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Edited Transcript of EPAM earnings conference call or presentation 9-May-19 12:00pm GMT

Q1 2019 EPAM Systems Inc Earnings Call

Newtown May 21, 2019 (Thomson StreetEvents) -- Edited Transcript of EPAM Systems Inc earnings conference call or presentation Thursday, May 9, 2019 at 12:00:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Arkadiy Dobkin

EPAM Systems, Inc. - Co-Founder, Chairman, CEO & President

* David Straube

EPAM Systems, Inc. - Head of IR

* Jason Peterson

EPAM Systems, Inc. - Senior VP, CFO & Treasurer

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Conference Call Participants

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* Amit Singh

BofA Merrill Lynch, Research Division - Research Analyst

* Arvind Anil Ramnani

KeyBanc Capital Markets Inc., Research Division - Senior Research Analyst

* Ashwin Vassant Shirvaikar

Citigroup Inc, Research Division - Director and U.S. Computer and Business Services Analyst

* Bryan C. Bergin

Cowen and Company, LLC, Research Division - Director

* Darrin David Peller

Wolfe Research, LLC - MD & Senior Analyst

* Joseph Dean Foresi

Cantor Fitzgerald & Co., Research Division - Analyst

* Margaret Marie Niesen Nolan

William Blair & Company L.L.C., Research Division - Analyst

* Mayank Tandon

Needham & Company, LLC, Research Division - Senior Analyst

* Moshe Katri

Wedbush Securities Inc., Research Division - MD of Equity Research & Senior Equity Research Analyst

* Vladimir Bespalov

VTB Capital, Research Division - Analyst of Industrials, Transportation, Infrastructure, Chemicals & Equities and Internet Analyst

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Presentation

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Operator [1]

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Greetings, and welcome to the EPAM Systems First Quarter 2019 Earnings Call. (Operator Instructions) As a reminder, this conference is being recorded.

I would now like to turn the conference over to your host, Mr. David Straube, Head of Investor Relations for EPAM Systems. Thank you. You may begin.

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David Straube, EPAM Systems, Inc. - Head of IR [2]

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Thank you, operator, and good morning, everyone. By now you should have received your copy of the earnings release for the company's first quarter 2019 results. If you have not, a copy is available at epam.com in the Investors section.

With me on today's call are Arkadiy Dobkin, CEO and President; and Jason Peterson, Chief Financial Officer.

Before I begin, I'd like to remind you that some of the comments made on today's call may contain forward-looking statements. These statements are subject to risks and uncertainties as described in the company's earnings release and SEC filings.

Additionally, all references to reported results that are non-GAAP measures have been reconciled to GAAP and are available in our quarterly earnings materials located in the Investors section of our website.

With that said, I'll now turn the call over to Ark.

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Arkadiy Dobkin, EPAM Systems, Inc. - Co-Founder, Chairman, CEO & President [3]

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Thank you, Dave, and good morning, everyone. Thanks for joining us. I would like to start with a few financial highlights of our first quarter.

We delivered revenues of USD 521 million, reflecting 23% year-over-year growth or 26% in constant currency terms. In addition, we delivered strong non-GAAP earnings per share of $1.25, which represents 34% growth from Q1 of 2018. We believe our Q1 results have given us a solid start to the fiscal year and underscore our continued relevance in the market.

We think it is especially important taking into account our remarks just 3 months back when we mentioned macro level uncertainties which everyone believed about us then and since [like] still do now, at least based on the recently reported performance of some regional market players. So at this point, we think our relevance has been owned through our nonstop focus on investing across the business, broadening our set of offerings, developing our talent further and overall constantly disrupting ourself to improve our chances as a company to be better prepared for the future.

While it isn't possible to share something significantly new in regard to what we did in Q1 versus previous period, I think a short summary could help serve as a reminder of what our focus is. So we have continuously shaping our consulting offering by strengthening our end market teams and blending in new capabilities, which we added to EPAM during 2018 organically and by acquisitions.

As we indicated before, our goal is to build well-integrated consulting offering across business experiencing technology expertise, which should allow us to empower our historically strong project engineering capabilities and bring real value to our clients with the solutions we are delivering. During the last quarter, we saw a good level of progress in this direction.

Also, we are continuously improving our project engineering capabilities across all global locations and constantly improving productivity, expertise and quality as well as the way of working and collaborating within our and clients' teams by investing in our own digital platforms to support it. And we are continuously thinking about and testing and practice new services, new solutions and alternative approaches to problem-solving, which we didn't consider before or didn't work in the past for us for one or another reason. And Q1 brought some new challenges forcing us to act outside of comfort zone and making us think differently, and we are excited to address those because it shows us a glimpse of the future.

Finally, as a result of all of that, we are changing the company constantly and experimenting with different models of how we work internally and how we interact with clients and partners to address the challenges we are together encouraging and to improve the overall speed of everything we do.

One good example of our nonstop evolution could be our digital factory concept, which allows EPAM to connect across all our capabilities in consulting, design, architecture and engineering and optimize overall delivery giving our clients a partner that can help them with total engagement cycle from ideation to production run.

Yes, we know. Most likely you've heard this before from others in the industry both in terms of the approach itself and probably even in brands and similarities. And it is true, it's very difficult to differentiate yourself just on the message. The difference clearly is in the execution where speed and quality of deliverables are critical. And those are the function of thousands of small details, including the ability to orchestrate multifunctional and multi-locational teams while constantly improving productivity and eliminating waste. And also the difference is in unstoppable desire to put forth the extra effort to overcome a constantly growing number of new obstacles.

