EPAM Systems, Inc. (NYSE:EPAM) Q4 2023 Earnings Call Transcript
EPAM Systems, Inc. (NYSE:EPAM) Q4 2023 Earnings Call Transcript February 15, 2024
EPAM Systems, Inc. isn’t one of the 30 most popular stocks among hedge funds at the end of the third quarter (see the details here).
Operator: Ladies and gentlemen, thank you for standing by. I would like to welcome everyone to the EPAM Systems Q4 2023 Earnings Conference Call. At this time, all lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session. [Operator Instructions] Thank you. I will now hand the call over to David Straube, Head of Investor Relations. You may begin your conference.
David Straube: Thank you, operator, and good morning, everyone. By now, you should have received your copy of the earnings release for the company's fourth quarter and full year 2023 results. If you have not, a copy is available on epam.com in the Investors section. With me on today's call are Arkadiy Dobkin, CEO and President, and Jason Peterson, Chief Financial Officer. I would like to remind those listening 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 the comparable GAAP measures 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.
Arkadiy Dobkin: Thank you, David. Good morning, everyone. Thank you for joining us today. As usual in Q1, it's time for us to reflect on the past 12 months and share what we think about the next 12. Before I do that, I want to thank our team around the world for their dedication to our clients and hard work throughout last year and for staying committed and engaged in the work ahead of us in 2024. Looking back to 2023, I will start from a short summary very much in line with what we shared in today's press release. We believe that EPAM performance in 2023 reflects our ability to navigate volatile demand growth simultaneously, and simultaneously is the key word here, [indiscernible] by both geopolitical and macroeconomic conditions.
After rebalancing most of our delivery talent footprint across Europe, Western and Central Asia, India and Latin America, and refining our go-to-market approach to meet current demand, we are now focused primarily on harmonizing our delivery quality, optimizing cost effectiveness, and proactively leveraging our extensive advanced technology and growing consulting capabilities to capitalize on GenAI and AI-driven opportunities of the future. In that context, first a few notes on 2023 and their relevance to 2024, and then I can move on aspects of our 2024 outlook. Let me start from geopolitical and economic impacts on the EPAM operations. In February of 2022, the Russian invasion of Ukraine made it necessary for us to relocate over 13,000 people plus families to new geographies.
While most of these relocations completed back in 2022, many adjustments did happen last year. And still today in 2024, we will continue to work on some downstream factors, including seniority pyramid, team composition and cost effectiveness across our traditional and new locations. I want to also especially recognize our team in Ukraine who prove that despite the level of challenges, they accepted a reliable partner for our clients, existing and new ones. A few additional notes on repositioning and stabilization of our talent delivery platform. As mentioned already, 2023 was a year of significant rebalancing for most of our global delivery. We work on scaling India and LatAm, and at the same time, preparing for future growth in development centers across Europe and Western and Central Asia, our key destination for majority of our relocated talents.
In 2023, India continued to be our fastest-growing location, practically since 2021. And while we were growing our capabilities there with accelerated speed, we also worked to ensure that our delivery culture remains focused on quality and client value. India will likely become our largest location by the end of 2024 or at least on match with our current scale in Ukraine. Latin America, specifically our locations in Colombia and Mexico, have been maturing significantly as we scaled out our cloud and data capabilities there to be prepared to meet rising demand from North American clients. And so, we are starting 2024 from significantly refactored geographic delivery platform, much more balanced than ever to bring together the practices, methods, and collaborative ways of working, and to focus on harmonizing our engineering competencies and critical capabilities in cloud, data, and now in AI, to be present now in each of our strategic locations.
In 2024, this is one of our key priorities and we expect these programs to be continuous areas of investment and differentiation for EPAM. As we mentioned in previous calls, there is a growing number of clients who after slowing their spending with us due to the war, have started to grow their engagements with us again by utilizing our much more diverse geographic footprint and advanced delivery capabilities. Supporting this trend will be another key priority, as we continue during 2024 to build up our capabilities both geographically and from our services mix perspective. To illustrate some relevant specific efforts, I will share several ongoing investments in engineering excellence AI learning juniors for all EPAMers covering standard copilots and other AI-assisted engineering productivity tools for all key delivery roles with specific adoption targets being set up for all locations.
