EPAM Systems, Inc. (EPAM) Q2 2012 Earnings Report, Transcript and Summary

Good morning, and welcome to EPAM's Second Quarter 2012 Earnings Conference Call. Today's call is being recorded and we have allocated 1 hour for prepared remarks and question and answer. [Operator Instructions] At this time, I'd like to turn the conference call over to Richard Zubeck [ph], Investor Relations. Please go ahead, sir.

Thank you, operator. Good morning, everyone. By now, you should have received the copy of the earnings release for the company's second 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 we 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, Richard. Good morning to everyone, and thank you for joining us today for our second quarter 2012 earnings call. I will discuss highlights from our second quarter, discuss our key achievements, as well as discuss specific challenges we are currently faced. After this, I will turn it over to Ilya for a more in-depth review of the second quarter financials. We are pleased to report another strong quarter. Our revenue grew 10% sequentially and nearly 30% year-over-year to $103.8 million. This is an important milestone as this is the first time in our history where we exceeded $100 million in revenues per quarter, and I am particularly happy to see that result. I'm proud of our people and of our accomplishments over the past years that made all this possible. So I want to say thanks to all our people for a job well done. We're also pleased to report a strong earnings growth and margin expansion. Non-GAAP income from operations increased 40% to a record of $19.1 million. And operating margins increased 140 basis points to 18.4% from 17% last year. Finally, non-GAAP diluted earnings per share were $0.37 or a 42% increase from last year. During the quarterly close on the acquisition of Thoughtcorp, a Toronto-based IT consultancy and software solution provider. Thoughtcorp had a 17-year history of delivering high-value IT solutions and complex software applications to many of Canada's most recognized companies within telecommunications, financial and retail segments. Thoughtcorp complements our existing global delivery capabilities with its proven expertise in areas important for us, such as Agile Development, Enterprise Mobility and Business Intelligence. And we are excited about the possibility this combination brings. As in the first quarter, we benefited from a growing trend in Europe where in the difficult times, companies are turning to evaluate strategic partners to help drive efficiencies and reduce their cost. Comparing to the second quarter of last year, revenue from clients located in Europe expanded 37%. Within North America, which continues to be our largest market, we also had good traction and increased revenue by 27%, driven by both existing and new accounts. In the CIS regions, revenues increased by 25% due to recognition of $4.3 million in nonrecurring revenue from a large World Bank-sponsored fixed-fee project that was completed this quarter. This revenue has been included within our previous guidance, and we don't expect any such other nonrecurring items during rest of the year. We also saw continuing growth across most of our verticals. ISVs & Technology grew 19%. Shift in software industry drives our clients to demand proven expertise in cutting-edge technologies such as big data, cloud and mobility, as well as related large re-platforming efforts. And we are one of the best positioned product development vendors to benefit from such demands. In this turn, the Retail and Consumer grew 87% as a result of