EPAM Systems, Inc. (EPAM) Q1 2012 Earnings Report, Transcript and Summary

Good morning, and welcome to EPAM's Fiscal First Quarter 2012 Earnings Conference Call. Today's call is being recorded, and we have allocated an hour for prepared remarks and Q&A. [Operator Instructions] At this time, I would like to turn the conference call over to Jeff Grossman, Investor Relations at EPAM. Please go ahead, sir.

Thank you, Operator. Good morning, everyone. By now, you should have received a copy of the earnings release for the company's first quarter 2012 results. If you have not, a copy is available on our website, www.epam.com. The speakers we have on today's call are Arkadiy Dobkin, CEO and President; and Ilya Cantor, Chief Financial Officer. Before I begin, I would like to remind you that some of the comments made on today's call and some of the responses to your questions may contain forward-looking statements. These statements are subject to the risks and uncertainties as described in the company's earnings release and other filings with the SEC. I would now like to turn the call over to Arkadiy Dobkin.

Thank you very much. Good morning, everyone, and thank you for joining us today for our first quarter 2012 earnings call. We are pleased with our performance as we reported quarterly results that were ahead of our expectations, delivering strong growth in Europe and the U.S., as well as in most of our key verticals and primary service areas. During the first quarter, total revenue grew 30% to $94.4 million year-over-year. Adjusted income from operations grew 27% to $16.1 million year-over-year, and we delivered non-GAAP diluted EPS of $0.31 per share for the quarter. Our first quarter results were driven by our growing diverse client base where Europe plays a significant role. Compared to the first quarter of last year, revenue from clients located in Europe expanded 62%. As we have pointed out before, the European landscape has changed over the last few years and has opened up for high-quality services delivery in nearshoring or offshoring modes. We have certainly benefited from this trend and expect that it will continue in 2012. Within North America, which represents our largest market, we also have good traction and increased revenue by 26%, driven by both existing and new clients. In the CIS region, revenue declined by 12% or $1.5 million due to timing of delivery of certain fixed-fee projects and some pressure on financial services clients in the region. Similar to last quarter, we saw strong growth from all our primary services lines. Software development revenue increased 31% to $63 million, application testing services increased 32% to $19 million and application, maintenance and support revenues increased 24% to $8 million. We saw continued growth across most of our verticals. Retail and consumer, which grew 112% as a result of increased demand for our strong expertise in the commerce and SAP technology solutions; travel and hospitality, which grew 50% as a result of several new clients and our ability to leverage our extensive content management and portal solutions, e-commerce, business intelligence and mobility expertise; banking and financial services, which grew 38% as a result of continuing penetration of strategic accounts within the investment banking industry; and ISV or independent software vendors and technology grew 21% in line with our intention to have significant portion of our business within that segment to continually improve our software engineering skills and understanding of the emerging technology trends based on real-life, hands-on experience serving the best technology companies in the world. We believe that during this quarter, we have captured additional market share across those verticals. Revenue growth in our Business Information & Media vertical was up only 2% year-over-year, mostly due to completion of the number of large projects for Thomson Reuters, as well as the Thomson decision to use their own internal resources for starting [ph] new projects. This decision was expected, and although the overall revenue is currently declining, our relationship with Thomson Reuters remains strong. We continue to see additional growth opportunities throughout the organization, and a number of new potential projects are becoming visible. As in the past, we saw strong growth within existing clients with average of 81% and 65% of our revenues during the first quarter of 2012, coming from the clients that have used our services for at least 2 and 3 years, respectively. This confirms the high quality of our services and the loyal nature of our customer base. In addition, we added a number of key new clients during this quarter. Revenues from our top 10 clients increased $12 million in the first quarter of 2012 as compared to the first quarter of 2011. This represented 42.5% of the increase in revenue in the first quarter of 2012. Overall, we believe we have a high growth potential over the next few years with most of our top accounts. In regards to our delivery capacity, as I indicated last quarter, one of our main near-term priorities is to invest more in our core existing competencies across both technology platforms and industry segments. We have to identify and hire new talent with such skills in order to expand our strategic vertical segments further. During Q1, we increased the number of such professionals in both U.S. and Europe. We also need to increase scale across our delivery centers. Through our close relationships with universities in Central and Eastern Europe, we are able to identify and attract the top new talent without materially impacting utilization or attrition rates. Relative to the first quarter of 2011, we had a net increase of 1,580 professionals over the past year and ended the quarter with approximately 7,300 engineers, with one of the lowest attrition rates in the industry. We remain on track to expand our headcount by 20%, 22% this year. We also will continue to identify and evaluate potential acquisitions to expand our geographic footprint and compliment our global delivery capabilities. As we move through 2012, we are paying close attention to the broader macroeconomic trends and general levels of IT spend. Thus far, we believe that budgets are in line with previous years. However, as you know, there is volatility in the overall macroeconomic environment and in the competitive landscape. So for the full year 2012, we are maintaining our guidance for revenue and earnings growth. With that, I would like to turn the call over to Ilya, who will walk you through the financials. Ilya?

