EPAM Systems' High Multiples Shouldn't Bother You
Summary
- EPAM Systems, Inc. is a U.S. IT-engineering company that operates in 30 countries providing IT product development, digital platform engineering, and product design services.
- The Total Addressable Market (TAM) of the company is estimated to be $1 trillion, while its market capitalization is around $19.2 billion.
- The cheapness of human capital is the key competitive advantage of EPAM.
- The company has high market multiples, which are justified by the rapid growth in revenue, EBITDA, and other key indicators. From this point of view, EPAM is more undervalued than overvalued.
- Based on carried out technical analysis, I would recommend buying EPAM at its current levels, or waiting for the price to approach its support level of $320.
Summary Investment Thesis
EPAM Systems, Inc. (NYSE:EPAM) is a global leader in the provision of IT engineering and consulting services for the development of software and other IT products.
The company does not have sharp jumps in its business shares, but in recent quarters it has been dominated by customers from the Business Information & Media sector.
The company estimates its total addressable market (TAM) to be $1 trillion (as of November 5, 2020), while the market capitalization of EPAM at the time of writing this article is only $19.2 billion. That is, the company has room to grow, and this growth is inevitable for some reasons.
Firstly, the company has a huge advantage over its competitors: the cheapness of human capital. Most of the employees work from Belarus, Ukraine, and Russia. The comparison of the average IT-salaries of those regions with the average IT-salaries in the United States made it possible to determine that EPAM can save tens of millions of dollars on this cost item.
Secondly, financial performance. All analyzed financial ratios speak of the sustainability of EPAM's business: small debt that can be paid off from the company's operating profit >10 times in a row; double-digit revenue growth amid rising working capital. Free cash flow for 9 months of the fiscal year 2020 grew by almost 20 times, YoY.
The market valuation ratios are quite high when simply compared with the industry average. However, if we match them with the real values of the company's growth (revenue growth, EBITDA growth, etc.), it turns out that these ratios are justified. Moreover, the company remains undervalued compared to its peers.
Concerning the technical analysis carried out, it can be argued that shortly the stock may get to the support level in its price channel. But if the price holds, then amid the bullish moving average crossover, the stock has every chance of continuing its long-term uptrend. So I would recommend buying EPAM shares at current levels, or waiting for the price to approach its support level of $320.
Business Description
Today EPAM Systems Inc. operates in 30 countries, providing IT product development, digital platform engineering, and product design services. The company was founded in 1993 by Arkady Dobkin, the current CEO. At the time of business creation, the company had 3 employees and $0 in revenue. A series of successful coincidences and the presence of talent and skills in the development of IT products brought the company several successful contracts just a few years after its foundation. At the time of 2019, the company generates >$2.9 billion in revenue and is a place of work for 38,000 employees.
EPAM operates in two main fields:
- 'Build': Consulting, Solutions Build & Implementation, IaaS & Infrastructure Utility Services.
- 'Maintain': Infrastructure Management Services, Hardware Management Services, Application Management Services, Business Process Outsourcing.
Source: EPAM’s website, 3Q Investors Presentation
In the context of EPAM's served companies, the business structure is as follows:
Source: Author based on EPAM Fact Sheet
It can be noted that in the last three quarters of fiscal 2020, the company received more revenue from the Business Information & Media sector, while last year Financial Services (most likely FinTech companies) dominated. Otherwise, there are no pronounced trends.
As the company notes, EPAM's Total Addressable Market (TAM) as of November 5, 2020, is about $1 trillion, while the company's market capitalization is only $19.2 billion. The TAM of the two largest parts of EPAM's business (Consulting + Solutions Build & Implementation = 45%) is about $460 billion (according to the company's presentation).
Cheap human capital is a competitive advantage for EPAM Systems, Inc.
The company has a significant advantage due to its human capital. Delivery professionals account for about 88.9% of the total labor force (according to the company's last Q-10 report). In the context of geography, their number was distributed as follows:
Source: Author based on EPAM Fact Sheet
As you can see, about 29% of all delivery professionals work from Belarus, while Ukraine is in second place (23%), and Russia goes third (16%). North America accounts for only 9% of the total delivery professionals number.
