EPAM Systems, Inc. (NYSE:EPAM) Q2 2023 Earnings Call Transcript

EPAM Systems, Inc. (NYSE:EPAM) Q2 2023 Earnings Call Transcript August 3, 2023

EPAM Systems, Inc. beats earnings expectations. Reported EPS is $2.64, expectations were $2.34.

Operator: Good day and thank you for standing by. Welcome to the EPAM Systems Second Quarter 2023 Earnings Conference Call. At this time, all participants are in a listen-only mode. After the speakers’ presentation, there will be a question-and-answer session. [Operator Instructions] Please be advised that today’s conference is being recorded. And I would now like to hand the conference over to your speaker today, David Straube, Head of Investor Relations. Sir, please go ahead.

David Straube: Thank you, Operator. Good morning, everyone. By now you should have received your copy of the earnings release for the company’s second quarter 2023 results. If you have not, the copy is available on epam.com in the Investors section. With me on today’s call are Arkadiy Dobkin, CEO and President; and Jason Peterson, Chief Financial Officer. I’d like to remind those listening 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 measures have been reconciled to the comparable GAAP measures and are available in our quarterly earnings materials located in the Investors section of our website. With that said, I will now turn the call over to Ark.

Arkadiy Dobkin: Thank you, David, and good morning, everyone. Before I get into the results of our second quarter, I would like to spend a few minutes on the mid-quarter update we provided in June. As I said in my prepared remarks, the broader concerns over the economy led to a shift in demand dynamics for our sector. So we found the shift has been much more pronounced due to the geopolitical impact on our delivery centers and our focus on the build and digital product engineering segments of the market, which represents about 80%, 85% of our engagement in the first quarter. This was especially evident in the technology vertical, which continues to be impacted by the pull-back in spend after years of strong investments in digital and product development efforts, while being spread broader across other industry segments as well.

Over the last quarters, we have also seen this impact in some of our largest clients, as they have held back for the direct spending from new build programs to the economic conditions and caution in their businesses. This factor has contributed to a high percentage of our shortfall over the first half of 2023. Now I will switch to Q3 and the rest of 2023. While we are starting to see a few encouraging signs, we will share more on that in a minute. Today, I would state that we expect still based on the current level of unpredictability, a negative dynamic to continue into the second half of 2023, but at the lower level than we saw in the first half of this year. With that, I would like to state that while we do understand that this is a difficult period for us and for those sector more broadly, based on insight from the past several years and past several quarters especially, we are turning that experience into pragmatic action plan, which we will be applying to our business throughout the remainder of this year and further into the future and consider this time an opportunity, which, as we all know, when new crisis presents to transforming ourselves.

Some of our current plans and actions are focusing on making real-time adjustment to our savings, go-to-market plan, customer engagement programs and global delivery talent platform stabilization. These key investments help us to prepare ourselves for strong rebound position. What is important also to note is that our primary focus on digital product and data engineering services combined with digital consulting, agency, design, content and digital marketing services, a real win-win. In other words, the primary services and market segments, which allow us to double company in the previous three years are staying intact, while we continue to tune our capabilities in line with the global market demands. Our point is simple, the entire IT sector is undergoing what we believe is an evolution of the services market moving from the core IT to digitalization, even more broadly and with significant acceleration.

And to consider new digitally nascent businesses faster to reinvent entire models and ways of working and now is the promise of generative AI capabilities empowerment as the core. We have been at the forefront of similar trends before, and once again, are looking to put EPAM as a center of new wave of transformative services. We fully expect as a result to be underpinned and even more driven exactly by our traditionally strong product platform engineering, data analytics and machine-learning capabilities, but now, in combination with what generative AI promises. So our thesis has been and continues to be that our core services profile will benefit in the medium and longer term from EPAM higher concentration on cloud data and engineering. And we will capitalize strongly on our core capabilities once the general situation in our segment rebounds.

The AI impact will become even more real in terms of complexity to future applications and platforms by encapsulating not just currently available elements of gen AI and a very visible needs for trust, reliability and security management of AI, but also by close integration with new classes of composite and adaptive AI platforms, as well as these foundational models in specific industry cloud platforms. In short, we are optimistic about the transformation — transformative opportunities to the core application stack coming from AI-led transformation, which is also well illustrated by our latest announcements. That is one of the key areas of our investments. The second critical part is a further diversification and stabilization of our global delivery platform, including the allocation of our talent more optimally across the world, while at the same time enabling our strong engineering quality standards across all EPAM locations.

