EPAM Systems Inc (EPAM) — Q4 2016 Earnings Call Transcript

Thank you operator and good morning everyone. By now, you should have received your copy of the earnings release for the company’s fourth quarter and fiscal 2016 results. If you have not, a copy is available at epam.com in the Investor section. With me 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 may contain forward-looking statements. These statements are subject to risks and uncertainties as described in the company’s earnings release and SEC filings. Additionally, all references to reported results that are non-GAAP numbers have been reconciled to GAAP and are available in our Investor Relations materials in the Investor section of our website. With that said, I will now turn the call over to Ark.

Thank you David and good morning everyone. Thanks for joining us. I would like to start with a simple reminder that last week we had the opportunity to come back to the New York Stock Exchange to celebrate the 5th anniversary of our IPO and to ring the closing bell. We are proud to see today, five years later, that we have been able to successfully negotiate many challenges during that period. Moreover, we have continuously brought significant value to our clients, and some results demonstrate year-after-year strong growth despite geopolitical uncertainties, economic instabilities, and large global competitors who have just started to notice the EPAM brand recently. EPAM changed a lot during the past five years; we have more than tripled the company size, significantly expanded our horizontal and vertical capabilities, and started global diversification of our delivery locations. We also invest in developing needed corporate functions that practically didn’t exist before. So, at this point, I would like to state that today, five years later, we are very confident that EPAM is in a much better position to continue growing than we ever have been before. Looking back at the past, we feel especially proud to report that during the last year, we reached quite a milestone we could only dream about in 2012. Our annual 2016 revenue crossed the billion mark and reached $1.16 billion, which corresponds to 26.9% year-over-year growth, or 29.4% in constant currency terms. Additionally, it represents 24% organic growth in constant currency. Now, let’s move into more details about what happened with EPAM in 2016. In 2016, while traditionally benefiting from our strong engineering expertise, we continuously focused on investing in the quality of our technology practices, engineering productivity, industry accelerator, and maturity of our delivery processes and tools. The overall goal was not only to maintain our advantage in that area but also to differentiate ourselves against growing competitors with our ability to engineer and deliver products and solutions that meet demand across strategically targeted markets. During 2016, we continued to enhance our digital and data capabilities as well. Specifically, we were concentrating on our core engineering and technology practices, which allowed us to deliver a much broader array of programs compared to the past, ranging from commercial software project development to digital end-to-end platforms, and now to business in digital strategic executions. As confirmation of that, we would like to share that during the last year, we won six customer innovation awards in partnership with several of our top clients, including being recognized as one of the top digital agencies in Europe. We also received recognition in analyst reports for our increasingly comprehensive capabilities in driving agile digital transformation across all key verticals. In fact, we were named the leader in digital platform engineering services in a survey of Digital Platform Engineering Services in Q2 2016. Lastly, in 2016, we continued to expand our global delivery footprint, which provided very important hands-on experience in several new geographies and enabled us to better understand how to