Epam Systems Inc

NYSE:EPAM

Earnings Call Transcript 2022-Q2

[David Straube, Head of Investor Relations]

Thank you, operator, and good morning, everyone. By now, you should have received a copy of the earnings release for the company's second quarter 2022 results. If you have not, a copy is available on epam.com in the Investors section.

With me on today's call are Arkadiy Dobkin, CEO and President; and Jason Peterson, Chief Financial Officer.

I'd like to remind those listening that some of the comments made on today's call may contain forward-looking statements. These statements are subject to risks and uncertainties as described in the company's earnings release and SEC filings.

Additionally, all references to reported results that are non-GAAP measures have been reconciled to the comparable GAAP measures and are available in our quarterly earnings materials located in the Investors section of our website.

With that said, I'll now turn the call over to Ark.

[Arkadiy Dobkin, Chief Executive Officer and President]

Thank you, David. Good morning, everyone. Thank you for joining us today. I want to start by reminding you of our earnings call three months ago and then our Investors and Analyst Day on May 19, when we shared our approach and higher-level plan for the following months.

At that time, we said that we didn't expect the war to end quickly. And as a result, our plans for adapting the company were developing based on a series of overlapping efforts or phases. Today, we are still very much in the war time, and we don't fully see a definitive conclusion for it in the near term. That means that, as we expected, we are continually adjusting our operations, our delivery organization and ways of working to what is our new normal now.

So let's go quickly by the progress we are making across those phases. The first phase is the focus of the safety of our employees and stabilization of our operations in Ukraine. At this time, all our employees are in safe locations, either within the country or in neighboring countries. And our teams continue to work supporting our customers at levels of productivity very much in line with what we experienced before the war or during war.

In addition, in this new normal, we continue to support our Ukrainian employees and their families as well as the Ukrainian people. We are providing various forms of humanitarian relief with EPAM Ukraine Assistance Fund and our $100 million assistance commitment, which we have now done in March. I would just add that we are constantly moved by the resilience and morale of our Ukrainian employees, and we want to take one more opportunity to thank them for their incredible commitment and level of purpose they demonstrate.

The second phase of our framework is acceleration of our global digitization efforts and continued growth of our diverse capabilities. And yes, this includes first of all geographical diversification of our delivery platform. But it also includes many other critical aspects of our operations and several key investments efforts, which ensures the quality of delivery while we are expanded rapidly across multiple tiers.

We are located in already digital delivery locations in India, Latin America and Central Asia, as well as establishing several newly-created delivery hubs and expected many existing sites across Central and Eastern Europe and Western and Central Asia as well. This is also supported by the active redeployment of many of our current employees. We decided to explore opportunities outside of their home countries and simultaneously establishing a strong EPAM cultural foundation in those locations to further develop the local talent market and fastly grow its EPAM hubs.

Looking at our global footprint. EPAM now serves customers from more than 50 countries around the world, which means we just doubled our country count in the last three years. And as a result, replenished our delivery platform across now four major geographies, which includes Central and Eastern Europe, India, Western and Central Asia and Latin America. Today's reach also didn't exist for us just a few years back.

Today, with those efforts and accelerated growth outside of impacted regions, we have reduced our delivery capacity there from roughly 60% in February of 2022 to 40% now. And we expect to reach a level of close to 30% in to the second half of 2022. Part of this process, we are well underway in our commitment of our exiting our operations in Russia, where we moved quickly and anticipate completing the process shortly. We are still working through a number of regulatory requirements in the country, which means that the timing of full transition is still difficult to predict precisely.

With that said, we can share that our local footprint went from over 9,000 people at the end of Q1 to just under 1,000 today. With that, I would like to say a big thank you to many people within EPAM global delivery and talent management and the financial organizations at very different seniority levels, who are enabling this massive talent transformation efforts across dozens of countries simultaneously and under very challenging timelines. Thank you.

