Magic Software Enterprises (NASDAQ:MGIC) is a company that we've followed in connection with our watchlisted pick, Asseco Poland (OTCPK:ASOZF). As part of the Asseco umbrella, its quality and performance was of interest to us, and it was more cheaply accessed through investing in Asseco rather than directly. Nonetheless, it merits consideration as a standalone stock as well in the technology mid-cap space. Overall, the company continues to create cash generative and resilient platforms for revenue and can be considered a quality pick. However, with the multiples becoming more dear, the conviction for investment isn't there.
The Q1 shows that the company continues to perform competing in premier geographical markets of Israel and the US. The organic revenue growth was 20%, with another 8% coming from consolidation of new acquisitions. These were recently more focused on the professional services lines, causing the share of gross margin from professional service businesses to grow from 52% to 56%. The balance comes from straight software offerings, and is a barometer for the technical ability of the company. The growth in professional services has driven down margins, and generally exposes margins a little more to labor shortages, where professional services businesses are more human capital intensive. The margin has fallen from 14% in Q1 2021 to 13.6%. The overall operating profit has grown meaningfully by 26%, reflecting almost the same growth rate as in revenue, meaning that operational improvements have been achieved to offset mix effects as the revenue has grown or the software offerings have grown very fast if not faster on an organic basis, somewhat offsetting mix effects introduced by consolidation. The company is executing excellently on profitable growth, and they continue to guide for double digit growth despite a wave of digitalization in 2021.
The growth comes welcomed, as the company benefits from a high degree of recurring revenue generation. 80% of the revenue comes from existing clients in longer-term engagements, but the growth can be maintained as per the guidance thanks to new signings that continue to grow their revenue platforms. What's more is that the plurality of the new engagements are coming from highly resilient segments in the market, like healthcare and defense, so the incremental growth is all contributing to a more stable revenue base as time goes on.
The main sectors where we see the growth coming from is basically in all the - in all our main sectors that we are working for - that we are working with is the healthcare that is still strong and picking up, it's the defense sector, it's the financing sector that is also strong.
- Asaf Bernstein, CFO
Startups are also an important segment for MGIC, and these of course are very exposed to an economic turnaround. If the equity markets fall on interest rate hikes, financing conditions for startups will decline. Since Magic Software offerings are ultimately investments that companies have to make in their businesses, a higher rate environment will impact this segment in particular. So far, no effects have been observed on account of market conditions, but the startup customers will be the first to falter if things get very rough.
From a valuation perspective, the PE for MGIC is now hitting 28x. While this is not unheard of for tech oriented consulting firms, or enterprise tech firms in general, being in line with companies like Accenture (ACN), it is not a particularly compelling valuation and earnings yield. The market seems to fully understand that despite its smaller size, MGIC is a formidable company and a strong tech exposure. For high conviction investors like ourselves, we cannot be interested in such a company. While incremental growth is being driven by some very resilient players, less resilient companies are still forming part of the mix, and with a large focus on maintaining a human capital base even in the good times, labor market conditions are something that has become a more pronounced risk for the company.
Finally, to follow up on one of the things we noticed last time, the cash flow generation hasn't been great. We don't want to speculate too much since we have no skin in the game, but it appears that the bloating in receivables from last quarter hasn't been settled yet, and it has been reclassified into longer-term receivables. Given that some of the growth is coming from startups, we wonder if these customers' financial profiles might be connected to these developments. But regardless, the company generates operating cash flow at a strong rate anyway, 100% on earnings.
Overall, the Q1 shows more strong performance from the company, but we're not buyers here.
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