EPAM Systems Inc (EPAM) — Q3 2016 Earnings Call Transcript

Thank you, and good morning, everyone. Right now you should have received your copy of the earnings release for the company's third quarter 2016 results. If you have not, a copy is available in the Investors 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 risks and uncertainties as described in the company’s earnings release and other filings with the SEC. Arkadiy?

Thank you, Lilya. And good morning to everyone. Thanks for joining us today. Today we are pleased to share our results for Q3, climbing revenues to $298.3 million, which is up 26.4% over the third quarter last year and a 28.7% growth in constant currency and 6.2% sequentially. Last time we talked about some demand and pricing changes in the market and our anticipation of some level of downstream effects on several BFSI accounts and a few consumer clients. Today we can say that, along with our industry peers, we continue to experience some level of unpredictability due to the Brexit situation, which impacted our revenue by 2.3% due to currency headwinds on top of continued questions around its longer-term impact. On another side, despite this general challenges everybody is talking about, we at EPAM have seen continued demand for our services. The demand we see for complex technology solutions and business transformative services has been well balanced; consulting design, engineering, integration and managed services give us further confidence in our long-term strategy and our ability to bring anticipated solutions to our clients and in turn continue to support our industry revenue growth of over 20%. So Anthony will provide more detailed financial updates, but I want to share several important Q3 highlights, which will also apply to our free cash flow for Q4 and the full year. First, we continue to see more diversification in our client concentration, more so through new acquisitions, but also through increased expansion in our existing clients falling outside of our top 20 accounts where we saw a 43% growth rate, which is consistently higher than the overall company growth. Because of this our top 10 concentration grew by 5% to 37.6% from last year and now it’s down almost 6% to 48%. Turning to verticals, media and entertainment delivery showed a 40% growth over the past four quarters primarily fueled by continued expansion with clients. Our imaging vertical, which includes a variety of clients, continued its strong growth as well, up 56% year-over-year. As part of this emerging story, we are excited to partner with several leading private equity owners; we selected a pharma vendor for health portfolio company to drive a life scale transformation program, along with enabling high potential digital startups to scale. We believe that these partnerships have good potential to grow as we demonstrate our value. All of our verticals grew over 20% year-over-year with the exception of travel and consumer, which came in just under that due to decelerating growth in two large and highly penetrated accounts. Additionally, the currency impact driven by several large detail accounts in the UK continues to be relevant, but we do see strong growth outside our travel and consumer vertical, globally with a number of strategic accounts growing over 40% year-over-year. Overall, we view this as a positive trend towards better diversification, which aligns with our long-term strategy of maintaining a balanced approach across our verticals. This should allow us to continue generating topline growth while mitigating risks from over-concentration in specific markets. Looking to our global operations, we continue to invest significant resources in developing the right mix of delivery capabilities by hiring global teams of experts who possess the skills needed to meet demand. During Q3, our headcount grew to over 19,000 IT professionals, reflecting a 36.2% year-over-year increase. There are several reasons for this. First of all, there were several large-scale clients, including UBS, from whom we anticipated demand to increase. However, once indications emerged that demand would be delayed, they had already committed to hiring—often hiring a significant number of staff in anticipation of a ramp that ultimately did not happen. Additionally, we saw weaknesses in the growth prospects of some key accounts, leading to lower than anticipated utilization and revenue. We worked to address this lack by redeploying talent to different new client programs, while others remained in standby due to anticipated new wins over the next several quarters. This led to an imbalance in our utilization. Overall, utilization came in at 72% in Q3, lower than the historical average. We expect to see continued softness in utilization into Q4. We work to deploy available capacity strategically. This affects our EPS guidance adjustments and Anthony will provide more details on this strategy. We are dedicated to building a global company with an expanded presence in over 25 countries, strengthening our operations through the hiring of several new senior leaders focused on employee engagement and management programs. Larry Solomon will be leading this team; he has extensive experience from his previous role at Accenture. Our investments in delivery capabilities and quality personnel remain critical to ensuring that we are well-positioned to deliver on our commitments to our employees and customers. This remains a strategic differentiator despite the current challenging business environment, positioning us to grow revenues over the next several quarters. In closing, we are purposefully managing our utilization and seeing progress in operational metrics such as operating cash flow, working capital and lower attrition numbers. With continued focus and investment in building our global delivery teams, we aim to generate a 25% growth without significant scale. With this, I turn it over to Anthony for a detailed financial update.

