Magic Software Enterprises Ltd. (NASDAQ:MGIC) Q3 2022 Earnings Conference Call November 14, 2022 10:00 AM ET
Company Participants
Asaf Berenstin – Chief Financial Officer
Guy Bernstein – Chief Executive Officer
Yuval Lavi – Vice President of Technology and innovation
Conference Call Participants
Chris Reimer – Barclays Bank PLC
Operator
Welcome to Magic Software Enterprises’ 2022 Third Quarter Financial Results Conference Call. At this time, all participants are in a listen-only mode. A brief question-and-answer session will follow the formal presentation. [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; and Magic VP of Technology and Innovation, Mr. Yuval Lavi. Magic third quarter 2022 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’d 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 views or expectations or otherwise.
Also, during the course of today’s call, management 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.
Asaf Berenstin
Thank you, operator, and thank you, everyone, for joining us today as we report our third quarter 2022 financial results.
During the call today, I will review highlight from our third quarter results and provide an overview of our achievements. Magic delivered its strongest topline and bottom line quarterly results with revenue increasing by 19% year-over-year to approximately $144 million, exceeding market expectations and net income increasing by 14.9% year-over-year to approximately $13.5 million. Growth in Q3 was broad-based with all geographies growing in double digits accompanied by a strong pipeline.
On a constant currency basis, revenues for the third quarter of 2022 would have increased by 23% compared to the same period last year with 19% reflecting organic growth. This achievement translated to a 14.4% year-over-year increase in our non-GAAP operating income in the third quarter with operating margin reaching 12.9% down from 13.4% in the same period last year. The decrease in our gross margin is mainly attributable to the change of our revenue mix related to our software solutions versus our professional services, which I elaborate on later on this call.
On a constant currency basis, operating income for the third quarter of 2022 would have increased by 19% to a third quarter record breaking result of $19.3 million with 15.4% reflecting organic growth. Magic’s third quarter results strongly demonstrate our sustained profit oriented approach. We continue supporting our existing loyal customers as well as closing new deals. The continued strategic focus on the execution of our priority topline growth resulted in yet another strong performance for the quarter with sales, mainly coming from the ongoing expansions of our business in North America and in Israel. Magic Software is a global company, operating across multiple markets and offering broad IT services portfolio. Our strategy allows us to carefully balance our growth resources, investment and risks across regions and markets.
Our solid execution in the third quarter and throughout this year validates our strategy of building a broad business portfolio, which provides the foundation for our sustained solid performance and growth as we continue supporting our customers throughout their innovative digital transformation journey based on our long-term engagement cycle.
Despite seeing some caution in the high-tech sector, we are still witnessing a healthy demand and developing a growing pipeline to deliver continued growth in 2022, as our customers increasingly engage us as a preferred partner for innovative digital transformation initiatives. And as such, we continue increasing our resources despite fierce competition of our talented IT workforce currently maintaining hundreds of open positions. We are extremely proud of the positive results we continue to demonstrate, particularly from our organic growth and from achieving this quarter another growth milestone causing for the first time the 4,000 employee and contractors headcount mark.
Despite the challenging macroeconomic environment and what seems to be a sense of customers’ longer decision making processes, this is a significant milestone and a key parameter to our continuous growth. We are still certain that we have all the tools in place for sustained growth. We have a well established track record of growth, profitability and high cash generation, and the Magic team worldwide is committed to executing our strategy to deliver growth and continue improving our shareholders value.
On the M&A front, we continue to explore M&A opportunities in the field that we operate in, as well as in fields that we target and identify growth opportunities as we have in the past. In August, 2022, we acquired The Goodkind Group or TGG as a U.S.-based company, which offers IT consulting services, permanent and temporary staffing services primarily to enterprises in various job types such as IT, finance, healthcare, and administration.
Founded in 2012, TGG team consists of approximately 280 billable employees all based in the U.S. and carries a monthly revenue run rate of approximately $2 million with an average operating margin of 10%. The purchase price was approximately $8 million in cash and an additional amount of $2 million, which will be paid in two equal annual installments in 2023 and in 2024 each on the first and second year anniversary on the acquisition dates.