Moving to also phase in the framework. Continuing to serve and expand demand for our services for our growing global customer portfolio. Over the last five months, we have repositioned absolute majority of all client projects who requested their work to be relocated based on their sense of risk mitigation factors. As we also know, that such requests will continue to happen in the future depending on the different fast developing external factors.

We just feel at this point, that we are much better prepared now to address such future needs. With this, I would like to state that while we continue to be extremely open and responsive to our customer needs and their preferences, we are seeing today some new incoming demand into the region and expect a significant proportion of our client portfolio, even with increased global diversification, to be continuously serviced from Ukraine and Belarus.

Another indication of our success in our third phase could be expressed by the growth of our top 20 and top 50 client portfolio. Most of them have been with us and stayed with us through multiple phases of change and growth. And thanks to their support today during such a huge and terrible disruption due to current war in Ukraine.

Finally, the last element of our framework is a focus on profitability, or Phase 4. As work has been repositioned to new geographies, we have begun the effort to align rate structures and optimize the performance of new delivery locations. This will continue throughout this year and into 2023. While still too early to provide specifics on our progress on this phase, we believe we will return to profit levels approaching EPAM's historical ranges during the first half of 2023.

In addition to all of that, we continue to progress our investment agenda across several key areas. EPAM Continuum is now the consulting brand recognized by leading analysts and strongly supporting our growing focus on more complex and advisory led engagements. Our cloud and data offerings are progressing fast into large modernization programs, enabled by our strengthening relations with key partners in this space. And we continue to see traction with EPAM's efforts in our IP and educational initiatives as well as our advanced remote supply model, enabled by our continuously invented digital platforms.

In short, we feel good right now about our progress to date, of rebalancing our global delivery and moving forward with all other additional initiatives. This should allow us to maintain the sequential constant currency revenue growth rate, despite the massive disruption we have encountered.

With that, I would like to provide some comments on the current demand environment, or at least how we see it from our side. While we really are doing better today than we expected, we, like our competitors and all of you, see a growing number of mixed economic indicators and caution in the market. At the same time, we still believe the near-term demand environment remains intact. We also believe the medium-term broad-based demand trends, which have driven activity in our industry in the past will continue to support our ability to drive strong organic growth at or above our old normal 20% target.

So while we are not immune to the impact of the global economic events, we shall being much better positioned today than in the past to address any future shifts. And we also believe EPAM remains well positioned for long-term growth and value creation opportunities, for our people, for our clients and for our investors.

To summarize, our priority remains to contain, as much as possible, the impact of the current disruption of the war during 2022. We have made significant progress in this area over the last five months. And in addition, we are significantly accelerating key elements of our overall strategy. Because to big extent, other than the closing of our operation in Russia, what is happening right now and what we now call our new normal is very much the accelerated effort towards certain strategic directions, which have been part of our medium to longer-term plans.

The resilience of our people, customers and operations have effectively created accepting this new normal for EPAM, an entirely different level of diversification, productivity and agility of the business to ensure future growth in this constantly changing market environment.

So overall, these challenging times are helping us to build better and more adaptive EPAM, and faster. And in closing, as I mentioned on our Q1 earnings call, and it's worth repeating, EPAM as a company fully stands with Ukraine. Since the beginning of the war, our absolute top priority has been and continues to be the safety and well-being of our employees and their families. One more time, thank you to all of our employees for this effort and their loyalty during these not at all easy times.

Now let me turn the call over to Jason, who will talk about our Q2 results and additional perspective as we look at Q3 and beyond.

[Jason Peterson, Chief Financial Officer]

Thank you, Ark, and good morning, everyone. In the second quarter, EPAM delivered another set of strong results, including a sooner-than-anticipated return to sequential revenue growth. These results were produced at a time when the company was experiencing unprecedented disruptions across all VPM's major delivery locations.

