EPAM Systems, Inc. (EPAM) Q1 2013 Earnings Report, Transcript and Summary

Greetings, and welcome to the EPAM Systems First Quarter 2013 Earnings Conference Call. [Operator Instructions] As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Mr. Anthony Conte, VP of Finance. Thank you, Mr. Conte, you may begin.

Thank you, operator, and good morning, everyone. By now, you should have received the copy of the earnings release for the company's first quarter results. If you have not, a copy is available on our website at www.epam.com, together with our supplemental data sheet. 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. Please go ahead, Arkadiy.

Thank you, Anthony. Good morning, and thank you for joining us today for our fourth quarter 2013 earnings call. This morning, we are pleased to report another strong quarter of industry-leading performance. Total revenue grew 31.6% to $124.2 million year-over-year, and 32.7% on constant currency basis. That's the high end of our guidance. Adjusted income from operations increased 16.8% to $18.8 million year-over-year. Adjusted earnings per share were $0.35, ahead of expectations. Performance was strong across all geographies. North America, our largest market, grew 38%. Europe was up 24%, and the CIS region increased 31%. With North America, IT technology is a major growth driver in Q1. The flexibility and agility become the keywords for customers today, are increasingly seeking different and better ways to tap into new opportunities to grow business for their clients and for themselves. The maturing FAST Cloud Forum, emerging cloud models, Big Data and Analytics and Enterprise Mobility are defining the way how IT is design there today. Products and Solutions segment. All that puts very different demands on the skill set and experience for their development partners. EPAM has been historically focused on IT Technology segment, and while this focus we had built very strong expertise in most of these important emergent and adjacent technologies. As such, we are well-positioned to benefit further from this very fast growing segment within the broader global delivery market. Also during this quarter, EPAM significant progress with a number of big accounts in traveling consumer and business information and media verticals. In addition, we started to gain real traction and realize synergies from our acquisitions of Thoughtcorp in Canada and Empathy Lab in Europe. In Europe, we also have strong forward momentum. With continued economical volatility, companies in Europe are just facing the requirements, and EPAM was ideally suited in Europe already, and we would have proven value and depth of service [indiscernible]. In particular, banking and finance customers continue to grow and expand with us. Another important growth area in Europe revolves around eCommerce. While selling through a multiple is nothing new, the growing complexity and constantly changing needs of front-end, back-end systems, the cost of integration efforts and disconnected business processes in place at many companies have made it economically prohibitive to deliver a truly optimized omni-channel experience. So you see today opportunities not only from new e-commerce implementations, but also from the platform and customization and integration initiatives around enterprise corners. On a related note, we have recently been granted Oracle Top Business Impact Partner, EMEA 2012 award during the 5th Annual Oracle Commerce Conference in Lisbon. This is a big deal for us. Our success as a leading partner in Europe Oracle Enterprise Commerce platform is supported by a long history of providing product development and R&D services for several related Oracle product lines. So that is a clear confirmation of our message of leveraging our IT Technology Services expertise further, now focused industry markets and the plan to capitalize on such leverage more in the future. Also on the topic of industry recognition in Europe, the work we did with Wolters Kluwer in the semantics search area has recently been awarded the 2013 European Outsourcing Association Award in category IT Outsourcing Project of the Year. In CIS region. We increased 31% year-over-year on steady growth in virtually every sector. In Russia, we see similar trends related eCommerce that we talked about it in the European market. Our business in traveling consumer vertical in Russia is growing. This was primarily due to the success of large web commerce initiatives, with such major retailers in the region as M.Video, a leading Russian consumer electronics chain; L'Etoile, which is Russia's largest cosmetic and perfumery network; and Sportmaster, the leading sports retailer in CIS. We believe that this vertical is going to continue to expand rapidly and will be an interesting opportunity for us. We are focusing our efforts on developing this further by bringing into the local markets our substantial expertise in eCommerce, which we accumulated globally today. With our recognized success as the top-tier Oracle partner, as well as expertise with other eCommerce solutions, we are very well-positioned to capture opportunities in Russia's bigger markets. Now I would like to spend a couple of moments talking about our most recent acquisition of Empathy Lab, and restate the distinct value proposition, especially in regards to the opportunities I mentioned before. This is a US-based digital strategy and execution firm, which specializes in consulting, digital strategies, user experience and design and digital product development. There are several key areas where Empathy is very complementing to our services. We know, based on experience, as majority of our clients in travel and consumer, business information and media and many clients within financial services vertical that user experience is becoming paramount to the success -- to the solutions we deliver. Traditional companies in those verticals converted themselves in software-driven enterprises. So EPAM Empathy Lab demonstrated, in their part, their ability to help clients in the new reality to define and understand business challenges and outcomes that can be achieved using modern digital strategies and user experience design, which become pervasive and persistent part across all spectrums of software solutions. Second, Empathy is a well-respected Oracle eCommerce partner. They helped improve EPAM solutions capability broadly in e-Commerce area. Working with such well-known brands such as Avon, DIRECTV and Liberty Global. Empathy Lab, also acts as the strategic advisor, program monitor and digital agency for the Red Cross. As a result of this partnership, the new redcross.org built on Oracle ATG Web Commerce, set a new record, handling peak volumes of donations for victims of Hurricane Sandy, while maintaining 100% uptime. Another major client, Liberty Global, awarded Empathy Lab for its contribution to Horizon TV Online, with 2012 Global Vendor Award for Innovation and Breakthrough at their annual technology summit in Amsterdam. The award recognized Empathy Lab as the leading partner and won over 1,000 vendors who support Liberty Global in this strategic and operational initiatives. We can continue this topic, but let me simply conclude that Empathy should help us to forge a more direct path to accessing chief marketing officer budgets, which, according to analysts' prediction during the next several years, will spend significantly more than CIOs do today, mostly driven by e-Commerce, social and mobile and marketing initiatives. We believe this to be true. Combining that with EPAM traditional strong focus on advanced technologies and [indiscernible] should allow us to continue growing at above-market rates. Turning to new business. New business acquisition was healthy during Q1, both organically and through relationship that existed at Thoughtcorp and Empathy Lab. This month is 1 year anniversary of the Thoughtcorp acquisition, and I'm pleased to report that our expectations made on synergies held very true so far. For example, we have acquired, less than 9 months ago, a major client, who will be among top 10 EPAM clients this year. During this quarter, the head of the Canadian mobile device manufacture, discussed a potential to become a major client in 2014. We also have several very key opportunities now to convert several large local customers in Canada to our global delivery client base. It's very different level of potential. Very similar trend we see right now with Empathy client, and during Q1, we already proved that there is multiple instances. Overall, we added new clients in each industry vertical and some of them show strong promise to ramp rapidly during 2013. With that, I will turn the call over to Ilya for the financial review.

