Magic Software Enterprises Ltd (MGIC) 2020 Q1 法說會逐字稿

Ladies and gentlemen, thank you for standing by. Welcome to Magic Software Enterprises' 2020 First Quarter Financial Results Conference Call. (Operator Instructions) As a reminder, this conference is being recorded.

With us online today are Magic's CEO, Mr. Guy Bernstein; Magic's CFO, Mr. Asaf Berenstin; and Magic's VP of Technology and Innovation, Mr. Yuval Lavi. Magic's quarterly earnings release was issued before the market opened this morning and has been posted on the company's website at www.magicsoftware.com.

Before we start, I'd like to remind everyone that this conference call may contain projections or other forward-looking statements. The safe harbor provision provided in the press release issued today also applies to the contents 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 conference call today, 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 would now like to turn the call over to Mr. Asaf Berenstin, CFO of Magic Software. Please go ahead.

Thank you, Ilana, and thank you, everyone, for joining us today as we report our first quarter 2020 financial results. We finished the second half of 2019 with a firm pipeline of business which we expected will serve our continued strong momentum into 2020. Our first quarter results demonstrate our continued focus on supporting our existing customers and closing new deals and the continued solid execution of our priorities of top line growth as we reported 19% year-over-year growth in the quarter with sales mainly coming from expansion of our businesses in North America and in Israel as well as in the Japanese market.

Overall, COVID-19 had only a slight impact in the first quarter as we prioritized our performance while adjusting our approach to operations. We work closely with our large customer base, supporting them in their transition to remote work format and addressing the challenges we face in this transition. The vast majority of Magic's employees had the tools to work remotely with the required infrastructure and guidelines in place. As a result, our transition to the work-from-home format was relatively smooth.

Today, most of our deliverables to our existing customers continue as planned. And we didn't see any significant impact on our revenue streams from existing customers. Having said that, we may encounter delays in the onboarding of new projects later in the year or new sales of our software solutions as enterprises may place new agreements on hold until there is less uncertainty from COVID-19.

As we said in the past, our business is benefiting from global trends that are driving our growth. This includes, first and foremost, the demand for a wide range of top technologies, methodologies and services for the SMB enterprise, digital transformation demand for services as organizations continue to migrate from legacy systems to modern, flexible, on-premise or cloud-based solutions as well as the need for meeting customers' expectations for a digital and more personalized experience.

Magic is well positioned to benefit from macro trends impacting our customers, which include the migration from legacy systems and the adoption of digital capabilities. The current business disruption related to COVID-19 highlights the need for enterprises to modernize their platform so they can improve remote access and other digital services. COVID-19 has proven to be an accelerator of the trends that began in the last few years. Today, more than ever, it has become essential for SMBs to increase digital capacity and service delivery through a variety of digital channels. This market shift will compel enterprises, small or big, to complete their digital transformation.

From Magic's point of view, we have optimized our model operations to meet the new business reality. Our direct customer relations as well as our trusted adviser approach have been a beneficial aspect of our business model, especially in this challenging business environment as we help customers address their new and unique challenges to COVID-19. In return, this helps us to secure a repeating revenue while increasing sales within our existing customer base. The close relationships we enjoy with our customers gives us a meaningful knowledge of their business challenges, unique operational environment and their teams. This connection helps us to be highly accurate in our response to their needs and delivery of additional services to enable their growth and success.

As we adapt to the new normal, our own operations have gone through some changes as well. The global business environment has rapidly evolved in reaction to COVID-19 and the agile response of Magic's team to this change is increasing our digital engagement model. Our priority remains executing all our strategies. For the remainder of 2020, we will continue to grow where we have already landed and leverage our investments. We remain focused to advance our competitive position as the one-stop shop for the SMB market with enhanced products and services. We seek business growth organically and with M&A, whilst we seek further opportunities to increase operating efficiencies and increased margin.

While there continues to be near-term uncertainty for COVID-19, we remain focused on execution. We have taken appropriate actions to provide the necessary flexibility and operating efficiency with the current circumstances. Solid demand for our offerings with a high repeating revenue and a solid balance sheet position us for success in this challenging environment. We are confident that as the global economy recovers, Magic will emerge stronger and well positioned for continued growth.

Turning now to first quarter business performance. I will now review our non-GAAP results, followed by comments on the balance sheet, cash flow and with our outlook for 2020 in light of the COVID-19 pandemic. Our first quarter revenue totaled $85 million compared to $71.8 million for the first quarter last year, reflecting a year-over-year of 19% growth. The organic revenue growth was 8% with the balance coming from the impact of NetEffects' acquisition completed during the third quarter of 2019.

