EPAM Systems Inc (EPAM) — Q2 2015 Earnings Call Transcript

Thank you. Good morning, everyone. By now, you should have received your copy of the earnings release for the company’s second quarter 2015 results. If you have not, a copy is available in the Investor Relations section on our website at epam.com. The speakers on today’s call are Arkadiy Dobkin, CEO and President; and Anthony Conte, Chief Financial Officer. Before we begin, I would like to remind you that some of the comments made on today’s call and some of the responses to your questions may contain forward-looking statements. These statements are subject to the risks and uncertainties as described in the company’s earnings release and other filings with the SEC. Arkadiy?

Thank you, Lilya. Good morning, everyone and thanks for joining us. Today, we’re reporting another strong quarter with 25% revenue growth over last year and 33% growth in constant currency terms. Our Q2 revenue is $280 million, above both consensus and guidance and represents sequential growth of 9% against Q1. Anthony will provide more detailed updates on our financial performance in the second quarter as well as explain the changes in our Q3 2015 guidance. Before that, I’m going to touch on business highlights and our operations priorities. As you know, we are well into 2015 plans at this point. We also know what we outlined in our previous conversations, that our strategies and plans were set out some time ago in an attempt to realize opportunities opened up for service providers due to the strong digital disruption in the traditional marketplaces. Today there is a significant number of corporate-wide information programs that many large and smaller companies are undertaking as a first priority. We are also convinced now that these disruptions present a very specific opportunity for EPAM through advances in the market, particularly in the product development services space. We discussed this previously in some detail. During the last quarter, we continued to move forward in line with our plans. In the beginning of the year, we mentioned that we wanted to bring our new brand to life and present more consistent messaging around our growth services in our target industries. As planned, we launched our new website in June, and while we consider its current state still a work in progress, we think it communicates our intent and direction better. Over the last couple of years, we have invested significantly, both organically and through strategic acquisitions, to develop strong digital capabilities within EPAM. We view this as a holistic mindset across all of EPAM's services, not just enhancing our standalone unit. We plan to continually invest in such capabilities and focus on growing new types of services that utilize decisive thinking and methods to capture new business opportunities for our clients. In addition to this, last month we increased our North American footprint in the digital space with an additional acquisition. This acquisition also strengthens our capabilities in web content technologies, specifically with expertise in recent platforms like Sitecore, which was recognized by Gartner as among the leaders in web content management platforms. It brings EPAM several interesting clients, including regional dynamics, Medicare, just to mention a few. We see that capturing the digital shift is crucial for these types of programs, and it requires very close integration of enterprise platforms. This leads us to our next important horizontal initiative that we call Intelligent Enterprise. It is a connective tissue that brings digital content information into the business at large. For us, this is about building on our core strengths in XLVI and Big Data while expanding into data science and analytics. It provides the ability to integrate everything with traditional ERP systems and migrate those applications to the cloud. In certain cases, we may take full ownership of those tasks. None of this is possible without a deep advanced skill set and strong hands-on understanding of next-generation technology platforms and accumulated enterprise-level R&D engagement. This is what our advanced technology service line is working on. From expertise in next-generation technologies to constantly changing delivery practices, we continue to innovate to prototype new ideas. We have two decades of experience, sharing total global technology knowledge with many technology companies and acting as an extension of their R&D units for years. This positions EPAM to provide a very different type of service to our demanding clients amidst the digital disruptions. When our advanced technology expertise merges with our capabilities in Intelligent Enterprise and digital engagements, we believe we have a compelling proposition for the market. As you all know, EPAM has always placed great emphasis on software engineering excellence. This was our primary focus for a considerable time. That focus has allowed us to attract a top portfolio of companies in technology powerhouses around the world to utilize our engineering services. In turn, this has helped us develop our advanced technology understanding and capabilities at a higher level. To support our Intelligent Enterprise and digital engagement service lines to the fullest extent, we continue to invest in and develop our core engineering competencies. We achieve this through structured talent acquisition, specific training programs, and harmonized talent retention strategies including regular software engineering conferences and local and global hackathons. Without this core engineering skill set, delivering on the new types of solutions our clients expect from us today would be impossible. This core engineering service line forms the foundation of much of the work we provide to customers across all our other service lines. We also continue to see a good amount of business in our traditional independent software vendor segment, which remains strategic for us and allows us to be in good shape and better prepared for the new engineering and technology shifts that are ongoing. In summary, our key challenges and investments focus on effectively combining traditionally different service lines and ensuring they work together from start to finish to address our client problems from both a conceptual and delivery standpoint. From a vertical perspective, we’ve seen impressive conversions in demand for vertical expertise alongside the new technology and service capabilities I mentioned. The retail business has shown strong traction, and I am optimistic about growth in life sciences and healthcare. This aligns with what is happening in financial services and media and entertainment as well. Geographically, we continue to expand primarily by following our customer engagement expansion plans in Asia and Europe, and we have also established a new presence in Mexico. Asia is becoming increasingly diversified in terms of verticals, providing support in core engineering tasks and digital for new customers in retail, media, and consumer verticals. This forms the high level of our go-to-market approach and is what we will continue to focus on while driving business development and enhancing current management practices. We are undertaking significant investments in marketing and branding efforts and programs. Finally, I’d like to share a few examples of the new engagements we are witnessing that highlight the types of services we can now provide. One strong example of our design and leadership driving true product development service is our work with Vodafone, where we are developing new products related to data analysis from motor scooters. We began with conceptual design, collaborating with the customer from the initial concept to full industrial design, application design, and final development. These types of design-led engagements present a real opportunity for us to capture more market share in this product development segment. On the technical product development side, we have become a key partner for Unify, who is building a generation cloud-based collaboration platform for enterprises. Well design is a crucial element of this engagement. There is significant technological capability required to build the project, allowing us to differentiate against strong global competition. Companies like Unify see us as a strategic partner to assist in these endeavors. We’re also witnessing existing clients like Adidas moving into new service models for platforms like marketing technology and agile delivery capacity. This is an exciting opportunity for us as it highlights our unique capabilities in transitioning from traditional IT services to the digital marketing space, relying heavily on strong conversion technology and core engineering skills. This differentiates us within the product development services sphere. With that, I will turn it over to Anthony to share more details on our performance and guidance.