This tool was released in 2023 with upgrades coming in Q1 and beyond. New upgrades to our digital delivery platform, now being AI enabled and leveraging a set of composable assets that include EPAM proprietary together with open source components and tools to connect to a variety of LLMs for supporting the most critical capabilities, protecting private data, and prompting cost effective and reliable consumption for external LLMs, EPAM DIAL platform. Finally, productivity measurement framework, allowing tailoring of engineering and agile best practices for continuous improvements of individual and team productivity in AI-assisted development environment. All those efforts should make it possible for us to become the most geographically diverse and broadly AI-assisted delivery talent platforms in the industry.
Now, about cost effectiveness. It became obvious at the end of 2022, throughout 2023, that to navigate current economic environment, we must continuously consider cost optimization efforts to react properly to all changes around us. Some targeted optimization efforts were ongoing in 2023 across both in market and global delivery locations. This has improved our utilization in the short term and allows us to fund several initiatives in 2023 and 2024. We will be considering similar efforts as appropriate in the future to ensure our adaptability needs. We are also actively working on rebalancing our seniority pyramid by engaging and training junior talent, while improving overall seniority in market and across our key global practices. About AI and GenAI efforts.
For years, we have been investing and scaling our data, ML, and predictive AI capabilities. Today, many of our clients are engaging us to do the foundational engineering and data ML work required to help them operate their current businesses, but also to enable them to start their work with generative AI. Since mid of last year, our majority of these are relatively small. We engage in over 400 GenAI-related projects. Our coverage of use cases is broad, from knowledge management to HCM, from product management to supply chain and service optimization, from advanced business process redesign to new interactive agent development, from engineering productivity enhancements by using GenAI tools to improving speed and quality of code generation and testing.
Last year, we launched DIAL, our enterprise-level orchestration platform, to accelerate development of GenAI-empowered business solutions. Recently, we released it for open source. We are encouraged by seeing a high level of interest from our clients expressed in over 60 pursuits with 15 active projects in progress right now. And some already in production implementations across the tech, insurance, retail, automotive, life science and business information vertical segments. One of the most interesting deployments was done for major global economic data institutions and one of the most rewarding has been our work in Ukraine on famous Diya, a government platform, which now includes GenAI and AI capabilities as well. Now, let's talk about the demand environment.
In 2023, we've managed to safeguard many of our programs and clients' portfolios. We also saw some pullback in spend last year and expect that this may continue to be a factor into 2024 as our clients execute vendor consolidation exercises to manage their costs. While this trend continues, and in some cases to our benefit, we are seeing encouraging signals of a general rebound for build-based solutions and for traditionally strong [indiscernible] capabilities in advanced tech, data experience, consulting, and AI. To capitalize on potential new demand, we are expanding our new business initiative by enhancing our sales strategies and go-to-market partnerships, dedicating resources to create new accelerators, establishing new engagement models and innovating our customer interaction method.
In 2023, it was also evident that we brought new clients at a rate higher than in previous years, and we plan to do it again in 2024. Still, in overall, we believe at this point the 2024 environment will be, at least for the first half of the year, a continuation of the second part of 2023 trends, with the potential demand up toward the second half. While we have made significant progress on involving our operations and despite the challenges we have faced in 2023, our work with clients have been increasingly recognized by leading analysts and provide in turn some independent support for the stories we shared. All the reports are very recent, last two, three months and present the up-to-date views on EPAM. About some new capabilities. In November 2023, EPAM was featured by Gartner in Competitive Landscape IT service providers to the Global Insurance Industry Report.
That is probably one of the first recognition by Gartner of our industry expertise and a result of our efforts to bring insurance consultancy and implementation services simultaneously for the clients' benefits. Putting together insurance consulting advisory practice was one of the key efforts for us during the last few years. Similar efforts today are underway in healthcare and life science, retail and distribution, oil and gas demand, [if you ask] (ph). In Q4 2023, EPAM was featured in Forrester report, the Cybersecurity Consulting Services Landscape Q4 2023. EPAM was highlighted as one of the top 33 cybersecurity consulting services providers, which is probably first recognition of a critical capability we are developing for the last years.
