Magic Software Continues To Create Revenue Platforms In Resilient Industries

Summary

  • Magic Software has about 80% of its revenue coming from long-term engagements with current clients.
  • Growth is being driven by the signing of contracts with new clients primarily in healthcare and defense.
  • These resilient industries are creating an attractive revenue platform for the company, and the cash generation drivers continue to fire.
  • The company continues to be a nice mid-cap tech exposure, but it's beginning to trade too dearly for us high conviction investors to be interested.
  • Looking for a helping hand in the market? Members of The Value Lab get exclusive ideas and guidance to navigate any climate. Learn More »

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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.

A Look at the Q1

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 MGIC Profile

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.

Valuation and Conclusions

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.

magic pr

Cash Flows (Q1 2022 PR)

Overall, the Q1 shows more strong performance from the company, but we're not buyers here.

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This article was written by

Author of The Value Lab
A long-only voice with eclipsing growth through 2020 and 2022 bear markets.

Valkyrie Trading Society seeks to provide a consistent and honest voice through this blog and our Marketplace Service, the Value Lab, with a focus on high conviction and obscure developed market ideas.

DISCLOSURE: All of our articles and communications, including on the Value Lab, are only opinions and should not be treated as investment advice. We are not investment advisors. Consult an investment professional and take care to do your own due diligence.

DISCLOSURE: Some of Valkyrie's former and/or current members also have contributed individually or through shared accounts on Seeking Alpha. Currently: Guney Kaya contributes on his own now, and members have contributed on Mare Evidence Lab.

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Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. 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.

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