Magic Software: Has Anyone Looked At The 2014 Revenue Potential?
Nov 4 2013, 15:56
Disclosure: I am long MGIC. (More...)
Overview
Magic Software Enterprises Ltd. (MGIC) is a significantly overlooked Israeli-based technology company that develops, markets, sells and supports an application platform and business and process integration solutions and offers information technology, or IT, professional services. The company's application and integration platforms are known for their code-free approach, allowing users to focus on business logic rather than technology requirements.
Not Well Known Among U.S. Investors
The ownership structure of the company, combined with an extremely quiet investor relations effort, have left this company virtually unknown among U.S. retail and institutional investors. MGIC's market capitalization is $233 million with the stock at $6.25, and the company had nearly $40 million in cash as of June 30, 2013, or a little over $1.00 per share in cash. Formula Systems (1985) Ltd. (FORTY), also based in Or Yehuda, Israel, owns 52.3% of MGIC's outstanding shares. Asseco Poland SA, a large IT company based in Poland, owns 50.2% of FORTY. With a public float of a bit more than $100 million, a complicated ownership structure, and headquarters in Israel, I'm sure many potential U.S. institutional investors simply take a pass on the opportunity to review MGIC's investment potential. However, as an individual investor, I'm most interested in identifying undervalued securities with attractive growth, cash flow, and return characteristics. Throw in a strong management team and a conservative balance sheet, and I'm more than willing to take a look. MGIC qualifies across these metrics, and I have been a shareholder in the company since February of this year. After taking a closer look at the company, I think this week's third quarter earnings release may provide investors with an opportunity to establish a position in the stock. The company's CFO has agreed to speak with me after the quarterly results have been released. Lastly, I hope the company is able to share details of its recent announcement to acquire Allstates Technical Services. The acquisition is expected to close within the next couple of weeks, and I don't think many investors are aware of the potential contribution from this deal.
Quiet Acquisition Announcement Is A Big Deal
On October 8, 2013 MGIC announced that it intends to acquire the U.S. operations of Allstates Technical Services for $10 million. Allstates is a subsidiary of KBR Inc. (KBR), the large engineering and construction firm. Allstates describes themselves as a full-service provider of technical staffing solutions. I believe the company has close to 1,000 employees and according to the press release, the acquisition broadens "Magic's existing US footprint and adds leading Fortune 500 companies to its customer base, making an important contribution to Magic's growth strategy. The acquisition will be managed by Magic's US-based Fusion Solutions LLC subsidiary." I found another article from Staffing Industry Analysts that reports Allstates has annual revenue of around $89 million. This is speculation on my part, but it seems that a well run IT staffing company can have net profit margins in the 3-4% range. I suspect Allstates has a relatively low level of profitability given the purchase price of $10 million, but I expect MGIC will have the opportunity to reduce SG&A by perhaps $1-3 million as it consolidates Allstates into its Fusion Solutions division. A 3-4% net profit margin could add $0.07-$0.09 to MGIC's annual EPS. In late August, Analysts International Corporation (ANLY) , a similar-sized IT staffing company with 900 employees and $106 million in revenue last year, was sold for $35 million. I hope investors receive confirmation of this type of opportunity after the acquisition closes in the middle part of this month.
Magic Has Grown Significantly Via Acquisitions In Recent Years
MGIC has a history of buying consulting and staffing services businesses, having spent over $15 million in 2010 on acquisitions in this area. The company made additional acquisitions of Complete Business Solutions Ltd in 2011 and Comm-IT Group in 2012 ($9 mil. for 80% of the company, with subsequent earnouts). Largely via these acquisitions, MGIC's consulting services revenue has grown at nearly a 50% annualized rate from 2009-2012, with revenue advancing from $24.3 million in 2009 to $80.3 million in 2012. Gross margins in this division have fluctuated in a range between 19-23% during this time period. Obviously the Allstates acquisition will have a very significant impact on the revenue line next year. Around two-thirds of MGIC's current 1000 employees fall within the technical support and consulting division. The balance are spread among research and development (14%), marketing and sales (11%), and operations and administration (8%). MGIC's strategy of acquiring IT people has two benefits. First it provides a level of stability and recurring revenue to the company. Secondly, MGIC attempts to leverage the relationships with its clients and cross-sell MGIC's software products. I want to explore this second concept more with the CFO given that software revenue growth has been fairly modest in recent years. I want to learn more about the cross-selling opportunity, particularly in light of the forthcoming acquisition of Allstates. If MGIC were to add $90 million in U.S. based revenue in 2014, sales by geography would be more than 70% in the U.S., with around 13% in Europe, 5% in Israel, and another 5% in Japan.
