EPAM Systems Inc (EPAM) — Q4 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 fourth quarter and full year 2015 results. If you have not, a copy is available in the Investor section on our website at epam.com. The speakers for 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. Thanks for joining us today. First, I hope our results addressed some immediate concerns about the profitability of EPAM amidst the recent stream of unexpected news. I am pleased to confirm that we have been able to navigate through our multiple challenges of 2015, including growing the level of SMEs during the last quarter despite weaknesses in the financial services sector and continuous negative FX impact on reported results in particular. So let me highlight now the most important facts for 2015. Q4 revenue increased by 29% year over year to $260 million and in constant currency, it represents 34.3% growth. More importantly, our organic growth representing 24% increased over last year, which translated into 29% constant currency growth. It was also exciting for us to cross $250 million in Q4, bringing us to a run rate price of a symbolic $1 billion annualized revenue mark this year. One more data point to mention is that last quarter was our 25th consecutive quarter of over 20% organic year-over-year growth and 16th since our IPO four years ago. I think it’s a good reference point for EPAM being included into Fortune 100 fastest growing public companies in 2015 where we were recognized as the fastest growing firm in the IT services segment. In Israel, we are closing the year with $914 million in annual revenue, which is a 25.2% growth in USD and 33% in constant currency over our 2014 results. And while it’s obviously disappointing to lose $55 million due to FX headwinds, we’re going to report our strong organic growth which represented 23% for the full year in USD and 31% in constant currency. So at this point, and before turning to Anthony to provide much more detailed financials on our 2015 results and 2016 guidance, I would like to talk a little bit more about the bigger picture. To remind what was in our focus during the last periods, what our progress to date was and what would be our focus and key efforts in the near future. First of all, three years ago, we decided that we plan to target a specific subset of the IT market which was driven by what is now often referred to as digital transformation disruption. We planned to benefit from our strong software engineering background built over the years of assisting top software and technology companies in developing new products and solutions. We also realized three years ago that to be successful in penetrating that market segment, we would have to address significant gaps in multiple areas, including specific delivery capabilities and much more advanced account managing practices. Only such players that would have a chance to play in that fast-growing market are those we should potentially reach a size of $80 billion by 2018 according to analyst predictions. Then three years ago, we set an internal goal to double our revenue by 2015 and identified a number of specific focused areas to make it happen. The last couple of years were really challenging and eventful for EPAM, with much work required due to global dynamics, from ongoing political conflicts and currency headwinds to shifts within some of our large customer relationships impacting our performance. I would like to highlight the following facts regarding EPAM’s continuous evolution and current state. Based on our plans, we started to build an advanced digital strategy and experience about three years ago, focusing strongly on integrating these capabilities into EPAM’s historically mature engineering DNA. We believe that while it would be much more difficult to do that in an integrated way, it should bring us strong competitive advantages in the long term. The journey is not finished yet. However, in 2015, we observed strong repeatable patterns in how we engaged with new deals and how we executed them. Our digital engagement practices visibly matured last year, becoming a recognizable force among our clients and many new engagements. Strong capabilities such as software design, for example, began to play a more important role in specific situations. Finally, in addition, NavigationArts, with their strong focus on content technologies, reinforced our leadership position in the digital solutions space. Those changes at EPAM, combined with our investments in industry-specific competencies as well as data and advanced technology services, enable us to expand significantly. First of all, across our fastest-growing verticals in 2015, which are travel and consumer, media and entertainment. Those grew 36.5% and 31.5% year over year respectively. That digital focus allowed us to add four of the top 10 global retailers as clients, and now we have 15 of the top 100. In most cases, we are assisting them with a range of digital transformation initiatives, many of which, like Tyres, Sephora, and Mary Kay among others, are driving significant revenue acceleration and are very strategic in nature. Similarly, we are working with five of the top 10 global media companies, including one of the largest, Liberty Global, and with Intel in the consumer vertical. We engage with the largest online agency in the world and the largest global hotel chain, for eight years, along with two of the top 5 low-cost global airlines. Turning to financial services, which continues to be our top vertical by revenue, we’re seeing a further diversification of services revenue, driven significantly through digital transformation initiatives. In 2015, we added four major financial services clients and we continue to expand our digital engagement efforts. For example, our focus on wealth management has helped our customers reimagine their role in an extremely competitive arena of financial services and successfully defend their market share against new entrants. With our growing ability to lead the transformation by providing end-to-end capabilities from strategy to delivery and user experience and global engineering, we can grow our digital platforms, like wealth management, as a more productized service operating simultaneously in multiple geographies. Digital engagement for financial services has expanded globally with teams supporting customer programs in the US, UK, Nordic, APAC, and now in the Middle East. In 2015, we also took