Thank you, Ark, and good morning, everyone. As detailed in our press release, our first quarter revenue grew 31.6% over last year to $124.2 million, or 32.7% on a constant currency basis, while adjusted net income grew by 14.7% to $16.5 million, and earnings per share were $0.35. All of our verticals performed well. IT and Technology was up 37.5% year-over-year, and 5.1% sequentially, accounting for 26% of revenue. This growth was driven by several of our top accounts in those verticals, as well as continued broad-based demand for complex software development and solutions for many of our existing, as well as several new clients. Banking & Financial Services continue to be a fast-growing vertical for us, increasing 45.9% year-over-year to 26.2% of revenues. Travel & Consumer increased 14.5% to 22% of total. Business Information & Media grew 8.8% to 14.2% of revenue. However, excluding the impact of Thomson Reuters, this vertical would be up 54.1% year-over-year, but then you also have to adjust for the impact of Empathy Lab, so adjusting for both Thomson Reuters and Empathy Lab's organic growth in this segment is 15% year-over-year. In our other vertical, this is up 74.1% year-over-year to 10.4% of revenues. We were benefited, primarily, from growth in the single particular large oil and gas client, as well as good performance in several of our telco accounts. Turning now to our performance by service line. Software development services revenue, which includes product development and application software development increased 33% to $84 million or 67.5% total. Testing increased 28% to $24 million or 19.4% of revenue. Maintenance and support revenues increased 31.5% to $11 million or 8.7% of total, compared to 8.2% of total in Q4. And Infrastructure Services increased 31% to 2.10% of revenue. On performance by geography, North America increased 37.7% to 51.9% of total. Again, here, we also had the benefit of Empathy Lab's, as well as the Thoughtcorp acquisition, neither of which were reported in the first quarter of 2012. Europe has grown 23.5%, almost entirely organically, and CIS increased 31.4%. However, I should note that CIS was down $9.5 million, sequentially, because of a really tough comparison to the December quarter of last year, which had a ramp-up in service delivery and related revenue recognition at 3 or 4 projects we did for several banks in the region, as well as backloaded delivery acceptance with a large government project in the region. This pattern, however, is relatively normal for the December quarter, when acceptance of the deliverables tends to be pushed towards the end of the year. Also contributing to the tough comparison is that we had some budget flush in CIS in the fourth quarter, which we spoke about during the last call. Our customers continue to be very loyal. 90% and 77% of our revenues in the first quarter of 2013 came from clients who had used our services for at least 1 and 2 years, respectively. This is excluding the impact of 2 acquisitions made in 2012. Revenues from our top 10 accounts increased 14.7% year-over-year. Excluding the impact of Thomson Reuters, our top 10 would have grown 26%. Turning to costs. Cost of revenue, exclusive of depreciation and amortization, was $77.9 million in the first quarter of 2013, which is an increase of 29.5% over $60.2 million reported in the last year period. Cost of revenue, excluding stock compensation, was $77.2 million in the first quarter or 62.1% revenue, compared to 63.2% of revenues in the same quarter last year. IT professional headcount increased 19%, while revenue increased 32%, as we have increased utilization slightly in the quarter. First quarter SG&A expenses were $27.1 million as reported. Excluding stock comp and acquisition-related costs, SG&A was $25.2 million or 20.3% of revenue, as compared to $16.6 million or 17.5% of revenue in Q1 of 2012. This difference is primarily due to increased cost of being a public company, as well as investments we discussed last quarter that we're making to support rapid growth and expansion of our business, including the development of account management and other onsite roles, as well as additional personnel and infrastructure build-out, necessary