Thank you, Ark, and good morning, everyone. After my comments, we will open the call to questions. As detailed in our press release, we had another solid quarter, growing revenues 30% to $94.4 million, while maintaining stable margins and a healthy balance sheet. Starting with the revenues from a vertical perspective, ISVs & Technology comprised 26% of revenues, down slightly from 27% last year, which was in line with our expectations. As we've stated in the past, we intend to maintain a substantial part of our business with ISV and tech clients as they are a part of the foundation of EPAM, and these relationships provide us the necessary means to stay in front of the general and emerging technology trends. Banking & Financial Services increased to 24% of total revenues from 22% last year as we continue to benefit from the growing trend of outsourcing by financial institutions. Our Business Information & Media vertical accounted for 16% of revenues compared to 21% last year; Travel and Hospitality, 12% versus 11% same time last year; and Retail and Consumer was 13% of revenues compared to 8% last year. Our vertical growth was led by Retail and Consumer and Banking & Financial Services, which grew 112% and 38%, respectively. As Ark mentioned, we reported an increase in revenues from our top 10 clients of $12 million as we continued to grow the size of our key existing accounts. Our top 5 and top 10 clients accounted for 35% and 48% of total revenues in the quarter. Time and material contracts continued to increase as a percent of revenues, with 89% versus 87% same time last year. Fixed-fee contracts represented 9% of total revenues this quarter versus 11% in the first quarter of 2011. Turning to our costs. Cost of revenues, excluding depreciation and amortization in the first quarter, was $60.2 million, representing an increase of 32.2% from $45.5 million in the first quarter of 2011. This increase was primarily due to a net increase of 1,500 IT professionals to support the growth and demand for our services. SG&A in the first quarter was 18.7% of revenues, down from 18.9% in the first quarter of 2011. Depreciation and amortization expense was $2.2 million, a slight increase from the $1.8 million reported in the same quarter of last year. GAAP income from operations in the first quarter of 2012 was $13.8 million, an increase of 17% over the first quarter of 2011. Operating margins were 14.6% for the first quarter compared to 16.3% same quarter last year. The decline in margins were primarily driven by stock compensation and certain nonrecurring charges. Non-GAAP income from operations in the first quarter of 2012 was $16.1 million, an increase of 27% over the first quarter of 2011. Non-GAAP operating margins were 17.1% for the first quarter compared to 17.5% in the same quarter last year. Interest income was $0.5 million, and we also reported a small net foreign exchange gain of less than $100,000 for the quarter. Net income for the quarter was $12.1 million, which is a year-over-year increase of 24%. Non-GAAP net income for the first quarter was $14.4 million or a diluted EPS of $0.31 per share. This represents a 29.2% increase compared to the first quarter of 2011. Our non-GAAP diluted share count used for the first quarter of 2012 was 46 million shares computed as if -- converted method as though the initial public offering had occurred as of the beginning of the quarter. Turning to our balance sheet. As of March 31, we had $112.7 million cash. Accounts receivable decreased to $54.2 million from $59.5 million at the end of 2011. We finished the quarter with a DSO of 53 days compared to 52 days in the first quarter of last year. Deferred revenues were $5.5 million, a sequential decline from $6.9 million. Unbilled receivables were approximately $42 million compared to $24.5 million at the end of 2011. During the quarter, net cash used in operations was $4.7 million compared to $0.4 million of net cash provided by operations in the first quarter of 2011. The cash used in operations for the quarter was primarily due to higher bonus payments relating to 2011 performance, as well as normal seasonal slowdown in billings with some of our larger clients during the quarter. Finally, I would like to provide you guidance for our second quarter and update our full year 2012 expectations. We expect Q2 revenues of between $100 million and $102 million, representing year-on-year growth of 25% to 27%. We expect non-GAAP diluted earnings per share to be in the range of $0.30 to $0.32 per share for Q2, with an expected share count of approximately 46.3 million and a tax rate of roughly 17%. For the full year, we continue to expect revenues between $411 million to $418 million, which represents growth between 23% to 25% over 2011 results. On a full-year basis, we expect earnings growth on a non-GAAP basis to be in the range of 10% to 12%, with a tax rate of approximately 17%. We will now open the call for a question-and-answer session. Operator?