on the challenge of driving industry change with continued investment in trading platforms, the introduction of blockchain hedge accounting, and other specific solutions. While overall growth in financial services was only 15%, without the impact of the Russian market, the growth would have been up to 23%, and in constant currency 27% over 2014 results. To complete our vertical stories, let me spend a couple of minutes on our other focus areas: software and hi-tech, and our most recent industry trends such as life sciences and healthcare. Software and hi-tech remains an important component of our client portfolio. While we have been engaged in this segment for many years, it is also critical for us to stay on top of technology trends as well as experiencing first-hand the most advanced processes and methodologies related to the delivery of complex and advanced solutions. We’re glad to report a healthy growth rate of 22.2% in this segment, which has allowed us to keep our engineering skills up to date and bring those capabilities back to many remaining engagements across our vertical portfolio. Finally, about our smallest but fastest-growing vertical: life sciences and healthcare. While we provided services in this area in the past, our most strategic entry occurred just in 2014 when we acquired industry expertise in several key accounts. During 2015, we focused on expanding into a few existing accounts. While it’s still too early to draw final conclusions, we’ve already seen the first positive results. Additionally, combining industry subject matter expertise with our advanced digital and data capabilities has allowed us to win several new interesting clients in this market. One example of our success is with Human Longevity Inc, a company recognized for creating the world’s largest and most comprehensive database of whole genomes. Additionally, each of our businesses is involved in a genomic clinical research program, which uses whole genome sequencing analysis, advanced clinical imaging, and innovative machine learning alongside curated personal health information to deliver a complete picture of individual health. When you have a unique combination of capabilities with an understanding of both science and advanced technologies, it allows us to seize opportunities, making Human Longevity our fastest-growing account in 2015 across this vertical. In Q4, our growth for this portfolio was over 45%, and today we are providing services to six of the top 10 global life science companies and five of the top 10 largest healthcare vendors, presenting very interesting opportunities to penetrate further. Now, I think it would be helpful to look closer at our client base beyond the vertical boundaries. While in general, the number of top brands in each vertical sector is important, it doesn’t provide a comprehensive picture about the level of diversification, penetration, and the expansion potential we should be realizing with those accounts. So let us talk a bit about that. We believe we have a pretty healthy client concentration ratio with our top clients representing 14.2% of our revenue, top 5’s 32.6%, top 20, 54.3%, and top 50, 70%. As such, with our lower client concentration from 2014, an example is Trizetto, which was acquired by Cognizant, and this did not significantly affect our growth numbers. By the end of 2015, we had approximately 50 accounts with annual revenue of $1 million among the largest 2,000 global companies, with 25 of them generating under $3 million annually, 7 of them providing between $3 million and $5 million in services, with four between $5 million and $10 million, and with another four, between $10 million and $20 million. Finally, we had six clients with revenue between $20 million and $50 million per year, with just one exceeding $100 million. We believe that the majority of those accounts should offer lending opportunities for expansion. We expect a natural shift of current budgets towards new digital and data platforms, allowing such expansion to occur, resulting in a larger share of client IT budgets. We’ve seen this trend happening with many of our clients. Today, in 20 of our top 25 accounts, there is at least one significant digital transformation program ongoing, and in five of our top 10 accounts, the digital platform represents a significant portion of total revenue. We anticipate that such services will grow over 2016 and take on even more work around digital products and platform engineering and integration across our existing client base. While we believe we have substantial opportunities across our existing client base, we continue to bring in new clients, expecting them to contribute about 10% to next year’s revenue growth. To conclude my highlights for 2015, I would like to mention that last year also witnessed significant expansion of our delivery capabilities geographically, ensuring our delivery platform is more balanced and diversified globally across time zones. By the end of 2015, we had the largest overall global footprint with resources in 25 countries and over 16,000 delivery professionals worldwide. We expanded in China, adding people and new global clients, established development centers in Godalaha and Prague, and, notably, entered India through the acquisition of Global Services at the very end of last year. Today, we can report significant direct clients with large distributed teams across Europe and India. Looking ahead to 2016, demand from both current and prospective customers remains strong. While we continue to see demand for our core engineering and advanced technology services, as mentioned before, we are experiencing a stronger shift toward services requiring combined digital product and platform engineering and integration capabilities. We believe EPAM is well-positioned to take advantage of this demand. We invest and will continue to invest in integrated services, including customer experience in digital platforms, data analytics, and cloud and service design. Like many others, we believe that deepening our understanding of IoT platforms and related data analytics services will become increasingly important in the near future, which will be another area of continuous investment for us in 2016. The combination of our solutions and vertical focus should position us well this year to leverage the shifting services market. With that, I will turn to Anthony to provide more details on our financial results and 2016 guidance.