Through insights differentiation points and practice over and over again is the only way to move forward. And that's the reason we are very excited to hear positive remarks from many of our clients about the impact of our efforts on their businesses while they are also sharing how different and sometimes difficult because of that, we are to work with.

That are the reasons we continue to be optimistic about our future in the maybe broadly overused term digital ecosystem where everything, including clients, consumers, partners, suppliers and the employees, all blended together into scalable and flexible platform environment.

So our goal is simple. We want to enable our customers to be competitive and disruptive in the marketplace through such innovative solution while helping them navigate successfully through multiple ways of technology changes.

And today, we continue to see consistent demand across our main verticals and in our emerging verticals for our uniquely blended capabilities. To do pragmatic consulting around digital platforms, data and analytics, automation and engineering capability and to put that together with the full depth and breadth of EPAM global delivery machine, which we're building over the years.

So at this point, I think we can repeat again as we did 3 months ago. Despite some of the macro-level uncertainties we are constantly wishing and reading about, we are looking at 2019 optimistically. We are confident that we can continue to remain relevant to our diverse and global client base through our ability to execute large-scale digital transformation programs and to help them to make some very ambitious innovations programs very real.

With that said, let me turn the call over to Jason for more details on our Q1 results and update on our business outlook.

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Jason Peterson, EPAM Systems, Inc. - Senior VP, CFO & Treasurer [4]

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Thank you, Ark. Good morning, everyone. I'll start with Q1 financial highlights, then talk about profitability, cash flow and end on guidance for the 2019 fiscal year in Q2.

In the first quarter, we delivered solid top line performance, exceeded our profitability expectations and grew earnings per share. Here are a few key highlights from the quarter.

Revenue came in at $521.3 million, a year-over-year growth of 22.9% on a reported basis or 26.3% growth in constant currency, reflecting a negative foreign exchange impact of 3.4%.

Looking at our first quarter revenue growth across our industry verticals, the drivers of growth remained very consistent and include digital transformation, an increased focus on customer engagement, product development and driving efficiencies and deeper insights through artificial intelligence, machine learning and analytics.

Financial services, our largest vertical, delivered 9.1% reported or 13.3% constant currency growth year-over-year. Growth in Q1 was impacted by timing of revenue recognition for several financial services clients in Russia.

In addition to the expected ramp-down of activity at a few clients, predominantly based in Europe, we continue to see increasing demand for our offerings in the payment processing and insurance space, which currently account for a modest share of revenues but represent a rapidly growing part of our financial services portfolio.

Travel & Consumer grew 13.6% reported and 18.1% in constant currency terms. Growth in Q1 was impacted by the ramp-down of quite a few consumer clients in Europe along with muted growth for a few clients based in North America.

Software & Hi-Tech grew 22.4% in the quarter. Business information and media posted 24.7% growth in Q1. Life Sciences & Healthcare grew 69.6%, reflecting broad-based growth across both industries and in existing and new client programs.

And lastly, our emerging verticals delivered 40.7% growth driven primarily by clients in energy, telecommunications and automotive.

From a geographic perspective, North America, our largest region, representing 60.7% of our Q1 revenues, grew 32.2% year-over-year or 33% in constant currency. Europe, representing 33.3% of our Q1 revenues, grew 13.3% year-over-year or 19.3% in constant currency. CIS, representing 3.5% of our Q1 revenues, contracted year-over-year on both a reported and a constant currency basis, declining 16.6% and 4.1%, respectively. Growth in this geography was impacted primarily by the timing of revenue recognition at several financial services clients. And finally, APAC grew 32.1% or 37.3% in constant currency and now represents 2.5% of our revenues.

In the first quarter, growth in our top 20 clients was 15.5% and growth outside our top 20 clients was approximately 29% compared to the same quarter last year.

Moving down the income statement. Our GAAP gross margin for the quarter was 33.9% compared to 34.5% in Q1 of last year. Non-GAAP gross margin for the quarter was 36.3% compared to 36.5% for the same quarter last year. GAAP SG&A was 19.5% of revenue compared to 21.1% in Q1 of last year. And non-GAAP SG&A came in at 17.7% of revenue compared to 19% in the same period last year, somewhat below the bottom end of the range that we target.

GAAP income from operations was $64.7 million or 12.4% of revenue in the quarter compared to $48.7 million or 11.5% of revenue in Q1 of last year. Non-GAAP income from operations was $89.2 million or 17.1% of revenue in the quarter compared to $67.7 million or 16% of revenue in Q1 of last year.

Our GAAP effective tax rate for the quarter came in at 5.4%, which includes $11.5 million excess tax benefit related to stock option exercises investing in restricted stock units. Our non-GAAP effective tax rate, which excludes the excess tax benefit and certain onetime items, was 22.5%.

Diluted earnings per share on a GAAP basis was $1.06 and non-GAAP EPS was $1.25, reflecting a 34.4% increase over the same quarter in fiscal 2018. In Q1, there were approximately 57.2 million diluted shares outstanding.

