Magic Software Enterprises Ltd (MGIC) 2019 Q3 法說會逐字稿

Ladies and gentlemen, welcome to Magic Software Enterprises 2019 Third Quarter Financial Results Conference call.

(Operator Instructions) As a reminder, this conference is being recorded.

With us on the line today are Magic's CEO, Mr. Guy Bernstein; Magic's CFO, Mr. Asaf Berenstin; Magic's CMO, Ms. Einat Etzioni; and Magic's VP, M&A and General Counsel Mr. Amit Birk.

I would now like to 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 provisions provided in the press release issued today also applies to the content of this call.

Magic expressly disclaims any obligation to update or review 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 today's 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 call over to Mr. Asaf Berenstin, CFO of Magic Software.

Please go ahead.

Thank you, Amit, and thank you, everyone, for joining us today as we report our third quarter 2019 financial results.

We entered the second half of 2019 with a set path line of business, which we expect will serve our continued strong momentum into year-end.

Our third quarter results demonstrated the continued solid execution of our 2019 priorities of top line growth while maintaining our operating margins.

Our third quarter revenues totaled $85.8 million compared to $72.1 million for the third quarter last year and $77.1 million in the previous quarter, reflecting 19% and 11% growth, respectively.

The outlook for our business remains robust, and we are benefiting from global trends that are driving our growth.

This includes, first and foremost, the demand for wide range of top technologies, methodologies and services for the SMB enterprise digital transformation demand for services.

On the M&A front, Magic has demonstrated a solid track record of acquisition that has accelerated top line and bottom line growth.

We have proven our ability to successfully integrate our position and improve the operational performance of the combined entities.

Through our acquisition strategy, we have expanded the offerings for our customers and increased our global footprint.

Our recent acquisition completed during the third quarter of NetEffects, a U.S.-based company, which specializes in IT, staffing and recruiting, will expand our footprint in the U.S. market and diversify our client portfolio.

NetEffects team and its solid customer base that includes several blue chip companies, will help Magic fulfill its commitment to its clients to serve as a one-stop shop for a full set of solutions and continuous expansion.

We continue with our efforts to find more potential companies that fit our strategy and our valuation range.

We continue looking for small to midsized companies with revenues in the range of $20 million to $60 million, which will follow our strategy, geographic expansion, complementary products and customer base.

On the marketing and brand awareness front, we continue to focus on 2 fronts on our software solutions division: the low cost application development and Industry 4.0.

In the beginning of the week, we hosted our annual Japanese partners and client conference in Tokyo.

More than 500 participants representing 250 ISVs and enterprises that include several blue-chip companies, discussed the Japanese industry trends, Magic's strategy, vision and road map.

We believe that the Japanese market serves as a growth engine for Magic as it is the fourth industrial nation in the world, and we believe in the adoption of low cost and mobile development platform.

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 2019 revised outlook.

Looking at the geographical breakdown of our revenues.

During the third quarter, North America accounted for 48% of our total revenue; Israel, 37%; Europe, 8%; and APAC and the rest of the world accounted for 7% of our annual revenue.

Most of our growth in 2019 in absolute level was traditionally for North America and Israel, which continue to be our strongest territories.

North America accounted for 40% of our growth for the 9 months and 26% in the first quarter, and Israel accounted for 52% of our growth for the 9 months and 59% in the third quarter.

Our revenues in North America for the 9-month period grew 9% year-over-year and our revenues in Israel for the 9-month period grew 17% year-over-year.

Turning now to profitability.

Our non-GAAP gross profit for the third quarter of 2019 was $28.9 million, up approximately 26% compared to $22.9 million in the third quarter of last year.

Our non-GAAP gross margin for the third quarter of 2019 increased to 33.7% compared to 31.8% in the third quarter of last year.

Our non-GAAP gross margin for the 9-month period of 2019 remained stagnant at 33.4% compared to 33.5% in the same period last year.

The breakdown of our revenue mix for the 9-month period of 2019 was approximately 26% related to our software solutions and 74% related to our professional services compared to 28% related to our software solutions and 72% related to our professional services in 2018 as a whole.

