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Magic Software Enterprises Ltd.

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Q2 2018 · Earnings Call Transcript

Aug 8, 2018

Operator

Ladies and gentlemen, thank you for standing by. Welcome to the Magic Software Enterprises Ltd.

2018 Second 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 & Innovation, Mr.

Yuval Lavi; and Magic’s VP, M&A and General Counsel, Mr. Amit Birk.

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

Please go ahead.

Amit Birk

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 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 conference over to Mr. Guy Bernstein, CEO of Magic Software.

Please go ahead.

Guy Bernstein

Good morning everyone and thank you for joining us today as we report our second quarter 2018 financial results. We are pleased to report another strong quarter as we continue our forward momentum with consistent year-over-year organic growth in our revenues operating income and net income which clearly demonstrates the solid execution of our well defined corporate strategy.

Our Q2 revenues for 2018 reached a record 70.2 million reflecting 7% year-over-year organic growth. Operating income for the quarter increased 26% year-over-year to a record 8 million and non-GAAP operating income increased 9% year-over-year to a record-breaking 9.8 million for the quarter.

We continue to strengthen our competitive advantages with product and solution development as we expand our footprint in all areas that we have identified as the fastest growing including integration and low-code application development markets. Our positive results are driven by the increasing demand for our diverse portfolio of innovative software solutions and professional services, evidenced by our ever expanding base of new customers and strategic partnerships with major organizations and echo systems including our recent partnership with Microsoft.

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

Asaf Berenstin

Thank you, Guy and good morning, everyone. Our second quarter revenues totaled $70.2 million compared to $65.5 million for the second quarter of last year, reflecting 7% year-over-year growth driven exclusively by our organic expansion with softer license in maintenance and support revenues contributing 50% of the growth and professional services contributing the remaining 50%.

Looking at the geographic breakdown of our revenues during the second quarter, North America accounted for 46% of total revenues, Israel 37%; Europe 12%; and APAC and the rest of the world accounted for 5% of our revenues. Most of our growth in 2018 in absolute number resulted traditionally from North America and Israel, which continued to be our strongest territories.

North America accounted for 39% of our growth and Israel for 47%. Turning now to profitability.

Our non-GAAP gross profit for the second quarter of 2018 was 23.4 million, up approximately 5% compared to 22.3 million in the second quarter of last year. Our non-GAAP gross margin decreased to 33.1% compared to 34% in the second quarter of last year.

The decrease in gross margin was mainly attributable to a 25% increase year-over-year in the rebate rate for our largest customer amounting to $300,000 resulting from increased level of operation with the remaining decrease resulting from certain low margin projects. The breakdown of our revenue mix for the second quarter of 2018 was approximately 30% related to our software solution and 70% related to professional services the same as 2017 as a whole.

Moving to operational costs. Our research and development expenses on a non-GAAP basis in the second quarter of 2018 totaled 2.7 million compared to 2.8 million in the same quarter of last year.

Our non-GAAP operating income for the second quarter increased 9% to 9.8 million compared to 9 million in the same period last year. This reflects an operating margin of 14% for this quarter compared to 13.7% in the second quarter of 2017 and 13.9% in the first quarter of 2018.

Our non-GAAP tax expenses this quarter totaled 1.6 million compared to a tax expense of 1.7 million in the second quarter of 2017. Our effective tax rate for the first half of 2018 and 2017 was approximately 19% compared to 21.3% [ph] in 2017 as a whole.

Our non-GAAP net income for the second quarter increased 22% to 7 million or $0.16 per fully diluted share compared to 5.7 million or $0.13 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 profits.

In addition we had financial income of $200,000 in the second quarter of 2018 compared to financial expenses of approximately $600,000 in the same period last year. Turning now to the balance sheet.

As of June 30, 2018, cash and cash equivalents, short-term bank deposits and marketable securities amounted to approximately 91.2 million compared to approximately 90.9 million at the end of 2017. Our total financial debt as of June 30, 2018 amounted to $34.8 million compared to $37.6 million at the end of the first quarter of 2018.

