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EPAM SYSTEMS, INC. - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations(Edgar Glimpses Via Acquire Media NewsEdge) You should read the following discussion and analysis of our financial condition and results of operations together with our Annual Report on Form 10-K for the year ended December 31, 2013 and the unaudited condensed consolidated financial statements and the related notes included elsewhere in this quarterly report. In addition to historical information, this discussion contains forward-looking statements that involve risks, uncertainties and assumptions that could cause actual results to differ materially from management's expectations. Factors that could cause such differences are discussed in the sections entitled "Forward-Looking Statements" in this item and "Part II. Item 1A. Risk Factors." We assume no obligation to update any of these forward-looking statements. In this quarterly report, "EPAM," "EPAM Systems, Inc.," the "Company," "we," "us" and "our" refer to EPAM Systems, Inc. and its consolidated subsidiaries. Executive Summary We are a leading global IT services provider focused on complex software product development services, software engineering and vertically-oriented custom development solutions. Since our inception in 1993, we have been serving independent software vendors, or ISVs, and technology companies. The foundation we have built serving ISVs and technology companies has enabled us to differentiate ourselves in the market for software engineering skills and technology capabilities. Our work with these clients exposes us to their customers' challenges across a variety of industry "verticals." This has enabled us to develop vertical-specific domain expertise and grow our business in multiple industry verticals, including Banking and Financial Services, Business Information and Media, and Travel and Consumer. We have client management locations in the United States, Canada, the United Kingdom, Germany, Sweden, Russia, Switzerland, Netherlands, Kazakhstan, Singapore, Hong Kong, China and Australia. Our clients primarily consist of Forbes Global 2000 corporations located in North America, Europe and the CIS. Our delivery centers in Belarus, Ukraine, Russia, Hungary, Kazakhstan, Armenia, Poland and China are strategically located in centers of software engineering talent and educational excellence. The majority of our employees are located in these delivery centers with compensation and benefits related to this pool of resources being the primary component of our operating expenses. Additionally, our global delivery model and centralized support functions, combined with the benefits of scale from the shared use of fixed-cost resources, such as computers and office space, enhance our productivity levels and enable us to better manage efficiency of our global operations by maintaining adequate resource utilization levels and implementing company-wide cost-management programs. As a result, we have managed to create a relatively homogeneous delivery base whereby our applications, tools, methodologies and infrastructure allow us to seamlessly deliver services and solutions from our delivery centers to global clients across all geographies, thereby further strengthening our relationships with them. Our focus on delivering quality to our clients is reflected by an average of 93.9% and 78.4% of our revenues in 2013 coming from clients that had used our services for at least one and two years, respectively. Year-to-Date 2014 Developments and Trends During the first half of 2014, our revenues were $335.1 million, an increase of approximately 30% over $257.4 million reported for the same period a year ago. Our performance remained strong across all of our key verticals, driving revenue growth in North America and Europe. We remain committed to maintaining and improving a well-balanced portfolio of clients. During the first half of 2014, our top five and top ten customers accounted for 33.1% and 44.9% of consolidated revenues, respectively. We seek to grow revenues by continually expanding the scope and size of our engagements, as well as by growing our key customer base through internal business development efforts and strategic acquisitions. During the first half of 2014, we made progress in this strategy and increased the reach of our offerings, both geographically and across industry verticals. On March 5, 2014, we completed an acquisition of substantially all of the assets of U.S.-based healthcare technology consulting firm Netsoft Holdings, LLC and Armenia-based Ozsoft, LLC (collectively, "Netsoft"). Netsoft works with leading health plans in the U.S. on their medical management and claims systems, and specializes in working with leaders in pioneering fields such as accountable care organizations, tele-medicine, healthcare analytics, personalized medicine, health information exchanges, and online self-service capabilities. The Netsoft acquisition added approximately 40 IT professionals to our headcount. On April 30, 2014, we acquired all of the outstanding equity of Joint Technology Development Limited, a company organized under the laws of Hong Kong, including its wholly-owned subsidiaries Jointech Software (Shenzhen) Co., Ltd., a company organized under the laws of China, and Jointech Software Pte. Ltd., a