EPAM Systems, Inc. — Q3 2012 Form 10-Q
Reporting period: Three and nine months ended September 30, 2012; filed November 13, 2012. The interim financial statements are unaudited. EPAM provides global IT services, with a focus on software development and engineering.
Financial performance and liquidity
| Metric | Q3 2012 | Q3 2011 | Nine months 2012 | Nine months 2011 |
|---|---|---|---|---|
| Revenue | $110.1 million | $86.4 million | $308.3 million | $239.4 million |
| Income from operations | $16.7 million | $16.9 million | $47.4 million | $39.6 million |
| Operating margin | 15.2% | 19.5% | 15.4% | 16.5% |
| Net income | $14.1 million | $14.0 million | $39.5 million | $32.0 million |
| Diluted common EPS | $0.30 | $0.33 | $0.85 | $0.14 |
| Operating cash flow | Not provided quarterly | $12.7 million | $28.2 million |
- Revenue grew 27.4% in Q3 and 28.8% year to date. Net income increased 0.8% in Q3 and 23.5% year to date.
- GAAP operating margin contracted despite higher revenue. Non-GAAP operating margin, which excludes specified items including stock compensation, was 17.4% for Q3 and 17.6% year to date, versus 21.0% and 18.6% in the comparable 2011 periods.
- Cash and cash equivalents were $105.9 million at September 30, 2012, versus $88.8 million at December 31, 2011. Current assets were $237.7 million and current liabilities $46.1 million. No borrowings were outstanding; $25.7 million was available under the revolving credit facility.
- Total liabilities were $47.6 million. The company reported no outstanding debt under its $30 million revolving facility, which expires October 15, 2013.
- Nine-month operating cash flow fell to $12.7 million from $28.2 million. Management attributed the decline primarily to growth in trade and unbilled receivables and lower accrued compensation, including bonus payments related to 2011 performance.
Material changes and business drivers
- Growth came from existing and new clients, continued European expansion, and the May 2012 acquisition of Thoughtcorp. Management also cited demand in Banking and Financial Services, Retail and Consumer, and ISV and Technology; two government tax-agency projects contributed to growth in the Other vertical.
- Europe revenue increased 45.8% in Q3 and 47.5% year to date. Russia segment revenue declined year to date, while North America and Europe segment revenue increased.
- Thoughtcorp contributed $3.9 million in revenue for the first nine months and was not material enough to require pro forma results. Acquisition purchase-price allocations remained provisional. The transaction included cash, issued shares, and employment-contingent restricted shares.
- Operating costs grew with staffing and business expansion. Cost of revenue increased faster than revenue; management cited 1,580 additional IT professionals year over year and higher stock-based compensation. SG&A increased in dollars but was broadly stable as a share of revenue year to date.
- In February 2012, EPAM completed its IPO. The company issued 2.9 million shares and received $29.0 million in net proceeds; all preferred shares converted into common stock. The change in share count affects EPS comparisons across periods.
Outlook, risks and unusual items
- No quantified revenue or earnings guidance was provided. Management said it expects time-and-material contracts to remain the majority of revenue and intends to continue pursuing strategic acquisitions to deepen industry and technology capabilities.
- Management described liquidity as adequate for foreseeable domestic needs, while noting that most cash held outside the United States was intended for foreign operations and not planned for repatriation. Repatriation could trigger withholding and U.S. taxes.
- Foreign-exchange exposure includes revenues and expenses in euros, pounds, rubles and other currencies. EPAM did not hedge with derivatives; management estimated a 1% move in either the euro or pound against the U.S. dollar would change net income by approximately $0.2 million.
- Client concentration remains relevant: Barclays Capital exceeded 10% of Q3 2012 revenue; no client exceeded 10% for the nine-month period. The top ten generated 45.5% of nine-month revenue.
- Tax rates increased: the effective rate was 15.2% in Q3 2012 versus 6.8% in Q3 2011, and 15.7% year to date versus 14.6%. The filing cites a shift in income mix away from lower-tax jurisdictions and unfavorable permanent tax differences. Belarus tax incentives and Hungarian tax credits are also relevant to future rates.
- Construction commitments included approximately $4.4 million remaining for a Belarus office building expected to become operational in the first half of 2013 and approximately $0.8 million for employee apartments expected to be completed in 2013. The apartment project was expanded from 12 to 26 units.
- The company reported no material legal proceedings and no material changes to the risk factors in its 2011 Form 10-K. Management concluded disclosure controls were effective as of September 30, 2012; there was no material change in internal control over financial reporting.
Important facts for investors to verify
- Whether receivables and unbilled revenue growth converts to cash, given the year-over-year drop in operating cash flow.
- Whether operating margins stabilize as staffing, stock-based compensation and acquired-intangible amortization increase.
- The final Thoughtcorp purchase-price allocation and ongoing acquisition-related compensation costs.
- Client concentration and revenue durability, particularly the Q3 contribution from Barclays Capital and the concentration in the top ten clients.
- Cash availability and tax consequences of any future repatriation, alongside foreign-exchange and country-specific exposure.
- Progress and final costs for Belarus construction projects and the employee housing program; the housing program had no outstanding commitment at quarter-end.
- EPS comparability: preferred-share conversion and IPO-related dilution materially changed the share base, so per-share comparisons should be read alongside net income and weighted-average shares.