EPAM Systems Inc (EPAM) — Q2 2021 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 2021 results. If you have not, a copy is available on epam.com in the Investors section. With me today are Arkadiy Dobkin, CEO and President; and Jason Peterson, Chief Financial Officer. I would like to remind those listening 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 the comparable GAAP measures and are available in our quarterly earnings materials located in the Investors section of our website. With that said, I’ll now turn the call over to Ark.

Thank you, David. Good morning, everyone, and thank you for joining us today. We delivered a strong set of results for the second quarter with revenues of $881 million, reflecting reported year-over-year growth rate of 39% and 36% in constant currency terms. Non-GAAP earnings per share were $2.05, an increase of 40% over the same quarter in 2020. Growth was very much broad based. All our geographies and most of our industry verticals experienced strong demand, reflecting the robust market environment and pushing our growth rate to historically high levels. On a sequential basis, quarterly revenues exceeded our Q1 results by more than $100 million, and we finished another quarter with very strong sequential growth. The reason for the surge in demand is pretty obvious. By now we all know that application development and cloud and data integration services are growing post-pandemic very strongly and driving corporate budgets forward. But in addition, it has become very visible that the current client transformation efforts are continuous and multidimensional, carrying uncertainty along with them now. That is the reason why, on top of application development and cloud integration at large, we are seeing very fast expanding demand for software-enabled business scenarios coming our way, too. Overall, and across all our industry verticals, we have a portfolio of both new and current customers. We see progression into new and larger multiyear engagements as our customers look in part to fulfill both engineering demand as well as demand for new collaboration models that bring in greater stakes in product design and product management. In short, clients really need simultaneous help with both strategy and implementations today. This means that we will have to smartly blend not only industry and functional consulting expertise, but a good portion of management consulting capabilities together with very scalable and tough notions we need in technology delivery services, which have been maturing over the years. All that requires us to experiment with new approaches to source different types of talent, manage numerous risks, and discover very new ways of work in general. And we’re doing all of that. First, certain operational practices introduced in response to COVID made us nimble and responsive to new customer demands. We have created even more adaptable internal digital platforms to manage our increasingly global business operation. Throughout 2021, we have focused on establishing repeatable approaches to drive growth across a more globally diversified delivery base while also expanding our domain capability and geographical footprint both organically and through acquisitions. Finally, we are constantly incentivizing our partner ecosystem with closer and more vertically aligned collaborations that position EPAM as a partner of choice for our cloud, digital, and industry solution innovations. This includes, for example, EPAM's active participation in the MACH Alliance and continuous contribution of over 4,500 EPAMers to open-source projects, which makes EPAM the #1 services company in the open-source community and among the top 20 global contributors overall. Let’s bring now some highlights on expanding our EPAM Continuum motion, which remains one of our core priorities, including the addition of strategy advisory services on top of already established industry and functional consulting capabilities. This is becoming important exactly because of growing client demand for software-enabled business scenarios. We now seek to help clients across a number of areas in their fast-changing businesses with both strategy and implementations simultaneously. During the last several calls, we shared specific client stories to illustrate our progress in the end-to-end solution and increasing impact of our consulting activities on our overall engagement. We brought examples from the gaming industry, which was one of the few that performed well even at the beginning of the pandemic uncertainty; and the health care industry, where we are helping with large-scale technology platform transformation efforts; and the data and analytics segment, where we assisted one of the most sophisticated global information providers with a massive cloud modernization story. Today, we would like to highlight a client from the retail industry where we have delivered across a range of end-to-end programs. This American multinational manufacturer and marketer of prestigious skincare, makeup, fragrance, and haircare