EPAM Systems Q3 2023 Earnings Call Transcript

Quartr
Provided by Quartr
November 2, 2023

There are 13 speakers on the call.

Operator

Thank you for standing by. My name is Regina and I will be your conference operator today. At this time, I would like to welcome everyone to EPAM's Q3 2023 Earnings Conference Call. 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

Star then the number one on your telephone keypad. Conference. I'd now like to turn the conference over to David Straube, Head of Investor Relations. Please go ahead.

Speaker 1

Thank you, operator, and good morning, everyone. By now, you should have received your copy of the earnings release for the company's Q3 2023 results. If you have not, copy is available on epam.com in the Investors section. With me on today's call are Coddy Dobkins, CEO and President and Jason Peterson, Chief Financial Officer. I'd like to remind those listening that some of the comments made on today's call may contain forward looking statements.

Speaker 1

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 disclosures that have been reconciled to comparable GAAP measures and are available in our quarterly earnings materials located on the Investors section of our website. With that said, I'll now turn the call over to Ark.

Speaker 2

Thank you, David, and good morning, everyone. Before I get into results of our Q3, I would like to recap what was said in regards to our expectations for Q3 full year outlook 3 months ago during our last call. We stated that while the current business environment is more focused on cost optimization versus our differentiated built and deployed offerings. We do believe the demand for transformation services will come back under the services market. We'll be moving from core IT to accelerated digitization to reinvent entire business models and ways of working with generative AI And even more driven exactly by our traditionally strong product platform engineering, data analytics and AI ML capabilities.

Speaker 2

At the same time, we said we still expect a negative dynamic to continue into the 2nd part of 2023, Even as the outlook begins to normalize, we stated that we are focusing on turning the experience from very challenging past quarters into pragmatic plans and action items, which will be applying to our business throughout the rest of 2023 and into 2024. These changes are transformational for us and already better positioning us in preparation for the return of stronger market demands. That was the first part of our premise. The second critical part was about our efforts To further globalize and stabilize our delivery ecosystem, propagate the power generation quality standards and optimize operationally our target allocations, call, while closely focusing on our gross margin improvement efforts. All that to continue throughout the remainder of this year And I expect it to go throughout 2024.

Speaker 2

So with that reminder, let's talk about 3 key topics Demand. We believe that while the demand for the new build for platform application remains lower than historic levels And the impact of rundowns and the hurdles continue to work through specific client portfolios. Our Q3 results point to sign of stabilization in our business, Both in new logos and in retain and expanding programs in our existing portfolio, we are seeing signs of renewed interest, Particularly in our life science and health care verticals, also in insurance and energy and not only there. What is important to highlight in today's business environment, we are putting all possible efforts to address our client current priorities, including adjusting a mix Well, these factors lead in sometimes to likely low short term profitability metrics. We are seeing signs that clients are returning to a balance between cost and quality and EPAM continues to be well positioned there.

Speaker 2

Also, it required today an increased focus on demand led sales and go to market motions and investments in global partnerships to winning and quickly growing new business. Over the last quarters, our global field organizations and our specialized practice teams focus on developing new offerings in key verticals and horizontals, expanding to new engagement models and extending our client portfolio to include new logos across a broader spectrum of brands, from large enterprises to mid market players, new and exciting start ups in key for us verticals. And more and more often, we are engaging these clients C level of both IT and Business functions. One of the examples of those relatively new for us ways to engage strengthening our partnerships, which have taken on a greater momentum recently with key collaborations driving net new go to market propositions, new IP and new client wins. Last quarter, You served our global partnership with Google Cloud to help our clients fast track the development of artificial intelligence, machine learning and data solutions strategic collaboration agreement with AWS.

Speaker 2

This will aim to accelerate modernization, adapt cloud native architecture and leverage artificial intelligence and advanced analytics to create customer value in key industries such as healthcare, life science, financial services, Insurance, Energy and Gaming. Furthermore, we expanded our partnership with Microsoft becoming a globally managed Enterprise System Integrator. The enhanced partner status in EPAM advanced cloud nature, AI and data expertise will enable us To help our clients modernize, transform and simplify complex enterprise platform application and processes to accelerate business growth powered by Azure OpenAI Service. Current results of these efforts are showing up an increasing number of conversations with clients and growing numbers of opportunities. And while it's still too early to say when we can So significant results in revenue growth.

Speaker 2

Our production load is starting to come back to the level comparable with our Q1. And we hope to see this trend take shape during the next quarters. Still, Despite signs of improving demand conditions, the global macroeconomic environment remains volatile, and we see certain trends reflecting in our own business, Notably in Europe, where the construction in the Q3 is likely to take a few quarters to reverse. Now we are going to global capabilities. India and LatAm for us are key growth delivery regions, Well, Central Eastern Europe and Central Western Asia are areas of stabilization after our massive relocation efforts, and recent future growth opportunities.

Speaker 2

Part of the effort regarding globalization and stabilization of delivery is the right sizing and cost optimization across multiple presentation based on current and future demand outlook and specific location capabilities, seniority of permits and office infrastructures. Some identical efforts are also relevant in several locations in Western Europe and North America. While optimizing some locations, we continue to reinvest in new talent in key initiatives to expand our engineering DNA across all strategic global delivery locations with continuous harmonization and upskilling efforts enabled by our own use of AI and EPAM Productivity Platforms. Those efforts are on the way as we speak And we're already seeing first results and expect to have additional benefits to materialize in 2024. This brings us to the topic of additional investments, which we mentioned in the past multiple times.

