EPAM – another overpriced technology IPO?
Date: 06 Feb 2012 23:00EPAM IPO is scheduled for 7 February 2012 with the IPO price range at $16-18.
The result of my DCF model is $12.2 which is -24% of the lower IPO border.
Here is the prospectus: EPAM IPO S-1 Amendment No. 6
Since IPO of Yandex on 24 May 2011 on NASDAQ its shares fell ~45% while NASDAQ index grew on ~5% during the same period of time.
EPAM is another technology company from CIS which is about to be sold on an IPO. Is IPO price too high and the risk of Yandex fate is too probable? Here is a brief look at EPAM DCF valuation.
Revenues
1) What is sustainable revenue growth rate?Analysis of 2007-2010 growth rates shows that this is correlated to the underlying GDP growth in the countries of sales. Below is the chart showing dependency of EPAM.
Using IMF GDP forecasts as of 24 Jan 2012 and linear trend, around 50% growth for 2011-2013 should be forecasted. So there are no macro risks for revenue growth slowdown.
How sustainable is fast growth rate at 50%? Growth in 2010 was 47.9%, 1H 2011 was 66%, and growth in 9m 2011 was 59%. Those growth numbers in 2010 and 2011 are "pre-IPO" revenue increases. 2012 growth should be less. I keep it at 15% and then increase it to 30% in 2013-2016.
EBIT
1) EBIT should contain two adjustments:- Foreign exchange loss – it's a natural part of this business since 2007
+ Stock based compensation, as it is not a cash expense and later on we will add to the number of shares outstanding effects from the options outstanding calculated using treasury stock method
2) Adjusted EBIT margin jumps from 5.7% in 2008 to 11.2% in 2009 to 15.1% in 2010 to 17.5% in 2011. While I believe in the first two steps, the last two are clear "Pre-IPO" squeezes.
It can be proved by a good benchmarking. In this fast analysis I looked at Accenture:
Accenture (NYSE:ACN) EBIT Margin
| 2008 | 2009 | 2010 |
| 13.0% | 13.4% | 13.6% |
Average for EPAM for 2009-2010 is 13.2%. I assume that the company will return to this level in two years.
Tax rates
How probable is that Belarus, Hungry and Russia will continue to give the company attractive tax breaks at current level? We would assume that as soon as the company becomes bigger and public, it will be harder to get tax benefits at the same level as a % of revenue, so it's assumed that effective tax rate will go to 25%.Other value drivers
1) One of the risks stated at prospectus is: "Our agreement with one of our largest clients gives it the option to assume the operations of one of our offshore development centers, and the exercise of that option could result in a loss of future revenues and adversely affect our results of operations."So, part of one of the offshore development centers was financed by a client and the clients can take this part and pay book value for the rest. Let's assume that if the client decides to execute this option, he will take only the part financed by him.
How big is the probability that it would happen? There is no information to judge, so it's 50%.
When can it happen? Any time between today and December 2014, so on average it would happen in 2013.
How to estimate the effect on EPAM operations? EPAM will get "de minimis price" for transferring of the offshore development center, so this will be effectively a loss of 6.1% of Revenue from 2013 with 50% probability.
2) Sell off stocks and execution of options by employees after lock-up period is over in 6m (beginning of July 2012)
This company was founded in 1993. Some of the people in the management team were waiting to cash out for 5, 10 or almost 20 years. According to the prospectus, nobody from individual or institutional owners are selling more than 18%. There is a considerable risk that they will start selling 6 months after the IPO.
Conclusion
The key questions are: in what revenue growth do you believe and what EBIT margin will the company manage to maintain? Both of them will not maintain current levels in the coming 5 years: one of them will be sacrificed to another.What happens with stock prices of technology companies from emerging markets oversold during the IPO? They fall. Take a look at Yandex again.
EPAM DCF Model
Tags: IPO, Stocks - fundamental analysis