Guy Bernstein - CEO Asaf Bernstein - CFO

Bhavan Suri - William Blair Kevin Dede - Rodman & Renshaw

Ladies and gentlemen, thank you for standing by. Welcome to the Magic Software Enterprises Ltd. 2017 Second Quarter Financial Results Conference Call. With us on the line today are Magic's CEO, Mr. Guy Bernstein; and Magic's CFO, Mr. Asaf Bernstein; and Mr. Amit Birk, VP, M&A and General Counsel. Magic's quarterly earnings release was issued before the market opened this morning and has been posted on the company's web site 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 contents 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, Magic will refer to certain non-GAAP financial measures. A reconciliation schedule showing GAAP versus non-GAAP results has been provided in the press release. A replay of this call will be available after the call in the Investor Relations section of the company's web site. I will now turn the call over to Mr. Amit Birk of Magic Software. Please go ahead.

Okay. So since you've read the Harbor statement then I will start. Thank you and good morning, everyone. Thank you for joining us today as we report our second quarter 2017 financial results. I'll provide you with the highlights of our second quarter results and then turn it over to Asaf, who will provide more detailed financial information. We'll be happy to address any questions at the end. Our financial performance over the past few years has been highlighted by consistent growth and increased level of profits, and our second quarter added to that momentum with another strong result on both the top and bottom line, driven by a mix of organic growth and mergers and acquisitions. Revenues for the second quarter reached $65.5 million reflecting 38% year-over-year growth, and non-GAAP operating income increased 37% to $9 million for the quarter. I'm proud that our strategy allows the company to achieve impressive growth in all areas of our activities. We continue to emphasize the bottom line and we are prepared to expand our footprint in all areas that we have identified as the fastest growing. We continue to be recognized by top industry analysts for our leading platform offerings. Magic xpi integration platform was once again featured by business analysts such as Ovum and Gartner. As we increase our focus on the growing integration market, we won new projects and expanded our customer base with scalable builds in all of our territories, including Japan, India, Europe and the United States. In addition to our offering in the field of application development and integration, we have established successful operations in the areas of cloud, mobile, big data solutions for startup companies, as well as in the field of IoT. We remain very positive about our ability to continue to accelerate growth and ramp up operating profits in 2017. Now I'd like to turn the call over to Asaf, our CFO, to discuss the financial results in more details. Asaf?

Thank you, Guy, and good morning, everyone. As Guy mentioned, our second quarter revenue was $65.5 million compared to $47.4 million for the second quarter last year, reflecting 38% year-over-year growth. Analyzing our revenue growth, our organic growth rate was approximately 15%, accounting for 40% of our second quarter year-over-year growth. I would like to emphasize that compared to the two most recent quarters, all of our growths were organic. Looking at the geographical breakdown of our revenues, our geographic mix remained steady during the second quarter. North America accounted for 47% of total revenue. Europe, which includes Israel, 46%; and APAC and the rest of the world accounted for 7% of our quarterly revenue. Most of our growth in 2017 as well as in the second quarter was from North America and Israel, which are our strongest territories. Turning now to profitability, our non-GAAP gross profit for the second quarter of 2017 was $22.3 million, up approximately 27% compared to $17.5 million in the second quarter of last year, and 4% compared to the first quarter of 2017. Our non-GAAP gross margin was 34%, down from 36.9% for the second quarter of last year and 35.2% compared to the previous quarter. The decrease in our gross margin compared to the respective quarter resulted solely from the shift in our revenue mix from software towards professional services. The breakdown of our revenue mix for the first half was 30% related to our software solution division and 70% related to our professional services, versus 35% to software solution and 65% to professional services in 2016 as a whole. Moving to operational costs; R&D expenses on a non-GAAP basis in the second quarter totaled $2.8 million compared to $2.4 million in the same quarter of last year. The increase in our R&D expenses is a result of our growing focus on expanding our integration offering and from the addition of Russia to our business portfolio starting from the third quarter of 2016. Our non-GAAP operating income for the second quarter increased 37% to $9 million compared to $6.5 million in the same period last year. This reflects an operating margin of 13.7% for the quarter, compared to 13.8% for the same quarter last year and in the trailing quarter. The consistency of our operating, margin despite the decrease in our gross margin is primarily attributable to the decrease in our operational costs as percentage of our revenue. Our non-GAAP tax expense this quarter was $1.7 million, representing an effective tax rate of approximately 20% compared to a tax expense of $1 million in the second quarter of 2016 reflecting an effective tax rate of 15%. We believe that our effective tax rate for the full year of 2017 will range between 20% and 22%. Our non-GAAP net income for the second quarter increased 11% to $5.7 million or $0.13 per fully diluted share compared to $5.2 million or $0.12 per fully diluted share in the same period last year. Turning now to the balance sheet, as of June 30, cash and cash equivalents, short-term bank deposits and marketable securities amounted to approximately $100 million compared to approximately $88 million at the end of 2016. Our total financial debt as of June 30th amounted to $43.2 million. From a cash flow perspective, we generated $4.6 million from operating activities in the second quarter, and $15.1 million during the first half of this year. Lastly, we are raising our guidance for 2017 full year revenue to between $245 million and $255 million on a constant currency basis, up from prior guidance of $225 million to $230 million, reflecting a revised annual growth rate of 22% to 26%. Our revised guidance is a result of our strong business momentum in recent quarters and our visibility into our second half of the year. With that, I will turn the call back to Guy for closing comments.

