Pounding the table on EPAM

Delayed "AI winner" at a bargain

As most AI heavyweight stocks (e.g. Nvidia, Microsoft) have already soared, some investors may be left feeling that they have missed the AI bandwagon.

We believe there's a delayed “AI winner” which the market is still sleeping on: EPAM Systems.

With the stock back at ~$230, the risk-reward here is highly attractive in our view.

Introduction

EPAM Systems is a high-quality IT service provider that has been a compounder stock. Like all IT services companies, EPAM is well placed as a ‘toll booth’ between corporations and technology to transform their businesses. It competes with the likes of Accenture and provides IT services to a diversified end-market consisting of clients in the financial services, travel, retail, software, healthcare among other industries. EPAM held its IPO in 2012, and since then, has grown more than 10x until the year ended 2022 with revenues of $4.8 bn and EBIT of $573 mn.

EPAM's winning streak came to an end in 2022. 

With Russia’s invasion of Ukraine the stock fell from $550 per share to $180 per share as the market was worried about EPAM’s outsized exposure to workforce/delivery centers in Ukraine, Belarus and Russia. However, the management at EPAM did a wonderful job de-risking the company from this exposure. They exited Russia by not only leaving their clients there but also by closing their delivery centers in the country. By the end of 2022, EPAM’s exposure to these volatile countries had reduced from 60% of overall workforce to 30% of overall workforce. EPAM moved some of the affected employees to neighboring countries and ramped up their hiring efforts in India and Latam. Due to this, the stock moved up to $450 per share a few months later in August 2022.

Very recently, EPAM reduced their guidance for 2023. They first reduced their guidance during their earnings but then followed this up with a further reduction in guidance a few weeks later. The management is now expecting negative growth in 2023.  

To put this into perspective, EPAM has achieved double-digit revenue growth every single year since its IPO in 2012. Below are the historical financials.

Management mentioned that clients are deferring projects due to which there will be little or no growth for the next few quarters. They guided for growth to come back in 2-4 quarters as clients can pause these projects but not cancel them. 

What happened?

1. IT spending is indeed slow. Like many other industries, IT services also ‘over earned’ during Covid and had a stellar performance in 2022. Some of this is now normalizing.

2. Some clients have de-risked EPAM due to their still substantial exposure to Ukraine.

3. Overall, revenue growth in this industry is very dependent on employee growth. EPAM has not grown its net employees - the losses in Russia and Ukraine have been made up by gains in India and Latam. It takes time in this industry to train employees and bring them up to high levels of productivity. 

In addition to all these issues, there is debate amongst investors on AI  - Are EPAM and other IT services providers AI winners or AI losers? Most IT services are billed on a ‘time and material’ basis and the ‘bear’ argument is that as software engineers become more productive fewer software engineers will be needed thus affecting growth for all IT services companies.

In this report, we will highlight EPAM’s strengths and address the debate surrounding AI.

EPAM is currently available for 21x depressed 2023 earnings per share. It is a $12 bn market capitalization company with $1.7 bn in net cash and a $500 mn share repurchase authorization.

An investor purchasing shares at these valuations can expect to compound with earnings growth with the added call-option of multiple expansion if EPAM is once again seen as a durable growth franchise. We believe that is the most likely outcome.  

IT services and EPAM’s competitive advantages

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.

According to Gartner, IT services is one of the fastest growing segments of overall IT spend. The IT service providers play in this bucket and grow 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 and can be economically sensitive. 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 and 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. So, they rely on consultants to keep them abreast of the latest technology trends. 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. 

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. 

The two biggest competitive advantages in this industry are scale and culture.

Scale

If you look at the history of IT services companies we observe that the big get bigger. Accenture currently has 700,000 employees. Why? Because scale matters in more than one way. 

On the revenue side it matters because an IT services company will not get a $10 mn project from a client until they have done a $10 mn project in that practice in their industry and can provide a good reference. Many times, an IT services business has to organically get to that level or acquire another company that has a good reputation in that practice and industry. The phrase, ‘no one gets fired for hiring IBM’ came from the fact that until you have a proven history of executing and becoming a low risk choice for customers, you will not get hired. EPAM has a reputation for being a good partner for corporations. 

