EPAM Systems Inc (EPAM) — Q2 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 second quarter 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; and Jason Peterson, Chief Financial Officer. Before we begin, I'd like to remind you that some of our 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 materials in the Investors Section of our website. With that said, I'll now turn the call over to Ark.

Thank you, David, and good morning everyone. Thanks for joining us. Let us start with a few key highlights on EPAM overall performance in the second quarter. Our growth was broad based across both geographies and industries, the revenue for Q2 climbing U.S.$649 million, representing 23% year-over-year growth or 23.7% in constant currency growth, from a vertical perspective, with a strong growth across the majority of our industry segments. In reporting currency, financial services, our legacy vertical continued the quarter with 7.6% growth which reflects the effect of the UBS revenue trends we discussed during our previous earnings call. Excluding the impact of UBS, financial services grew 31.6% in Q2. Demand from financial services is being driven by digitalization, regulatory changes in addition to record improvements. Travel and consumer finished the quarter at 21.7% growth with demand climbing from digital transformation projects as well as day-to-day earnings side programs. Software and Hi-Tech grew 20.2% for the quarter based on a diversified portfolio of software emerging start-ups and technology companies going over digital platform transformations. Media and entertainment grew 52.3% driven by our engagements in digital services, major information providers, publishers, and broadcasters. Life Sciences and Healthcare grew 3% over the same quarter last year. Year-over-year growth was mostly affected by a retirement at one of our clients, with a significant increase in revenue in Q2 of last year. Excluding this effect, year-over-year growth was 21.5% and 6.7% sequentially. Worth mentioning in healthcare, we continue to see demand in patient health management initiatives across major healthcare players and medical hospital managing provider in Q2 to all countries. Emerging verticals at 60.1%, growth was driven mostly by energy and telecommunications. Revenue expectations across our clients continue to grow outside of the top 20 accounts climbing at 37% with growth in the top 20 adjusted to 10% or more than 18% excluding the effect of UBS. Our continued focus on helping our clients address the challenges of digitally driven changes has led to broad opportunities across the Fortune 2000. In Q2, our growth was broad-based year-over-year. In constant currency terms, North America grew 27%, while Europe grew 19% year-over-year or 34% excluding the effect of UBS. These two geographic areas combined represent 94% of our revenues. Additionally, our CIS region grew 17% and APAC grew 24% in constant currency terms. Our people. We ended with over 20,480 professionals, a 12% increase year-over-year, bringing our total in-place headcount to more than 23,200. Utilization for the quarter was 79.6%, climbing higher than our historical ranges due to tighter management during this period. We do expect utilization in Q3 to be down due to seasonality and natural volatility in supply and demand cycles. In a balanced market that is always increasingly competitive, we remain focused on attracting, retaining, and developing the right talent to support the current and future growth needs. In regards to overall market demand, the rate of disruption among our clients continues to offer a fast pace, creating the challenge of successfully mitigating through important technology and operational confirmations. We believe we're still in the early stages of this digital era, this digital platform engineering extending from the consumer to the enterprise, driving the need for next-generation capabilities in areas such as full stock engineering, automation, and cyber security. We continue to see real strengths in demand across our verticals, service lines, and geographies, and we believe this demand for next-generation capabilities and engineering skills will continue for the foreseeable future. As we will grow our business to position it for the future, our priority will be to continue investing across multiple areas including corporate and people talent infrastructure, in line with our growth rate needs to allow us to establish new and growing capabilities with a focus on delivering increasingly sophisticated end-to-end integrated business and technology solutions initiated by our advanced engineering capabilities. Our profitability for the first half of this fiscal year reflects this ongoing investment, and going forward, you should expect this level of investment to continue and at times vary quarter-to-quarter. With that, let me turn it over to Jason for a detailed financial update of our Q2 results and our fiscal 2017 guidance.

