Epam Systems Inc (EPAM) 2017 Q2 法說會逐字稿

Greetings, and welcome to EPAM Systems Second Quarter 2017 Earnings Call. (Operator Instructions)

I would now like to turn the conference over to your host, David Straube.

Thank you, operator, and good morning, everyone. By now, you should've received your copy of the earnings release for the company's second quarter fiscal 2017 results. If you have not, a copy is available at epam.com in the Investors section. With me on today's call are Arkadiy Dobkin, CEO and President; and Jason Peterson, Chief Financial Officer.

Before we begin, I'd like to remind you that some of our 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 numbers have been reconciled to GAAP and are available in our Investor Materials in the Investors section of our website.

With that said, I will now turn the call over to Ark.

Thank you, David, and good morning, everyone. Thanks for joining us. Let us start with a few key highlights on EPAM overall performance in the second quarter. Our growth was broad-based across both geographies and industries, with revenue for Q2 coming in at USD 349 million, representing 23% year-over-year growth or 23.7% in constant currency growth.

From a vertical perspective, we've had strong growth across a majority of our industry segments. In the [operational] currency, Financial Services, our largest vertical, finished the quarter with 7.6% growth, which reflects the effect of the UBS revenue trends we discussed during our previous earnings call. Excluding the impact of UBS, Financial Services grew 31.6% in Q2. The momentum in Financial Services is being driven by digitalization, regulatory changes in addition to back office improvements.

Travel & Consumer finished the quarter at 21.7% growth, with demand coming from digital transformation projects as well as data-driven insight programs.

Software & Hi-Tech grew 20.2% for the quarter, based on diversified portfolio of mature software houses, emerging start-ups and technology companies growing over digital platform transformations.

Media & Entertainment grew 52.3%, driven by our engagements in digital services with major information providers, publishers and broadcasters.

Life Sciences & Healthcare grew 3% over the same quarter last year. Year-over-year growth was mostly impacted by the timing of work with one of our clients with significant increase in revenue in Q2 of last year. Excluding this effect, year-over-year growth was 21.5% and 6.7% sequentially.

(inaudible) within Healthcare, we continued to see demand in patient health management initiatives and added a major health care player and medical hospital management provider in Q2 to our client list.

Emerging verticals at 60.1% growth was driven mostly by energy and telecommunications. The diversification across our clients continues with growth outside of the top 20 accounts coming in at 37%. With growth in the top 20 at just under 10%, or more than 18%, excluding the effect of UBS. And our continued focus in helping our clients to address the challenges of digitally driven changes had led to broader opportunities across Fortune 2000.

In Q2, our growth was broad-based across geographies. In constant-currency terms, North America grew 27%. Europe's growth was 19% year-over-year, or 34% excluding the effect of UBS. These 2 geographic areas combined represent 94% of our revenues. Additionally, our CIS region grew 17% and APAC grew 24% in constant currency terms.

Our people. We ended with over 20,480 professionals, a 12% increase year-over-year, bringing our total employee headcount to more than 23,200. Utilization for the quarter was 79.6%, coming in higher than our historical ranges due to tighter management during this period. We do expect utilization in Q3 to be down due to seasonality and natural volatility in supply and demand cycles. And in talent market that -- there, it always is increasingly competitive. We remain focused on attracting, retaining and developing the right talent to support EPAM current and future growth needs.

In regards to overall market demands. The rate of disruption among our clients continues to evolve at an extremely fast pace, creating the challenge of successfully integrating some important technology and operational transformations. We do believe we are still in the early stages of the digital era. With digital platform engineering extending from the consumer to the enterprise, driving the need for next generation capabilities in areas such as full stack engineering, (inaudible) automation and cybersecurity. We continue to see real strengths in demand across our verticals, service lines and geographies, and we believe the demand for next generation capabilities and strong engineering delivery skills will continue for the foreseeable future.

So as we evolve our business to position it for the future, our priority will be to continue investing across multiple areas, including corporate and people talent infrastructure, in line with our growth rate needs to allow us to establish new and growing capabilities with a focus on delivering increasingly sophisticated end-to-end integrated business and technology solution, differentiated by our advanced engineering capabilities.

Our profitability for the first half of this fiscal year reflects this ongoing investment. And going forward, you should expect this level of investment will continue and, at times, vary quarter-to-quarter.

With that, let me turn it over to Jason for a detailed financial update of our Q2 results and our fiscal 2017 guidance.