integrate and develop, benefiting from new global delivery within EPAM and for our clients. Now, turning to our vertical performance. In 2016, we had very strong growth across three of our six industry verticals included in Media and Entertainment, Life Sciences and Healthcare, and Emerging Verticals, all of which grew over 40%. We see very promising opportunities across all of those segments, where we have established a good presence, but still only at the initial stages of potentially significant growth this year. Financial services finished the year with 17% growth, which reflected a Q4 growth of 4.6%. It’s important to note that without the effect of UBS our growth in Q4 would have been 21.2% and over 30% for the full year in reported currency, which demonstrates a healthy growth of this segment across Europe, North America, and Asia. Travel and Consumer finished the year at 20.5%, which reflected a Q4 growth rate of 10.8%. We attribute this temporary slowdown to currency impact in the Euro Zone of approximately 5%. Retailers and consumer brands continue to show positive returns on investment in digital. In addition to completion of significant milestones in multi-year projects with two of our clients, as we expand our capabilities in this segment, we expect to deliver innovative solutions not only in platforms but also in business models, including helping our customers address digital disruption and support long-term growth here of over 20%. Lastly, our traditionally strong software and hi-tech portfolio grew 23% for the year, allowing us to reach this important segment's strategic target of 20%. Overall, the specification of our concentration continues to show a positive trend. For the year, our growth rate outside the top 20 accounts was 44.3% while growth in the top 20 was 12.5%. In terms of our people and talent development, we recognize the simple fact that we have to continuously invest in our people to stay relevant in the market. The commitment to talent is the single biggest factor in our sustained growth. At the end of 2016, we brought on board a senior HR and talent leadership team to elevate our client management and engagement functions with new roles. This should allow us to create a more growth-oriented environment with diverse multi-cultural talent, and in turn, well position the company to hire new, highly skilled, multi-disciplinary, hybrid teams capable of taking on the most complex technology challenges and delivering the most innovative solutions for the industry. We also continually innovate in our internal employee engagement software system and in engineering tools and practices. We invested significantly in 2016 in internal training initiatives through a network of collaborative global events as well as in-person and online courses. As a result of all these efforts, we believe that EPAM today is better positioned to continue hiring and developing our global talent. Specific to headcount, in Q4 we ended with over 19,680 professionals, which is a 22% increase year-over-year. Before I turn the call to Anthony for an update on our financials and 2017 outlook, let me cover a few other tactical points that we focused on during our previous update three months ago. First of all, regarding UBS: in January we announced strategic agreements with UBS which extend our nine-year relationship with them for the next three years. This agreement, worth more than $300 million, allows EPAM to continue focusing on innovative end-to-end solutions, which should help our clients reduce time-to-market and improve their ROI on technology investments. Now, regarding utilization, we have made significant improvements since last quarter, finishing Q4 at 75.9%, which is almost a 4% improvement compared to Q3. We still are not at the level we would like to be, but we are very optimistic in our ability to reach a more normalized level in the first half of 2017. With that, let me turn it over to Anthony for a detailed financial update for 2016 and our 2017 guidance.