Turning to our cash flow and balance sheet. Cash flow from operations for Q1 was negative $0.2 million compared to a positive $7.3 million in the same quarter last year. And free cash flow was negative $13.6 million compared to a negative $3.4 million in the same quarter last year. Cash flows this quarter were impacted by payments related to our annual variable compensation programs, which paid out at a higher level based on our 2018 performance and to a lesser extent an increase in DSO between Q4 and Q1.

DSO was 78 days compared to 73 days at the end of Q4 fiscal 2018 and 83 days in the same quarter last year. We continue to be pleased with our DSO performance.

Moving onto a few operational metrics. We ended the quarter with over 27,800 delivery professionals, a 17.6% increase year-over-year and a net addition of more than 1,100 production professionals during Q1. Our total head count ended at more than 31,400 employees. Utilization was 79.9% compared to 77.6% in the same quarter last year and 80.2% in Q4.

Now let's turn to guidance. Starting with fiscal 2019, revenue growth will continue to be at least 22% reported and at least 23% in constant currency terms after factoring a 1% estimated unfavorable foreign exchange impact. We expect GAAP income from operations to continue to be in the range of 12.5% to 13.5%, and non-GAAP income from operations to continue to be in the range of 16% to 17%. We expect our GAAP effective tax rate to now be approximately 12%, and our non-GAAP effective tax rate to continue to be approximately 23%.

Earnings per share. We now expect GAAP diluted EPS to be at least $4.61 for the full year, and non-GAAP diluted EPS will now be at least $5.19, reflecting a modest improvement in expected profitability for the full year. We now expect weighted average share count of 58 million fully diluted shares outstanding.

In Q2 of fiscal year '19, revenues will be at least $549 million for the second quarter, producing a growth rate of at least 23% reported and at least 24% in constant currency terms after factoring in a 1% estimated unfavorable foreign exchange impact.

We expect GAAP income from operations to be in the range of 12% to 13% and non-GAAP income from operations to be in the range of 15.5% to 16.5%, reflecting a higher level of holidays in the CIS region and the impact of our annual compensation increases.

We expect our GAAP effective tax rate to be approximately 9% and non-GAAP effective tax rate will be approximately 23%.

Earnings per share. We expect GAAP diluted EPS will be at least $1.12 for the quarter and non-GAAP EPS will be at least $1.21 for the quarter. And lastly, we expect a weighted average share count of 57.9 million fully diluted shares outstanding.

Finally, a few key assumptions that support our GAAP to non-GAAP measurements. Stock compensation expense is expected to be approximately $16.2 million in Q2, $15.2 million in Q3 and $15.6 million in Q4.

Amortization of intangibles is expected to be approximately $2.4 million for each of the remaining quarters. The impact of foreign exchange is expected to be approximately a $2 million loss for the remainder of the year with $1 million in Q2 and $500,000 in each of the remaining quarters.

Tax effective non-GAAP adjustments is expected to be around $4.3 million in Q2 and approximately $4 million in each remaining quarter. We expect excess tax benefits to be around $10 million in Q2, $6.8 million in Q3 and $4.2 million in Q4.

And lastly, given the amount of interest income we expect for fiscal 2019, we are adding an assumption related to interest and other income for the remainder of the year. We expect interest and other income to be $2.7 million for each of the remaining quarters.

In summary, our Q1 results reflect solid demand for our services, underpinned by a diverse mix of projects and offerings across the industries we serve. We remain confident that our strategy of combining our core engineering heritage with consulting, advanced technology and digital business services positions EPAM well for the future.

With that, let's open the call up for questions.

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Questions and Answers

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Operator [1]

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(Operator Instructions) Our first question comes from the line of Ashwin Shirvaikar with Citi.

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Ashwin Vassant Shirvaikar, Citigroup Inc, Research Division - Director and U.S. Computer and Business Services Analyst [2]

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Ark, Jason, good start to the year. I guess my -- let me start with the obvious question. I guess your first half growth is about 25% constant currency. The low end of your full year outlook remains 23%. I think the Russia reference, not a full year factor, given it's all about timing. Not sure about the European client ramp-downs you mentioned. Any further detail would be great there. But more importantly, if you're expressing optimism on a full year basis, what keeps you from bringing up the low end of your outlook?

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Jason Peterson, EPAM Systems, Inc. - Senior VP, CFO & Treasurer [3]

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So fair question. We feel good about how we've started Q1. And clearly, based on our guidance for Q2, we feel good about the demand environment. What we are seeing is a couple of things, which is one is that we are seeing a little bit of a pullback in spending on European banking clients. And that informs our guidance for the full year. And in addition, we're seeing a little bit of unevenness in demand associated with consumer and retail primarily in Europe. And again, what you're seeing is some good, strong growth across certain of our customers there, and then what you're seeing is a few customers where -- whose business models are somewhat challenged and probably further challenged by uncertainty associated with Brexit, who are pulling back a little bit on spending. And so the guidance, I would say, is thoughtful. And again, what we continue to see is strong demand overall across the business. You can see the growth rates in Life Sciences & Healthcare. You can see the growth rates in Hi-Tech, in our emerging verticals. And so we feel very good about the demand environment, but we just want to be a little bit thoughtful as we enter Q2 about the remainder of the fiscal year.

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Arkadiy Dobkin, EPAM Systems, Inc. - Co-Founder, Chairman, CEO & President [4]

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And I would add, Ashwin, traditionally that we're projecting what we're seeing right now. So what would happen in Q3, Q4, it's -- will be happening, but at this point, we see this as ability. So -- and Q2 become better projected, so we increase the guidance. We don't feel we can increase the guidance right now for the full year yet.