This rebalancing effort will be performed over the next three quarters to four quarters, in part to drive higher levels of gross margin performance. Our other plans and actions today are focused on our immediate demand generation and new logo acquisitions. During the first half of 2023, and specifically in Q2, we drove new logo activity at high levels than when compared to 2021 and 2022. We see this as a positive sign of our return to demand. We should accelerate the recovery and allow us to return to grow as soon as the current client base stabilizes. A few example for our new Q2 clients include; one of the world’s leading B2B travel platforms, a large European-based multi-national resilient marketplace, organizing for trading of shares and other securities; a multi-billion dollar molecular diagnostic company specialized in detection of early-stage cancers; a leading global insurance provider of financial protection, absence management and supplemental sales benefits solutions; and global infrastructure services companies in the energy space.

In these new programs, we are starting to include a more diverse stack of our capabilities from consulting to different types of implementation efforts. Some of those clients we expect will support our next growth journey. In addition, we also see some programs with existing clients who have started ramping-up. Recently, Canadian Tire announced a seven-year strategic partnership with Microsoft to accelerate their modernization and drive retail innovation across their Canadian markets. Leveraging our decade long relationship with Canadian Tires, EPAM will be a trusted and proven engineering partner in digital system integrator to lead there. So there are some signs indeed that the overall demand environment is coming to more normal terms for us.

We probably will be able to share more next quarter of how strong those signs are going to be. But in anyway, it also confirms that EPAM continues to remain very relevant and competitive, even in current market of low demand for the build function, which is a good entry point to share some of our go-to-market progress, especially in relationship with hyperscalers. In June, we announced a global strategic partnership with Google Cloud across our global markets, cloud solutions and focusing on specific efforts in our larger verticals, including financial services, consumer to economy and entertainment, healthcare, life sciences, energy and Hi-tech to help our customers to modernize and transform their businesses. We are also encouraged and energized by the momentum we are seeing with our other major cloud partners, Microsoft and AWS.

More to come on this direction very soon. But just as a preview, you might have seen that we were recently made Microsoft’s Great Partner of the Year for 2023 with couple other venerable recognitions with Microsoft Partner Network. In, overall, we made very strong progress in establishing a real 360-degree relationship with all three major players and plan to be sharing more over the course of the next few weeks publicly. Two final points. First, I just want to reiterate our view that there is a tremendous amount of work to be done in continued modernization, application development and integration, and in considering and designing the models and strategies for business change. Our commitment to our expanding capabilities and engineering consulting can now work to create a next-generation agency will help us to compete and win a new demand climate once customers gain confidence observing optimization initiatives and return their retention to growth.

Second, I wanted to touch on AI one more time. As it is obviously on everyone’s mind these days. So how do we see its impact to our business and more critically to our customers and the industry at large? And of course, what are you doing to position EPAM for long-term success? EPAM has a long history of investing in R&D and our call to action over the years has been to make the promises of technology real. So rather than sharing any specific dollar amount we plan to spend on AI, which is very difficult to estimate with the current speed of change. We can instead share how we are thinking about directional investments today. Currently, we pick investments with two principles in mind. Whatever you do have to be pragmatic to EPAM in terms of relevancy and deliverability for our clients; and second, it has to be responsible and cost-effective.

This translates to two broad categories of things we are working on and you probably already saw some of this being announced. We are building accelerators in IT that help orchestrate full transformation program using the best available capabilities of large language models and related from works and tools. A significant portion of this is the work we are doing to change how we — ourselves work from how we build growth to how we position and operate our company. We are working across thousands of use cases to focus, first of all, on responsible, and very importantly, cost-effective solutions. Otherwise, future real progress will be difficult. To do so, we are focused on expanding our partnership, including with cloud providers and leading research centers to ensure those critical aspects and also focus ourselves on aligning internally across consulting and experience in technology to address that.

The reality is that the production ready AI services application landscape is still very much at the entry stage of maturity today. While we see it is a very large and accelerating opportunity for us, specifically in our primary market segment. We are currently focusing on all type of activities to learn and experiment more from proof-of-concepts to real scale pilots and some scaled production initiatives. So just like advances to our cloud over a decade ago, drove demand for advanced engineering, next-generation architecture and hybrid and derivative delivery models, we are confident that this wave of AI-led requirements will drive more demand for advanced data engineering in cloud computing, content creation and the artificial intelligence native application, as well as the new UX and UI paradigms.

