EPAM Systems, Inc. — Q3 2013 Form 10-Q
Reporting period: Quarter and nine months ended September 30, 2013; unaudited. EPAM provides software engineering and IT services, with delivery operations concentrated in Central and Eastern Europe and the CIS. Financial amounts below are in U.S. dollars; millions unless stated otherwise.
Financial performance
| Metric | Q3 2013 | Q3 2012 | Nine months 2013 | Nine months 2012 |
|---|---|---|---|---|
| Revenue | $140.2 | $110.1 | $397.5 | $308.3 |
| Operating income | $20.2 | $16.7 | $53.3 | $47.4 |
| GAAP operating margin | 14.4% | 15.2% | 13.4% | 15.4% |
| Net income | $16.4 | $14.1 | $43.2 | $39.5 |
| Diluted EPS | $0.34 | $0.30 | $0.90 | $0.85 |
| Operating cash flow | Not separately presented for the quarter | $11.8 | $12.7 |
Revenue increased 27.3% in Q3 and 29.0% year to date; net income rose 16.9% and 9.5%, respectively. Non-GAAP operating margin was 17.0% in Q3 versus 17.4%, and 16.2% year to date versus 17.6%. The company’s non-GAAP measure excludes stock-based compensation, acquisition-related costs, purchased-intangible amortization and certain other items.
At September 30, cash and cash equivalents were $123.0 million, versus $118.1 million at December 31, 2012. Current assets were $305.2 million and current liabilities $52.1 million. Total liabilities were $53.9 million; there was no outstanding borrowing on the $40 million revolving credit facility, leaving the company with substantial net cash. The facility matures January 15, 2015, bears interest at LIBOR plus 1.25%, and is secured by specified company assets and subsidiary shares.
Nine-month investing cash outflow was $18.9 million, including $10.9 million of property and equipment purchases and net spending on employee housing loans. Financing cash inflow was $12.7 million, primarily from option exercises and related tax benefits. Cash increased $4.9 million over the period. Operating cash flow was below net income, principally reflecting growth in unbilled revenues and accounts receivable.
Material changes and operating drivers
- North America and Europe drove growth. Nine-month segment revenue rose 44.5% in North America and 18.6% in Europe; Russia rose 22.5%, while Other fell 33.3%.
- Banking and Financial Services and ISVs and Technology were prominent growth verticals. Management also reported a recovery in Business Information and Media, particularly excluding declining revenue from Thomson Reuters.
- Operating expenses grew faster than revenue in several areas. SG&A rose 31.9% in Q3 and 40.4% year to date, with higher facility costs, acquisition-related stock compensation and public-company costs among the cited factors. Headcount of IT professionals increased from 8,132 to 9,065 year over year.
- The effective tax rate rose to 19.3% in Q3 from 15.2%, and to 19.1% for the first nine months from 15.7%. Management attributed the increase to a larger share of profits in the U.S. and shifts in delivery work from Belarus to higher-tax Ukraine and Russia.
- Cash conversion and working capital merit attention: unbilled revenues increased to $65.0 million from $33.4 million at year-end. Management linked the increase to revenue growth and a higher mix of fixed-price projects, which reached 14.9% of nine-month revenue.
Outlook, risks and unusual items
- No specific numerical revenue or earnings guidance is provided. Management said existing cash and expected operating cash flow should cover operating and capital needs for at least the next 12 months, while noting that future results depend on business performance, economic conditions and other factors.
- Management cited continued growth opportunities in North America and Europe, expansion of existing client relationships, acquisitions and strategic investments. It also noted that delays in finalizing customer arrangements reduced segment profitability in Russia and Other; the Other segment’s narrative description of its result appears inconsistent with the positive segment-profit figure in the table.
- Geographic and currency exposures are significant. $95.5 million of cash was held outside the U.S.; the filing separately reports $75.0 million held in CIS countries, including $63.4 million in Belarus. Management does not intend to repatriate foreign cash; remittance could trigger withholding and U.S. taxes. The company does not hedge currency exposure and reported foreign-exchange losses.
- Customer concentration remains relevant: the top five and top ten customers generated 30.4% and 42.0% of nine-month revenue. Barclays Capital represented 9.9% of year-to-date revenue. Two customers together accounted for 33.8% of unbilled revenue.
- Employee loans reached $6.3 million, mostly Belarus housing loans; no allowance was recorded. The company identifies borrower, employment, collateral-value and regional economic risks. Outstanding commitments included $3.8 million for a Belarus office building and $0.7 million under the housing program; operating lease obligations totaled $32.3 million.
- Management reported no material legal proceedings and no material change to previously disclosed risk factors, except the addition of employee-loan risks and potential board changes if a major shareholder sells shares. The company reported effective disclosure controls as of September 30, 2013.
Important facts for investors to verify
- Whether the large increase in unbilled revenue converts to billed receivables and cash, and whether operating cash flow improves.
- Whether margins stabilize after year-over-year declines in GAAP and non-GAAP operating margins, given rising SG&A and compensation costs.
- Revenue and profitability trends by segment, especially the weaker Q3 segment profit in Europe and Russia and the filing’s inconsistent description of the Other segment result.
- Cash concentration and banking exposure in Belarus and the CIS, potential tax costs of repatriation, and the company’s unhedged foreign-currency exposure.
- Collection and collateral risks in the employee housing-loan program, as well as customer concentration and reliance on large client relationships.