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Funding Thesis
EPAM Techniques (NYSE:EPAM) diminished the monetary outlook for the second quarter and full 12 months 2023 income and earnings on June 5, only one month after the Q1 earnings name on Could 5, 2023.
This was not sudden as I had given a Promote suggestion after the Q1 earnings have been reported starting of Could, see – EPAM Techniques: Disappointing Q1 Outcomes And Probably Extra Ache Forward (Downgrade To Promote). Shares are down 25 % since then.
Like previously two quarterly earnings calls, the CEO and CFO once more expressed confidence in the course of the name on June 5 that the following quarters will see an enchancment in buyer demand for his or her digital engineering companies, however once more there isn’t any onerous proof for this. They speculated {that a} restoration would begin within the first or second quarter of 2024.
The diminished outlook means the P/E ratio for EPAM remains to be round 27, based mostly on the forecasted earnings per share for 2023. So, shares are nonetheless priced for progress – though administration couldn’t present a lot readability about how and when that progress will return.
Additional unhealthy information may drive the shares right down to and even beneath their 2022 low of round USD 175, round 10 % decrease than the place they’re now. Until there may be readability or excellent news relating to demand enhancements, I like to recommend ready for a decrease entry level for brand new investments. Nonetheless, I’m altering my suggestion to Maintain. A Promote suggestion doesn’t make a lot sense anymore after the massive drop has occurred.
Diminished monetary outlook for Q2 and FY 2023
EPAM now expects 2023 income within the vary between USD 4.65 and 4.8 billion (beforehand USD 4.95 to five.0 billion, so -2% YoY). Income in 2022 had been USD 4.825 billion. GAAP earnings per share are actually anticipated to be between USD 7.28 to 7.68 (beforehand USD 8.11 to eight.31). GAAP EPS in 2022 was USD 7.09.
EPAM expects non-GAAP adjusted EPS between USD 9.80 and 10.20. The distinction between GAAP and non-GAAP EPS is generally inventory based mostly compensation. EPAM quantifies the impact to be round USD 2.46 per share or 3% of income. This isn’t large, however substantial contemplating the working margin is round 11%. Due to this fact, I choose to make use of the GAAP quantity. Inventory-based compensation won’t go away, it’s only a regular manner of how EPAM rewards workers and a repeating value (to shareholders).
The change is pushed by weakening demand from new and present accounts. Within the phrases of the CEO and president, Arkadiy Dobkin:
Within the weeks since our Q1 earnings name, we now have seen our shoppers turn out to be much more cautious with spending particularly within the ‘construct’ phase of the worldwide IT companies market. After cautious evaluation of modifications in our Could and June forecast information, we now have come to grasp that pipeline conversions are occurring at slower charges than beforehand assumed and we’re additionally seeing some discount within the whole pipeline.
In absolute phrases, the outlook just isn’t so unhealthy. If the steering is heading in the right direction, 2023 income shall be simply barely beneath the earlier 12 months, and earnings per share even just a little larger YoY. The issue is the valuation. A P/E ratio round 27 means there may be nonetheless an expectation of serious future progress mirrored within the valuation, and shares are costly for a corporation that’s not rising and ready for the market surroundings to enhance.
That’s, in fact, if the forecast is right. A minimum of for my part, EPAM administration has misplaced some credibility by predicting demand progress that didn’t materialize each when presenting the This autumn 2022 outcomes and once more 1 / 4 later when presenting the Q1 2023 outcomes. The Q1 2023 earnings name was only a month in the past on Could 5.
On a smaller scale the corporate remains to be sticking to this sample and forecasting a greater second half of the 12 months than the primary half. Whereas working earnings from operations in H1 ought to solely be between 10 and 11 % of income, the forecast for the complete 12 months is for 11 to 12 %.
Is it simply the market?
EPAM administration mentions the market surroundings as the principle driver for the demand contraction. There could possibly be different causes too which are extra company-specific.
EPAM has persistently traded a a lot larger P/E ratio than rivals, and the likes of Cognizant (NASDAQ:CTSH), Capgemini (OTCPK:CAPMF) are nonetheless considerably cheaper.
This was perhaps justified when EPAM was rising 20-25% YoY. Additionally, EPAM is completely different than Cognizant, Capgemini or Accenture (NYSE:ACN) relating to its enterprise mannequin. EPAM does nearly no IT companies and legacy software upkeep work. The main target is on constructing new issues and reworking legacy software landscapes. It additionally doesn’t have a big consulting enterprise like Accenture. EPAM has tried to maneuver upwards from engineering to consulting and design with its EPAM Continuum model, however when it does these issues it’s normally tied to an engineering engagement.
One other distinction was the geographic distribution of its supply places, which very closely tilted in direction of Ukraine, Russia, and Belarus. This gave EPAM a really aggressive combine of excellent engineering expertise at a low worth.
Russia and Belarus are actually gone. One consequence is that EPAM has turn out to be dearer (the CFO explicitly talked about this on the call on June 5) because of the geographic redistribution of the workforce away from Russia/Belarus/Ukraine.
The IT companies market is price-sensitive. Furthermore, EPAM’s contracts are overwhelmingly time & materials. The ratio between time & materials and stuck worth has even elevated over the past quarters and is now nearly 90:10. Time & materials made up 88.7% of income in Q1 2023. It had been solely 85.1% two years again in Q1 2021.
So, from a shopper perspective, the shopper is shopping for folks to get work completed. They aren’t agnostic to supply places. Location determines the value, so this issues so much. For bigger organizations, which make up most of EPAM’s clients, threat can be an vital issue. Ukraine remains to be the biggest supply location for EPAM, however I assume that for a lot of organizations sourcing solely from Ukraine is a no-go from a threat perspective in the intervening time.
Conclusion
When presenting the modified steering, the EPAM CEO, Arkadiy Dobkin, was requested what makes him assured that the market contraction is barely momentary. His reply was that he had seen this a number of occasions over the past 20 years. Every time the marketplace for digital engineering companies went again to 10-15 % progress charges after only one, two or three quarters, and EPAM was persistently capable of outperform that market progress. He stated he’s assured that it will likely be the identical this time round.
Which may be so, however I believe it isn’t assured. I’m additionally not satisfied that we’ll see the P/E ratios between 50 and 100 once more quickly, if ever.
Whereas I do assume that EPAM is a well-managed firm, it issues me considerably that administration seems passive. EPAM administration doesn’t assume, or a minimum of they don’t discuss it, that they should take particular actions and make modifications to develop once more. They appear to be in ready mode till the market surroundings improves.
EPAM doesn’t pay and has by no means paid a dividend, nor does the corporate do significant inventory buybacks. So, the one the way in which shareholders can profit is capital appreciation. With a P/E ratio near 27 and unclear progress prospects, the chance/reward ratio in the intervening time remains to be unfavorable – for my part. We’d see the 2022 lows of USD 175 being examined, and if progress doesn’t materialize over the following quarters as administration expects, the inventory may go beneath that.
There could be a buying and selling alternative when EPAM inventory bounces again, however a straight reversal from right here again to progress is way from assured.
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