As we mentioned during our Q1 earnings call, in addition to our customary non-GAAP adjustments, expenditures related to EPAM's humanitarian commitment to Ukraine, the exit of our Russian operations and costs associated with accelerated employee relocations have been excluded from non-GAAP financial results. We have included additional disclosures specific to these and other related items in our Q2 earnings release.

During Q2, EPAM generated revenues of $1.19 billion, a year-over-year increase of 35.6% on a reported basis and 40.1% in constant currency terms, reflecting a negative foreign exchange impact of 450 basis points.

Looking at the performance of our industry verticals and geographic regions in the quarter. Growth was negatively impacted by the ongoing exit of our Russia operations and the effect of foreign exchange on our U.S. dollar reported results. Were helpful, I will provide an adjusted year-over-year conversion.

Beginning with our industry verticals. Travel & consumer grew 61.1%, driven by strong organic growth, primarily from our retail customers as well as revenue contributions from recent acquisitions. Life sciences and healthcare grew 40.1%, with strong growth coming from the health care industry, in addition to growth in life sciences. Financial services grew 29.4%, with growth coming from asset management, payments and banking. Excluding our Russia customers, growth was 41.5% or 45.7% in constant currency.

Business information & media delivered 25.4% growth in the quarter, driven primarily by customers in the business information industry. Software and hi-tech grew 22.7% in the quarter. And finally, our emerging verticals delivered 36.1% growth, driven by clients in telecommunications, energy, manufacturing and automotive. Excluding our Russian customers, growth was 40.6% or 49.1% in constant currency.

From a geographic perspective, Americas, our largest region representing 60% of our Q2 revenues, grew 36.8% year-over-year or 37.9% in constant currency. EMEA, representing 35% of our Q2 revenues, grew 45.2% year-over-year or 58% in constant currency. EMEA performance was driven by strong organic growth, combined with the incremental contribution from recent acquisitions. CEE, representing 2% of our Q2 revenues, contracted 46.7% year-over-year or 58.2% in constant currency. Revenue growth in the quarter was impacted by the ramp down of services to our Russian customers. And finally, the APAC grew 20.8% year-over-year or 25% in constant currency terms and now represents 3% of our revenues. In Q2, revenues from our top 20 clients grew 27% year-over-year, while revenues from clients outside our top 20 grew 41%.

Moving down to the income statement. Our GAAP gross margin for the quarter was 29.2% compared to 33.8% in Q2 of last year. Non-GAAP gross margin for the quarter was 31.5% compared to 35% for the same quarter last year. Compared to Q2 2021, risk margin in Q2 2022 was negatively impacted by the ongoing transition of customer work to higher-cost geographies as well as lower utilization in Russia.

GAAP SG&A was 19.5% of revenue compared to 17.2% in Q2 of last year. And non-GAAP SG&A came in at 15.2% of revenue compared to 15.6% in the same period last year. GAAP income from operations was $93 million or 7.8% of revenue in the quarter compared to $125 million or 14.2% of revenue in Q2 of last year. The lower level of profitability was primarily driven by costs associated with the exit of our Russian operations, relocation of our employees, and humanitarian expenditures and support for Ukrainian employees.

Non-GAAP income from operations was $177 million or 14.9% of revenue in the quarter compared to $155 million or 17.6% of revenue in Q2 of last year. We are pleased with our operating profit in a quarter when the company was also executing a significant geographic transformation. Our GAAP effective tax rate for the quarter was negative 114.9%, primarily driven by excess tax benefits related to stock-based compensation as well as a onetime deferred tax benefit associated with tax planning. Our non-GAAP effective tax rate, which excludes the excess tax benefits as well as onetime benefit from tax planning, was 22.9%.

Diluted earnings per share on a GAAP basis was $0.32, reflecting a negative $1.62 or 83.5% decrease year-over-year. GAAP EPS includes the impact of Ukraine and humanitarian expenditures, expenses related to accelerated staff relocations, costs related to the planned exit of our Russian operations and the FX impact of Russian ruble appreciation on the intercompany payables denominated in rubles and U.S. dollar-denominated assets held by our Russian entity. Our non-GAAP diluted EPS was $2.38, reflecting a $0.33 increase or 16.1% growth over the same quarter of 2021. In Q2, there were approximately 59 million diluted shares outstanding.