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Ashwin Vassant Shirvaikar, Citigroup Inc, Research Division - Director and U.S. Computer and Business Services Analyst [5]

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Got it. Understood. No, that's good detail. I guess the second question is, based on at least our checks, digital transformation-type contract sizes are increasing. That work, it continues to incorporate middle and back office not just front office-type work. First, would you agree with that? And so -- if so, can you talk about some of the changes that you continue to make internally, the tools and so on to get a good level of incremental share from those bigger deals?

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Arkadiy Dobkin, EPAM Systems, Inc. - Co-Founder, Chairman, CEO & President [6]

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Yes, definitely. Transformation impact in not just front office but the whole stack of technologies and business processes and business platforms. And while kind of simplistic understanding of digital or what was your question on front end, in our experience, we always were very strongly engineering-driven, as you know. And it means that we traditionally, we're working on development of the many core platform for large project companies, helping them with this. And then getting experience how to do implementation, customization of this. From this point of view, we have the skills. And during the last couple of years, we actually went down with solutions for -- and corporations, and it's changing us. And we're investing a lot in advancing and modernization technologies for legacy systems, and we have some progress -- visible progress there as well. So now we actually can optimize from end-to-end, and that's becoming bigger portion of our business. But still on development and very highly engineering customization points of view, not on managing or maintaining the legacy stuff or the cautious stuff.

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Operator [7]

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Our next question comes from the line of Jason Kupferberg with Bank of America Merrill Lynch.

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Amit Singh, BofA Merrill Lynch, Research Division - Research Analyst [8]

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This is actually Amit Singh. Just wanted to start off on a question related to the last question on financial services. So the pullback that you talk about among European clients, I wanted to get a sense of -- is this something new? Or has this been going on for a while given your financial services revenue growth has been decelerating over the last few quarters? And also, if you could update us on the health of the financial services clients in North America? And then how should we look at your overall vertical growth going forward? Should we expect the growth to further decelerate from here?

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Jason Peterson, EPAM Systems, Inc. - Senior VP, CFO & Treasurer [9]

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Right. So thanks for that question. So the first thing I want to focus on is just the overall demand environment for the company. So we've always talked about the company having a broad series of sort of what I would refer to as growth engines. That's both new and existing clients. And then what you can see is that we're able to deliver growth across a broad range of verticals. New vertical at EPAM constitutes more than 22% of revenue, and that would be financial services. We're actually seeing very strong growth in fintech, in asset management, in card payment and processing, and we're beginning to see some very exciting growth and actually with our insurance customers, which today make up a small part of our business, but we expect to grow relatively rapidly in both the near- and the mid-term. So we've got a lot of sources of growth inside financial services and what we're just seeing a handful of banking clients, we just want to acknowledge that there has been a little bit of pullback there and that's what informs our guidance. As Ark said, what we want to do is guide for the full year to what we can see today. And again, somewhat of a reduction that we saw in Q1 informs the guidance for the remainder of the year.

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Amit Singh, BofA Merrill Lynch, Research Division - Research Analyst [10]

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Okay, perfect. And then if you could provide a little bit more, you talked about consulting and I believe your overall consulting employees were around 2,000 maybe a quarter or so ago. How has that changed over the last quarter? And then related to that, as you're adding more of these consulting capabilities and people, should it have an impact on your long-term margins? Because based on your current guidance, it seems like this year, you'll likely be towards the upper end of that 16% to 17% range.

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Arkadiy Dobkin, EPAM Systems, Inc. - Co-Founder, Chairman, CEO & President [11]

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So we -- during the previous calls, we kind of touched on this and our message was that we're not trying to create a separate line of business, which is consulting rather than create integrated solution from advising to delivering and optimizing actually the end result, and this is still the goal. So it's very difficult. We don't have even like specific head count on consulting as a pure consulting services because it's more like attribute of multiple professionals in EPAM, which blend specific roles and specific engagements. So very difficult to answer questions with metrics so because we are measuring -- trying to measure this on the end results. The number of people in market increasing but -- and we're planning to increase. How this will impact the margin? So in general, in general, profitability in market -- margins within market people, a little bit lower than our global delivery centers from our point of view. At the same time, the consultative behavior and consultative type of engagement growing and we're seeing that some of this bringing us different marginality on the clients because we're getting all year in the engagements. We can advise, and we can actually work with clients in very different manner. So we do think that it's not going to impact our margin in the long time, but investment necessary in our kind of IFO guidance is what we're communicating right now.

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Operator [12]

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Our next question comes from the line of Maggie Nolan with William Blair.

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Margaret Marie Niesen Nolan, William Blair & Company L.L.C., Research Division - Analyst [13]

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So Ark, in your prepared remarks, you talked about some new challenges that you faced in Q1. Is this some of the vertical-specific challenges that you outlined on the call? Are there other challenges that were happening during the first quarter? Can you elaborate a little bit on those? And then also you've kind of tied that into the ability to create new solutions or services. Is there anything there in particular that stands out as something that could be an interesting development for the business or a growth driver for the business?

