Magic Software Enterprises Ltd (MGIC) 2018 Q3 法說會逐字稿

Ladies and gentlemen, thank you for standing by.

Welcome to the Magic Software Enterprises Ltd.

2018 Third Quarter Financial Results Conference Call.

With us on the line today are Magic's CEO, Mr. Guy Bernstein; Magic's CFO, Mr. Asaf Berenstin; Magic's Software Division VP of Technology and Innovation, Mr. Yuval Lavi; and Magic's VP, M&A and General Counsel, Mr. Amit Birk.

I will now turn the conference over to Mr. Amit Birk of Magic Software.

Please go ahead.

Thank you, and good day, everyone.

Our 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.

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 view or expectations, or otherwise.

Also during the course of this call, we will refer to non-GAAP financial measures.

A reconciliation schedule showing GAAP versus non-GAAP results has been provided in the press release issued before the market opened this morning.

A replay of this call will be available after the call on our Investor Relations section of the company's website.

I will now turn the conference over to Mr. Guy Bernstein, CEO of Magic Software.

Please go ahead.

Good morning, everyone, and thank you for joining us today as we report our third quarter 2018 financial results.

We are pleased to report another strong quarter as we continue our forward momentum with consistent year-over-year double-digit organic growth in our revenues, operating income and net income, which clearly demonstrates the solid execution of our well-defined corporate strategy.

Our Q3 revenues for 2018 reached a record-breaking $72.1 million, reflecting 10% year-over-year growth.

Non-GAAP operating income also increased 10% year-over-year to a record-breaking $10 million for the quarter.

The third quarter, which included the summer months and the Jewish holidays, was particularly challenging as -- and therefore, we are proud to see an increase of approximately 9% in revenues from software and value-added services in Israel and a 10% increase in overall revenues.

We continue to strengthen our competitive advantages with the development of product and solutions while gaining new customers and expanding our business with existing customers, allowing us to build on our strong foundation and to achieve ongoing growth.

Now I would like to turn the call over to Asaf, our Chief Executive Officer -- Chief Financial Officer, to discuss the financial results in more detail.

Asaf?

Thank you, Guy.

Good morning, everyone.

Our third quarter revenues totaled $72.1 million compared to $65.7 million for the third quarter last year, reflecting 10% year-over-year growth, driven almost exclusively by our organic expansion with all of the growth resulting from our professional services offerings, while on a year-to-date basis, 90% of the growth resulted from the sale of professional services and 10% from the sale of our software solution.

Looking at the geographical breakdown of our revenues.

During the third quarter, North America accounted for 53% of total revenue; Israel 34%; Europe 8%; and APAC and the rest of the world accounted for 5% of our revenues.

Most of our growth in 2018, in absolute numbers, was from North America and Israel, which continued to be the strong -- our strongest territories.

North America accounted for 70% of our growth in the third quarter and Israel for 28%.

And on a 9-month basis, North America accounted for 52% of the growth and Israel for 43%.

Turning now to profitability.

Our non-GAAP gross profit for the third quarter of 2018 was $22.9 million, up approximately 1% compared to $22.8 million in the third quarter of last year.

Our non-GAAP gross margin decreased to 31.8% compared to 34.7% in the third quarter of last year.

The decrease in gross margin was mainly attributable to the increase in CVS rebate rate year-over-year, which amounted to $1.6 million compared to $900,000 in the same quarter last year and the negative impact of the summer months in September, where we had fewer working days due to the Jewish new year holidays.

The breakdown of our revenue mix for the third quarter of 2018 was approximately 27% related to our software solutions and 73% related to our professional services compared to 30% related to our software solutions and 70% related to our professional services in 2017 as a whole.

Moving to operational costs.

R&D expenses on a non-GAAP basis in the third quarter of 2018 totaled $2.1 million compared to $2.5 million in the same quarter of last year.

