EPAM Systems Inc (EPAM) — Q1 2019 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 2019 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 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 risk 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 materials located in the Investors section of our website. With that said, I will now turn the call over to Ark.

Thank you, Dave, and good morning everyone. Thanks for joining us. I would like to start with a few financial highlights of our first quarter. We delivered revenues of $521 million, reflecting 23% year-over-year growth or 26% in constant currency terms. In addition, we delivered strong non-GAAP earnings per share of $1.25, which represents 34% growth from Q1 of 2018. We believe our Q1 results have given us a solid start to the fiscal year and underscore our continued relevance in the market. This is especially important considering our remarks just three months back when we mentioned macro-level uncertainties that everyone worried about at that time, and it seems like they still do now, at least based on recently reported performance from some regional market players. Currently, we believe our relevance has been maintained through our relentless focus on investing across the business, broadening our set of offerings, developing our talent faster, and overall, constantly enhancing our sales to improve our chances as a company to be better prepared for the future. While it isn’t possible to share anything significantly new regarding what we did in Q1 versus previous periods, I think a short summary could help remind everyone of our focus. We are continuously shaping our consulting approach by strengthening our end-market teams and integrating new capabilities that we have added to EPAM during 2018, both organically and through acquisitions. Our goal remains to build a well-integrated consulting offering across business, experience, and technology expertise to empower our historically strong project engineering capabilities, ultimately bringing real value to our clients with the solutions we are delivering. In the last quarter, we saw a good level of progress in this direction. Additionally, we are improving our product engineering capabilities globally, enhancing productivity, expertise, and quality, along with the methods of working and collaborating both within our teams and with our clients' teams, by investing in our own digital platforms to support these efforts. We are continually exploring and practically testing new services and solutions, as well as alternative approaches to problem-solving that we previously might not have considered or that did not work for one reason or another. Q1 presented some new challenges that obliged us to step outside of our comfort zone and start thinking differently, and we are excited to face those challenges because they provide us with a glimpse of the future. As a result of all this ongoing effort, we are continuously transforming the company and experimenting with different operational models for how we work internally and how we interact with clients and partners to tackle challenges together and improve the overall agility of our operations. A prime example of our continuous evolution is our digital platform strategy concept, which allows EPAM to interconnect across all of our capabilities in consulting, design, architecture, and engineering, optimizing overall delivery and providing our clients with a partner that can assist them with the entire engagement cycle from ideation to production. Yes, we recognize that you have likely heard similar sentiments from others in the industry regarding the approach itself and potentially even in brandings and similarities. And it's true—differentiating oneself based solely on messaging is quite challenging. The real distinction lies in execution, where the speed and quality of deliverables are crucial, and those are driven by thousands of small details, including the capacity to coordinate multi-functional and multi-locational teams while consistently enhancing productivity and eliminating waste. Furthermore, the difference is anchored in an unyielding commitment to put forth the extra effort necessary to overcome a growing number of new obstacles. Proving these differentiation points repeatedly in practice is the only way to advance, and that’s why we remain highly optimistic about our future in what may be broadly termed the digital ecosystem, where everything—clients, consumers, partners, suppliers, and employees—intersects within a scalable and flexible platform environment. Our objective is straightforward: We aim to enable our customers to be competitive and disruptive in the marketplace through innovative solutions while aiding them successfully navigate various technology changes. Currently, we continue to observe steady demand across our main verticals and in our emerging ones for our uniquely blended capabilities in providing pragmatic consulting around platforms, data and analytics, automation, and engineering, all while drawing on the full depth and breadth of EPAM's Global Delivery model that we have developed over the years. I think we can reiterate what we expressed three months ago: Despite some macro-level uncertainties that we continually monitor and discuss, we are looking at 2019 with optimism. We are confident that we can continue to stay relevant to our diverse and global client base through our capacity to execute large-scale digital transformation programs and support them in making significant innovation programs a reality. With that said, I would like to hand the call over to Jason for more details on our Q1 results and an update on our business outlook.