company organized under the laws of Singapore 22-------------------------------------------------------------------------------- Table of Contents (collectively, "Jointech"). Jointech provides strategic technology services to multi-national organizations in investment banking, wealth and asset management. The acquisition of Jointech added over 200 IT professionals to our headcount and significantly extended our footprint in South-East Asia. With this acquisition, we expect to create an integrated global platform focused on serving large multinational customers within the Banking and Financial Services vertical, and extend our global value proposition in the region. On June 6, 2014, we acquired substantially all of the assets and assumed certain specified liabilities of each of GGA Software Services, LLC, Institute of Theoretical Chemistry, Inc., and GGA's Russian affiliate (collectively, "GGA"). Established in 1994, GGA develops best-in-class scientific informatics applications and content databases; creates state-of-the-art algorithms and models; and delivers IT support, maintenance, and QA services to the world's leading healthcare and life sciences companies, including eight of the top ten largest pharmaceutical companies. The acquisition added over 300 IT professionals and over 120 scientists to our highly-experienced employee base and created a significant growth opportunity in the Life Sciences and Healthcare industry verticals. We also see tremendous potential in combining our traditionally recognized strengths with GGA's algorithm development, mathematical modeling, and sophisticated content database development capabilities. The capability to develop and operationalize platforms, combining tools, models and data, has broad applications across other strategic industries on which EPAM focuses, including the Banking and Financial Services, Business Information and Media, and Retail and Consumer verticals. Summary of Results of Operations and Non-GAAP Financial Measures The following table presents a summary of our results of operations for the three and six months ended June 30, 2014 and 2013: Three Months Ended Six Months Ended June 30, Increase June 30, Increase 2014 2013 Dollars Percentage 2014 2013 Dollars Percentage (in thousands, except percentages) Revenues $ 174,695 $ 133,184 $ 41,511 31.2 % $ 335,079 $ 257,382 $ 77,697 30.2 % Income from operations 18,476 17,535 941 5.4 % 40,333 33,071 7,262 22.0 % Net income 14,814 14,118 696 4.9 % 32,178 26,798 5,380 20.1 % The key highlights of our consolidated results for the second quarter of 2014 and six months ended June 30, 2014, as compared to the corresponding periods of 2013, were as follows: • The European geography continued its strong performance, generating revenue growth of $20.5 million and $42.6 million during the three and six months ended June 30, 2014, or 42.9% and 45.7%, respectively, over the corresponding periods of 2013; • Revenue increased in all our key verticals, and in particular within the Banking and Financial Services and Travel and Consumer verticals, which grew $17.0 million and $7.7 million, respectively, in the second quarter of 2014 over the corresponding period of 2013, and $31.9 million and $16.9 million on a year-to-date basis. • Our organic growth was complemented by three completed strategic acquisitions which expanded our highly skilled employee base, geographic footprint and service capabilities. In addition, we added capabilities in the Healthcare and Life Sciences vertical forming a foundation for emerging verticals. • Income from operations grew by 5.4% and 22.0% during the three and six months ended June 30, 2014, respectively, compared with the three and six months ended June 30, 2013. As a percentage of revenues, income from operations decreased by 2.6% and 0.8% during the three and six months ended June 30, 2014, respectively, over the corresponding periods in 2013. The decrease was due to a combination of factors, including an increase of over $2.0 million in stock-based compensation expense, a $1.6 million increase in amortization expenses related to our 2014 acquisitions, and a $2.0 million writedown of prepaid assets to adjust the book value of prepaid construction costs to an estimated recoverable amount. • Net income increased by 4.9% during the second quarter of 2014 compared with the corresponding period of 2013. On a year-to-date basis, the net income increased by 20.1% over the corresponding period of 2013. Expressed as a percentage of revenues, our net income decreased by 2.1% and 0.8% during the three and six months ended, respectively, due to the items noted above, as well as the adverse effects of higher effective tax rate and foreign exchange rate changes in 2014 when compared to last year. The operating results in any period are not necessarily indicative of the results that may be expected for any future period. 