The decrease in the percentage of our software solutions is due to the acquisition of NetEffects and the expansion of our professional services portfolio.

The breakdown of our gross profit mix for the 9-month period of 2019 was approximately 51% related to our software solutions and 49% related to our professional services, same as in the respective period last year.

Moving to operational costs.

R&D expenses on a non-GAAP basis in the third quarter of 2019 totaled $3 million compared to $2.1 million in the same quarter of last year and $3.2 million in the previous quarter.

The increase in our R&D expenses related mainly to the first-time consolidation of PowWow.

As evidenced in many other software development companies in recent years, Magic has also been moving its development efforts to India and opened a new R&D center in St.

Petersburg to support its growing base of global customers.

These centers which caused [the employees] close to 400 employees are aimed to help us drive innovation and provide support for new and existing projects across our product portfolio, providing scale to our organization with an efficient cost structure and is critical to our support of -- and future growth.

Our non-GAAP operating income for the third quarter increased 18% to $11.8 million compared to $10 million in the same period last year.

This reflects an operating margin of 13.7% for this quarter compared to 13.8% in the third quarter of 2018 and 13.9% in the second quarter of 2019.

As earlier stated, our results for the quarter included for the first time the consolidation of NetEffects, our recent acquisition, which is accretive to our results.

Our non-GAAP tax expenses this quarter totaled $1.4 million compared to a tax expense of $1.6 million in the third quarter of 2018.

Our effective tax rate for the 9-month period of 2019 was approximately 16% compared to 18% in 2018 as a whole.

We estimate that our effective tax rate for the full year of 2019 will range between 19% and 21%.

Our non-GAAP net income for the third quarter increased 19% to $8.1 million or $0.17 per fully diluted share, compared to $6.8 million or $0.14 per fully diluted share in the same period last year.

Turning now to the balance sheet.

As of September 30, 2019, cash and cash equivalents, short and long-term bank deposits and marketable securities amounted to approximately $100 million compared to approximately $116 million at the end of the previous quarter.

Our total financial debt as of September 30, 2019 amounted to $28 million.

From a cash flow perspective, we generated $6.1 million from operating activities in the third quarter and $32.7 million during the 9-month period of 2019.

In summary, this quarter's strong financial results demonstrate that Magic is continuing its impressive forward momentum with growth in both revenues and profits.

Our record breaking 9-month results for 2019 present that our strategic business initiatives are paying off.

I would like to turn now to our guidance for 2019.

Looking out to the remainder of 2019, we anticipate continuing with our growth momentum and are increasing our full year 2019 revenue to the range of $317 million to $320 million compared to our previous guidance of $313 million to $319 million.

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

(Operator Instructions) The first question is from Maggie Nolan of William Blair.

I'm wondering how much of a contribution NetEffects had in the quarter and what you expect that contribution to be going forward.

Basically, during the quarter, their contribution to the top line was around $5 million.

This is the core run rate.

But we believe that the projections for next year should be up by between 8% to 10% at the moment.

Okay.

And you said it was accretive to the business.

Do you expect that to continue?

Are there any investments that you think you need to make while you're integrating NetEffects?

No.

See, first of all, it is accretive now and it will be accretive in the future.

We are currently also doing as we always do, implementing our synergies with our other operation in the U.S. in order to improve its profitability.

Okay.

Great.

And then the comments at the beginning, you all sounded fairly positive on the pipeline.

Can you give us a little bit more detail about how that pipeline looks versus prior years?

And if there's any change in terms of what you're seeing in the way of deal size or deal length?

I think that basically, it's more to the fact that the first half of the year began for us pretty slow.

We experienced a slowdown from, at least against our -- versus our expectations from CVS, which is our largest account.

I think that the fact that we added NetEffects is one of the reasons or examples for our wish to diversify our customer portfolio, and let's say, be less sensitive to changes in significant clients.

We started the second half with some nice projects that were cooking during the first half.

And from that, we are -- this is why we are more positive and with what we expect from the second half versus the first half.

