EPAM Systems Inc (EPAM) — Q1 2017 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 first quarter of fiscal 2017 results. If you have not, a copy is available at epam.com in the Investors Section. With me on today's call are Arkadiy Dobkin, CEO and President; Anthony Conte, Chief Financial Officer; and Jason Peterson, Senior Vice President of Finance. Before we begin, I'd 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 investors materials in the Investors Section of our website. With that said, let me turn the call over to Ark.

Thank you, David, and good morning, everyone. Thanks for joining us. Let us start with the main highlights on EPAM overall performance in Q1. Revenue for Q1 was growing strongly across our business, coming in at $324.7 million representing a 22.7% year-over-year growth and 23.9% constant currency growth. From a vertical perspective, all our industry segments, with the exception of financial services, were up more than 20% organically in constant currency terms. In reporting currency, Software and Hi-Tech grew 21.4% for the quarter, with demand coming from high-end product development services we provide across a number of our key clients in this vertical as well as fast-growing startups. Media and Entertainment grew 50.9%, due to the demands related to enhancing end-user capabilities as well as extending the consumer e-commerce experience. Life Sciences and Healthcare had growth of 28.7%, which was driven by the expansion of our engagements into commercial and enterprise IT environments. Additionally, our expertise in data sciences and genomic data continues to make us a partner of choice across all life science clients, which increasingly focus on translational informatics and precision medicine. Travel and Consumer finished the quarter at 18.9% or 21.8% in constant currency. This demand coming from digital transformation projects as well as data-driven insight programs. Financial services finished the quarter with 4.9% growth, which, as you understand, reflects the effect of the UBS revenue trends we discussed during our last couple of calls. Finally, emerging verticals had 45.1% growth driven mostly by energy and telecommunications. From geographical points of view, in both North America, which represents 58% of EPAM market today; and Europe, which is 35.2%, our organic growth was over 24% in constant currency. And in the CIS region, revenue was growing over 20% in constant currency terms as well. It'd be also worth mentioning that in Q1, our client portfolio across Fortune 2000 companies reached 120 customers, and now is the most diverse it has ever been at EPAM. This reflects our ongoing focus on the well-balanced growth of our client base across the industries and geographies. For this quarter, our growth rate outside the top 20 accounts was 34%. Growth in the top 20 accounts was 12%, and, excluding UBS, top 20 growth was 20.1%. Several other points I would like to address upfront. On UBS, we do believe the account is stable at this point and we saw a slight sequential growth this quarter. It is also worth mentioning that excluding the effect of UBS, our financial services would be growing 19.7%. Utilization and people. As we said before, we plan to focus on utilization during the first half of 2017. Today, we can say that we are on the right track with 77% utilization, which is where we expected it to be. Specific to headcount in Q1. We ended with over 19,678 professionals, a 15% increase year-over-year, bringing our total employee headcount to 22,400 people. Raising headcount reflected our ongoing focus on driving utilization improvements. On profitability, upsetting our strong revenue performance in Q1, we did have a few unanticipated items, which weighed on our margin and overall profitability. Anthony will provide more details in his comments. Overall, our Q1 results have placed us on solid start for the fiscal year. It also demonstrated broad-based growth across our verticals, which underscores the relevance of our capabilities to the clients and EPAM continues focus on investing in the quality of our technology practices, engineering productivity, industry accelerators and maturity of the delivery processes and tools, as well as broadening the overall service verticals we bring to the market. In short, this result reflects well our ability to respond to such market demand as professional product development needs enabled with EPAM unique core engineering and delivery capabilities. Digital transformation needs for large enterprises to re-envision their existing businesses as well as to develop new lines of businesses to sustain current positions while being able to continue addressing the attacks of disruptors in their respective markets. Lastly, constant search for partners for innovation. In an effort to create differentiated IP and new software-driven products and business models, and applying technology to radically optimize today's operational environment. In other words, to become disruptors in their own or new markets. The market trends we generated those demands continue to be the backdrop of both our growth and what is driving our clients' agenda. As they transform their businesses to remain competitive in the fast-paced and dynamic environment. Moreover, it is forcing us as a company to transform ourselves to satisfy such demands even faster than we ever expected to do before. I think we'll talk on this topic in more detail during our Investor Day next week in New York. With that, let me turn it over to Anthony for a detailed financial update for our Q1 results and our fiscal 2017 guidance.