Thank you, Ark. Good morning, everyone. I'll start with some financial highlights, talk about profitability, then cash flow and end on guidance. As Ark mentioned, we delivered strong top line performance and generated solid free cash flow in the second quarter.

Here are a few key highlights from the quarter. Revenue closed at $349 million, 23% growth over the second quarter of last year and 7.5% sequentially. Year-over-year, constant currency growth was 23.7%, reflecting a modest headwind of 0.7%, which was less than anticipated. Actual revenues compared to our Q2 guidance benefited from stronger revenue production of $2.9 million and a favorable currency impact of $6.1 million.

From a geographic perspective. North America, our largest region, representing 59% of our Q2 revenues, grew 26.6% year-over-year and 26.9% in constant currency. Europe, representing 34.8% of our Q2 revenue, grew 16.8% year-over-year and 19.4% in constant currency. Absent the effect of UBS, growth in Europe was 34% in constant currency. CIS grew 27.2% year-over-year or 17.1% in constant currency and now represents 4.2% of our revenue. And lastly, APAC grew 21.9% year-over-year and 24.3% in constant currency and now represents 2% of our revenue.

So moving down the income statement. Gross margin for the quarter was 36.9% compared to 36.3% for the same quarter last year. The 60 basis point year-over-year increase resulted from higher utilization, which ended at 79.6% compared to 74.1% in the same quarter last year and 77.5% in Q1 of fiscal 2017. The increase in utilization was offset by a negative foreign exchange impact, a higher level of payroll tax related to options exercises and employee compensation. In constant currency terms, gross margin was 37.8%.

GAAP SG&A was 23% of revenue compared to 22.6% in Q2 fiscal 2016. Included in this quarter's SG&A were higher costs related to an increase in personnel-related expenditures, including payroll tax associated with the exercise of stock options; in addition, an increase in investments to continue supporting expansion in our client-facing geographies.

Non-GAAP SG&A, which excludes stock-based compensation expense and certain other items, came in at 20.4% compared to 19.6% in the same period last year. As Ark mentioned, our SG&A reflects the continued investment in our talent acquisition, extension of our global footprint and building onsite capabilities, with a focus on supporting our long-term sustainable growth strategy.

GAAP income from operations was $40.7 million compared to $32.1 million in Q2 last year, representing 11.7% of revenue in the quarter. Non-GAAP income from operations was $55.8 million compared to $47.6 million in Q2 last year, representing 16% of revenue. Our GAAP effective tax rate for this quarter came in at 13.2%. The lower-than-expected tax rate was the result of the adoption of the recently announced stock-based compensation pronouncement and the generation of a greater-than-expected tax benefit due to a higher level of exercised options. Our non-GAAP effective tax rate was 22.7%.

For the quarter, we generated $0.68 of GAAP EPS, which reflects an FX gain rather than an expected FX loss, lower-than-expected stock compensation expense in addition to the lower tax rate. Non-GAAP EPS was $0.80 compared with non-GAAP EPS of $0.71 in the second quarter of last year, reflecting a 12.7% increase.

Total shares outstanding for Q2 were approximately 54.8 million, higher than the expected level of 54.3 million, largely due to the sizable number of options exercised in the quarter.

Turning to our cash flow and balance sheet. Cash from operations for Q2 was $27.9 million compared to $38.5 million in the same quarter last year. The year-over-year decline is primarily due to the impact of a reduction in DSO in Q2 last year, coupled with an increase in DSO in Q2 of this year. Free cash flow came in at $22.2 million compared to $31.1 million in the same quarter of last year, resulting in a 50.7% conversion of adjusted net income. Total DSO was 82 days compared to 88 days in the same quarter last year. AR DSO was 54 days and our unbilled DSO was 28 days.

Turning now to guidance. Starting with full year fiscal 2017, revenue growth will now be at least 23% and we expect constant currency growth will continue to be at least 23%. For the full year, we now expect the impact of foreign exchange will be flat. We expect GAAP income from operations to now be in the range of 12% to 13%, and non-GAAP income from operations will now be in the range of 16% to 17%, which reflects our first half performance. We expect our GAAP effective tax rate will now be approximately 16% and our non-GAAP effective tax rate will now be approximately 22%.

Earnings per share. We now expect GAAP-diluted EPS will be at least $2.57 for the full year, driven primarily by a lower effective tax rate attributed to a greater-than-expected excess income tax benefit from stock-based compensation. Non-GAAP EPS will now be at least $3.29 for the full year. The updated non-GAAP EPS reflects greater-than-expected employee stock option exercises, driving both higher total share count and greater payroll tax expense. We now expect a weighted average share count of 55.2 million fully diluted shares outstanding.