I would mention one thing that, again, we have 40% of our business coming from the Israeli market.

And the Israeli market fourth quarter will have its annual...

Holiday.

Holiday season, which also will have a negative impact of around 6% of the revenues of the -- coming from Israel during the fourth quarter.

And despite that, we still believe that we'll manage to compensate with other activities, which are more worldwide.

I think all in all, we see a trend -- a global trend that there are way more investments into this digital world.

And therefore, more projects, bigger sizes of projects and we definitely enjoy that.

The next question is from Tavy Rosner of Barclays.

Congrats on the strong results.

You mentioned NetEffects.

Can you comment on who their customers are?

And what kind of traction you expect to get from them in the coming quarters?

Basically, I'm not in liberty to mention the names of the customers.

We just, first started this, let's say, the working together with the management there.

And during the June and July, they have some blue-chip companies.

They have -- they are showing a growth projected when looking at the last, let's say, 2 to 3 years operation.

We believe that together with our presence in the U.S. market, we can even contribute more to their growth.

But in terms of names, this is -- it's not a large company.

As I've already said, they only contribute like $5 million per quarter.

At their current level of operations, they have around 20, 25 customers with like half of them contributing around 70% of the revenues.

So I don't think that by the name -- Mastercard, for example, is one of their customers.

[Bayer] also is another customer of them, which are, again, large accounts.

So I don't think it's an issue to mention them.

Yes.

That's helpful.

And then you talked about Japan, which is interesting because it keeps on coming on the radar when talking about Industry 4.0.

And what percentage of revenues do you currently have in Japan?

How big do you think it can get based on what you're seeing there at the moment?

I think currently Japan is not that big in terms of revenue, though it's a pure technology sale.

And it's a different way of doing business in Japan.

Everything is through ISVs, and we definitely see a trend in Japan in the past 2 years of growth.

So we don't know exactly what to expect for the next years, but it looks quite positive right now.

The next question is from Kevin Dede of HCW.

Last question on NetEffects.

What and how did you pay for $20 million in annual service revenue?

It's a complex deal but I think the down payment is like $9 million, with some earn out over the next 3 years.

So this is, all in all, we will -- we should pay, if everything goes well, probably $12 million?

$12.5 million, and we get also -- we are also paying for the working capital of around $4 million, which we're getting the company from the first day.

So this is why the company is also accretive not just on the P&L, but also on the cash flow.

Okay.

So when did it close?

I mean were we seeing the full effect of it in September -- in the September quarter?

Yes.

It closed beginning of -- very early in July.

But this is why we were also mentioning it in our previous conference call.

Right, right, right.

Okay.

Okay.

About how many heads, how many service heads came with the deal?

They are close to 200.

Okay.

So where does that put your total service headcount?

We have today around 2,600 employees.

And in terms of -- most of them, of course, are for professional services.

Around 80% are professional services basically.

Okay.

I understand, Asaf, you mentioned CVS.

Can you just sort of give us a little bit more color on what's going on there?

I know that there was some pressure on margin, but I was just hoping you could dig in a little bit on the rebate side.

I would say, on CVS it's kind of a double sword.

On one hand, from the mergers that they had with Aetna, we do see some more business coming from Aetna on one side.

On the other side, we did see an experience, a decline in their budget.

So in comparison to last year, we lost around $5 million in terms of terminals of third quarter.

On the other hand, it's true that if you take a company, for example like NetEffects, which have a lower level of revenue versus what we get from our operation in CVS, still the fact that they are not that big in the customer size gives them the ability to benefit from much higher margins.

As with CVS, we get a more aggressive, let's say, rebate mechanism.

Still, we are very glad to the business that we get from CVS.

This is a long year relationship that we have with them and cooperation is good.

I'm sure that once the, let's say, all merger activity will end, we will continue to see business back from them in the future.

Okay.

Asaf, you also mentioned development in India and St.

Petersburg.

Can you talk to, I guess, what drew you to trying to develop software in Russia and how you see the business arrangement and the political environment between Israel and Russia?

So I would answer that.

First, in the past, we acquired a company that had an operation in St.