Looking at the geographical breakdown of our revenue during the first quarter. North America accounted for 47% of total revenues; Israel, 41%; Europe, 7%; and APAC and the rest of the world accounted to 5% of revenue. Most of our growth in absolute numbers was traditionally from North America and Israel, which continue to be our strongest territories. North America accounted for 43% of our growth in the first quarter, and Israel accounted for 53% of our growth in the first quarter.

Turning now to profitability. Our non-GAAP gross profit for the first quarter of 2020 was $26.5 million, up approximately 12% compared to $23.6 million in the first quarter of last year. Our non-GAAP gross margin for the first quarter of 2020 decreased from 32.9% in the first quarter of 2019 to 31.1% in the first quarter of 2020. The breakdown of our revenue mix for the 3-month period of 2020 was approximately 23% related to our software solutions and 77% related to our professional services compared to 26% related to our software and 74% related to our professional services in 2019 as a whole. The decrease in the percentage of our software solution is mainly due to the acquisition of NetEffects and the expansion of our professional services portfolio. The breakdown of our gross profit mix for the 12-month period of 2019 was approximately 45% relating to our software solution and 55% related to our professional services compared to 50% related to software and 50% related to our professional services in 2019 as a whole.

Moving to operational costs. R&D expenses on a non-GAAP basis in the first quarter of 2020 totaled $3 million compared to $2.5 million in the same quarter of last year and $2.9 million in the previous quarter. The increase in our R&D expenses related mainly to the first-time consolidation of PowWow and to increase development efforts in our R&D center in India in support of our growing base of global customers.

Our non-GAAP operating income for the first quarter of 2020 increased 9% to $11 million compared to $10.1 million in the same period last year. This reflects an operating margin of 12.6% for the first quarter compared to 14% in the first quarter of 2019 and 12.5% in the fourth quarter of 2019.

Our non-GAAP tax expenses this quarter totaled $1.5 million compared to a tax expense of $1.7 million in the first quarter of 2019. Our effective tax rate for the 3-month period of 2020 was 20% compared to 19% recorded in 2019. We expect our effective tax rate in 2020 to be in the range of 20% to 21%.

Our non-GAAP net income for the first quarter increased 41% to $9.4 million or $0.19 per fully diluted share compared to $6.7 million or $0.14 per fully diluted share in the same period last year. Excluding the impact of the devaluation of the new Israeli shekel versus the U.S. dollar during the first quarter on our financial income, net income would have increased by 26% to $8.4 million or $0.17 per fully diluted share.

Turning now to the balance sheet. As of March 31, 2020, cash and cash equivalents, short-term and long-term bank deposits and marketable securities amounted to approximately $89 million compared to $98 million in the previous quarter. Our total financial debt as of March 31, 2020, amounted to $20 million compared to $23 million in the previous quarter. The decrease in our total cash balances mainly resulted from a $15 million payment made towards an acquisition of 20% of the minority interest in Roshtov Software Industries, Ltd, increasing our equity interest in Roshtov from 60% to 80%, as part of our continued effort to improve our financial position and as a testimony of our confidence in our existing operations. Roshtov is an Israeli-based software company with over 3 decades of proven experience in patient medical record information management system and a market leader in Israel.

From a cash flow perspective, we generated $13.1 million from operating activities in the first quarter.

As to our dividend policy, we know that it states that in each year, the company will distribute a dividend of up to 75% of its distributable profit, subject to discussion of our Board of Directors to change that percentage or decide not to distribute a dividend. In determining the dividend to be distributed for the second half of 2019, our Board of Directors decided in spite of the global impact of COVID-19 to approve a dividend distribution for the second half of 2019 in an amount of $0.08 per share or $3.9 million, which in the aggregate with the amount distributed with respect to the first half of 2019 of $7.6 million reflect approximately 56% of Magic Software net income attributable to its shareholders for the year 2019 and demonstrate our continued confidence in our business and our ability to continue generating positive cash flow. The dividend is payable on June 25, 2020, to all of the company's shareholders of record at the close of the date -- NASDAQ Global Select Market on June 9, 2020.

In closing, I would like to turn to our guidance for 2020. The global economy experienced significant disruption from COVID-19, and we have managed the pandemic's effect for both our employees and our customers worldwide. That said, our business model has shown its strength under this new business environment. From an operational perspective, we are a software company, which fortunately allows us to reasonably begin to work from home. Today, 98% of Magic worldwide employees base is successfully working from home or from client site. Gradually and carefully, employees are starting to return to our offices. As a result, we have a very high visibility of our revenue stream from existing customers, which is almost 80% of our revenue. These factors give us confidence for the remainder of the year.