Now, about some established capabilities, which were confirmed recently. In November, 2023, EPAM was recognized as the top 3 companies in the Magic Quadrant for Critical Capabilities for Customer Software Development Services Worldwide by Gartner. EPAM leadership and strengths were specifically highlighted in leveraging generative AI, pioneering DevOps and providing superior customer support and unique user experience. In November, December 2023, IDC named EPAM as a leader in three reports: IDC MarketScape for Worldwide Experienced Design Services Vendor Assessment; IDC MarketScape for Worldwide Experienced Built Services Vendor Assessment; and IDC MarketScape for Worldwide Software Engineering Services Vendor Assessment. Finally, Ad Age recognized EPAM as the number six largest agencies in the United States and number 18 in the world's largest agencies companies categories.
In just seven years, EPAM has moved from number 130 to number six among US agencies. Before I hand over the call to Jason, I would like to take a moment to share a couple of points on some aspects of our results for 2023 and our outlook for 2024. In 2023, we generated $4.69 billion in revenues, reflecting a correction of 2.8% year-over-year. Excluding the impact of exiting our Russian operations, revenue declined 1.8%. Adjusted income from operations was 16.3% of revenue and above the midpoint of our initial guided range. Also, the current market conditions don't represent at all an ideal demand environment for EPAM. Our 2023 results highlight our commitment to adapting the company to suit the current circumstances while continuously preparing for the more beneficial demand environment in the future.
What I want to point out as well is that our Q4 results shows a sequential revenue growth, first time after three previous quarters of sequential declines. About 2024 outlook: Because of our ability to adapt to new client demands and market conditions, we are optimistic about the opportunities ahead of us towards the end of 2024. Demand to build postponed during the last two years should rebound, driven by long-term pressures for legacy modernizations, by needs for advanced customer-centric solutions, and by the massive interest to understand how to apply GenAI and general AI capabilities to build new platforms and solutions. Even while we continue to navigate current economic and geopolitical environment carefully, we will invest in strategic initiatives organically and with support of expanded M&A activities, in demand generation efforts and in people programs.
This will have some effect on our profitability in 2024, but we believe these are the right actions to ensure long-term growth and stronger market positions. Let me turn the call over to Jason to provide more details on our fourth quarter and full year results in addition to our initial view of 2024 expectations.
Jason Peterson: Thank you, Ark, and good morning, everyone. In the fourth quarter, EPAM generated revenues of $1.16 billion, a year-over-year decrease of 6% on a reported basis and a 7.3% decrease in constant currency terms, reflecting a positive foreign exchange impact of 130 basis points. The reduction in Russian customer revenues, resulting from our decision to exit the market, had a 70 basis point negative impact on year-over-year revenue growth. The modest sequential growth in the quarter was the result of stabilizing demand. Revenues in Q4 were higher than we expected when we said Q4 guidance, due to both stronger client demand and significant benefit from favorable foreign exchange. Beginning with our industry verticals.
Life sciences and healthcare grew 11.6%. Growth in the quarter was driven primarily by clients in life sciences. Travel and consumer decreased 4.4%, with solid growth in travel and hospitality, offset by declines in revenues derived from consumer goods and retail customers. Financial services contracted 7.1%, driven by declines in banking, partially offset by work performed from marketplace exchange and finance information and analytics clients. Excluding the impact of the exit of our Russian operations, revenue on a year-over-year basis declined 5.5%. Business information and media declined 14.8% in the quarter. Revenues in the quarter continued to be impacted primarily by a reduction in spend across a number of large clients, due to uncertainty in their end markets, particularly in the mortgage data space.
Software and hi-tech declined 16.8% in the quarter. The year-over-year growth rate was negatively impacted by the reduction in revenue from our former top 20 client we mentioned during our previous earnings calls and generally slower growth in revenues across the range of customers in the vertical. And finally, our emerging verticals delivered growth of 4.2%, driven by clients in energy, manufacturing and education. From a geographic perspective, the Americas, our largest region representing 58% of our Q4 revenues, declined 7.6% year-over-year or 7.7% in constant currency. On a sequential basis, growth remained relatively flat, consistent with the previous quarter. EMEA, representing 39% of our Q4 revenues, was flat year-over-year and declined 3.5% in constant currency.