EPAM is also a good partner for the major cloud service providers (CSPs). By virtue of its scale and experience with implementation, EPAM has been designated a preferred vendor. This dynamic is illustrated below:

“They (EPAM) have really good relationships with Google and AWS…What winds up happening is for AWS or Google contracts, if you lock in to, say, a five-year deal worth $500 billion, Google then gives you what they call PSF, which is professional service funding, in order to make the migration to the cloud. They'll give you, say, $60 million, $70 million to do that. You can only spend that PSF money against certified Google partners. Quite honestly, there's maybe a half dozen that are really good and EPAM is one of those.”

- CTO at Priceline, an EPAM customer (June 2023, Stream Transcript)

This puts EPAM in an enviable spot where it can earn a steady inflow of business by default as clients actively seek its services.

On the cost side, scale matters as a company needs resources to train their workforce on the newest technology - something that changes all the time. The successful companies were able to transition their business from application development to ERP implementation to cloud migrations and now they will have to transition to AI-related technologies. All this requires significant resources and a margin buffer that only the larger IT service providers can absorb. 

EPAM is well diversified within verticals (financial services, travel, business information & media, software, and life sciences).  It takes a lot of time and effort to methodically diversify your business in this sector and each vertical can be thought of as a new business line. EPAM also not does not have large concentration risks when it comes to clients with top 10 clients making up about 23% of revenues.

Within verticals, the business is highly recurring. Once a client is secured, IT service providers strive to capture greater share of spend over time. The financial services industry, for example, has a constant need for IT services due to complicated back offices, changing compliance requirements, mergers and acquisitions, or digitizing services. An IT service provider needs to work hard to take its fair share of the client’s IT budget but the good ones do just that. Whatever the client’s need, the IT service provider has a solution.

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 (he should have bought Accenture instead!)

Culture

EPAM is a founder-led company. Culture is key. IT services are execution heavy businesses. Projects have to be delivered on time and on budget to satisfy the client. Importantly, an IT services company's culture not only reflects its values but also shapes its strategy as well.

From the outset, founder/CEO Arkadiy Dobkin has anchored his organization around a culture of engineering excellence and innovation. While IT services firms may all look and sound quite similar at first, industry insiders and CTOs understand the differentiation.

“Anybody who has worked with EPAM knows that if they’re not the preeminent then they’re in the top two of product engineering, product development companies…Accenture is still a better overall consulting organization, whereas EPAM is still considered - even though Accenture has these capabilities - as the company you want to work with when it’s time to build that product”

- Former Director of Business Development, EPAM (April 2023, Stream Transcript)

“In my opinion, they're probably the best at doing this in the industry. They far away are better than TCS (Tata), Cognizant, your typical offshore vendors. They're really a specialist at modernization of product stacks, which has been great. They have a really good practice around DevOps and modernization. They've been fabulous.”

- CTO at Priceline, an EPAM customer (June 2023, Stream Transcript)

"I would say in my experience in working directly with EPAM is that they have a core engineering expertise that is top shelf. They can bring that to bear on whatever projects or programs that they're involved with. They seem to have a team of core scientific engineers that aren't necessarily dedicated to any particular project but are there to help in any fashion to accelerate or solve very difficult problems that come into play that may stall a project. Their ability to do that is pretty profound."

- EPAM Competitor (February 2022, Stream Transcript)

We believe EPAM’s culture allows it to adeptly navigate technological shifts and keep at the forefront of change. EPAM has invested ahead of new technologies in order to stay relevant with its clients and increase its share of wallet.

Within the IT services industry, there are some net winners and then some net losers. IT work is continuously getting commoditized. Bulge brackets like Accenture or Infosys have a ‘legacy’ business that is facing pricing pressures and negative growth as well as new ‘digital’ business lines that are growing like a weed. Newer IT service companies with very strong engineering capabilities such as EPAM, and others like Endava, Globant, Luxoft (now acquired by DXC), have much more of these ‘digital’ revenues due to which they grow much faster but this also makes them more dependent on discretionary spend. 