Thank you, Ark. Good morning everyone. I will begin with our Q1 financial highlights, then discuss profitability, cash flow, and conclude with guidance for the 2019 fiscal year and Q2. In the first quarter, we delivered solid top-line performance, exceeded our profitability expectations, and grew earnings per share. Here are a few key highlights from the quarter. Revenue came in at $521.3 million, reflecting a year-over-year growth of 22.9% on a reported basis or 26.3% growth in constant currency, which accounts for a negative foreign exchange impact of 3.4%. Analyzing our first quarter revenue growth across our industry verticals, the drivers of growth remain very consistent, including digital transformation, an increased focus on customer engagement, product development, and optimizing efficiency and insights through artificial intelligence, machine learning, and analytics. Financial services, our largest vertical, delivered 9.1% reported or 13.3% constant currency growth year-over-year. Growth in Q1 was impacted by the timing of revenue recognition for several financial services clients in Russia, along with an anticipated decrease in activity at a few clients primarily based in Europe. We continue to see increasing demand for our offerings in payment processing and insurance, which currently represent a modest share of revenues but constitute a rapidly expanding part of our financial services portfolio. Travel and consumer grew 13.6% reported and 18.1% in constant currency terms. Growth in Q1 was influenced by the ramp down of a few consumer clients in Europe, alongside muted growth for a few clients in North America. Software and high-tech grew 23.4% during the quarter. Business information and media posted 24.7% growth in Q1. Life sciences and healthcare grew an impressive 69.6%, reflecting broad-based growth across both sectors and in existing and new client programs. Lastly, our emerging verticals delivered 40.7% growth, driven mainly by customers in energy, telecommunications, and automotive. Geographically, North America, which is our largest region representing 60.7% of Q1 revenues, experienced a growth of 32.2% year-over-year or 33% in constant currency. Europe, accounting for 33.3% of Q1 revenues, grew 13.3% year-over-year or 19.3% in constant currency. The CIS region, representing 3.5% of revenues, contracted year-over-year both on a reported and a constant currency basis, declining 16.6% and 4.1% respectively. This decline was primarily affected by the timing of revenue recognition at various financial services clients. Finally, the APAC region grew 32.1% or 37.3% in constant currency and now constitutes 2.5% of our revenues. In Q1, growth in our top 20 clients was 15.5%, while growth outside our top 20 clients was approximately 29% compared to the same quarter last year. Moving down the income statement, our GAAP gross margin for the quarter was 33.9%, compared to 34.5% in Q1 of the previous year. The non-GAAP gross margin for the quarter stood at 36.3%, compared to 36.5% for the same period last year. GAAP SG&A was 19.5% of revenue compared to 21.1% in Q1 of the prior year, while non-GAAP SG&A came in at 17.7% of revenue versus 19% in the same quarter last year, somewhat below the bottom end of our targeted range. GAAP income from operations was $64.7 million or 12.4% of revenue during the quarter compared to $48.7 million or 11.5% of revenue in Q1 last year. Non-GAAP income from operations was $89.2 million or 17.1% of revenue in the quarter compared to $67.7 million or 16% of revenue in Q1 of the previous year. Our GAAP effective tax rate for the quarter was reported at 5.4%, including an excess tax benefit of $11.5 million related to stock option exercises and the vesting of restricted stock units. Our non-GAAP effective tax rate, excluding this excess tax benefit and specific one-time items, was 22.5%. Diluted earnings per share on a GAAP basis was $1.06, while non-GAAP EPS was $1.25, reflecting a 34.4% increase compared to the same quarter in fiscal 2018. In Q1, there were approximately 57.2 million diluted shares outstanding. Turning to cash flow and balance