Thank you, Ark, and good morning everyone. I'll start with some financial highlights, then profitability and cash flow, and end with guidance. As you heard in Ark's comments, our growth strategy is engineered to deliver consistent results and we have seen another strong performance in Q3. Here are a few key highlights: Revenue closed at $298.3 million, up 26.4% over Q3 of last year and 6.2% sequentially, representing constant currency growth of 28.7%. Geographically, North America remains our largest region, representing 56.4% of our Q2 revenues, up 34.8% year-over-year. Europe was up 19.3% year-over-year and 25.6% in constant currency, making up 37% of our Q3 revenues. APAC grew slightly and now represents 2.3% of our revenue, while CIS is flat year-over-year. In terms of profitability, GAAP income from operations increased by 22.1% year-over-year, representing 11.4% of revenue in the quarter. Our non-GAAP income from operations for the quarter rose by 19.9% over the prior year to $49.7 million, reflecting 16.7% of revenue. Our effective tax rate for the quarter stood at 21.3%. For the quarter, we generated $0.49 of GAAP EPS and $0.76 of non-GAAP EPS, which includes the tax impact on non-GAAP adjustments based on approximately $53.9 million diluted shares outstanding. Utilization challenges continue to affect our income from operations and EPS. Utilization ended lower than anticipated at 72%. Non-GAAP SG&A, excluding all stock compensation expenses, came in at 19.5%, slightly lower than last year. We continue to focus on leveraging our SG&A spend and executing our talent acquisition, workforce planning, and balanced management strategies for sustainable growth. Our attrition remains low at 10.4%. Turning to our cash flow and balance sheet, cash from operations for Q3 was $61.8 million, reflecting an 11% year-over-year increase. Free cash flows came in at $55 million, or 136% of adjusted net income conversion. Our cash flow improvement is partly due to our decreased Days Sales Outstanding (DSO). This quarter, our AR DSO was 58 days and our unbilled DSO was 25 days for a total of 83 days compared to Q2's total of 88 days. As we mentioned in past quarters, we implemented changes to improve our processes, which contributed significantly to this. We have a better process in place now but cannot predict whether Q3 levels will hold steady. Moving on to guidance, following our comments regarding macro demand pressures in the industry, our current outlook for Q4 revenue is expected to be at least $310 million, resulting in full-year revenue of $1.156 billion, a 26.5% increase over the prior year with constant currency growth of 29%. GAAP diluted EPS will be at least $0.54 for the quarter and $1.94 for the full-year. Non-GAAP EPS will be at least $0.78 for the quarter and $2.90 for the full-year. The $0.11 GAAP EPS drop in guidance is attributed to compounded effects of lower utilization across multiple quarters combined with FX losses on assets in foreign jurisdictions. The $0.07 non-GAAP drop in guidance is related exclusively to utilization challenges. Now, I'll turn it back over to Arkadiy for additional comments.

One more important comment. As we stated in our press release, Anthony, while he will be staying with us through the third quarter of 2017, plans to resign as the company's Senior Vice President, Chief Financial Officer and Treasurer at the end of this period. Anthony has been a key part of our growth and success over the past 10 years. We are thankful for that and wish Anthony all the best in the future. To ensure continuity, during the next quarters, Anthony will continue to assist us in our search for a successor and help guarantee a smooth transition. Now we can turn to the Q&A part.

Hi, guys. This is Maggie Nolan in for Anil. I was hoping that you could give us a little bit more color on the two travel requests that you're seeing some softness at, as well as the adjustment with your other top clients and the dynamics there?

I think we shared several notes this morning. First of all, there is impact on some financial services clients, which we discussed before, and some trends in the consumer sector that are noticeable. Certain results are coming from, again, just specific accounts - which we mentioned in the last call.

We can't really mention the clients if that's what you're looking for. I mean, there are two of our larger travel and consumer clients that are fully penetrated, and we're starting to see a slow down in the growth rates for those two accounts. But there's nothing concerning; they are still growing, just at a slower rate. There are a number of up-and-coming accounts within the vertical, but they are still relatively new and not material at this stage to offset the slowdown we're seeing in those two fully penetrated accounts. That dynamic is what's hitting us now, but we're still very confident about this vertical, and as these newer accounts begin to gain traction, growth should continue and we expect to get back to the levels we have seen in the past.

Okay, great. Does that help? Yes. That's very helpful. Thank you. And then the other question I had is how are you planning to address the utilization challenges moving forward, and how is this going to impact your hiring plans over the next couple of quarters while keeping in mind your long-term growth plan? Thanks, guys.

As we also mentioned this topic already, in general, we felt some long-term planning for a couple of accounts that didn’t materialize. We have excessive capacity in specific locations that we cannot utilize immediately, and we might take a decision not to rush but to seek opportunities through additional training. We will still continue hiring in locations where we plan to grow further. As a result, we found our utilization rates lower than expected. We plan to make the right assignments for this extra capacity to achieve more normal levels, which is probably 3% to 4% up. It’s difficult to say exactly when this will happen; it might take a couple of quarters, but that's what we're planning right now. The good part is that it’s a manageable process; it's not something we cannot control, just a choice to invest in people during this period.