23-------------------------------------------------------------------------------- Table of Contents In our quarterly earnings press releases and conference calls, we discuss the following key measures that are not calculated according to U.S. generally accepted accounting principles ("GAAP"): • Income from operations, as reported on our consolidated and condensed statements of income and comprehensive income, excluding certain expenses and benefits, which we refer to as "non-GAAP income from operations." • Non-GAAP income from operations as a percentage of reported revenues, which we refer to as "non-GAAP operating margin." We believe that these non-GAAP measures help illustrate underlying trends in our business, and we use these measures to establish budgets and operational goals (communicated internally and externally), manage our business and evaluate our performance. We also believe these measures help investors compare our operating performance with our results in prior periods and compare our operating results with those of similar companies. We exclude certain expenses and benefits from non-GAAP income from operations that we believe are not reflective of these underlying business trends and are not useful measures in determining our operational performance and overall business strategy. Because our reported non-GAAP financial measures are not calculated according to GAAP, these measures are not comparable to GAAP and may not be comparable to similarly described non-GAAP measures reported by other companies within our industry. Consequently, our non-GAAP financial measures should not be evaluated in isolation from or supplant comparable GAAP measures, but, rather, should be considered together with our consolidated and condensed financial statements, which are prepared according to GAAP. The following table presents a reconciliation of income from operations as reported on our condensed consolidated statements of income and comprehensive income to non-GAAP income from operations and non-GAAP operating margin for the three and six months ended June 30, 2014 and 2013: Three Months Ended Six Months Ended June 30, June 30, 2014 2013 2014 2013 (in thousands, except percentages) GAAP income from operations $ 18,476 $ 17,535 $ 40,333 $ 33,071 Stock-based compensation expense 5,891 3,850 9,099 6,426 Amortization of purchased intangible assets 2,222 704 2,872 1,403 Acquisition-related costs 299 10 880 48 One-time items 2,000 (331 ) 2,000 (331 ) Non-GAAP income from operations $ 28,888 $ 21,768 $ 55,184 $ 40,617 GAAP operating margin 10.6 % 13.2 % 12.0 % 12.8 % Effect of the adjustments detailed above 5.9 % 3.1 % 4.5 % 3.0 % Non-GAAP operating margin 16.5 % 16.3 % 16.5 % 15.8 % From time to time, we acquire businesses and incur operating expenses which we would not otherwise have incurred. Such expenses include acquisition-related costs and amortization of acquired intangible assets. These costs are dependent on a number of factors and are generally inconsistent in amount and frequency, as well as significantly impacted by the timing and size of related acquisitions. Additionally, the size, complexity and volume of past acquisitions, which often drives the magnitude of acquisition-related costs, may not be indicative of the size, complexity and volume of future transactions. Amortization of purchased intangible assets is excluded from our non-GAAP measures to allow management to evaluate our operating results as if these assets have been developed internally rather than acquired in a business combination. We believe this approach provides a supplemental measure of performance in which the acquired intangible assets are treated in a manner comparable to the internally developed assets. Stock-based compensation expense is excluded from our non-GAAP measures because we believe such exclusion allows for a more accurate comparison of our operating results among the periods, as well as enhances comparability with operating results of peer companies. We also exclude certain other expenses and one-time charges because we believe they are not indicative of what we consider to be organic, continuing operations. Such items include goodwill impairment write-offs, legal settlement expenses, and certain other non-cash one-time charges. See our "Results of Operations" section below for a more detailed discussion and analysis of these charges. 24-------------------------------------------------------------------------------- Table of Contents We have significant international operations, and we earn revenues and incur expenses in multiple currencies. When important to management's analysis, operating results are compared in "constant currency terms", a non-GAAP financial measure that excludes the effect of foreign currency exchange rate fluctuations. The effect of rate fluctuations is excluded by translating the current period's revenues and expenses into U.S. dollars at the weighted average exchange rates of the prior period of comparison. See Item 3, "Quantitative and Qualitative Disclosures About Market Risk" of this report for a discussion of our exposure to exchange rates. Effects of Inflation Economies in CIS countries such as Belarus, Russia, Kazakhstan and Ukraine have periodically experienced high rates of inflation. Ukraine has been recently undergoing heightened political and economic turmoil. Yearly inflation, by various estimates, is forecasted to reach 14% to 16% by the end of 2014. Despite $3.2 billion received from the International Monetary Fund and additional $13 billion pledged by other international organizations and countries in 2014, the negative outlook in Ukraine's economy continues. In addition, in March 2014, several credit rating agencies revised their outlook on Russia to negative to reflect potential material and unanticipated financial and economic consequences