The other way to get scale and capabilities is acquisitions. Good providers do many tuck-in acquisitions to gain either expertise or clients. EPAM had done many successful acquisitions over its history and integrated them into their culture.

"When they identified in the past that there's a capability that's going to be in higher demand in the market, and they lack the capability internally, they did the smart thing in my estimation. They went ahead and purchased one or two or several really strong players, and integrated them."

- EPAM Competitor (December 2021, Stream Transcript)

But culture can at times be a double-edged sword. An overly engineering heavy culture has made it challenging for EPAM to evolve into a more integrated practice. EPAM has been pushing towards this strategy, for example, with its 2018 acquisition of Continuum, a consultant specializing in innovative design.

We believe the challenge is less so about EPAM’s internal integration difficulties, but more so a matter of customer perception. Over the years, EPAM seems to have been pigeonholed by most clients as primarily an engineering solutions provider. Perceptions can be hard to change. EPAM’s main client contacts tends to be CTOs, making it difficult to pitch solutions in non-technical fields. On the other hand, competitors like Accenture have direct access to CEOs and CFOs allowing them to be included in a broader range of business and strategy discussions. This is something EPAM’s management is acutely aware of and are trying to address.

AI Narrative

The common bear case against IT services firms goes as follows:

Corporations are going to hire a team of software engineers and then with the help of AI tools like ChatGPT or Bard they will be successful in enabling corporations to build AI capabilities. Software engineers will also become more productive due to which fewer software engineers are needed affecting revenues for IT services companies.

We believe these narratives are totally wrong. Not only will EPAM survive this AI era, but it will thrive within it. Let us explain.

First, a little bit of history. This is actually not the first time that the IT services industry has suffered from similar false narratives. Initially, all IT work was application development but when SAP and Oracle brought packaged software the narrative was that IT services is done; but IT services pivoted to implementing ERP and made out like bandits! Then, cloud software started to become dominant and this software did not require a lot of implementation and the narrative again shifted to the death of the IT services business. But, IT services pivoted to cloud migrations and digitally enabled custom projects that were increasingly possible because of the flexibility offered by the cloud.

Historically, IT services has successfully navigated multiple transformative shifts, and has emerged stronger and more valuable as a result. We think this will be no different in the AI era.

Indulge us here but we asked ChatGPT on how a corporation can incorporate AI into their business - What does one need for machine learning?

“To effectively implement machine learning, several key components and considerations are necessary. Here are the main requirements for machine learning:

Quality Data: This involves relevant, accurate, and properly labeled or annotated data. The data should be representative of the problem domain and cover a wide range of scenarios and examples.

Data Preprocessing: Before feeding data into machine learning algorithms, preprocessing is often required. This includes cleaning the data by removing noise, handling missing values, normalizing or standardizing features, and performing feature engineering to extract meaningful representations.

Machine Learning Algorithms: A variety of machine learning algorithms exist, including supervised learning, unsupervised learning, reinforcement learning, and more. Selecting the appropriate algorithm(s) for the specific task at hand is crucial. 

Training Set: A labeled training set is needed for supervised learning, where the input data and their corresponding target values are available. The training set is used to train the machine learning model by adjusting its parameters or weights based on the provided examples.

(The other key points mentioned are Model Selection and Tuning, Model Training, Model Evaluation, Deployment and Integration and finally, Monitoring and Maintenance)

In essence, what we read above is that there is a LOT of work that needs to be done in order to enable a corporation to reap the benefits of AI. All this work has to be performed by someone! We think EPAM and other engineering-focused IT services providers will be the key enablers of this move to AI.

But we can even take a step back. A significant barrier to the deployment of AI is the prevalence of outdated technology systems and infrastructures within companies. Corporations still have data on premises on different platforms and they first need to bring it in one place and on the cloud to even begin implementing AI. Data processing, computational resources, scalability, security, interoperability, the list goes on and these are all factors that traditional on-premise systems struggle to support when it comes to the requirements of modern AI deployments.

Suppose you are the CTO of a Fortune 500 company. One day, you find over the news that a competitor has started deploying a cutting-edge AI tool that’s leading to higher customer satisfaction. The next day, your CEO comes knocking and asks when can we deploy this. Will you tell him to wait another year? There is competitive pressure now for CTOs to ensure that their companies are “AI ready”. And here, EPAM's expertise comes into play.

