EPAM - Not another software development outsourcing story
Some years ago, there was a film of which I have read called "Not another Teen Movie." I do not see many films and even when that movie first came out, it wouldn't have been something of great interest to me. The kinds of teens I know are either nerds or pseudo-nerds, and this movie was apparently about cool high school characters of the kind I have never seen. In any event, EPAM (NYSE:EPAM) is really a bit different than the typical outsourcing companies that are a part of the landscape. It is located in Newtown, PA, a distant suburb of Philadelphia, but its antecedents and many of its key personnel come from Belarus, one of the former constituent republics of the old Soviet Union, as well as the Ukraine and Russia. While the politics of Belarus is far different than the democracies we know, the cost of doing business in that part of the world allows this company to charge very competitive rates and still deliver strong operating margins.
On balance, EPAM has been a software product development company with 72% of its revenues coming from the software development process. It does have services that encompass less complex application testing and application maintenance, generally the cash cows of the IT outsourcing space. It does attempt to differentiate itself from the Indian outsourcing vendors in that it focuses a bit more on higher end projects such as the IoT, the data and analytics space and digital marketing and commerce. But then again, every Indian outsourcing company worth its salt either has or is building capabilities in those areas.
And so it happens that EPAM has become one of the larger outsourcing vendors, and largest service providers overall, of which most readers have probably never heard. It is covered by 13 analysts who publish their forecasts and ratings on First Call. On balance, analysts appear to like the name with a rating average of just above buy and with a price target of almost $79, about 17% above current levels.
The company has grown rapidly through the years, and today employs more than 18,000 IT professionals and that number is growing in the mid-30%/year. The company is forecast to reach $1.15 billion in revenues this year. And of course it is reasonably profitable in comparison to other high-end IT consultancies with GAAP operating margins of 11% thus far in 2016 and non-GAAP margins of 16%. Those margins are lower than would be typical for most Indian outsourcing companies but are fairly typical for companies that get most of their revenues from outsourcing product development, developing B2B commerce platforms and providing digital platform engineering services. Indian companies make huge margins in outsourcing software maintenance, which is typically half of their revenues. Software maintenance is 7% of revenues.
Although most of the company's service delivery personnel are located in what is called the CIS (the old Soviet Union) most of its expenses are denominated in dollars and GBP. As a result, there is not a significant FX risk from the fluctuations of volatile currencies such as the rubles of both Russia and Belarus and hryvnia (Ukrainian currency).
When I first heard the name of this company, I thought of the Greek general from Thebes, Epaminondas, who eventually defeated the Spartans and brought his city into prominence. And being old enough and having that kind of background, I thought of the eponymous story from the south as well. Given the culture of that age, and its jarring clash with the political correctness of these times, I will stick to the story about the Greek general named who developed a brilliant tactical innovation that overthrew the Spartans. He led additional expeditions against the military tyrannies of Sparta and ultimately Athens as well and was killed leading his troops at the battle of Mantinela. He is noteworthy not only for his tactical innovations but because of his support for democracy and his willingness to retire from power when he had a chance to establish himself as a dictator. EPAM the company has nothing whatsoever to do with Epaminondas the general - but it is an interesting story, regardless. I doubt that the founders were thinking about Epaminondas and his achievements when they first organized the company, and today it is certainly not a consideration.
The company has enjoyed a mixture of both organic and inorganic growth, but has managed to keep organic top line growth above 20%, with much faster growth than that overall, and has more or less consistent trends in both GAAP and non-GAAP operating margins. There is some moderate Q4 seasonality, although it is not anything like what one sees in an enterprise software vendor.
Any recent history that makes the name compelling at this point?
EPAM shares have been relatively weak since the end of April and have lost about 14% of their value since that time. To put that in context, over that same time span, the IGV index has increased by 11%. So, that is more than a small level of underperformance over the last five months.
The company missed both Q1 and Q2 EPS estimates by a bit and estimates for this quarter have come down a bit from $.80 to $.75. The EPS estimate for next year also has decreased by 4% and revenue growth in 2017 is projected to be just 21% compared to a 27% growth rate estimate for this year.
