MGIC - Magic Software Continues Organic Growth Risks Enterprise Tech Reckoning

• Magic Software continues to post great inorganic growth with strength in healthcare and defense.
• Our concern is over the receivables still, where credit terms might have been loosened.
• Cash flows are down, but the markets still appear healthy for enterprise tech.

Magic Software ( MGIC ) is a company that we follow because of its association as a holding of Asseco Poland ( ASOZF ) which was one of our favourite companies in 2021. Organic growth continues to be strong, driven by healthcare and defense business, primarily professional services related to cloud, but receivables remain very high. Overall, the company continues to perform consistent with expectations from enterprise tech, but is not compelling individually.

Q2 Note

The company provides both software and consulting related to cloud configuration and integration. The professional services segment continues to grow in the mix, and as opposed to recent pressures on gross margin in the segment, inflation of labor has stalled allowing gross margins to improve within the segment from the teens into the 20s. However, mix effects, i.e. the growing presence of professional services in the mix, has drawn down the GM by about 1%. The split currently is 18:82 professional services to software, and on a gross profit basis about 41:55 changing from 45:55, showing this negative mix evolution where professional services GM is 20% vs 65% on software.

Revenue growth continues to be high at 17.5% on a constant currency basis, with 90% of this growth being organic, and this is being driven by healthcare and defense verticals which are unsurprisingly among the most resilient commercial sectors. Overall, the customer profile is that of larger companies, which have not yet cut back on enterprise tech spending, consistent with what we've seen in the recent tech earnings week . Cloud integration services continue to be in high demand.

Caveats

Substantial organic growth is nice, and helps justify the 30x PE. But there are some caveats that we've been following that leave some outstanding questions, and have us watching from the sidelines on MGIC. The receivables have grown substantially from last year, and they remain large and a drain on the incremental cash flows. Last year the receivables were at about $110 million, while now they're above $140 million . The bloat isn't too substantial relative to the double-digit growth, but it does exceed it by enough to notice it. For the FY it was a big cash flow drain, and it was sudden and didn't reverse . The reason it's a concern is because companies can relax credit terms to customers in order to up-front revenues. The growth is still very substantial, and couldn't be attributed fully to this effect, but we'd wonder what the growth rate would be under more normalised conditions.

While receivables are an idiosyncratic concern, we also worry more generally about the situation in tech. The bifurcation between weak performing consumer tech and strong performing enterprise signals that there might be a reckoning as consumer pessimism passes through to the corporate side. Overall, it is best to stay on the sidelines here.

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