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Arkadiy Dobkin, EPAM Systems, Inc. - Co-Founder, Chairman, CEO & President [14]

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Okay. I think it's kind of 2 questions. In reality, it is exactly overlapping and one thing for us because the challenge is coming from -- and clearly, there is multiple challenges in Q1. Just confirmation of this trend over different quarters because we have it constantly. But what I was talking about some challenges coming from the new type of services, which we bring from our internal disruption going to some areas where we'll not necessarily know all answers. And it's almost as a rule, when clients don't know the answers as well, otherwise they wouldn't be coming to us. So it create challenges how to do new type of projects, new type of engagement with new type of capabilities. And with our organic kind of internal disruption and bringing new capabilities through acquisitions, we're creating opportunities to go to this unknown situations and test new type of ideas and solutions and services. And that's what I was kind of referring to earlier today.

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Margaret Marie Niesen Nolan, William Blair & Company L.L.C., Research Division - Analyst [15]

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Okay, understand. And then as you think about kind of these new engagements and more of these transformational types of engagements, of the business that you've been winning, how much of that would you characterize as transformational? And then on the pipeline as well, are you seeing an increase in the transformational deals in the pipeline? And any quantification of that would be appreciated.

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Arkadiy Dobkin, EPAM Systems, Inc. - Co-Founder, Chairman, CEO & President [16]

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I cannot give you like specific numbers, but it's definitely increasing pretty rapidly the type of the deals coming to us where it's a critical transformational efforts or initiatives on the client base. Like 3, 4 years ago, it was single. Now probably we participate in dozens of this type of engagements.

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Operator [17]

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Our next question comes from the line of Bryan Bergin with Cowen and Company.

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Bryan C. Bergin, Cowen and Company, LLC, Research Division - Director [18]

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A follow-up here on the consulting and design services. Can you give us a sense of the base of clients that you've penetrated with those offerings? Are you having success winning new engagements by leading with these offerings? And I'm curious if there are relationships you're starting that are -- that have different counterparts than your traditional target in a client.

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Arkadiy Dobkin, EPAM Systems, Inc. - Co-Founder, Chairman, CEO & President [19]

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I'm sorry. Can you repeat?

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Bryan C. Bergin, Cowen and Company, LLC, Research Division - Director [20]

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Yes, sure. So with respect to the consulting and design services, how much of the base of your existing clients have you penetrated with those services? And then with respect to -- if you are leading with this offering, are you dealing with different people and different counterparts at the client than you traditionally would be?

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Arkadiy Dobkin, EPAM Systems, Inc. - Co-Founder, Chairman, CEO & President [21]

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Yes. We're probably -- penetration with this type of service is pretty deep. So it's -- again, we've not given specific numbers, but it's way over 50% of our businesses, like probably closer to 70%, 80%. And type of people we interact broadening, but it's still a lot of interaction with IT people because actually the company is serious about involving IT operation in cooperation with business and with digital leadership working together. So I think we're seeing more and more different characters on client side, but IT still driving big portion of this because complex platforms result technology practically impossible to deliver.

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Bryan C. Bergin, Cowen and Company, LLC, Research Division - Director [22]

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Okay, that makes sense. All right. And then just on talent sourcing, you continue to show a nice separation between the head count and the revenue growth. Do you think this is sustainable? Can you talk about the hiring ramp there and then the competition also for talent, any changes?

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Arkadiy Dobkin, EPAM Systems, Inc. - Co-Founder, Chairman, CEO & President [23]

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I think on separation, there is nothing new here. So we were indicating multiple times what the structure of this, and I think it continues to be the same. It's slightly increasing in our case onshore presence. New contracts coming with better rates. So there is promotion inside of the existing contracts because of accumulated experience of our people. And that's practically the same growth per person from revenue, which we've seen. And the second question was about challenges for sourcing?

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Bryan C. Bergin, Cowen and Company, LLC, Research Division - Director [24]

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As far as -- yes, talent -- the competition for talent, any changes there? Still tight?

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Arkadiy Dobkin, EPAM Systems, Inc. - Co-Founder, Chairman, CEO & President [25]

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Yes, we don't have any easier way to do it. So we still -- it's still very tough market and investments in training, investment in people, in the retention, in education very important. Plus clearly the type of interesting deals, which we're running, brings us opportunity to attract more talented components of the workforce. But challenges are there, sorry, absolutely.

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Operator [26]

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Our next question comes from the line of Mayank Tandon with Needham & Company.

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Mayank Tandon, Needham & Company, LLC, Research Division - Senior Analyst [27]

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Good quarter again. Jason, maybe you could parse through the revenue profile going forward in terms of your head count plans? Any potential for further improvement in utilization? And also what type of pricing tailwinds you're building into your expectations for the rest of the year?

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Jason Peterson, EPAM Systems, Inc. - Senior VP, CFO & Treasurer [28]

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Yes, that's a fair question. So from a pricing standpoint, as Ark indicated, is that if you're doing a revenue per head count, is there is an ongoing gradual shift towards somewhat more talent in market. So that will have a positive uplift, okay? As Ark also indicated, we just did our promotion cycle. Usually, we have a certain amount of rate alignment after that, and then we continue to get price increases at existing customers. And with newer customers and other opportunities, there's potential for pricing as well. So what we're looking at right now is an environment that probably is somewhat similar to what we've seen in past time periods and probably a similar level of wage inflation. Certainly not an elevated level wage inflation. And so I think that, that sort of bodes for fairly consistent sort of pricing in a wage inflation environment.