Thank you, Ark, and good morning everyone. I will spend a few minutes taking you through the second quarter results, and then I will talk more about our outlook for Q3 and the full year. As usual, you can find the full details of our results in our press release and on the quarterly factsheet located in the Investors section of our website. Q2 was another solid quarter of revenue, closing at $217.8 million, and showing a 24.7% increase over last year and an 8.9% increase over the previous quarter, exceeding both consensus and guidance. Currency headwinds compressed our Q2 revenue by about 8%, meaning in constant currency, we would have grown 32.5% over Q2 2014. Sequentially, we are up 8.9% from Q1 and 6.7% in constant currency terms, indicating we enjoyed some favorable currency dynamics compared to our revenue. The key currency mix of our revenue in Q2 has remained relatively consistent with what I shared in Q1. North America remains our largest segment, representing 50.7% of our Q2 revenues, which is up 27.6% year-over-year and 30.4% in constant currency, with the difference mainly due to movements in the Canadian dollar. Europe saw a year-over-year increase of 27.5%, making up 40.1% of Q2 revenue. In constant currency terms, Europe would have increased by 37.4% year-over-year. APAC continues to grow, diversifying away from just banking and financial services, now representing 2.8% of revenue and growing 14.9% sequentially. The CIS region continues to struggle, with a year-over-year decline of 20.9%, accounting for only 5.4% of revenue in Q2. This drop is related to both currency and volume, but in constant currency terms, CIS would have grown by 8.5% year-over-year. Regarding our industry verticals, we have seen some tempering of growth in the banking and financial services industry this quarter, at about a 10.7% growth rate, primarily due to a significant slowdown among Russian banking customers, which has offset the healthy growth we see in the banking sector across other regions. We are experiencing encouraging expansion in the travel and consumer space, especially in Europe, growing 42.3% year-over-year and 18% compared to the prior quarter. Life sciences and healthcare, our newest vertical, grew 8% sequentially, while business information and media and ISV both exhibited continued strength, generating over 20% year-over-year growth. Our other vertical, which consists of clients from various industries, declined by 6% year-over-year, primarily due to the decrease in the Russian ruble but improved by 6% sequentially. We observe positive trends in our customer concentration metrics. Our top 20 accounts grew 22.3% year-over-year and now represent 55.3% concentration, down 1% from last year. All clients outside the top 20 grew by 27.5% year-over-year. As for our expenses, we concluded the quarter with over 13,200 IT professionals, a 20% increase compared to Q2 2014 and a 10.8% increase year-to-date. Currency also provided some benefits to our cost of revenue compared to the prior year, with approximately an 8% constant currency advantage versus Q2 of 2014, and the allocation of our currencies across our expense base remains consistent with what I shared in Q1. Utilization for the quarter was up at 76%, slightly down but still within our target range. GAAP income from operations increased by 27.8% year-over-year, representing 10.8% of our revenue in the quarter. GAAP income from operations includes stock-based compensation and several other acquisition-related costs that we exclude from our non-GAAP measures. Stock-based compensation for the second quarter increased by 108% compared to the prior year, primarily driven by a 60% increase in our stock price. Approximately 40% of the total Q2 charge and 55% of this increase is associated with acquisitions made in 2014. Our non-GAAP income from operations for the quarter, after these adjustments, increased by 27.7% year-over-year to $36.9 million, representing 16.9% of revenue. Our effective tax rate for the quarter rose to 21.3%. The tax rate is increasing due to subtle changes in our organic geographic mix of current year earnings, shifting toward countries with higher statutory rates. Additionally, new tax jurisdictions or deeper concentrations into some existing jurisdictions from the acquired businesses in 2014, including the U.S., Western Europe, and Asia, also contributed to the increase in the tax rate. For the quarter, we generated $0.64 of non-GAAP EPS at the top end of our guidance and $0.37 of GAAP EPS based on approximately 52 million diluted shares outstanding. Our balance sheet remains strong. We finished the quarter with about $205 million in cash. During the second quarter, our operating activities generated approximately $2.2 million in cash. Unbilled revenue was at $92 million as of June 30th. Accounts receivable was at $135 million, and DSO ended the quarter at approximately 51 days. With that, I'll now turn to our guidance. We are increasing our full year 2015 revenue growth expectations to between 23% and 25%. Non-GAAP net income growth for 2015 is now anticipated to be in the range of 22% to 24%, and our effective tax rate is expected to be approximately 21%. For the third quarter of 2015, EPAM expects revenues between $238 million and $240 million, representing a growth rate of 23% to 25% compared to Q3 2014. Our non-GAAP diluted EPS for the third quarter of 2015 is projected to be in the range of $0.66 to $0.68 based on the estimated weighted average share count of 52 million shares. GAAP diluted EPS is expected to fall within the range of $0.43 to $0.45. With that, I would now like to turn the call back over to the operator and open up for Q&A.