Thank you, Ark, and good morning everyone. I will spend a few minutes taking you through the fourth quarter and full year 2015 results. Then I will discuss our outlook for 2016. Let me start by saying that we are pleased with our overall results for the fourth quarter and full year 2015. Our business is well positioned for growth, but with the current instability in the marketplace, there still remains some uncertainty. But as Ark mentioned, we have sustained over 20% organic growth for every quarter since our IPO, continuing to improve the fundamentals at EPAM. Q4 was another solid quarter of revenue, closing at $260 million, 28.7% over last year and 10.3% over the prior quarter. This includes the impact of Alliance Global and NavigationArts, which contributed slightly over $10 million, resulting in organic revenue of $215 million and organic growth of 24% year-over-year and 7.6% sequentially. Currency continues to be a significant piece of our story, as headwinds have continued to compress our organic Q4 revenue by about 6%, meaning in constant currency terms, we would have grown 29% over Q4 2014 and 6% sequentially. For the full year of 2015, we closed at $914 million of reported revenue, 25% over last year after 8% currency headwinds, meaning constant currency growth was 33%. Organically, we ended just over $900 million or 23% growth, but in constant currency would have been 31%. North America, our largest geography, represents 53% of our full year revenue and is up 40% from Q4 and 32% year-over-year, with constant currency growth of 43% and 35% respectively. Europe was up 24% year-over-year and 23% in Q4, representing 39% of full-year revenue. In constant currency terms, Europe would have been up 32% year-over-year and 28% in Q4, reflecting the impact of both euro and sterling volatility over the past year. For APAC, we saw 26% growth year-over-year and 30% in constant currency. The CIS was down 23% for the year and 16% compared to Q4 2014, representing under 5% of revenue in Q4. In constant currency terms, the region would have seen about 9% growth for the quarter and 11% for the year. Our customer concentration numbers for Q4 remained consistent with prior quarters, and for the full year, our top 20 accounts grew 23% year-over-year and 30% in constant currency, representing 54% of revenue. All other clients outside our top 20 grew 28% year-over-year to 39% in constant currency. From our IPO date to today, we have managed to reduce the revenue concentration of our top 20 accounts from 60% down to 54% while maintaining consistent mid-20% growth. Turning to our expenses, we completed the year with over 18,000 employees, an increase of about 30% compared to 2014, including approximately 1,200 employees from Alliance Global. Currency generated some benefits to the cost of revenue in the quarter when compared to the prior year. There was approximately a 7% constant currency benefit versus Q4 2014, and the allocation of our currencies across our expense base remained fairly consistent. Utilization for the quarter was at 77%, up 30% from Q3, and the full year ended at 75%. GAAP income from operations increased 32% year-over-year to represent 12.2% of revenue in the quarter. Stock-based compensation expense for the fourth quarter increased 54% over the prior year, mainly driven by the significant increase in the average closing price of the stock. Additionally, 38% of the total Q4 charge and 23% of the increase is related to the acquisitions. Our non-GAAP income from operations for the quarter, after adjustments, increased 30% over the prior year to $47 million, representing 18% of revenue. For the full year, non-GAAP income from operations was up 29% to $158.7 million or 17.4% of revenue. Our effective tax rate for the quarter and full year came in at 20.4%. For the quarter, we generated $0.78 of non-GAAP EPS and $0.52 of GAAP EPS based on approximately 53 million shares diluted outstanding. For the full year, we generated $2.73 of non-GAAP EPS, $0.07 above guidance and 23% above 2014. GAAP EPS was $1.62, 16% above 2014 based on 52 million weighted shares diluted outstanding. Our balance sheet remained strong. We finished the quarter with approximately $199 million of cash plus $30 million in time deposit accounts. During the fourth quarter, operating activities generated approximately $11 million of cash, and for the full year, we had $76 million of operating cash flows. Unbilled revenues were at $96 million on December 31. Accounts receivable were $175 million, and DSO ended the quarter at approximately 53 days. And now for our guidance. For the full year 2016, revenue growth will be at least 26% after factoring in about 3% estimated currency headwinds, meaning constant currency growth will be 29%. Organic revenue is becoming harder to separate due to the full integration of NavigationArts, and we anticipate, once Alliance Global is fully integrated during Q2 2016, that a clear separation will be very difficult. However, our initial plan does include the impact of both 2015 acquisitions, and excluding them, organic constant currency growth would be at least 23%. Since currency will remain a theme in our financial results for 2016, our assumptions are that the currency mix will remain materially similar to 2015 for both revenue and expense. For Q1 2016, revenue will be at least $258 million or 29% growth after 3% currency headwinds, meaning constant currency growth will be at least 31%. Organic revenue will be at least 23% constant currency. Adjusted income from operations for the full year will remain in our guidance range of 16% to 18%. Stock compensation expense is expected to be around $55 million, with $13 million in Q1 and $14 million in Q2 through four. Amortization of intangibles will be about $6.5 million or about $1.6 million per quarter. GAAP EPS will be at least $0.43 in Q1 and at least $2.05 for the full year. Non-GAAP EPS will be at least $0.70 in Q1 and at least $3.20 for the full year. With that, I would now like to turn the call back over to the operator and open up for Q&A.