Speaker 2

We are continuously investing in our strategic priorities such as expansion of differentiated consulting agency, data MLAI and cloud capabilities with focus on vertical expertise. Development of go to market offerings and solutions, Our strong cloud engineering data and ML core services profile should position EPAM to benefit In the medium and long term from the impact of both current and up demand for modernization and also from the fundamental skills shortage in complex technological transformations which still persist today. The impact will become even more real In terms of complexity of future applications and platforms, we're encapsulating not just currently available elements of GenAI And requirements for trust, reliability and security management of AI, but also by closely integrated With new classes of composite and adaptive AI platforms as well as with foundational models and specific industry cloud platforms. One of the key propositions offered by EPAM is our ability to make AI real. As part of this focus, a number of our labs and centers platform have created IP that we are using to productize our learnings and to share them with our clients through our open source initiatives.

Speaker 2

We mentioned our work with DIAL, our AI Orchestration Workbench In our previous call, and today we see a number of extensions of this platform into specific use cases and specific industries Based on real life problems, which we are addressing is a growing variety of integrated AI tools and data sources. One of our most significant investments related to Ag is the development and internal rollout of the PAM responsible Ag Framework And a broad employee training to adopt it. Today, we are confident that EPAM has the necessary capabilities and talent to help our clients to evolve in the general adoption of AI and also in modernization of applications and proper data engineering efforts As it's become generally understood that fundamental capabilities and readiness in cloud and leading indicator are necessary prerequisites for success. Still the level of interest continues to indicate the demand for air related services will build momentum into 2024 and beyond. I believe that provides good level of overview of current state and our key areas of focus.

Speaker 2

To summarize, I would like to say that with the exciting opportunities in front of us, we are still facing a complex demand environment. We are working to invest for the future while balancing supply and demand for skills and capabilities across a much more diverse delivery footprint. This challenge continues as the war in Ukraine extends into the 3rd year as well as the new disruptions Think Middle East escalations requires to continuously adopt the company in appropriate manner. Good thing at this point that he will be well trained to manage all of that. So with that, I would like to pass to Jason to share more details and numbers for Q3 and for an update for our business outlook

Speaker 3

Q3. Thank you, Ark, and good morning, everyone. In the Q3, EPAM generated revenue of over $1,150,000,000 a year over year decrease of 6.1% on a reported basis or 8% in constant currency terms, Reflecting a favorable foreign exchange impact of 190 basis points. Revenue in the quarter continued to be impacted by reduced program spending across a number of our clients as well as ongoing client caution related to new project starts. The reduction in Russian customer revenues resulting from our access from the market had an approximate 50 basis point negative impact on year over year revenue growth.

Speaker 3

Excluding Russia revenues, year over year revenue for reported in constant currency would have decreased financial services decreased 3.3%, driven by declines predominantly in banking, partially offset by growth in asset management. Consumer decreased by 6.2%, primarily due to declines in consumer goods, partially offset by solid growth in Travel and Hospitality. Life Sciences and Healthcare declined 4.2%. The year over year growth rate was negatively impacted by the ramp down The large transformational program in late 2022, which we have mentioned during our previous earnings calls. On a sequential basis, growth in life sciences and healthcare was positive 8.6 percent and we expect to return to positive year over year growth next quarter.

Speaker 3

Business information and media declined 12% in the quarter. Revenue in the quarter was impacted by a reduction in spend across the number of large clients Based on uncertainty in their end markets, particularly in the mortgage data space. Software and high-tech contracted 15.1%. The year over year growth rate was negatively impacted by the reduction in revenue from a former top 20 customer we mentioned during our previous earnings calls And generally slower growth in revenue across a range of customers in the vertical. And finally, our emerging verticals delivered solid growth of 8.5%, Driven by clients in Energy, Manufacturing and Automotive.

Speaker 3

From a geographic perspective, Americas, our largest region, Representing 59% of our Q3 revenues declined 9.3% year over year or 9.5% in constant currency. Q1 results. On a sequential basis, growth in the Americas was relatively flat, an improvement from the declines in previous quarters in 2023. EMEA representing 39% of our Q3 revenues grew 1.8% year over year and decreased 3.5% in constant currency. CEE, representing less than 1% of our Q3 revenues, contracted 66.4% year over year 58.8 percent in constant currency.

Speaker 3

Revenue in the quarter was impacted by EPAM's exit of its Reston operations. And finally, APAC declined 20.2% year over year or 19.8% in constant currency terms and now represents 2% of our revenues. Revenue in the quarter was impacted primarily by the ramp down of work within our financial services vertical. In Q3, revenues from our top 20 clients declined 8.3% year over year, while revenues from clients outside our top 20 declined 4.9%. Moving down the income statement, our GAAP gross margin for the quarter was 31.1% compared to 32.6 Q3 of last year.