The decrease in R&D expenses is due to a shift of development project to our offshore sites in India and St.

Petersburg, and to the release of our newest Magic xpa 4.0 Angular-based web application framework version and our Magic xpi 4.7 version during the first half of 2018.

Our non-GAAP operating income for the third quarter increased 10% to $10 million compared to $9.1 million in the same period last year.

This reflects an operating margin of 13.8% for this quarter with no change compared to the third quarter of 2017 and compared to 14% in the second quarter of 2018.

As I discussed earlier on the call, our operating margin was negatively impacted by the summer months and the Jewish new year holiday.

Our non-GAAP tax expenses this quarter totaled $1.6 million compared to a tax expense of $2.1 million in the same quarter of 2017.

Our effective tax rate for the first 9 months of 2018 and 2017 was approximately 18.4% compared to 21.3% in the 2017 as a whole.

We estimate that our effective tax rate for the full year of 2018 will range between 20% and 21%.

Our non-GAAP net income for the third quarter increased 30% to $6.8 million or $0.14 per fully diluted share compared to $5.2 million or $0.12 per fully diluted share in the same period last year.

The increase in our net income is consistent with the increase in our revenues and operating profit.

Our EPS for the quarter was negatively impacted by an amount of $0.01 per fully diluted share, resulting from the issuance of 4.3 million shares at a price of $8.20 per share in a private placement, for net proceeds of approximately $34.5 million to certain Israeli institutional investors and to Formula Systems, our controlling shareholder.

We intend to issue the net proceed of the offering to support our continued organic growth momentum and funding of potential acquisitions.

Turning now to the balance sheet.

As of September 30, 2018, cash and cash equivalents, short-term and long-term bank deposit and marketable securities amounted to approximately $120.2 million compared to approximately $90.9 million at the end of 2017.

Our total financial debt as of September 30 amounted to $34.1 million compared to $34.8 million at the end of the second quarter of 2018.

From a cash flow perspective, we generated $4.2 million from operating activities in the third quarter and $20.3 million during the first 9 months of this year.

With that, I will turn the call back to Guy for closing comments.

Guy?

Thank you, Asaf.

In summary, we are pleased once again to report record-breaking results based on organic growth reflecting the solid demand for our software solutions and professional services, which serve to help our customers on their digital transformation journey.

We continue working towards building closer client relationships, investing in those relationships and building a strong foundation for growth, and we look forward to ending the year with even more positive results.

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

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

This is Chris Reimer on for Tavi.

Regarding the gross margin, we see the reduction in both Q-over-Q and year-over-year following the same quarter last -- the same last quarter.

Could you comment a little more on the mix, the revenue mix?

And how you see it going forward?

Yes.

As we said, in opposed to 2017, as a whole, where we were -- 30% of our business was based on our software solution and technology and 70% was based on the -- on professional service offering.

In 2018, for the 9 months, we are at 27%, so -- from sale of technologies, so this is a slight decline in the growth compared to the -- a more significant growth that we experienced in the professional services.

In that sense, the mix of our revenues caused the devaluations of our gross margin.

But in absolute numbers, of course, the company continues to grow on its gross profit and on its operating level.

And we also managed to benefit from the structure of the company and still maintain our 14% operating profit level -- operating margins level.

Okay.

And last quarter, on the call, you gave a lot of color on the partnership with Microsoft and how it could be mutually beneficial.

Can you comment on any customer traction so far?

And if it's meeting your expectations?

Yuval?

I think the customer attraction is quite positive as we see it in the market and still in the early age of the partnership, but we are pushing now to the goal partnership level with Microsoft and it should be released -- should have a PR on that quite soon.

And we do see already other partners of Microsoft approaching us for mutual offering in the market, so we feel positive that this is going to take us forward in a serious way.

The next question is from Maggie Nolan of William Blair.

I wanted to check in on expectations for the fourth quarter, and if the full year expectations for the top line have changed given the third quarter performance?