That said, we faced some headwinds. Macroeconomic uncertainty is impacting the time line to close new business and commence new implementations. As a result, we are revising our 2020 revenue guidance to a new range of $350 million to $360 million as compared to the prior range of $360 million to $370 million, reflecting a 2.7% reduction in the midpoint of the range. The operational efficiency measures we took to adjust our cost to the possible lower revenue expectations and our ability to do so across all departments differently allows us to minimize its negative impact over our operating profit.

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

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

This is Chris Reimer on for Tavy. You talked about the impact that COVID-19 has had on new orders. Can you run us through some of the push maybe that you've seen from new customers? And do you think it's because they're just being conservative when it comes to new investments?

I see -- I will divide it into twofold. On the one hand, we see young companies that are being a bit more cautious in terms to their cash flow and, therefore, performing and delaying part of the project. And on the other hand, the sales prospects that we had in the pipe, we assume that it will take longer to close.

Okay. How is the M&A pipeline at the moment? Assuming some of the valuations out there may have come down a little bit, is there any color you can add on that?

Yes. We have probably 4 deals in the pipe. I would say that 2 of them started before this pandemic, and 2 of them came in probably as a result of people being more cautious and they think it's a good timing to mitigate the risk. But yes, before due diligence and we need to proceed.

The next question is from Maggie Nolan of William Blair.

You talked about some of the operating efficiencies that you're driving in the business. Can you talk through those in a little bit more detail? And help us understand what that operating margin may look like in the second quarter or the third or fourth quarter as it compares to what you saw in the first quarter here.

Okay. So in the first quarter, I must say that we had 3 divisions that were underperforming. And therefore, we got a hit and reduced the operating level to 12.6% rather than where we should be, around 14%. Having said that, we are working on the 3 companies to bring them back to their ongoing level. And at the same time, because of this crisis and because you see that you can work in more efficient ways, we decided to take the extra step and improve the operating level. I believe we will see results more towards Q3.

In terms of steps that we have to take, we have, let's say, out of approximately close to 2,000 employees which are dealing with the billable projects, we had to put approximately 150 people on unpaid vacation. We had some cost-cutting in terms of salary adjustments or freeze of salary increase, which also was supposed to support the maintaining of our operating margin. I think the fact that the company already in previous years tried to support the movement of its R&D and delivery capabilities towards India and towards St. Petersburg also support ability to manage and maintain a steady and solid operating margin.

Okay. Great. And then in terms of your top line guidance and how you put that together, what are the conversations that you're seeing maybe with clients in April versus May that kind of informed the composition of that guidance and how it may progress over the course of the year in terms of -- is June going to be weaker? Is there an expectation that there's a recovery towards December? Any color there would be helpful.

Basically, during the month of March and beginning of May, it was, at least in Israel, still the high peak of the corona and shutdown. I can tell you that from approximately 150 people that were on unpaid vacation during these months, during May, it was at least cut by half. And currently, as we speak, we believe that by the end of May, we will have approximately 30 people that are still on unpaid vacation.

So we see customers are asking us to bring back the employees, starting to engage on the work that was currently still in process. But you still see some hesitation of what to expect from them in the coming, let's say, at least in the third quarter. I think that in the fourth quarter, if things will pick up in the pace that they currently seem to be picking up, we will see a back to -- at least somehow back-to-normal activity on the fourth quarter. But for the second and third quarter, people are still on uncertainty level.

Understood. And then one quick housekeeping for me. What is the amount of organic growth embedded in that guidance that you gave for the full year?

As we said, out of the 19% growth, 8% came from -- basically, we didn't do any acquisitions, so everything is coming from the business that we currently have. But 8% is coming from organic activity, and the remaining is from the acquisition that we completed during the third quarter of NetEffects in the U.S., which was not consolidated during the first quarter of 2019. So it's like 40% organic and 60% nonorganic.

And for the full year?

Again.

Will that hold for the full year expectation as well?

Meaning?

In terms of the guidance that you've put out there, organic versus...

Yes.

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

Asaf, you were going so fast I missed the geographic breakdown of sales. Could you run through that again? Sorry to make you do that.

No, you always make me do that, so I'm already accustomed. Basically, we are -- basically, there's no significant change. We are always between the 47%, 48% to 49% in the U.S. and 38% to 41% in Israel. So this quarter, it was 47% in the U.S. and 41% in Israel, 7% in APAC and the rest of the world.