Magic's Technology Is Well-Positioned In Growing Markets
At a high level, MGIC has positioned themselves to participate in the rapid growth of Cloud Computing, Social Media, Mobile, and Big Data.
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Source: Investor Presentation
MGIC's primary software offerings include its Magic xpa Application Platform, which the company says "provides a simple, code-free and cost-effective development and deployment environment that lets organizations and ISVs quickly create user-friendly, enterprise-grade, multi-channel mobile and desktop business app that employ the latest advanced functionalities and technologies." The second major software product is the Magic xpi Integration Platform, which "delivers enterprise-grade integration, business process automation, and data synchronization solutions." (Source: MGIC web site).
Success Stories and Strong Partnerships
I will admit that I'm still moving up the learning curve on how MGIC truly fits in today's technology ecosystem. I found it helpful to review some of the company's success stories. For those seeking a more technical view on the company and its products and services, there's a Yahoo Group dedicated to MGIC topics which has over 4,000 members. Over the years, MGIC also has forged a number of key strategic partnerships, with the likes of SAP (SAP), Salesforce.com (CRM), IBM (IBM), Oracle (ORCL), Microsoft (MSFT), and MicroStrategy (MSTR).
Financial Review: Good Cash Flow and A Cheap Stock
From a financial perspective, MGIC has generated a healthy level of free cash flow in recent years, which has been used largely to fund $37 million in acquisitions from 2010-2012. If I assume the company can grow earnings at a 10% annual rate over the next few years and a 3% rate thereafter, plus a potential contribution of around $3 million in earnings from the Allstates acquisition, I can conservatively derive a discounted cash flow price target of over $8 today, representing about 30% upside to fair value. MGIC's tax rate is expected to increase in the coming years, as its operating loss carryforwards wind down, particularly in the U.S. I expect Israeli-based income will be exempt from taxation for the next few years. I don't have a full quarterly earnings model built for the company but acknowledge that the tax rate and currency rates might prove to be headwinds for the soon to be reported third quarter. The Israeli Shekel appreciated further versus the U.S. dollar during the third quarter and was up by more than 10% year over year. Based on currency exposures at the end of 2012, I estimate this could negatively impact earnings in the third quarter by up to $0.02 per share. This becomes meaningful in the context of a single Non-GAAP earnings estimate of $0.13 for the quarter (Source: Yahoo Finance).
Risks Exist And This Week's Earnings May Provide An Opportunity
While I believe there is substantial upside to the MGIC story, I acknowledge that there are risks as well. Continued successful integration of all the acquisitions is not an easy task, and the Allstates acquisition is quite large for the company in terms of headcount additions. MGIC has customer concentration, with Ericsson accounting for 19% of professional services revenue in 2012, or a little more than 9% of last year's $126 million in total revenue. MGIC has chosen to capitalize about two-thirds of its software development costs over the past few years, which could turn into a problem if the company makes any strategic errors on its ongoing software development. Lastly, I expect MGIC will meet the consensus estimate for third quarter revenue of $34.2 million when results are released this Wednesday (11/6/13), but I am concerned that the EPS number might come in light vs. the $0.13 estimate. I would view any price weakness as an opportunity to initiate/add to positions. In September 2012, MGIC established a dividend policy, pledging to distribute up to 50% of its annual distributable profits. The company has paid $0.31 in dividends per share thus far ($0.10 paid in 2012Q4, and $0.12 was paid in 2013Q1, and $0.09 in 2013Q3). U.S. investors are subject to a 25% Israeli withholding tax on dividends.