Or anything that you're seeing in the fourth quarter here?

No.

Currently, we don't see any reason to change it.

I think we'll be in line with the range that we gave.

Okay, great.

And then it seems like you've seen a pick up in the amount of digital transformation work that you're doing.

And how much of your revenue is really tied up with that type of engagements?

And can you give us a sense for what the margin is of that type of work, maybe compared to the overall company average?

No.

It varies between the -- the projects.

In some of the projects we are just providing services, in some of the projects we are taking full responsibilities, so it's not -- it's quite different between customers who have to -- between one customer to the other.

But all in all, you see that, I think, probably 70%, 80% of the customers are preparing for this transformation because they see it's coming.

And we can also say it's a huge trend that we see again in the market that is pointing back to our long life product of low-code application platform.

And this is where we see a new blooming period for the concept of low-code application platform, especially hand-in-hand with our latest release of our Angular front end, which is actually hitting the targets of digital transformation in the enterprise.

Okay, understood.

And then have you seen as a result any change in the contract sizes or contract lengths?

And then kind of building on that, can you give us some color on how the pipeline looks, maybe with those 2 aspects in mind as well?

We definitely see that projects that were planned for a period of time are being expanded.

And the pipeline?

This company has like probably 80% of the businesses between recurring and repeated business, so nothing has changed.

Okay, understood.

And then last one from me.

Just wanted to hear your thoughts on kind of what are the normalized SG&A level going forward.

Seems like it's been a little bit lower the last couple of quarters, perhaps balancing out some of the decline that we've seen in gross margin.

But I know you've also talked about in the past about efforts to hire additional salespeople, so kind of wanted to hear about the balance between those 2 dynamics and where you expect SG&A to land as a percentage of revenue going forward?

I think that basically, I don't expect any significant change in the SG&A as a percentage of our revenues.

We always manage to and try to keep the level of stability of the company at the -- at least the 14% level, and we managed to do it for some quite time.

In terms of our growth, it is also being reflected by the increase of our personnel.

If we started the year with around 2,000 employees, we are closing the 9-month period with around 2,200 employees.

It shows that the most of the increase is coming from additional professional service experts, but also on the front-end of the sales people, we grew around 8%, recruiting additional 30 new salespeople to the team.

And this is what we -- also contributes to increase in revenues that we experience, and we intend to keep that momentum also in 2019.

Your next question is from Kevin Dede of HCW.

Asaf, I missed a couple numbers, just because it's really early for me, and I had a long flight yesterday, so sorry about that.

You said that your mix was 53% North America, 8% Europe, 5% rest of the world, but I missed Israel.

34%.

Okay.

Then you also said Israel contributed in absolute numbers to 28% of the growth, but -- and you said 50-something for U.S., I missed that one, too.

Yes, you're correct.

So it's plain 5-0 for growth in the U.S.?

It's 52% for the U.S. and 28%...

52%?

Okay, yes.

And 28% for Israel.

Okay.

I was wondering if there was any way to characterize what you think that September quarter would have looked like had there not been such excessive seasonality in Europe and with the Israeli holidays.

Yes.

I think it's a big number because if you look between August and September, I think in September, we had like what?

5 days.

Like 6 days or 7 days of -- 6 working days versus 22 in regular months.

So I'm sorry, guys.

So you think that what?

There were 7 working days in September?

6 working days in September.

Instead of regular 20 days that you have in a full month -- in a regular full month.

Okay.

Okay.

The other thing that, I guess, is just interesting to me is the change in the mix, and I was wondering if you would just take a step back and give us a little more color on that.

Granted the 70-30 has been pretty consistent for years, and pleased to see the software sales come down a little bit.

I'm wondering what you think is causing that?

Is it just that, I mean, it's stable, it just hasn't been growing as quickly?

Or do you think there has been a change in the type of software that people are looking to you to supply?