Turning to our cash flow and balance sheet. Cash flow from operations for Q2 was $78 million compared to $69 million in the same quarter of 2021. Free cash flow was $59 million compared to free cash flow of $46 million in the same quarter last year. We ended the quarter with approximately $1.3 billion in cash and cash equivalents. At the end of Q2, DSO was 71 days when compared to 69 days for Q1 2022 and 70 days for the same quarter last year. We expect to maintain DSO in and around this level throughout 2022.

Now moving on to a few operational metrics. We ended the quarter with more than 54,850 consultants, designers and engineers, a year-over-year increase of 28.1%. Our total headcount for Q2 was around 61,300 employees. Compared to Q1, we saw a net decrease of approximately 300 headcount. Significant additions in India, Central Europe and Latin America were offset by the reduction of headcount in Russia.

Utilization was 78% compared to 80.2% in Q2 of last year and 78.4% in Q1 2022. Our Q2 utilization includes those employees who have been assigned in a backup capacity to support projects substantially delivered from Ukraine. Although these employees were accounted to utilize for the purpose of our utilization calculations, this work was largely unbilled. Additionally, during the quarter, utilization in Russia was significantly lower compared to the same quarter of 2021. Utilization in Ukraine remains steady in a level similar to, but somewhat lower than 2021.

Now let's turn to our business outlook. As a reminder, on February 28, we withdrew our full year business outlook due to the uncertainties related to Russia's invasion of Ukraine. For the remainder of this year, we plan to provide guidance for the next quarter only and expect to resume our full year guidance at the beginning of the 2023 year. However, I will provide some additional insights and assumptions which will help frame our Q3 guidance and expectations for the second half of 2022.

At this time, we continue to see a stable demand environment, which, combined with the progress in repositioning our workforce and portfolio, we expect will drive continued sequential revenue growth throughout the second half of 2022. However, with our reduced Russian customer revenue, we expect to see the impacts of tougher year-over-year revenue comparisons in both Q3 and Q4. We will continue to provide color regarding the impact the Russia exit has on EPAM's growth rates.

We continue to see relatively high levels of productivity from our Ukrainian staff who were substantially located in the safer portions of the country. Our Q3 guidance assumes that we will maintain Ukrainian utilization levels only slightly lower than pre-war levels. Those Russian employees who wanted to relocate, we have relocated the majority of that population during the second quarter. Therefore, we expect a lower level of employee relocations in Q3.

Parallel with the repositioning of our people, we are working through the process to align our cost and rate structures to reflect the prevailing economics in the geographies to which demand has been redirected. In many cases, the result will be increased billing rates to reflect higher costs, although we expect some lag in the establishment of these higher bill rates.

The movement in customers, projects and people, we expect some short-term inefficiencies, including a higher level of bench, and therefore, a somewhat lower utilization as we scale new and existing delivery locations. The combination of these factors will continue to weigh on our profitability. However, we expect to see an improvement in profitability between Q2 and Q3 and are currently forecasting profitability in Q4 at levels similar to those we expect to achieve in Q3.

And finally, today, EPAM has spent over $34 million as part of the company's $100 million humanitarian commitment to our Ukrainian employees and their families. We expect further humanitarian expenditures will be made throughout 2022 and into 2023.

Now moving to our Q3 2022 outlook. We expect revenues to be at least $1.210 billion, producing a year-over-year growth rate of at least 22%. In constant currency terms, revenue growth is expected to be at least 26%. Included in these growth rates is approximately 400 basis points of revenue contribution from acquisitions closed over the last 12 months. I will also point out that we expect customers based in Russia to contribute less than $10 million in revenues in the quarter compared with the $44 million in Russia-based customer revenues generated in Q3 of 2021.

