EPAM Systems, Inc. — Form 10-Q Summary
Reporting period: Quarter and six months ended June 30, 2014. Amounts below are in U.S. dollars; financial statement amounts are generally shown in millions.
Business context
EPAM provides software engineering and IT services, primarily to large multinational clients. It reported four segments: North America, Europe, Russia and Other. During the first half, EPAM completed acquisitions of Netsoft, Jointech and GGA, broadening its healthcare, life sciences, banking and Southeast Asian capabilities. The acquisitions had a recorded purchase price of $67.3 million, including contingent consideration.
Financial performance and liquidity
| Metric | Q2 2014 | Q2 2013 | First half 2014 | First half 2013 |
|---|---|---|---|---|
| Revenue | $174.7 | $133.2 | $335.1 | $257.4 |
| Income from operations | $18.5 | $17.5 | $40.3 | $33.1 |
| GAAP operating margin | 10.6% | 13.2% | 12.0% | 12.8% |
| Net income | $14.8 | $14.1 | $32.2 | $26.8 |
| Diluted EPS | $0.30 | $0.29 | $0.65 | $0.56 |
| Non-GAAP operating margin | 16.5% | 16.3% | 16.5% | 15.8% |
Revenue grew 31.2% in Q2 and 30.2% in the first half. First-half growth reflected organic expansion and acquisitions. Europe was particularly strong, with first-half segment revenue up 47.2%; North America revenue rose 27.5%. Russia and Other revenue declined year over year in the first half.
Cost of revenues, excluding depreciation and amortization, was 63.0% of revenue in Q2 and 63.4% in the first half, versus 62.7% and 62.7%, respectively. Operating margin declined despite higher revenue, reflecting higher stock-based compensation, acquired-intangible amortization, acquisition costs and a $2.0 million construction-related charge. The effective tax rate was 19.5%, compared with 19.0% in both comparable periods.
First-half operating cash flow was $33.0 million, compared with cash used of $3.8 million a year earlier. Investing activities used $33.2 million, including $26.5 million for acquisitions. Cash and cash equivalents were $175.1 million at June 30, 2014, up from $169.2 million at year-end. EPAM had no borrowings under its $40.0 million revolving facility; the facility matures January 15, 2015. Total liabilities were $111.3 million and stockholders’ equity was $426.6 million. Management said existing cash and expected operating cash flow should cover operating and capital needs for at least the next 12 months.
Material changes and management commentary
- Acquisitions added scale and capabilities; the acquired businesses contributed $7.2 million of revenue and $0.5 million of net income for the first half, as presented in the filing. Purchase-price allocations were provisional.
- Q2 GAAP operating income rose 5.4%, slower than revenue growth; first-half operating income rose 22.0%. Non-GAAP operating margin improved year over year, while GAAP margins fell.
- UBS AG represented more than 10% of revenue in Q2 and the first half. The top five customers accounted for 33.1% of first-half revenue and the top ten for 44.9%.
- Management cited continued demand in banking and financial services and travel and consumer, and described opportunities from the acquisitions. No specific revenue or earnings guidance was provided.
Risks, contingencies and unusual items
- Belarus construction project: The contractor stopped work and EPAM terminated the construction agreement in July. EPAM recorded a $2.0 million probable loss; estimated additional investment to complete the building was up to $7.0 million. Up to $4.5 million of contractor advances might not be recoverable, and any additional liability was not reasonably estimable.
- Geopolitical, inflation and currency exposure: Management discussed economic and political uncertainty in Ukraine, Russia, Kazakhstan and Belarus, including inflation, currency movements and possible sanctions. First-half foreign-exchange loss was $2.5 million. EPAM did not hedge foreign-exchange exposure.
- Cash concentration: $156.2 million of cash was held outside the United States, including substantial balances in Belarus. Management noted that CIS banking systems are less developed and corporate deposits are not insured. Repatriation could trigger withholding and U.S. taxes.
- Acquisition valuation: $33.8 million of acquisition-related contingent consideration and performance-based awards were measured using Level 3 inputs. Changes in acquired-business forecasts, milestone probabilities or EPAM’s share price could affect fair values and results.
- Management reported no material changes to the risk factors in its 2013 Form 10-K and no material legal proceedings. Disclosure controls were assessed as effective.
Important facts for investors to verify
- Whether revenue growth and customer demand continue, particularly in Europe and banking and financial services, and whether customer concentration changes.
- Whether operating margins recover as acquisition, compensation and integration costs evolve; compare GAAP results with the company’s non-GAAP measures.
- Cash conversion and working-capital trends, especially unbilled revenue, which increased to $67.9 million from $43.1 million at year-end.
- Completion cost, timing and recoverability of advances for the Belarus facility, including any further claims or liabilities.
- Performance and final purchase accounting for the three acquisitions, and changes in contingent consideration or acquisition-related compensation.
- Exposure of cash, operations and earnings to CIS banking, geopolitical, inflation and foreign-exchange risks.