From a utilization standpoint, and I do need to make this clear around sort of that quarterization or seasonality of our business, what we usually see is that first half of our fiscal year has got lower available, what we call, capacity or what other companies call build days. And so in our environment, we've got significant holidays associated with Orthodox Christmas. In Q1, we've got significant holidays associated with May in the CIS region in Q2. So we have fewer available working days. And as a result, that usually has a somewhat negative impact on profitability. And in the second half, we've got more available working days, and then you see a general improvement in profitability. And you'll see that in our patterns throughout the last couple years. And so right now, we're running at a relatively high level of utilization. We think we'll run at a higher level than maybe we have in past years. But I would expect a modest decline in utilization as we go from Q1 to Q2, in part because of the elevated vacations associated with May.

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Mayank Tandon, Needham & Company, LLC, Research Division - Senior Analyst [29]

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Great. That's helpful color. And then if I can just follow up on the verticals, could you provide any more details on what the emerging verticals comprise? And also how are you thinking about expanding into new areas, either through M&A or organically?

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Jason Peterson, EPAM Systems, Inc. - Senior VP, CFO & Treasurer [30]

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Okay, that's fair. And so from a -- from the emerging standpoint, there's a series of customers in there, but we generally sort of focus on energy, which has been strong growth here in Q1. We're seeing good growth in automotive, and then we're seeing some interesting activity and growth in telecommunications. From an M&A standpoint, a lot of the focus has been on developing incremental, sort of in-market consulting capability. And then there's also probably some opportunities to get some additional sort of skills and talent. But probably the focus from an M&A strategy standpoint has not changed dramatically. We're still focused more on sort of consulting capabilities in market.

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Operator [31]

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(Operator Instructions) Our next question comes from the line of Joseph Foresi with Cantor Fitzgerald.

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Joseph Dean Foresi, Cantor Fitzgerald & Co., Research Division - Analyst [32]

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I want to get a sense of demand, and I wanted to ask the question this way. How much of the engagements that are coming in or the new engagements from the new work that's coming in are new engagements versus takeaways? And have you seen any shift in that work? I know it's traditionally been brand-new engagements.

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Arkadiy Dobkin, EPAM Systems, Inc. - Co-Founder, Chairman, CEO & President [33]

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You mean that new engagement in existing clients?

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Joseph Dean Foresi, Cantor Fitzgerald & Co., Research Division - Analyst [34]

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Yes. Is that still primarily new work? Or is that more takeaways? And have you seen any shift there?

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Arkadiy Dobkin, EPAM Systems, Inc. - Co-Founder, Chairman, CEO & President [35]

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I think it's approximately -- it's very difficult sometimes to qualify what is new engagement or not, especially in the modern -- this platform build-out because it's usually extension of something which we were doing before. But I don't think there is any shift in this. There is new initiative still. And there is a continuation of, kind of large subcomponents of the platform development. And most of this all connected as well.

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Jason Peterson, EPAM Systems, Inc. - Senior VP, CFO & Treasurer [36]

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And so Ark, consistent trend has been that if you look at the incremental dollars on a year-over-year basis, that 60% of incremental revenue dollar comes from existing clients and 40% of the incremental revenue dollar comes from new clients. And so that trend stays pretty consistent. Again, we continue to grow quite rapidly at many of our largest and longest-standing customers. And we continue to get quite a bit of incremental revenue from new customer engagements.

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Joseph Dean Foresi, Cantor Fitzgerald & Co., Research Division - Analyst [37]

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That's very helpful. Yes. And then my second one, I guess, I'll ask about guidance again, and I'll ask it differently on the margin side. They seem to want to continue to go up. What are the levers there? Why not take a look at the guidance for the full year on the margin side? And what keeps you conservative on that side?

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Jason Peterson, EPAM Systems, Inc. - Senior VP, CFO & Treasurer [38]

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Okay. And so our guidance does indicate that we have somewhat more confidence that we can run the business at a somewhat higher level of profitability than what we thought when we began the fiscal year. So that takeup in EPS reflects some of that sense that we can incrementally improve profitability. But I think as we look at the business, we want to make certain that we continue to invest in the business that does have some amount of SG&A-related investment. And I think gross margin will be sort of relatively consistent with what we saw last year. And so I think it's kind of informed by the desire to continue to invest in the business. And as Ark's talked about, the notion of, let's say, challenges with customers is that we are bringing additional capabilities to market. We're filling in with capabilities that maybe we haven't historically had. Okay. We're learning from that. Our clients are learning from that. We think it makes us more relevant to clients, and then it supports our growth long term, which is expected to continue to be in excess of 20% per year.

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Operator [39]

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Our next question comes from the line of Moshe Katri with Wedbush Securities.

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Moshe Katri, Wedbush Securities Inc., Research Division - MD of Equity Research & Senior Equity Research Analyst [40]

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Is there a way to quantify the impact from the ramp-downs on revenue growth for the quarter? And then as a follow-up, you mentioned that fintech and insurance are both offsetting the weakness in your traditional banking business in Europe. Can you give us a -- maybe some color on which percentage of the overall financial services vertical these 2 emerging growth areas account for?

