 platforms on each side of what needs to be connected. And now we are kind of building the -- what I call the developer journey in the joint platform, and yes, definitely going to be a competitive offering to other products in the market. And this is where we also see a big opportunity to jump on new customers consuming this platform. Also in the Japanese market, we are -- as opposed to our usual behavior where we first come with the global market and only after that coming to the Japanese market. Since we have a big demand on the web client development and the Angular technology, we are going to look at bringing it to Japan earlier with some prospect or customers that are talking to us about implementing it to 1 million concurrent user platform, where usually -- it never used to be our playground, but now we see that our partner is kind of pulling us there, and we are answering the challenge definitely.

Okay. Yuval, thanks for the color. Can you give us -- can you speak a little bit more to time lines? And I don't know if you have early customer feedback or if you're at beta yet. Can you just sort of give us your perspective on time lines and when we might expect to see it in the market full-blown?

Full-blown, it will be somewhere in second Q next year, okay? The idea is to start having the kind of design partners that are working with us or are early adopter beta sites mid of Q1 around February. And then started taking out to customer mid of Q2 with doing the full-blown marketing and global availability beginning of half 2.

Okay. Fair enough. Yes. That sounds like you -- I think the way you portrayed it on the August call -- so it seems like you're sticking to your time lines. Now you mentioned going to Japan early. Are you going to release it globally across your entire network? Or are you still thinking in terms of geographic release?

Oh, no. We're going to global -- all over the globe. What I said is that again, traditionally, the Japanese market is -- prefer us to go with the dot-0 version to the global market and not take it into Japan, and Japan is taking dot 1, dot 2 versions, et cetera, because there are -- when we say it's perfect for them, it's still not perfect. But yes, it's Japanese style. But again, we have such a huge demand from the communities that we're going to kind of put an extra effort with the Japanese branch in order to shorten the gap between the global availability -- or the rest of the world and Japan only to be between weeks to 1 month or 2, not more than that.

Okay. On the development side, I mean I -- if I understand correctly, you've got developers in Israel and then somewhere in Central Europe, too. So I imagine it's a combined team effort. Are you having any trouble funding the resources that you need to stay on track?

Not really because, again, I think we can say that we had and we overcome it by actually merging the existing team to the new team. So we are working with part of the people and the technical people in the U.S. that came with PowWow, the team in the Ukraine that we have in St. Petersburg, but also a big team in India that we are shifting from our existing R&D of xpa and pulling them to PowWow technologies, which, again, they're going to be merged as one technology. So we managed to overcome the challenge of bringing new talents in this time of the COVID-19 with actually shifting a little bit focus of our other products internally.

Okay, Yuval. Asaf, can you give us maybe -- I mean it seems like Israel is really bouncing back. And I think the big question in my mind is how many of your consultants are actually going on-site versus working remotely? Did that change at all in the September quarter? I know when we talked about it in August, it seemed to me that most of your guys are still remote but I know -- I mean I know this pandemic has really intensified. And I'm just wondering if it's sort of changed your operating perspective at all.

Of course, it changed our operating -- our operating imperative, let's say. Most of our people are working from home. We are now doing the call from home, except for the defense sector when we have -- when we must -- due to security reason, have people either on-site or in our offices. All other -- most of all other people are working from home. First and most -- and foremost, because we don't want to have a situation when one gets infected or tested positive and everybody else needs to go home or infecting themselves. So this is something that surely has changed, and I don't think that it is -- for the short run, is not going to change back. Israel, you need to remember, is still on the second phase of going back to normal. So we went to -- into a shutdown, and we are now gradually only getting out of the shutdown, and people are also saying back that -- the government is now also saying back that they want to do another curfew, so everything, 7:00 p.m. So yes, we changed it. We moved to smaller offices where we could, by the way. And you also see us on the -- on our margin.