Speaker 3

Non GAAP gross margin for the quarter was 32.9% compared to 34.4% for the same quarter last year. Gross margin in Q3 2023 reflects the negative impact of pricing pressure and lower utilization, Partially offset by a lower level of variable compensation expense. GAAP SG and A was 16.9% of revenue compared to 16.1% in Q3 of last year. Non GAAP SG and A in Q3 2023 came in at 14.4% of revenue compared to 14.1% in the same period last year. GAAP income from operations was $114,000,000 or 9.9 percent of revenue in the quarter compared to $180,000,000 or 14.7 percent of revenue in Q3 of last Q2.

Speaker 3

Included in our GAAP results in the quarter is the $25,900,000 loss on the sale of the company's remaining holdings in Russia $8,400,000 of severance as we take steps to reduce our cost structure to better align with demand. Non GAAP income from operations was 196 $1,000,000 or 17 percent of revenue in the quarter compared to $232,000,000 or 18.9 percent of revenue in Q3 of last year. GAAP effective tax rate for the quarter came in at 26.3%, which includes a one time tax charge connected to the disposal holdings in Russia and lower than expected excess tax benefits related to stock based compensation. Non GAAP effective tax rate was 23.2%. Diluted earnings per share on a GAAP basis was $1.65 Our non GAAP diluted EPS was $2.73 Reflecting a $0.37 decrease compared to the same quarter in 2022.

Speaker 3

In Q3, there were approximately 58,900,000 diluted shares outstanding. Turning to our cash flow and balance sheet. Cash flow from operations for Q3 was $215,000,000 compared to $252,000,000 in the same quarter 2022. Free cash flow was $211,000,000 compared to free cash flow of $234,000,000 in the same quarter last year. At the end of Q3, DSO was 73 days and compares to 71 days for Q2 2023 and 69 days for the same quarter last year.

Speaker 3

The uptick in DSO reflects an increase in the time some clients are taking in the review and approval of payments combined with the last day of the quarter following on a weekend. Share repurchases in the Q3 were approximately 318,000 shares for $78,500,000 at an average price of $246.44 per share. As of September 30, we had approximately $372,000,000 of share repurchase authority remaining. We ended the quarter with approximately $1,900,000,000 in cash and cash equivalents. Moving on to a few operational metrics.

Speaker 3

We ended Q3 with more than 48,500 consultants, designers, engineers, trainers and architects. Including the impact of our exit from Russia, production headcount has declined 10% compared to Q3 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 54,600 employees. Utilization was 72 point 7% compared to 73.5% in Q3 of last year and 75.1% in Q2 2023.

Speaker 3

Now let's turn to our business outlook. We are encouraged by the results of our demand generation efforts and new customer revenues resulting from these efforts. However, the level of new customer revenues being generated is still not enough to offset the impact from existing project ramp downs and reduce spending from our top 20 clients. We are beginning to see a degree of demand stability emerging in our North American portfolio, But we are also expecting an impact from planned ramp downs at several of our European customers. Although there are encouraging signs, demand remains somewhat uncertain.

Speaker 3

In addition to the negative impact that Q4 seasonality usually has on revenue, we've also had a large number of employees relocate to countries that celebrate December holidays. In Q4, we are also expecting unfavorable foreign exchange headwinds in comparison with Q3. These factors are producing a sequential decline in Q4 revenue despite the stabilizing demand environment. Our Ukrainian delivery continues to operate efficiently and our teams remain highly focused on maintaining uninterrupted production. Our guidance assumes that we will continue to deliver from Ukraine productivity levels consistent with previous levels throughout 2023.

Speaker 3

During the Q3, we elevated our focus on aligning our cost structure with the near term demand environment, initiating a cost optimization program designed to reduce operating costs by 2.5% to 3%. This effort is clearly more intentional than our previous supply and demand balancing efforts. We think it is necessary to take this action in part to allow for further investment across our strategic initiatives, demand generation efforts and people programs. As I mentioned earlier, we had $3,400,000 in severance related costs in Q3, of which $7,100,000 related to the cost optimization program. In Q4, we expect to recognize a further $15,000,000 in expenses as a result of this cost optimization program.

Speaker 3

We expect headcount will continue to decline in Q4 due to limited hiring and managed attrition, which will drive utilization slightly higher in the quarter. Moving to our full year outlook, we now expect revenue to be in the range of $4,663,000,000 to 4,673,000,000 Reflecting a year over year decline of approximately 3%. On an organic constant currency basis, excluding the impact exit from Russia. We expect revenue to also decline by 3%. We expect GAAP income from operations to now be in the range of 10% to 11% non GAAP income from operations to continue to be in the range of 15% to 16%.

Speaker 3

We expect our GAAP effective tax rate to continue to be approximately 22%. Non GAAP effective tax rate, which excludes excess tax benefits related to stock based compensation is expected to continue to be 23%. Earnings per share, we expect that GAAP diluted EPS will now be in the range of $7.07 to $7.15 for the full year non GAAP diluted EPS will now be in the range of $10.31 to $10.39 for the full year. We now expect weighted average share count of 59,100,000 fully diluted shares outstanding. Moving to our Q4 4 2023 outlook.