sheet status, cash flow from operations for Q1 was negative $0.2 million, compared to a positive $7.3 million in the same quarter last year. Free cash flow stood at negative $13.6 million, compared to a negative $3.4 million in Q1 of the previous year. This quarter's cash flows were affected by higher payouts related to our annual variable compensation programs, which were disbursed at a higher level due to our strong performance in 2018, and to a lesser extent, an increase in Days Sales Outstanding (DSO) from Q4 to Q1. DSO increased to 78 days from 73 days at the end of Q4 fiscal 2018 and 83 days in the same quarter last year. However, we are pleased with our DSO performance overall. Focusing now on some operational metrics, we ended the quarter with over 27,800 delivery professionals, indicating a 17.6% year-over-year increase, alongside a net addition of over 1,100 production professionals during Q1. Our total headcount is now over 31,400 employees. Utilization was reported at 79.9%, compared to 77.6% in the same quarter last year, and 80.2% in Q4. Regarding our guidance, for fiscal 2019, we anticipate revenue growth to be at least 22% reported and at least 23% in constant currency terms, factoring in an estimated unfavorable foreign exchange impact. We expect GAAP income from operations to fall within the range of 12.5% to 13.5%, while non-GAAP income from operations is predicted to be between 16% and 17%. We expect our GAAP effective tax rate to be around 12%, while our non-GAAP effective tax rate is expected to rest at approximately 23%. For earnings per share, we now project GAAP diluted EPS to reach at least $4.61 for the full year, while non-GAAP diluted EPS will be at least $5.19, indicating a modest improvement in expected profitability for the fiscal year. We now anticipate a weighted average share count of 58 million fully diluted shares outstanding. For Q2 of fiscal year ’19, we estimate revenues will reach at least $549 million for the second quarter, yielding a growth rate of at least 23% reported and at least 24% in constant currency after accounting for an estimated unfavorable foreign exchange impact of 1%. We expect GAAP income from operations to be between 12% to 13% and non-GAAP income from operations to fall between 15.5% to 16.5%, primarily influenced by a higher level of holidays in the CIS region and the impact of annual compensation increases. Our anticipated GAAP effective tax rate is approximately 9%, while the non-GAAP effective tax rate will be roughly 23%. For earnings per share, we anticipate GAAP diluted EPS of at least $1.12 for the quarter, and non-GAAP EPS will be at least $1.21 for the quarter. We expect a weighted average share count of 57.9 million fully diluted shares outstanding for that period. Finally, we have outlined a few key assumptions supporting our GAAP to non-GAAP measurements. Stock compensation expense is anticipated to be around $16.2 million in Q2, $15.2 million in Q3, and $15.6 million in Q4. The amortization of intangibles is expected to be approximately $2.4 million for each remaining quarter. The negative effects of foreign exchange are estimated to result in roughly a $2 million loss for the rest of the year, with $1 million in Q2 and $500,000 in each of the remaining quarters. We expect tax-effective non-GAAP adjustments to be about $4.3 million in Q2 and around $4 million in each of the remaining quarters. Excess tax benefits are anticipated to be approximately $10 million in Q2, $6.8 million in Q3, and $4.2 million in Q4. Given the expected interest income for fiscal 2019, we are also including an assumption related to interest and other income for the rest of the year, anticipating that will be $2.7 million for each outstanding quarter. To summarize: our Q1 results reflect solid demand for our services, supported by a diverse mix of projects and offerings across the industries we serve. We remain confident that our strategy—which combines our core engineering heritage with consulting, advanced technology, and digital business services—positions EPAM well for the future. With that, let’s open the call for questions.