Petersburg, and therefore, we have our own people working with us for many years.

So we have the experience with them.

I don't think the political situation is influencing whatsoever.

I must say that they are way cheaper than what we can find in Israel or in the States.

And in terms of capability, you can find a lot of talent over there.

So overall, the balance is working for us.

Okay.

Can you give us a ballpark on like how many people you've got there versus the rest of your R&D team?

As I said, in total, in between India and St.

Petersburg, we are close to 400 people.

Right, right, right.

Okay.

So Asaf, SG&A popped up in the third quarter versus the June quarter.

Is that a function of NetEffects?

And what sort of back-office synergies do you think you can manage to that integration?

And where do you think that goes?

I think, yes, basically the -- more than 50% of the growth in our G&A came from the acquisition of NetEffects.

I think that in -- basically on synergies, our contribution was, we believe in the sales mechanism, in the aggressive -- the fact that we can back the growth of the company, which until today, was held by a private individual, which normally they tend not to risk their own fund.

Now the fact that we can support the growth and increase their working capital capabilities, will assist in the growth.

On terms of synergies, I don't think that that growth will cause to, let's say, will bring to additional increase in the OpEx, except for sales expenses.

So I think that we -- with that, both the increase in revenues and both the fact that we can support them on that growth, will not expand their G&A.

And with that, we'll improve their margin.

No.

Yes, I understand.

I was just wondering, I mean, on a non-GAAP basis, it's almost $15 million.

I was wondering if you think there's costs that you can extract.

And what do you think that number goes to, say, in fourth quarter?

I don't think that immediately beginning of the fourth quarter you'll see a dramatic change.

Something in the range of few hundred thousand dollars that I do expect to see already a savings in the fourth quarter.

Okay.

Okay.

Fair enough.

On other partnerships that you have, could you talk a little bit about your arrangement with Tata analytics?

And where you see your business growing there by geography?

And what sort of other accounts you think they can drag you into?

We are -- again, Tata is not a partner of ours, mainly not one that significantly has -- even if we are working with them, that they have any significance on our business or opportunities.

Okay.

I guess, I misunderstood that.

Apologies.

And thanks for clarifying for me.

All right.

So on -- also on the P&L, if I understood correctly, you expect the full year tax rate to be 19% to 21%.

Is that correct, Asaf?

Yes.

We are currently at 16% level for the 9 months.

But let's say that we do manage out of the acquisition that we did with NetEffects, the fact that we can implement some tax saving initiative with the way that we report this acquisition as if we bought the assets of the company rather than the stock.

And the fact that with PowWow, we can also utilize some of their NOLs and the fact that we can also do some initiatives in, let's say, moving the IP of PowWow from the U.S. in Israel, that was the main driver that reduced our effective tax rate in 2019.

Currently, we are -- this is still fresh, both the acquisition of PowWow and the acquisition of NetEffects.

And the fact that we are still working out the, let's say, the details -- the tax details with our tax advisers, I wanted to be more, let's say, careful and conservative.

And this is why I kept the range something between 19% and 21%.

But my expectation is to be lower than that, let's say, for the year-end.

If you want the numbers that will represent next year, like 2020, that's the range, 19% to 21%.

Okay.

Fair enough.

Okay.

Last question.

You mentioned 51% software solutions and 49% professional services.

But I got confused.

I wasn't sure if that was a breakdown in gross profit or in revenue.

That's the breakdown of gross profit.

So despite the fact that the software division is around 30% of our revenues, it still contributes like half of our gross profit.

Okay.

Could you review the revenue breakdown?

It's basically, we do -- again, it's no change.

We -- as we -- as I said, 26% of our revenue is from the software division, 74% is from the professional services.

Basically that's that.

(Operator Instructions) There are no further questions at this time.

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

So thank you very much for joining our call this quarter, and we hope to bring you some good news in the next quarter.

Thank you.

Thank you.

This concludes the Magic Software Enterprises Ltd.

Third Quarter 2019 Results Conference Call.

Thank you for your participation.

You may go ahead and disconnect.