Speaker 3

We expect revenue to be in the range of $1,130,000,000 to $1,140,000,000 producing a year over year decline of 8%. On an organic constant currency basis, excluding the impact of the exit from Russia, we expect revenue to also decline by approximately 8%. For the Q4, we expect GAAP income from operations to be in the range of 10% to 11% and non GAAP income from operations to be in the range of 16% to 16%. We expect our GAAP effective tax rate to be approximately 24% and our non GAAP effective tax rate to be approximately 23%. Earnings per share, we expect GAAP diluted EPS to be in the range of $1.67 to $1.75 for the quarter non GAAP diluted EPS to be in the range of $2.47 to $2.55 for the quarter.

Speaker 3

We expect a weighted average share count $58,800,000 diluted shares outstanding. Finally, a few key assumptions that support our GAAP to non GAAP measurements in the 4th quarter. Stock based compensation expense is expected to be approximately $36,300,000 Amortization of intangibles is expected to be approximately $5,700,000 The impact of foreign exchange is expected to be minimal. Tax effect of non GAAP adjustments is expected to be around 12,000,000 We expect excess tax benefits to be around $1,300,000 and we expect to recognize approximately $15,000,000 in expenses related to our cost optimization program. In addition to these customary GAAP to non GAAP adjustments, inconsistent with the prior quarters in 2023, we expect to have ongoing non GAAP adjustments in Q4 Resulting from Russia's invasion of Ukraine.

Speaker 3

Please see our Q3 earnings release for a detailed reconciliation of our GAAP to non GAAP guidance. Quarterly financial results. Finally, one more assumption outside of our GAAP to non GAAP items. With our significant cash position, we are generating a healthy level of interest income and are now expecting interest and other income to be $14,000,000 in the 4th quarter. Looking beyond 2023, we intend to provide our 2024 business outlook during our Q4 earnings call scheduled for February.

Speaker 3

However, I would like to provide some commentary at this time to help frame our initial thoughts. As Ark mentioned, the demand environment remains uneven and we believe this will persist at least into the first half of twenty twenty four. We've been pleased with the progress we're making on demand generation and we'll continue to prioritize revenue growth into 2024, which in some pursuits include some degree of discounting. Additionally, in 2024, we expect to incur incremental costs Q2, due to more normalized variable compensation as well as salary increases from our annual compensation cycle, which typically occurs in Q2. Although the cost optimization program will better align our 2024 cost structure, we still expect wage pressure combined with a limited ability to improve client pricing ability to drive historical levels of revenue growth and profitability in a more normalized demand environment.

Speaker 3

Operator, let's open the call up for questions.

Operator

Our first question will come from the line of Bryan Bergin with TD Cowen. Please go ahead.

Speaker 3

Hi, good morning guys. Thank you. I guess, let's start on the demand stabilization trends that you highlighted here again. I heard you mentioned production levels, I think, coming back Q1 1Q levels. Can you dig in a bit more there?

Speaker 3

Is that prevalent across industries? And is it consistent across the large client cohort? And just anything how that informs early 2024 client tech budget discussions.

Speaker 4

Okay. Let me clarify what we mean. We're trying to see the trend what's happening with our production. It's not about revenue, it's how much work we do. Because there are a lot of different parameters, which is influence revenue from FX to number of Days to rates, to discounts and everything else.

Speaker 4

But from the load point of view, the trend is We've seen we're coming back to number of people who are doing production work, getting comparable to what we saw in Q1. That's what it means. It means that in general, we find kind of the way to stabilize Our share of the business even with some businesses declining with us, but With some new opportunities growing and some actually clients coming back to us. So from the main environment we have and This is what we mentioned as well. We've seen more conversation about programs, more opportunities, but Exactly as we mentioned, or this morning, there is no clear timeline of realization.

Speaker 4

So it's still difficult to say, but seems like pressure on some clients to do work getting So when it started to be realized and difficult to say, especially with everything, geopolitically moving as it's moving as we see right now. So more conversations, More opportunities to discuss pretintangible, but there is no clear start date.

Speaker 3

Okay, understood. And then my follow-up on the cost optimization plan. So Jason, what's the timeframe on achieving that savings target. And can you talk about how you're balancing efficiency here in the near term versus global diversification investments for future growth? Yes.

Speaker 3

So the program is designed to achieve somewhat over $100,000,000 or as we talked about in the prepared remarks, 2.5% to 3% of our cost structure. Most of the actions will be taken by the end of the year. And then I would say there would be some residual actions that would take place early in 2024 with the idea of giving us effectively $100 plus 1,000,000 in savings To allow us to further invest in 2024. And so that's in demand generation programs, things like partnership programs, It's in capabilities, generative AI, further consulting and then it also will allow us to effectively sort of fund a more normalized variable compensation in salary campaign next year. And so again, I expect Much of the savings to be achieved by the end of this year and there'll be probably still some actions taken in Q1.

Speaker 3

Truly, the costs that we talk about in Q3 and Q4 truly are incremental costs related to either severance, payouts in different countries, facilities, lease exits, other costs that are incremental and again allow us to achieve a certain amount of savings as we enter 2024.

Speaker 4

Thank you.

Operator

Your next question will come from the line of Moshe Katri with Wedbush Securities. Please go ahead.

