EPAM Systems

EPAM's second-quarter revenue grew 3% year over year in constant currency. GAAP operating margin improved by 150 basis points to 10.8%. Management's revision of full-year revenue growth outlook to 3.2%-4.2% from 4.0%-6.5% sent shares down 14% in intraday trading.

Why it matters: Results by business groups were mixed. Financial services and healthcare maintained strong momentum, posting 12% and 8% respective year-over-year growth. Project ramp-downs led to software's 1.3% year-over-year revenue decline. EMEA had another quarter of double-digit growth, but Americas' revenue only expanded 0.5% year over year, the softest result in over two years. Management attributed the guidance revision to an underwhelming go-to-market motion in North America. We model a stable selling, general, and administrative expenses ratio of around 16.5% over the next five years, reflecting steady go-to-market investment to bring EPAM's outstanding growth record in Europe to North America.

The bottom line: We maintain our $136 fair value estimate for no-moat EPAM. Shares currently look undervalued. We believe the North America headwind is temporary and should improve as enterprise IT spending sentiment recovers. EPAM's client relations are solid in this region. It is a smaller service provider, but we do not think EPAM's service delivery is behind any competitors. Recent partnerships with OpenAI, Anthropic, and Google support its comprehensive service portfolio, which effectively addresses enterprises' needs. We believe the market is underappreciating EPAM's margin improvement. Gross margin was 30.4% this quarter, and management expects gross margin to surpass 32% for the rest of the year. The cost discipline should give EPAM more resources for artificial intelligence and go-to-market investments.

Key stats: Expected free cash flow conversion of 70% in 2026 is below the typical level of 80% and above but should not affect EPAM's capital allocation strategy around stock repurchases.

Another metric that might have raised investor concerns was that revenue from time-and-materials contracts increased by 20 basis points to 78%, which is opposite to the general trend of fixed-price contracts taking a larger share in IT services. We think the increase in time-and-materials contracts is linked to EPAM's temporary softness in North America, and investors are making too early a call if they interpret it as a sign of the company losing pricing power. Over the long term, we expect EPAM's percentage of revenue from fixed-price contracts to continue rising.

Our fair value estimate for EPAM Systems is $136 per share, which implies an adjusted price/earnings ratio of 10 times and an enterprise value/adjusted EBITDA ratio of 5 times. We model a 5% cumulative annual growth rate for EPAM over the next five years, mainly driven by the secular demand of discretionary IT spending as companies develop new digital experiences leveraging AI and other emerging technologies.

We think the long-term demand for digital transformation services is solid, given the secular increase in people’s reliance on digital tools for all kinds of tasks. However, with AI-assisted coding tools quickly gaining traction, it remains to be seen where companies like EPAM stand in an expanded ecosystem, where the barrier to software engineering is much lower than before. In addition, we expect continued expansion of EPAM’s consulting business, which should add nice growth to the top line once the macroeconomic environment improves.

We forecast EPAM’s gross margin to stabilize around 30% and a moderate operating margin expansion to 12% from 10% over the next five years. Expansion into higher-end consulting services and AI-led productivity gains should become a major margin tailwind for EPAM, which is largely offset by wage increases across offshore locations and increased competition in the IT services industry due to the prevalence of agentic AI. Integration of acquired companies that have a different margin profile can also adversely affect EPAM’s margin, as it takes time to achieve synergies between two entities.

We assign EPAM Systems a no-moat rating.The company has gone through a lot of turmoil over the past decade, including a cyclical downturn in IT services demand, political unrest in Belarus, and the war between Russia and Ukraine. However, EPAM’s operations remained resilient, and the firm quickly adapted to a new environment by distributing its employee base from Eastern Europe to other regions and continents. More recently, generative AI started to show its potential to disrupt knowledge-based work, including IT services. One of the areas that has already seen major change with AI is software development, which overlaps with the kind of projects that EPAM undertakes for its customers. Therefore, we are not confident that EPAM can keep its return on invested capital above its cost of capital over the next decade.

Unlike many of its larger counterparts that provide a full menu of IT services, EPAM has a clear focus on consulting and digital platform engineering—key components that help clients bring new digital experiences to their consumers. These projects are usually highly customized, and most customers come to EPAM not knowing exactly how existing digital tools can help them achieve their business goals. As a pioneer in software development, EPAM can leverage its deep pool of professionals to quickly adjust its workflow according to evolving client needs. After EPAM gains more knowledge about the client’s profile, it can create some friction for clients to switch to another service provider for additional updates and maintenance projects. As of 2024, over 65% and over 34% of EPAM’s revenue came from clients that have been with the company for at least five and 10 years, respectively.

We think EPAM’s shift to a more balanced global delivery model can enhance its ability to retain customers. Before the 2010s, EPAM relied heavily on engineers based in Belarus, Ukraine, and Russia to take advantage of the relatively low labor costs in these countries. However, with the introduction of advanced real-time collaboration tools and an agile software development framework, many clients now view traditional software outsourcing to offshore locations as a less flexible approach that does not necessarily offer optimized efficiency when delivering digital experiences based on new technologies. EPAM has been consistently promoting a more distributed delivery model where clients can collaborate with contractors in the same time zone, and the Russia-Ukraine war has significantly accelerated this process. Nowadays, EPAM has large engineering bases across India, Eastern Europe, Central Asia, and Latin America to better serve its customers around the world.

Nowadays, there are many emerging generative AI tools that can produce applications just like an entry-level software engineer, and they pose a tangible threat to the long-term demand for customized application development. We like EPAM’s strategy to constantly expand its capacity based on clients’ project scopes in response to these new AI-based programming tools. An expanded partner ecosystem that includes AWS, Microsoft Azure, and Google Cloud gives EPAM the capability to undertake large-scale system integration projects that go beyond the clients’ internal tech expertise, creating more opportunities for EPAM to augment the lifetime value of a customer by carving out a larger part of their IT spending. Operational stability is key to any digital transformation project. If the service provider that developed the incumbent system has capacity, customers usually stay with them for follow-on projects, as switching to another vendor can potentially lead to service disruptions and cost overruns due to the new vendor’s unfamiliarity with existing processes and tech stack. We believe further expansion of EPAM’s system integration capabilities can help the company accumulate its switching costs in the AI era.

We see some signs of intangible assets for EPAM. The company has accumulated much technical expertise by establishing in-depth relationships with key customers such as Epic Games. In addition, EPAM’s integrated offerings, like Continuum, where the company combines consulting and technology to reinvent customer experience, are a service unique to EPAM. However, we still think EPAM’s specialized knowledge is too thin to support an economic moat on a stand-alone basis at the moment. To earn a moat based on intangible assets, we need stronger evidence that EPAM can transform its relatively high positioning on the IT services value chain into a durable margin advantage over its peers.

EPAM’s expansion into system integration workflows and an expanded partnership ecosystem should help the company carve out a bigger share of total enterprise IT spending.

EPAM has a big presence across all major IT outsourcing destinations, which means the company is more flexible to adjust its workforce based on market demand and keep its cost structure under control.

EPAM’s consulting capabilities continue to grow, allowing the company to take on higher-margin integrated digital projects that leverage different capabilities at the same time.

EPAM’s core workflows are more discretionary in nature, which means the company can take a larger hit during economic downturns.

EPAM is a relatively small IT services provider, and it can be challenging for the company to coordinate service delivery across four different regions around the world.

Artificial Intelligence is becoming more prevalent in application development, potentially hurting the long-term demand for EPAM’s services.