products is undergoing their transformation to drive a deeper connection to their customers, optimize operations, and shorten their supply chain. It’s in part a response to consumer changes because of the global pandemic with a wider shift in the luxury and retail business model. We are working with the company to develop a control tower equivalent of their supply chain, connecting several internal and external data points, including product performance across geographic regions, competitor analysis, consumer engagement index, social media, and even weather events to create a predictive view and form a real-time production and placement of their products in consumer markets. This supply chain optimization project leverages our business consulting, data analytics, and engineering capabilities. With a blending of physical and digital consumer buying behaviors, we developed a virtual trial platform, allowing the consumer to apply a cosmetic using AR/VR technology, in addition to creating a virtual consultation and the ability to engage with their consumers in new ways. The platform can be repurposed across their multiple cosmetic brands. The digital engagement platform strengthened the user journey during the pandemic months when stores were closed across the world and has driven better conversion rates and results for consumer acquisitions online. It’s already obvious that major consumer behavior shifts have occurred and are here to stay, so the company and EPAM believe that their future sales will be largely driven by digital platforms and the increased functionality based on the latest technology trends. Now, moving on to the topic of talent. While the supply of talent continues to be the major challenge faced by all players in our sector, EPAM continues to grow rapidly in Central and Eastern Europe and in India. Additionally, we opened a new delivery location in Ontario, Canada, and are also expanding our operations in Latin America with an acquisition in Colombia of a digital and engineering company, which we just closed a couple of days ago. We’ll share more details just in a couple of minutes. In total, in Q2, we welcomed more than 3,800 net hires organically to EPAM, this talent joining the company from our university programs, lateral hires in our delivery locations, and increasingly, senior-level hires in our market geographies with extensive industry experience. The latter allows us to expand our EPAM Continuum penetration of the North American market with the addition of business experience and technology consulting teams in half a dozen new locations. While in Europe, we also brought new consulting capability via acquisition. In total, in the first half of 2021, approximately 6,700 net additions have joined EPAM, a number greater than what we historically ever added on a full-year basis. As in the past, to maintain hiring at an accelerated rate, we continue to make significant investments in our global talent development, upskilling, and educational programs. We believe that in addition to these investments, our internal platform progression in talent analytics and AI will continue to bring us a new level of engagement and capability to deploy increasingly higher-value services to our global enterprise customers. We also believe that while all this should allow us to continuously scale, it will also ensure the quality standards of our delivery services without compromising costs. Last time, we shared news about three companies being added to EPAM via our M&A efforts. Recently, we made two more acquisitions to extend our consulting and engineering capabilities while also expanding our presence in several of our key geographies. Last week, we announced our acquisition of CORE SE, a consultancy think tank specializing in IT strategy and technology-driven transformations with a presence in Berlin, Dubai, London, and Zurich. CORE will strengthen EPAM’s strategy consulting footprint and extend our talent footprint in the DACH region. Earlier this week, we also closed the acquisition of S4N, a digital software engineering company. In addition to their primary application platform development expertise, the company specializes in machine learning, data architecture, and cloud operations. Located in Bogota, Colombia, and with a presence in Seattle, Washington, the acquisition of S4N expands EPAM’s geographic presence in Latin America. We are extremely pleased to extend EPAM’s new talent and capabilities offered by those two firms. Regarding acquisitions, I would like to close with some additional comments related to our recent efforts in this area. We already see a visible contribution from our recent M&A activities in such areas as cyber advanced analytics, specifically from PolSource, which is one of the largest deals to date. We should say that we are rapidly shaping new EPAM offerings and accelerating our go-to-market activities within the fast-growing sales force ecosystem. With that, let me hand the call over to Jason, who will provide more specifics on our Q2 results and update our 2021 business outlook.