Speaker 5

Hey, thanks. Thanks for taking my question. I want to focus a bit about your selling efforts And using India as one of those, I guess delivery centers to be able to kind of pitch those new engagements. Maybe you can talk about some of your successes here. And on top of that, how does that differ in terms of your ability to generate profitability compared to what you have pre, I guess, hostilities in Eastern Europe.

Speaker 5

Maybe you can talk a bit about that.

Speaker 4

So I think as we mentioned multiple times, India is growing for us. Industrial investment for us as well from the investing to Please, the capabilities which we have there because it's relatively new location even if it's fastest growth for the last probably 3 years. So we're building purposely The same type of practices as we have globally from digital engagement to significant data practice and cloud practices. Difficult one in general in this environment because of pressure everywhere from any locations which we have. So But I think we see definitely opportunity to uplift there with the market demand coming back And we are accumulating a lot of experience now.

Speaker 4

We have very sizable programs there. So we also understand that we can hire With comparable quality through against traditional investments, which we do with that. So I think we're pretty optimistic about this and with everything what's happened, as we mentioned several times, I think they will become proportionally much bigger part of EPAM deliveries. Yes. And I'll just follow in

Speaker 3

on the profitability. So, as we've talked about in the last call and again we'll continue to talk about here today is that we continue to have some characteristics with heavier pyramid than we had traditionally operated with, the ongoing kind of pressures on pricing and then some amount of wage inflation. And so it's hard to sort of return to more typical profitability as we enter the next handful of quarters or maybe most of 2024. But when we look at India, given some time and particularly more demand, We think the ability to sort of run that geography at levels of profitability consistent with what we did in Eastern Europe is certainly possible and more than possible I would say it's likely. So it's just right now we're still working through as Ark said some of the imbalances on pricing and again a heavier delivery pyramid.

Speaker 5

Understood. And then in that context, can you just remind us your headcount mix by Eastern Europe, Latin America and then India, where are we today and where do we what sort of mix do we want to get 2 down the road.

Speaker 3

Yes. So we're clearly less than 30% in Eastern Europe And heading towards kind of low 20s.

Speaker 4

India is currently less than We're about 26%, 27% between Ukraine and Belenecs, okay. Eastern Europe or Central Europe, like it's different, Because we are pretty significantly present in Poland and Hungary and all of this. And India is becoming right around 2nd largest delivery location. Right now, it's 2nd largest out to you, Craig. Thank you.

Operator

Your next question comes from the line of Ashwin Shirvaikar with Citigroup. Please go ahead.

Speaker 6

Can you hear me now?

Speaker 4

We can.

Speaker 6

Okay. So, I guess the question is when I look at your when I look at the results either by geography or by vertical And on a sequential basis, I kind of compare the growth rates what they were 2Q versus the growth rate in 3Q. Almost everything is either decel or relatively unchanged. You have obviously the very idiosyncratic thing going on with life sciences. And I'm kind of wondering, because that I'm trying to share that with the with what I sense is A little bit more positivity in terms of commentary, because of stabilization.

Speaker 6

So can you comment on how the environment and the conversations with clients Have evolved over the course of the quarter. Was September radically different than July? How are things evolving in October, a little bit more color of where we are going in terms of what seems to be stabilization in more areas that would be useful.

Speaker 4

Okay. I think I because the general numbers And optical is declined from amount of work which we do right now It's definitely stabilized because if and It's difficult to have apple to apple comparison, but with all our attempts, it's actually getting latest load. There are still big programs, which in which We continue to decline based on the client decisions done in even during the last year. That's what you see some big clients. On another side, after this period, why there is a positivity?

Speaker 4

We see that For some more complex programs clients coming back to us and started conversation or Even some decisions when programs starting to come back to us. The opportunities, but this was the equipment to do by beginning. Some of them sizable means that clients started to seriously consider as they need to do it. And unfortunately, some of the clients delay them so much while there are very specific deadline. They have ahead of them as they will have to start making decisions.

Speaker 4

So as this conversation happened, but They're still not making calls. But the level of conversation is different level. That's a positivity as well. And there are a lot of small new business where we enter in, Which is historically for us, it wasn't very normal because EPAM never was going to be programmed from day 1. It's usually where Antipoint and then the potential anywhere proving that we can do more complex, Better quality work and then it was growing.

Speaker 4

So we have a lot of seeds right now for the future. So, but actually main point that we definitely see is that production load is getting Most people. Yes.

Speaker 3

I think, Ashwin also, if you look, clearly on a year over year basis, the numbers still don't look sequentially Despite the fact that we still saw a decline between Q2 and Q3, that decline was less than the decline we had in Q2. And we look ahead to Q4. We still have a modest decline, but I would say that's largely sort of foreign exchange to a certain extent as we talk about the billability or the available bill days in Q4. And so if you adjust for that, it does feel like our demand is stabilizing, Particularly in North America as we talked about during our prepared remarks.

Speaker 4

And something to mention like I know that there are a lot of concern if we would be able to deliver quality from new locations. That looks more positive as well for us because We're getting more and more experience and more and more scales outside our traditional strength in Eastern Europe, while in Eastern Europe and Western Central Asia, we have also stabilized in the total, while in general, geopolitical environment is still very, very focused.