pressure on firms to improve their online customer experience, enable Web 2.0 rich internet applications and support mobile commerce. Banking and Financial Services grew 38%. Customers in this industry continue facing many challenges and looking for higher deployment and reliable vendors to help addressing those challenges. And EPAM proved such value during the last several years and continues to grow with a number of strategic investment banking accounts. Our Business Information and Media vertical was essentially flat year-over-year, mostly due to a continued drop-down at Thomson Reuters. Excluding the impact of this cutback, this vertical would have grown 17%. And in overall, we continue to maintain a very healthy balance of revenues between our indices, geographies and customs. From the same quarter last year, we had a number of new wins, which we are particularly excited about. We cannot go into specific names, but EPAM acquired highly strategic accounts in nearly every sector in which we compete. About 20 of new clients are on $1 million plus run rate right now. About 1/2 of those could be considered to have potential of becoming $10 million plus accounts within the next 24 months. We also saw strong growth within our existing accounts with approximately 80% revenues coming from clients that have used our services for at least 2 years. This, again, confirms the high quality of our services and the loyal nature of our customer base. On the surface, we had a net increase of about 1,600 IT professionals over the past year or roughly 26% growth and ended the quarter with 7,750 engineers. And we continue to maintain one of the lowest attrition rates in the industry. Turning to the outlook. There are several key issues. First, Thomson Reuters announced further unexpected forecasts and provided services during the last several years. This impacts our outlook for the second half of the year by approximately $2 million to $3 million. We are dealing the situation by aggressively reallocating the people to a number of other new and existing growing accounts, but this will impact results in any case. Second, currency cost has approximately $1.6 million in Q2 revenue comparing to previous guidance. And if exchange rates stay in current levels, it would cost another $3 million or so comparing to our original full year guidance. Third, based on the conversations we have had with our existing clients, IT budgets appear to be in line with previous year, but decisions time for initiating new projects are extended in some cases. Based on this, we had taken a more conservative stance and revising our full year revenue outlook to be $412 million to $418 million, which represents year-on-year growth of 23% to 25%. On the positive side, we're increasing our earnings growth expectation to be 16% to 18% for the year versus the previous guidance of 11% to 13%. There are several reasons for this, such as continuing focus on cost control, moderate wage inflation and a slight benefit from currency. So to recap. We had another good quarter with solid revenue and earnings growth and margin expansions. We were able to acquire some great new accounts, and we had strong growth from existing accounts. We also continue to recruit and retain smart and talented people. At the same time, we now face some challenges, specifically from further cuts of [ph] Thomson Reuters and headwinds from currency. But fundamentally, our business remains strong, and we continue to execute according to our plan. With that, I would like to turn the call over to Ilya, who will walk you through the financial results. Ilya?