The decrease in our total debt in the second quarter of 2018 resulted from a mix of loan repayments and devaluation of loans which are denominated in Israel shekel. From a cash flow perspective, we generated 8.8 million in operating activities in the second quarter and 16.1 million during the first half of this year.

In our press release issued today, we announced that Magic Software Enterprises board of directors declared a semi-annual cash dividend in the amount of $0.155 per share and in the aggregate amount of approximately $7.6 million for the first half of 2018, reflecting approximately 75% of our net income and 47% of our cash flow from operating activities for the first half of 2018. In July 12, 2018 we concluded the issuance of 4.3 million shares or 9.5% of our outstanding ordinary shares for an aggregate amount of approximately $35 million based on the price of 8.2 per share from several leading Israeli institutions, investors and from assistant on controlling share holders.

We intend to use the net proceed of the offering to support our continued organic growth momentum and a funding of potential acquisitions. We are reiterating our 2018 full year revenue guidance which we expect to be in the range of 283 million to 293 million on a constant currency basis reflecting an annual growth rate of 10% to 14% throughout the year.

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

Guy Bernstein

Thank you, Asaf. So in summary this quarter’s strong financial result demonstrate that Mandy continues its impressive forward momentum with growth in both revenues and profit.

Our record breaking first half results for 2018 confirm that our strategic business initiatives are paying off. We announced new cutting edge technology in the application development arena which has a significant competitive edge and is already gaining a great deal of positive interest throughout the industry.

We continue to expand our important partnerships in the fast growing integration market and will continue to invest in our business with new and existing clients as well in our growth areas, including mobile cloud and big data to deliver increasing value to both our clients and shareholders. With that, I will now turn the call over to the operator for questions.

Operator

Thank you. Ladies and gentlemen, at this time we will begin the question-and-answer session.

[Operator Instructions]. The first question is from Tavy Rosner of Barclays.

Please go ahead.

Chris Rayner

Hi, this is Chris Rayner on for Tavy. Thank you for taking my questions.

The slight decrease in gross margin this quarter you mentioned was attributable to a customer. Could you explain that again, or give some more color on that?

Guy Bernstein

Yes we have one of our largest customers which has an increasing rebate program, so based on the amount of revenues that we generate, we can increase the level of rebate that we need to apply over the revenues that we generate. In 2019, there was a 20%, 25% increase in the rebate level that we apply over such revenues due to the increased level of operations that we have

Chris Rayner

I see, so this is a onetime thing?

Guy Bernstein

No, it’s not a onetime thing. It depends again on the level of operations that we will generate with them.

I think that in this case of the second quarter, as I mentioned there were also some projects that will as I likely characterize with low margin which I believe that will not have such a significant influence in the second half of the year so I expect gross margin to improve.

Chris Rayner

Okay, thank you. Also on operating margin there was a slight increase, is there anything driving that or was that just a result of the current operations?

Guy Bernstein

We are doing two things that are basically or experience two things that basically impacted our quarterly operating margin. First of all we see a continuous increase in the sales of the software and software licenses that have in the second quarter of 2018 the increase that we experienced in revenues was 50% related to a software and software license and maintenance and support agreement and the remaining 50% to professional services.

On the other hand, we keep trying to maintain a level of expenses that matches the level of operations that we have today and also several of our activities to offshore to our offshore facilities in that relates to the R&D. We have the facility in India, and one facility in St.

Petersburg which of course lowers the research and development expenses.

Chris Rayner

Okay, and one last one just around your competition. After the acquisition of MuleSoft, do you see increased competition in your addressable markets?

Guy Bernstein

Practically we don’t really feel this competition, we have still a strong partnership with the sales force and at the beginning we were quite concerned with this acquisition but we met the people in sales force and currently it looks like you know we are not really competing because MuleSoft is targeting like more kind of tier 1 and tier 2 customer then we are targeting the SME market, so currently it works fine. The opposite, meaning we are gaining even more business because of the buzz in the industry.

