Deep Dive: EPAM Systems (EPAM US)
IT services compounder at a dislocated valuation
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Summary:
EPAM is a high quality IT services provider that has been compounding earnings at a high rate for the last 10 years.
The stock is currently dislocated - down more than 70% as of the date of writing. EPAM’s delivery centers are distributed throughout the world but have a major presence in Ukraine, Belarus and Russia (clients are mostly based in the US and Europe).
We have laid out a framework for analyzing IT services business. We have also performed scenario analysis on the possible future trajectory of EPAM in light of the geopolitical circumstances. In each scenario the stock price should be materially higher in 24 months.
Before we begin, we want to say that we, at Value Punks, are appalled by the human tragedy and pray for a swift end to this senseless conflict.
EPAM is a global IT services firm with presence in 40 countries and 58,800 employees. The company provides services to a diversified end-market consisting of clients in the financial services, travel, retail, software, healthcare among other industries. The company is well placed as a ‘toll booth’ between technology and corporations who increasingly need technology to transform their business.
Over its history, EPAM has been a ‘compounder’. The Company has a sticky and growing client base that it supports with its deep engineering expertise. EPAM came to the market via an IPO in 2012 (at $12/share), and since then has grown revenues and operating profits almost 10x. Due to its quality, capital allocation, increasing scale and inflecting margins, investors had awarded the company a very high (average) multiple of 50-60x LTM earnings over the last 5 years.
Recently, the stock price has declined from a high of $720 in October 2021 to ~$180 per share. Some of this is due to the rout in technology stocks but the bigger issue at hand is that about half of EPAM’s engineers are based in Ukraine, Belarus and even Russia.
Before the invasion, EPAM issued its 2022 guidance and expected revenues to increase 37% with stable operating margins. The street had its EPS doubling in three years from 2021 levels. Furthermore, EPAM has a fortress balance sheet with $1.2 bn in cash on a $11 bn market capitalization (11% of mcap). EPAM pulled this guidance a few days later and the stock cratered. The company later issued a press release supporting Ukraine and committing $100 mn for relocation of its employees in Ukraine.
Here are the historical financials ($USD millions (GAAP)):
This report will discuss the global IT services industry broadly, before diving into a discussion of EPAM’s business. We’ll also provide a way to think through the risks related to the current geopolitical situation. In doing so, we won’t be making any macro calls on geopolitics, but rather approach it from the bottom-up using scenario analysis as a way to visualize the risk-reward. Given the wide range of potential outcomes here and the fluidity of the situation, this one deserves a more nuanced treatment than a ‘simple buy’ recommendation. We hope that with this, the reader can come to an informed decision on this unique (and potentially attractive) opportunity, and decide for themselves if they find the risk-reward setup suitable.
Context
All IT services companies look the same. They all provide bodies that specialize in technology to businesses that need to either cut costs or improve processes. Under the hood, however, they are all a little different. Understanding these nuances can be the difference between a value trap and a compounder.
Drivers of IT spending
Worldwide IT spending is projected to total $4.5 trillion in 2022, an increase of 5.1% from 2021, according to the latest forecast by Gartner. This spend is divided into the following categories:
We can see above that software and IT services are the fastest growing segments of overall IT spend. The IT service providers play in these buckets and grow faster due to the following,
Increasing IT spends: These spends are typically a function of IT budgets. These budgets are typically a certain percentage of revenues. The trend is that most corporations are allocating a larger and larger part of their spends to technology - software is in fact eating the world. These spends have further tailwinds from:
Cloud computing
Cybersecurity
Work from home
Digital marketing
Increasing outsourcing: Larger businesses can afford in house technology departments but for most businesses technology is not their core expertise. It is also difficult to hire and retain good technology talent. In the past, most companies let IT companies manage their costs but increasingly IT services companies are helping businesses transform the way they do business (i.e. digital transformation).