Our clients, who themselves make up a significant segment of technology companies in technology-led enterprises are in the mindset of already started to aim arms race, which we should believe will be a real engine for the future growth. Some of that, we are already starting to see within our demand pipeline. With that, I would like to pass to Jason to share more details and numbers for Q2 and for an update for our business outlook for the remainder of 2023.

Jason Peterson: Thank you, Ark, and good morning, everyone. Before covering our Q2 results, I wanted to remind you that in addition to our customary non-GAAP adjustments, expenditures resulting from Russia’s invasion of Ukraine, including EPAM’s humanitarian commitment to Ukraine, business continuity resources and accelerated employee relocations have been excluded from non-GAAP financial results. We have included additional disclosures specific to these and other related items in our Q2 earnings release. In the second quarter, EPAM generated revenue of $1.17 billion, a year-over-year decrease of 2.1% on a reported basis and a decrease of 2.4% in constant currency terms, reflecting a favorable foreign exchange impact of 30 basis points.

Revenue in the quarter was impacted by reductions in program spending across a number of our clients, as well as ongoing client caution related to new project starts. The reduction in Russian customer revenues resulting from our decision to exit the market had 100-basis-point negative impact on year-over-year revenue growth. Excluding the Russia revenues, year-over-year revenue for reported and constant currency would have decreased by 1.1% and 1.7%, respectively. Beginning with our industry verticals. On a year-over-year basis, travel and consumer declined 1%, primarily due to declines in retail, partially offset by solid growth in travel and hospitality. Financial services grew 3.2%, with growth coming from asset management and insurance services.

Business information and media decreased 4.1% in the quarter. Revenue in the quarter was impacted by a reduction in spend at a number of large clients based on uncertainty in their end markets, particularly in the mortgage data space. Software and Hi-tech contracted 10.3%. The decline in the quarter reflected a reduction in revenue from the former top 20 customer we mentioned during our previous earnings call and generally slower growth in revenue across a range of customers in the vertical. Life Sciences and Healthcare declined 10.9%. Revenue in the quarter was impacted by the ramp down of a large transformational program mentioned during our previous earnings calls. On a sequential basis, growth in Life Sciences and Healthcare actually was a positive 2.9%, driven by new work at both existing and new logos.

And finally, our emerging verticals delivered solid growth of 8.6%, driven by clients in energy, manufacturing and automotive. From a geographic perspective, Americas, our largest region representing 58% of Q2 revenues, declined 5.9% year-over-year or 5.7% in constant currency. The growth rate in the quarter was impacted in part by the ramp down of life sciences and healthcare customer we mentioned during our previous earnings call. EMEA, representing 39% of our Q2 revenues grew 8.5% year-over-year or 6.5% in constant currency. CEE represented 1% of our Q2 revenues contracted 61.1% year-over-year or 45.8% in constant currency. Revenue in the quarter was impacted by our decision to exit our Russia operations and the resulting ramp-down in services to Russia customers.

And finally, APAC declined 19.7% year-over-year or 18.6% in constant currency terms and now represents 2% of our revenues. Revenue in the quarter was impacted primarily by the ramp-down of work within our financial services vertical. In Q2, revenues from our top 20 customers declined 2.4% year-over-year, while revenues from clients outside our top 20 declined 1.9%. Moving down the income statement. Our GAAP gross margin for the quarter was 30.9%, compared to 29.2% in Q2 of last year. Non-GAAP gross margin for the quarter was 32.6%, compared to 31.5% for the same quarter last year. Gross margin in Q2 2023 reflects a lower level of variable compensation expense, partially offset by the negative impact of lower utilization. GAAP SG&A was 16.7% of revenue, compared to 19.5% in Q2 of last year.

SG&A in Q2 2022 included a more significant level of expenses resulting from Russia’s invasion in Ukraine. Non-GAAP SG&A in Q2 2023 came in at 14.8% of revenue, compared to 15.2% in the same period last year. Reductions in both cost of revenue and SG&A during the quarter reflect the company’s ongoing focus on managing its cost base, as well as reduced variable compensation expense due to the lower level of financial performance expected for the year. In Q2, EPAM incurred $5 million in severance-related expense included in both GAAP and non-GAAP SG&A, as the company works to better align its cost structure with the current demand environment. GAAP income from operations was $144 million or 12.3% of revenue in the quarter, compared to $93 million or 7.8% of revenue in Q2 of last year.