of sanctions that the European Union and United States may impose in connection with situation in the Crimea region. In February 2014, the government of Kazakhstan devalued the local currency, tenge, by 19%. The government is currently forecasting inflation of 6% to 8% in 2014, however, political and economic instability in the region contribute to the economic uncertainty in Kazakhstan. Over a three-year period ended December 31, 2013, significant inflation has been reported in Belarus. The National Statistical Committee of Belarus estimated that inflation was approximately 118.3% in 2013 and it continued to ramp during the first half of 2014. The measures currently used by the Belarusian government to control this recent inflation include monetary policy and pricing instruments, including increasing interest rates and the use of anti-monopoly laws to prevent the increase in pricing of goods, as well as privatization and using foreign borrowings to replenish the budget and stabilize local currency. Inflation, government actions to combat inflation and public speculation about possible additional actions have also contributed materially to economic uncertainty in Belarus. Belarus may experience high levels of inflation in the future. In the first half of 2014, we had approximately $0.9 million, or 0.3%, of our revenues denominated in Belarusian rubles. Periods of higher inflation may slow economic growth in those countries. Inflation also is likely to increase some of our costs and expenses, which we may not be able to pass on to our clients and, as a result, may reduce our profitability. Inflationary pressures could also affect our ability to access financial markets and lead to counter-inflationary measures that may harm our financial condition, results of operations or adversely affect the market price of our securities. Results of Operations The following table sets forth a summary of our consolidated results of operations for the periods indicated. This information should be read together with our unaudited condensed consolidated financial statements and related notes included elsewhere in this quarterly report. The operating results in any period are not necessarily indicative of the results that may be 25-------------------------------------------------------------------------------- Table of Contents expected for any future period. Three Months Ended Six Months Ended June 30, Increase June 30, Increase 2014 2013 Dollars Percentage 2014 2013 Dollars Percentage (in thousands, except percentages) Revenues $ 174,695 $ 133,184 $ 41,511 31.2 % $ 335,079 $ 257,382 $ 77,697 30.2 % Operating expenses: Cost of revenues (exclusive of depreciation and amortization)(1) 110,102 83,547 26,555 31.8 % 212,556 161,484 51,072 31.6 % Selling, general and administrative expenses(2) 38,671 28,541 10,130 35.5 % 71,030 55,624 15,406 27.7 % Depreciation and amortization expense 5,451 3,854 1,597 41.4 % 9,140 7,471 1,669 22.3 % Other operating expenses, net 1,995 (293 ) 2,288 (780.9 )% 2,020 (268 ) 2,288 (853.7 )% Income from operations 18,476 17,535 941 5.4 % 40,333 33,071 7,262 22.0 % Interest and other income, net 1,164 769 395 51.4 % 2,140 1,399 741 53.0 % Foreign exchange loss (1,239 ) (869 ) (370 ) 42.6 % (2,480 ) (1,368 ) (1,112 ) 81.3 % Income before provision for income taxes 18,401 17,435 966 5.5 % 39,993 33,102 6,891 20.8 % Provision for income taxes 3,587 3,317 270 8.1 % 7,815 6,304 1,511 24.0 % Net income $ 14,814 $ 14,118 $ 696 4.9 % $ 32,178 $ 26,798 $ 5,380 20.1 % (1) Included $2,525 and $1,079 of stock-based compensation expense for the three months ended June 30, 2014 and 2013, respectively, and $3,928 and $1,858 of stock-based compensation expense for the six months ended June 30, 2014 and 2013, respectively; (2) Included $3,366 and $2,771 of stock-based compensation expense for the three months ended June 30, 2014 and 2013, respectively, and $5,171 and $4,568 of stock-based compensation expense for the six months ended June 30, 2014 and 2013. Three and Six Months Ended June 30, 2014 Compared to the Three and Six Months Ended June 30, 2013 Revenues During the three and six months ended June 30, 2014, our revenues grew in excess of 30.0% over the corresponding periods in 2013, to a record $174.7 million and $335.1 million of revenues, respectively. The increase was attributable to a combination of factors, including deeper penetration to existing customers and attainment of new customers, both organically and through acquisitions, which became accretive to our revenues from the date of acquisition. During the three months and six months ended June 30, 2014, revenues in North America, our largest geography, grew $18.4 million and $34.7 million, or 27.0% and 26.5%, respectively, over the same periods last year. Expressed as a percentage of consolidated revenues, the North America geography accounted for 49.6% and 49.4% during the three and six months ended June 30, 2014, respectively, which represented a decrease of 1.6% and 1.5% over the corresponding periods in 2013. The decrease was primarily a result of accelerated growth in Europe. Revenues from our Travel and Consumer vertical increased by $3.0 million, or 23.9%, in the second quarter of 2014 as compared to the corresponding period of 2013, and $8.3 million, or 36.1%, on a year-to-date basis. The increase in this vertical was primarily driven by the fast expansion of our strategic relationship with a large retail chain, which we acquired in 2012. This customer has been one of our top ten customers since the second quarter of 2013. During the three and six months ended June 30, 2014, revenues from this customer accounted for 12.2% and 17.3% of total revenue growth in North America, respectively. During the first half of 2014 we continued our focus on creating synergies with customers in other verticals, including such industry segments as Healthcare Insurance and Life Sciences. During the three and six months ended June 30, 2014, combined revenues from customers in the Other vertical accounted for $6.9 million, or 37.3%, and $12.3 million, or 35.5%, of the overall growth in the North America geography, respectively. 