Okay. Can you give us a little more insight on the valuation at Roshtov and Comblack too, both? You guys decided to increase your stake. I'm just -- I know someone's already asked you about the M&A pipeline, and spoke -- you spoke on the valuations a little bit. I guess what I'm wondering is, given your cash balance, you have a great opportunity to take advantage of changes in the environment. And I'm wondering what you see and what your focus is. Do you think you'll try to go for more professional services? Or do you think you'll try to develop your technology capabilities. Could you give us some more insight on that?

Yes. As we say always, we prefer the technology part. Unfortunately, the prices are way higher on the tech side. We are checking both as long as we see the synergies. Currently, we have like, I would say, probably 1 tech company and 3 services companies in the pipe.

Okay. When you look across the world, certain countries are handling the pandemic differently. Like in Sweden, I don't think they did anything. And I think things were sort of scaled back in Germany versus other places. And I think Japan too was also trying to come back quickly. Can you talk to how you see countries now dealing with the pandemic and how that might change the way your geographic revenues grow?

I think that our main, I would say, probably our main concern is the States. Although people are quite used to working from home and -- but still, it's -- still, in a way, it's a concern for us because we are -- you are still in this -- in the middle of this episode. I think in Israel, where we have like our other main revenue stream, we are in a good position, and we feel more comfortable today. As for the rest of the countries, I think in Europe, between Germany and France, Germany is handling it okay. France is probably less okay than Germany, but still in terms of the business, it's -- for us, it's working okay. Japan, the same. The rest of them are rather small countries and based on recurring business so we are less concerned.

Okay. Guy, can you talk about Roshtov and its capabilities and why specifically you wanted to increase your stake there and whether or not you think you can take those -- that skill set and use it in other countries?

Okay. So as for Roshtov, we are talking about a very good and profitable company. We are struggling in terms of translating the operating level to the bottom line, and therefore, we are trying to improve that. And as a result, we are going after the minorities in order to improve the bottom line on one hand and, on the other hand, still to let our partners over there still keep some kind of incentive. And since after like, I don't know, probably, what, like 4, 5 years that we have Roshtov, we feel quite confident with this transaction, not to talk about the fact that, as a result of this whole situation, in Israel, they are doing better and better.

As for taking them out of Israel, we are checking some opportunities, but I must say that I don't know. At the end, it's a very intensive project that usually involves like the minister of health in specific countries. So yet to be seen. But all in all, the company is improving all the time.

When we first acquired Roshtov, the profit level that they did and the profit -- and the annual profits that they do now have increased by 40% from 2016 until the end of 2019. They have a very strong customer base. They are -- as Guy mentioned, they are doing very, very well because they are in the health care industry. The fact with this pandemic has also increased their activity now as it even got stronger without this pandemic. And again, for us, it's a better way to improve our ROI to our shareholders.

Okay. So can you talk a little bit about the professional service business in the U.S.? And I guess, what sort of resonates with me is a large retail customer that you have, and I know that they were going through a merger, and they kind of scaled back their development activities. And now, I guess, on top of that, with the pandemic, it seems that they might be even more reluctant to continue to invest. And I'm just wondering if you could talk to that example and maybe what you see is a prevailing mindset. I mean, I know you've spoken very bullishly on the call about the opportunities that you have helping your client companies build their software capability. But I'm particularly concerned about what you see happening in those companies that have a retail facing and a retail presence.

Let's say the major one that we are working with in the U.S. is CVS. And I don't think that the pandemic has made their business any less good than what it was before, that even the opposite. I think that -- and again, we didn't see any decline in the operation. Again, the opposite, we sold even $2 million more this quarter than we had -- than we sold them in the fourth quarter. So we even improved our operation with them during the first quarter.

I think the problem that we are now facing is how much can we rely on continued growth rather than a standstill on the level of operations that we have with them thus far. That's the only question.

Okay. When you take a step back and you look at the development projects in general, can -- I mean there was a big driver for many of your customers to move more of their business to the cloud and maybe more business to mobile. And I have the impression that you haven't seen that change much. And maybe it's even accelerated. And I was wondering if you could just maybe be more specific about the big drivers on development.

Well, I think what we can see, especially in this pandemic and the situation that -- and we see it around the world of customers on one hand who still wants to go forward. On the other hand, they're not jumping right and left to any new ideas or new things. And this is positioning us in a very good place where we're actually taking the route of legacy modernization. So we are an expert in legacy, and we're also moving to the modernization.