Chris Rayner

Okay, thank you very much.

Operator

The next question is from Bhavan Suri of William Blair. Please go ahead.

Bhavan Suri

Hey gentlemen, thank you for taking my questions. I guess may Guy just to start off with a follow up on the competitive environment.

You guys have always been sort of a low code development environment before it sort of became sort of now the excitement, the interest in that area. When you look at sort of that space where you guys have had a niche for a long long time, are you seeing more from guys like Appian at all in that space or Nintex or some of those folks.

Are you seeing any impact from some of the guys now starting to pick up on that sort of low-code environment space?

Guy Bernstein

Not really, we see here and there we see ALT Systems, but not the one that you mentioned.

Bhavan Suri

Yes. ALT Systems and Appian are the two sort of the main guys out there, interesting?

And then, I guess then when you look at the developments you just release new level of xpa. What's driving the growth?

Is it still I mean for while is cloud and integration, and then mobile had a pretty big impact and obviously we now know native first and mobile first and native apps are working. What sort of driving some of the organic growth you are seeing today?

Which one of product sets or is it sort fairly broad-based?

Guy Bernstein

I think it's fairly broad-based. I think the main trigger is that many of our existing customers are starting to develop again based on the new technology that we launched and its start to bring more business.

So before, they were kind of looking for complementary technologies for the development, now I think the situation is a bit different.

Bhavan Suri

Got it. Got it.

And then a follow-up on that, just on the vertical offering, Telco has been sort of positive sometimes negative, you obviously you have a very large Telco customer. Any update on how that engagement is going?

Guy Bernstein

Yes. I'll let Yuval answer this one.

Yuval Lavi

Sorry, I missed the beginning of the question.

Guy Bernstein

Our customers are always seeing for the new technology.

Yuval Lavi

Okay. Yes.

So our customer base existing is amazingly really excited about it and I feel the feedback on a daily – day-to-day business activity that we do with them. I think also to complement the question that you had before, basically the biggest incentive that we see here is what we call the digital transformation.

And as we look at digital transformation and as the industry look at digital transformation is basically the consumer – the end customer digital experience. So this is what our customers need to provide.

And this is what we provide to our customers. And this is something that there been missing in the last few good years and now we provided as well as Guy mentioned they don't need to step outside of our ecosystem.

This is the biggest incentive and the biggest feedback that we get from them at the moment.

Bhavan Suri

Got it. Got it.

Then, I guess let's touch on the Microsoft relationship. Obviously if we go back – I've covered you guys a while, but let's say three, four years ago Microsoft was a competitor and sort of it was this partnership that you still develop, but Microsoft also sort of competing technology.

So Guy or maybe someone on the call, just a little more about sort of the Microsoft relationship, and I guess more importantly what is that mean going forward, are you guys post selling to customers? Is Microsoft recommending you?

Is it part of Azure? How should we think about what that relationship may mean not this year maybe even on next year two, three years down the road in terms of driving new customers and revenue?

Guy Bernstein

Okay. So I'll refer first to the competition part.

I think Microsoft is huge organization and therefore they are competing with everyone in some way. Talking about whether it's a Dotnet [ph] or the integrated [Indiscernible] they are not really competitors.

Here and there, yet you find them. Now with relation to the partnership, the goal is of course from both side is to go with Microsoft use, of course, Azure because this is their interest in return for them to promote us.

And I think they are quite aggressive about it. And from the discussions it looks like this is what they want, yet to be fair of course.

But we met some of their partners, they did with them, we are learning more and more about them and it looks like they are quite there. So, hopefully we'll bring them the right technology and we'll start to push it.

Bhavan Suri

Got it. Got it.

And then a couple on the financial front for me – actually maybe just one, on sales and marketing, that came down pretty dramatically as percent of revenue. I guess first strategically Guy, are you thinking about sort of – when you think about new versus existing customer, as you think about the growth, is there a shift in how you're attacking that?