Thank you, Ark, and good morning, everyone. After my comments, we'll open the call for questions. As Ark highlighted, Q2 was another solid quarter where we grew revenues nearly 30% to a record $103.8 million, while expanding margins and maintaining a healthy balance sheet. I'd like to start by providing more details and color around our guidance for the third quarter and the year. And you heard, there are 2 specific issues that came up very recently that impacted the top line outlook. As Arkadiy noted, Thomson Reuters informed us of additional and unexpected cuts in our services. We expect the impact of their decision to be approximately $2 million to $3 million in the second half of the year. This estimate, though, does not include any potential upside from reallocation of those resources to other growing or new projects. In other words, a revised full year guidance assumes 100% hit to utilization, which may or may not be the case over the next several months. Second, a stronger dollar negatively impacted revenues by approximately $1.6 million in Q2 compared to previous guidance. And if exchange rates stay at the current levels, it would cost another $3 million or so compared to our original full year guidance. Remember that this is only top line, and in fact, we benefited in Q2 slightly at the operating margin level from offsetting impact of currency on our expense base. So these are 2 specific issues that caused us to slightly decrease full year revenue guidance. Furthermore, we are raising our earnings growth projections for the year. This is primarily a result of 2 things: one is our continuing focus on cost controls. Our SG&A, excluding stock compensations, declined as a percent revenue by 140 basis points compared to last year to 19.1% of revenues. And two, better than the planned wage inflation. So putting all this together, one, we expect Q3 revenues to be between $107 million and $109 million, representing year-on-year growth of 24% to 26% and sequential growth of 3% to 5%. Two, we expect non-GAAP diluted EPS to be in the range of $0.34 to $0.36 per share for Q3 with an expected share count of approximately 45.6 million and a tax rate of approximately 16%. For the full year, we expect revenues to be between $412 million to $418 million, which represents growth of 23% to 25%. On a full year basis, we're raising adjusted earnings growth to be in the range of 16% to 18%, with an assumed tax rate of approximately 16%. So onto the rest of the financials. Starting with revenues from a vertical perspective, ISVs & Technology comprised 24% of revenues, down slightly from 26% last year, which was in line with our expectations. Banking and Financial Services increased to 23% of total revenues from 22% last year. Our Business Information and Media vertical accounted for 15% of revenues compared to 20% last year, reflecting a continued decline of Thomson Reuters as previously mentioned. Travel and Hospitality, 10% versus 12%, same time last year. Retail and Consumer with 12% of revenue compared to 8% last year. And finally, other with 14% of revenue compared to 9% last year, which was driven entirely by a $4.3 million of nonrecurring revenue related to a large World Bank-sponsored project mentioned earlier by Ark. We reported an increase in revenues from our top 10 clients of $12 million as we continue to grow the size of our key business accounts. Our top 5 and top 10 clients accounted for 32% and 47% of total revenue for the quarter compared to 35% and 48% in the preceding quarter, respectively, so a slight decline. We continue to generate a substantial portion of our revenues from our existing client base, with approximately 80% of revenues generated by customers who have been with us for at least 2 years. Time and material contract decreased as a percent of revenue with 85% in the second of quarter of 2012 versus 87% in the second quarter of 2011. Fixed-fee revenues represent 13% of total revenue in the second quarter of 2012 versus 10% in the second quarter of 2011. This shift is, again, a direct result of the previously mentioned fixed-fee project revenue referenced in Q2. Moving aside, our fixed-fee revenues would be roughly 9% of our revenues in the quarter and 88% in time and materials. Turning to our cost. Cost of revenue, excluding depreciation and amortization, in the second quarter was $63.8 million, representing an increase of 30.7% from $48.8 million in the second quarter of 2011. This increase was primarily due to a net increase of 26% in IT professional headcount. SG&A in the second quarter was 20% of revenues, down from 21% in the second quarter of 2011. Depreciation, amortization expense was $2.4 million, a slight increase from $2 million reported in the second quarter of 2011. GAAP income from operations in the second quarter of 2012 was $16.8 million, an increase of 55% over the second quarter of 2011. Operating margins were 16.2% for the second quarter compared to 13.6% for the same quarter last year. The improvement in operating margins is due largely to the nonrecurring goodwill impairment charge taken in the second quarter of 2011, as well as lower professional fees and continuing leverage of our overhead costs. Non-GAAP income from operations in the second quarter of 2012 was $19.1 million, an increase of 40% over the second quarter of 2011. Non-GAAP operating margins were 18.4% for the second quarter compared to 17% the same quarter last year. Net income for the quarter was $13.3 million, which is a year-over-year increase of 61%. Non-GAAP net income for the second quarter was $16.9 million or a diluted earnings per share of $0.37. This represents 42.3% increase compared to the second quarter of 2011. Our non-GAAP diluted share count used for the second quarter of 2012 was 46.4 million. Turning to our balance sheet. As of June 30, we had $104.9 million in cash. During the quarter, net cash provided by operations was $6.4 million compared to $10.4 million of net cash provided by operations in the second quarter of 2011. Year-to-date cash provided by operations was $1.6 million compared to $10.8 million last year. So in conclusion, our business is fundamentally sound, our pipeline is healthy and we're continuing to execute according to our plan. We will now open the call for a question-and-answer session. Operator?