EPAM, despite the EPS miss, actually reported a strong Q2 with 34% constant currency revenue growth and 27% constant currency organic growth. But the company suggested on its last earnings conference call that its most important customer overall, UBS (NYSE:UBS), and by far its most important account in the financial services sector, had shown signs of what was described as "demand compression."
The CEO, Arkadiy Dobkin went on to say in the script for the call and several times in response to questions that "we do anticipate some downstream effect both on overall pricing and demand elasticity with several key accounts in the BFSI vertical."
It has been nearly two months since those comments were made and the overall reaction to Brexit in the macro picture has been muted. Most IT companies have reported that demand in EMEA was at or ahead of their expectations. At least in the group of companies that I follow, no one specifically blamed EMEA or Brexit for missing estimates. As it happens, this company gets 57% of its revenues from North America and gets 36% of its revenues from the European region. It also gets 4% of its revenues from the CIS area (the old Soviet Union) and less than 3% of its revenues from APAC. I think that most other IT services vendors have found that demand to be relatively satisfactory in North America. Most other IT services vendors including such stalwarts as Infosys (NASDAQ:INFY) and Cognizant (NASDAQ:CTSH) have found demand to be soft in the financial services vertical and some of the vendors have seen spotty weakness in other elements of different vertical markets as well.
The Financial services vertical has been and remains EPAM's largest specific vertical. That is typical for any high-end IT consultancy, and indeed there are companies that are focused on just the financial services vertical. It represented 26% of revenues in the last two quarters, and that is down a couple of hundred basis points over the past couple of years. The strongest relative verticals have been life sciences and healthcare, 78% growth and 10% of revenues, followed by media and entertainment with 47% growth and 14% of total revenues. The other three vertical segments have shown little relative change with regard to revenue contribution. The company is currently forecasting constant currency growth in the 28% range. The growth seen in its two fastest growing verticals alone would be sufficient to produce 15% growth. Just on this kind of math, it appears that the company, back in August, went a bit overboard in reducing its growth expectations.
The other segment analysis of interest is that compared to many other IT services vendors, the top 20 are growing in the high teens while the balance of the base is growing at 45%. I think that the ability to find new name accounts and the ability the company has had to decrease its customer concentration are very positive factors.
The quarter has another two days to run as I write this, but of course I do not have any specific information as to what might have happened. But I think that overall expectations have been cut significantly based on macro concerns that may have been valid at the start of August, particularly with regards to the issues among larger European financial institutions such as UBS, and are perhaps a bit less of a concern coming into October. The specific revenue forecast EPAM had made for the current quarter is $295 million, up 4% sequentially and reflecting the specific headwinds which were questioned and described ad infinitum during the conference call. It is certainly possible for companies in this business to miss. It happens all of the time. On the other hand, usually these kinds of companies have a firm baseline of work going into the quarter. Transactional business is a function of closing new accounts and of large existing users adding to projects or needing some specific assistance to insure projects underway are completed on time. The summer quarter is typically a low point for transactional business and so a relatively smaller sequential growth rate is a reasonable expectation in Q3. On the other hand, it seems that the macro of Q3, particularly in Europe, was less dire than the fears of many. And this company has been seeing spectacular growth - 45% last quarter - from its "less large" customers below its top 20. That suggests to me that it would not be too surprising if EPAM exceeded its revenue and EPS forecasts for Q3.