APAC declined 10.9% in both reported and constant currency terms and now represents 2% of our revenues. And finally, CEE, representing 0.1% of our Q4 revenues, contracted 91.6% year-over-year or 91.3% in constant currency. Revenue in the quarter was impacted by the exit of our operations in Russia. Going forward, I will no longer comment on the CEE region in our quarterly prepared remarks, given that its revenue contribution is immaterial relative to our total revenues. In Q4, revenues from our top 20 clients declined 5% year-over-year, while revenues from clients outside our top 20 contracted 7%. Moving down the income statement. Our GAAP gross margin for the quarter was 31.1% compared to 32.4% in Q4 of last year. Non-GAAP gross margin for the quarter was 33% compared to 34.1% for the same quarter last year.
Gross margin in Q4 2022 was positively impacted by the timing of year-end revenue recognition. GAAP SG&A was 18.5% of revenue compared to 16.6% in Q4 of last year. GAAP SG&A in the quarter was impacted by one-time charges, including expenses associated with the company's cost optimization program. Non-GAAP SG&A came in at 14.2% of revenue compared to 14.8% in the same period last year. SG&A expense for Q4 2023 reflects some cost efficiencies achieved in the quarter, as well as lower variable compensation compared to Q4 2022. GAAP income from operations was $122 million or 10.6% of revenue in the quarter compared to $170 million or 13.8% of revenue in Q4 of last year. Non-GAAP income from operations was $200 million or 17.3% of revenue in the quarter compared to $220 million or 17.8% of revenue in Q4 of last year.
Our GAAP effective tax rate for the quarter came in at 23.4% versus our Q4 guide of 24%, due to greater-than-expected excess tax benefits related to stock-based compensation, partially offset by higher state taxes and the impact of losses in certain non-US acquired subsidiaries. Our non-GAAP effective tax rate, which includes the impact of state taxes and subsidiary losses and excludes excess tax benefits, was 25.1%. Diluted earnings per share on a GAAP basis was $1.66. Our non-GAAP diluted EPS was $2.75, reflecting a decrease of $0.18 or 6.1% compared to the same quarter in 2022. In Q4, there were approximately 58.9 million diluted shares outstanding. Turning to cash flow and our balance sheet. Cash flow from operations for Q4 was $171 million compared to $186 million in the same quarter of 2022.
Free cash flow was $161 million compared to free cash flow of $165 million in the same quarter last year. We ended the quarter with approximately $2 billion in cash and cash equivalents. At the end of Q4, DSO was 71 days and compares to 73 days in Q3 2023, and 70 days in the same quarter last year. Share repurchases in the fourth quarter were approximately 143,000 shares for $36.5 million, at an average price of $255.96 per share. As of December 31, we had approximately $335 million of share repurchase authority remaining. Now, moving on to a few operational metrics for the quarter. We ended Q4 with more than 47,350 consultants, designers, engineers, trainers and architects, a decline of 10.4% compared to Q4 2022. This is the result of lower levels of hiring, combined with both voluntary and involuntary attrition, as we continue to balance supply and demand.
Our total headcount for the quarter was more than 53,150 employees. Utilization was 74.4% compared to 73.6% in Q4 of last year and 72.7% in Q3 2023. Turning to our full year results for 2023. Revenues for the year were $4.69 billion, producing a decline of 2.8% reported, and a decline of 3.4% in constant currency terms compared to 2022. Excluding Russia revenues, the reported year-over-year growth rate would have been negative 1.8% reported and negative 2.4% in constant currency terms. GAAP income from operations was $501 million, a decrease of 12.5% year-over-year and represented 10.7% of revenue. Our non-GAAP income from operations was $765 million, a decrease of 6.5% compared to the prior year and represented 16.3% of revenue. Our GAAP effective tax rate for the year was 22.3%.
Our non-GAAP effective tax rate was 23.7%. Diluted earnings per share on a GAAP basis was $7.06. Non-GAAP EPS, which excludes adjustments for stock-based compensation, acquisition-related costs and certain other one-time items, including costs associated with our cost optimization program, was $10.59, reflecting a 2.8% decrease over fiscal 2022. In 2023, there were approximately 59.1 million weighted average diluted shares outstanding. Cash flow from operations was $563 million compared to $464 million for 2022. And free cash flow was $534 million, reflecting an 85.4% adjusted net income conversion. And finally, share repurchases in 2023 were approximately 686,000 shares for $164.9 million at an average price of $240.49 per share. Our 2023 results reflect EPAM's ability to manage the business through challenging macro conditions, while positioning the company for the return to a more normalized demand environment.