Thank you, Asaf. In summary, we are pleased to report that we delivered another strong performance in the second quarter with year-over-year double digit growth on both our top and bottom lines. We are confident in our market strategy and are always examining ways to enhance our portfolio, both organically and through acquisitions, to best serve our customers' needs for forward-looking software solutions. With that, I will now turn the call over to operator for questions.

[Operator Instructions]. The first question is from Bhavan Suri of William Blair. Please go ahead.

Hey guys. Thanks for taking my question, and congratulations. It's a solid, solid set of numbers there. I guess my first question is you had a very strong sort of top line performance. Were there specific projects or engagements, Guy, around either integration or mobility or cloud, so xpa or xpi or sort of the cloud offerings you think that drove that upside and outperformance?

Hi Bhavan. I think, first of all, we see a trend across the board in all our solutions and services we see expanding. Specifically, we saw a trend this quarter, one of our biggest customers, changed all his VMF program and, as a result, we were left with fewer vendors with this customer. So we definitely see a lot of growth over there. Of course, on the top line it is very good for us. On the profit side, of course, we will [indiscernible] based on our agreement, with a better rebate. So it's less good for us. But all in all, we see it across the board.

Got it. And then when you look at the pipeline, Guy, and you think through, you obviously sell to software houses, but you also sell to corporations that leverage the platform. Is there any shift in which mix you're seeing, or is it still really inconsistent with sort of historical levels?

I think it's quite consistent. It varies between the quarters. But, all in all, it's quite consistent.

Got it. And then maybe one for Asaf. Asaf, when you look at the growth rates, just some sense of what the inorganic versus organic growth rates, where obviously, some of the organic stuff looks very healthy, too. But a breakdown on the top line would be helpful. Thank you.

Sure.

Next question?

The next question is from Kevin Dede of Rodman & Renshaw. Please go ahead.

Hi. Thanks, Asaf, for offering a little insight on the top line between software and professional services. I think the big question for me really is just the gross margin trend. I know you expect it to improve a little bit on leverage, operating leverage. I'm just kind of curious on how you see business unfolding, given the raise in guidance and that breakdown between software and professional services. Given -- I guess my general assumption is that margins are a little less on the service side. Just wondering if you could talk to that a little bit?

Hi Kevin. Basically, I think that if we look at the last six months as a whole versus last year, then we see that in terms of our revenue growth, around 85%, 86% of our growth came from professional services and 16%, 14% came from license and maintenance agreement. We do see improvement on that side. We have scaling up some nice deals that we expect to be closed during the second half of the year. So I'm sure that -- or let's say my expectation originally was that our gross margin will remain steady. As Guy mentioned, we have benefitted from increased level of revenues coming from one specific customer of ours, that limited the amount of professional service vendors that he works with and we were chosen as one of those vendors. So that made the main reason for the continued decline in our gross margin.

Because of the increased rebate.

Okay. Now clearly you're doing a great job growing the business. I guess the question for me on continued growth, really relates to the marketing endeavors, and granted you're acknowledged by Ovum here. But can you talk to how you're able to translate that recognition into more recognition overall for the business services that you offer, raising your profile, and how are you expanding your marketing activities? I mean you did a great job controlling SG&A, but I think with improvements in the top line, you'd expect that you'd be able to offer a slightly higher marketing budget to help continue to grow going forward.

So let's put it this way first. The business model is such that we try as much as we can to work with scalable models. It means that we mostly work with partners. Especially on the technology side, sometimes you sign the agreement and it takes time for them to scale up. Even on the professional services, many times we work on cross-selling within our customers, so we do invest a lot in it. And all in all, the first half usually is way weaker in terms of technology versus the second half. So we definitely expect second half to be better in terms of margins.