26-------------------------------------------------------------------------------- Table of Contents During the three and six months ended June 30, 2014, revenues from the Business Information and Media vertical increased by $3.4 million, or 25.5%, and $5.9 million, or 22.0%, over the corresponding periods of 2013. The growth in this vertical in 2014 was attributable to additional revenue streams created by our 2012 acquisitions, as well as resumed growth in revenues from certain long-time customers, including Thomson Reuters. Our ISVs and Technology vertical accounted for 19.2% and 16.1% of total growth during the three and six months ended June 30, 2014, respectively. During the three and six months ended June 30, 2014, our Banking and Financial Services vertical remained our dominant vertical in Europe and accounted for 56.4% and 61.3%, respectively, of overall revenue growth in this geography. During the second quarter and first half of 2014, revenues from the Banking and Financial Services vertical increased $11.6 million, or 47.9%, and $26.1 million, or 57.2%, respectively, over the corresponding periods of 2013. It was also our largest and fastest growing vertical on a consolidated basis. Continued solid performance of the Banking and Financial Services vertical was attributable to an increased demand for our services and ongoing relationships with existing customers located in Europe. In particular, 19.9% and 26.5% of consolidated revenue growth during the three and six months ended June 30, 2014 was attributable to increased business from certain our largest customers located in the United Kingdom and Switzerland. Furthermore, we continue to see growing demand for our services from European-based customers within the Travel and Consumer and Business Information and Media verticals. During the three and six months ended June 30, 2014, combined revenues from these verticals increased by $6.3 million and $12.0 million, respectively, over the corresponding periods last year and accounted for 30.9% and 28.1% of total growth in this geography during periods indicated. Revenues in the CIS geography decreased $0.8 million, or 5.4%, during the three months ended June 30, 2014, and $3.5 million, or 11.4%, on a year-to-date basis as compared to the corresponding periods of 2013. The decrease in revenues was primarily attributable to revenue recognition delays related to fixed-price projects, budgetary delays with certain customers located in Russia, as well as decline in revenues from one of our largest customers in Kazakhstan. Cost of Revenues (Exclusive of Depreciation and Amortization) During the three months ended June 30, 2014, cost of revenues (exclusive of depreciation and amortization) was $110.1 million representing an increase of 31.8% over the corresponding period of 2013. As a percentage of revenues, cost of revenues (exclusive of depreciation and amortization) increased by 0.3% to 63.0% of consolidated revenues. An increase in cost of revenues (exclusive of depreciation and amortization) in the second quarter of 2014 was primarily driven by a $25.8 million increase in personnel-related costs, including an increase in stock-based compensation expense of $1.4 million. The increase was mainly attributable to a 16.7% growth in the average production headcount as compared with the second quarter of 2013. During the six months ended June 30, 2014, cost of revenues (exclusive of depreciation and amortization) was $212.6 million representing an increase of 31.6% over the corresponding period of 2013. As a percentage of revenues, cost of revenues (exclusive of depreciation and amortization), increased 0.7% over the corresponding period of 2013, to 63.4% of consolidated revenues. An increase in cost of revenues (exclusive of depreciation and amortization) in the first half of 2014 was primarily driven by a $49.4 million increase in personnel-related costs, including an increase in stock-based compensation expense of $2.1 million. The increase was primarily attributable to a 13.7% growth in the average production headcount as compared to the same period last year. Selling, General and Administrative Expenses We continued to invest in key areas, including sales, infrastructure, industry expertise, and other functions supporting global operations. During the three months ended June 30, 2014, selling, general and administrative expenses were $38.7 million representing an increase of 35.5% over the corresponding period of 2013. As a percentage of revenues, selling, general and administrative expenses increased 0.7% over the corresponding period of 2013, to 22.1% of consolidated revenues. An increase in selling, general and administrative expenses in the second quarter of 2014 was primarily driven by a $7.1 million increase in personnel-related costs. This was mainly due to a 18.0% growth in the average non-production headcount as compared to the same period last year. In addition, we incurred $1.3 million of costs related to our 2014 acquisitions, including $1.0 million of stock-based compensation expense, which resulted in a 0.7% increase in selling, general and administrative expenses expressed as a percentage of revenues. This was partially offset by increased efficiencies in utilization of shared resources, and, to a lesser extent, favorable exchange rate movements in the CIS region. 