Hi, Ark. Hi, Jason. Good start to the year.

Thank you.

I guess let me start with the obvious question. Your first half growth was about 25% constant currency and the low end of your full-year outlook remains 23%. I think the Russia reference is not a full-year factor, as it’s all about timing; not sure about the European client ramp downs you mentioned; any further details would be great there. But more importantly, if you’re expressing optimism on a full-year basis, what keeps you from bringing up the low end of your year outlook?

That’s a fair question. We feel good about how we’ve started Q1 and based on our guidance for Q2, we feel optimistic about the demand environment. However, we are seeing a couple of trends: we’ve noticed a slight pullback in spending from European banking clients, and that also influences our guidance for the full year. Moreover, we’re observing some uneven demand in the consumer and retail sectors, primarily in Europe. We have solid growth with certain customers, but a few clients seem challenged, especially due to uncertainties related to Brexit, which led them to reduce spending. Therefore, our guidance reflects this prudent approach but we remain confident in the overall demand across most areas of our business, especially considering the strong growth in life sciences, healthcare, and high-tech sectors.

I would add that what we are projecting right now will also carry implications for Q3 and Q4. The anticipated developments in Q2 will influence our forecasts, but for now, we don’t feel comfortable raising guidance for the full year.

Got it. Understood. Now, that’s good detail. I guess the second question is based on, at least our checks, digital transformation-type contract sizes are increasing. That work continues to encompass middle and back office, not just front-office type work. First, would you agree with that? And if so, can you discuss some changes you're making internally with tools and processes to capture more market share from these larger deals?

Yes, definitely. Transformation affects not only the front office but the entire stack of technology and business processes. While the simplistic understanding of digital has traditionally focused on the front end, we have always been strongly engineering-driven. That means we've historically been engaged in the development of core platforms for major product companies, assisting them with implementation and customization. In the last couple of years, we have invested significantly in advancing and modernizing technologies for legacy systems, with visible progress to date. We are now able to optimize processes from end to end, which is becoming an increasingly larger portion of our business.

Got it. Thank you, guys. Good quarter.

Thank you.

Hi, guys. This is actually Amit Singh. Great quarter overall. Just wanted to start off with a question related to the last discussion about financial services. So, regarding the pullback that you mentioned among European clients, is this something new, or has this trend been ongoing for a while now, considering your financial services revenue growth has been decelerating over the last few quarters? Also, could you provide an update on the health of your financial services clients in North America and how we should view your overall vertical growth moving forward? Should we expect further deceleration?

Right, thank you for that question. First off, the overall demand environment for the company remains robust. We have a well-diversified set of growth drivers, both from new and existing clients. Notably, new verticals such as financial services constitute over 22% of our revenue. In particular, we are witnessing strong growth in fintech, asset management, card payments, and processing, and we're starting to see promising progress with our insurance clients. Even though we are experiencing some pullback from several banking clients, our growth trajectory is still supported by multiple engines of revenue generation.

Okay, perfect. And if you could provide a bit more insight into your consulting services—last quarter, your consulting headcount was around 2,000. How has that changed recently? Additionally, as you expand these consulting capabilities, do you anticipate any impact on your long-term margins? Your guidance suggests you could be leaning towards the upper end of your 16% to 17% range this year.

During previous calls, we touched on this. Our strategy is not to create a separate line of business focusing solely on consulting. Rather, we aim to develop an integrated solution that spans advising, delivering, and optimizing outcomes. This is an ongoing process, and we don’t have a specific headcount for consulting services, as the contributions stem from multiple professionals throughout EPAM contributing in various roles within distinct engagements.

Alright, perfect. Thank you very much.

Good morning. Ark, in your prepared remarks, you mentioned some new challenges you faced in Q1. Are these the vertical-specific issues you've mentioned on the call, or are there other challenges that emerged during the first quarter? Can you elaborate a bit on these? Also, can you connect this to your ability to develop new solutions and services? Is there anything in particular that stands out as an interesting development or potential growth driver for your business?

I think it's two questions that are indeed interconnected. The challenges we face in Q1 confirm ongoing trends seen in different quarters, but I'm referring to the challenges arising from new types of services we are providing through our internal restructurings, which involve exploring areas where we may not have all the answers. When clients come to us without clear solutions, that's a significant challenge in terms of how to manage new projects and engagements with new capabilities. We are constantly innovating and revitalizing ourselves and through our internal disruptions and acquisitions, transforming challenges into opportunities for new ideas, solutions, and services.

Understood. As you consider these new transformational engagements, how much of the business that you've recently won could be classified as transformational? Moreover, in your pipeline, are you observing an increase in transformational deals? Any quantification would be appreciated.

I can't provide specific numbers, but it's clear that the volume of critical transformational efforts and initiatives from our clients is increasing rapidly. Three to four years ago, such requests were rare, but now we are involved in dozens of these engagements.

Hi, thank you. A follow-up here on the consulting and design services—could you give us a sense of how much of your existing client base has been penetrated by these offerings? Are you successfully winning new engagements by leading with these services? Are you starting to engage with different roles and counterparts at these clients than you typically would have?