Thank you, Ark, and good morning, everyone. We are very pleased with our Q2 results, which reflect strong growth across a broad range of industry verticals and geographies. In the second quarter, EPAM delivered revenues of $881.4 million, a year-over-year increase of 39.4% on a reported basis and 35.9% in constant currency terms, reflecting a positive foreign exchange impact of 350 basis points. This quarter’s revenue growth was substantially driven by the continued improvement in the company’s ability to expand delivery capacity in response to the extremely strong demand for EPAM’s services. Moving on to industry vertical performance. We delivered very strong sequential and year-over-year growth across the travel and consumer, financial services, telecommunications, energy, manufacturing, and automotive industries. Looking at the year-over-year performance across each of our industry verticals, travel and consumer grew 59.9%, driven by very strong growth from both our consumer and retail clients, who are initiating and expanding large-scale transformation programs as they look for different ways to connect to their end customers. Financial services grew 51.5%, with very strong, broad-based growth coming from banking, insurance, wealth management, and payment platform providers. Like last quarter, growth was driven by modernization and transformation of core applications, in addition to new payment platforms associated with real-time payments. Software and hi-tech grew 33.2% in the quarter. Life sciences and healthcare grew 33.1%. Business information & media delivered 12.5% growth in the quarter. Growth in the quarter reflected a tougher comparison with the same quarter last year, with several clients having experienced substantial growth in the first half of 2020 with revenues from those programs generally plateauing late in 2020. Finally, our emerging verticals delivered 56.4% growth driven by clients in telecommunications, energy, manufacturing, and automotive. From a geographic perspective, North America, our largest region representing 59.8% of our Q2 revenues, grew 38.1% year-over-year or 36.9% in constant currency. Europe, representing 33% of our Q2 revenues, grew 38% year-over-year or 29.9% in constant currency. CIS, representing 4.4% of our Q2 revenues, grew 70.8% year-over-year and 74.6% in constant currency. Strong performance in both financial services and materials, in addition to travel and consumer, contributed to growth in Q2. Finally, APAC grew 44.4% year-over-year or 38.9% in constant currency terms and now represents 2.8% of our revenues. In Q2, revenue growth across the portfolio resulted in increased customer diversification, with our top 20 clients growing 19% while our clients outside our top 20 grew 55%. Moving down the income statement, our GAAP gross margin for the quarter was 33.8% compared to 33.7% in Q2 of last year. Non-GAAP gross margin for the quarter was 35% compared to 35.1% in the same quarter last year. Gross margin for the first half of 2021 reflects some degree of elevated labor costs in certain locations, which we expect to manage with rate increases and staffing rotation. GAAP SG&A was 17.2% of revenue compared to 18.1% in Q2 of last year. Non-GAAP SG&A came in at 15.6% of revenue compared to 16% in the same period last year. While the absolute dollar spend of our SG&A has increased, the relative percentage of revenue remains lower than historical averages. GAAP income from operations was $125.3 million or 14.2% of revenue in the quarter compared to $83.4 million or 13.2% of revenue in Q2 last year. Non-GAAP income from operations was $155.2 million or 17.6% of revenues in the quarter compared to $108.2 million or 17.1% of revenue in Q2 last year. Our GAAP effective tax rate for the quarter came in at 6.9%, which includes a higher-than-expected level of excess tax benefits related to stock-based compensation. Our non-GAAP effective tax rate, which excludes excess tax benefits, was 22.9%. Diluted earnings per share on a GAAP basis was $1.94. Non-GAAP diluted EPS was $2.05, reflecting a 40.4% increase over the same quarter in 2020. In Q2, there were approximately 59 million diluted shares outstanding. Turning to our cash flow and balance sheet, cash flow from operations for Q2 was $68.8 million compared to $146.2 million in the