Moving to the financials and starting with the geographical breakdown of our revenue. During the third quarter, North America accounted for 55% of total revenues; Israel, 37%; Europe, 6% and APAC and the rest of the world accounted for 2% of the third quarter revenue. Our revenue in North America reached a record high of $79 million, up 20% compared to $66 million in the same period of the previous year accounting for 56% of our growth in the third quarter with 13% organic growth. On a sequential basis, North America revenue grew by 7.8% from $73.3 million in Q2 of 2022 with 1.9% sequential organic growth. Revenue in Israel also reached an all-time high of $53.4 million, up 22% compared to $43.8 million in the same period last year accounting for approximately 42% of our growth in the third quarter.
On a constant currency basis, revenues in Israel increased by approximately 28% compared to the same period last year. On a sequential basis, revenues in Israel increased by 4%, approximately $2 million from $51.4 million recorded in the second quarter of 2022. Israel region was significantly affected by currency headwinds as new Israeli Shekel weakened against the dollar. On a constant currency basis, our sequential growth would have been 5.6%.
Turning now to profitability. Despite the significant currency headwind, we were able to deliver a growth in our gross profit as our non-GAAP gross profit for the third quarter of 2022 reached $40.5 million, up approximately 18.5% compared to $34.2 million in the third quarter of last year. On a constant currency basis, gross profit would have increased by approximately 20.2% compared to the third quarter of last year to approximately $41.1 million.
Our non-GAAP gross margin for the third quarter of 2022 decreased by 20 basis points from 28.3% in the third quarter of 2021 to 28.1% in the third quarter of 2022. The decrease in our gross margin is mainly attributable to the change of our revenue mix related to our software solutions versus our professional services as well as to the devaluation of the new Israeli Shekel and the Euro versus the U.S. dollar.
On a constant currency basis, compared to the third quarter of last year, our gross margin would have remained constant at 28.3%. The breakdown of our revenue mix for the nine-month period of 2022 was approximately 17.5% related to our software solutions with a gross margin of approximately 64% and 82.5% related to our professional services with a gross margin of approximately 20%.
While in the same period of 2021, 21% of our revenues were attributable to our Software Solutions segment, with a gross margin of approximately 64% and 79% related to our professional services with a gross margin of approximately 20%. The increase in the percentage of our professional services is due to the continued strong demand for our professional experts, driving our professional service revenue stream as well as the acquisition of TGG concluded during the third quarter 2022. The breakdown of our gross profit mix for the nine month period of 2022 was approximately 40% related to our software solutions and 60% related to our professional services compared to 46% and 54% in the same period last year, respectively.
Moving to operational costs. Our non-GAAP operating income for the third quarter of 2022 increased by 14.4% to $18.5 million compared to $16.2 million in the same period last year and $17.6 million in the second quarter of 2022. This reflects an operating margin of 12.9% for the quarter compared to 13.4% in the third quarter of 2021 and 12.8% in the second quarter of 2022.
Financial expenses met during the quarter, we had financial debt interest expenses of $468,000 resulted from our $59 million financial debt. As interest rates expect to continue to rise, we expect our interest expenses to continue to grow. Net income attributable to non-controlling interest. As our business combination model has often relied on keeping former shareholders in acquired entities as a minority stakeholder in addition to their managerial roles, in such entities, we are allocating a portion of our net income to those minority shareholders.
Net income attributable to non-controlling interest amounted this quarter to $1.4 million compared to $1.3 million in the same period last year. Our non-GAAP tax expenses this quarter totaled $2.7 million compared to a tax expense of $2.3 million in the third quarter of 2021. Our effective tax rate for the nine month period of 2022 was approximately 23% compared to 22% recorded in 2021. We expect our effective tax rate in 2022 to be in a range of 22% to 23%. Our non-GAAP net income for the third quarter increased 14.9% to $13.5 million or $0.26 per fully diluted share compared to $11.8 million or $0.24 per fully diluted share in the same period last year.
Turning now to balance sheet. As of September 30, 2022, cash and cash equivalents, short and long-term bank deposits and marketable securities amounted to approximately $88.8 million compared to $93.9 million in the previous quarter. Our total financial debt as of September 30, 2022, amounted to $59 million compared to $56.5 million in the previous quarter.
During the third quarter of 2022, our cash flow from operating activities reached $21.9 million. In closing, I would like to turn now to our guidance for 2022. Given our solid backlog and our strong pipeline, we are revising upwards for the third time this year, our 2022 annual revenue guidance to a new range of $555 million to $565 million, up from the prior range of $550 million to $560 million for the year, reflecting annual growth of 15.6 to 17.6.