Yes, our penetration of these services is quite deep—well over 50%, likely closer to 70-80%. As far as the types of individuals we interact with, we are seeing a broader spectrum; however, we still engage significantly with IT personnel because complex platform development warrants collaboration between IT operations and business, alongside digital leadership.

That makes sense. Thank you. And regarding talent sourcing, you've shown a good separation between headcount growth and revenue growth. Do you believe this trend is sustainable? Can you discuss your hiring plans, and the competitive environment for talent?

We have consistently indicated that the separation you’re seeing continues as expected and may even enhance slightly. New contracts are yielding better rates due to the experience our teams have accumulated. Regarding talent competition, it remains challenging, requiring substantial investment in training, retention, and professional development. The intriguing projects we are undertaking also present us with opportunities to attract top-tier talent.

Thank you.

Thank you. Good morning. Good quarter again. Jason, could you break down the revenue profile moving forward in light of your headcount plans, any potential productivity improvement, and what pricing trends you’re building into your expectations for the rest of the year?

That's a fair question. From a pricing standpoint, as Ark mentioned, we are observing gradual shifts toward more specialized talent in the market, which adds a positive aspect. After our recent promotions, we introduced some rate alignments, and we anticipate ongoing price increases with both existing and new clients. Overall, we expect this environment to remain consistent with our recent experiences—no significant changes in wage inflation. Regarding utilization and potential, we're currently operating with a high utilization level but typically expect a modest decline as we transit from Q1 to Q2 due to higher vacation days around May holidays.

Great, that’s helpful context. Could you elaborate on your emerging verticals and how you plan to expand into new areas, either through M&A or organically?

Sure. Regarding our emerging verticals, we focus on segments like energy, which showed strong growth in Q1; automotive, which is also increasing; and telecommunications, where we see potential growth. In terms of M&A, our attentiveness has been on acquiring incremental consulting capabilities while creating opportunities to enhance our skill set. There haven’t been major shifts in our M&A strategy; we remain focused primarily on enhancing consulting capabilities within the market.

Great. Thank you.

Hi. I wanted to gauge demand by asking how many of the new engagements coming in are day one engagements versus extensions of existing work. Have you noticed any shift, or is it still primarily new work?

It's often challenging to classify whether an engagement is new or existing, especially in the context of progressive platform developments. There’s still a significant focus on new initiatives and some of the larger components of our platform development are continuous extensions. However, I don’t think we’ve experienced any notable shifts in this regard.

Our consistent trend shows that for every new revenue dollar we gain, approximately 60% comes from existing clients and 40% from new clients. This balance has remained stable. We continue to experience rapid growth with longstanding customers while generating substantial revenue from new customer engagements.

That's really helpful. My second question is about your guidance on margins; they seem to keep improving. What levers are driving this, and what keeps you from increasing full-year guidance regarding margins?

Our guidance indicates we have greater confidence in maintaining higher profitability levels than we had when we started the fiscal year. The increase in EPS reflects this sentiment, but we also need to ensure continued investment in the business, which involves some SG&A expenditure. I expect gross margins to remain stable based on last year's levels, influenced by our commitment to invest in further capabilities.

Hi, thanks, good morning. Can you quantify the impacts from the ramp-downs on revenue growth for the quarter? Additionally, you mentioned that fintech and insurance are offsetting weaknesses in traditional banking. Could you provide percentages for how much these areas contribute to your overall financial services vertical?

I would prefer not to dissect specific components of the financial services practice at this time. However, we have considerable growth opportunities in fintech and our insurance segment is small but rapidly progressing. Overall, despite a reduction in spending from certain banks, our growth remains strong across the business due to its diversity. I’d like to reiterate our business is more often constrained by supply rather than demand. In instances of reduced demand from individual clients, we can typically redirect resources to other accounts.

We can quickly adjust any client concentration, and we're confident that even if one or a few clients reduce their engagement, we can adapt. This is a pattern we’ve observed regularly over the last several years, as we've managed substantial growth despite periodic challenges. Thus, unless we encounter drastic economic changes, we feel secure about overall continuity.

Thank you, that’s helpful.

Hi, thanks for taking my question. I had a question regarding your earlier remarks about the declining spending from specific banks in Europe. Is this a recent development, or has this been ongoing, considering you’ve observed some in-sourcing as well?

