Magic Software Enterprises, Ltd. (MGIC) is a platform-as-a-service (PAAS) provider and an IT services and consulting company. The company’s revenue has doubled from 2008 and EPS has quadrupled during the same timeframe. This impressive sales and EPS growth has been fueled by the strong mobile and cloud services trend as well as an equally massive market trend towards social media and big data.
Particularly the segments of rich Internet applications, mobile and software-as-a-service (SAAS) are important sub-trends that benefit the most from Magic’s core software products. According to Gartner, the PaaS market will experience consistent growth, with worldwide PaaS revenue totaling $1.5B in 2013, and growing to $2.9B in 2016, representing a 25% CAGR.
Investment thesis
PaaS and other segments are expected to keep growing on a very steep upward trajectory, providing space for Magic to keep increasing its sales and profits and delivering excellent value to shareholders thanks to the company’s 30 years of experience in the IT business, strong recurring revenue model, scalable and extensive business model with strong partnerships and a revenue well-diversified by customers, products and geographies.
However, Magic absolutely needs to keep growing sales of its core software products or acquire new software solutions because other revenue, such as maintenance and support as well as the IT consulting business, is largely derived from sales of these door-opener software products, which provide considerable upsell opportunities.
The company’s pristine balance sheet and zero debt, coupled with high cash reserves, will enable Magic to keep complementing its organic growth with smart, accretive acquisitions. The company also expressly stated that it expects to make additional acquisitions in the future.
Magic currently trades at a very attractive 10.28x forward P/E. If cash is excluded, the forward P/E is even more attractive, at an 8.8 multiple. My conservative estimate of a future annual EPS growth at 10% for the next five years makes Magic approximately 10% undervalued.
To better cater to its shareholders, Magic has initiated a dividend in 2012. The current yield sits at an attractive 3.9% level, although investors should take into account that the dividend is paid semi-annually and is subject to an Israeli dividend tax that is currently at 25% for a majority of shareholders with a stake below 10%. The effective dividend yield is 2.9% in the worst case of an investor who is unable to claim any portion of the dividend tax back. The 40% forward payout ratio is relatively low and provides a good potential for further dividend increases down the road.
All in all, Magic is an undervalued small-cap that is turning into a dividend growth stock. Its growth will continue to be fueled by mobile and cloud computing megatrends. The Magic stock promises investors a large upside in the future, but investors need to be prepared for periods of volatility and significant temporary downsides during times of temporarily slower sales growth.
Company background
The Israel-based company Magic Software Enterprises is a global developer and provider of application development as well as business and process integration platforms. The company also provides professional IT services and IT consulting.
Value for customers and partners
The company’s offerings provide its partners and customers with the ability to develop business software applications, leverage existing IT resources, enhance business agility, and focus on core business priorities to gain maximum return on their existing and new IT investments. Magic Software is well known for its metadata-driven, code-free approach that allows users to focus on business logic rather than technology requirements and programming.
This approach represents the main principle and value of Magic’s two flagships products, the Magic xpa Application Platform and the Magic xpi Business Application Integration Platform, which Magic sells to customers using specific popular software applications, such as SAP, Salesforce.com, Oracle JD Edwards, Microsoft SharePoint and other eco-systems. Another key product of the company is the Magic AppBuilder.
Business model and economic moat
The company’s products and services are available through a global network of regional offices, independent software vendors, system integrators, distributors, value-added resellers, original equipment manufacturers and consulting partners in approximately 50 countries. Magic empowers customers and partners around the globe with smarter technology that provides a multi-channel user experience of enterprise logic and data.
Magic offers targeted solutions and know-how tailored for individual industries such as banking, manufacturing, real estate, IT and many others. Magic draws on 30 years of experience, millions of installations worldwide, and strategic alliances with global IT leaders, including IBM, Microsoft, Oracle, Salesforce.com, and SAP, to enable its customers to seamlessly adopt new technologies and maximize business opportunities.
Sales analysis
Total revenue has been rising by 27% CAGR in the past five years and net profit has quadrupled during the same time period, as R&D grew only mildly and SG&A costs rose at a much slower pace than sales. In 2012, Magic experienced a notable slow-down in the growth of revenue as well as net profit, primarily as a result of virtually stagnant software sales and slower, but still strong, growth in consulting services. Geographically, most of the sales stemmed from the U.S. and Europe.
The general revenue trend in the past few years has been very mildly rising sales from software licensing fees, complemented by rapidly rising revenue from maintenance and technical support services as well as consulting services. The revenue and growth are clearly shifting from software to the accompanying value-added services. Consulting services now make up over 60% of revenue, with the rest being split almost equally between software and maintenance and support. The rapidly rising maintenance and support revenue is expected to overtake software sales in the near future.