[Operator Instructions] And our first question is from the line of Moshe Katri with Cowen.

So you had -- you've exceeded expectations, raised guidance for Q2 and then you maintain your guidance for the year. I just want to confirm what you're kind of saying during the call that we're doing this just because we're trying to be conservative. Am I correct here?

Moshe, this is Ilya. Look, we have pretty good visibility into Q2, but as you know, there's also a challenging market environment and a competitive landscape. We have less visibility into the second half of the year than we do into Q2. So we're comfortable with $411 million to $418 million in revenues. So, I mean, there's a little bit of a degree of conservatism, but truly, we don't want to be out ahead of the market right now.

Understood. And then Arkadiy, you said something in your opening remarks about weakness in financial services. Maybe you can kind of repeat what you said. I kind of missed it.

No, I was referring to financial services in CIS region, not in general. So this is related only to our portion of business in former Soviet Union.

Okay, great. And then can you just repeat some of the revenue metrics by, I think, by the service lines in terms of the growth rates? I think you went through it kind of quickly.

Sure. Okay. Starting with software development in the first quarter, grew 31% compared to the same quarter last year; testing, 32% growth; maintenance and support, 24% growth; infrastructure services, 33.7%, and those are the main components.

Okay, great. And lastly, Thompson Reuters is roughly 9% of revenues for the quarter?

Roughly. A little bit less than.

Our next question comes from the line of Ashwin Shirvaikar with Citibank.

I guess my first question is, as you roll out some of these verticals and they get the scale, especially with application development and services like that, are you finding a need for different or higher level of training? Or, I mean, do the new people have to be trained differently as you hire them? Can you comment a little bit on that?

We're definitely, as we mentioned before, planning to bring different caliber of people specifically for developing our competency or expanding our competencies and to perform kind of different roles on-site in client-facing situations. And for this, there are special training efforts we're putting together. It's the same as the special recruitment efforts as well. In general, the services which we provide in line with what we were doing before, so training was in our focus for a long time. It's not something really new effort which we're establishing right now. So again, but for some special roles, there is a difference and we are paying attention to this.

Okay. And one question on client ramps, which, I think, a few of your competitors have had potential issues with in the last few months. The clients that you signed already, as you ramp those clients, are you finding any hesitancy on their part or are they pretty much proceeding as planned in terms of those bookings rolling into revenues?

Okay. First of all, I would like to kind of point out that it's difficult to compare the business and type of clients we have with some of the very large outsourcing firms which you're referring to, okay? So it's probably not exactly apple-to-apple comparisons in behavior of the clients. At the same time, there are some changes, but I don't think it's something unusual happening. I think it's pretty much in line with normal business when some clients expect some level of ramp-up and then change it or some of them ramping up actually faster than they expected as well. So we have seen both directions right now. We've seen some people were trying to stay flat and then changing plans to increase the team very, very quickly.