Thank you Ark and good morning everyone. I will start with some financial highlights, talk about profitability, cash flow, and then end on guidance. As Ark mentioned, we are pleased with the quarter having delivered strong top-line performance, generated significant free cash flow, and improved our utilization. Here are a few key highlights from the quarter: Revenue closed at $313.5 million, which is a 20.5% increase over our fourth quarter of last year and 5.1% sequentially, representing a year-over-year constant currency growth of 22.8% and organic constant currency growth of 20%. From a geographic perspective, North America, our largest region, representing 58.7% of our Q4 revenues, grew 26.8% year-over-year. Europe, representing 33.9% of our Q4 revenue, grew 12.3% year-over-year or 19.3% in constant currency. CIS grew 14.4% year-over-year and now represents 4.2% of revenue, while APAC decreased 2.8% and now represents 2% of our revenue. Moving down the income statement, gross margin for the quarter was 36.8%, compared to 39.2% for the same quarter last year. The primary driver for this decrease was utilization, which ended at 75.9%, compared to 78.8% in the same quarter last year, although it was an improvement from the 72% in Q3 of this fiscal year. This quarter's utilization reflects our continued efforts in balancing supply and demand across our business. Non-GAAP SG&A, which excludes stock compensation expenses and certain other items, came in at 20.2%, compared to 21.3% in the same period last year. We continue to leverage our SG&A strategically, focusing on talent acquisition, workforce planning, and balancing the bench while hiring functional management to bring value to our long-term sustainable growth strategy. GAAP income from operations increased 17.7% year-over-year to represent 11.9% of revenue for the quarter. Non-GAAP income from operations for the quarter increased 9.7% over the prior year to $51.5 million, representing 16.4% of revenue. Our effective tax rate for the quarter came in at 22.7%, driven by a shift in the geographic mix of revenues, and for the quarter, we generated $0.46 of GAAP EPS and $0.77 of non-GAAP EPS, which reflects the tax effect on non-GAAP adjustments and is based on approximately 53.4 million diluted shares outstanding. Turning to our cash flow and balance sheet: Cash from operations for Q4 was $53.7 million, compared to $11.8 million in the same quarter last year. Free cash flows came in at $44.3 million, resulting in an adjusted net income conversion ratio of 108%. Our strong quarterly performance and ongoing DSO improvements were the primary factors in the strong free cash flow performance. This quarter our AR DSO was 59 days, and our unbilled DSO is 18 days for a total of 77 days, compared to a total of 95 days in the same quarter last year, which is driving most of the cash flow improvements. We expect DSO to normalize in the low-80s during fiscal 2017. Let me sum up or finish the fiscal year: Revenues for the fiscal year closed at $1.16 billion, demonstrating 26.9% growth over 2015, which represented a constant currency growth rate of 29.4% and makes fiscal 2016 a milestone year for EPAM as we crossed the 1 billion revenue mark. Organic constant currency growth for the full year is 24%, further demonstrating our ability to drive growth through an ongoing challenging marketplace. GAAP income from operations increased 26.2% year-over-year to represent 11.5% of revenue for the year. Our non-GAAP income from operations increased 20.9% over the prior year to $191.8 million, representing 16.5% of revenue. Our effective tax rate for the year was 21.5%, and we generated $1.87 of GAAP EPS and $2.90 of non-GAAP EPS, based on approximately 53.2 million diluted shares outstanding. Cash from operations for the year was $164.8 million, compared to $76.4 million for fiscal 2015, while free cash flow came in at $135.5 million, or 88% adjusted net income conversion. Turning now to the guidance: We expect revenue growth for fiscal 2017 of at least 20%, factoring in approximately 3% estimated currency headwinds, meaning we expect constant currency growth to be at least 23%. We anticipate GAAP income from operations to be in the range of 12% to 14%, and non-GAAP income from operations to be in the range of 16% to 18%. We expect our effective tax rate to be at least 19%. This reflects the adoption of the stock-based compensation pronouncement, ASU 2016-09, which will be effective January 1, 2017. For earnings per share, we expect GAAP diluted EPS to be at least $2.45 for the full year, and non-GAAP EPS to be at least $3.38 for the full year. We anticipate a weighted average share count of 54.8 million fully diluted shares outstanding. For Q1 of fiscal 2017, we expect revenues to be at least $315 million, reflecting a growth rate of at least 19%, after accounting for 3% currency headwinds, meaning we expect constant-currency growth to be at least 22%. For the first quarter, we expect GAAP income from operations to be in the range of 10% to 11%, and non-GAAP income from operations to be in the range of 15% to 16%. We expect our effective tax rate to be at least 20%. For earnings per share, we anticipate GAAP diluted EPS to be at least $0.49 for the quarter and non-GAAP EPS to be at least $0.72 for the quarter, with a weighted average share count of 53.9 million fully diluted shares outstanding. Finally, a few key assumptions that support our GAAP to non-GAAP measurements: Stock compensation expense is expected to be around $55.4 million, with $13.4 million in Q1 and $14 million in each remaining quarter. Amortization of intangibles will be about $7.5 million, or approximately $1.9 million per quarter. FX assumptions are expected to be around a $7 million loss for the year, with $1.6 million in Q1 and $1.8 million in each remaining quarter. The tax effect of non-GAAP adjustments is anticipated to be $18.8 million for the year, with $4.2 million in Q1 and $4.9 million in each remaining quarter. With that, let me turn the call back to Ark.