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Jason Peterson, EPAM Systems, Inc. - Senior VP, CFO & Treasurer [41]

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Yes, I think it -- I'd probably wouldn't spend a lot of time with this moment sort of dissecting kind of different components of the financial services practice. Okay. What I can say is that we've got a significant series of growth opportunities in fintech. We talked about insurance, which is small and we think rapidly growing. But then I'm going to pull back and just kind of talk about the business overall is that EPAM has always had a broad source of growth opportunities across industry verticals, across both new and existing clients. And so I think how I would speak about both the quarter and the full fiscal year is despite some softness in spending with banks, the company is continuing to grow our business in excess of 20% per year. In part because we're not dependent on financial services as a source of growth for the company. I think when I look long term, I think the other thing that I would say is that historically, and today would be no different, and we continue to be relatively more supply constrained than we're ever been demand-constrained. So even if there is a modest reduction in demand across a couple customers, often times what you'll find in more than often almost always is there's an opportunity to deploy resources on other accounts.

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Arkadiy Dobkin, EPAM Systems, Inc. - Co-Founder, Chairman, CEO & President [42]

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So in short, we're very kind of happy with our client concentration, and we don't think there is any danger that even if one client will go down, we wouldn't be able to handle it or a couple of clients. And historically, that's exactly what's happening multiple times during the last 5, 6 years. So never impacted our overall growth. So unless the broader economic changes somewhere, we feel pretty confident.

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Operator [43]

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Our next question comes from the line of Arvind Ramnani with KeyBanc Capital Markets.

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Arvind Anil Ramnani, KeyBanc Capital Markets Inc., Research Division - Senior Research Analyst [44]

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I just had a question regarding your earlier commentary on -- some of the software spend at some of the specific banks in Europe. Is it mostly related to Brexit? Or is there some other banks going through some in-sourcing as well?

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Arkadiy Dobkin, EPAM Systems, Inc. - Co-Founder, Chairman, CEO & President [45]

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So it might be combination of this. So because some banks are going through in-sourcing can wait and we're hearing about it for very long time. At the same time, even our big banks, while not necessary very optimistic part of the story, it is pretty kind of controlled story for us at this point. But what exactly driving this, it's very difficult to answer. Because we don't have direct answers as well when we're asking this question.

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Arvind Anil Ramnani, KeyBanc Capital Markets Inc., Research Division - Senior Research Analyst [46]

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Great. And as it pertains to Brexit, I mean, clearly, there's some uncertainty now and maybe some slowdown in spending. But do you think that the slowdown, as it pertains to Brexit, is temporary? And once there's clarity and if things kind of separate, things -- the next 12 to 18 months, spending could actually accelerate?

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Arkadiy Dobkin, EPAM Systems, Inc. - Co-Founder, Chairman, CEO & President [47]

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Listen, I -- my answer probably would be a little bit funny. But if you think everything is temporary, and we saw so many changes like during the last year. So it's always was going some clients were going down and then going up. I'm pretty sure that Brexit is not a permanent thing. Life will make some changes, replacements, and demands will come back. Is it going to be slowed down for 6 months or 18 months? That's what I don't know. Or maybe not at all impact.

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Arvind Anil Ramnani, KeyBanc Capital Markets Inc., Research Division - Senior Research Analyst [48]

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Great. And just kind of on the recruiting environment, given that Luxoft is now being absorbed by DXC, has that made the recruiting environment easier? Or is that continue to be difficult to recruit?

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Arkadiy Dobkin, EPAM Systems, Inc. - Co-Founder, Chairman, CEO & President [49]

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With all respect to EPAM and to Luxoft, I don't think that create any impact on the overall recruitment situation across Europe because it's a much bigger ecosystem. I think in general, it's still challenging, and we're planning all our actions about where we go and where we recruit, how we're doing this. We're planning in kind of assumption that it would be real challenge. So I don't think situation with Luxoft changes the labor market in any way. But definitely not simplifying market.

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Operator [50]

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Our next question comes from the line of Vladimir Bespalov with VTB Capital.

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Vladimir Bespalov, VTB Capital, Research Division - Analyst of Industrials, Transportation, Infrastructure, Chemicals & Equities and Internet Analyst [51]

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Congratulations on the good results. My first question will be on revenues per delivery professionals. If my calculations are correct, I see some decrease in revenues per delivery professional in the first quarter, even though the utilization rate was pretty high and close to what you saw in the fourth quarter. Could you comment a little bit what is behind this and how this should develop going forward? And my second question will be on capital allocation strategy. I know that you are always considering M&A activities. But do we have a lot of cash on your balance sheet? So are you thinking about any other ways of using this cash, for example, share buybacks or dividend distributions or whatever?

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Jason Peterson, EPAM Systems, Inc. - Senior VP, CFO & Treasurer [52]

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Yes, and so on the first question, when we do the calculation that I think you're doing, what we would see is that revenue per head count actually is increasing. Maybe what you're saying is that revenue -- the growth in revenue per head count is not at exactly the same level as we've seen in, let's say, the last couple of quarters. And the one thing that is an important factor is foreign exchange. And so when we do that -- we do that calculation just so we can kind of understand your perspective is that -- is it -- you have to look at foreign exchange and utilization. And from a growth in revenue per head count, if you adjust for those 2 factors, the growth in revenue per head count is pretty consistent with what we've seen in past quarters.

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Arkadiy Dobkin, EPAM Systems, Inc. - Co-Founder, Chairman, CEO & President [53]

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In constant currency.