27-------------------------------------------------------------------------------- Table of Contents During the six months ended June 30, 2014, selling, general and administrative expenses were $71.0 million, representing an increase of 27.7% over last year. As a percentage of revenues, selling, general and administrative expenses decreased by 0.4% to 21.2% of consolidated revenues. The decrease in year-to-date selling, general and administrative expenses as a percentage of revenues was primarily attributable to increased efficiencies in utilization of shared resources and, to a lesser extent, favorable exchange rate movements in the CIS region. This decrease was partially offset by a $1.8 million increase in acquisition-related costs and stock-based compensation expense related to our 2014 acquisitions. Depreciation and Amortization Expense During the three and six months ended June 30, 2014, depreciation and amortization expense was $5.5 million and $9.1 million, respectively, as compared to $3.9 million and $7.5 million in the corresponding periods last year. Expressed as a percentage of revenues, depreciation and amortization expense increased 0.2% and decreased 0.2% during the three and six months ended June 30, 2014, respectively, as compared with the corresponding periods of 2013, which was mainly due to amortization of intangible assets related to our 2014 acquisitions, partially offset by significantly higher non-recurring capital expenditures in the second quarter of 2013. Other Operating Expenses, Net In the second quarter of 2014 we recorded a $2.0 million writedown in prepaid assets related to the construction of our corporate facilities in Belarus. Please see Note 11 of our unaudited condensed consolidated financial statements in "Part I. Item 1. Financial Statements" for further information. Interest and Other Income, Net Net interest and other income was $1.2 million and $2.1 million during the three and six months ended June 30, 2014, respectively, representing an increase of $0.4 million and $0.7 million when compared to the corresponding periods last year. The increase was primarily driven by interest paid on cash accounts in Belarus and, to a lesser extent, interest earned on employee housing loans. Provision for Income Taxes Our worldwide effective tax rate for the three months ended June 30, 2014 and 2013, was 19.5% and 19.0%, respectively, and 19.5% and 19.0% during the six months ended June 30, 2014 and 2013, respectively. Movements in our worldwide effective tax rate for the three and six months ended June 30, 2014, as compared to the corresponding periods of 2013, were primarily due to (a) a larger portion of our pre-tax profits attributable to tax jurisdictions with relatively higher effective tax rates (as compared to effective tax rates in the CIS region); (b) a relative shift in offshore services performed in Belarus, where we are currently entitled to a 100% exemption from Belarusian income tax, to other countries in the CIS region (specifically Ukraine, and, to a lesser extent, Russia), both of which have higher income tax rates than Belarus; (c) adjustments to the statutory rates in several countries (primarily the United Kingdom, Ukraine and Hungary); and (d) the second quarter 2014 acquisitions which added new tax jurisdictions into our worldwide effective tax rate analysis. Results by Business Segment Our operations consist of four reportable segments: North America, Europe, Russia and Other. The segments represent components of EPAM for which separate financial information is available that is used on a regular basis by our chief executive officer, who is also our chief operating decision maker ("CODM"), in determining how to allocate resources and evaluate performance. This determination is based on the unique business practices and market specifics of each region and that each region engages in business activities from which it earns revenues and incurs expenses. Our reportable segments are based on managerial responsibility for a particular client. Because managerial responsibility for a particular client relationship generally correlates with the client's geographic location, there is a high degree of similarity between client locations and the geographic boundaries of our reportable segments. In some specific cases, however, managerial responsibility for a particular client is assigned to a management team in another region, usually based on the strength of the relationship between client executives and particular members of our senior management team. In a case like this, the client's