Thank you, Ark, and good morning, everyone. I'll start with some financial highlights, talk about profitability, cash flow and end on guidance. As Ark mentioned, we delivered strong top-line performance and generated significant free cash flow in the first quarter. Here are a few key highlights from the quarter. Revenue closed at $324.7 million, 22.7% over the first quarter of last year and 3.5% sequentially. Year-over-year, constant currency growth of 23.9%, reflecting 1.2% of headwinds less than anticipated. Actual revenues compared to our Q1 guidance benefited from stronger revenue production of $5.1 million and more favorable currency impact of $4.6 million. From a geographic perspective, North America, our largest region, representing 58.3% of our Q1 revenues, grew 24.2% year-over-year; Europe, representing 35.2% of our Q1 revenue, grew 19.6% year-over-year or 24.9% in constant currency; APAC grew 3.5% and 6.1% in constant currency and now represents 2% of our revenue. Lastly, CIS grew 43.1% and 20.3% in constant currency and represents 4.5% of our revenue. Moving down the income statement; gross margin for the quarter was 36% compared to 36.7% for the same quarter last year. The 70 basis point year-over-year decline was primarily driven by 1% impact from foreign exchange, meaning in constant currency terms, gross margin would have been 37%. Utilization ended at 77.5% compared to 76.7% in the same quarter last year and 75.9% in Q4. GAAP SG&A was 24.2% compared to 23.3% of revenue in Q1 fiscal 2016. Included in this quarter's SG&A was an unexpected $1.9 million facility construction-related expense as well as higher stock compensation expense related to the recent growth in the stock price. Non-GAAP SG&A excludes all stock compensation expense and certain other items came in at 20.8% compared to 20.5% in the same period last year. We continue to leverage our SG&A spend strategically, focusing on talent acquisition, workforce planning, balancing the bench, and hiring functional management who can bring value to our long-term sustainable growth strategy. GAAP income from operations growth was 2.1% year-over-year, representing 9.5% of revenue in the quarter. Non-GAAP income from operations for the quarter increased 14.6% over the prior year to $49.3 million, representing 15.2% of revenue. Our effective tax rate for the quarter came in at 17.3%, the lower-than-expected tax rate was a result of the adoption of the new pronouncement, which generated a greater than expected tax benefit to the higher level of exercised options. Our non-GAAP effective tax rate is 21.9%, which excludes the impact of this pronouncement. For the quarter, we generated $0.44 of GAAP EPS, which reflects a higher-than-expected stock compensation expense related to the increase in our stock price in addition to higher FX losses than planned. Non-GAAP EPS was $0.72 based on total shares outstanding for Q1 of approximately $53.9 million. Turning to our cash flow and balance sheet. Cash from operations for Q1 was $31.2 million compared to $10.9 million in the same quarter last year. Free cash flow came in at $25.5 million, resulting in an adjusted net income conversion ratio of 65.5%. Total DSO was 77 days compared to 94 days in the same quarter last year. AR DSO was 49 days and our unbilled DSO was 28 days. We continue to be pleased with the improvements in these areas and would expect DSO to normalize in the low 80s during fiscal 2017. Turning now to guidance. Revenue growth for fiscal 2017 reflects an updated foreign exchange headwinds assumption of 2% and revenue growth will now be at least 21%. We expect constant currency growth to continue to be at least 23%. We expect 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%. For earnings per share, we continue to expect GAAP-diluted EPS of at least $2.45 for the full year and non-GAAP EPS to be at least $3.38 for the year. We expect a weighted average share count of 54.8 million fully diluted shares outstanding. For Q2, revenue will be at least $340 million for the second quarter, reflecting a growth rate of at least 20% after 2% currency headwinds, meaning we expect constant currency growth to be at least 22%. For the second quarter, we expect GAAP income from operations to be in the range of 11% to 12% and non-GAAP income from operations to be in the range of 16% to 17%. We expect our effective tax rate to be at least 19%. For earnings per share, we expect GAAP diluted EPS to be at least $0.55 and non-GAAP EPS to be at least $0.80 for the quarter. We expect a weighted average share count of 54.3 million fully diluted shares outstanding, with a few key assumptions supporting our GAAP to non-GAAP measurements. Stock compensation expense is now expected to be approximately $14 million in Q2 and $12 million in each remaining quarter. Amortization of intangibles is now expected to be approximately $1.9 million in each remaining quarter. FX losses are now expected to be approximately $2 million for each quarter. Lastly, the tax effects of non-GAAP adjustments are now expected to be approximately $4.6 million in each remaining quarter. With the recent adoption of ASU 2016-09, as a result of momentum on our stock price, we expect future volatility in our effective tax rates and GAAP EPS. With that, let me finish with a few thoughts. As most of you know, this is my last earnings call with EPAM. I've enjoyed meeting many of you and appreciate your interest and support in EPAM. I'm very proud of all the accomplishments our employees and all the work that we do for our clients. While this will be my last earnings call, I will remain at EPAM, working closely with my successor, Jason Peterson, for a smooth CFO transition as he takes on the role May 10. Thank you. And now let me turn the call back to Arkadiy.