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Jason Peterson, EPAM Systems, Inc. - Senior VP, CFO & Treasurer [54]

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Yes. Just you've got to adjust for foreign exchange as our type of constant currency and then utilization. And then from the standpoint of capital allocation is as you indicate, we continue to have an inorganic strategy and that will consume capital. And we're evaluating opportunities for, let's say, for our capital allocation strategy over time, but nothing that we would announce and wouldn't announce a change at this time.

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Operator [55]

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Our next question comes from the line of Darrin Peller with Wolfe Research.

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Darrin David Peller, Wolfe Research, LLC - MD & Senior Analyst [56]

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A couple of quick questions. One high-level question is just a kind of question about competition at RFPs. I mean we're hearing from different competitors [words] that are completely different kind of trends. And honestly, sounds like the backdrop and the demand environment is very strong. But we see certain kinds of competitors that seem to be struggling based on the kinds of tax. So I guess, first of all, are you -- are you seeing different players go head-to-head with you for the same kinds of deals that you're competing for now? Then maybe you've seen -- you would have seen 2 years ago, are there just different people in the room? And then from a backdrop standpoint, and an end market, is consolidation, whether it's in health care, it's financial services, has that been impacting you guys as well are your clients not shown as much of the, let's call it, like a March budget release versus what you've seen in past? We've just heard something that from other -- some of your competitors as well. So I'd love to hear a little more color on that, please.

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Arkadiy Dobkin, EPAM Systems, Inc. - Co-Founder, Chairman, CEO & President [57]

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I think there are some movements in type of services we'd share different companies providing, but in general, I think it's pretty consistent group of competitors which we've seen. What I've seen is quite consistent. It's still very broad from very big multinational system integrators. And some local companies focused on very specific competencies. So that was, for us, was the case like 5, 6 years ago, and I think it's very similar right now. With the exception that while we're going for the bigger use, we're seeing big guys more often than before. So the second question, I didn't -- it was a little bit breaking on you. Can you repeat the second question?

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Darrin David Peller, Wolfe Research, LLC - MD & Senior Analyst [58]

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The second question -- yes, I was trying to figure out if you guys -- there's been consolidation among the clients. So if certain health care clients are merging or financial banks are merging, are you seeing that impact the demand environment at all? And to some degree, we also heard that there was less of a budget release in March, where some of these -- some of your clients might actually finalize their budget for the year than prior years. Didn't sound like you saw that, but I'm curious.

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Jason Peterson, EPAM Systems, Inc. - Senior VP, CFO & Treasurer [59]

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Yes, I mean, we're clearly seeing extremely strong demand in health care and life sciences and on both sides of that. And so we're not seeing a slowdown associated with a budget release or lack of budget release.

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Arkadiy Dobkin, EPAM Systems, Inc. - Co-Founder, Chairman, CEO & President [60]

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And also, there is consolidation and there are splits as well. So some big companies like getting in different groups. So it's happening with us as well, which is creating potentially several clients with different strategy growing on us. But I don't think consolidation was an issue for us so far.

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Darrin David Peller, Wolfe Research, LLC - MD & Senior Analyst [61]

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All right. And then just one quick financial question, Jason. I mean when I look at the free cash numbers, you came in at a bit below what we expected. Just curious to hear what -- I think you touched on it a bit in the prepared remarks what happened in the quarter. But if you could give us a little more color on what you expect for the year from your free cash flow? And what did M&A contribute in the quarter? And maybe what -- just remind us what you expect again for the year.

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Jason Peterson, EPAM Systems, Inc. - Senior VP, CFO & Treasurer [62]

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Yes. I'll take the last question first. So M&A contributed about 200 basis points of growth in Q1. For the full year, we'd expect that M&A would contribute about 100 basis points of growth. And then in terms of the -- coming in low versus your model, are you referring to cash flow or profitability or revenue or what specific?

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Darrin David Peller, Wolfe Research, LLC - MD & Senior Analyst [63]

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The free cash flow number I'm talking about.

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Jason Peterson, EPAM Systems, Inc. - Senior VP, CFO & Treasurer [64]

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Yes, so I mean quite honestly, there's 2 major practices. One would be the variable compensation element, and we had a very strong 2018 and as a result, there was a relatively higher level of variable compensation paid out. So that's one. And then DSO increased again from 73 to 78. But 78 is still very good DSO for us. You'll note that we've run in the 80s in the past and so I'm still quite happy with the DSO. But it's really the somewhat elevated level of variable compensation payout due to the high level of performance we had in 2018. And to a lesser extent, the impact of the increase in DSO. So in the -- I guess if I would add one more thing, we're quite seasonal from a cash generation standpoint. And so in Q1, you would have the variable compensation element. You have a little bit of variable compensation in Q2, and our strongest cash generation quarter is usually again in the second half of the year.

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Operator [65]

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Ladies and gentlemen, that does conclude our question-and-answer session. I'll turn the floor back to Mr. Dobkin for any final comments.

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Arkadiy Dobkin, EPAM Systems, Inc. - Co-Founder, Chairman, CEO & President [66]

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Thank you for joining us today. So just to summarize, I think it should be clear from this call that we -- with all the noises happening around us, which is nothing new and practically constant, we do feel pretty strong about the year, and I think Q1 confirming this. And see you next quarter. Thank you.

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Operator [67]

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Thank you. This concludes today's teleconference. You may disconnect your lines at this time. Thank you for your participation.