Anthony, I am wondering if you could just touch a little bit on the cash flows. It looks like they were down in the quarter and down year over year. I am wondering, is that a function of perhaps the acquisitions or maybe just timing on the quarter?

Sure. Hi, David, it is primarily a timing issue. We are seeing just some extended terms from a lot of our clients, with many people pushing for longer 60 to 90-day payment terms, which has caused a little bit of a bump up in my overall DSO. It pushed some of our end-of-year receivables into January. We actually collected about $35 million in January alone. As far as cash flows outside of accounts receivable, if you noticed, our tax payments – if you look at our cash flow, tax payments are going up. My cash tax rate has climbed as we have more employees sitting in the US and UK; I am seeing higher cash taxes going out the door. So that also impacted my cash flow when you look at it year-over-year. ADI does impact my cash flow, but that’s not within the operating cash flows, so that’s not really down within the investing section.

So can you give us some parameters for modeling 2016 free cash flow in terms of what you expect for CapEx, cash taxes, or any other working capital items that may affect the difference between net income and cash flow?

Sure. From a CapEx perspective, we’re forecasting around $19 million to $20 million worth of CapEx, and as far as cash taxes go, we are looking at roughly a 20% cash tax rate.

So no real diversions there?

Correct. The cash tax rate has actually crept up a couple of points over the past couple of years. When we first IPOed and stock options started to vest and get exercised, we saw a larger than normal benefit from stock option exercises as a deduction to our taxes, which has now leveled off. As such, that has been bringing the cash tax rate up a bit, impacting my cash flow.

And then just a quick question on pricing, just wondering, is the pricing environment similar to what we experienced, or are your expectations for '16 looking like '15? Should we expect to get the typical growth in revenue of around 6% similar to what we’ve gotten historically?

We’re actually being a little bit more conservative around pricing for 2016, just based on what we’re seeing in the marketplace. It’s still early in the year for us to fully vet out how everything will settle, which usually gets clearer toward the end of the first quarter. We're looking at more conservative revenue growth of about 3% to 4% as we model it due to everything that’s occurring in the economy these days.

And just finally, I know you gave the growth rates for the top customers. Do you happen to have those for the quarter on a constant currency basis for the different categories that you disclosed?

For the top 5 clients, the constant currency growth was not calculated for the actual quarter, but for the full year, the growth rates were 31% for the top 5, 30% for the top 10, and 27% for the top 20.

I just wanted to ask about what this means in our checks regarding client-specific response to the current environment, macro uncertainty, etc. It seems that the impact on demand and sometimes pricing is causing your cash flow terms to shift. Is this a broad concern or more client-specific?

It’s more of a broader statement. Historically, my payment terms have been around 30 to 45 days, but now many clients are pushing for 60 to 90-day payment terms, which has caused a noticed increase in our DSO. We are adjusting slightly in response because larger clients often have extended terms that have become the norm. That’s why you’re seeing a bit of upward pressure on our DSO with many larger clients.

Ark, I appreciate your commentary on the bigger picture. How do you see the evolving environment matching your product set and service portfolio? Are new investments needed, particularly in light of changing demands?

Ashwin, when you say at a high level regarding the investment required, what do you mean exactly?

Are you expecting to make more investments in products or platforms in response to market needs?

We’re making significant progress, but as you mentioned, this is a common trend where the landscape is changing rapidly. This level of investment required is very high, especially as we adapt to the rapid evolution of technology. As such, we must remain committed to expanding our offerings, particularly around areas like the Internet of Things, which we mentioned today.