It seems to be a combination of factors. Some banks are definitely engaging in in-sourcing, a trend we've been aware of for a considerable time. At the same time, large banks are not being overly optimistic at this point. Determining the exact reasons behind these trends is challenging, as we don’t always receive clear responses.

Regarding Brexit, there’s currently some uncertainty that might be causing a slowdown in spending. Do you believe this is temporary, and if things settle down, spending could accelerate over the next 12 to 18 months?

I would emphasize that everything is temporary in business cycles. We’ve witnessed many changes over the past year. I’m confident that after navigating Brexit uncertainties, demand will bounce back, though I'm uncertain whether this slowdown will last for six months or 18 months.

Lastly, regarding the talent sourcing environment—now that Luxoft is being absorbed by DXC, has this made recruitment easier, or is it still proving to be challenging?

With all due respect to Luxoft and EPAM, I don't believe this affects the overall recruitment landscape in Europe. It’s a much broader and complex ecosystem, and we still face challenges in talent acquisition. We continue evaluating our strategies for recruitment, ensuring success in this difficult market.

Thank you, and good luck for the remainder of the year.

Hello. Congratulations on the good results, and thank you for taking my questions. My first question is about revenues per delivery professional. If my calculations are correct, it appears that there was a decrease in revenues per delivery professional in Q1, despite high utilization levels similar to Q4. Could you comment on this and how it may develop? My second question is about your capital allocation strategy. I know you're always evaluating M&A activity, but you have significant cash reserves on your balance sheet. Are you contemplating using this cash differently, such as share buybacks or dividend distributions?

Regarding your first question, it appears there may be a misunderstanding; while growth in revenue per delivery professional may not have been as pronounced as in previous quarters, the figure itself is still increasing. Adjusting for foreign exchange impact and utilization, we maintain solid growth in revenue per headcount consistent with what we have seen in prior quarters.

In constant currency terms.

As far as capital allocation is concerned, we continue to lean towards pursuing inorganic growth options, which will naturally necessitate capital usage. We're evaluating other strategies for capital allocation over time, but we don’t have any announcements or changes to disclose right now.

Thank you very much.

Thanks, guys. I have a couple of quick questions. Firstly, higher-level inquiry: regarding competition for large RFPs, is there a shift in players, and are you noticing a different competitive landscape compared to two years ago? Also, is there notable consolidation in demand across client sectors, such that the budget release cycle appears different than prior years?

While we’ve seen some shifts in the types of services being offered by competitors, the competitive landscape remains quite similar with significant involvement from large multinational system integrators and smaller, niche companies. Although we are pursuing larger deals now than before, we have seen the larger competitors participating more frequently.

Regarding potential consolidation in healthcare or financial services, has this had any impact on your demand environment? We’ve heard that March budget releases are less pronounced than in past years.

We’re experiencing vigorous demand in healthcare and life sciences, and we have not witnessed any reduction in budget allocation in those areas. Regarding the impact of consolidation on demand and budget flows, we haven't seen issues or delays in releasing budgets.

Additionally, while we observe certain clients undergoing consolidation and strategic changes, that hasn’t hindered our growth trajectory significantly; it might even create new opportunities for us in the future.

Thank you for the additional clarity. Finally, a financial question—your free cash flow metrics came in slightly below expectations. What contributed to this and what can we expect for the year? Also, what percentage did M&A represent in Q1 and what do you foresee for the future?

To recap, M&A accounted for about 200 basis points of growth in Q1. By year-end, we expect it should contribute approximately 100 basis points of growth. The variations in free cash flow were influenced by higher variable compensation payouts tied to our strong 2018 performance, alongside the impact of an increase in DSO transitioning from Q4 to Q1. However, we’ve had reasonable DSO metrics, maintaining a positive outlook. Keep in mind, we typically generate strong cash flow during the second half of the year.

Got it. Thanks again.

Thank you for joining us today. To summarize, it should be clear from this call that despite the surrounding noise, which is nothing new, we feel quite strong about the year ahead, and I think Q1 has affirmed this. See you next quarter. Thank you.