Non-GAAP income from operations was $191 million or 16.3% of revenue in the quarter, compared to $177 million or 14.9% of revenue in Q2 of last year. Our GAAP effective tax rate for the quarter came in at 20%. Non-GAAP effective tax rate was 23.3%. Diluted earnings per share on a GAAP basis was $2.03. Our non-GAAP diluted EPS was $2.64, reflecting a $0.26 increase compared to the same quarter in 2022. In Q2, there were approximately 59.2 million diluted shares outstanding. Turning to our cash flow and balance sheet. Cash flow from operations for Q2 was $89 million, compared to $78 million in the same quarter of 2022. Free cash flow was $82 million, compared to free cash flow of $59 million in the same quarter last year. At the end of Q2, DSO was 71 days and compares to 69 days for Q1 2023 and 71 days for the same quarter last year.

Looking ahead, we expect DSO will remain steady throughout 2023. Share repurchases in the second quarter were approximately 195,000 shares for $41.4 million at an average price of $212.77 per share. As of June 30th, we had approximately $450 million of share repurchase authority remaining. We ended the quarter with approximately $1.8 billion in cash and cash equivalents. Moving on to a few operational metrics. We ended Q2 with more than 49,350 consultants, designers, engineers, trainers and architects. Production headcount declined 10% compared to Q2 2022, the result of lower levels of hiring, combined with voluntary and involuntary attrition as we continue to balance supply and demand. Our total headcount for the quarter was more than 55,600 employees.

Utilization was 75.1%, compared to 78% in Q2 of last year and 74.9% in Q1 2023. Now let’s turn to our business outlook. As Ark mentioned, we have seen a higher level of new logo acquisitions and revenue from our focused efforts on demand generation. While this progress is encouraging, the level of revenue generated is not enough to offset further expected reductions in client budgets, ramp-downs and delays in new program starts. With the range of outcomes, we outlined on our June 5th call, we are maintaining our expectations for a muted demand environment, with sequential decline in Q3 and further sequential or flat revenue growth in Q4. Our Ukrainian delivery organization continues to operate efficiently and our teams remain highly focused on maintaining uninterrupted production.

Our guidance assumes that we will continue to be able to deliver from Ukraine in productivity levels at or somewhat lower than those achieved in 2022. Consistent with previous cycles, we will continue to thoughtfully calibrate our expense levels, while investing in our capabilities and focusing on the preservation of our talent in preparation for a return to higher levels of demand. We expect headcount will continue to decline modestly in Q3 due to limited hiring and more typical attrition and we will continue to limit hiring until we see improving demand. We expect utilization to decline slightly in the second half of the year, primarily driven by a higher level of expected vacations. Lastly, at the end of July, we completed the sale of our Russian business, which will result in a decline in Russian revenues from Q2 to Q3.

But we will also recognize an estimated loss on sale of $18.4 million, which will impact our Q3 and full year GAAP results. Additionally, this will drive a further modest reduction in headcount. Moving on to our full year outlook. We now expect revenue to be in the range of $4.65 billion to $4.70 billion, reflecting a year-over-year decline of approximately 3%. On an organic constant currency basis, excluding the impact of the exit in Russia, we expect revenue decline to also be approximately 3%, both at the midpoint of the range. We expect GAAP income from operations to now be in the range of 10.5% to 11.5%, which includes the loss associated with the sale of our Russian business. The non-GAAP income from operations to continue to be in the range of 15% to 16%.

We expect our GAAP effective tax rate to continue to be approximately 22%. Our non-GAAP effective tax rate, which excludes excess tax benefits related to stock-based compensation is expected to continue to be 23%. For earnings per share, we expect that GAAP diluted EPS will now be in the range of $7 to $7.20 for the full year and non-GAAP diluted EPS will now be in the range of $9.90 to $10.10 for the full year. We now expect weighted average share count of 59.1 million fully diluted shares outstanding. Moving to our Q3 2023 outlook. We expect revenues to be in the range of $1.14 billion to $1.15 billion, producing a year-over-year decline of 6% to 7%. On an organic constant currency basis, excluding the impact of the exit in Russia, we expect revenue to decline by 8.5% to 9.5%.

For the third quarter, we expect GAAP income from operations to be in the range of 10% to 11% and non-GAAP income from operations to be in the range of 15.5% to 16.5%. We expect our GAAP effective tax rate to be approximately 24% and our non-GAAP effective tax rate, which excludes excess tax benefits related to stock-based compensation to be approximately 23%. For earnings per share, we expect GAAP diluted EPS to be in the range of $1.62 to $1.70 for the quarter and non-GAAP diluted EPS to be in the range of $2.52 to $2.60 for the quarter. We expect a weighted average share count of 59.1 million diluted shares outstanding. Finally, a few key assumptions that support our GAAP to non-GAAP measurements in the third quarter and the remainder of the year.