to keep up with the rapid growth of our business. Depreciation and amortization expense for the first quarter was $3.6 million or $1.4 million, or 63.6% increase over Q1 of 2012. The increased depreciation is due to additional CapEx for equipment to support the growth in headcount, as well as $0.6 million from amortization of intangibles from the Thoughtcorp and Empathy Lab acquisitions. Non-GAAP income from operations was $18.8 million for the first quarter, representing a 16.8% gain over the first quarter of the previous year. For the first quarter of 2013, non-GAAP operating margin was 15.2%, down from 17.1% a year ago, primarily due to the several factors that I just described. As there were several nonrecurring actors impacting margins this quarter, we anticipate that our margins will improve moderately from here during the rest of the year, and remain within our target range of 16% to 18%, although there can be variations during the periods as we continue to invest to support our growth. Net interest income was $0.6 million for the quarter. GAAP foreign exchange loss was about $500,000 for the quarter. Non-GAAP net income or net income, excluding the impact of foreign exchange, acquisition costs, amortization of acquisition and intangibles and stock-based compensation, was $16.5 million for the quarter or $0.35 per diluted share, up 12.9% from $0.31 reported in Q1 of 2012. Now let's look at the balance sheet. We ended the quarter with $103 million in cash. Cash used in operating activities was $11.7 million. This was due to typical seasonal factors, such as year-end bonuses, tax payments and growth in unbilled revenue. Unbilled billed revenue was $53.6 million at March 31, compared to $35.7 million in December 31. However, we have subsequently billed $17 million of $53.6 million in April. So this is a typical seasonal pattern. Net cash of $6.5 million was used in investing activities during 2013, up $2.8 million, primarily the result of employee loans issued in the first quarter of 2013. Net cash provided by financing activities was $4 million, primarily due to funds received in connection with employee stock option exercises. Accounts receivable were $75.7 million at the end of Q1, down 4% from year-end. We finished the quarter with a DSO or days sales outstanding of 56 days, same as last quarter. On a final note, there's a lot of discussion and uncertainty about the Senate immigration reform bill and a provision to that bill, related to H-1B and L-1 visas. We get many of our people that are in the U.S. today from our offshore locations on L-1 visas, which are not the focal point of the bill. Only 16% of our U.S staff are H-1Bs, which is relatively close to the 15% limit that is in the current draft. So even if it's assuming the current draft survived substantially in its present form, which we believe is highly unlikely, we don't believe this issue will have a meaningful impact on EPAM given that approximately 90%, 95% of our services are delivered offshore. And potentially, this could also be an opportunity for us, if there is significant disruption to others caused by the final version of this bill. Turning to our guidance for Q2 and the balance of the year. On the outlook for the year, we're seeing a healthy demand environment from our existing accounts, and we also see solid business development activity in the pipeline. Therefore, we continue to feel confident in the outlook we've provided to you last quarter. And as such, for the full year, we are reiterating our prior guidance of revenue growth of 23% to 25% over 2012 results. On a full year basis, we continue to expect non-GAAP earnings growth to be in the range of 12% to 15%, with the tax rate of approximately 20%. For the second quarter of 2013, we expect revenue between $131 million and $133 million, representing growth rate of 26% to 28% over the second quarter of 2012. Non-GAAP diluted earnings per share expected to be in the range of $0.38 to $0.40, based on weighted average of 48 million diluted shares and a 20% tax rate. I should note all guidance excludes any assumption for nonoperating currency gains or losses. With that, I would like to turn the call back to the operator to open it up for Q&A.

