EPAM Systems Inc (EPAM) — Q4 2018 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 fiscal 2018 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 I 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 measures have been reconciled to GAAP and are available in our quarterly earnings material located on 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. We finished this year in a strong position across several dimensions of our business. Financially, we delivered revenue of $1.84 billion, reflecting 27.1% year-over-year reported growth or 26.9% in constant currency terms. Our non-GAAP earnings per share was $4.38—a 26% increase over fiscal 2017. Additionally, we generated free cash flow of $255 million. 2018 was an important year for us. First of all, at the end of December, we celebrated our 25th anniversary. While we have been in business for 25 years, we still act, change, grow, and feel like a very young and dynamic company. We tirelessly continued to expand our capabilities and work towards driving deeper connections with clients. We have done this organically through very selective acquisitions and by growing some of our more strategic partner relationships. As we look across our portfolio of clients, the types of engagements we are executing and the types of demand we're seeing for the future is broader than pure engineering. This is a change we have spoken about before in how we view our investments and capabilities. In 2018, we observed the shift from pure software product development to much more complex, scale, and business-critical engagements for our clients. With all our expanding capabilities, many of which have been recognized by industry analysts as vital accelerators, we're not only a software engineering company at our core but also a strong design and experience consultancy, a growing business and innovation consultancy, as well as an emerging training and educational firm. A critical effort across these newer capabilities is bringing them to our clients in the form of aligned multifunctional teams working towards one common goal – realizing the overall value of the solution for client benefit rather than merely generating new revenue streams for EPAM. This integrated change is challenging in complex enterprise environments, requiring a careful balance between executing proven strategies and introducing new capabilities. We're looking at these challenges from the constant perspective of the value add to clients. While it's easy to frame these accomplishments in the context of the last fiscal year, they represent progression points on a longer journey we are on to continuously adapt to the demands of the digital ecosystem. We continue to focus significant efforts on developing our people through investments in our talent management, educational, and delivery platforms that help us scale, engage, and retain our capabilities globally. During the year, we added over 4,200 people across the organization and strengthened our talent pool globally. Despite macro-level uncertainties, we are optimistic about 2019. We believe we can remain relevant to our diverse and global client base through our ability to execute large-scale digital transformation programs and help them realize ambitious innovation initiatives. I will turn it over to Jason for a detailed financial update on last year and our guidance for 2019.

Thank you, Ark. And good morning, everyone. I'll start with the 2018 financial highlights, then discuss profitability, cash flow, and end with our guidance for the 2019 fiscal year and Q1. In the fourth quarter, we delivered very strong topline performance, exceeded our profitability expectations, and grew earnings per share. Revenue came in at $504.9 million, a year-over-year growth of 26.5% on a reported basis, reflecting negative foreign exchange impact of 2.4%. Looking at revenue growth across industry verticals, drivers of growth remain consistent and include digital transformation and increased focus on customer engagement, product development, and efficiencies through artificial intelligence and analytics. Financial services, our largest vertical, delivered 16.9% reported and 21.1% constant currency year-over-year growth. Growth in Q4 was impacted by a continued expected ramp-down of activity at a few clients outside of our top five, predominantly based in Europe. Travel and consumer grew 17.3% reported and 20.6% in constant currency terms. Growth in Q4 was impacted by a slowdown with certain consumer clients in Europe. Software and hi-tech grew 26% in the quarter. Business information and media posted 24% growth in Q4. Life sciences and healthcare grew 71.3%, reflecting broad-based growth across all industries. Our emerging verticals delivered 38.1% growth, driven by clients in energy, telecommunications, and automotive. From a geographic perspective, North America grew 36.9% year-over-year, while Europe grew 12.1%. In the fourth quarter, growth in our top 20 clients was approximately 22%, and growth outside our top 20 clients was approximately 30%. Regarding the income statement, our GAAP gross margin for the quarter was 36.8%, compared to 36.4% in Q4 of last year. Our GAAP income from operations was $78.3 million or 15.5% of revenue this quarter, compared to $52.1 million or 13% of revenue in Q4 last year. Our GAAP effective tax rate was 23.9%, reflecting certain one-time tax charges. Diluted earnings per share on a GAAP basis was $1.05. In Q4, cash flow from operations was $123.1 million compared to $71.2 million in the same quarter last year. Our total headcount ended at over 30,100 employees. Turning to guidance, we are guiding to at least 22% revenue growth for fiscal 2019, expecting GAAP income from operations to be in the range of 12.5% to 13.5% and non-GAAP income from operations in the range of 16% to 17%. For Q1, we expect revenues to be at least $518 million, producing a growth rate of at least 22% reported. In summary, our 2019 outlook reflects continued strong demand for our services. With that, let's open the call for questions.