What kind of headcount growth are you thinking about in '16 and what sort of utilization rate?

Headcount should be around 20% to 25%, and utilization should be around 77%. We always target getting into the 76 to 78 range, so we’re modeling right in the middle.

You’ve provided strong guidance in a difficult environment. Are you building some buffer into this? Are you accounting for risks of pricing pressure or clients pulling back temporarily?

We have high confidence in the numbers shared, but as I mentioned earlier, we are being a bit more conservative with our pricing estimates, given the current environment.

Can we get an update on Google? You discussed this extensively at the last analyst day.

It’s growing, but regarding specifics, I don’t think we can disclose details. It's currently our second-largest account.

Can you give specifics on growth expectations from UBS in '16?

We generally avoid sharing specific client growth expectations.

I want to talk about investments. If we look at your full 2016 guidance, the bottom line seems to be growing somewhat slower than the top line. It appears there may be implied year-over-year declines in operating margin. Is it fair to conclude that 2016 might see margins in the lower to mid-range of your 16-18% target?

Our overall guidance is positioned to come within that range. We are continuing with investments, and much of the outperformance that you observed in 2015 was partially assisted by favorable currency movements, which we don’t plan on factoring into our forecasts. We maintain a neutral stance concerning currency benefits, ensuring that our targets reflect our ongoing investments to support growth.

While you don’t assign client-specific projections, do you believe that growth rates within your top 5 or top 10 can be maintained in constant currency through 2016?

Absolutely. We feel confident in our strong client list and see numerous opportunities ahead for growth.

You can look at historical numbers; those ratios have remained stable over the last several years. Our assumption is they will continue to align in the upcoming years as well, though predicting individual outcomes can be challenging.

Any updates on recruiting and the employment landscape?

In general, we see wage inflation and attribution rates lower than in prior years. This reflects conditions in Eastern Europe, but the recruiting environment remains challenging and competitive, especially for the talent we seek.

Ark, you disclosed information on clients in the $20 million to $50 million range. Do you anticipate any of those clients breaking through the $100 million threshold? If so, what’s the timeframe?

I don’t think any will exceed the $100 million mark within the next year or two, but a couple have the potential for that type of business.

Regarding your 10% revenue share from new customers, can you outline potential verticals or geographies driving this?

It will closely align with our existing vertical focus. We are launching new products through sales while also leveraging capability acquisitions. This should be consistent with our historical numbers.

Unbilled revenue closed at $96 million this quarter, and accounts receivable reached $175 million.

I didn’t catch that number for unbilled revenue. Was it $96 million?

Yes, $96 million, down from $104 million in Q3.

I'm curious about the nature of your digital work. Are you reaching a point where you have platforms or solutions that can serve multiple clients, or is it still primarily project-based?

We’re indeed pushing toward something more productized. We have made strides with reusable assets, notably around wealth management and digital integration proposals.

How are you planning the growth of your India operations given its potential?

It will be more comfortable for us to discuss our plans as we grow and develop actual operations in India. We are aiming to replicate our technology profile from our global operations. We will notice a significant shift in more complex work offerings from this region.

Can you highlight where exactly you are seeing macro weakness?

I would say that macro trends are evident in competitor reports. Overall, we haven’t seen drastic changes, but unpredictability has increased, such as fluctuations in FX rates.

Does it seem there is a degree of conservativeness in your expectations?

We aren’t overly worried, but the level of unpredictability is indeed high.

What’s your view on how the Alliance acquisition is impacting pricing moving forward?

Our goal is to align pricing with EPAM standards. However, we will monitor how the integration rolls out and what market conditions arise.

How are you positioned as your largest customer consolidates its IT vendor list?

We are optimistic about our position and do not foresee any significant changes impacting our role.

Can you clarify which markets are expected to improve or decline in terms of labor sourcing in 2016?

None of our markets will decline. Every market we are currently in is seeing growth from a labor sourcing perspective. Some of our traditional markets, such as Belarus, continue to expand in headcount, while smaller locations like Poland and Hungary are likely to show faster growth percentages.

We’ve been diversifying away from former Soviet Union countries towards the European Union and globally into APAC, with growth in markets like China and India. There are no expected declines in any of these regions. As usual, thank you very much for spending time this morning with us. It was a good year, and we hope to prove that 2016 will also be a good year. I also want to remind you that we are organizing our second annual investor day on March 9 in New York City, where you can find more information about EPAM and client stories.