Or was this just sort of a one quarter anomaly versus sort of wrapping up to get new logos? And then sort of just trying to understand that ticked down?

Thanks.

Asaf Berenstin

First of all it’s a one quarter anomaly. Basically we do see an increasing amount of sales people that we include.

It depends – because we have certain amount of royalties agreement that we have and we made some provision for these agreements in the first quarter based on the level of sales that we saw that we're going to produce this year then it took a little bit down on the second quarter based on the type of software that we sell. Other than that there wasn't any significant impact to the sales and marketing versus last year.

Guy Bernstein

Yes. I think it's the opposite, more and more towards hiring sales people.

Bhavan Suri

Do you want to share any sort of plans, Guy, in terms of numbers of people.

Guy Bernstein

We are struggling like everyone else in the industry because hiring sales people today especially in the state I don't have to tell you. It’s a struggle.

We need to pay them a lot and it take them like at least three to six months to become kind of effective. And in six months time whether they are effective or you need to replace them.

Yuval Lavi

Or someone will hire them for more. Yes, yes.

Guy Bernstein

Yes. But we increase the level of the package that we pay them in order to hire more people.

And it's not yet satisfying, but we have some progress on this one.

Bhavan Suri

Great. That's helpful.

Gentlemen, thank you for taking my questions.

Guy Bernstein

Thank you.

Operator

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

Please go ahead.

Kevin Dede

Hi, Guy. Can we dive in a little bit deeper on the Microsoft deal?

Can you give us maybe the amount of time that you spend with them thus far? And how your pipeline has changed?

And specifically where you think they're looking to leverage your technology?

Guy Bernstein

Okay. So in terms of the time we spend with them, we think its last probably for the past three years.

And I must say that in terms of that pipeline we are not there yet, meaning, we need to do something first in order to go on their platform and then they'll start to promote us. So, Yuval, you can give more detail.

Yuval Lavi

I think what we do with the partnership with Microsoft -- and again, Microsoft did a tremendous shift in the last year or so, okay. They are kind of looking forward and putting behind all the legacy solutions as database, operating system, et cetera.

They only vision and only thing that they care about now is cloud and it's Azure and Azure consumption. So this is the partnership, the new program -- or partnership program that they started to launch six months or something like that, okay.

And this is what we joined in this session. And this is why competition is not relevant anymore.

And the idea for them is to invest a lot of money in marketing us together with us and other partners, okay, just in the purpose of having more and more end customer consuming Azure services, okay. This is the only thing that they see in front of their eye.

And this is also why they pay double commission internally et cetera. So for now we are looking just to deploy our technology on their infrastructure in order for new customers that are coming to us to consumer Azure services, even if it's indirect.

They don’t need to have licenses on Azure. They can go through us.

And on the same thought we are looking now technology wise to take more services of Azure and embed them into our technology in order to have a bigger footprint in the Azure playground. And there we'll need to make a decision based on cost efficiency and stuff like that to see if this is the best tool that we really want to push, because as we all know Microsoft are great, but not all the tools are the best.

So we need to select which tool we want to employment from platform, but this is the vision of the partnership. This is where they pushing us.

And this is where we also see the opportunity.

Asaf Berenstin

That really needs to be clear, we are not expecting Microsoft to come up with lead for us. We are still the one that needs to come with the lead, register them at the Microsoft program and once we do that, we get from Microsoft the assistance for the focal point in the organization that can help us promote the sale, of course that person gets incentivize as you Yuval mentioned, and that the shift [ph].

Yuval Lavi

Sorry, part of the program that they have is partner to partner what they called – that mean, if they have one partner solution that they identify that we can actually be a complementary to his solution that will push him to us in order to cooperate together. And this is one big advantage that we see there.

Kevin Dede

Okay. That helps a lot.

So really its about working and leveraging their Azure cloud platform?

Guy Bernstein

No, not only the Azure, also the other partners. There are conference they introduced us to like 100 of their partners that they believe we can join forced with in order to sell our integration platform.