Okay.

Thank you. Could you tell us what the organic revenue growth was in the quarter and expectations for organic growth in the fourth quarter? The Alliance acquisition is lapping in November; is there anything else that’s lapping?

Nothing else is lapping. For Q3, organic revenue growth was 21%, and organic constant currency growth was about 23%.

Okay. And I think Ark commented on expecting over 20% growth going forward; is that still a reasonable expectation looking out for 12 to 24 months based on the pipeline that you see you?

Yes, we believe that’s a reasonable expectation. Even so, these numbers are impacted by the same reasons that we have discussed today, including our utilization situation and certain locations which we couldn’t realize immediately. We believe we can continue growing at over 20%.

Is there anything changing significantly? I’m sometimes asked about Indian vendors and whether they're able to move up the stack and compete with you.

We feel the same way as before. The market is big, specifically in the subset of the market where we operate, and while everyone is improving, it generally impacts opportunities for growth.

Understood. Thank you.

Hi, guys. This is Amit Singh for Jason. Sorry to get back on this question again, but the utilization part; the long-term plans for certain clients that you saw did not materialize—were these clients primarily in the banking financial services sector? What does that mean for your revenue growth for next year? Is this revenue that you were expecting to come in that is not going to materialize now?

Yes, it was primarily in financial services. This might impact us over the next several quarters, but we believe the market is strong enough, especially in the areas we operate, to allow us to grow over 20%, which is our key message. It’s difficult to predict how specific clients will perform over the next quarter or two or next 12 months; we’re not relying on specific clients but rather on diversification across client balances, specific verticals where we are profitable. Our strategy remains focused on achieving growth over 20%.

Great. One quick question for Anthony; sorry to see you resign, but what is the duration of the non-compete that you have?

It will be 12 months from the time that I actually leave, which will be the actual non-compete period.

Okay, great.

I have no intentions of going to a competitor or competing with EPAM in any way. I actually intend to remain a shareholder of EPAM. The most of the reasons for my departure are related to personal business interests outside of EPAM.

Thank you very much.

Hi. Thanks. Is the standard 16% to 18% non-GAAP EBIT margin still achievable over the next couple of quarters, given what's going on with the utilization issue? If not, what is a realistic range to expect?

At this point, we are staying with that 16% to 18% range, but as you've seen this year and what I expect to continue in the coming quarters, we are feeling pressure that may keep us at the lower end of that range.

Right now, we feel that we have some room in utilization and we’ll be improving. Utilization is probably the strongest impact on this number, and unless the market changes drastically, we expect to remain within that corridor in the future.

Got it. In terms of your robust headcount increase, are you saying you are hiring in certain locations while clients don’t want resources based there?

No, we are saying there are several reasons for this, which is a broader situation. We committed to grow to meet expected demands in specific client engagements but were delayed a couple of times. As a result, we have excess capacity in specific locations where we had already begun hiring despite slower growth in others. This has created some disconnect in our utilization. We believe these issues are manageable.

Got it. Thank you!

Hi, good morning. Thank you for taking my question. I think in the beginning of the year you were talking about factoring 3% pricing increases for this year for 2016. Do you have any early indications about expectations for the next 12 months? Are we still talking about 3%?

I think we will share this with you next quarter; it’s too early for us to say right now.

Okay. And in the last conference call, you mentioned a little about pricing pressure; are you still seeing the same environment?

At this point, pricing is usually locked down in the first half of the year when you talk about renewals for existing accounts, and as new accounts come in, it's varied during negotiations. That hasn’t changed dramatically from what we discussed last quarter. We are still feeling organic constant currency pricing at just under 3%.

Thank you very much.

Hi, guys. This is Mike Reid on for Joe Foresi. Thanks for taking our question. I just saw that the euro ticked up to a percentage of revenues this period. Could you provide a bit of detail on the causes?

The euro hasn’t moved dramatically this quarter. It’s stabilized as a percentage of revenue for the past several quarters; that’s why I don’t see it as a significant increase.

Is it not on the stat sheet? It was up to 12% from about 9%.

Yes, but it's been running consistently in that 10%, 11%, 12% for quarters. There’s nothing significant moving the euro concentration; just normal contracting.

Okay, thanks. And the DSO down again—will that level be sustainable?

At this point, we're not comfortable stating that the Q3 DSO is sustainable. It dropped significantly due to efforts put forth over the past quarters. We will need a couple of quarters to see if this trend holds.

Right. Thanks, guys.

Hi. Anthony, could you repeat the as-reported versus constant currency performance in Europe?

Europe constant currency was 25.6% versus reported at 19.3%.

Yes, that’s what I was looking for. And regarding the tax rate, Anthony, I'm curious about your special economic zones, do you see any changes in taxation from that region going forward?