For the third quarter, we expect GAAP income from operations to be in the range of 9.5% to 10.5% and non-GAAP income from operations to be in the range of 15% to 16%. We expect our GAAP effective tax rate to be approximately 19% and non-GAAP effective tax rate, which excludes excess tax benefits related to stock-based compensation, to be approximately 22%. For earnings per share, we expect GAAP diluted EPS to be at least $1.65 for the quarter and non-GAAP diluted EPS to be at least $2.48 for the quarter. We expect a weighted average share count of 59.4 million diluted shares outstanding.

Finally, a few key assumptions that support our GAAP to non-GAAP measurements in the third quarter. Stock-based compensation expense is expected to be approximately $38 million. Amortization of intangibles is expected to be approximately $5.7 million. The impact of foreign exchange is expected to be negligible. Tax effects of non-GAAP adjustments is expected to be around $13.6 million. And finally, we expect excess tax benefits to be around $5.9 million in the quarter.

In addition to these customary GAAP to non-GAAP adjustments, and consistent with Q2, we expect to have ongoing non-GAAP adjustments in Q3 resulting from Russia's invasion of Ukraine. Please see our Q2 earnings release for a detailed reconciliation of our GAAP to non-GAAP guidance.

We're pleased with our Q2 performance, which is the result of a lot of hard work by our employees around the globe, whom I want to thank for their dedication and the world-class service that they provide to our customers.

Operator, let's open the call for questions.

[Operator]

Our question comes from Bryan Bergin of Cowen.

[Bryan Bergin, Cowen and Company]

I wanted to start with a growth composition question. So can you comment on how the attribution of growth between new clients versus existing clients turned out in 2Q? And how you see that progressing over the course of the second half? Just trying to understand if you're seeing a return to new client inflow versus servicing, that existing base amid all of this global transition. And really just trying to understand how you're thinking about the recovery of new logo flow if you haven't gotten back to it already.

[Jason Peterson, Chief Financial Officer]

Bryan, so this is Jason, and thanks for the question. From a demand standpoint and revenue growth, we continue to see solid growth in the existing customers and probably with a little bit of a slowdown in new customers in Q2, because I think you'll remember that our focus, certainly in March, probably April and May was really focused more on retaining existing customers. So we continue to grow significantly with the existing customers, as you can see by our revenue beat.

And then probably by the time we got to the second half of Q2, we began to focus again on new logo activity. And so right now, you've got quite a bit of new logo-driven demand that we expect to come in the second half. But again, I think that probably just as a top line, I'd say that we continue to see growth in both our new and our existing customers.

[Bryan Bergin, Cowen and Company]

Okay. That makes sense. And then just on the workforce, if you excluded the workforce attrition from Russia, can you give us a sense of how the sequential billable headcount landed in the second quarter? And really just how you're thinking about your ability to return to the pre-war quarter-over-quarter headcount levels across the broader global footprint as you go through the second half.

[Jason Peterson, Chief Financial Officer]

I'm going to let Ark talk about headcount, but let me just mention attrition. So if we exclude Russia, where we've had higher both voluntary and involuntary attrition, our attrition rates have remained very consistent in Q4, Q1 and Q2.

Ark, do you want to talk about headcount?

[Arkadiy Dobkin, Chief Executive Officer and President]

Yes. And on headcount, I think definitely, the total number is impacted by our exiting in Russia right now. But in general, just to understand, we're pretty comfortable that we will be able to return to our pre-war situation. I think it's difficult to compare this with 2021, which was a special year for everybody from the growth perspective where sometimes we were growing the headcount against 2022, like in 30% plus, sometimes 40% per quarter on an annual basis.

So I don't think anybody will be coming back to this. But definitely, to what we were experiencing in quarter-by-quarter and also on the annual growth in '19, for example, or in '18, we will be coming back to the same speed. And we're comfortable with this based on what we were sharing during our Analyst Day. We position ourselves outside of this traditional Eastern European landscape which we have, in Latin America, in Western and Central Asia and India as well. So that's making us pretty comfortable that we will be able to address the demand.