Kevin Dede

Okay.

Guy Bernstein

Okay.

Kevin Dede

Do you have a view, I mean, clearly you see the competitive environment changed at least within the Microsoft partnership arena, but do you have a view to others that might have a comprehensive integration package as you do that it addresses the SME market? Or do you think you're at this point you think you're pretty much exclusive there?

Guy Bernstein

I think at this point we don't see that much competition. Its between the high end where you see MuleSoft or I don't know, Informatica or maybe even Dell Boomi.

The low end, where you see all the cloud all the cloud solution, the pure cloud solutions that you just plug and play some simple integration solutions, and at the mid-level I think you don't have that much competition. On the other hand talking about whether its Microsoft or whether its other ecosystems that we can use.

We are trying everything. We are pushing all the time.

And you know, this company is growing like, I don't know, 20% average every year, improving all the time. So, probably if something is – will both [ph] then we'll be very happy of course.

But its not that we now, we stop everything and we count only on Microsoft.

Kevin Dede

No, no, no. Obviously clearly I understand that.

I guess what's interesting is just sort of dynamic nature of the software business and how prevalent cloud services have become. You guys have been working really hard and to be able force just relationship with them, I think specially given the way that their business is changing?

Guy Bernstein

Exactly.

Kevin Dede

Right, I think that puts you in a good position?

Guy Bernstein

This is why we see the potential because Microsoft became very aggressive changing their business model.

Kevin Dede

Okay. So in that it bakes the obvious question given the rise of Amazon AWS, what can you talk to about working with them potentially or IBM and as you see these major companies started to push their cloud services, clearly they're all looking each other trying to figure out how to grab as much market share as possible.

What's your strategy there and what can you talk to?

Guy Bernstein

So, at the end of the day as you mentioned are at least three big player, if I put IBM as well, those are four, but and this is what I said before if I'm going to select a Azure solution for a specific scenario or not, I'm not going to commit fully to Microsoft or be exclusively Microsoft unless at the end of the day we'll see that its really, really having a huge impact on the numbers. I think our model at the moment is really try and move as much as being a cloud agnostic but to cooperate with everyone.

By the way they are doing it, okay. If you look at Microsoft, Microsoft and Google are doing an amazing cooperation around ambulance, okay.

So why do I need to select one of the two, okay I want to play with both of them. So this is the concept that we are looking at.

The fact that we are not going to exclusively commit to anyone, we are trying to be a cloud agnostic as far as much as we can and offer at the end of the day not software, but more solutions and moving from just selling a pure licenses that we did so far to work with partners and with existing customer to offer solutions around ARPUs and infrastructure.

Guy Bernstein

I want to say one more thing that you know talking about the three main ones in this cloud area. Microsoft I think is very more solid in terms of the potential partners or clients that they have for our integration process, because they have the dynamic, they have all kind of other development companies did with their platform.

So they are a bit more mature if you compare them to Google or AWS.

Yuval Lavi

And you can add to this one that AWS Amazon, they do have quite huge community that we never set into AWS because of the Amazon platform, not technology but because like Kmart or all the other competitors that are competing on this market, okay will go immediately to Azure and not to AWS. So this is opening a new market or full addressable market from our point.

So the results will kind of negative relationship for Amazon because they are coming with two hats and with the technology and the Amazon store.

Kevin Dede

All right, interesting point, okay. If we were going to go back and look at your own R&D and tool development, the latest version of XPA for has angular capabilities included.

And I guess I was hoping you could take a step back maybe just look from the 20,000 foot perspective and give us a feeling for where you see the largest demand for technology? Given your agnostic cloud position but leaning more toward Microsoft given their entrenched position in the enterprise, just maybe help us understand how you see demand for your tools and how you are using R&D to meet that?