The special tax benefit we enjoy from Belarus affords us a tax holiday through 2021. That's the only current special tax regime we have. We expect our tax rate to be in the 21% range for the foreseeable future.

Got it. If I could—there may be some seasonality related to DSO in Q4?

Historically, we've had some Q4 seasonality where firms try to clear budgets and finalize payments by year-end. Thus, I'm hesitant to confirm trends until we've experienced a few consistent quarters. There’s a chance we could benefit in Q4 if these trends continue, but I’d like to wait and see.

Got it. Thank you.

Yes, hi. Thanks for taking the question. A couple of brief ones. First, regarding the pricing environment; I'm seeing non-GAAP operating margins down one percentage point year-over-year—is this entirely due to utilization issues, or is pricing affecting this as well?

Utilization is indeed the largest impact on our profit margins this year. There are other dynamics as well, such as increased offshore operations which naturally command lower price points compared to onsite services. Slight shifts in pricing structures due to acquisitions such as in India and China—those impacts add pressure as well. Therefore, I would say utilization is the top concern with additional pricing shifts being secondary.

Got you. Also, regarding your offshoring penetration, should we expect this price deflation to continue over the following quarters as offshoring increases?

That’s a good point. We expect the current pricing dynamics to remain as they are, particularly with more offshoring boosting lower price points. It will take time to see the long-term impact on profitability, though.

We plan to increase our onshore presence while slowly enhancing our offshore strategies; we’re committed to growing in these aspects.

Clear. Thank you. Can you also share a few thoughts about the UBS account—how demand is shaping up?

As we mentioned earlier, we can't make predictions about UBS. While there may be some slowing, it’s difficult to quantify right now. We focus on maintaining a balanced account and diversifying our business across industries.

Good morning. Thanks for taking my question. I understand Thomson Reuters recently announced a restructuring effort. Can you comment on the relationship with this large client?

Thomson Reuters is listed as one of our preferred vendors. Although it has logistical issues in the past, the growth of this account has far exceeded previous projections. Despite high variability in performance, we’re focused on diversifying our client relationships.

Does Larry Solomon's appointment indicate a strategy to build delivery capability in North America?

Larry has extensive experience, including global management. His last few years were focused in North America, which is beneficial, but he also understands the global market. His expertise will aid in our strategic objectives.

Hi, guys. This is Jason Washburn for Arvind. I just want to touch on the transition with Anthony leaving. Will there be an overlap for hiring a new CFO, and is the timeline extendable if needed?

The transition time frame is about nine months; I am committed through Q3 of 2017. We’ll begin the search immediately and are optimistic about finding a successor within that timeline.

If we experience difficulties in fulfilling this timeline, we can discuss options at that time.

Thanks, guys. That's it from me.

Thank you. Is there a way to look at the growth mechanics moving forward, perhaps comparing the growth rate of the top 20 clients versus the rest? It seems like we’re diversifying our client mix more than before.

Historically, the majority of our growth has come from clients outside our top 20; we’re seeing growth exceeding 40% year-over-year. The top 20 accounts are now growing, but at a lower rate, making deep client engagements more crucial for our forecasted over 20% growth trajectory.

Got it. Regarding the utilization issues, what steps are you taking to maximize workforce utilization while addressing the challenges? Should we expect headcount growth to moderate as you do so?

Yes, we believe headcount will moderate over the next couple of quarters to align with capacity utilization. We feel confident that this situation is manageable and will focus on deploying resources effectively.

Understood. By the way, I noticed that the attrition rate is on the rise; how does this relate to the demand from the larger customers?

This was likely in line with general parameters—1% or 2% volatility. We’ve been building up staff and may have more than necessary at certain points. Small shifts like this happen.

In the past, we discussed the 7% to 8% attrition as unsustainable; we expected to see an uptick as those unusually low numbers weren’t typical.

Got it. Great, thanks for that.

In terms of current FX impact––assuming the current spot rates hold, how might that look for Q4?

Thanks very much.

Hello and thank you for taking my questions. Could you comment on the financial services sector and the UBS account? Do you see any stabilization opportunities in the long term?

We believe there are still many opportunities in the financial sector but need to remain cautious about expectations of rapid growth. While we see potential growth, the situation remains uncertain at this point.

Thank you. Regarding your cash reserves, do you anticipate making any new acquisitions or diversifying vertically?

We have slowed down during 2016 not due to a lack of opportunities but rather to focus on further due diligence. We continue considering options for acquiring expertise to support our growth strategy without dramatically expanding our verticals.

Thank you.

Thank you everyone for joining. We addressed questions and in summary, we have had a challenging quarter based on utilization, but we are confident in our ability to continue growing. We hope to provide updates during the next call. Thank you very much.