One caveat of the stagnant software sales and rapidly growing consulting revenue is that revenue from in-house-produced software, related professional services, maintenance and support sport superior margins to both third-party software resale and other consulting services unrelated to the sale of its software. If the product mix continues to develop toward the lower share of in-house software sales and related services, the company’s overall margins may slightly suffer.
Ericsson represents the single largest company driving 19% of Magic’s total sales and 30% of the IT consulting services sales segment. This large share of one customer represents a potential risk going forward.
Customers
Magic has successfully completed many installations and has more than 3,000 global partners, thousands of customer and millions of users worldwide use its products and services. Some of the well-known brands that belong to a vast array of Magic’s customers are pictured below.
Competitive landscape
Competition is not only intensive but it is expected to intensify, as the PaaS and SaaS market has increased at fast growth rates, attracting many competitors. Magic competes with a multitude of companies offering services in the areas of application platforms, business integration and business-process management and in the applications and services markets.
Magic also competes with providers of outsourcing services, systems integrators, computer systems consultants and other providers of technical IT consulting services. Specific competitors, such as Microsoft, IBM, Sun Microsystems, Accenture and Capgemini, are strong and much larger than Magic, but less focused and less specialized in the areas and segments where Magic operates.
Financial results
Financial results for the second quarter that ended June 30, 2013 include a 24% YoY revenue growth, while non-GAAP operating income increased 8% YoY. Non-GAAP net income fell 7% YoY. GAAP net income decreased 3% YoY to $3.5M and GAAP diluted EPS fell to $0.09 per share from $0.1 per share last year. The decrease was mainly attributable to an increase in tax expenses recorded for the second quarter.
Half-year results for the H1 2013, which smooth out the usual heavy QoQ revenue and profit fluctuations, shed more light on the company’s continued, yet slowing down, growth. For the first half of 2013, revenue increased 17% YoY, while non-GAAP operating income grew 8% YoY and non-GAAP net income fell 7% YoY. GAAP net income decreased 10% YoY and GAAP diluted EPS reached $0.19 versus $0.21 a year ago. Again, the decrease in income was attributable to an increase in tax expenses recorded for the second quarter.
Financial outlook
The company’s CEO was bullish on these earnings results and mentioned that he is pleased that the company managed to maintain double-digit growth in the first half of 2013 across all of its products and regions. Magic also continues to win new and repeat business and expand its professional service activities. The European and Japanese markets have been steadily improving. The company remains bullish that it can deliver strong value to its customers, partners and shareholders in the future.
Growth strategy
Specifically, the company aims to help its customers transition to enterprise mobility and maximize revenues, competitiveness and operational efficiencies through integration of their enterprise systems. This strategy will be achieved through a combination of organic growth and well-targeted acquisitions.
a) Organic growth
The company continues to acquire new customers as well as upsell additional products to its existing customers. Some of the notable recent installations include Agricultural Bank of China, China’s third-largest lender, Mul-T-Lock, a leading global manufacturer and distributor of security solutions as well as Godrej Properties, one of India’s top real estate developers. The company also implemented a monitoring and control system for Safe City Project in Buenos Aires, Argentina.
Magic also implemented usage of its xpa Application Platform to enhance and mobilize the key sales application of BNP Real Estate. Revenue will also continue to pour in from previous long-term contracts and recurring revenue, such as the three-year $1.5M contract with a major UK financial services provider announced in December 2012.
c) Acquisitions
Magic Software has a long history of successful acquisitions. Since 2010, Magic has been on an acquisition spree, and takeovers have been a primary force behind Magic’s rapid sales and EPS expansion throughout the past five years, as well as before. What is remarkable is that Magic achieved such impressive acquisition-driven growth, yet, it has virtually zero long-term debt.
2010
On January 17, 2010, the company purchased the consulting and staffing services business of a U.S.-based IT services company, expanding Magic’s presence in the consulting and staffing services for telecom, network communications and the IT industry.
In November 2010, Magic signed a global alliance agreement with MicroStrategy Incorporated, enabling Magic to deliver an integrated business intelligence solution to its Magic xpa and Magic xpi customers worldwide.
2011
Moving on to 2011, Magic acquired its South African distributor, Magix Integration. Magix Integration specializes in the software integration and application development of Magic’s platforms as well as the support of large-scale and complex systems in the public and financial sectors in South Africa.
In May 2011, Magic acquired 95% of Complete Business Solutions Ltd. and 100% of Complete Information Technology Ltd., leading software solution providers and business partners of SAP and experts on SAP One ERP implementation.