Stock-based compensation expense is expected to be approximately $39 million for each of the remaining quarters. Amortization of intangibles is expected to be approximately $5.5 million for each of the remaining quarters. The impact of foreign exchange is expected to be a $1.5 million gain for each of the remaining quarters. Tax effect of non-GAAP adjustments is expected to be around $11.7 million for Q3 and $9.3 million for Q4. We expect excess tax benefits to be around $2.7 million for Q3 and $1.8 million for Q4. In addition to these customer GAAP to non-GAAP adjustments and consistent with the prior quarters in 2023, we expect to have ongoing non-GAAP adjustments in 2023 resulting from the Russian invasion of Ukraine. Please see our Q2 earnings release for a detailed reconciliation of our GAAP to non-GAAP guidance.

Finally, one more assumption outside of our GAAP to non-GAAP items. With our significant cash position, we are now generating a healthy level of interest income and are now expecting interest and other income to be $11.7 million for each of the remaining quarters. Lastly, I’d like to thank our employees for their continued dedication and focus on our customers. Operator, let’s open the call up for questions.

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Q&A Session

Operator: Thank you. [Operator Instructions] Our first question will come from Bryan Bergin of TD Cowen. Your line is open.

Bryan Bergin: Hi. Good morning, guys. Thank you. I wanted to just kick off with large client visibility, and I guess, existing base stability. Can you talk about the conversations you are having among your top 10 or top 20 clients? Are you getting closer to stability in this space, and I am curious, just as we look at the implied sequential decline in 3Q and perhaps 4Q, just trying to understand the attribution to the decline among the large clients still in that base versus the intake of new work coming in at lower dollar levels versus like conversion delays and slower ramps of work?

Arkadiy Dobkin: Hello. Good morning. I think visibility or predictability is probably better than it was a couple of quarters ago. So and we can plan better. But there is still a slowdown which started a couple of quarters ago and we are working with it. And there is also some asynchronous points between clients when they were making some of the decisions. So, there is elements of unknown still there. But again, in general, we feel it is much more stable. We also see in top 20 that some clients starting to return in discussion about growth. Again, it’s difficult to comment when exactly it happened. But we see some signs that they tried some additional vendors who were not satisfied coming back to us with discussions. So, I think, in general, feeling about Ukraine, despite of situations that would get deliberately more active period still from the client perspective, but from expectation of the stability from work conditions, taking in account during the last 18 months, we didn’t have particularly one unproductive day.

So, people believe that the clients starting to feel the link, why don’t this [ph] — for those who continue that. So, I think, in general, more stable, still unknown and there is still slowdown going a little bit. So we hope that it will be start like in the next couple of quarters.

Bryan Bergin: Okay. And a follow-up just on the workforce diversification, can you give us a sense on how the current operating footprint is comprised as of the close of the June quarter, just roughly a mix between billable in Ukraine, Belarus versus Central Europe versus LatAm and APAC? Thanks.

Jason Peterson: Yeah. So we are under 30% from a CIS region. So that’s primarily, as you indicated, Ukraine and Belarus. We are continuing to see maybe a little bit of growth in India. So that continues to be a significant delivery location for us. And right now, while we are working through demand, probably, we see some stabilization in Latin America, but again, continues to be a significant part of our expected current and future delivery footprint.

Bryan Bergin: Okay. Thank you.

Operator: Thank you. One moment please for our next question. Our next question will come from the line of Jason Kupferberg of Bank of America. Your line is open.

Tyler DuPont: Hi. Good morning, Ark and Jason. This is Tyler DuPont on for Jason. Thanks for taking the question. I just wanted to start by asking about operating margins. During the quarter, they have seen some pretty strong, 130 bps greater than the top end of the guidance range. Can you just spend a minute or two parsing out sort of what led to that outperformance and sort of how you are thinking about margins through the back half of the year, where there is any sort of incremental investment opportunities available, or any color there?

Jason Peterson: Yeah. So, clearly, with the demand environment that we are seeing, we are trying to make certain that we are cautious about spending, while still making certain that we are making investments in sales channels and partner programs, and clearly, our AI capabilities that would allow us to return to significant growth in the future. But we are focused clearly on SG&A and you are seeing efficiency there. And then, you are also — some caution around what we are doing with headcount, and generally, what you are seeing is it’s a little bit of tuning in different delivery locations and lower hiring, very modest hiring, which is then offset by attrition and has resulted in these net reductions in headcount. The other piece and we did talk about it I think in the script, is — there is a variable compensation element.