For Q3, revenues will be at least $367 million for the third quarter, reflecting a growth rate of at least 23% after 1% currency tailwinds, meaning we expect constant currency growth will be at least 22%. For the third quarter, we expect GAAP income from operations to be in the range of 11.5% to 12.5%. And non-GAAP income from operations to be in the range of 15.5% to 16.5%. This range reflects the seasonal impact of utilization in Q3. We expect our GAAP effective tax rate will now be approximately 16.5% and our non-GAAP effective tax rate will now be approximately 22%. For earnings per share, we expect GAAP diluted EPS will be at least $0.68 and non-GAAP EPS to be at least $0.84 for the quarter. We expect a weighted average share count of 55.6 million fully diluted shares outstanding.

A few key assumptions which support our GAAP to non-GAAP measurements. The stock compensation expense is now expected to be approximately $11.2 million in Q3 and $10.9 million in Q4. Amortization of intangibles is now expected to be approximately $1.9 million in each remaining quarter. FX losses are now expected to be approximately $2 million for each quarter. Tax effective non-GAAP adjustments is now expected to be approximately $4 million in each remaining quarter.

Lastly, with the recent adoption of ASU 2016-09 and as a result of movement in our stock price, we expect future volatility in our effective tax rate and GAAP EPS. We expect an excess tax benefit of approximately $2 million for each remaining quarter.

Thank you, and let me turn the call back to David.

Thanks, Jason. (Operator Instructions) Operator, would you provide instructions for those on the call, please?

(Operator Instructions) Our first question is from Anil Doradla with William Blair.

Good job on the top line. So when you look at the top line and the upward revision for the full year, was that driven by any particular end market, customers? Or was it kind of more widespread as you saw in the current quarter?

It's usually -- again, you saw that concentration of clients is kind of becoming better balanced. So basically, it's spread. But we definitely have a number of new large clients which are growing very fast and creating potential for future growth. So again, it's mixed, but there are very specific engagements which are driving the business now.

And in terms of geographic expansion over the next, call it, 12 months, is there any particular geography around the world where you expect to emphasize in terms of headcount growth?

Headcount growth. Our headcount growth plan for us right now is usually pretty much balanced around all our main delivery locations. So clearly, it's still Eastern Europe, which includes all Hungary, Poland, Belarus, Ukraine. Russia is where we plan to grow, and India too.

And if you don't mind me sneaking in one thing. The EPS reset, was that purely driven by just this option stuff going around? Or was there any other particular -- you talked about options and share count. But was there anything else? Or it was just driven by this?

Yes, the $0.09 reduction is just largely driven by the result of the impact of the greater-than-expected stock option exercises. And so as we said, it's basically 2 impacts: one, you've got the additional payroll tax expense; and then the second is just the dilution impact, and that's broken out by $0.07 by the additional payroll tax expense and $0.02 from the dilution.

Our next question is from Steve Milunovich with UBS.

You're building pretty significant cash on the balance sheet. How do you think about the use of cash over the next couple of years?

Yes, from a use of the cash standpoint, to date, we've prioritized the allocation of capital for our inorganic growth strategy. At the same time, we are sensitive to dilution. So capital allocation is an ongoing topic that we've discussed with the board. No change at this time. But I think we would update you as we evolve our thinking on that topic.

Okay. And at the Investor Day, you spoke about recruiting the right talent to keep moving up the value stack. Part of that was getting domain experts with more consulting capabilities. Can you update us on how that initiative is moving? And how we should think about the impacts on margin and revenue per engineer going forward?

So we definitely are executing on this plan and we bring in people. So how it's going to impact any financial metrics is difficult to predict at this point. So clearly, it could be a little bit [volatile] because we bring in -- we're planning -- we are bringing and we're planning to bring more consultative people in the market with higher costs and there probably would be some gap between the time they join and the time they start to really perform and become billable. But again, there is no specific projection how it's going to impact. We do believe that we will be able to manage it in our normal way of business.

Our next question is from Arvind Ramnani from KeyBanc.

This is Jason Washburn in for Arvind. We're just curious, what investments are you guys making in AI? What capabilities do you currently have in AI? And how do you expect your business model to change if AI becomes more integral to your offering?