Thank you, Anthony. A few points before we turn to Q&A. Our 2017 outlook reflects the continuous strong demand for our services. We should expect the markets we serve to be disrupted and go through natural cycles. At the same time, we are very confident that our strategy of combining our traditional technology and engineering advantages with our proven capabilities in digital transformation, design, and emerging consultancy should enable EPAM to responsibly mitigate these events and drive results from a business that has very solid fundamentals in our view, with industry-leading growth rates. With that, let me turn the call back to the operator for Q&A.

Darrin, are you on mute?

Hi, I was wondering, Ark, if you could provide an update on what you had discussed regarding the supply-demand mismatch on the Q3 call. From your guidance, it seems like it will still have some impact in Q1, and then it should return to normal. So part of the question is to get that update, and part of it is what can you do in the future to prevent this sort of thing from happening?

Okay. Thank you for your question. Just to remind everyone, the mismatch was mostly driven by two components. One of them was UBS's change in plans for future growth and our preparedness to provide services by hiring people in specific locations for that client. The second was our integration processes and the new experience with operating in new geographies. Between these two factors, we experienced a mismatch. We decided not to reduce headcount because we know that growth is ongoing. There is relatively strong demand, and we don't need to hire more people one quarter later anyway; thus, we decided to continue investing in talent. That mismatch began to appear not just last quarter but in the second part of the previous year. As we mentioned today, Q4 actually performed about 4% better in utilization compared to Q3. At the same time, it will take probably another quarter to get back to normal, maybe even two quarters, so it's difficult to predict. Fortunately, there is a right approach to eliminate these issues in the future, but it is a challenging equation because it does not fully depend on us. There is some level of unpredictability in client situations in the market. To be honest, this type of occurrence can happen anywhere in the world. There is a relative volatility in utilization that depends on specific clients. When it's a major client, it tends to be more noticeable, but as mentioned, we are paying much more attention to this. We have also brought in additional experienced people from outside who have dealt with similar issues on a bigger scale, and we hope to manage this much more closely right now. So that’s all I can share.

No, that's good. Thank you. And then the other question I had—actually, I have quite a few questions, so let me quickly ask about free cash flow. Should we expect roughly a 90% conversion rate again this year? Also, I noticed that there is a lot of healthcare-related hiring and capability enhancement at EPAM. I was wondering if you can provide an update on that specific vertical?

You mean in Life Sciences and Healthcare? We are quite optimistic about this area. We started focusing on it two years ago, and as we stated today, it’s growing strongly right now at over 40%. At the same time, it’s relatively small because Life Sciences and Healthcare only accounts for 10% of our business today. However, we are certainly very interested in this sector and plan to invest in it further. We are looking to build additional expertise and consider developing some consultancy around it. Overall, we think this is a significant growth area for us.

And regarding your question on cash flow at the beginning, we don’t provide specific guidance at this point around cash flow or cash flow conversion. Clearly, 2016 saw improvement driven primarily by the improvements in DSO. We are continuing to stabilize and normalize DSO, and in the future, we might discuss guidance around that number. But at this point, we are just issuing a DSO guide, which is to be in the low-80s, based on our expectations. We are working on cash flow, but possibly sometime in the future we can give guidance on free cash flows and conversion.

Got it. Thank you, guys.

Good morning, guys. I just wanted to start with a question about the underlying assumptions in the 2017 guidance, specifically regarding pricing, utilization, and revenue growth at UBS.

Sure. For pricing, we are anticipating low single-digit growth, around 2% to 3%. This is in constant currency, and in reported terms, it will likely be zero or possibly less than zero given our currency assumptions. For utilization, our guidance remains the same—we are aiming to get it back into the 76% to 78% range.

This will probably be clarified during the deal discussions.

Are you anticipating any share loss within the UBS account?

All we can share is that we have this deal, which actually brings stability and predictability for us. While it’s very difficult to forecast, right now, it looks quite stable, and we are optimistic.

Okay. And then just on the margin side, I think the EPS in Q4 came in just a hair below what you were targeting. It sounded like utilization came in about as expected, with a nice quarter-over-quarter improvement. Was there anything else you would call out regarding margins that fell short of your expectations in Q4?

No. Margins turned out mostly aligned with what we discussed last quarter. Nothing else short of expectations.

Okay, and just one last quick question for me. How much movement was there in the top 10 accounts during 2016? How many of those top 10 in 2016 do you anticipate will remain in that position for 2017, and will there be new high-growth accounts in the top 10?

There is relatively small volatility in this area. We expect two or three accounts from the second dozen to make it into the top 10, which is normal. We didn’t lose any accounts from this combination, although there is always some replacement as the bottom two, three, or four accounts tend to move between the top 20.

So nothing outside of the normal course. Every year, we have some movement, and we don’t expect anything different in 2017.

Okay. Thank you.

I would like to comment because I think it would be multiple equations regarding concentration and top line. Just a reminder: looking back five years to 2012, Thomson Reuters was a prominent client for us, and at that time, it was possibly as large of a proportionate share as UBS or maybe even larger. The second-largest client was two or three times smaller. Over time, Thomson Reuters moved out of our top five, yet we continued to grow and balance revenue streams. Today, after that volatility, we are still maintaining a healthy concentration.

Okay. Thank you; that's helpful.

Hi, thank you for the incremental disclosures, Anthony, regarding the financials. I wanted to ask, Ark, in your prepared remarks, you mentioned that you completed some milestones with two clients, which I thought were in the consumer vertical. Did I get that right? Could you repeat what you said about that?