Guy Bernstein

Okay, we see it basically in the trends of what’s happening in the web environment, web development environment, okay. And if we look a little bit there, I think it’s a few more years back if you look at the web development environment, when we started web in the 90s website with 1000 line of code was considered to be a big website, but over the years we added from the technology point of view, uplift and Ajax and stuff like that and we slowly, slowly moved to a more complex web applications.

I think the one that made a tremendous change is the fact that Java script in the last three years just actually won the game. Okay, three years ago, five years ago we had the negotiation, do we go for mobile, for instance, native or HTML 5, this fight is one, okay.

JavaScript is actually the most common development language in our days, but the problem is that JavaScript is un maintainable, it’s not scalable, you cannot really write the one million lines of code application using JavaScript. This is also why you see in the market Microsoft came up with TypeScript, okay?

This is a the type safe way of writing JavaScript etecetera and this is also why you see a frameworks Angular, like Vue, like React are being adopted more and more because the vision behind them is actually to make life easier for the developer. And as you mentioned before, one of you guys that this is what we’ve been doing for the last 35 years, okay.

This is our philosophy and paradigm over the whole year, that make life simplier for developers, okay. Now we kind of catching up on the new wave and riding with our philosophy using the new technology.

So this is where we see the most adaptation, that people want to do amazing look in field application but they don't want to write million lines of code and trying to maintain them.

Kevin Dede

Okay, that’s a great backdrop, but could you just take it one step further and give us greater insight on where you're really seeing that Paul. Is it specifically in just web development or are you seeing more, -- I guess could you just talk to it with relation to mobile and an integration in general?

Yuval Lavi

See again, the concept and this is what I mentioned before the digital transformation. The fact that anybody is looking to give a digital experience to his customer, okay.

That means that tons of new small and big application and exposing existing business functionality that you have today, if I take the bank for example. So the bank is working with computer for 50 years and the fact that I can put a check into my bank, that’s no problem, but the fact that I can take now a check and just use it for my mobile and you know take a picture and then deposit into my bank account this is the digital experience that the consumer are expecting today.

And this is the big bank that we are seeing now from everybody, small and big customers, that this is what they need and they need to do it fast. So this is where -- and by the way, it's combined with integration, because at the end of the day when I take the – my camera on my phone and take a picture of my check and want to put it into my bank account, at the end of the day do need to go to the main frame, okay.

So there is a full process including integration there and we try to enjoy from both light. It doesn't have to be together.

It can be the integration, either the mobile or both of them, but this is the big pie that we're trying to take as biggest chunk as we can.

Kevin Dede

Okay. Last question from just change gears little bit, still a very heavy cash balance.

I know you guys have been concerned on valuations, given this big focus on development and matching the way technology has been changing with the Microsoft deal, can you talk a little bit to your pipeline how much attention its getting especially in light of this recent deal? Stock deal -- that is a stock sale.

Guy Bernstein

Okay. So we have this stock deal, before that we were really close to finalize an acquisition, unfortunately we felt that it’s a bit risky in terms of the results that they've shown us just before with the signing.

So we decided to wait a big and either improve the churns or postpone the transaction and catch up like in a few months and see what will improve. So this is a story behind it.

We were just about to close it and it was not doing that way.

Kevin Dede

Okay. Fair enough.

Anything else on the horizon that you can speak to? Have valuations changed?

Are you perhaps looking at technology now that can enhance your cloud capability, any other color?

Guy Bernstein

No we look for things all the time whether it’s technology companies or you need service oriented companies. We have some in the pipe, not something that is worth mentioning at this point.

Kevin Dede

Okay, fair enough. Thanks very much gentlemen.

Guy Bernstein

Thank you.

Operator

[Operator Instructions] There are no further questions at this time Mr. Bernstein, would you like to make your concluding statements.

Guy Bernstein

Yes, thank you very much for joining us now on this call today and we sure hope to bring you more good news in the next quarter. Thank you.

Operator

Thank you. This concludes the Magic Software Enterprises Ltd second quarter 2018 results conference call.

Thank you for your participation. You may go ahead and disconnect

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