What I like about the set-up is that the shares are priced for "growth compression" and yet the macros that led to the forecast of growth compression have turned out far more benign than originally feared. The UK economy itself appears to have been quite resistant to the impact of Brexit. The EU as a whole has not seen the kind of negative impact that some had feared because of Brexit. And while there are doubtless issues within the financial services sector in Europe (Commerzbank (OTCPK:CRZBF) has announced significant layoffs today), there have certainly been fewer headlines regarding their problems and far more headlines regarding the problems at Wells Fargo (NYSE:WFC). European business confidence was reported to have rebounded to the strongest levels in September, post Brexit. What it all means to the business of EPAM in the third quarter is not really visible to observers. What it ought to mean is that many of the issues that the company called out during its conference call that related to macro headwinds never really became a factor. This may have set the stage for both an EPS upside and some better commentary regarding the macro conditions as they relate to the company's Q4 outlook. Recently, the company published a blog whose points are that the impact of Brexit has been far less than feared. Significantly, the author, Jim Warburton, Senior Director, Business Consultancy at EPAM, wrote that "investment programs, in the main, have carried on uninterrupted." Indeed, the blog goes on to say that the impact of Brexit might be to stimulate demand as financial institutions need to buy additional solutions to deal with the separation of the UK from the single market. That is part of the formula for a potential upside and would stand the conventional wisdom on its head.
What about the EPS shortfall and the guidance cut?
Headline commentary for EPAM in the wake of its last quarter related to the fact that the company had missed the consensus forecast by $.01 and that it had reduced its full-year EPS forecast from EPS of $3.20 to EPS of $2.97. The issue in terms for earnings for a company such as this is utilization. Gross margin for a company like this is all about utilization, and utilization is far more complicated than it might seem from a 30,000-foot level. For many years, I had the great privilege to follow Sapient (NASDAQ:SAPE), another competitor in the high-end IT consulting space. Sapient was ultimately bought by the French advertising firm Publicis (OTCQX:PUBGY). The premium really didn't compensate shareholders, including this writer, for the agonizing years of waiting for a financial turnaround that never really happened.
Nice people, very smart, some incredible pioneering work in terms of online marketing, but the company was never able to put together more than a single quarter in which it made its earnings forecast. They were simply never able to get utilization right on a consistent basis. It is a more difficult task than might be imagined. The shares always seemed cheap, but the company really generated the kind of sustained profitability necessary to support a decent valuation. Sapient's problem, and often the problem for many of the companies in this space, is effective utilization. One of the things that EPAM has gotten right over the past several years has been its stable utilization trends that have translated into reasonable and stable gross margins.
The problem with utilization in this business is having the right people with the right skill level available to staff jobs that are in verticals in which they have expertise. In particular, if there is pressure in one job or in one vertical, it isn't easy to shift resources to another vertical. The people may seem to be fungible at some level but the fact is that they really aren't. This happened again and again at Sapient - it was, to be sure more of an issue for that company which really had and still has three very distinct business lines. But it is a fact of life in the high end-IT consulting practice. GAAP gross margins in Q2 were about 36.3% which compared to 38.3% in the prior year. On a sequential basis, GAAP gross margins were consistent between Q1 and Q2. Management's forecast and its explicit commentary on the call was that it had taken appropriate steps in its hiring practices such that it believed that gross margins would return to prior levels in the balance of the year.
The fact is that the competition for high skill IT professionals is relatively lower in the CIS at this point than it is in India although wages are still a bit higher, at least to this point. Minsk and Kiev have loads of technical graduates and far fewer job opportunities than is the case in India these days. And that means that unlike India, where companies do have to consider competitive hiring pressures in staffing strategies, that is far less the case for EPAM which means it does have the ability to react quickly to changes in demand conditions.
Overall, as mentioned earlier, EPAM was able to maintain its operating margins and grow EPS significantly last quarter because it was able to squeeze selling general and administrative costs to 22.6% of revenue in the June quarter, down from 25.7% of revenues in the prior year's quarter, and down from 23.2% the sequential prior quarter.
Management's current EPS forecast is predicated on the company achieving margins within its normal targeted band of 16%-18% non-GAAP. That being said, if gross margins return to historic levels as has been forecast, the potential for operating margins to be at or above the "normal" band used in the EPS forecast exists. It is another of the potential shorter-term upsides that are part of this story.
Secret Sauces, Special Sauces, Any Sauces?
When looking at a professional services company the principal asset is the people. It isn't as though there is some kind of patented product or that anyone really has a special, unique service delivery methodology. This company is a little bit different than its peers in that most of its service delivery personnel come from the Ukraine and from Belarus. The IT wages in this area are low, the technical standards of the consultants are high and the demand for consultants in the region is measured, to say the least.