Thank you, Ark. Good morning everyone. Our service and financial highlights talk about profitability, then cash flow, and then guidance. As Ark mentioned, we delivered strong top-line performance and generated solid free cash flow in the second quarter. Here are a few key highlights from the quarter. Revenue closed at $349 million, a 23% growth over the second quarter of last year and 7.5% sequentially. Year-over-year constant currency growth was 23.7%, reflecting a modest headwind of 0.7%, which was less than anticipated. Actual revenues compared to our Q2 guidance benefited from stronger revenue production of $2.9 million and a favorable currency impact of $6.1 million. From a geographic perspective, North America, our largest region representing 59% of our Q2 revenues, grew 26.6% year-over-year and 26.9% in constant currency. Europe, representing 34.8% of our Q2 revenue, grew 16.8% year-over-year and 19.4% in constant currency. Absent the effect of UBS, growth in Europe was 34% in constant currency; CIS grew 27.2% year-over-year or 17.1% in constant currency and now represents 4.2% of our revenue. Lastly, APAC grew 21.9% year-over-year and 24.3% in constant currency and now represents 2% of our revenue. So, moving down the income statement, gross margin for the quarter was 36.9% compared to 36.3% for the same quarter last year. The 60 basis point year-over-year increase resulted from higher utilization, which ended at 79.6% compared to 74.1% in the same quarter last year, and 77.5% in Q1 of fiscal 2017. The increase in utilization was offset by a negative foreign exchange impact, a higher level of payroll tax related to options exercised, and employee compensation. In constant currency terms, gross margin was 37.8%. GAAP SG&A was 23% of revenue compared to 22.6% in Q2 fiscal 2016. Included in this quarter's SG&A were higher costs related to increased personnel expenditures, including payroll tax associated with the exercise of stock options. In addition, there was an increase in investments to continue supporting expansion in our client base in geographies. Non-GAAP SG&A, which excludes stock-based compensation expense and certain other items, came in at 20.4% compared to 19.6% in the same period last year. As Ark mentioned, our SG&A reflects the continued investment in our talent acquisition, extension of our global footprint, and building onsite capabilities focused on supporting our long-term sustainable growth strategy. GAAP income from operations was $40.7 million compared to $32.1 million in Q2 last year, representing 11.7% of revenue in the quarter. Non-GAAP income from operations was $55.8 million compared to $47.6 million in Q2 last year representing 16% of revenue. Our GAAP effective tax rate for this quarter came in at 13.2%. The lower than expected tax rate was a result of the adoption of the recently announced stock-based compensation pronouncement and the generation of a greater than expected tax benefit due to a higher level of exercised options. Our non-GAAP effective tax rate was 22.7%. For the quarter, we generated $0.68 of GAAP EPS, which reflects an FX gain rather than unexpected FX loss lower than expected stock compensation expense, in addition to the lower tax rate. Non-GAAP EPS was $0.80 compared with non-GAAP EPS of $0.71 in the second quarter of last year, reflecting a 12.7% increase. Total shares outstanding for Q2 were approximately 54.8 million, higher than the expected level of 54.3 million, largely due to the sizable number of options exercised in the quarter. Turning to our cash flow and balance sheet, cash from operations for Q2 was $27.9 million compared with $38.5 million in the same quarter last year. The year-over-year decline is primarily due to the impact of a reduction in DSO in Q2 last year, coupled with an increase in DSO in Q2 of this year. Free cash flow came in at $22.2 million compared with $31.1 million in the same quarter last year, resulting in a 50.7% conversion of adjusted net income. Total DSO was 82 days compared to 88 days in the same quarter last year; AR DSO was 54 days, and our unbilled DSO was 28 days. Turning now to guidance, starting with full year fiscal 2017, revenue growth will now be at least 23%, and we expect constant currency growth will continue to be at least 23%. For the full year, we now expect the impact of foreign exchange will be flat. We expect GAAP income from operations to now be in the range of 12% to 13%, and non-GAAP income from operations will now be in the range of 16% to 17%, which reflects our first half performance. We expect our GAAP effective tax rate will now be approximately 16%, and our non-GAAP effective tax rate will now be approximately 22%. Earnings per share, we now expect GAAP diluted EPS will be at least $2.57 for the full year driven primarily by a lower effective tax rate attributed to greater than expected excess income tax benefit from stock-based compensation. Non-GAAP EPS will now be at least $3.29 for the full year. The updated non-GAAP EPS reflects greater than expected employee stock option exercises driving both higher total share count and greater payroll tax expense. We now expect a weighted average share count of 55.2 million fully diluted shares outstanding. For Q3, revenues will be at least $367 million for the third quarter, reflecting a growth rate of at least 23% after 1% currency tailwinds, meaning we expect constant currency growth will be at least 22%. For the third quarter, we expect GAAP income from operations to be in the range of 11.5% to 12.5%, and non-GAAP income from operations to be in the range of 15.5% to 16.5%. This range reflects a seasonal impact of utilization in Q3. We expect our GAAP effective tax rate will now be approximately 16.5%, and our non-GAAP effective tax rate will now be approximately 22%. For earnings per share, we expect GAAP diluted EPS will be at least $0.68 and non-GAAP EPS to be at least $0.84 for the quarter. We expect a weighted average share count of 55.6 million fully diluted shares outstanding. A few key assumptions which support our GAAP to non-GAAP measurements. Stock compensation expense is now expected to be approximately $11.2 million in Q3 and $10.9 million in Q4. 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. The tax effect of non-GAAP adjustments is now expected to be approximately $4 million in each remaining quarter. Lastly, with the recent adoption of ASU 2016-09, and as a result of movement in our stock price, we expect future volatility in our effective tax rates and GAAP EPS. We expect an excess tax benefit of approximately $2 million for each remaining quarter. Thank you. And let me turn the call back to David.