same quarter of 2020. Free cash flow was $46.2 million compared to $134.7 million in the same quarter last year. The lower level of free cash flow in Q2 2021 relative to Q2 2020 was the result of changes in DSO in each quarter, higher levels of cash payments made in Q2 2021 associated with corporate income tax, and the absence of tax payment deferral programs made available in Q2 2020 as part of government COVID-related programs. We ended the quarter with approximately $1.3 billion in cash and cash equivalents. At the end of Q2, DSO was 70 days and compares to 67 days in Q1 2021 and 73 days in the same quarter last year. We expect to maintain DSO around the same level for the remainder of the year. Moving on to the operational metrics. We ended the quarter with more than 42,800 consultants, designers, and engineers, a year-over-year increase of 32.6%. Our total headcount for Q2 was more than 47,850 employees. Both groups of employees grew just over 10% sequentially. Utilization was 80.2% compared to 83.9% in Q2 of last year and 81.4% in Q1 2021. Now let’s turn to guidance. With a strong first half behind us, a robust demand environment, and increased confidence in our ability to scale production headcount to meet this demand, we are raising our business outlook for 2021. Starting with our full year outlook, revenue growth will now be at least 37% on a reported basis, and in constant currency terms, will now be at least 35% after factoring in approximately 2% favorable foreign exchange impact. We now expect approximately 300 basis points of revenue contribution coming from acquisitions we closed in the last 12 months, including CORE SE and S4N. We expect GAAP income from operations will now be in the range of 13.5% to 14.5%. Non-GAAP income from operations will now be in the range of 17% to 18% based on the strength of our first half and anticipated ongoing efficiencies in SG&A spending as a percentage of revenue. We expect our GAAP effective tax rate will now be approximately 11%, and our non-GAAP effective tax rate, which excludes excess tax benefits related to stock-based compensation, to continue to be approximately 23%. For earnings per share, we expect that GAAP diluted EPS will now be in the range of $7.70 to $7.89 for the full year, and non-GAAP diluted EPS will now be in the range of $8.25 to $8.44 for the full year. We expect a weighted average share count of 59 million fully diluted shares outstanding. For Q3 of 2021, we expect revenues to be in the range of $957 million to $965 million, producing a year-over-year growth rate of approximately 47% at the midpoint of the range. We expect the favorable impact of foreign exchange on revenue growth to be approximately 1%. Lastly, we now expect approximately 450 basis points of revenue contribution to come from acquisitions we closed in the last 12 months. For the third quarter, we expect GAAP income from operations to be in the range of 13.5% to 14.5%, and non-GAAP income from operations to be in the range of 17% to 18%. We expect our GAAP effective tax rate to be approximately 13%, and our non-GAAP effective tax rate, which excludes excess tax benefits related to stock-based compensation, to be approximately 23%. For earnings per share, we expect GAAP diluted EPS to be in the range of $1.89 to $1.96 for the quarter, and non-GAAP diluted EPS to be in the range of $2.15 to $2.22 for the quarter. We expect a weighted average share count of 59.2 million diluted shares outstanding. Finally, a few key assumptions that support our GAAP to non-GAAP measurements. Stock-based compensation expense is expected to be approximately $27.6 million in Q3 and $25.7 million in Q4. Amortization of intangibles is expected to be approximately $5.6 million for each of the remaining quarters. The impact of foreign exchange is expected to be approximately a $1.5 million loss for each of the remaining quarters. The tax effect of non-GAAP adjustments is expected to be around $7.6 million in Q3 and approximately $7.1 million in Q4. Finally, we expect excess tax benefits to be around $13.7 million in Q3 and $12.8 million in Q4. In summary, we are pleased with our Q2 and first half 2021 results, which, combined with the broad-based strength we see across the business, provides support for what we believe will be a very strong 2021 performance.

