EPAM Systems Stock: Out Of Its Depth (NYSE:EPAM)

Thesis

In my final article on EPAM Techniques (NYSE:EPAM), I confirmed how the previous development stalwart is slowing down. At the moment, I had a ‘impartial/maintain’ outlook on the inventory and looking back, this was a misplaced alternative to learn from the draw back because the inventory has fallen 26.92% since then in comparison with the S&P500’s rise of two.06%.

The corporate lately reported weak Q1 FY23 outcomes and a fair worse outlook. The inventory is already down 11.94% however I imagine it’s nonetheless too dangerous to carry on as the corporate appears very a lot out of its depth within the present IT Providers atmosphere with materials headwinds on each development and margins. Subsequently, I’m revising my score all the way down to a ‘promote’.

A nasty quarter and a fair worse outlook

During the last 2 quarters, the single-digit annual development charges have been fairly uncharacteristic of EPAM’s former constant 20%+ YoY glory:

Be aware that Q1 FY23’s 7.0% development fee excludes a non-recurring development fall affect from the exit of Russia-related enterprise

On a QoQ foundation, revenues fell 1.6%. This was weak however a bit higher than anticipated; the mid-point of the guided vary final quarter implied a 2% QoQ decline.

Regardless of in-line revenues, the inventory fell 10.33% on Might 5, 2023. That is attributable to a really sharp minimize within the 2023 development steerage from 9% YoY to a mere 3% YoY on an natural, fixed forex foundation. Furthermore, administration guided for continued slowness in Q2 FY23, indicating one more QoQ decline in revenues. Headcount additions within the business are a number one indicator of future demand. On this indicator too, there are clear indicators of a pointy development slowdown as the corporate sees a web discount of 1750 employees and guides for one more headcount discount in Q2 FY23 together with restricted hiring for the remainder of the yr.

EPAM is out of its depth and dropping share

EPAM is geared towards the $748 billion ‘construct’ a part of the general $1.8 trillion know-how companies market:

‘Construct’ sort spends are extra discretionary than ‘keep’ sort spends. The issue now could be that the present atmosphere strongly favors ‘keep’ sort spends:

As an alternative, over the past 3 months, it grew to become very clear that the financial atmosphere is extra centered than it has been for many years, on price optimization, which for now benefiting extra conventional outsourcing corporations with robust price take out choices.

– CEO Arkadiy Dobkin within the Q1 FY23 earnings name, creator’s emphasis

This can be a very regarding assertion because it implies there’s continued danger of loss in market share; a pattern that began to materially have an effect on the enterprise from This autumn FY22:

…we’re realizing proper now that some work, future work, which we historically, we’ll be getting from current shopper base, have been supplied most likely to some various distributors

– CEO Arkadiy Dobkin within the This autumn FY22 earnings name, creator’s emphasis

The extent of the shift in demand sentiment has caught the administration workforce without warning:

…we underestimated the breadth of the macroeconomic slowdown and the depth of the affect particularly within the transformational sector of the IT companies market.

– Writer’s emphasis

I imagine all these are indicators that EPAM and its administration are out of their depth in these difficult instances.

Administration is implicitly guiding for additional margin contraction

Normalized (excluding the affect of assistive non-recurring Russia – Ukraine spends), GAAP gross margins fell 170bps from 32.8% to 30.1%:

Be aware that that is ~90bps worse than what was anticipated by administration in This autumn FY22. On this case, administration attributed this sharp decline to account margin compression (pricing pressures). But, they anticipate 33% gross margins within the second half of FY23, unlocked by pricing will increase. Given how out of depth EPAM seems to be within the present demand atmosphere, I’m skeptical about any margin enlargement taking part in out.

Administration is successfully guiding for a 14-15% adjusted non-GAAP margin band. The Q1 FY23 print of this determine was 14.5%. Nevertheless, I argue that the true degree is definitely 15.3% since there’s an 80bps affect of a one-time $9.5 million severance price skewing the figures. This paints a worse image of the underlying economics; as an alternative of the unique -50bps to +50bps margin enlargement steerage, the corporate administration is successfully taking a look at an additional 30bps to 130bps margin contraction from the normalized (corrected for one-offs) margins at the moment.

Takeaway

EPAM is actually struggling within the present IT Providers demand atmosphere. I can not keep in mind the final time I noticed a pointy 600bps minimize from 9% YoY development to three% YoY development on this business.

The important thing problem for the corporate appears to be structural; its core forte within the ‘construct’ facet of IT Providers has enabled it to persistently clock in rolling 20%+ income CAGRs persistently for a decade. Nevertheless this has now modified as enterprises are squarely preferring distributors who’ve robust competencies on the ‘keep’ work. I anticipate these troubles to proceed resulting in pricing pressures and market share losses.

The normalized adjusted working margin print for the enterprise in Q1 FY23 is 80bps increased than reported as a result of a one-time affect of severance prices. Contemplating this base-line, it’s obvious that administration’s margin steerage implies additional margin contraction from the bottom degree operations as an alternative of a flat margin band. I imagine that is one thing that has the potential to negatively shock the road subsequent quarter.

General, as I anticipate additional adverse outcomes and surprises in Q2 FY23, I downgrade the inventory from a ‘maintain’ to a ‘promote’ for current shareholders. I imagine it’s best to attend for the sequential development declines and margins to stabilize earlier than fascinated by a re-entry into EPAM inventory.