[Operator Instructions] Our first question is from the line of Moshe Katri with Cowen and Company.

Arkadiy, you spoke about long sale cycles or decision sale cycles. Can you kind of elaborate a bit more on that? Are we seeing this in a specific region or vertical? Are we being just conservative? And then, are we seeing any delays or cancellation in that respect?

I wouldn't say that it's like all -- across all regions or all our line segments, more related to our relatively small business in AES region today and probably 1 or 2 accounts. So again, we see this, and exactly like we have mentioned, it's in some specific cases, but building and see it as a company turn.

Okay, that's fair. And then just a follow-up, Thomson Reuters. Can you just remind us how many people are kind of deployed at this account right now? How quickly can you redeploy them without incurring the incremental utilization rate hit? And then maybe kind of give us some more details on what happened at Reuters in the past few weeks, as you said.

We have around 500 people deployed today. Well, as we mentioned, it would -- with another notification judged during the last couple of weeks, which was in addition to what kind of carefully planned level of ramp down, which we discussed on previous calls. We don't know about specific reasons why it was done. At the same time, we're already starting to redeploy this. We have several really fast-growing accounts with similar skills, and we started the redeployment process very, very aggressively right now. Well, it does seem that in several months, we will be able to utilize these people because it's a very experienced team and was working together for a long time. So it's kind of creating additional opportunities for us.

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

Yes, my first question is also on Thomson Reuters. The -- just a clarification, the 100% hit to utilization, I'm assuming it's for both revenues and profit that you assumed in your numbers. And as you redeploy these people, would they be at higher billing rates, given what we know about Thomson Reuters' lower rate?

The answer to your question is yes to both.

Okay. And then -- that was quick. And then on Russia, if you could update us on the situation there. It was one of the sources of weakness, particularly in financial services last time. How is that tending?

So as far as Russia is concerned, specifically, the region is not growing. We -- in the CIS region, as we mentioned, we had a onetime nonrecurring revenue recognition item of $4.3 million, which showed growth for the region but -- of $3.1 million or 25% or so. But if you strip that out, it would be in a slight decline. We don't particularly see sort of additional volatility to this extent from here on out. But we also don't count on growth from that region either. And this is, as we've talked about in the past, by design.

This is not a focus where you draw different -- sort of draw down these revenues over time.

Yes.

Our next question comes from the line of Darrin Peller with Barclays.

Can you just, first of all, comment on the pipeline of what you're seeing, where you're seeing it from, what kind of business? A little more detail and color will be helpful in terms of new pipeline, new bookings, maybe geographically, as well as type of business from a discretionary, and how long the contracts are now. I mean, I know when you guys first went public on...

Yes. Within -- there's a good traction right now in Europe and North America. Both of them growing, and we've had some exceptions like we've mentioned already. Between specific industries, I would say that we have very good opportunities in ISV sector in United States. We also continue to grow way too fast in the financial services in Europe. One of the fastest growing area is Retail and Consumer and Travel and Hospitality for us. So that it's the fastest-growing sector and it's all related to demand through new online experience, commerce-related applications. So -- and we've seen a lot of opportunities around this area, and we actually are very aggressively building up our focus competencies and solution practices specifically in this area.

Our next question is from the line of Alexander Vengranovich with OTKRITIE Capital.

I have a question regarding your potential cost-cutting measures -- cost control measures, which you are planning and already started as far as I understand. As it's implemented in the company, it should result in an increase in net income. Could you please elaborate on this?

Yes. We didn't say we were starting a cost-cutting program. We said we were raising earnings growth guidance because we continued to maintain a really sharp focus on cost controls, as we've always done. And this has been slightly ahead of expectations. That's one of the reasons for raising the earnings growth target. But we are in really good shape. We don't feel we need to sort of have a comprehensive cost-cutting program. It's just business as usual.

That's the normal result of our -- we're still growing with this. We're growing in revenue, we're growing in headcount and clearly, billable headcount, and it's clearly a portion of G&A going down. That's what we specifically mentioned.

Okay. And second question. Could you please update us on your M&A plans for this year? Are you still planning to continue M&A activity?

I don't think we can give you any specifics. You saw that we completed our first acquisition for this year in Q2. And we had some -- had opportunities in our pipeline, but I don't think we can give you any specific answer right now.

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

I just wanted to follow up with a different question also. Around the expense side, obviously, there's been margin improvement going on. Can you just give us a little more color on what we should be expecting in terms of sustainability of that and -- maybe little more specifics, or specificity on what exactly you're doing to really bring out cost in the model and what can go on?

