Best Of Breed: EPAM Systems – EPAM Systems (NYSE:EPAM)


Background

EPAM Systems (EPAM) is a leading IT outsourcing firm that is an under-the-radar name in consultancy. EPAM provides software product development and digital platform services primarily in North America, Europe, Asia, and Australia. The company was founded in 1993 by Arkadiy Dobkin who goes by Ark. Ark realized the success of Indian consultancy firms such as Tata Consultancy Services Limited (OTCPK:TTNQY), Wipro Limited (WIT), and Infosys Limited (INFY). Ark has strong connections back in Belarus and Eastern Europe where the caliber of software engineers is very high. This created a clear opportunity and Ark has executed very well ever since. EPAM’s high level of execution from its IPO in February 2012 has led the stock price to increase from $14/share to $114.63 or a 714.29% increase over a 7-year period. Ark and his team continue to grow through both organic and strategic acquisitions and I expect EPAM’s outperformance of the market to continue.

Economic Moat

EPAM has significant stickiness to its service offerings, which can be best demonstrated by its customer retention. EPAM has 90% customer retention for clients who have been with the firm longer than 1 year. It has a loyal client base with its 10 top clients using EPAM’s consultancy services for an average of 10 years. Its top 5 customers have been utilizing EPAM’s IT services for 11 years.

The strong loyalty among customers has allowed Ark to have 80-90% visibility into the annual revenue. Strong client loyalty has enabled EPAM to have tremendous organic growth with 31 consecutive quarters growing 20% or more. This is a stunning feat among any business and is far superior over its peers such as Cognizant (CTSH), Wipro Limited, and Infosys Limited. (Source)

EPAM has managed to almost triple its revenue in the last 4 1/2 years from $157.6M (all numbers are in USD) in Q4 2013 to $468.2M in Q2 2018. Wipro in the same time frame has grown revenue from $1.82B to $2.01B, Infosys from $2.09B to $2.92B, and Cognizant – strongest of the group – going from $2.42B to $4.08B (source SA data). Stagnating revenue at Wipro and slowing growth rates at Infosys point to stronger competitors in the market such as EPAM. Even Cognizant which is best of breed among peers, in my opinion, has seen growth rate drop from around 20% annually in 2013/2014 to currently high single-digits. One caveat to be mentioned is that it is easier for smaller companies to have their growth rate increase faster.

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The strength of EPAM’s services is a mix of quality of talent, strong leadership, and lower cost of IT talent as over 80% of its workforce is in Belarus, Ukraine, Russia, and Central Europe. Russia, Poland, Hungary, Czech Republic, Ukraine, and Bulgaria are all ranked in the top 12 countries according to HackerRank.

(Source)

These countries are the central talent hubs for EPAM. The source is from 2016, but should fairly accurately reflect current talent pools. The extreme software talent in Central/ Eastern Europe compares very well to its Indian competitors as India is ranked at #31. Forrester Research has also indicated that EPAM is far superior to its IT consulting peers in both strategy and market presence:

(Source)

Revenue Diversification

The original focus for Ark and the EPAM team was predominantly on software and high-tech software firms at the beginning. Software and high-tech firms accounted for 75% of sales in 2006. Ark has been able to diversify his revenue base very well so that software/high-tech firms only account for 19% of sales as of Q3 2018. EPAM has made major inroads with multiple industries that proves not only its superior technology solutions, but also its ability to have strong domain knowledge required by many leading companies.

EPAM Systems is currently working with 5 of the top 10 biggest investment firms in the world, 9 of the top 10 pharmaceutical companies, and all 4 of the biggest Broadcast Network firms. Furthermore, EPAM delivers consultancy services to 14 of the top 30 Broadcast. Picking up new customers outside of its traditional software market shows the malleability of EPAM’s offerings. Significant industry and increasing geographic revenue streams show a solid proof of concept for EPAM to grow into new markets and new industries.

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(Source)

Intangibles

Investing in founder-led companies has always proven better results for myself as there is inherently more attachment to company performance. Ark has been running EPAM for 26 years now and I hope to see him continue for much longer. Founder-led companies also typically have managements which have an outsized portion of their wealth tied to the stock price performance. Ark is no different with currently owning 4.1% of EPAM or slightly over 250M in stock.

The high level of interest alignment with shareholders is typically a very good sign when I am researching companies. Ark has multiple votes of confidence from his employees with an 88% CEO approval, 78% would recommend EPAM to peers, and a 3.8 score for employment with EPAM. Having a founder who is highly dedicated to the company, strong financial alignment with shareholders, and strong employee confidence code well to creating significant alpha.

(Source)

Risks

The main risk I see for EPAM is if and when Ark decides to retire. I think anytime a company has been run by a single leader for such a long time, it is hard for a successor to successfully run a company with the same level of efficiency and passion. I do not know of any succession plans in place. When Ark announces any significant step-down in responsibility, I will certainly be keen to see who steps up to make the major decisions. Ark is currently only 58, so he could feasibly be with the company for a very long time. There are many founders who run their companies well into their 60s and 70s and even longer as demonstrated by Warren Buffett (88) and Charlie Munger (95), so this does not seem like an imminent concern.

Financials

EPAM has a rock-solid balance sheet with $685.1M in cash and only $25M in long-term debt. Operations are very profitable with Q3 2018 cash flow from operations totaling $102.3M. There should be no need for any type of significant equity raise and shareholder dilution in the near future. EPAM has a 27% CAGR for the last 5 years and 31 consecutive quarters with 20%+ organic growth. Given long-established relationships with key customers and a growing number of strategic accounts, EPAM is in a great position to continue its outperformance.

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Accounts worth $20M+ in value have grown significantly from 4 in 2013 to over 10 in 2017. Accounts valued $10-20M have doubled from 8 to 16 over the same period. There is a very clear trend in EPAM’s ability to acquire and grow key accounts and I fully expect this trend to continue.

(Source)

Investment Thesis

I believe that IT consulting firms in general will become more in demand as technology’s increased rate of change will necessitate outsourcing highly complex tasks to specialists like EPAM Systems. EPAM’s current market cap is $6.27B as of this writing. Consulting peers such as Cognizant at $36.76B, Infosys at $41.59B, and Wipro at $23.21B show that there is still plenty of opportunity to steal existing market share, let alone any industry growth. EPAM is still a small player in a large industry that I believe has proven its ability to outperform its peers. I personally like to invest in companies that are relatively small to their field, thus reasonably enabling a company to increase 5x or 10x its current market cap over a long period of time.

EPAM Systems is an underfollowed consulting firm that has proven its ability to outperform its peers. EPAM has proven its ability to acquire, retain, grow, and profitably service clients in existing and new markets. Ark is highly dedicated to the company, has strong financial alignment with shareholders, and strong employee confidence. Consistent growth in revenue, earnings, cash flow, and customer stickiness make EPAM Systems a high conviction pick. I would recommend a buy and hold strategy for EPAM at or below $120/share.

Disclosure: I am/we are long EPAM. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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