[Operator Instructions] Our first question comes from the line of Ashwin Shirvaikar with Citi.

My first question is for -- just looking beyond Q2 for the rest of this year, should we expect a similar pattern of sequential revenue growth that we did to last year?

I think the short answer is approximately yes. And we don't guide quarter-to-quarter, we're still confident in the full year guidance that we did provide.

Just to add, it's Arkadiy. So it's very difficult to predict the jump, which we had in Q4 last year. So we're not counting on this type of event, so just to make sure we are on the same page.

Right. Actually, the right thing to do is to not have, at this stage, any assumptions around fourth quarter budget flush. So the second question, I guess, is, if I could just drill down on the DSOs and the unbilled DSOs in particular. And I know, Ilya, that you said that $17 million of the $53 million was billed in April. But in general, as your projects get a little bit more complex, I guess, to Ark's point, the key made in his remarks, should we expect the DSOs and unbilled DSOs to go up modestly from here, just from a cash flow modeling perspective?

I think it's probably -- we're not going to depart materially from today's DSO levels, and we're working diligently and continuously on making sure that we have favorable payment terms negotiated upfront in our contracts, and also that we follow-up diligently on collecting receivables. However, particularly as there is some fluctuations, in particular, where you saw in CIS region in Q4 in quarter 1, you can expect some volatility, in particular, from that region. But I wouldn't say that we're going to be materially different from today's level.

Got it. The last question, just a clarification. The 16% number that you gave, with regards to the, I guess, the Senate Bill, was that just for H-1s or H-1/L-1 combined? And if it was just for H-1, what is the L-1 percentage? Because there are elements in the bill that apply to L-1, as well as I think.

Sure. The 16% applies only to H-1Vs, and the difference being 15% and 16% for us is literally 5 people. So that's very small, if some or all go on green cards, which is the typical path, and we don't have an issue. L-1s are 27% of our US-based staffing. So together, it's about 43% on total on temporary visas.

Our next question comes from the line of Moshe Katri with Cowen and company.

Ilya and Arkadiy, can you talk a bit about some of the investments that you are going through, making actually, this year? Where are we in that phase, and maybe talk a bit about what you're doing on the sell-side of the business as well?

Moshe, so our investments, there is nothing drastically new in line of investments we do. So we were talking about increasing number of on-site people to make sure that our connection with clients are better, and we better prepare it to manage more complex projects as we're getting involved all the time, more and more. So this is one area of investment. We're investing in building competency centers, so this requires some level of dedication and non-billable people to be able to summarize the knowledge and actually distribute and provide guidance and very specific presale support. So it's clearly another area and require very qualified personnel to perform. And thanks for reminding us about our sales aspirations. So that's clearly one more investment focus for us, and we're hiring people in this segment as well. And as you all know, it all was kind of under-invested area at EPAM, where we were getting business a lot through referrals and existing relationships. So I would say that it's in focus today also. General stuff, each company like -- because we're growing in infrastructure and all that, but I would focus more on the kind of client base and capabilities and competency capabilities, which is very, very important for us.

Okay. And then can we talk a bit about Thomson Reuters? And it's still about 4% of revenues and I'm assuming, was it down or flat sequentially for the quarter?

It's still going down quarter-by-quarter, okay. But at this point...

I'm sorry, it's about 3.6%. I think it's stabilized, but we don't clearly...

So there is no -- like we -- again, we know what was scheduled for ramp-down from the past, and 3 in projects in exactly on this ramp-down. So I'll really mention right now, it's 3.6% of our revenue. And I don't think we can add anything else. So it's basically client-dependent. There are some new work coming. We're just quoting to get relatively sizeable, completely new deal inside of Thomson Reuters, but it's in our capabilities. But it's probably all I can share right now.

Our next question comes from the line of David Grossman with Stifel. David M. Grossman - Stifel, Nicolaus & Co., Inc., Research Division: I'm wondering if we could go to the gross margin. After a couple of periods of decline, it increased in the December quarter and then increased again in the March quarter. And I'm just wondering, is that from the core business? Is it acquisition-related? Or is there something else fundamentally going on in the gross margin line?