Hey guys, good morning and good job on the top-line. So when you look at the top-line and the upper division for the full year, was it driven by any particular end market customers or was it kind of more widespread as you saw in the current quarter?

It’s usually, again, you saw the concentration of clients is becoming better balanced or basically it’s spread, but we definitely have a number of our new large clients which are growing very fast and creating potential for future growth. So, it's needed, but there are very specific engagements that drive this now.

And in terms of geographic expansion over the next, call it, 12 months, is there any particular geography around the world where you expect to emphasize in terms of headcount growth?

Headcount growth for us right now is usually pretty much balanced around all our main delivery locations. So clearly still Eastern Europe, which includes all of Hungary, Poland, Belarus, Ukraine, Russia, and Israel. We're planning to grow in India too.

And don't mind me speaking, the EPS reset, was that purely driven by just this option stuff going around, or was there any other particular? You talked about options and share count, but was there anything else or was it just driven by this?

Yes, the $0.09 reduction is largely driven by the result of the greater than expected stock option exercises. As we've said, it's basically two impacts: the additional payroll tax expense and the dilution impact, which breaks out to $0.07 from the additional payroll tax expense and $0.02 from the dilution.

Thank you very much. You're building pretty significant cash on the balance sheet. How do you think about the use of the cash over the next couple of years?

Yes, from a use of the cash standpoint, today we prioritize capital allocation for our inorganic growth strategy. At the same time, we are sensitive to dilution. Capital allocation is an ongoing topic that we discuss with the board. No change at this time, but I think we would update you as we evolve our thinking on that topic.

Okay. And at the Investor Day, you spoke about recruiting the right talent to keep moving up the value stack. Part of that was getting to main experts with more consulting capabilities. Can you update us on how that initiative is moving and how we should think about the impacts on margin and revenue per engineer going forward?

We are definitely executing on this plan and we're bringing people. So how it’s going to impact any financial metrics is difficult to predict. Clearly, it could be a little bit volatile because we're bringing in. We're planning to bring more consultative people, and there may be some gap between the time they join and the time they start to really perform and become billable. But again, there’s no specific projection on how it’s going to impact; we do believe that we would be able to manage it in a normal way of business. Hello?