It’s obviously a very strong quarter and a very strong outlook. It sounds like, to some extent, it was volume driven and your ability to access labor pools that you previously envisioned being more difficult. Can you help us better understand what changed over the course of the last three months that enabled you to access that labor? Were you doing something different? Did something break in the market? Perhaps some more insight into what evolved over the last three or four months?

I think it was happening across multiple efforts, which we started not necessarily even three months ago but even before COVID, looking at our delivery ecosystem. We were talking about diversification, going to different markets, and growing in existing locations. We were not sure about the exact results, but the last couple of quarters confirmed that most of the efforts were fruitful and we grew pretty well not only in Eastern Europe anymore but also across India. We started to work more aggressively in Latin America as well. Even in some markets in Western Europe and the U.S., we were hiring more people than we were anticipating before. So I think it’s across multiple components.

So was there anything specific, Ark, among those initiatives that was particularly effective in driving your ability to recruit?

Again, I don’t think there is one magic source. It’s broadly based, with India becoming another point of growth for us in addition to Eastern Europe before.

Yes, David. We had a broader range of geographies from which we were recruiting. Additionally, our ability to bring in staff in a more distributed mode gives us access to staff and resources in different geographies, even within the countries that we’ve traditionally recruited. So I think that it’s both that and clearly, we’re working hard to meet demand.

And I think you mentioned in your prepared remarks about the ability to offset some of the gross margin pressure from higher labor costs with pricing. Was last year an unusual year where you had pricing going up, and labor markets were trying to keep pricing down to your clients? Did that start to change in the first half of the year, or is that something that’s more prospective?

Yes, one of the things we’re beginning to see even in the middle of this year, which is different than certainly last year and probably prior years, is we are getting midyear rate increases. We are working with clients to begin to take up rates as we entered Q3. We expect to see greater-than-usual rate increases in 2022. There’s a real focus on account margin, with some prioritization of staffing related to both profitability and the strategic nature of the client. The dynamics on the pricing side are certainly improving while we still have to manage in an elevated wage inflation environment.

Right. And just one last question: I think you mentioned the acquisition contribution for the third quarter and the year. I just want to make sure I got that right. Was it 450 basis points for the year, and 450 basis points from...

Yes. So it’s 450 basis points for Q3 and 300 basis points for 2021.

I wanted to ask you about your comments regarding digital platforms and repeatable approaches to delivery. Is this one of the drivers of margin expansion in the business? Is that an overstatement, or is that part of what’s giving you confidence to raise the full-year margin guidance a little bit?

We don’t believe that it’s a margin-related benefit. It’s mostly about how to manage and deliver and how to bring talent into the company and be able to operate more actively. So our employees will probably deliver while we grow and as we’re growing right now.

Fair enough. Could you give us an update on your consulting strategy in terms of cross-sell? Also comment on the driver of your bullish guidance—how much has consulting played a part in accelerating your broader growth in terms of client engagement or getting more work on the table?

At large, there’s not much change from our previous comments. We’re not trying to build a completely separate line of business in consultancy. We’re trying to deliver more end-to-end solutions and advise clients early in this end-to-end story. We see progress, accumulating more experience in bringing these multifunctional teams, including consultants and designers and engineers, for complex opportunities. We hope to make more impact and potentially benefit even in the margin situation, but we still have to prove that it’s going to work this way.

Outstanding quarter here. Congratulations. I want to ask about your prepared remarks alluding to clients coming to you for software-enabled business scenarios. Does that change your long-held view that you’re a services company, and you don’t want to become more of a software company? Are you perhaps tweaking your viewpoint around software in any way?

I think when we’re talking about software enablement, it’s more related to the previous question about how much consulting and how new business models could drive the opportunity for us to build solutions with a significant portion of custom development. Most of the solutions require understanding of what’s happening in real-time and not necessarily relying on standard enterprise packages. Our typical implementations or solutions would today still include 70-80% of custom code on top of some standard components. This combination should enable new business models, and that’s what we mostly mean. If we have the right level of consultancies, we can advise what the final solution would look like and then help to build and implement it.

Understood. That’s very helpful. Does the current outlook reflect that all of those verticals have reasonably fully recovered, or is there still some recovery to come from those verticals impacted last year?

I would say our results still reflect that there are some impairments in some verticals. Our outlook would include expectations for some improvement, particularly in travel and hospitality, where we’re beginning to see sequential growth but not necessarily annual growth. We think that business information & media will continue to deliver revenue growth below our average revenue growth. Although we believe that life sciences & healthcare will provide a strong market opportunity, we have a few customer programs that are coming to an end in Q3.

I was struck by utilization being down around 80%. How long can you stay ahead of the curve from that perspective? How should we think about utilization evolution over the coming quarters?

Utilization traditionally for us ran below 80%. We have had very high utilization due to unique circumstances in Q2 of 2020, which was almost 84%. But that was unparalleled utilization for us. Once you get to 80%, it does limit your ability to grow with new accounts or clients. We believe that running in the high 70s, somewhat below 80%, is a better place for us. We might see somewhat higher levels of vacation in the second half of 2021, so we would model utilization below 80% in the second half of this year.