The advantage lies in the difference in living standards in developed and developing countries. If a senior IT specialist in North America makes $120,000 a year, that is considered a small salary. Whereas in Belarus, Ukraine, or Russia, even a smaller figure will be considered a huge income. This is confirmed by statistics:
Source:
PayScale, Information Technology ((IT)) Services Salary
Source: SalaryExplorer, Information Technology Average Salaries in Belarus 2021
If we translate the last figures into $US, it turns out that on average an IT specialist in Belarus earns from $593.3 to $1861.4 per month, that is, from $7,119.6 to $22,336.8 per year, which defies any comparison with salaries in the US or Canada.
Salaries in Ukraine and Russia are about the same as in Belarus:
Source: SalaryExplorer, Information Technology Average Salaries in Ukraine 2021
Source: SalaryExplorer, Information Technology Average Salaries in Russia 2021
That is, on average, a Russian IT-specialist makes $16,968 per year, and a Ukrainian one - $9,828.48, also per year.
The company benefits from the fact that most of its employees work remotely, in fact, being in countries where there is great competition in the IT sector, but where salaries are several times lower than in developed countries. Since EPAM Systems Inc. is a large IT company for these countries, there is a demand for its open positions in these regions. Accordingly, EPAM can attract the best employees by paying them above-market salaries and still benefit from the difference in living standards. At the same time, North America brings the largest share of EPAM's revenue:
Source: Author based on EPAM Fact Sheet
Thus, there is no doubt that with such a large addressable market (~ $1 trillion) and such a huge competitive advantage in the form of cheap human capital, the company will continue to grow further, conquering more and more of the IT engineering market worldwide.
Financial Performance
Obviously, the capabilities of the company came in handy in the era of "distanization" of the economy around the world:
EPAM's solid third quarter performance was the result of an improving demand environment along with the ongoing expansion of the Company's capabilities—enabling us to continue supporting our customers in the execution of their transformation programs.
Source: EPAM's CEO, Arkadiy Dobkin. Seeking Alpha, November 5, 2020
Therefore, the company showed impressive revenue growth in 3Q 2020: +20.57% QoQ, and the total net profit for the three quarters was $264.6 billion, which is 17.34% higher, YoY.
The total value of cash & cash equivalents on the company’s balance sheet amounted to $1,023.7 billion, which is 28.33% more than a year earlier (YoY). Days Sales Outstanding (DSO) in the third quarter of 2020 was 70, while last year the figure was 6.67% lower (75). Working capital grew by 21.79% over the same time period. The profitability ratios are as follows:
Source: Author based on EPAM Fact Sheet
The EPS growth is especially striking: for 3Q 2020, growth was 31.89%, QoQ. Free cash flow in total for three quarters of 2020 amounted to $2.3 billion, while in the same period last year the company was able to generate only $110.6 million, i.e. the growth for this item was almost 20x!
Other key financial ratios are as follows:
Key financial ratios | Three Months EndedSeptember 30 | Nine Months EndedSeptember 30 | |||
2020 | 2019 | 2020 | 2019 | ||
ROA | 3.48% | 2.43% | 8.70% | 8.21% | |
ROE | 4.79% | 3.42% | 11.95% | 11.55% | |
Current ratio | - | - | 4.22 | 3.81 | |
Acid Test ratio | - | - | 3.03 | 2.52 | |
Cash ratio | - | - | 2.94 | 2.42 | |
Debt ratio | - | - | 0.0097 | 0.0111 | |
Debt-to-Equity | - | - | 37.37% | 40.60% | |
Times interest coverage | - | - | 10.67 | 8.69 | |
Source: Author based on EPAM Fact Sheet
For the 3rd quatre FY2019/20 EPAM showed ROA of 3.48%, which is 43.2% higher, QoQ. In 9 months, the company's ROA increased by 5.9%. ROE in the third quarter amounted to 4.79% (+40.05%, QoQ), and in total for three quarters, this value increased by +3.46%, YoY.
The company has a fairly strong balance sheet: an insignificant share of debt in total liabilities results in the Debt ratio of 0.0097, which is -12.61% lower than last year, YoY. The company can cover this debt >10 times with operating profit for 9 months! The company's Debt-to-Equity ratio has historically been small, but it decreased by 3.23 points, amounting to 37.37%.