activity would be reported through the management team's reportable segment. Our CODM evaluates the Company's performance and allocates resources based on segment revenues and operating profit. Segment operating profit is defined as income from operations before unallocated costs. Generally, operating expenses for each operating segment have similar characteristics and are subject to similar factors, pressures and challenges. Expenses included in segment operating profit consist principally of direct selling and delivery costs as well as an allocation of certain shared services expenses. We use globally integrated support organizations to realize economies of scale and efficient use of resources. As a result, a majority of our expenses is shared by all segments. These shared expenses include Delivery, 28-------------------------------------------------------------------------------- Table of Contents Recruitment and Development, Sales and Marketing, and support functions such as IT, Finance, Legal, and Human Resources. Generally, shared expenses are allocated based on measurable drivers of expense, e.g., recorded hours or headcount. However, certain expenses are not specifically allocated to specific segments, as management does not believe it is practical to allocate such costs to individual segments because they are not directly attributable to any specific segment. Further, stock based compensation expense is not allocated to individual segments in internal management reports used by the chief operating decision maker. Accordingly, these expenses are separately disclosed as "unallocated" and adjusted only against our total income from operations. Revenues from external clients and segment operating profit, before unallocated expenses, for the North America, Europe, Russia and Other reportable segments for the three and six months ended June 30, 2014 and 2013 were as follows: Three Months Ended Six Months Ended June 30, June 30, 2014 2013 2014 2013 (in thousands) Total segment revenues: North America $ 88,275 $ 69,076 $ 168,473 $ 132,133 Europe 71,514 48,424 139,173 94,577 Russia 13,371 13,498 24,119 25,851 Other 1,523 2,176 2,915 4,789 Total segment revenues $ 174,683 $ 133,174 $ 334,680 $ 257,350 Segment operating profit: North America $ 21,529 $ 16,213 $ 39,726 $ 30,394 Europe 9,714 8,118 23,849 16,489 Russia 2,199 1,687 1,064 2,319 Other (900 ) (148 ) (2,218 ) (64 ) Total segment operating profit $ 32,542 $ 25,870 $ 62,421 $ 49,138 North America Segment During the three months ended June 30, 2014, revenues from our North America segment were 50.5% of total revenues representing an increase of $19.2 million, or 27.8%, over the corresponding period in 2013. During the three months ended June 30, 2014, segment operating profits increased $5.3 million, or 32.8%, as compared to the same period last year, to $21.5 million net operating profit. During the six months ended June 30, 2014, revenues from our North America segment were 50.3% of total revenue representing an increase of $36.3 million, or 27.5%, over the corresponding period of 2013. During the six months ended June 30, 2014, segment operating profits increased $9.3 million, or 30.7%, as compared to the first half of 2013, to $39.7 million net operating profit. The increase in revenues during the three and six months ended June 30, 2014 was primarily driven by continued expansion of existing customer relationships, and to a lesser extent, by revenues from new clients. Furthermore, this quarter 2014 and year-to-date operating results of the North America operating segment benefited from our recent acquisitions of Netsoft and GGA. As a percentage of revenues, the North America segment's operating profit was 24.4% and 23.6% during the three months and six months ended June 30, 2014, respectively, and 23.5% and 23.0% in the corresponding periods last year. Europe Segment Europe continues to be a rapidly growing segment in our portfolio, given our nearshore delivery capabilities, and our value proposition in delivering quality software engineering solutions and services. Our business model continues to gain considerable traction with European-based clients primarily in the Banking and Financial Services and Travel and Consumer verticals. Furthermore, our second quarter 2014 and year-to-date results also benefited from the acquisition of Jointech, a company with locations in South-East Asia, which created a new value proposition for our existing customers within the Banking and Financial Services vertical, particularly in the areas of investment banking, wealth and asset management, and extended our reach with that customers into new geography. We expect that many of our new and existing customers in other business verticals will use our services in that fast-growing region resulting in possible revenue and operating profit increases to the Europe segment. 