Okay. Can you talk a little bit more specifically about the sales force? Are you just completely relying on partners? Or how are you trying to develop that base of partnerships that you have?

So I guess our business is, I will probably say, 30% is indirect and 70% is direct. So we -- based on our history, we cannot rely only on indirect business. So we do have quite a lot of salespeople.

Okay. Are there plans in place to expand that base in North America? And given that your growth has been driven by North America and Israel, what are your plans outside?

Okay. So first, relating to North America then, we did increase the sales team in North America. I can say that it's not easy because some of it, you hire people and you need to -- some of them, they need to replace the ones that either are leaving or the ones that are not good enough. So this thing of sales guys in the States is quite a struggle. Most people are rather expensive and it takes you -- you give them time in order to prove themselves and it's not always working. But lately, we did some change in the way we work over there and hopefully -- we started to see some first signs in terms of the scale of the deals we are doing, which is good, but it's still first signs. Talking about the rest of the world, if it works in the States, probably we will move on and implement it elsewhere.

Okay. The big question also for everybody usually is, how the acquisition pipeline looks. Can you talk a little bit about what you're seeing, what you think might work, whether you're looking for technology additions or just avenues to grow the business?

So of course the first option for us to look for technology for complementary technology companies. Unfortunately, prices in the market are exaggerated and it's very hard for us to close deals for, let's say, reasonable prices. But we've proved in the past that we know how to deal with it. Of course, most of the acquisitions we are doing are coming through some relation. It's either people that we used to work with, people that we see that are working for the same customers and therefore we see what they do and they partner with us for the same projects. So it's rather safe acquisition. This is what we did until today. Rather small, but rather safe. The ones that are coming from bankers, it's a bit tricky because usually it's quite expensive and when you talk about technology companies, it's even very expensive. And bankers tend to manipulate the numbers to show a much better company than it is. We do spend still a lot of time on checking companies that are coming from bankers. Unfortunately, we didn't have anything serious today that we can say, we are close to do anything on this side. But all in all, prices are very expensive in the market.

So Guy, if I understand it correctly, in most cases you usually just buy part of a company and sort of wait to see how things play out before you buy the rest. And if I have my figures straight, there are still a couple of deals where you're not 100% the owner. And I'm wondering, what the plans are with some of those deals that you've done in the past where you haven't stepped in for 100%.

Okay. So for us, the target, of course, is to become 100% at some point in these companies. The tricky thing is that in some of the companies the founders that are running company, are doing a tremendous job and you are debating whether it will be the wise thing to do, because you don't want them to lose interest in the company because they are quite dominant in the company and they are really pushing the company and they are doing well. So lately, we are trying to come up and negotiate with some of them to take part of what they have in order to get more percentages in those companies.

Right. Okay. But in some way still leave them incented to continue to perform?

In some of them, yes.

Okay. Can you talk to the staffing that you have now in professional services? And based on the raise in guidance, do you think you've got enough consultants that you're working with? And could you talk a little bit about how the market looks, given that employment -- certainly employment levels in the States are -- I mean you talked about how tough it is to find salespeople. I can imagine on the professional services side it must be even more difficult. Can you just talk to that level, talk to what you think?

I think first of all, the comparison between professional people and salespeople is not a good comparison because when you hire a sales guy usually he is talking the talk, he walks the walk and he's good at sales. So he can sell you himself easily. The problem is that whether he delivers after that or not. While you talk about professional guys, it's much easier to evaluate what they want in terms of their capabilities. So it's easier for us. Yes, whenever there is a lot of demand in the market, prices are going a bit up. But at the end, we roll it to the customer, so we need to pay for that, but they need to decide whether they want to hire capable guys or they are willing to take younger people that will cost them less. So we play with it. We feel comfortable. It changes from time to time. I can tell you that in the States right now, we don't see it as a problem. In Israel, on the other hand, we definitely struggle, with all the startups here that are paying like tons of money to talented people. So it's more of a struggle. In Europe, I think it is working well for us. So it varies between the time and the territory.

And just in terms numbers, let's say from the beginning of the year, we already increased our professional service personnel level by 10%. So we do have organized processes that can handle the recruitment of new employees alongside with our growth.

Okay. Asaf, appreciate the percentage increase, but what's the total headcount now?

Today, we are at 1,800.

Okay. All right well. Congratulations gentlemen. Appreciate the color and the insight.

Thank you.

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

Yes. So thank you very much for joining our call this quarter and we hope that we bring more good news in the next quarter. Thank you.

Thank you. This concludes the Magic Software Enterprises Limited Second Quarter 2017 Results Conference Call. Thank you for your participation. You may go ahead and disconnect.