[Operator]

Our next question comes from Darrin Peller of Wolfe Research.

[Darrin Peller, Wolfe Research]

It's good to see the execution. And I really just want to hone in on the actual headcount changes that you've been making over the last couple of quarters and how it's playing out in the new markets with the newer delivery centers now. And really just to give us a quick update on what kind of performance you're seeing out of those newer locations, whether it's where you move people or you've been really growing your headcount.

[Arkadiy Dobkin, Chief Executive Officer and President]

So our increase was between 1,200 and 1,300 people in Q2. And all of this clearly was outside of Ukraine, Belarus and Russia. So we share -- if you think and compare it with the past, exactly explain why we feel comfortable right now that we will be able to continuously grow in the future as well with similar rates which we experienced before.

[Darrin Peller, Wolfe Research]

Okay. And so when we think about the execution and the utilization of those, where do you see in terms of time frame then being at more of a full run rate so they can actually produce the same types of revenue? And as a quick follow-up, I mean, the newer regions you were talking about at your Investor Day, some in the Latin American areas and some in further and incremental areas, even in Eastern Europe, if you could just give us a quick update on how it's progressed.

[Jason Peterson, Chief Financial Officer]

Yes. So from a utilization standpoint, if I talk about Q2, what we saw, as you would expect, is quite low utilization in Russia. But one of the reasons why you had the revenue beat that we had is our utilization was quite a bit higher in the rest of the world than we had originally expected. So utilization levels have remained pretty solid and particularly quite solid in Ukraine, considering everything that's going on there.

We are expecting as we go from Q2 to Q3 that we may see somewhat lower levels of utilization. Because as you transition work from one country to another, you might end up with a somewhat larger bench in, let's say, the donating country and then we're building up capacity in these newer countries. And again, you have a little bit more bench there.

But as Ark said, I think we feel really good about our ability to add headcount to support demand. We've made really good progress in both transitioning resources to some of these new geographies and adding resources in these geographies. And as Ark said, we're around sort of 40% of our delivery capacity in the traditional sort of CIS region. So I think we feel good about not only our execution in Q2, but our ability to support ongoing demand in Q3 and Q4.

[Operator]

Our next question comes from Maggie Nolan of William Blair.

[Margaret Nolan, William Blair]

I wanted to check in on how the conversations regarding those -- adjusting those rate cards to the new delivery locations you're going as well as, obviously, wage inflation is probably complicating this. And then on the kind of new delivery locations aspect of it, do you expect a resolution by 2023? Or will there be an impact of that kind of adjustment phase that persists into the next year?

[Jason Peterson, Chief Financial Officer]

Yes. Maybe I'll let Ark comment on customers, but just in terms of the algebra. What we see as we transition resources to new geographies is that you have a change in compensation almost immediately. And then there's a lag, as you know, Maggie, in terms of our ability to get rate increases. And so we have some customers where the rate increases are immediate, some customers where there might be a quarter lag and some customers where we might not see rate increases until as we enter 2023.

Traditional to EPAM operating structure, we collect data on all of this, which is updated on a daily basis. We run dashboards. And so we can see that we're making good progress, both in terms of the conversations. In some cases, we actually already have the rate changes in place. In other cases, we have agreement to have the rate changes in place later in the year. So Maggie, I think we're making really good progress and I would expect, let's say, the vast majority of those conversations to be completed with higher rates as we enter Q1 of 2023.

I don't know, Ark, do you want to talk about conversations with clients?

[Arkadiy Dobkin, Chief Executive Officer and President]

I think, exactly like Jason said, we're still in the process. And right now, the feel is pretty optimistic from the result of this process. We know a significant number of clients already agreed on rate adjustments. Some of it is delayed for the next month, two or three. So as that's what we mentioned already today, that we expect approaching the profitability rate similar to pre-war conditions in 2023.

