Company Overview
Magic Software Enterprises (NASDAQ:MGIC) is an established and global provider of business software products headquartered outside of Tel Aviv, Israel. Magic has seen impressive growth of its business since its founding in the early 1980’s, expanding its line of software offerings and partnering with and providing services to other established players such as IBM, Oracle, Microsoft, Salesforce, and others. The company specializes in proprietary application development and business process integration software solutions and related professional services, and is also a vendor of a variety of IT professional services. From the outset, Magic sought to provide streamlined software solutions to clients that aided them in business information management with its initial software offerings. Allowing for metadata-driven programming that offered instant debugging, Magic’s platform was quickly adopted by the Israeli government, and international growth soon followed. The current range of software offerings by Magic Software Enterprises is extensive, with the company catering to a wide variety of business technology needs. The company offers software solutions that tackle most of the modern world’s problems with business integration with technology, ranging from simple business app development to more complex support systems suited to supporting large corporations and other business initiatives. Although the company offers numerous software products, I briefly provide an overview of only their flagship software offerings that are most utilized by consumers and drive the most substantial part of the company’s revenues and growth.
Magic xpi Integration Platform – a centralized platform where consumers can have all of their business data on a cloud, integrated and connected in such a way that access is both easy and streamlined. The integration platform is designed with the user in mind, offering visuals and interfaces that allow the client to easily control all of their business processes, and even automating some of them through the software. The platform is fully supported by Magic Enterprises, allowing for consultation opportunities between the company’s designers and the clients’ in-house IT professionals.
Magic FactoryEye Industry 4.0 – designed for industry and manufacturing, this software tracks performance metrics and allows manufacturers to have a more thorough, accurate, and up-to-date understanding of production and performance. The platform is a data management tool that frees manufacturers from the tedious hands-on requirements of data management, allowing them to focus on production and process improvement.
Magic xpa Web Application Framework – a unique software product that allows businesses to develop and design their apps. Magic takes the burden of design and integration off the clients’ shoulders and delivers a product to the clients’ specifications that both suits their needs and meets their preferences.
Through these software products and others, Magic Software Enterprises has established itself as a global leader in IT support software, and although they have enjoyed impressive growth over the last several years, the company’s most recent earnings report highlights some serious external risks the company faces that were not only unaccounted for, but are also outside of the company’s abilities to mitigate.
Financials
Magic Software Enterprises has recently released its quarterly earnings results for the 4th Quarter of fiscal year 2023:
Taken on the surface, it would appear that Magic Software Enterprises experienced a general slowdown in business for the final quarter of 2023 compared to the same time last year. Highlights of the most recent earnings report detail how revenues for 2023 decreased by 5.6% to $535.1 million compared to $566.8 million in 2022, operating income for 2023 decreased by 7.5% to $57.1 million compared to $61.8 million in 2022, non-GAAP operating income for 2023 decreased by 3.7% to $71.8 million compared to $74.5 million in 2022, and net income attributable to shareholders for 2023 decreased by 8.5% to $37.0 million. The CEO, Guy Bernstein, expressed optimism for 2024 in a statement he made detailing how despite recent challenges, customers will continue to value the company’s products, implying that retained clients will sustain the business. While he acknowledged deteriorating financials and the problems that caused them, addressing the new external risks that have arisen, such as the widening conflict with Hamas, the issues arising from the Houthi rebels, and the loss of a significant portion of its American business, he merely reassured investors that he’s hopeful these risks will just go away on their own as opposed to offering real, tangible solutions. In light of declining revenues and income across the board, hope is not sufficient.
External Risks
Magic Software Enterprises faces significant risks to its business that primarily stem from external sources far outside of the company’s control. I will address each risk separately and detail how the risks have both affected the company presently and will continue to affect it in the near future. Given the nature of these risks, it is my opinion that unless macroeconomic trends reverse themselves while geopolitical issues also reverse themselves simultaneously, Magic Software Enterprises’ financial situation will continue to deteriorate, as the company suffers from external challenges beyond its control. The company is currently trying to navigate these challenges much like a rowboat caught up in a hurricane, and unless these risks disappear on their own accord, the next earnings report for the first quarter of fiscal year 2024 will be similar to the previous one, only now reflecting accelerated losses as the situation worsens. Here are some of the key risks affecting Magic Software Enterprises:
1) Economic Risks
Given that Magic Software Enterprises is a global business, it is subject to the whims of currency fluctuations, exchange rates, and the actions of central banks, as they pertain to interest rates. In response to the outbreak of hostilities between Israel and Hamas, the central bank of Israel has taken steps to strengthen the economy and maintain currency stability. This sudden change in economic climate has, according to CFO of Magic Software Asaf Berenstin, negatively impacted the company’s Shekel-denominated operations in Israel to the tune of $5.6 million for the fourth quarter alone.
Economic uncertainty has a tight grip on the fiscal direction of Israel for the time being, and this will continue to cause headwinds for Magic’s operations there. Israel currently faces the prospect of inflation due to rising costs and risks of importing goods through the Red Sea. As a reactionary precaution, the Israeli central bank will be pressured to maintain high interest rates. Currently, the interest rate in Israel is the highest it has been in over a decade, hovering above 3%. The Bank of Israel has made no statements regarding when they might lower interest rates again.
Bank of Israel Interest Rate
Higher interest rates hurt Magic Software, as they currently carry a large debt balance and consistently see that balance grow through the procurement of new loans. Interest expenses on the company’s corporate debt has doubled year over year, as the company has seen its debt grow from $51 million to $81 million in the span of twelve months. Unfortunately, for Magic Software, most of the debt has a variable interest rate, so the negative impact of the company’s debt can be expected to punish the company more severely, as the macroeconomic climate remains unstable.