In December 2011, the acquisition spree continued with Magic acquiring the AppBuilder activity of BluePhoenix Solutions Ltd., a leading provider of value-driven legacy IT modernization
solutions. This takeover was one of the more strategic ones, as the company started offering the large-scale, custom app building capabilities to its customers.
2012
In July 2012, Magic acquired an 80% interest in Comm-IT Group. This group is a software and systems development house that specializes in providing advanced IT and communications services and solutions, with this move set to expand and strengthen Magic’s professional services and solutions.
d) Dividends
As mentioned in the introduction of this analysis, Magic initiated a dividend in 2012. Specifically, it paid two semi-annual installments — the first amounted to $0.10 per share, and the second rose to $0.12 per share. The trend looks promising, given the strong EPS and EPS growth as well as a hefty cash balance of more than $1 per share and a low 40% forward payout ratio. I am convinced the dividend will become regular and will also increase quite often and by meaningful amounts as the company’s dividend policy allows a payout of up to 50% of its annual distributable profits.
Valuation
Magic’s future sales are hard to predict with any high degree of certainty because of fluctuations in orders and partially the project-based nature of the business. However, the recurring nature of the core of the company’s revenues provides for a stable basis of revenue, which will be supplemented by the fluctuating quarterly gains of sales from new and existing customers as well as any potential acquisitions.
I expect an average annual increase of the company’s EPS to reach 10% given the strong history of 61% annual EPS increase rate in the past five years, influenced by the low 2008/2009 base but also by Magic being in the rapid phase of its growth. Most recent financial numbers point to a more timid growth of revenues at a 17% annual rate and a non-GAAP operating income growth around the 8% mark. This is the rate that I expect going forward, and it provides room for errors and a healthy dose of conservatism, which I always apply.
Given the company’s ability to supplement any organic EPS growth with acquisitions thanks to its long-lasting history of many successful acquisitions, its strong cash position and zero debt, I am confident the 10% growth rate is comfortably achievable on average for the next five years. I expect a zero terminal growth rate afterward and a higher-than-my-usual discount rate of 11% due to higher sales volatility and many risks, for example a dependency of 19% of the company’s sales on one customer, Ericsson.
Applying the above numbers and assumptions into my Future Discounted Cash Flow calculation, the fair value of Magic Software currently stands at $6.78. The stock is approximately 10% undervalued.
Should the company manage to grow at a faster pace of 15% per year, the intrinsic value would be $8.21, offering a 33% upside. Under a 20% growth scenario (remember, the EPS grew at a 60% CAGR over the past five years), the stock would be valued at $9.89, offering a 60% upside.
What is the downside risk though? Well, if the EPS fail to grow from the current trailing EPS level of $0.42 per share, the company’s fair value would be roughly $3.82, which is plenty of downside, 38% to be precise. And we have not even gotten to valuing this stock at a liquidation value. Even if we take the current full book value as a liquidation price, shareholders would walk away with roughly $3.16 in their pockets, which would be roughly a 49% downside.
Risks
Magic needs to keep growing sales of its core software products because other revenue, such as maintenance and support as well as its IT consulting business revenue, is largely derived from sales of these door-opener software products. Thanks to its strong cash position and zero debt, Magic can complement organic growth with acquisition-driven revenue increase.
Intense competition, described in more detail earlier in this analysis, is the second major challenge for the company, which threatens its ability to stay competitive and keep growing.
Furthermore, the company’s revenue typically experiences quarterly fluctuations due to many factors, including customers’ order cycles, the company’s product release and upgrade schedules, competitive releases and activities and many others, which cause Magic’s stock to be volatile. This trend is expected to continue.
Margins may suffer if the company sells proportionally less of its own software and related professional, maintenance and support services in favor of third-party software and IT consulting services.
One largest customer, Ericsson, accounts for 19% of the company’s sales, representing a potential risk if it suddenly lowers the level of cooperation with Magic.
Conclusion/Recommendation
Magic Software Enterprises is a volatile and risky stock with an impressive history of sales (27% five-year CAGR) and EPS growth (60% five-year CAGR), largely boosted by acquisitions. Currently the company grows its EPS at a rate of roughly 10%, as it hasn’t made any acquisitions for over a year. If the company’s growth accelerates to 20% per year, the company offers a 60% upside from the current price of $6.17 per share. Even if Magic manages to keep growing at my conservative rate of 10%, it is 10% undervalued. However, the stock also presents a downside risk of up to 38%, should the growth stall immediately to zero and never pick up again.
All in all, Magic is a risky but potentially rewarding investment, and by initiating a dividend with a strong 2.9% effective yield, Magic is becoming a very attractive dividend growth stock.
By Martin Vlcek, Seeking Alpha.