There is no big rush. And we see actually customer a bit slowing down on the new high-level ideas or concepts and are going to, okay, let's get what we have and take it the next few steps, which is, again, mobile or maybe some cloud services, but nobody is going in the big bang at the moment. And again, it's giving our existing customers a push back to our side.

Okay. Can you talk a little bit about your own R&D? I know you made a big point in trying to improve operations by doing more development, outsourcing more development outside of Israel. I'm wondering, what's your development focus? And how do you see the investment dollars that you put in R&D helping your customers manage the current environment?

I think, again, the move that we did to India and to St. Petersburg are proving to be very successful, obviously from the cost point of view but also from the efficiency of the deliverables. We see -- we have a good set of skilled people. And they are actually doing very, very good work on also delivering what we need as an ongoing but also pushing forward to new ideas and new technologies. And yes, we see it in the new features that we are bringing towards our cloud solutions, towards our mobile solutions with our legacy tools that -- over the years, the development platform and the integration platform. So again, we are not jumping to, kind of leapfrogging to a new product. We are actually taking our existing products with our existing customers with our existing employees to modern technologies, methodologies and way to deliver solutions.

(Operator Instructions) The next question is from Asaf Barel Chandali of Oppenheimer Israel.

Congrats on a great quarter. Just kind of a technical question here, 2 parter. So for 2Q, anything that would kind of make you think differently about the usual seasonality where you're seeing sequential growth from 1Q to 2Q? And then what kind of assumptions are you guys making, whether they be macro or with respect to some of your customers that are driving the kind of the 2H '20 guide?

Again, I think that for us, we don't see any significant change normally in terms of seasonality. I'll say it in 2 words: One, the second half is normally is much better than the first half in Magic. We normally have a much stronger second half than the first half. This is one. The second, again, in the second quarter, we have -- as I said, we have like 7% of our head count which was on leave, unpaid leave. On the other hand, we managed to offset the impact. So that impacts the top line. On the other hand, we managed to offset that with the steps that we'd taken in putting also our nonbillable or back-office personnel also on unpaid leave to minimize any negative impact on our operating profits. And also, April is the Passover Jewish holiday, which also have some negative impact on our revenue, but this is something that happens every year on the second quarter.

Other than that, as we -- currently, as we said, except for the uncertainty that are currently in the market that we want to feel more conservative and because of that, we slightly updated our guidance and lowered it by 2.7%, lowered the midpoint by 2.7%. I think we pretty much, as we mentioned all through the call, feel very comfortable from the existing business that we currently have with our customers.

Okay. I guess just a follow-up here. Whether it be for results for the quarter, if you guys want to break out on a constant currency basis, what was the FX impact on the full year guide?

Normally, we don't have a significant currency impact because wherever we have operations, we have a foot on the ground. So if we provide projects in Germany, we have an office in Germany, where we have people that are delivering the project, the same in Japan and the same, of course, in the U.S. and in Israel. So normally, we don't have any material impact of fluctuation.

The thing that happened this quarter is that, in certain areas, we accumulated a significant amount of cash, which was denominated in U.S. dollar. And once the U.S. dollar hit the ILS 3.86 level versus the shekel, we converted the cash that we had on hand. So we like managed to record a profit of around $0.5 million.

And the second thing is the devaluation that we have over a loan that we have of around $40 million denominated in shekels, which was devaluated and made the same amount of profit around $600,000. So this is something like -- we call like -- let's call it funny money, so money that you have on hand and you just convert to shekels or liabilities that are denominated in shekel and, based on changing currencies, made their impact. But on the level of the actual operation, there's not much impact.

The next question is from [Nahum Moshe].

I wanted to know, how do you position yourself to take advantage from the G5 resolution?

We have -- we are working on a limited -- on some limited basis with -- on the telecom industry. I think that is one of the -- as Guy mentioned on the call, one of the P&L centers that was underperforming, was the one that is more focused on the telecom industry. We feel that we have what it takes to get benefit from the G5 upgrade. But this is something that is yet to happen. So once it will happen -- we are working with Ericsson. We provide projects and services to Ericsson. We are working around T-Mobile. These clients, once we get this G5 going on, I think that it will have a positive impact on our operation. But again, it's on still a limited scale, something around -- I think that the total revenues on an annual basis that we have from the telecom sector would be something around between $30 million to $40 million out of the $350 million, $360 million that we anticipate for the year.

There are no further questions at this time.

Mr. Bernstein, would you like to make your concluding statement?

Yes. So thank you, everybody, for joining our call, and we hope to bring you some more good news in the next quarter. Thank you.

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