Good morning, guys. This is Jason Washburn in for Arvind. I'm just curious about what investments you are making in AI. What capabilities do you currently have in AI and how do you expect your business model to change if AI becomes more integral to your offering?

We have competence through this specific expertise. We are involved in multiple implementations of process automation solutions. I don’t think we can judge how it’s going to impact significantly anything in the short-term. But we are definitely focusing on this area, and it’s one of the most interesting future service lines for us. We didn’t have traditional BPO services which would be mostly impacted by this. So, we do invest in this and we do have some advantage.

Hello, my question is actually on your margins guidance. You lowered the upper balance of the guided ranges for the full year despite previous strong revenue trend; could you elaborate a little bit what is behind this?

Sure. We are really narrowing the range from 16% to 18% to 16% to 17%, and it’s largely just a reflection of our first half results. If you'll remember, we had 15.2% in Q1 and 16% in Q2. I should remind you that the Q1 performance included the impact of the $1.9 million land tax, and so the narrowing reflects our first half performance. If you do the math, you'll see that we’re expecting improvement in the remainder of the year.

Good morning and thanks for taking my questions. On pricing, since the last conference call, you said that you were talking about a stable pricing environment. Is that still the case?

Yes. We've seen a stable pricing environment. As we've talked about in the past, we continue to get angled price increases across a number of our customers, so definitely stable, with the opportunity for some improvement on an annual basis.

No, we talked about it pretty extensively, I think during the previous calls and the last investor day. There are no changes since the last periods. We’re improving delivery quality, and we want to align this to the general EPAM standards. That’s our main focus right now.

Hi, I wanted to ask about the working capital increase on the cash flow. I think it's driven by the increase in DSO, so could you please elaborate a little bit? What were the reasons for it, and should we expect further negative cash impact from working capital? Thank you.

Sure. Yes, primarily this story is around the DSO. You are seeing a substantial improvement in DSO on a year-over-year basis. I think you'll remember that we were over 90 days in Q1 of last year; we were flat at 88 days in Q2 of last year, and now we’re down to 82 days which is kind of where we guided. But the 82 days is an increase over Q1, and clearly that does have an impact.

Thank you for taking my follow-up question. I would like to ask you about UBS and outlook. If my calculations are correct, they are approaching the levels stipulated by your long-term agreements in terms of revenue generation. Could you elaborate on that level? Do you expect the impact of UBS on your growth rate to diminish? In general, what do you see as the outlook for the coming quarters for this account? Thank you.

Again, we don't have any specific updates on this. I think our long-term agreement actually indicates a minimum commitment. How this account is going to develop in the future is very difficult to predict. We don't see any specific signs to share. It is in a stable condition now.

Yes, I would just add to that, so UBS is certainly stable; it’s performing within our expectations. We continue to see rapid growth in smaller accounts and new accounts within EPAM, so what I do think you'll see is that it has a modest impact on growth rates over time as we continue to grow other accounts.

I just wanted to ask about the staffing again. It seems like your hiring rates slowed down a little bit this quarter. Is that the case, or is this just something a little bit maybe seasonal? Related to that, can you give us an attrition figure for the quarter? Thank you.

I think it’s for a little bit different reason. Several quarters ago we were talking about our utilization levels which were below what we wanted, and some unexpected branch existed due to some changes on UBS side. Clearly, our recruitment cycles were under very detailed control, so right now we are coming back to current exercise; the current 12% increase is much more than it was last quarter. We are increasing hiring right now, but it’s some normal kind of cycling. As usual, thank you very much for joining us today. We had a pretty strong quarter on the revenue side, and we continue growing. I would share, actually, one insight: our growth outside of UBS right now is around 29%, which means that the future is stability of the account. The growth should be strong, and with this, we will see you next quarter. Thank you very much.

Thank you.