I can tell you that in certain aspect, we do see customers preferring a subscription-based model rather than perpetual sales of licenses.

Again, these haven't had a significant influence on the -- on our revenues yet because it's not something that is to a significant extent in the company.

But we do see customers that are reflecting on moving from perpetual-based licenses to term-based licenses and to subscription model.

From that aspect -- in the aspect of the growth that we experienced, we do probably still experience a higher growth rate in the professional services, around 12% to 13% for the Q and for the 9 months versus around 6% or 7% for the technology for beginning of the year and pretty stagnant in the third quarter of 2018 versus last year.

Still growing by the 6% on the technology side versus 13% on the professional service side, we managed to contribute 30% of the -- almost 40%, actually, of the increase in our operating profit for the year versus only 60% of the professional services.

So though the professional services on the top line are increasing quite higher, still on the profit level, we get much more contribution on the sales of technology.

Our margins on the sale of technology that we get are approximately 85% to 90%.

Our average professional service gross margin that we get is between 20%, 21%.

And as we said in this quarter of 2018, on the third quarter, that margin even -- although on the professional services even went down to 18.5%, 19% because of the holidays and the summer months, which we expect to recuperate in the fourth quarter.

Wow, Asaf.

Okay, great.

That's a great view, that's a great view.

Can we talk a little bit more about the -- move to subscription?

It's not necessarily clear to me how that -- I guess, how that changes profitability and how it changes revenue recognition.

Can you just talk about it a little bit?

I mean, so you're seeing people -- your customers make the switch, and I guess, yet the contracts have a stipulated length of time, most of them are renewed, I'd understand that.

But I just want make sure I understand how the revenue needle changes.

So basically, when you have a perpetual sale of license, you get one lump sum of revenues and on top of that we get 20%, 22% of the maintenance support going forward.

When we do a subscription-based model, for example, in the web application version that we just now released, the payment is based on an internal investment of 2.5 to 3 years in opposed to a regular perpetual sale of license.

So again because this version was only released during the first half of -- at the late part -- last part of the first half of 2018, we still don't see any impact on that.

But on that aspect, it should be an incremental revenue for the company, but not as material, I think, we would have sold perpetual license.

Right, right, right.

Okay.

Okay.

Can you also talk about the -- I mean, types of projects?

I mean it wasn't that long ago that many of your customers were trying to push to mobile.

And I'm wondering if you're seeing much of that yet or still rather, and whether or not you take most of your customer focus is in trying to drive cloud-based solutions and integration.

We see -- again, I think the mobile development is less focused now in the market.

It's actually -- again, we are in the market of buzzwords.

So the digital transformation is the leader now.

And regardless to what device I'm going to put it either in the desktop, the tablet or the laptop, so it's kind of an omni-solution, okay?

And yes, definitely, we see, especially in our -- companies like software companies that are working with us, the vendors that are going through cloud solution for themself and this is pushing them also for the pricing model based on subscription and also the use of web technology and cloud-enablement technology.

And the enterprises, our customers, some of them are pushing to the cloud and some of them are staying on-premise.

Again, all of them are looking into some kind of a web-based solution, either mobile or desktop, but we look at it as a nonissue since we are looking into the Angular-based development, et cetera, which is regardless to the end device that is using it.

Okay.

Just a little more on that.

Can you talk specifically about where you see those -- I guess, those initiatives the most?

Is it -- it's still dominated in the U.S.?

Or is it starting to gravitate to Europe, especially in that medium-sized, small-sized enterprise space?

I think we see it both in Europe and in the U.S., but maybe the U.S. is a little bit more leading in the area of cloud solution and a subsolution.

So we definitely see all our eyes, these are looking to provide some way of start offering to their customers, and this is where it goes hand-in-hand with our offering.

Okay.

Can you give us a little insight on -- I mean, I know that the employment level here in the U.S. is getting pretty tough to find practiced technology people.

I mean, at least that's what we keep hearing.