Speaker 6

That last point is really good to hear. In terms of pricing, because when you kind of Talk about transaction load and volume versus results. Does that imply soft pricing environment. And if you could break that down into how much of that is a geo mix type of issue as opposed to apples to apples pricing, price crunching. And then Over the last few quarters, you have mentioned obviously that because of the war in Ukraine, You had to move people to newer geographies and there was a pricing impact That clients needed to absorb because of that.

Speaker 6

Are we past the impact of that

Speaker 3

Yes. So let me quickly do, on a year over year basis, You would have had the impact of those movements if we took people from Russia and Belarus and Ukraine and moved into higher cost geographies. But if you begin to look at what's happening here in Q3 and what we think we see in Q4 is that you've got both effects and unfortunately I can't give you the exact percentage, But certainly one of the effects is that we are seeing more demand for India based resources where the rates are lower. So that would speak to the mix shift that you talked about. And then the other thing as Arik has indicated and I mentioned as well is the pricing environment still is it's somewhat challenging In some cases, concessions provided to existing customers and then with newer engagements also starting with a sharper pencil.

Speaker 3

And so you've got both impacts and I think that you'll see them show up more so in Q4 and probably in the first half of twenty twenty four, which again is part of the discussion around what we see for profitability in coming quarters.

Speaker 6

Understood. And that's what you're adjusting for then. Okay, I got it. Thanks.

Operator

Your next question will come from the line of David Grossman with Stifel. Please go ahead.

Speaker 7

Thank you. I was wondering if I could just follow-up a couple of points that were just made in the last question. I guess, I'm just trying to reconcile. You've given us a lot of good information about production, about headwinds from customer losses, some of the larger customers that you've been talking about over the last several quarters and other dynamics. So I guess I'm just trying to reconcile all of that because I think, Jason, you said that when you back out FX and seasonal kind of workdays or work hours that it feels flattish.

Speaker 7

So it sounds like the newer work that's coming on is offsetting those headwinds. Is that a reasonable way to think about things as we kind of move into 2024? I know you don't want to give guidance, but Does it feel like those headwinds that you've been experiencing in the last couple of quarters that have been driving sequential declines in revenues Should pretty much abate by the end of this year.

Speaker 3

Yes. Obviously, the world is a very complicated place at this time. And so I want to be Careful not to make an absolute assertion, but certainly at this time, we are seeing more stability In customer programs and budgets. And so, particularly as we look at North America, it doesn't Feel like we've achieved some degree of stability, less of these unexpected sort of surprises and ramp downs and we believe that we're seeing similar as we entered Q4. As I did mention in my prepared remarks, we do have a couple of customers in Europe already notified us and we've been aware of it for a little while that we'll see some ramp downs there.

Speaker 3

But again, it feels right now that we're seeing less of these sort of unexpected surprises that drove both the miss In Q2 and has resulted in sequential declines. And Absolutely, if you adjusted out the build A impact, you'd have flat revenue as you go from Q3 to

Speaker 7

And maybe a similar question on the margins in terms of It looks like your utilization went down again sequentially and you've got again the wage pricing dynamic, which sounds like the timing may Expanding into calendar 2024. So and then you factor in, you've taken some cost cutting actions. So When you roll up all those different elements, is it reasonable to think that you're still targeting your historical range as we go in So 2024 that that's kind of what the objective is based on the actions you've taken thus far in 2023.

Speaker 3

So, I think with some of the actions we're taking and some of the stabilization demand, I think that you'll see better utilization in Q4 and we clearly hope to improve utilization in the first half of twenty twenty four. However, with the lower bill days, You'll still have some compressed gross margin in Q4, which is why we've sort of guided the way we have with the 15% to 16%. What I do think as we entered 2024 is There is still an imbalance between customer pricing and wage inflation. And as I think you've noted before, David, We do expect to return to have more normalized variable compensation. And so, I think as we enter 2024, We haven't done all the work on this yet.

Speaker 3

We don't quite know what wage pressures are going to be next year. And again, we're still trying to assess what happens with some of the deals we close here in Q4 and how that will impact future pricing as we enter 2024. But the sense is that it's possible that we could See profitability decline somewhat as we move from 2023 to 2024. And then as I've been talking about over the last couple of earnings calls, we view 2024 as a transitional year where we get the opportunity to work through a few things. We expect at some point more rational sort of supply demand and then that will give us opportunities on both pricing and with a return to more traditional profitability more likely in 2025.

Speaker 7

Great. Thanks for that. Just one quick follow-up to those. So the kind of wage pricing dynamic, is that the biggest headwind to gross margins as we go into next year, just letting that play out.

Speaker 3

Yes, I would say that that continues to be the wage pricing dynamic is The uncertain element, which is why it's harder for me to sort of comment on it right now, but I will be able to the next time we talk. But yes, I would say that the ongoing imbalance Sort of customer pricing and wage.

Speaker 7

Got it. Great. Thanks very much. Appreciate that.

Operator

Your next question comes from the line of Ramsey El Assal with Barclays. Please go ahead.

Speaker 8

Thanks so much for taking my question. I wanted to ask about booking conversion trends. And if you could just comment on things like How average portfolio duration is trending or timeline to convert bookings to revenue or pipeline erosion trends? I'm just kind of curious, are you seeing consistency and stability when it comes to conversion or is it more of a moving target still kind of in this tough environment?