Yes, you’re right. I mentioned that our temporary slowdown in the Retail and Consumer vertical was due to several reasons, including the completion of two significant programs.

Would you anticipate a return from those customers on projects, or are you moving on? How should we think about that?

Those projects are ongoing, though we may see a temporary slowdown before new initiatives arise. We are optimistic about starting new programs or engaging new clients, making this situation fairly temporary.

Thank you.

Thanks, guys. Just a question regarding organic assumptions versus inorganic for 2017, and a bigger picture query around deal activity, particularly around tuck-ins related to digital capabilities. You've always done this in the past, but it's been a bit slow on that front. Can you touch on this at a high level, while also discussing what you're aiming for in the pipeline?

First, our guidance for 2017 is organic growth—anticipating at least 20%—with 23% in constant currency. We are achieving strong organic growth, so we are not factoring in acquisitions into these numbers. Regarding the comment you made about digital not growing rapidly enough, I believe that we have sufficient digital revenue at over 70%. Could you clarify your concerns about this?

Our M&A strategy has not changed; 2016 experienced light activities, not for a lack of effort, as we have a pretty robust pipeline. We evaluated several companies through due diligence last year, but none came to fruition for various factors. We are still actively seeking capabilities and looking for tuck-in type deals, so nothing has changed.

As Anthony mentioned, it's tough to project, as the situation can be quite binary. We're looking for good opportunities; we have a solid pipeline.

I appreciate that, and just one last quick follow-up: regarding immigration reform, which has been discussed frequently lately, you’ve mentioned it’s not as material for you due to the size of H-1Bs. Could you please refresh us on your position?

It's early to understand the specifics of any changes under consideration, and making speculative assumptions at this point is premature. However, we have just over 100 individuals on H-1B visas out of approximately 1,300 billable consultants in the U.S. So, under 10%.

So you could manage that in terms of shifts in resource mix, if necessary.

That’s correct.

Thank you, I’ll return to the queue.

Thank you. Can you help us understand the growth guidance composition for 2017? Specifically, the expected contribution to growth from top five, ten, twenty accounts, and how that may compare with prior years due to changes like the UBS dynamic?

Clearly, the UBS growth will be quite different now than in earlier years. However, it’s challenging to quantify as there are multiple dynamics with various clients. We are confident in our strong client base among our top 100 clients with many Fortune 1000 and Fortune 2000 clients where our revenue share is low, indicating significant opportunities available for us.

Given that reducing reliance on top clients typically has a favorable margin impact, should we expect the same outcome as we move through 2017?

I’m not sure the margin is directly correlated to shifting from top clients. I noted earlier about the Thomson Reuters case and how we effectively balanced that shift while maintaining growth.

Yes, utilization certainly contributes. 2016 saw unusually low utilization, and we can expect pick-up in that area, which will help margins. However, we must also strike a balance regarding continuous investments into the business to ensure sustained growth.

Currency impacts significantly influence margins, as seen in the market volatility with the euro and pound in prior years compared to our delivery locations.

Understood. Thank you for clarifying that. Additionally, regarding the visa situation, although you aren’t heavily dependent on them, we understand you have previously considered increasing U.S. staffing levels. How is your thinking evolving on this topic?

We acknowledge that we are focusing now on making EPAM a more attractive employer for individuals coming from varied locations. Thus ,our investment in talent management and acquisition across North America and Europe is a vital response to address any potential risks. While historically, we have had a low proportion of onsite versus offshore resources, we are strategically increasing this metric but remain capable of working effectively in a globally distributed setting.

All right, very good. Thank you.

Hey guys. A couple of questions focused on the 2017 guidance. If I may rephrase the question, Ark and Anthony, what would you say are the top one or two challenges in achieving the 20% guidance?

In general, the business model in services tends to be quite straightforward; however, balancing various variables is critical. Our fundamentals are strong, and in 2017, I expect the same challenges as in previous years, specifically balancing client demand with the right talent in appropriate locations and at the right time. Currency and geopolitical conditions are also concerns, but we've navigated through these for the last three years. Overall, we have been reputable and vigilant in management.

So your stance is essentially that it’s business as usual; the same issues will persist in 2017.

Yes, we believe that given the size of our company today, configurations of capabilities, and client demand we currently see, we have excellent opportunities for growth, and we are very confident in that.