As far as the gross margin is concerned, we did improve our utilization a bit in this quarter, and we're continuing to work on improving it moderately during the rest of the year. If you notice, we've added, in the quarter, only 19% headcount year-over-year, compared to 32% revenue growth. While this gap is not expected to continue in its dimension, we do sort of expect a nonlinear pattern to headcount additions versus revenue growth. David M. Grossman - Stifel, Nicolaus & Co., Inc., Research Division: Okay. And then, as I think about that and the relationship between -- I know you talked about the investments just a minute ago that you're making in the business that's impacting operating expenses, at what point do those cross, where you get more stability in the operating margin? Or do you just think you're going to be bouncing around in this bandwidth of the 16% to 18%, just depending on the quarter and the year?

I mean, we're in rapid growth mode. And again, we continue to invest in the business. I think if we decide to stop investing, that's going to impact future revenue growth. And in our stage of development, this is -- our priority is to continue to grow. And so we will continue to live within our stated margin range. You might not see it sort of exactly linear quarter-to-quarter, but for the full year, we expect to be in the 16% to 18% range. And we feel pretty confident about that. David M. Grossman - Stifel, Nicolaus & Co., Inc., Research Division: Okay. And then just going back to the new customer activity, can you give us a sense of just how much, I guess, I don't know if I could call it pipeline or new business signed in the last 6 months, but some metric that will give us a sense of what the new customer acquisition activity has been over the last 2 quarters?

I would give you more like, what revenue we have today, which we closed during the last 12 months. And in Q1, it's approximately $12 million, $13 million for business, which was acquired during the previous 12 months. So this is not counting clients, which we got from Thoughtcorp or Empathy Lab. This is kind of new, new clients. But in our situation, when we're talking about sales and new business and investments, you also need to realize that we have very good client base, which is, from this point of view, should be considered as a pretty significant source of growth for us, in addition to new, new clients. And when we're talking, again, about sales and account management, it's not just about new, new business, it's about how we can bring more value to existing clients, and how we can convert this $1 million or $5 million accounts to, respectively, $5 million, $10 million and $15 million, $20 million accounts. And we have a number of very big opportunities with this and this is required investment from us for the right people who would be able to help in this setting, just to make sure it's very clear. David M. Grossman - Stifel, Nicolaus & Co., Inc., Research Division: In that context, did you say that the top 10 grew 15%. Is that what we said in the quarter?

Yes, that's correct. But if you exclude the impact of Thomson Reuters, then sort of the top 9 has grown 26%.

We still kind of floors in average growth of the company, which means that the next number of clients growing faster, and they actually create even more opportunities for us to grow. David M. Grossman - Stifel, Nicolaus & Co., Inc., Research Division: Okay, got it. And then, just one last thing, I'm wondering, Ilya, can you just remind us what your expectations are for the non-GAAP adjustments for the year in terms of stock comps and amortization?

Sure. Stock comp, approximately $12 million or $13 million for the year. And amortization, just one second, it's about $2.4 million on amortization. David M. Grossman - Stifel, Nicolaus & Co., Inc., Research Division: $2.6 million, I'm sorry?

$2.4 million.

[Operator Instructions] Our next question comes from the line of Elizabeth Colley with Needham & Company. Elizabeth Colley - Needham & Company, LLC, Research Division: This is Elizabeth for Mayank Tandon. Can you give us any color on M&A plans and what sort of areas you might be targeting, as far as geographies, verticals, services?

I think we can only restate what we were sharing before. Our M&A is focused in a couple of areas, mostly in competencies, to grow our technologies and some industry spectrum and potentially, capacity in additional geographies. And that's what we're looking for and that's what we're evaluating. But I don't think we can share a very specific plans at this point. Most likely, you will find out about it only from future press releases. Elizabeth Colley - Needham & Company, LLC, Research Division: Okay. And one more question. How should we think about wage inflation for the rest of the year? And what do you guys think the margin impact, what do you expect it to be this year, and even looking into next year?

I think it's a little bit too early to -- and we don't guide to wage inflation. So we had our main wage inflation cycle come through in January. It was within expectations. The competitive environment continues to be challenging, as it is for all the players in our industry, whether it's in India, China, Russia or wherever else. So the best we can say is that we're continuing to see wage inflation in a competitive environment, the stack up according to, more or less of how we predicted it. But for the rest of your, we'll see how it goes.

Mr. Dobkin, there are no further questions at this time. I'd like to turn the floor back over to you for closing comments.

Thank you. Thank you, everybody for attending our call today. In summary, we're pleased with the results of the previous quarter, and we feel good about the next quarter and for the 2013, at least, as it sounds for right now. So we look forward to talking to you next time and provide additional updates like in approaching within 3 months. So thank you for attending and have a great day.

Thank you. This concludes today's teleconference. You may disconnect your lines at this time. Thank you for your participation.