So, from a financial point of view, the company is successful: nothing fundamentally prevents the stock from growing further.
However, I see certain market barriers that could stop or significantly slow this growth
1. Currency risks of the company. If you look at the latest income statement, you will see that the company is losing quite a lot of money on the translation adjustments of foreign currency:
Source: Author's notes on EPAM’s latest 10-Q
Foreign exchange revaluation expenses for 9 months of 2020 amounted to about $15.8 million, which is 251.67% more, YoY.
Of course, the company hedges its risks: during the analyzed period, $3.4 million was spent on derivatives. This risk exists due to the large number of the company's expense transactions in the currency of the countries where EPAM operates:
Source: Author based on EPAM Fact Sheet
Obviously, with a higher percentage of US revenue, the company incurs higher costs in dollars. However, the second place is occupied by the Russian ruble, which tends to devalue frequently. This puts the company's foreign exchange risk at the leading positions among the other idiosyncratic risks.
2. High market multiples. EPAM's market multiples seem to be quite high, compared to its peers:
Company / Ratio | P/E (TTM GAAP) | P/S (TTM) | EV/Sales (TTM) | EV/EBITDA (TTM) | P/CF (TTM) |
EPAM Systems, Inc. | 63.15 | 7.41 | 7.1 | 44.38 | 37.67 |
CGI, Inc. | 24.98 | 2.26 | 2.45 | 14.17 | 13.82 |
Gartner, Inc. | 70.49 | 3.56 | 4.14 | 26.49 | 20.57 |
Leidos Holdings, Inc. | 24.32 | 1.23 | 1.62 | 15.37 | 9.52 |
Booz Allen Hamilton | 24.89 | 1.63 | 1.81 | 17.71 | 14.81 |
Amdocs Limited | 18.77 | 2.23 | 2.21 | 11.63 | 13.87 |
Average | 37.77 | 3.05 | 3.22 | 21.63 | 18.38 |
Source: Author based on the data from Seeking Alpha
Relative to all market multiples, every (without exception) EPAM's multiple is on average twice higher than the average.
Different approach to comparables valuation
However, it is impossible to tell right away that EPAM's multiples are unfair. Who knows what, for example, the P/E ratio should be correct for EPAM? I believe that one should also look at the growth of the company versus the growth of its competitors:
Source: Author based on the data from Seeking Alpha
As shown by the key growth values, EPAM Systems Inc. is well ahead of its competitors. If you approach the comparative multiples valuation through a comparison of growth and market multiples, you can get the following:
Source: Author based on the data from Seeking Alpha
On most charts comparing companies' growth and their market multiples, EPAM's point is above the trend line, which may indicate a potential overvaluation.
On the other hand, there're some exceptions that I've noticed. Here's one of them:
Source: Author based on the data from Seeking Alpha
On the last chart, EPAM's point is very close to the trend line, but still slightly below it. You need to understand that comparison of growth and market multiples, like any other way to valuation, is approximate.
I am inclined to believe that EPAM generally is more undervalued than overvalued when judged by a combination of factors. The company has a strong business, financial strength, and market multiples are underpinned by explosive growth in key operational indicators. Against the background of the previously described comparative advantage of the company and the assessment of the total addressable market, I consider EPAM to be the undisputed leader in its industry; at the same time, the company is undervalued, despite its high market multiples.
Technical analysis
Source: EPAM, Investing.com
Since the publication of its most recent 10-Q (red vertical line on the chart), the stock has lost >4% in value. However, there was no news that could, in theory, overshadow the company's strong report and push the price lower. Anyway, this might be even better for potential investors - they can buy the stock even cheaper.
Source: EPAM, Investing.com
At the moment, on the daily chart, the formation of a sideways trend is visible with an unaided eye. The price continues to move within the price channel, getting closer to the support level of $320. As we can see from the chart, this is even for the better: a downward movement will provoke one moving average (MA 13) to cross the other moving average (MA 34), leading to a bullish crossover. This can push the price towards its resistance level.
The RSI is in the middle of the normal range (44.84), giving no signals of oversold/overbought.
In general, I recommend buying EPAM at its current levels. But those who want to buy even cheaper should wait until the price approaches its support level of $320.
This article was written by
Analyst’s 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.
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