And I'm wondering what your experience has been?

Are you still able to find the people that you need?

Granted you what, I guess, based on Asaf's comment, your employee count went up about 10%.

And I apologize, I missed the time frame on that.

Was that through the course of this year?

Or...

Yes.

From the beginning of the year.

Oh, from the beginning of the year, okay.

Is there any -- are you finding a tough time trying to get the people that you need?

Or keep the people that you need?

And are you finding that it's, I mean, given there is a little impact on professional service margin on the -- given the loss of working days, but I'm just wondering if you're seeing any pressure on wages too in order to keep the people that you need?

I think that this is a struggle that not only companies -- that every company is basically dealing.

It's not something that is also relevant to the States, it's relevant to all the markets that we operate in, especially as we said in the Israeli and the U.S. market which are our main markets that we are operating.

We -- again, we managed to balance these challenge by the fact that we get a very good demand, a very high demand for new projects.

And we get confidence from our customers on our delivery, which allows us also to increase penetration and expand the revenues that we generate from our existing customers.

And with that, we manage again to make -- let's say, to make life interesting also to our employees.

We utilize the different development and project delivery method in order to allow our employees to work in parallel, I would say, or in a short period of time over several different project with several different customers and different aspect to make their lives again more interesting, and again, to improve their professionality.

So this is how we tackle the issue of having people stay with the company for a long period of time.

Okay.

Just back to the Angular solution for my last question, if it makes the last question anyway.

Can you give us a little more insight on how you see customers reacting to that?

And I guess, whether or not you're seeing a lot of other competitive firms offer similar type of solution through Microsoft?

No.

Again, I think the market from our experience, and since we are addressing the (inaudible) and we didn't even approach recruiting new customers.

We are going to existing customer and the feedback is amazing.

I mean, the people jumping on it even though it's the first version, and we are coming up at the end of this month with another release of the version.

But the reaction in the market is great, and we're already seeing quite a lot of new projects being implemented in, if it's the level of the PLC or if it's in the level of going into production.

And this is very reassuring for us.

As far as other platforms, actually, I think Microsoft doesn't even have an offering in this area and this is something that we are looking now to actually go together and kind of come with a joint offering, but it's really, really in early stages to come to a joint offering in Azure environment for a low-code application platform based on our technology and Microsoft infrastructure.

As far as other companies that offer, I think we are getting a huge backwind from Angular because Angular is being adopted, highly adopted by the market, over 1 million developers in the community at the moment, and it keeps on growing.

So it's kind of being a magic word, the minute that you mention that you have an Angular offering, the customer is saying, "Oh, we are actually looking to it.

Actually, we want that." So it's a huge help for us the fact that we choose Angular as our first released version.

We are looking into the future, also looking and releasing React or Vue or other front-end clients and framework in our offering.

Okay.

That's really helpful.

The advantages, really, are just that it's easier to code, right?

I mean, if you take a look at from the 20,000 foot perspective?

Yes.

The idea at the end of the day, if you look at the web application development over the years, the lines of codes just grew dramatically from a few thousand lines of code per application to a million more lines of code per application and this is unmanageable, and -- and it's not realistic really to deliver solution based on that, and we are kind of making a dramatic cut of the lines of code that you need to maintain in your Angular solution, but still have all the freedom and the power of Angular and fully UI that you want to implement in the web.

So we -- taking our paradigm of local development and ease of development and ease of maintenance and bringing it to the world of web, an amazing UI, a responsive UI.

So we feel that we have the good formula that the developers/an enterprise need to deliver support for their digital transformation.

So what's sort of the next step you think?

I mean, given you reupped your partnership with SAP, you've got a great relationship with Microsoft, it's developing.

Where do you stand with Oracle?

How else do you build the marketing side, the marketing side, so more small, medium enterprise businesses understand your capabilities?

I think as far as partnership, we are partnering with everyone.