Can you comment on how the EPAM brand itself is resonating in these new areas locally? Are you adapting and adjusting it as needed based on what you’re seeing in hiring trends?

I think recognition of how different we are in the market created additional curiosity for those we’ve hired. They’re trying to understand if they would have good opportunities to grow inside of EPAM. We have very different interest from the more experienced portion of the talent pool globally than we had a couple of years ago. Our brand recognition in the markets we operate has visibly illustrated that there is a higher level of recognition and hope for opportunity inside of many minds, different services companies with a strong engineering heritage—this makes EPAM attractive for talent.

Can you comment on the pace at which you’re able to add new resources to your engagements after they’re hired? Has that been accelerated versus the historical pace given this level of demand?

Everybody knows that the demand trends have changed in the last 12 months due to the pandemic. Clients are working under agility pressure and ready to speed up the whole process. There is a significant effort and harmonization throughout the supply chain as we grow. We can better optimize timelines from opening opportunities to staffing now than we could a couple of years ago.

You talked about a progression into new and larger, multiyear engagements. Can you provide any numbers around that as far as some sense of how much larger or longer these deals are than one or two years ago?

It’s difficult to quantify precisely, but we see significant increases in the number of clients with contracts of $100 million, $50 million, and $20 million. That number is visibly increasing right now, but I can’t provide specific quantified points. We’re now working with clients that are growing from zero to $20 million, $30 million, or $50 million, and this acceleration is very noticeable.

Is it both MSAs and individual SOWs that are getting bigger and longer? Has that affected your sales approach and strategy as you pursue larger engagements?

I don’t think it’s related to specific MSA sizes. We’re probably in a similar situation as before. Most clients maintain the flexibility to stop engagements legally and contractually.

Given how much your growth is accelerating, have you seen any change in the composition of your top 5, top 10, top 20 clients?

There’s probably not a lot of change with the top 5, but there has been rotation in the 11 through 20 cohort. We have several customers that have gone from zero to our top 20 in a year or less, due to strategic imperatives.

If you’re asking about clients asking us to bring people on-site, probably not. The situation is still very unstable, and even if there are some movements, it’s likely to change quickly. Everyone is in a wait-and-see mode regarding on-site working.

In a strong demand environment, is there an opportunity to evaluate your client portfolio or become more selective over which clients you’d like to work with? What does your ideal or target client profile look like?

You’re absolutely right. There are opportunities to do this, and we are carefully reviewing the situation and changing priorities as needed. Yes, we’re looking for ideal clients constantly and finding some. But, we are evaluating these choices and where to invest.

In terms of growth outside our top 20, it’s likely coming from decisions around looking for clients with significant growth potential that also have attractive profitability.

Regarding M&A, we’re continuously evaluating our pipeline. We’re looking for new capabilities in market expertise, consulting components, and determining what would be best for our delivery strategy. We’ve found better companies willing to join us; we closed five deals this year.

Any color on how compressed the timelines are for clients regarding project completion? What does a roadmap look like compared to pre-COVID?

The pressure for performance and delivery is much higher now because of the ongoing COVID situation. Clients understand there is limited time to adjust business models and build solutions to remain competitive. This applies to all markets and puts pressure on both clients and us.

What’s your client’s appetite? Are you leaving work on the table? How do rate increases play into your strategy for hiring headcount right now?

It’s hard to predict exactly how we will grow, but based on our current understanding, we think about 3,000 additions per quarter is achievable without compromising quality. We continue to evaluate the pace and make necessary adjustments to meet our growth needs.

We feel good about the demand environment. It supports our ability to have conversations about rate increases. A rise in revenue per head is promising, but wages are increasing, complicating discussions with clients. We’re working hard to maintain and improve gross margins over time.

Thank you, everybody, for joining today. As usual, if you have any questions, David is available to help. Looking forward to talking to you in three months. Thank you.