Magic's Growth Strengthens Asseco Case, But Receivables Are Bloating

Summary

• We follow Magic Software because it's held by Asseco Poland, one of our favourite Eastern European companies that has sold off over the Russia-Ukraine conflict.
• It continues to deliver strong organic growth and generate a lot of repeat business.
• While professional services is growing in the mix, and we'd prefer strength in the software side, Magic demonstrates continued demand for digital transformation.
• Q4 was especially strong despite difficult comps, delivering double-digit growth, but operating cash flow weirdly declined.
• The dividend is also attractive for a tech company, but we'd have liked analysts to question the receivables situation before we recommend buying.
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Magic Software (NASDAQ:NASDAQ:MGIC) is a tech consulting and software company that delivers digital transformation solutions, focusing on getting businesses deployed on the cloud. In a post-COVID environment, business has been booming. Despite strong comps towards the end of 2020, the company continues to deliver organic growth in Q4 and good cash flow conversion. While there are some modest risks on the cost side, revenue growth and operating leverage is more than compensating for them, and MGIC continues to be an attractive growth story at a pretty reasonable price. For Asseco (OTCPK:ASOZF), which has taken a hit over being in an eastern stock market during the Russia-Ukraine war, the MGIC performance also bolsters their prospects in businesses non denominated in a stricken PLN.

A Look At Q4

The Q4 results showed much of the same growth that you would expect from tech businesses with the tailwind of accelerated digital transformation. Revenues are up, operating profits are up, with non-GAAP net income up too.

Highlights (MGIC Q4 SEC filing)

The flat GAAP net income is due to accretion of the value of redeemable assets in the non-controlling interests, where the redeemable value is estimated higher than carrying value but less than fair value. This means that the price for MGIC to redeem those shares is higher due to accretion on those shares. Since it is MGIC's option to redeem those shares, and they don't have to, it doesn't have an economic meaning for current shareholders. The dividends paid to those redeemable minority interests are the same every year.

Dividends (Q4 MGIC SEC filing)

About half of the growth in revenues for MGIC is inorganic due to a decent amount of acquisitions that the company does. They acquired Enable IT a couple of quarters ago, which increased the proportion of professional services in the mix.

The organic growth is still substantial at 13%, and this is a consequence of a large proportion of repeat business.

In terms of existing customers versus acquired new customers, 80% of our revenues are normally generated by our existing, a long-term relationship with our customers, seeing us as their preferred vendor of choice to all of their transformation -- digital transformation journey.

Guy Bernstein, CEO of MGIC

It also explains the persistence of the professional services revenue, which is now more than 80% of the mix too, because the consultants are recalled into the businesses to continue to lead their digital transformations.

Closing Remarks

There are a couple of things to remark on as far as MGIC goes. The growth of professional services in the mix, while not a bad thing at all, does moderately increase the company's exposure to risks around the labour market. Any business that depends on consultants providing billable hours for the business depends also on the talent of those consultants, which can be costly to develop if a business experiences elevated turnover. With the great resignation gripping the workforce, this risk is higher now than it used to be.

Magic also declared their cash dividend, where the total dividend has grown by almost 2x over the last year. Currently the yield is at 2.34%, which is quite high for a company whose revenues and profits are growing so quickly. While the company is sustaining a nice yield, a few things should be pointed out over its cash flows. The operating cash flows declined despite the substantial topline and bottom line growth due to bloating in receivables.

Bloating Receivables (MGIC Q4 SEC filing)

No comment is made on this, which is not very appealing; however, Asseco mentioned in its own disclosures that public sector customers created receivables due to delays in budget approvals in Israel. The problem is that we are not aware that MGIC has so many public sector customers. In fact, most of their business is occurring in banking, tech and healthcare. Banks are not public institutions in Israel. This operating cash flow decline remains an important outstanding question since a bloating of receivables by 5x is a worrying sign.

The multiple of 32 for PE appears very reasonable given how current growth trends might be extrapolated, but we wonder about the bloating in receivables, which should give investors pause before making an investment. Nonetheless, with the PLN having declined substantially with respect to the EUR, for Asseco, the growth in non-PLN denominated business insulates them from those FX declines in an international portfolio, where the Formula Systems (NASDAQ:FORTY) holding company segment that includes MGIC and other US/Israeli businesses accounts for about 15% of Asseco's overall EBIT.

Analyst’s Disclosure: I/we have a beneficial long position in the shares of ASOZF either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.