Speaker 4

I think it's still second. At the same time, if you're talking about length of the relationship, I think that's exactly what you said, that it's very much stabilizing and we don't see the same kind of That's a very different like versus Q1 situation and now, okay. I think it's much more manageable, I think much more transparency in situation.

Speaker 8

Okay. Thank you. And a quick follow-up from me. I wanted to ask about follow-up on a prior question about the headcount numbers globally. And in particular, I'm just curious, the absolute headcount numbers in Ukraine and Belarus.

Speaker 8

Should we think about those as relatively stable at this point? Or do you have plans to further drawdown. I'm thinking particularly in Belarus, especially given kind of the way Russia kind of ended this quarter officially. I'm just curious whether we should think about the absolute numbers as the sort of watermark that's going to be persistent or whether we could see More declines on an absolute basis in the region.

Speaker 4

I think the answer is very simple. Like We believe that Ukraine would be more stable and Belarus less stable just based on the situation of supplydemand ratio. And in absolute numbers and Relative numbers, Belarus declined during the last several years, much, much, much more significantly than Ukraine. And I think this trend might be there depending on geopolitics and client reactions.

Speaker 3

Okay. Thank you very much.

Operator

Your next question comes from the line of Jason Kupferberg with Bank of America. Please go ahead.

Speaker 7

Good morning, guys. I just wanted to come back to some of the commentary around quarter over quarter growth rates. I know that's what you guys have been watching most closely just to assess demand and you've talked about stabilization here. So just looking ahead to the Q1 of 2024, do you think we get back to positive quarter over quarter revenue growth Ben, I think the Street is looking for about 3% growth. So just wanted to get your take on that.

Speaker 7

I mean putting any potential moves in FX on the side, Given some of the stabilization in parts of the business, do you think we're back in positive territory in the Q1?

Speaker 4

I think you should expect our assets will tell you this exactly in 3 months. But again, we're seeing positivity right now, but we'll check-in 3 months.

Speaker 7

Right. Okay. And just to follow-up, Jason, on some of your margin commentary, I want to make Sure. We've got the messaging right there because it sounds like most of the cost optimization is going to get reinvested. So it sounds like what you're Suggesting is in 2024, non GAAP margins are perhaps down versus 2023 and then 2025, you're kind of back to normal range like 16% or 17%.

Speaker 7

Is that directionally Yes.

Speaker 3

So we still we haven't worked through pricing. We haven't worked You know, right. Total through what we think is going to happen from the wage environment, I think, in certain markets is pressures are not as pronounced, but then there's other markets where there's very, very high cost of living inflation. And so what I'm saying is, we haven't worked Sure, yes, but I think it's certainly possible that you could see us talk about 2024 with lower profitability. And that was just in response to the question around, Do we think that we'll maintain profitability in 2024?

Speaker 3

I just want to make certain that there's an indication that we could be Lower as we enter the fiscal year and again working to get ourselves back into a position where we could operate in the 16% to 17% range in 2025.

Speaker 6

Very helpful. Thank you.

Operator

Your next question comes from the line of Maggie Nolan with William Blair. Please go ahead.

Speaker 9

Hi, good morning. This is Jesse on for Maggie. Thanks for taking our questions. So first, How do you feel EPAM is performing compared to the market? Do you think that you're starting to take share?

Speaker 4

I think we started to return to taking some share. Okay. I think an existing clients will stabilize while again there are some long term like longer term calls, which some clients make and they have a plan and they will be executing according to the plan. As Jason mentioned, there are several clients in Europe, which we know What's going to happen? So on another side, in existing clients, I think we stabilized and at some of the clients we started to take share back.

Speaker 9

Got it. Thanks, Eric. And then Were you going to say something else?

Speaker 4

No.

Speaker 9

Okay. And then for my follow-up, Europe appeared to be a bright spot, but Jason, you mentioned the incremental ramp downs there. Have you seen any changing behaviors or sentiment from clients in that geo? Or are there just some client specific challenges that cause those ramp downs?

Speaker 3

We saw Europe actually declined somewhat sequentially between Q2 and Q3. And so we are seeing Europe's a little bit more mixed, but generally it has been positive relative to North America. And then we've got a couple of these customers that we talked about. So it's not what I would call broad based and I would call it more customer specific.

Speaker 4

I think we're looking at this almost year to year comparison becoming less meaningful at this environment because there is so big change between these 2 years. So right now, the quarter by quarter comparison Really showing what's happening. And from this point of view, actually You're welcome. Thank you.

Operator

Your next question will come from the line of Jamie Friedman with Susquehanna. Please go ahead.

Speaker 10

Hi. I had a slightly longer term question, Ark. I was wondering How would you compare the relevance of and the mind share of some of the key services that you're known for, especially application development in terms of the tech stack, is application development more or less meaningful relevant in today's technology architecture. How do you see that evolving if at all?

Speaker 4

I think this is we will try to predict a little bit the future. And from this future point of view, I think application development will become even more important with everything that's happened. So it's very easy to optimize yourself to in time environment. The goal point and that would happen quarters from now or couple of years from now. And from this point of view, we still believe that this is what we started this conversation this morning that we still believe that differentiations which we build And build function and strong credibility capability would be extremely critical visual Which is changing on our eyes.