Sure. No, that's fair. I was asking on an average level. On an average level, not so changed. So that's really...

On average, we feel that it's very similar to previous periods right now, at least in our type of clients, okay?

[Operator Instructions] And our next question comes from the line of Darrin Peller with Barclays.

Just one question first. On hiring plans, during the IPO process, I know you mentioned you were planning on making more investments in certain personnel, especially around SAP work and other kinds of work to build out. Is that laying out as -- playing out as expected? Are clients doing more business with EPAM in those areas, beyond the traditional areas that you've worked on in the past? Maybe just start there.

During the IPO and after this, we were pointing out that some competencies which we developed -- SAP just one of them -- were very critical for us to enter our relationships with accounts. Because again, with our size and with our kind of profile of the company, we're opening doors differently than very large, 10x bigger than us providers. So -- and this has actually worked for us, and we increased the number of people who capable, present our special skills in these areas of competencies. So this is happening according to our plans right now.

Good. And then would you say that your hiring plans overall are continuing to run at the same rate relative to the revenue growth you had expected when you first had the IPO also? Has anything changed on the overall big picture hiring plans?

No, based on what we see right now, it's exactly in line with our projections.

Okay. And then just last question for me. On your guidance, you've obviously -- you've done well in the first quarter out of the gate. You've maintained guidance right now. I mean, can you give us a sense of your confidence? If you're not changing the guidance, can you just give us a sense in your confidence level around it? I mean, given the environment, obviously, there's clearly some questions as was brought up earlier on the macro and some of your competitors. I know it's not easy to compare. But can you give us a little color on your confidence in your guidance? Maybe it would go a long way.

Yes, I'll let Ilya to start answering and then I'll add what I think.

Darrin, yes, again, we have very good visibility into Q2. We have less visibility into Q3 and Q4 as we do in Q2, but the visibility is not outside of what we normally have at this point in time. What gives us a little bit of pause is, again, as you mentioned, the macroeconomic environment, some of the things the peers were saying. However, we are fairly confident in getting to $411 million to $418 million revenues. We're much less so confident in hitting numbers beyond that range at this time, but certainly, we will have more information for you at our next earnings call.

Okay. Maybe just -- go ahead, Ark. Were you going to say something?

Again, I would point it out the difference between like -- clearly, very carefully, listened yesterday to the Cognizant call, for example. And again, our client base is different and you understand this. So predictability like our power [ph] agreements is also a little bit different. We're getting to the clients with tens of millions, but the number of these clients are relatively small yet. And basically, the plans which they're sharing with us is also limited, I mean, if it's talking about clients between $1 million and $5 million, for example. So that's why kind of to understand the Ilya answer, we're very well and very comfortable with our Q2, but we don't have enough visibility in Q3 or Q4 to go beyond what we're projecting right now.

[Operator Instructions] And our next question comes from the line of David Grossman with Stifel, Nicolaus.

Ark, could you maybe just share with us a little more on the new client activity in the quarter? And I may have missed it, I'm sorry if I did. Just how many new clients you signed and if you could give us a sense for the size of those clients, as well as what your pipeline looks like now versus what it looked like 3 months ago or I guess maybe a couple of months ago.

Well, in general, pipeline, again, we're exactly in line with our guidance for revenue, $411 million, $418 million. So basically, the probability is increasing for Q3 and Q4. And based on the new clients like in Q1, we increased number of clients probably by a dozen. But if you're talking about clients, which we're considering can bring within next 12 months significant revenue, we think we have around 5 clients of this size. And also, kind of coming a little bit back, we were talking or sharing some information about new clients in the past, and these clients are actually growing nicely with us. And we have a number of clients which are coming from $1 million range to $5 million range and from $5 million range to $10 million range. This is happening. So we're kind of increasing a number of large clients in our portfolio right now.

