EPAM Systems, Inc. — Q1 2014 Form 10-Q
Reporting period: Three months ended March 31, 2014; comparisons are with Q1 2013 unless noted. EPAM provides software engineering and IT services, principally to large multinational clients. Financial amounts below are in U.S. dollars.
Financial performance and liquidity
| Metric | Q1 2014 | Q1 2013 | Change |
|---|---|---|---|
| Revenue | $160.4 million | $124.2 million | +29.1% |
| Gross profit, calculated as revenue less cost of revenues | $57.9 million | $46.3 million | Gross margin 36.1%, versus 37.3% |
| Operating income | $21.9 million | $15.5 million | +40.7%; operating margin 13.6%, versus 12.5% |
| Non-GAAP operating income and margin | $26.3 million; 16.4% | $18.8 million; 15.2% | Excludes stock compensation, acquired-intangible amortization and acquisition costs |
| Net income | $17.4 million | $12.7 million | +36.9%; net margin 10.8%, versus 10.2% |
| Diluted EPS | $0.35 | $0.27 | +29.6% |
| Operating cash flow | $16.2 million provided | $11.7 million used | Improved $27.9 million |
Net cash used in investing was $11.7 million, including $5.7 million placed in time deposits and $2.4 million paid at the Netsoft acquisition closing. Financing provided $3.1 million. Cash and cash equivalents increased $4.9 million during the quarter to $174.1 million; the cash-flow statement reports $102.8 million at March 31, 2013.
At March 31, 2014, current assets were $352.3 million and current liabilities $60.5 million. Total liabilities were $62.4 million and stockholders’ equity $396.3 million. EPAM had no borrowings under its $40 million revolving facility, which matures January 15, 2015. Cash plus available facility capacity was approximately $214.1 million. The filing says management expects cash and operating cash flow to cover operating and capital needs for at least the next 12 months.
Material changes and operating trends
- Revenue growth was driven by existing-customer expansion, new clients and acquisitions; the filing attributes $6.3 million of Q1 revenue to acquisitions. Headcount of IT professionals rose by 1,040 year over year to 9,759.
- Europe was the strongest growth area: segment revenue increased to $67.7 million from $46.2 million, while segment operating profit rose to $14.1 million from $8.4 million. North America revenue increased to $80.2 million from $63.1 million.
- Russia segment revenue declined to $10.7 million from $12.4 million and reported a $1.1 million operating loss. Other segment revenue was $1.4 million and reported a $1.3 million operating loss. Management attributed the losses to delayed customer budgets and revenue recognition; it estimated $3.0 million of Russia revenue for services already performed remained unrecognized at quarter-end.
- Banking and Financial Services and Travel and Consumer were key growth verticals. The Business Information and Media vertical also accelerated, with revenue growth of 19.2%, including resumed growth from certain long-time customers.
- Cost of revenues rose 31.5%, faster than revenue, and gross margin declined. Management said the margin pressure included costs associated with Russia services for which revenue was not yet recognized. SG&A rose 19.5% but declined as a share of revenue.
- Foreign-exchange loss increased to $1.2 million from $0.5 million, primarily due to Ukrainian hryvnia devaluation. The effective tax rate rose to 19.6% from 19.1%.
Acquisitions, outlook and risks
- EPAM acquired Netsoft and Armenia-based Ozsoft assets on March 5 for preliminary consideration of $5.6 million, including $1.8 million contingent cash consideration and $1.4 million deferred cash consideration. The purchase-price allocation was provisional; acquired goodwill and intangible assets could be reallocated, and the filing says changes could be significant. Netsoft contributed $0.4 million revenue and $0.1 million net income in the quarter.
- After quarter-end, on April 30, EPAM acquired Jointech for initial consideration of $20 million, payable in cash and stock, plus potential earn-out consideration of up to $25 million. This transaction was not reflected in Q1 results.
- The filing provides no specific revenue or earnings guidance. Management describes continued investment in sales, expertise and global operations, and identifies acquisitions as part of its growth strategy. It also cautions that quarterly results may not indicate full-year or future performance.
- Risks highlighted include geopolitical and economic instability, inflation and currency devaluation in CIS markets; foreign-exchange exposure; reliance on banks and cash deposits in the CIS; customer concentration; and the ability to sustain growth and margins. Approximately $90 million of cash was held in CIS countries, including $79.4 million in Belarus. EPAM said it did not intend to repatriate cash held outside the U.S.; repatriation could incur withholding and U.S. taxes.
- Customer concentration increased: the top five and top ten customers represented 33.5% and 45.5% of revenue, respectively; UBS AG alone exceeded 10% of revenue. Stock-based compensation was $3.2 million, and EPAM granted 2.31 million options in Q1. Litigation and off-balance-sheet exposures were not reported as material; no material legal proceeding was disclosed.
Important facts for investors to verify
- Whether the estimated $3.0 million of delayed Russia revenue was subsequently recognized, and whether associated costs affected reported margins.
- Final Netsoft purchase-price allocation, earn-out outcomes and any related compensation expense; also the financing, dilution and earn-out results for the post-quarter Jointech acquisition.
- Cash location, accessibility and potential tax costs of repatriation, particularly the concentration of deposits in Belarus and other CIS countries.
- Customer concentration and the sustainability of growth in Europe and key banking and consumer accounts.
- Future operating and gross margins, including the impact of hiring, wage and inflation pressures, currency movements, and the distinction between GAAP and management’s non-GAAP measures.