Speaker 4

We don't know when all this will be impacted, but even I mentioned multiple times, I do believe that there is a huge technical debt on data in cloud environment in the world. And right now, it's taken kind of second priority in this environment. But it couldn't be done for too long because there are some companies which not invest and will be So I think it will come back and everything what's happening with AI will be changing the whole application infrastructure, new opportunities will have to be rebuilt again. So that's why I think it's for us to try to reach how to maintain this advantage.

Speaker 10

Got it. Thanks for that. I'll drop back in the queue to give someone else a chance. Thank you.

Operator

Your next question will come from the line of James Faucette with Morgan Stanley. Please go ahead.

Speaker 11

Great. Thank you very much. I wanted to Ask quickly a couple of questions. First on pricing, Jason, you mentioned a little bit of discounting, etcetera. Can you help us think through kind of the longer term implications?

Speaker 11

I know you've alluded to it in terms of At some point, being able to recover that. But can you just help us think through what that mechanism typically would look like and what would make sense over the medium to long run?

Speaker 3

Yes. And this is one we're probably using ARC's response of it would vary or it depends is probably appropriate, but I'll just give you some versions of it. Certainly, as you As people wanted to be more cost efficient, India has been a more attractive play. We do think that that, India will continue to be an important delivery location for us, But that you'll also see more demand over time in our other geographies. And so what you may see in the next couple of quarters is still a more pronounced mix of India delivery, but we don't think that that's necessarily permanent.

Speaker 3

At the same time from a pricing standpoint, oftentimes it does take probably a year to reset. And so it's hard to kind of go demand is higher tomorrow and now your price is higher. Oftentimes, the relationships are sort of set over a year. And so that's why In some of the earlier calls, I've said, I think you're going to enter 2024 with an environment that where it's difficult to take up price. And then we'll probably end up somewhat locked in during 2024, okay, not in all clients and not in all roles.

Speaker 3

And then we've got more opportunity to adjust price probably later in the year. And of course, we'll be exposed to wage inflation during our traditional compensation campaign in Q2. Great. I appreciate that, Jason. And then my second question was just How do

Speaker 11

you think about and this is for Ark and or Jason, obviously, but how do you think about any changes that you need to adjust to long term if we're in a higher interest rate for longer environment. I guess I'm just thinking that Historically, EPAM has been really good at doing acquisitions and acquiring new technologies to stay at kind of leading edge. But with the cost of capital now being higher, do you have to adjust how you think about the importance and role of acquisitions in future Stratagen Capability Development. Thanks.

Speaker 3

I think we would still continue with the same strategy that we've had with doing acquisitions that allow us to expand capabilities And then sort of help further our opportunity to grow organically. And so certainly, we'll be careful as we have been, but I think that you'll still see a significant focus on acquisitions that are probably more in that sort of small to midsize tuck in.

Speaker 4

I guess that's an advantage we have from our financial position. We have very strong cash position Do not rely on the outside market to do exactly what we were doing in the past because it was relatively small acquisitions targeted for specific content series or very specific geographies. And we Very good shape to continue doing this. I think that's outlook might change.

Speaker 3

Great. Appreciate those comments.

Speaker 4

Absolutely. Thank you.

Operator

Your next question will come from the line of Puneet Jain with JPMorgan. Please go ahead.

Speaker 12

Hi, thanks for taking my question. I wanted to ask on financial services, some of your peers have talked about seeing some weakness there and you also mentioned banking within Financial Services as weak. So can you double click on what you're seeing there like are the headwinds broad based within banking or are they client specific?

Speaker 3

Yes. For us, clearly, we have one large client where it's probably client And we have seen some, I guess, some reduction in revenues there. And then there's a number of other banks that we would work with We've also seen declines. So, I would say it's probably relatively broad for banking, But other elements of the financial services practices are also seeing growth. And so banking certainly somewhat soft, With opportunities in asset management and other areas in financial services including insurance.

Speaker 12

That's great. And then like it was nice to hear that some of the programs, some of the projects clients are coming back. Is that incremental work driven by clients need to modernize their core systems maybe because of generative AI Or are these still more cost optimization type of deals?

Speaker 4

I think where the returns happen, usually it's a program where some clients also just use the level because I can do it with somebody else. And that's usually the trigger for the return, but then It's actually triggering opening new opportunities with us as well. So we have already several situations during the last Several quarters when it's happening. So Genent AI, we talked about it. We still think that Direct impact on the revenue is not going to be exactly there yet, but A lot of activities and with all investments which we do in R and D right now and definitely differentiated ourselves.

Speaker 4

We See the client reaction is what you're showing. So it started to create tangible opportunities, but again the size of them

Speaker 12

Got it. Thank you.

Operator

With that, I'll turn the call back over to Mr. Dobkin, CEO and President for any closing remarks.

Speaker 4

Again, thank you for joining today. So I think with all kind of numbers which we shared, we're still looking More positive to the situation than several waters. Unfortunately, the world is still continues to be very unpredictable place and that's why it's difficult to make more clear statements sometimes. So let's meet in 3 months and see what we will be able to serve them. Thank you very much.

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Earnings Conference Call
EPAM Systems Q3 2023
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