We did have really good margin expansion in this quarter. Part of that was driven by also the onetime revenue recognition item, right? So kind of full disclosure. So we don't expect sort of aggressive expansion of margins like we saw in Q2, in Q3 and Q4, particularly, since our sequential growth we're projecting right now, at least in the model, to be kind of 3% to 5% in Q3 and flattish in Q4 to Q3. So I would moderate sort of expectations about margin expansion from here. As far as your question with regards to taking cost out of the model, again, just like -- I take, though, you dropped off when we were answering a similar question to Alexander. We don't have a comprehensive cost-cutting program going on, it's just business as usual where we always keep a sharp focus on cost. Our SG&A continues to drive leverage into the model. We did see slightly better wage inflation results and we've moderated those expectations for the year as well so that helped.

Our next question is from the line of David Grossman with Stifel, Nicolaus.

Ilya, could you just review, perhaps, the flow of FX down the P&L in terms of revenue and margin? Obviously, we can see the benefit in terms of a gain or loss from FX, but perhaps you can run us through the impact above that.

Okay. So as we mentioned, compared to where we were in Q1, Q2 was negatively impacted on a top line basis by about $1.5 million, $1.6 million. And this came primarily from the euro and ruble. I think pound actually strengthened a little bit. Net-net, it actually gave us a slight benefit in the bottom line, but nothing sort of material to speak of. But if -- again, if we're extending this trend forward, and we're just doing sort of simple dumb math, $1.5 million in Q3, $1.5 million in Q4, would cause another $3 million in top line headwinds. So this is what we're projecting right now. Again, our currency mix is such that we're actually neutral in the bottom line, and this is what we saw in Q2. We don't expect the situation to change materially from there. Hopefully, that answers your question.

When you say neutral to the bottom line, is that including the foreign exchange loss or excluding that?

This is excluding the foreign exchange loss, which, on the P&L right now for Q2, really represents a remeasurement of local currency, monetary assets and liabilities to a functional. So that kind of stuff aside, the economic impact to our P&L is neutral and at times even slightly positive.

Right. So the 1.39 is just balance sheet translation, then?

Remeasurement, yes.

And I guess, just going back to your change in outlook. I mean, I think if you take Thomson Reuters as with $2 million to $3 million and then the FX impact of another $3 million that you just outlined, that pretty much accounts for the change for the year. So should we take from that the balance of the installed base at least and the new business activity that you would actually assume for the balance of the year is pretty much consistent with where we were 3 months ago? Or is that too much of a generalization there?

Well, barring a disaster scenario, yes, it is the answer. We're still in a good place. We still see a healthy pipeline. We still see a good client activity. As Ark mentioned, we had really good results from new client acquisition in the past couple of quarters. So fundamentally, the sort of the tweak to the guidance does relate to those 2 specific issues. And to the extent that we're taking a somewhat conservative approach and not sort of recognizing the benefits of potential reallocation of Thomson Reuters personnel, that's sort of tempered also by the fact that while we don't know what Thomson Reuters is going to do, what we know is what we know right now. We think we've baked in all the bad news, but that's what we said last time.

Our next question is a follow-up question from the line of Moshe Katri with Cowen and Company.

Ilya, I guess, you mentioned the fact that you're expecting wage inflation to moderate. Can you kind of provide some more details on that in terms of where -- what sort of comp increases are baked into the model now versus where -- what sort of increases were baked before?

I think we mentioned before that we were going to have wage inflation around 10% to 12%. We're now seeing it below 10%.

All right. And is there a way kind of to break it down by the various regions? Or this is kind of across the board?

This is really across the board. It's really across the board.

At this time, I'm showing no further questions. I'd like to turn the conference back over to management for any closing remarks.

Okay, thank you. Thank you, Richard. So what we can confirm is that there are some exceptional issues, which we have seen this quarter. In general, business is strong and we have a lot of prospects. And we have most of -- practically, all of our top 10 accounts, except Thomson Reuters, in very good shape and most of them growing pretty fast. So we are very confident in the current situation into the company and have actually various opportunities for the future. So -- and I think we're internally considering the situation with Thomson Reuters as a good opportunity as well. Thank you.

Thank you, sir. Ladies and gentlemen, this does conclude EPAM's Second Quarter 2012 Earnings Conference Call. Thank you very much for your participation. You may now disconnect.