So we have [competence and center-specific] expertise in this. So we're actually involved in multiple implementation of [process] automation solutions. So how it's going to impact significantly anything in, more or less, short term, I don't think we can judge on this. But we're definitely focusing on this area, and it's one of the most interesting future service lines for us for sure, especially that we don't have traditional BPO services, which would be mostly impacted by this. So we do invest in this area and we do have some advancement there.

Our next question is from Vladimir Bespalov.

My question is actually on your margins guidance. You lowered the upper balance of the guided ranges for the full year despite pretty strong revenue trend. Could you elaborate a little bit what is behind this?

Sure. So we're really narrowing the range from 16% to 18% to 16% to 17%, and it's largely just a reflection of our first half results. So if you'll remember, we had 15.2% in Q1 and 16% in Q2. And so I should remind you that the Q1 performance includes the impact of the $1.9 million land tax. And so the narrowing, I think, just kind of reflects kind of our first half performance. And I think if you do the math, you'll see that we're expecting improvement in the remainder of the year.

(Operator Instructions) Our next question is from Avishai Kantor with Cowen and Company.

On pricing, so on the last conference call, you said that you were talking about stable pricing environment. Is that still the case?

Yes, we've seen a stable pricing environment. And as I think we've talked about in the past, we continue to get annual price increases across a number of our customers. So definitely stable and with the opportunity for some improvement on an annual basis.

And a follow-up. Regarding the acquisition in India. Any changes in how it is factored into the model in the last 3 to 6 months on the impact of the India acquisition on the modeling last 3 to 6 months?

Well, we talked about it pretty extensively, I think, during the previous calls and I think we [talked to it] in some investor days. There is no change since last periods. We're improving delivery quality and we kind of are bringing this to the general EPAM standards. So that's the main focus right now.

Our next question is from [Paval Levitz] with Crédit Suisse.

I wanted to ask about the working capital increase on the cash flow. I think it's driven by the increase in DSO. Could you please a little bit elaborate on this? What were the reasons for it? And shall we expect a further negative cash effect from working capital?

Sure. So -- yes, so primarily the story is around the DSO. And so what you've seen is actually a substantial improvement in DSO on a year-over-year basis. So I think you'll remember that we were over 90 in Q1 of last year. We were at, I think, 88 in Q2 of last year. And then we're down to 82, which is kind of where we guided. But the 82 is an increase over Q1, and so clearly that does have some impact.

Our next question is from Vladimir Bespalov with VTB Capital.

I would like to ask you about UBS and the outlook here. If my calculations are correct, they are approaching to the level stipulated by your long-term agreement in terms of revenue generation, a little bit above that level. So do you expect like, going forward, the impact of UBS on your growth rates to diminish? And in general, what do you see as the outlook for the coming quarters for this account?

Again, we don't have any specific update on this. I think our long-term agreement actually indicated the minimum commitment. So -- and we, at this point -- about this, how this account is going to develop in the future, it's very difficult to predict. We don't see any specific signs to share. The same like we were talking about them before, it is in pretty stable conditions in our view.

Yes, so just to add to that. So UBS is certainly stable, it's performing within our expectations and we continue to see rapid growth in smaller accounts and new accounts within EPAM. So what, I do think you'll see, is that it has, let's say, a more modest impact on growth rates over time as we continue to grow other accounts.

(Operator Instructions) Our next question is from Mitch Mitchell with BCS.

I just wanted to ask about staffing again. It seemed like your hiring rates slowed down a little bit this quarter. Is that the case? Or is this just something that's a little bit maybe seasonal, sort of lumpiness in the hiring process? And then just related to that, can you give us an attrition figure for the quarter?

I think it's a little bit different reason, because several quarters ago, we were talking about our utilization levels, which were below what we wanted and some unexpected [bench] exerted due to some changes on the UBS side. And clearly, our recruitment cycles were under already detailed controls. So -- and right now, we're coming back to hiring exercise. So the current 12% increase is much more than it was last quarter. So we're just increasing hiring right now, but it's a normal kind of cycling right now.

(Operator Instructions) Okay. Ladies and gentlemen, we have reached the end of the question-and-answer session. I would like to turn the conference call back over to Ark for closing remarks.

As usual, thank you very much for joining us today. So I think we have a pretty strong quarter on revenue side. We will also continue growing. I would share actually one metric, like we were talking about UBS, and our growth outside of UBS right now around 29%, which means that in the future, with stability of the account, the growth should be good. So -- and with this, we will see you next quarter. Thank you very much.

Thank you.

Thank you. This concludes today's conference. You may disconnect your lines at this time, and thank you for your participation.