Now, let's turn to guidance. Before moving to the specifics of our 2024 and Q1 outlook, I would like to provide some thoughts to help frame our guidance. As Ark mentioned, the demand environment remains uneven and we believe this will persist at least in the first half of 2024. We have been pleased with the progress we are making on demand generation, and we'll continue to prioritize revenue growth into 2024, which, in some pursuits, include some degree of discounting. In 2024, we expect to incur incremental costs due to more normalized variable compensation levels, in addition to wage inflation in certain geographies. This higher level of compensation, combined with the limited ability to improve client pricing in the near term, will continue to put pressures on margins in 2024.
Finally, despite the war, our operations in Ukraine have not been materially impacted, and our teams remain highly focused on maintaining uninterrupted production. Our guidance assumes that we will continue to be able to deliver from our Ukraine delivery centers at productivity levels similar to those achieved in 2023. Now, starting with the full year outlook. Revenue growth will be in the range of 1% to 4%, on both a reported and constant currency basis. The impact of foreign exchange is expected to be negligible. At this time, we expect a nominal revenue contribution from inorganic revenue for 2024. Lastly, we are seeing some improvement of demand, but the visibility for the year is still limited. Although we are guiding to modest sequential growth in Q1, increases in demand may not sufficiently offset revenue impacts resulting from seasonality in all quarters in 2024.
We expect GAAP income from operations to be in the range of 9.5% to 10.5% and non-GAAP income from operations to be in the range of 14.5% to 15.5%. We expect our GAAP effective tax rate to be approximately 21%. Our non-GAAP effective tax rate, which excludes excess tax benefits related to stock-based compensation, will be 24%. Earnings per share, we expect the GAAP diluted EPS will be in the range of $7.20 to $7.60 for the full year, and non-GAAP diluted EPS will be in the range of $10 to $10.40 for the full year. We expect weighted average share count of 59.3 million fully diluted shares outstanding. For Q1 of 2024, we expect revenues to be in the range of $1.155 billion to $1.165 billion, producing a year-over-year decline of approximately 4%, with the expected impact of FX to be minimal.
For the first quarter, we expect GAAP income from operations to be in the range of 9% to 10%, and non-GAAP income from operations to be in the range of 13.5% to 14.5%. Our Q1 income from operations guide reflects the impact of the resetting of social security caps, normalized variable compensation and somewhat higher bench levels, where we expect to see improvement throughout the year. We expect our GAAP effective tax rate to be approximately 11% and our non-GAAP effective tax rate, which excludes excess tax benefits related to stock-based compensation to be approximately 24%. For earnings per share, we expect GAAP diluted EPS to be in the range of $1.79 to $1.87 for the quarter, and non-GAAP diluted EPS to be in the range of $2.26 to $2.34 for the quarter.
We expect a weighted average share count of 59.1 million diluted shares outstanding. Finally, a few key assumptions that support our GAAP to non-GAAP measurements for 2024. Stock-based compensation expense is expected to be approximately $198 million, with $44 million in Q1, $48 million in Q2 and $53 million in each remaining quarter. Amortization of intangibles is expected to be approximately $26 million for the year, evenly spread across each quarter. The impact of foreign exchange is expected to be a $1 million loss for each of the quarters. Tax effective non-GAAP adjustments is expected to be approximately $46 million for the year, with $11 million in Q1, $11 million in Q2 and $12 million in each remaining quarter. We expect excess tax benefits to be around $28 million for the full year, with approximately $17 million in Q1, $5 million in Q2 and $3 million in each remaining quarter.
Finally, one more assumption outside of our GAAP to non-GAAP items. Our growing cash reserves are generating interest income, and EPAM is receiving governmental incentives from several countries in which we established delivery operations. As a result, in 2024, we are anticipating an increased level of other income. We expect interest and other income to be around $66 million for the full year, with $16 million in Q1, $20 million in Q2 and $15 million in each remaining quarter. My thanks to all the EPAMers who made 2023 a successful year, and will help us drive growth throughout 2024. Operator, let's open the call up for questions.
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