Confirming this, Gartner mentioned that, through 2025, organizations will increase their reliance on external consultants, as the greater urgency and accelerated pace of change widen the gap between organizations’ digital business ambitions and their internal resources and capabilities. Garner also mentions that among businesses planning to boost tech spending in 2022, IT budgets are expected to grow by 26% (31% in North America vs. 21% in Europe), on average. In 2022, the top factor driving companies to increase budgets is an elevated priority on IT projects (49%), which could indicate multi-year modernization efforts that were accelerated by remote work, and a steady shift to cloud-based services have chipped away at legacy technology.
This jives with EPAM’s guidance.
IT services is not a new business. US businesses such as IBM, HP, Perot systems and the like were successful in this business for many years. Warren Buffett had been reading IBM’s annual report for 50 years before he bought the stock. He talked to Berkshire companies and reasoned that most companies do not switch their IT providers. He was absolutely right in his assessment of the industry - it is a very sticky business - but picked the wrong horse (should have bought Accenture instead!).
We digress.
Evolution of the industry
In the 1990’s there were two main tasks performed by IT services companies - infrastructure and applications. Most big companies needed someone to set up and manage servers, network and other equipment. In addition, starting with the financial institutions/banks, they also needed custom applications that could help them become more efficient.
The late 1990’s brought the rise of the Indian IT services industry. These companies could manage a corporation's back office for much less than IBM or Perot or HP. They had cheap English speaking programmers who could take over the task of developing and maintaining custom applications from India (enabled by the internet). Before packaged software, most large corporations developed their own custom software (some banks are still running applications on Cobol and Fortran). The Indians could do it for much less! They also took over the maintenance of current software. Most back offices were a mess with different custom applications which never talked to one another. The first phase of the Indian industry’s development was taking over the client’s “mess for less”.
The western IT services companies faced deflation in their core services business due to the emergence of Indian IT services providers. They then read Peter Druker and left the commoditized business and started offering more specialized services such as packaged software implementation, building and maintaining infrastructure for a fixed rate or offering technology consulting. Even then they lost a lot of business over the last 25 years, first in commoditized services, and then in more specialized services as the Indian IT services providers kept moving up the value chain.
The Indians just had a huge cost advantage. An engineer in India could be hired for 1/10th the cost! Due to this, most large Indian IT service providers had operating margins of 35-40% while their western counterparts managed with 15-20% margins. Slowly but steadily, the western companies started building delivery centers in India and the cost arbitrage started deteriorating. The margins have more or less converged.
Until 2010, most of this work was still confined to the back office. Clients, however, increasingly needed help with the revenue generating parts of the business. Software was eating the world and they did not know how to make sense of it. They needed apps, transition to cloud, data analytics and the like in order to be competitive in this very tech enabled world. In order to update their front office they also had to make changes in their back office.
Bernstein, a research house, puts it succinctly, “Digital is a unique wave as it is integrated with the entire technology stack – front end apps, back end data center/cloud, legacy apps, data sources – all need to be integrated to realize an end to end digital transformation outcome. This has also led to integration of spends which are no longer restricted to the CIOs but also the CMOs, CDOs, COOs, etc.” A bank cannot become digital if the back office is still doing batch processing (well, that's not totally true as some banks have come up with band-aid solutions!).
This led to the rise of new IT sourcing companies with very strong engineering capabilities that were ahead of their time. EPAM, Globant, Luxoft (now acquired by DXC) appeared on the scene with delivery centers based in Eastern Europe or Latin America. The legacy businesses for most traditional outsourcing companies were now experiencing deflation as clients needed to find dollars to spend on transforming their businesses. Plus there seems to be a quality differential!
The Indian companies always have lower prices than companies in Eastern Europe or in Central Europe, but the real competitive advantage for the companies that are coming out of Eastern Europe and Central Europe is that they produce quality. The total cost of a project may be lower than the total cost of a project out of India, even though the price per person is much lower in India than in Central Europe or Eastern Europe.
-EPAM ex-Global Head of Division (Aug 2020) - Stream transcript
An Accenture or an Infosys now has two very different businesses within their portfolios - a legacy business which is facing deflation and de-growing mid single digits and a new digital services business that is growing at high double digits. Net result is that these businesses grow at high single or low double digit rates. Newer IT service companies such as EPAM grow at a much faster rate because their revenues are exclusively in the digital category.
Analyzing EPAM