Thank you. Good morning, Ark. Good morning, Jason. And congratulations. My first question is, Ark, you started off mentioning a high degree of confidence entering 2019. And I'm wondering how this translates to the financial model. Is there higher visibility? Maybe higher than the normal 80% to 90% range. Or is it the slightly higher starting point for growth? And then, how does it factor into your hiring plans?

Hi, Ashwin. Yeah. We have a good level of confidence, but it's not unusual; it's more in line with what you've seen before, which gives us a good feel. But after growing significantly over the past years, we're still carrying the same level of visibility and confidence. In regards to talent acquisition, it remains challenging, and we believe we can support the necessary level of growth based on what we see in the labor market.

Got it. And then, the follow-up there is on the cash flow. Jason, good job there on the cash flow conversion, the DSO level. Would you say ahead for 2019 that the DSO level might be sustainable? Is there a target that you can give us with regards to cash flow conversion?

Yes, we saw a nice improvement with DSO at 73 in Q4. We usually see a seasonal impact in Q1 where DSO might increase somewhat, likely reaching around 80. Our ongoing focus on DSO remains strong. The other thing to remember is we see strong cash flow in both Q3 and Q4 of the fiscal year, with some lower cash flow generation expected in Q1 and Q2 due to our variable compensation elements.

Got it. Thank you, guys. Congratulations again.

Thank you.

Hi, guys. This is actually Amit Singh. Just quickly wanted to talk about the adjusted operating margins. This quarter was very strong at 18.4%, the strongest since the second quarter of 2012. Could you talk about what led to that strong margin in the quarter?

Certainly, the beat on revenue supports SG&A efficiency and leads to higher utilization. We saw higher utilization, high revenue overall, and SG&A was lower than expected due to a one-time benefit. In Q1, we usually see lower bill days and utilization as there are more holidays in certain regions.

So, just a follow-up to this for fiscal 2019 guidance. You're guiding to 16% to 17% margins for the full year, down from the higher end of that range last year. Why should overall margins decline?

In 2019, we will continue to invest to maintain growth over 20% a year. We expect SG&A to return to the 18% to 19% range. While we have price increases and wage inflation, we believe we can manage profitability in that range, considering investments for future growth. Seasonal patterns typically lead to lower profitability in the first half of the year than in the second half.

Perfect. Thank you very much.

Sure. Thank you.

Good morning. I want to follow-up on the M&A contribution question. I think you said 1% for the full-year 2019. What's the contribution in the first quarter specifically? And what was the contribution in the fourth quarter of 2018 as well?

In the first quarter, we expect a 200 basis points benefit. In Q4, it would be a 250 basis points benefit as we had Continuum acquired in Q1 last year and Think in November 2018.

Very helpful. Thanks. You've talked about more complex, larger scale engagements. Can you comment on the competitive environment? Do you expect to see increasing competitively bid deals or any changes in your pricing ability?

We have been competing with top firms for some time, and the proportion of these deals for us is increasing year by year. While we've been able to price differently, it's not impacting the total picture just yet. We hope that changes in the future, but predicting how this will happen is a challenge.

So, you're talking about changes in the method of pricing?

Rates in general are different now; complex projects require teams with consulting skills, impacting pricing. Methods of pricing also differ, particularly in automation projects. However, this is a small portion of our revenue, and any impact may be seen later.

Understand. Thank you.

Thank you.

Thank you. I'm wondering, Jason, could you help us out and deconstruct the revenue guide? What's the contribution expected from acquisitions in 2019?

At least 22% revenue growth for fiscal 2019, and we expect a 1% benefit from acquisitions. Netting that out, we expect reported growth of around 21%. We've seen a shift toward onsite capabilities, which supports higher revenues but does not directly lead to a gross margin improvement.