Again, approaching this there are too many moving parts. Some of them not even related to these events, because if we think about what's happening, foreign exchange, for example, and sometimes, it's the market situation as well within euro and U.S. dollars and then what currencies we pay compensation in the future. So it's a more difficult conversation. But rates are right on the way, and we are optimistic on this, in this sense.

[Margaret Nolan, William Blair]

That's helpful. And then Jason, how does the cash you generated this quarter compare with your expectations going into the quarter just given all the atypical expenditures you've had of late? And then what's the expectation for how cash flow should trend from here?

[Jason Peterson, Chief Financial Officer]

Yes. I would say that cash flow was pretty good. I think we tried to hold DSO to 70, and it did end up at 71. And to them may have had a modestly negative impact. And we're trying to sort of keep DSO in and around or maybe slightly lower than 71 on a go-forward basis. We do expect cash flow conversion to be over 100% in Q3, which is kind of more consistent with sort of historical patterns. And right now, both our cash position and our ability to generate cash is pretty encouraging.

[Operator]

Our next question comes from Jason Kupferberg of Bank of America.

[Tyler DuPont, Bank of America]

This is Tyler DuPont on for Jason. Last quarter, you had suggested that you could be back to pre-war normalized growth in margins by the first part '23. But based on the 2Q results and the 3Q guidance so far, do you feel this could happen even sooner? And can you just like quantify what your benchmarks are for those pre-war levels?

[Jason Peterson, Chief Financial Officer]

I think when we -- so we're guiding to, what, 15% to -- 15% to 16% in Q3. And what I said, just in case it wasn't clear in the fixed portion of the call here today, is that we expected that we could see profitability in a similar level in Q4. So that's already trending back towards that traditional sort of 16% to 17% range. .

And when we kind of talk about our historical range, that's more what we mean rather than the elevated profitability that we would have seen during very, very high demand periods last year. But again, I feel that the progress to date, I think, is pretty good, as you can see by the guide. And as Ark said, we're continuing to work through the pricing and the other adjustments, but it's still a little too early to sort of communicate exactly where we expect 2023 to end up.

[Tyler DuPont, Bank of America]

Okay. Perfect. And just one more. As you continue on your path for headcount diversification, can you maybe discuss some of the regions that have been relatively easier to build out versus the ones that have been a bit more challenging? And on that line, do you feel that you are past the riskiest phase of your headcount diversification efforts?

[Jason Peterson, Chief Financial Officer]

Okay. Yes, from the standpoint of the ability to add headcount, we feel that we've actually -- we're ahead of our own goals in terms of building out Latin America. And we've seen strong growth in India, seen very strong growth in Central Europe. And so yes, I mean, the market continues to be a bit of a challenge. But I don't think we've had any real difficulty hiring to meet demand and to create the capacity that we want to have outside of what we call the impacted regions. .

And so not to say that things couldn't change in the future, but right now, I think we feel pretty good about our ability to build out capacity outside of the region through both relocations and through the additional headcount, effectively hiring in the region.

[Operator]

Our next question comes from James Faucette of Morgan Stanley.

[James Faucette, Morgan Stanley]

I wanted to dig in again on demand and client relationships. Obviously, the client retention has been quite good, et cetera. But as you're moving resources around, is there -- are you still having customers decide and indicate that they want to change delivery locations and what are the trends around that? And how quickly do you expect customers if they are doing that to get settled on their preferred delivery regions?

[Arkadiy Dobkin, Chief Executive Officer and President]

I think it's a very right question. And I think there is no simple answer in which it would be addressed in. Everybody kind of approach -- there are some groups of clients which are really trying to mitigate risk and move out of the region in danger. There are some clients which is continuously working almost in kind of pre-war scenarios. And there are some new clients come in there as well.