It's great that you guys raised the overall reported guidance. I just wanted to get a sense of that in the second quarter. It seems like the FX headwinds were slightly lower than what you guys were expecting, around 70 basis points lower. For the full year, you previously talked about a 6% year-over-year FX headwind. I’m trying to get a sense of whether that expectation has changed as well. Ultimately, I’m trying to obtain your constant currency revenue growth guidance for the full year.

Yes, hi. The expectation for the full year has not changed. We saw some pullback in currency in Q2, but if you look at what happened really over the past month, it appears that the Ruble is starting to fall again. We’re seeing some weakness in the Hungarian Forint and the Pound in Europe as well. Therefore, my assessment is that our expectations remain consistent with the guidance we’ve provided, which is around a 5% to 6% full year FX headwind. The Q2 outcome being slightly below our initial expectation seems to be reversing in Q3 at this point.

Regarding the guidance raise, if you could break it down: how much of it is due to the second quarter upside versus the expected contributions from Navigation Arch? Also, can you provide some insight into how much inorganic contribution is anticipated in your 2015 revenues?

It’s very hard to separate the two. With Navigation Arch, we've already begun full integration, and we have plans to market as one company, so the guidance actually includes a well-integrated go-to-market approach. I can’t definitively separate the organic growth from that contributed by Navigation Arch; given our integration strategy, I would estimate that for the first half, the revenue would be roughly divided 50-50 as organic and inorganic. However, the distinction is fairly blurred based on how we’re progressing with integration and the traction we’re seeing with their existing accounts.

Just one last question from me. Regarding margins, you guys are showing a year-over-year adjusted operating margin improvement this quarter of about 40 basis points. How much of that improvement is related to FX, and are you still expecting to remain within that 16% to 18% range for the full year?

Yes, we are expecting to stay within that range. The impact on margins from FX is relatively minor. We usually maintain a reasonable hedge, and while we see some genuine headwinds on revenue, there are no significant benefits on the expense side, making any impact from currency negligible.

Just a small clarification. I missed a bit of your prepared remarks, but regarding the infrastructure service, I know it's a small portion of your business. Can you update me on its performance? Growth has not been very strong sequentially or year-over-year.

Nothing special is occurring. I would say it is not a significant part of our business. We do not actively pursue or market our infrastructure services. Many of our offerings in this area are closely linked to the other services we provide in the software development space. Thus, it fluctuates randomly within a range of 8% to 9%.

Arkadiy, as a follow-up, can you discuss your ability to source talent and recruit the right personnel? You're hiring many people, moving in the right direction, but I would like to hear about the talent pool. Several competitors are opening shops in your operational locations.