This revised revenue guidance for the year takes into consideration the following negative impacts. The devaluation of the new Israeli Shekel and the euro versus the dollar, the Israeli October holiday season, which this year mainly occurred during the fourth quarter, the Israel election day, which also took place in November and the U.S. end of year holiday season.
These negative factors reduced our overall billable working days in the fourth quarter compared to the third quarter by 6.5 days, which are equivalent to approximately $5 million or 3.5% of our revenues. To summarize, from a financial perspective, Magic’s hybrid business model of software solutions and software services is solid, strong and proved itself even in uncertain times.
We continue to grow our revenues, our profits and our cash flow, and we are paying dividend on a semiannual basis. From a business perspective, we are diversified both in our offerings and in the geographies in which we operate. We have thousands of customers with 85% of our revenues resulting from repeated business carried with our existing customers based on our long-term engagement cycle, which result in business flexibility and risk mitigation to our shareholders.
With that, I will now turn the call over to the operator for questions.
Question-and-Answer Session
Operator
Thank you. Ladies and gentlemen, at this time we will begin the question-and-answer session. [Operator Instructions] The first question is from Chris Reimer of Barclays. Please go ahead.
Chris Reimer
Hi. Congratulations on the strong quarter and thank you for taking my questions. I’ll start with what’s probably on everyone’s mind. Are you seeing any change in customer behavior? You mentioned earlier the delays or potential slowness in new deals. And I was wondering if you could comment on how you’re seeing that, how you’re seeing the change in new deals or with current customers?
Guy Bernstein
Okay. So I would say that for now, there is a lot of talking in the market about the slowdown and the fact that the customers are hesitating. I must say that in our business for now, we don’t really feel it. So still, we see the strong demand. And we don’t really see hesitation or delays.
Chris Reimer
Okay. Thanks.
Asaf Berenstin
I would say that in terms of the pipeline, we see that the pipeline continues to be strong. It takes a little bit more time to sign the agreement. So we do the scope and we work with the client, and we are fully engaged with them. But to conclude the signature, takes a little bit more time. That’s it.
Chris Reimer
Okay. And how would you characterize trends you’re seeing around operating expenses? And what would you say are the main challenges right now in really managing OpEx levels?
Guy Bernstein
I’d say that although we expected that due to the environment in the market and the talks about recession, we will be – it will be easier for us to hire employees and talent. But for now, I must say, it’s not the case. We are still struggling to find people. Salaries are still in the sky. But we managed it before, and we will continue to manage it. It’s not – it could improve only for the better.
Chris Reimer
Got it. Okay. That’s it for me.
Guy Bernstein
Thank you.
Operator
The next question is from Kate Cronstein of William Blair. Please go ahead.
Unidentified Analyst
Hi everyone. Thanks for taking my question and congrats on the quarter. I wanted to start off with a question around revenue guidance. Can you talk us through the biggest drivers behind the increase in the guidance this quarter?
Guy Bernstein
I must say it’s across the board, so I cannot just pick something specifically that made the change. I think we are improving in terms of the operations, in terms of the sales cycles, we are doing probably a better job, but it’s across the board. Not in a specific place.
Unidentified Analyst
Okay. Great. It’s good to know. And then last quarter, I know you called out seeing a little bit of slower demand from younger companies. Is this still a trend that you are seeing?
Guy Bernstein
Yes, yes. It is still a trend that we see. We are being very cautious with the ones that didn’t raise money or that we know that are like in the final amount that they can spend. So we are being very strict with them. And we continue with the ones that are heavy cash. But we are being cautious about it.
Unidentified Analyst
Okay. Great. That’s good to know. Thank you. That’s all for me.
Guy Bernstein
Thank you.
Operator
[Operator Instructions] There are no further questions at this time. Mr. Guy Bernstein, would you like to make your concluding statement.
Guy Bernstein
Yes. So again, thank you, everyone, for joining our call. It was a good quarter, and we definitely hope to bring you some more good quarters in the near future. Thank you very much.
Operator
Thank you. This concludes the Magic Software Enterprises Ltd. 2022 third quarter results conference call. Thank you for your participation. You may go ahead and disconnect.
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