It is more difficult, by the way. The problem with that, that we're trying to cope because we have very gifted people and you want to continue having them relate to the business. And once they're working from home, they are losing some of their DNA with the business, so to keep them identified with the Magic way. And it is something that for us is now more challenging, something that we didn't handle until today because everybody worked together and there was the camaraderie feeling.

Yes -- no. Understood. I think all businesses are facing that company culture issue. I know we are. I mean I haven't been in our New York office since March. I guess my question was really whether or not things have changed from the second quarter. And I guess they haven't, right? You're still maintaining the same sort of operating conditions with everybody working from home.

Yes, what changed is the atmosphere with the client. The clients are now more willing. You don't hear people are saying, "Let's stop the -- let's stop projects," or "Let's reduce the capacity." This is what have changed from the client side.

Kevin, I think from the second quarter, the client understood that this is basically the new reality. So if at second quarter we faced some pushbacks on new projects, it's not the case anymore.

Well, yes. Obviously, Guy, I think you did a great job. I mean sales were up 10% -- almost 10% sequentially. So clearly, your -- what you said in August stands true, right? Because you said that -- you said your clients aren't really holding back. So congratulations on the quarter.

Thank you.

The next question is from Asaf Barel of Oppenheimer.

Congrats again on a strong quarter. Just to start off with maybe a housekeeping question. Can we get an organic growth number for the quarter?

Yes. On the top line, we were -- Q-versus-Q, we were 40%, nonorganic; 60%, organic.

Okay. Do you mean that sequentially or year-over-year?

Year-over-year.

Okay. Great, great. Okay. And then on product mix, you guys had noted -- what you guys had noted on the breakdown implies a pretty strong result for the software business. Is there any update you can give us on that front? I know it's just kind of something we speak about less on the conference call. Also, if there was any impact from the Magic-Hands acquisition that was closed? So any color would be helpful.

Again, the Magic-Hands acquisition, it's a very small operation. It's a company that does a little bit under EUR 2 million a year. The logic behind the acquisition was to bring in around 20 magicians to -- and bringing a partner that has some kind of -- they have an application built using the Magic tool but take the management team, take the magicians in and upgrade our Dutch activity, our Dutch branch, following the leave -- the retirement of one of the managers there, the branch manager there. So that was the logic behind it. It's not material in terms of our business. It is material in terms of our prospect from the Dutch market.

Okay. Yes. So maybe I'll just kind of reiterate the first part of my question, which is more important. It sounds like the software business is growing again. I mean you tell me if I'm doing the math wrong here, especially when I compare 3Q versus 2Q of this year. So any color on the software business would be helpful.

Yes. The software business is growing and grew versus last year. You don't see it so much on -- you see an improvement on the margin but not so much because the capacity of our professional services is still huge versus -- 75% of the revenue still comes from the professional services. We did sell something like 20% more than last year in terms of our software. And this is what also helps to bring -- to improve the bottom line.

Okay. Any kind of drivers there? Or is it just kind of a logical next step in terms of people trying to become more and more digital?

I think that people are trying to get more digital. I see -- we see it on the project side. We see it on the software side, and so it is what it is.

Okay, okay. Great. Gross margins were quite strong this quarter, well above kind of the post-acquisition rates for Q '19 and even stronger versus first half of 2020. Any onetime effects here? Can we actually expect this kind of number to continue? Or do we need to take it back down moving forward?

Let's say that -- still staying conservative, let's say that we -- normally, the fourth quarter is our strongest quarter in terms of professional services and also in terms of software. So I hope -- so I don't expect any significant changes for this year. For next year, first of all, because of the type of prospect that we have on the M&A side, I would assume that Magic should range between the 31% to 31.5% to 32.5% on the gross profit.

(Operator Instructions) There are no further questions at this time. Mr. Berenstin, would like to make your concluding statement?

So thank you, everyone, for joining our call this quarter, and we definitely hope to bring you some more good news next quarter. Thank you very much.

Thank you.

Thank you. This concludes the Magic Software Enterprises Ltd. Third Quarter 2020 Results Conference Call. Thank you for your participation. You may go ahead and disconnect.