29-------------------------------------------------------------------------------- Table of Contents During the three months ended June 30, 2014, revenues from our Europe segment were 40.9% of total segment revenues representing an increase of $23.1 million, or 47.7%, over the corresponding period of 2013. During the three months ended June 30, 2014, segment operating profits increased $1.6 million, or 19.7%, as compared to the corresponding period of 2013, to $9.7 million net operating profit. During the six months ended June 30, 2014, revenues from our Europe segment were 41.6% of total segment revenues representing an increase of $44.6 million, or 47.2%, over the corresponding period of 2013. During the six months ended June 30, 2014, segment operating profits increased $7.4 million, or 44.6%, as compared to the corresponding period of 2013, to $23.8 million net operating profit. Russia and Other Segments During the three months ended June 30, 2014, revenues from our Russia segment were $13.4 million representing a decrease of $0.1 million over the corresponding period of 2013. During the three months ended June 30, 2014, operating profits of the Russia segment increased $0.5 million as compared to the same period last year, to $2.2 million of net operating profit. During the three months ended June 30, 2014, revenues from our Other segment were $1.5 million representing a decrease of $0.7 million over the corresponding period of 2013. During the three months ended June 30, 2014, operating profits of the Other segments decreased $0.8 million over the same period last year, to $0.9 million of operating losses. On a year-to-date basis, revenues from the Russia and Other operating segments decreased $1.7 million and $1.9 million, respectively, when compared to the corresponding periods of 2013. Operating profits of the Russia and Other segments decreased $1.3 million and $2.2 million, respectively, when compared with the operating profits of these segments in the corresponding period a year ago. Revenues and operating profits in the Russia and Other segments are subject to volatility resulting from revenue recognition delays related to finalizing budgets for certain arrangements with major customers in those segments. If recognized, such revenues would improve the operating margin of the Russia segment by approximately 2.2% and 9.2% in the second quarter and first half of 2014, respectively. We were unable to estimate revenues attributable to the services rendered under certain arrangements with our largest customer in the Other segment during the three and six months ended June 30, 2014 and cannot provide assurance these revenues will be recognized in future periods. Liquidity and Capital Resources Capital Resources At June 30, 2014, our principal sources of liquidity were cash and cash equivalents totaling $175.1 million and $40.0 million of available borrowings under our revolving line of credit. As of that date, $156.2 million of our total cash and cash equivalents was held outside the United States. Of this amount, $91.4 million was held in U.S. dollar denominated accounts in Belarus, including deposits that accrued interest at an average interest rate of 4.2% during the first half of 2014. Our subsidiaries in the CIS or APAC do not maintain significant balances denominated in currencies other than U.S. dollars. We have a revolving line of credit with PNC Bank, National Association (the "Bank"). Effective January 15, 2013, we entered into a new agreement with the Bank (the "2013 Credit Facility") which increased our borrowing capacity under the revolving line of credit from $30.0 million to $40.0 million and extended the maturity of the facility to January 15, 2015. Advances under the new line of credit accrue interest at an annual rate equal to the London Interbank Offer Rate, or LIBOR, plus 1.25%. The 2013 Credit Facility is secured by all of our domestic tangible and intangible assets, as well as by 100% of the stock of our domestic subsidiaries and 65% of the stock of certain of our foreign subsidiaries. The line of credit also contains customary financial and reporting covenants and limitations. We are currently in compliance with all covenants contained in our revolving line of credit and believe that our revolving line of credit provides sufficient flexibility such that we will remain in compliance with its terms in the foreseeable future. At June 30, 2014, we had no borrowings outstanding under the line of credit. The cash and cash equivalents held at locations outside of the United States are for future operating expenses and we have no intention of repatriating those funds. We are not, however, restricted in repatriating those funds back to the United States, if necessary. If we decide to remit funds to the United States in the form of dividends, $156.2 million would be subject to foreign withholding taxes, of which $144.2 million would also be subject to U.S. corporate income tax. We believe that our available cash and cash equivalents held in the United States and cash flow to be generated from domestic operations will be adequate to satisfy our domestic liquidity needs in the foreseeable future. Our ability to expand and grow our business in accordance with current plans and to meet our long-term capital requirements will depend on many factors, including the rate, if any, at which our cash flows increase, our continued intent not to repatriate earnings from outside the U.S. and the 30-------------------------------------------------------------------------------- Table of Contents availability of public and private debt and equity financing. To the extent we pursue one or more significant strategic acquisitions, we may incur debt or sell additional equity to finance those acquisitions. Cash Flows The following table summarizes our cash flows for the periods indicated: |