Thank you, Anthony. At this time, I'd like to thank you for your dedication, commitment, and leadership over the last 10 years. Speaking on behalf of the global EPAM team, we wish you all the best in your future endeavors. That said, I think we're ready to take some questions. David?

Thanks, Ark. I'd like to ask that each of you keep to one question and a follow-up to allow as many participants as possible to participate. Operator, would you provide instructions for those on the call, please?

Hey guys, thanks. Good solid start for the year. Can we just get some color on what sort of assumptions that we have in the model right now for the year in terms of pricing and then wage inflation, these are the two assumptions. And then, as a follow-up, what should we expect for UBS and then the dilution from the India-based acquisition this year?

Sure. Pricing, basically, we're seeing kind of stable pricing in line with the expectations and what we've seen over the past couple of years. So no real change in our pricing assumptions from anything we've discussed in the past. And wage inflation, we are talking about approximately 4% is the wage inflation figure that we were figuring in for the year.

Yes. And then…

And then, Moshe, what was the second half of that question?

What should we look for UBS this year? You said it was slightly up sequentially. And then are we getting to that inflection point where the dilution from India kind of subsides or not yet?

We don't give specific guidance on any clients. So we're not really giving any specific guidance around UBS. And as far as India...

So India, the Indian part has already been taken into account in our guidance, so I don't think we can add anything. So we're working together with growing accounts and bringing services from India into EPAM, but I don't think we can give any specifics or numbers or whatever.

It's all baked into our model and our guidance.

Alright. Thanks, Anthony and good luck.

Thank you.

Hey guys, congrats from my side too. So one big picture question, Arkadiy and Anthony; you started off a good quarter. Sounds like the tone is pretty positive, why not raise the full year guidance on the top line?

We have seen positive impacts from foreign exchange this quarter, which contributes to our overall revenue performance. It is still early in the year, and there is considerable volatility in the market with many uncertainties. This is why we feel confident maintaining our current guidance at this time.

So just a degree of conservativeness and you just want to see how the year plays out?

It's our regular degree of being realistic, so let's not talk about conservativeness at this point.

And just to point out, the Q1 overperformed, Anil, is really only 1.5%. So you're not talking about, if you exclude the currency, you're not talking about a huge overperformance that would drive some really higher expectations for the full year beyond what we've already put in there.