Right. As a follow-up, when looking at the 2017 outlook, is there a specific focus in geographical hiring as you build out the year?

This aligns with our previous performance. We remain optimistic regarding growth capabilities and opportunities in Eastern Europe, improving capabilities in India currently. In China, we mostly operate in market capabilities, but we are starting to deliver for global clients. We will continue to focus on North America and Western Europe, and we will also make strides to increase the proportion of in-market resources.

Perfect. Best of luck in 2017, guys.

Thank you.

Hi. Can you provide an update pertaining to spending in financial services, specifically on that vertical? Are there any identifiable impacts from political changes in either Europe or the U.S.?

We provided comments earlier regarding growth percentages in financial services that do not include UBS. It’s clear that without UBS, we achieved around 22% growth, despite currency headwinds. We remain enthusiastic about this vertical, having invested significantly in special competencies like payments; hence, we have an array of projects in motion.

Understood. Regarding UBS, while you won’t provide specifics on this client, can you comment if any concessions were made during the three-year deal? For instance, were there discounts involved for minimum volume commitments?

All I can say is that our expectations are quite aligned with our historical metrics around this account. We’ve made this deal, which allows us to enjoy stability and predictability moving forward.

Sure. One last question for me: how are things looking on the labor front? Are you having difficulties finding talent at this stage, particularly given your concentration in Eastern Europe? What about wage increases and attrition rates in that area?

This is closely tied to our business fundamentals; we’ve mentioned this in each call. My usual response is that there are no new challenges regarding talent acquisition. At this stage, it’s been an ongoing challenge for the last 20 years across various locations. We are actively investing in training and have expanded our geographical footprint, and we believe we are effectively addressing these challenges, as demonstrated by our growth over the past five years.

Thank you.

You mentioned pricing this year will remain fairly flat. What’s happening with wages, and will you see any margin pressure if wages increase?

Wage inflation is targeted to remain around 3%. We expect it to be balanced with our pricing strategy, which is projected to stay stable. Hence, there shouldn’t be significant margin pressure.

Any update on the CFO search?

We’re in the search process and progressing well; we’re evaluating several candidates currently. I don't have further updates to provide at this moment.

Understood. Finally, regarding marketing, this used to be a largely word-of-mouth business. How have your sales and marketing initiatives matured?

Firstly, word-of-mouth in the services business can be quite advantageous; there’s less need for countless clients when we could effectively manage a few good ones. Over recent years, it should be apparent to those following us how the marketing function has changed, and that our analyst recognition has improved dramatically. The brand is now well-known, and our business development functions have also evolved positively. We’re combining referrals with strong analyst recognition in Forrester and Gartner reports to show a significant change.

Thank you.

Hi, guys. Thanks for taking the questions. I have three quick ones. Firstly, how much of the UBS contract is factored into the FY 2017 guidance? Is that something you can share?

We have included our expectations for the UBS contract in the guidance—it's all factored into the broader projections.

Can you provide your views on the pricing environment? If we exclude utilization and normalize for that, would you expect gross margins to remain relatively stable year-on-year?

Yes, I would expect to see stability in gross margins. Pricing and wage inflation are relatively balanced, and this will allow us to maintain stability absent major changes in utilization.

Lastly, could you comment on the potential impact on EPAM’s effective tax rate if U.S. corporate tax rates change? For example, if the rate dropped from 35% to 20% or even 15%?

It's quite difficult to say, given that all of this is primarily speculative at the moment. We are monitoring developments closely, but it’s too early to assess its potential impact.

Understood. That's all from me.

Operator, I think we have time for one more question.

Good morning. My first question is how much of your business in financial services is attributable to regulatory and compliance work? What impact might deregulation have?

About 20% of our work in financial services is regulatory-related, and we don’t anticipate significant shifts based on current visibility.

Will the rate of shifting billable employees between delivery locations change in 2017?

No, there will not be aggressive shifting of billable employees, as it hasn't been historically important. In our case, it remains stable.

Thank you.

Firstly, we look forward to seeing you at our Annual Investor and Analyst Day on March 14th in New York City. I want to confirm that we are confident and have addressed the questions raised during the call. Thank you for attending, and if you have any questions, David should be able to assist.