It would be helpful if you could identify who is opening. I believe we are mostly in line with our regular core maintenance efforts. I’ve mentioned this in prior calls: in general, there is a talent shortage, and I have outlined our strategies for addressing this issue. We aim to not just hire from the market but to also nurture our in-house talent while working with universities. I wouldn't say anything new happened this quarter, nor do we have significant issues similar to what we experienced quarters ago. This challenge has persisted for decades, and it seems it will continue to do so.

Good morning. This is Peter in for Steve. Thanks for taking my question. Anthony, could you provide us with the attrition rate for the quarter?

Attrition came in at about 7.5% for the quarter, and yes, it is voluntary.

I see, voluntary. That marks two quarters at 8% or below. Is this affecting your plans for headcount growth for the year?

We’re adjusting based on that and continuing to monitor attrition levels. As we stated in Q1, we are benefited by some macroeconomic factors affecting the CIS region, keeping attrition low. We expect attrition levels to normalize eventually, so we will adjust our headcount and recruitment efforts accordingly based on our attrition trends.

Do you have an idea regarding the expected headcount growth needed to meet this year-end?

We're targeting roughly high teens to 20% headcount growth.

I noticed SG&A is up about 300 basis points as a percentage of revenue year-over-year, consistent with last quarter. Should we consider this to be a new baseline? Additionally, if the currency were to reverse and work against you, how flexible are you in managing that spending?

We can definitely manage our spending. The increase you're observing is due in part to opening several new locations, which incurrs new facility expenses and some overheads, though there are no upfront investments involved to launch these operations. This causes the increase in my SG&A. As for the currency impact, a lot of SG&A expenses are in U.S. dollars, which means we don’t get substantial benefits from currency shifts. Most currency fluctuations tend to impact our cost of revenue, resulting in some of the swings you're seeing as a percentage of revenue. The benefit from currency changes helps our gross margin increase, but SG&A doesn’t get as much relief from currency impacts.

Understood. I noticed revenue per engineer, adjusted for currency, is up nicely about 6% to 7% year-over-year. Can you attribute this increase to a changing dynamic in the mix of work, or has pricing uplift contributed?

Honestly, we don’t closely examine that particular metric of revenue per headcount, so I can’t provide a specific answer. We have, however, observed price increases that are still being realized. Unfortunately, currency headwinds are diminishing some of those price hikes since we receive a significant amount of our revenue in Rubles, Pounds, Euros, etc. We're also increasingly selling higher-value services and are progressively transitioning toward more product development services.

We’re not sharing specific data, but we indeed perceive this as a digital consultative approach, providing us with different entry points and opportunities across all the verticals in which we operate. We have highlighted a few notable examples, but there are many more to discuss and represent various trends.

I want to discuss the European market. It appears there was an increase of around $7 million to $8 million from Q1 to Q2. What is specifically driving that growth? Where are you seeing the strongest trends currently?

In Europe, specifically, the travel consumer segment has been one of our strongest sectors for the quarter. Additionally, banking and financial services continue to provide substantial growth. Companies like UBS, which is based in Europe, continue to grow significantly for us. There are a number of new banking clients and increased traction across various travel customers and in the consumer space.

It seems that CIS as a percentage of total revenues is stabilizing and has actually increased for the first time in several quarters. It now represents approximately 5% of total revenues. Do you expect this to be the run rate for the rest of the year?

Yes, we expect it to stabilize around this level. Q1 traditionally is a slower quarter for CIS due to seasonal factors, particularly the holidays in January and low billing in February. Therefore, Q2 reflects a more normalized trend that we expect to hold, assuming the continued impact of the Ruble's depreciation, which we’ve seen resume its decline starting in July.

Last one for me, Anthony. Can you provide the bridge between GAAP and non-GAAP for the full year and the quarter?

To clarify the bridge, we can share that stock compensation will remain relatively stable for the remainder of the year, approximately $11.4 million to $11.5 million per quarter in the second half. Amortization of intangibles should be around $1.5 million per quarter. Additionally, I anticipate foreign exchange costs to be roughly $1 million a quarter in losses, but this can fluctuate significantly.

Good afternoon. I am curious about your guidance that has increased by about $14 million to $15 million. How much of that is attributed to Navigation Arch?

As I addressed earlier, it’s tough to separate out Navigation Arch since we’ve already begun integrating it fully. Our go-to-market approach is much more interconnected compared to previous acquisitions. Therefore, there is no clear distinction. I would estimate approximately a 50-50 split between organic and Navigation Arch growth. However, due to the level of integration we've achieved, that line is notably blurred.

Can you provide insights on the revenue base of the company concerning your acquisitions?

No, I’m sorry, we don’t share that specific information.

Thank you, everybody, for your participation today. It was a good quarter for us, and there aren't any specific news; overall, we are doing well. We’ll be speaking with you in three months. Thank you, and have a good day.