As a follow-up, Arkadiy, you mentioned that UBS appears to be stabilizing and that there was a bit of sequential growth. What is your outlook for UBS this year? Do you believe you have better visibility now, and what makes you confident that it has stabilized at this point?

First of all, all we can share on UBS in more or less certain terms is that what we shared in press release when we said about our $300 million plus contract over the next three years. This has worked more or less certainly. So right now, we do believe that the account stabilized because we're seeing that we're not dropping revenue anymore, and we have some good visibility. But at the same time, let's not forget that last year, all this happened just in one month, and we were thinking about one scenario for H2, and then this happened, completely different scenario. So that's why I'm reporting back to being realistic at this point at this stage of the year.

Alright, good. And congrats and Anthony, best of luck on the next feat.

Thank you, Anil.

Hi, this is Mike Reid, on for Joe. Thanks for taking our question. Did you give the client concentration this period for the top clients or UBS?

We did not. UBS is now below 10%, so it's not a disclosable item. So we're not going to be talking about that top concentration or any concentration below 10%.

Okay. The next two levels, 5% and 10%, seem to have increased slightly during the period. Is that attributed to some growth in those clients, or were there other factors involved?

Really just a little bit of growth in those clients. And it wasn't that significant of a move. So moderate growth in there.

Okay. One last one, if you don't mind. The headcount was barely up from the previous period, is that signaling anything or is that just kind of showing that you're getting the workforce better re-optimized and better utilization?

It's definitely the second. And we talked about it during the last two calls that we were a little bit light on utilization. So we're just bringing this to a normal state.

Okay. Great, thanks guys.

Thanks. I appreciate you taking the question. Clearly, very good results for Q1, really good beat on revenues. Can I ask what you had may have already partially answered, but in the second half, are you expecting any specific headwinds from UBS or anything else? And also kind of what kind of pricing uplift have you baked into your guidance?

There is nothing specific we can discuss regarding the second half, as Ark mentioned. There are still uncertainties as we look ahead, so we are comfortable with the guidance we provided. We are not targeting any specific accounts. Regarding pricing, what I mentioned earlier is that we are experiencing stable pricing with a slight uptick, consistent with trends over the past couple of years.

My follow-up is for the kind of second quarter guide, kind of what operating margin have you assumed in the at least $0.80 EPS guidance?

For second quarter, the guide for operating margin was 16% to 17%.

Okay. Great. Anthony, it's been really good working with you. Good luck and I hope you can continue to stay in touch.

Very good. Thank you. I hope so as well.

Hey guys, thanks for taking the question. This is Ben, in for Steve this morning. Maybe just one for me, Anthony, on the margin front. Kind of what are your expectations from here going forward? I guess, it was lower than it typically is in margin. What takes the margin from here, what are the factors that we should be thinking about?

Are you looking at operating margin, just so I'm clear with the margin we're addressing?

Operating margin.

Operating margin in Q1 was within the expected range. We had projected Q1 to be between 15% and 16%, but it came in slightly lower due to an unexpected construction-related expense of approximately $1.9 million. Looking ahead, we expect Q2 to fall within the 16% to 17% range and for the full year to be around 16% to 18%. Overall, we are not anticipating any changes beyond our expectations, and Q1 was just a bit lower in the range than we had anticipated.

Okay. And just on the utilization side; would you characterize that as being kind of fixed and in a place where you're happy with going forward?

Yes, I think we're in the range which we were talking about. And we'll try to maintain as much as possible with the regular volatility and ability.

Alright, thanks. And good luck Anthony.

Thank you.

Yes, good morning. Thank you for taking my question. So you're saying that you continue to invest in your consulting capabilities. What type of consultants are you really referring to? Are you talking about Accenture type management strategy consultants or more like digital technology consultants?

We're talking about business consultancy, which means industry knowledge and understanding. And we're talking about both digital consultancy and technology consultancy, which we definitely need to bring to higher improved levels.

Okay. For my follow-up question, with the major Tier 1 Indian offshore vendors planning to expand their presence in the U.S., have you noticed any signs of wage inflation resulting from that?