I think the biggest trend that we can see in the market in the last 5 years-or-so is partnering, okay?

All the competitors are competing and partnering, Google and Microsoft are competing and partnering, and everybody, and we're doing the same at the end of the day where in one end, we're competing, on the other end we're partnering.

And we are all looking to bring the best offering that we can to the potential customer.

So yes, partnering up is part of our strategy.

Okay.

Yes, I understand clearly.

I'm just curious about how you're going to build exposure in the end market, right.

I know you count on your ISE, but I'm wondering how you can help support them in your effort in presenting your solutions, especially given that you've got some powerful tools.

Again, I think we are running.

For instance, with Microsoft, we are partnering with Microsoft and with the partner-to-partner program that they have, so just going into a joint offering to the potential customers, so this is in one hand.

On the other hand, when we are going to a smaller ISV, we're doing a direct sales and a direct marketing, and we are counting on them to actually adopt our platform.

We are looking to provide, down the road, a cloud solution, a SaaS solution that will allow actually a smaller companies of smaller size need to work to our platform and our environment so their time to market will even be faster.

So as far as go to market, in a way, we are running in all the different channels, I don't know if I can say that we have one is that dominant than more than the other.

Okay.

Fair enough.

Last question for me.

Just a view to the acquisition pipeline, and what you guys are seeing, where do you think it stand?

And what the outlook for that might be this year and next year?

Again, as we always said, this is, again, based on the opportunistic opportunities, we -- as you know, as you well know by now that all of the acquisition that we actually did over the last 5, 6, 7 years, were all coming from within the business, either our competitors or our partners.

We do have 2 -- let's say, 2, 3 opportunities.

One of them is relatively big.

But because it is, let's say, relatively big versus the normal M&A opportunities that we get, it somewhat prolonged the process.

We hope that we will manage to close something beginning of next year.

But again, at any given time, I can tell you that we have some sort of discussions or LOI or even due diligence that we're doing on companies.

You sometimes get sellers overpromising the companies that they are operating, some of them I don't know, get back in line with the company or in the selling process.

As I said, we hope to close at least 1 by beginning of next year.

We have a follow-up question from Maggie Nolan.

Just one quick follow-up from me on the number of working days.

So you said 6 working days in September this year.

How many working days were there in September last year?

And then how many working days for the full quarter this year versus the same quarter last year?

Last year, we had around 16 working days, 15, 16 working days versus the 6 working days that we had this year.

July and August are normally considered to be full working days with 20, 21 available working days, but we do get, during those months, people leaving for their summer vacation, doing bridges between the weeks.

So in that aspect, these are still considered to be a slower month versus, let's say, the first quarter of every year.

But this is something that -- on the summer vacation aspect, this is something that is repeated every year.

It's no different.

I think the main negative impact that we experienced this year was the fact that we only had 6 days in September versus 15, 16 days last year.

(Operator Instructions) We have a follow-up question from Kevin Dede.

So that, Asaf, right.

So the main reason that there were few days in September is because all the Jewish holidays ended up in one month.

But that means that mean that you should see more working days in Israel during the December quarter, correct?

Yes.

We -- of course, in 2017, October had less working days because of the split of the holidays, and now we expect Q4 to be again a pickup on that.

But on the other hand, and this is the balance that we get today.

If on the -- when we get, let's say, a slow quarter on the Israeli geography because of Jewish new year holidays, in Q4, we will have the Christmas and Thanksgiving.

So -- but we'll have the Israeli market or the Israeli geography to compensate that.

So in that aspect, when the Israeli is high, the U.S. may be low and vice versa.

There are no further questions at this time.

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

Yes.

So thank you once again for joining us this quarter.

And we definitely hope to bring you some more good news next quarter.

Thank you, guys.

This concludes the Magic Software Enterprises Ltd.

Third Quarter 2018 Results Conference Call.

Thank you for your participation.

You may go ahead and disconnect.