Okay. And I guess just getting back to some of the earlier comment about kind of the tone from your existing customers, and I think I appreciate your scale relative to some of the others that have reported issues. But that said, it sounds like the ramp within your installed base of clients is pretty consistent with what your expectations were and the ramp that you were seeing 3 months ago. Is that a fair comment?

That's true. That's a fair comment. That's exactly what we'd like you to understand.

And then in terms of just looking at the competitive landscape, I've seen some activities from some of the larger players in the region. Is there any real change there or is it pretty much what it's been historically?

We believe it's very much in line with historical situation. When you're saying locally, you mean exactly competition for revenue in our regions or competition for resources or...

For resources, ramping headcount.

Again, it's not easy, as we mentioned many times before, but it's pretty much in line with what we expected so far.

Yes, I'm sorry, maybe you mentioned this, but what is your expectation or your updated expectation for wage increases this year?

So like what we were communicating before was around 12%, and this is approximately what we expect, maybe a little bit lower. But we will see much better closer to the mid of the year.

Okay. And any update in terms of expanding the capacity in Minsk? Is that pretty much on track?

Expanding capacity in Minsk?

You mean the Minsk building?

Yes, exactly.

Yes, it's in construction right now. Yes, under construction.

Okay. All right. And then maybe just a couple of quick questions for you, Ilya. In terms of the balance sheet, if I'm looking at this right, it looks like you had a pretty big increase in unbilled receivables. Is that just maybe 1 or 2 particular contracts in timing or is there difference in terms of the amount of percentage of completion underway or is it something else that drove that up sequentially?

Right. So Q1 is -- seasonally sees a buildup in unbilled revenues as paperwork gets completed, as purchase orders get finalized. So this is not an unusual trend. We did have a little bit more in terms of unbilled receivables specific to a top-5 account, which has been resolved at this time. So this is definitely not anything out of the ordinary, and as the business gets bigger, the unbilled receivables get bigger as well.

And should we expect that to be down then sequentially in the June quarter?

Absolutely.

Okay. And in terms of the pro forma adjustments, I'm sure the stock comp number went up with the stock price, but is -- can you help us perhaps with a sense of where those pro forma adjustments are, how we should be modeling those pro forma adjustments for the year now, both stock comp and intangibles? And perhaps you could share with us what the onetime charges were in the quarter.

Yes. Okay. So in the first quarter, we had one stock compensation charge relevant to a restricted stock grant given to a named executive officer. That will not recur, but it's pushing out stock comp in the first quarter by about $700,000. Also in the first quarter, we had initiated our long-term equity incentive plan with an initial set of grants to a fairly deep swath of our senior managers, call it about 300 to 400 people. That didn't impact Q1 that much because it was granted late in March, but it will continue to impact the outer quarters. So that said, stock comp would be around or was around $1.5 million in the first quarter because of the combination of sort of the stuff that's coming forward from last year, plus the one-off grant to Section 16. But the outer quarters will look about the same, about $1.5 million, $1.6 million, because they will have the impact of the initiation of the long-term equity incentive plan, so also about $1.6 million across the year.

Okay. And the onetime items in the quarter?

So the other item of significance that's a onetime item is about a $600,000 -- around about a $600,000 charge that shows up in other expenses. That's related to purchase accounting relevant to an acquisition we did in 2010 that had a trigger on requiring us to issue 53,000 shares of stock once we go public. Obviously, we went public so we issued that stock, so we took that charge. And that's a nonrecurring charge.

I see. And then the amortization of intangibles should stay at the level we're at in the first quarter as well?

Yes, it's about $150 million, $160 million. That will be consistent unless, of course, we make an acquisition.

Right. And then I didn't catch the actual headcount number, the billable headcount number. Do you mind repeating that real quickly, where you were at the end of March?

Sure. 7,300.

And with that, I would like to turn the call back to management for any closing remarks.

Thank you, everyone, and have a good day.

Ladies and gentlemen, that does conclude our conference call for today. You may now disconnect.