Not at this point, but at the same time, again, that's exactly what we don't know.

Yes, hello, good morning guys. Thank you for taking my questions and best of luck to Anthony. I just wanted to understand the trends for the financial services throughout the year. Obviously, you guys mentioned UBS, there's Barclays out there, which was also kind of sort of flat lately. Could you help us understand what the trajectory is for the remaining few quarters of the year?

So I think it would be similar to what we're seeing right now. We still have a lot of opportunities around this account, but again, it's very difficult to predict what would happen. And there are a lot of opportunities around the second line of our account in financial services and some technology companies plan in tech area as well. So we're optimistic on this, and as you see the result effect of UBS. We're very close to 20% growth there.

That's helpful. Can you provide an update on your labor sourcing trends in Eastern Europe right now? Is there a decrease in Ukrainian dollars, or is there potential for an increase in other regions? What are the latest dynamics regarding your engineers?

We currently do not observe any notable differences compared to what we have experienced over the past few years. We anticipate that it will closely align with those previous trends, but we cannot be certain. This remains one of the uncertainties moving forward.

Hello, congratulations on good growth. I have a couple of questions today. The first is basically on your cash position, which is pretty large share, how you're going to use it? And are there any M&A deals in the pipeline, if you could tell us about. And the second one is, on your SG&A expenses. The growth appears to be quite significant. So how should we look at these expenses going forward?

The main reason for the buildup of cash is for mergers and acquisitions, and we are currently evaluating a number of potential deals. While I can’t share specific details, we have a strong pipeline in place. Regarding SG&A expenses, the first quarter saw a slight increase due to an unexpected expense of $1.9 million, which accounted for just over half a percent of our revenue. This expense is not expected to recur. We will keep focusing on managing SG&A and aim to reduce it as a percentage of revenue.

Okay, thank you.

Pleasure.

Arkadiy, a question we get a lot and we don't know how to answer, so I have to ask you. Could you give us some perspective as to where we are in the digital journey. How do you measure that? How would you know if it was ending? What's the client appetite look like for digital purchases?

I'm not sure I can provide a clearer picture for you. However, it's certainly a key factor driving our growth. There is a strong demand for quality transformational digital services, and it's a primary focus for us. We have several internal metrics we are evaluating, though measuring this can be tricky, as it is delicate for everyone involved. On the operational side, we are working to enhance our front office capabilities and are making significant efforts to integrate these with our engineering capabilities, as we believe this is what sets us apart. We are focusing on a robust digital transformation of user experience skills alongside engineering complex solutions, and we are seeking consultancy for additional components as well. Overall, this is a broad answer, which you may have anticipated.

Yes. And Jason, I was just wondering if you could share with us, I know it’s early days on the job, but your last job worked out pretty well. What do you see as the, I guess to out phrase it generally, what is that attracted you to EPAM, what sort of skill sets do you think that you can bring to enhance their operations?

As you indicated, I'm still counting my time in weeks rather than months. As to why I came to EPAM, Cognizant is a really good company, but there is just something really exciting about EPAM. As Ark was talking about here, you've got the software heritage, you've got the focus on digital engagement. So the company just really has strong capabilities and you sense that, even in your first couple of weeks on the job. So you've got the opportunity to address these growing markets and demand trends and business transformation, and it just looks like it's a really exciting place to be. From an experience standpoint, there are a lot of ways to get to high growth. EPAM has obviously shown that it has got a lot of capabilities in that area. As you indicated, I bring my experience from Cognizant. I was there for about nine years in various finance roles; before that, I worked for a series of technology companies in Silicon Valley. So I bring some interesting perspectives as well.

Thank you. And best of luck Anthony. Thank you.

Thank you.

Thank you. We look forward to seeing you all at our scheduled Annual Investor Day on May 9, in New York City. And thanks for attending today's call. And if you have any questions, David here is always here to help. And one more time, thank you to Anthony and good luck.

Thank you.