2) Geopolitical Risks
Israel is in a state of political uncertainty due to the ongoing war between the country and Hamas. Many of the economic risks Magic Software faces find their origins in the geopolitical risks, as many of them are linked with one another. For example, inflationary fears associated with the potential cost increase of importing goods can be attributed to the Houthi rebels in Yemen attacking cargo ships destined for the Israeli port on the Red Sea. Although Israel is gaining market confidence back as the war with Hamas rages on, the initial shock of the conflict affected Magic Software and, in my opinion, will continue to do so.
In Israel, military service is mandatory for a fixed period, and many are required to remain on conscription lists as reservists. Magic Software employs roughly 1,700 people in Israel, and shortly after the war with Hamas broke out, approximately 200 employees were drafted into active service, impacting the company’s Israeli operations. The CFO, Asaf Berenstin, has cited the sudden drafting of the company’s employees as a direct cause of the most recent earnings announcement’s depressing results.
3) Loss of Clients
Perhaps even more significant than the economic instability and geopolitical challenges faced by Magic Software is the sudden loss of a large number of the company’s clients in North America. A sudden and unexpected decline in demand for Magic’s software products and IT services occurred in the last quarter of 2023, and in my opinion, neither the CFO nor CEO has a good explanation as to why there is a sudden loss of business. According to the CFO, a large number of blue chip customers in the United States suddenly left the platform without advance notice, and the company finds itself in a pickle given how much of its business model revolves around retained clients, especially in the United States. According to the company’s most recent investor presentation in December 2021 (the most recent available), the company has seen the United States grow as a geographic presence of its percentage of revenues at the expense of other parts of the world. The company relies more on the American market than its own domestic market for its products and services.
The sudden loss of a significant portion of its American business is hurting Magic’s revenues, and the CEO and CFO are downplaying the impact it will have on future earnings. Although they acknowledge that the short-term prospects are not ideal, they are optimistic that Magic will continue to grow and find new business to replace that which was lost, as well as hopeful that the company’s efficient business model will help keep costs down during these times of uncertainty. Unfortunately for them, however, many of the company’s American clients opted to immediately suspend their materials-based projects and active times with Magic’s software platforms.
Outlook
Throughout the conference call for the 4th Quarter earnings release, the CFO repeatedly assured listeners that Magic Software Enterprises will weather the numerous storms and continue growing, once they have all passed. While accounting for the sudden drop in revenues for 2023, he repeatedly cited external factors that were “beyond their control,” and assured investors that these risks were all temporary.
Looking forward, the CFO offered guidance that suggested that the company will both experience growth and recover from the setbacks, indicating that the previous quarter’s results were just a small hiccup in an otherwise unbroken stream of growth. He offered guidance suggesting that in 2024, Magic Software Enterprises will expect to report year-over-year growth of anywhere from 7.5% to 9.5%. Not only is this figure overly optimistic, it is not even realistic in my view. In order for the company to resume its growth track and recover from this slowdown, several things must happen in sequence, much the same as they happened in sequence to cause the headwinds. Firstly, the war between Hamas and Israel must reach a swift conclusion. Given the prospects of the conflict widening to include Yemen’s Houthi rebels, as well as Lebanon’s Hezbollah, this seems unlikely. Ceasefire resolutions are bogged down within the U.N., no hostage deal between Hamas and Israel seems forthcoming, and Israeli Prime Minister Benjamin Netanyahu has announced that he wants to launch a new offensive into Gaza’s southernmost sectors. There are no reasons to expect the conflict will end anytime soon, but Magic’s CFO has cited that it needs to end in order for the company to resume its growth track, while expressing optimism that the end of the conflict is near.
Furthermore, its North American business must expand to both recapture lost clients and obtain new ones. Much of the company’s business model revolves around keeping clients on its platforms, so any loss of client is impactful to future revenues. The sudden and inexplicable loss of several important clients will prove problematic for the company, particularly if new ones are not found to replace them. The 2024 guidance predicts revenue growth somewhere between 7.5%-9.5%, which translates to total revenues of about $540 million. This figure accounts for future growth that is not yet obtained, and in essence is a way to count on business origination that is currently nonexistent. If Magic Software fails to acquire new clients in the American market, it will not only fail to meet its target growth rate, but will also, in my opinion, report further losses, when it releases its next quarterly earnings.
Reversals
Although Magic Software Enterprises faces many risks right now, there are many possibilities for the risks to be alleviated. The company’s leadership may be correct in predicting that the war with Hamas will reach a speedy conclusion and that the Houthi rebels will scale down their attacks against shipping in the Red Sea, leading to a strong and robust recovery for the company when it reports earnings for the next quarter.
In addition to the possibility of peace between Israel and Hamas, there is also the possibility that Magic Software can focus on its North American sales, recouping its lost business from the previous quarter. Securing more business in the North American market will strengthen the company’s cash flows and income statement, demonstrating to investors that the previous quarter’s disappointing results were in fact a one-time occurrence.
Although it is possible that the external risks to Magic Software’s business will all fade away in the span of one or two fiscal quarters, I do not believe it to be likely, and although peace in the Middle East and a reversal in the declining North American market will disrupt my thesis, I maintain the view that things will get worse before they get better for the Magic Software Enterprises.
Conclusion
Given the array of risks Magic Software faces, it’s a cautionary investment at best. The company’s leadership appears confident that last quarter’s disappointing earnings results will be a one-time occurrence, but the risks the company faces are going to be more persistent than initially perceived. Given how the risks are very real while the cure is completely hypothetical, I anticipate further trouble on the horizon for Magic Software Enterprises, resulting in a further decrease in its stock price. Current economic and geopolitical uncertainties combined with a general decline in its business make this stock a strong sell.
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