“They (EPAM) are what I'd say a best-in-class company for modernizing tech stacks…they're building out our real-time data infrastructure for us now to train and build out all of our machine learning models. They're doing that right now and they're well-positioned to do that. The generative AI stuff, we're going to do in-house just because we have a large data science population already and have been doing machine learning for quite some time. Any of the heavy lifting around modernizing our data infrastructure over the next couple of years, EPAM will be doing that work.”

- CTO at Priceline, an EPAM customer (June 2023, Stream Transcript)

AI could also act as a further tailwind for the trend of IT outsourcing. AI is more complex, open-ended, and brings in an entirely new set of risks and considerations. Further, the potential cost of mishaps could be greater with AI. This should lead to more outsourcing, because firstly, firms will likely struggle to keep pace internally with rapid advancements, and secondly, management will be reluctant to shoulder accountability that is so foreign to them. Historically, consultants and IT services firms have thrived on complexity, often capturing a large share of customer wallets through new services.

But what about the risk that the billable hours decrease due to higher productivity from AI?

Lower level tasks will get automated while software engineers will migrate over time to high level tasks. Keep in mind that code writing may be 20-30% of a project. The balance is requirements gathering, use case development, design, and testing. Determining the business problem and coming up with a commercial solution is the end product and not lines of code.

What’s also missing in the discussion is that IT services companies could bill at a higher rate for high-value added services:

“The people they are bringing on are people that are billable at 3X or 4X of what a standard junior person is…I just think they (EPAM) are better positioned at leveraging technology to reduce, let’s say headcount size, but that revenue number is always going to continue to increase.”

- Former Director of Business Development, EPAM (April 2023, Stream Transcript)

Lastly, we caution against any linear thinking. It’s impossible to know at this point what kind of market expansion AI will bring. For example, the internet brought along the whole field of cybersecurity, now a $200 bn market created from ‘scratch’. What do you think AI could do? Whatever it may be, we are confident that IT services firms will be among the first to seize those new opportunities.

To wrap up, what is happening now?

We think the factor that is playing into the current revenue softness at EPAM is that whenever a new technology comes into play, clients usually want to see it mature a little before they fully commit. Initially, they sanction experimental projects and proof of concepts before committing serious dollars to the new technology. We believe this is 2-4 quarters away. Hence, EPAM is a delayed AI winner.

This is a company which investors should accumulate during patches of soft IT spending. You’d want sufficient exposure before the next wave of spending comes. As long as IT budgets are increasing, the better IT service providers will find things to do. We believe AI is a net enabler and will lead to accelerated growth in revenues and earnings for IT services companies like EPAM.

By the way, we have focused on EPAM in this report, but a lot of what we wrote also applies to its digital focused peers like Endava or Globant.

Conclusion

EPAM remains a high quality founder-led business that has hit a rough patch. We believe that this is a small bump and EPAM will get back to growth in a few quarters. 

Overall, the company can be had for 21x depressed 2023 guided earnings (this is on a non-GAAP basis). Before 2022, analysts had estimates going to $16 per share in earnings for EPAM by 2025. While this is no longer possible, we model $14 per share in 2025 and $16+ per share in 2026. In addition to the reduction in growth, EPAM is also not optimized when it comes to margins. We believe it can move on to high teens margins in a more normalized environment. 

In all this, AI remains a big variable and we think the surprise is likely to be on the upside. 

This is a $320-400 stock in three years if they can do $16+ in earnings per share in 3 years and get valued at 20-25x earnings. It is more likely than not that the multiple will be much higher if they do return to 15% plus growth. 

Importantly, EPAM has a strong balance sheet with $1.7 bn in net cash and can buy back more shares or do tuck-in M&A to further enhance shareholder value. EPAM has a $500 mn buyback authorization in place which should help with dilution and earnings accretion. 

Economic cycle is a big risk. IT service providers are dependent on IT budgets which are then dependent on revenues. If there is a downturn in the economy and revenues come down - that will affect IT budgets. 

Disclosure: The author(s) of this report have a long position in EPAM

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