Okay, got it. And what are your efforts to create a broader platform at the bottom of the pyramid to enhance available supply?

We constantly invest in education and platforms to manage people. This is an ongoing focus to ensure we have the talent needed to meet growing demands.

Our 2019 plan includes an elevated level of new graduates to focus on enhancing our workforce in certain geographies.

Got it. Just one last question. You mentioned SG&A had a one-time benefit. Could you provide the size of that?

It was approaching approximately $1 million, which was a substantial one-time benefit in the quarter.

Got it. All right. Thanks very much.

Thanks, guys. I just want to follow-up on the run rate of revenues from the fourth quarter. Are you guiding on it based on financials or any other vertical? How sustainable is that growth year over year?

From a healthcare standpoint, we’re seeing strong demand as we enter Q1 and anticipate continued high growth. In financial services, we have some traction among several customers, despite a few issues in Europe. Overall, we have a broad range of growth opportunities across various verticals.

Is there anything happening within the financial institutions that we should keep an eye on that could get worse or influence your guidance?

I don't believe there is anything concerning right now. It’s essential to view revenue traction in terms of verticals and project types. Volatility between verticals may be significant but overall growth is relatively stable.

Understood. And regarding margin, do you see improvements continuing through the year despite the seasonal variations?

We focus on account-level profitability and see opportunities for price increases. Investments in capabilities, like Google Cloud, will support growth moving forward.

Thank you. That's helpful.

Sure.

Hi. Thanks for taking my call. I wanted to get your sense of the overall demand environment. Is there an improvement compared to the previous year? What are the underlying drivers?

The demand remains consistent, with no significant changes compared to the past. We maintain a strong focus on fast-growing market components relative to larger competitors.

We’re seeing good growth in life sciences and healthcare, particularly in North American hi-tech and financial services, as well as opportunities in the energy space.

Thanks. Regarding automation, can you share any updates on your initiatives and whether you're expanding vendor partnerships?

We are expanding the number of vendors we're working with, and the work in this area is growing for us, resulting in beneficial consulting engagements.

Great. Sounds good. Thank you.

Thank you.

Hey, thanks. I wanted to discuss wage inflation. Can you provide insights on where we are seeing pressures? Additionally, emerging verticals showed strong performance this quarter; could you elaborate?

Emerging verticals include automotive, energy, and telecom, which are showing strong growth. We aren't at a point yet to separate these in reports, but opportunities are robust. Wage inflation is consistent with previous years, around 5%, with some geographic hotspots, but overall we haven't seen significant changes.

Great. Thank you.

Hey, good morning. This is actually Kyle Peterson on for Mayank today. Can you comment on attrition rates amidst a competitive talent market?

Attrition is slightly elevated relative to historical averages, typically influenced by compensation payouts. We keep a close watch as we approach payout times.

There may be volatility in attrition, but it's not new, and we anticipate further upward pressure given the competitive environment.

What about the M&A pipeline? Any updates on your appetite for future deals?

Our strategy remains unchanged; we are always looking and communicating regarding potential acquisitions, focusing on client engagement and specific capabilities.

Great. Thanks, guys.

Thank you.

Hi. Good morning. I wanted to ask two questions. First, when I look at headcount from the end of 2017 to the end of 2018, it grew about 17%, but revenue was up about 27%. Can you verify that and discuss whether 2018 was an extraordinary year in that regard?

The higher revenue growth relative to headcount is due to shifts towards onsite capabilities, which has a higher bill rate. This shift does not directly translate into profitability, but it helps support larger programs and growth.

Do you disclose the onsite/offshore mix?

We share updates verbally but may not have it in the fact sheet.

Thank you. In regards to your top five customers, I noticed a 12% growth, which is less than the average. Can you comment on that?

One of the top five customers had a piece of their business split off, impacting our reported figures. We still maintain revenue from both customers.

Operator? Operator, are you on the line? So, for those that are remaining on the call that we're not able to get through the Q&A, we will follow-up with you after this call. But why don't we go ahead – Ark, go ahead and proceed with the closing.

Thank you, everybody, for being with us. 2018 was a very good year for us, and we hope to continue growing. Talk to you in the next quarter. Happy Valentine's Day.

Thank you.