The downside to using the CIS geography as the focus for its service delivery personnel is that many users have concerns regarding security and industrial espionage. As many readers are aware, data security is a paramount concern among many decision makers and whether justified or not, the CIS or the geo where most EPAM service personnel are located has a reputation among some potential users as an area in which the data security environment might be challenged. Obviously, the issues with regard to security haven't prevented this company from achieving remarkable growth, but they are ones that need to be mentioned.
Overall, EPAM has a "land and expand" strategy so that security concerns have been mitigated for specific clients in the course of this company doing projects that have achieved planned objectives and have not seen security breaches.
I think that the other secret sauce the company has is that it simply seem to have a far greater record of success with its projects than its competitors.
I can't really say why that is so, but here is the quote from Forrester when it comes to describing the company's position in what Forrester calls Digital Platform Engineering Services (DPES).
The company exhibited the strongest grasp and execution of DPES of all of the vendors evaluated in this report. Customers consistently cited EPAM as a strategic partner in business-critical digital transformation projects... clients have also enlisted EPAM to rewrite back-end systems to support the overall customer experience."
I think it is overkill to try to point out some of the other areas in which the company appears to have significant competency advantages. Just as an example - something called blockchain is causing serious disruption as a technology to enable higher levels of security as well as other functional advantages in the fintech space. This company was early to that party and has a competency center that enables users to develop a variety of use cases that can be differentiators for their businesses.
Overall, the company appears to sell users with very specific expertise in the more advanced components of digital transformation that most users are unlikely to want to create in-house due to cost constraints. The company has formed many partnerships with industry-focused consultancies that focus on EPAM providing expertise in a particular technology and the partner providing vertical expertise. It is a model that has been effective and it is a tweak on the sauce that sets it apart.
I think that the size of the company and the skill set of the company's management have allowed it to jump on technology trends in IT in their infancy and to exploit those trends in order to achieve significantly greater organic growth than its competitors. That is basically the secret sauce that this company has and is likely to continue to have into the future.
EPAM's valuation appears to be quite reasonable relative to its organic revenue growth and its record of profitability. Based on the current valuations, the company has an enterprise value of about $3.3 billion. The consensus revenue estimate for the current year is $1.16 billion and for the following year, it is $1.41 billion. As I have written above, it is likely that both of those estimates will prove to be conservative. Using the consensus estimates, however, yields an EV/S of 2.8 and based on 2017 estimates the EV/S is 2.1X. These are valuation metrics that compare quite favorably with most of the other businesses in the space.
The P/E based on the current consensus is just under 23X this year's earnings estimates and is at 19X the consensus estimates for 2017. These have to be considered favorably in the context of today's overall valuation environment and the relatively rapid growth the company has enjoyed for several years. Overall, the top line will have doubled in three years more or less and non-GAAP EPS will have more than doubled since 2012. These growth rates are perhaps the fastest that have been seen in the IT outsourcing space and dwarf those of the more visible Indian outsourcing vendors such as Cognizant, Infosys and Wipro (NYSE:WIT).
I usually like to talk about cash flow at this point. For the record, the company's free cash flow yield based on 2015 numbers is just over 2% because of a rapid rise in receivables. Billed and non-billed receivables reached in excess of 90 days last year, far beyond reasonable levels. Receivable balances have been trimmed this year and that has led to a significant growth in cash flow. Cash flow on current trends will more than double this year but most of that has to do with the decrease in DSOs as the company works to ameliorate the collection of receivables. Over time, cash flow and reported earnings should be close analogs. CapEx for this company is running at rate of less than $30 million/year and it should remain at that kind of rate for the foreseeable future.
Stock-based compensation has been moderate and is not growing. So far, this year stock-based compensation has been at 1.5% of total revenues and at 17% of GAAP reported earnings.
I think that the combination of strong growth, a conservative short-term outlook and a modest valuation make this a good set-up for forecasting significant levels of positive alpha going into the future.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.