So -- but again, as you probably understand, too, it's all a little bit moving target. We're working month by month, day by day, and sometimes, seeing something unexpected. But in general, I think we shared exactly the numbers which we kind of aggregate in what we understand going to have. We're clearly not in business as usual in general situation. So when we have to move thousands of people and rest of our business continue to approach apparently outside, a lot of delivery capacity, it's nothing as business as usual.

But if you think that we're still growing and especially if you think how growth happening without Russia, because this is where we disconnected, our organic constant currency growth outside of Russia in Q2 was like 37%. So which means that there is normal demand if you take in account that we exiting there. So I know I've not given you a precise answer, but there is no precise answer. There are clients which is trying to completely change, approaching the right clients which are picking up on this capacity which released from them. And in some respect, a little bit similar to what we were experiencing in 2014, second time.

[James Faucette, Morgan Stanley]

Got it, got it. That's really helpful though. And then on top of everything else, what have been the macro-related conversations with your clients, both in terms of existing and potential? And are you seeing any indications of softening, whether it be lengthening sales cycles or having clients approaching and say, hey, these are projects that we'd like to put off because we're a little uncertain? And are you having those conversations at all? And how is macro contemplated in your outlook, if at all?

[Arkadiy Dobkin, Chief Executive Officer and President]

Are you relating to situation in Eastern Europe or you...

[James Faucette, Morgan Stanley]

Or just the economy, yes, the economy more generally, yes.

[Arkadiy Dobkin, Chief Executive Officer and President]

Okay. I think, first of all, for us sometimes it's difficult to distinguish one to another because it's not necessary clients said exactly why this conversation might happen. So these conversations are happening. But again, they were happening like 12 months ago, they were happening 24 months ago. If it's a little bit more often, maybe. But it's still difficult because it's even volatile by quarter by quarter. And the reasoning for this could be that the situation where majority of our resources are or economy. So it's very difficult to distinguish for us.

[Operator]

[Operator Instructions] Our next question comes from Surinder of Jefferies.

[Surinder Thind, Jefferies]

Following up on the earlier question about just clients' desire for the delivery model. Are those -- are the client conversations continuing to evolve in the sense that there were clients last quarter that requested a change in their -- where delivery is from, and this quarter, there's new sets of clients that are asking for delivery changes? Or how should we think about the potential for your year-end targets to kind of evolve? Like I realize you kind of said that it's fluid. But I just wanted to make sure I understand all the push-pull factors here.

[Arkadiy Dobkin, Chief Executive Officer and President]

So I think -- again, I think we're repeating ourselves, but everything is a little bit moving target. Some clients were asking last quarter if we're settled. Some clients might be asking today and will be asking tomorrow as well. So at the same time, if you aggregate, we see the picture where demand independently from locations is still pretty strong. So -- and that's what I mentioned, which is not exactly right comparison, but some sense similar to what we experienced eight years ago when some clients were completely leaving the region and some other clients were picking up. And we see these trends as well.

What would be bigger, we will see probably in two and three quarters. And it's also dependent on what would be happening. What would be actually happening in the region and what would be results of the current war as well. But with -- on top of this, and that's what we're communicating, we're pretty comfortable with speed of growth outside of the region. When we're talking about Latin America and India, West and Central Asia, we're pretty comfortable that we would be able to grow from apply point of view in line with what we need.

[Surinder Thind, Jefferies]

Understood. And then in terms of just a clarification on Russia, it sounds like all of the individuals that you wanted to relocate or have requested relocation are done. So what is left in Russia at this point? And is it assumed that all of that work will be transitioned within the next quarter or 2? Any color there or any additional color there?

[Arkadiy Dobkin, Chief Executive Officer and President]

Yes. We’re finalizing the conditions how we exit in Russia completely. And I mentioned today that the Russians regulated their requirements, and we're going through this right now, which might take another month or so. And after this, the rest of headcount which we have in Russia today will be outside of EPAM, which is currently already less than 1,000 people.

[Operator]

Our next question comes from Ramsey El-Assal of Barclays.

[Ramsey El-Assal, Barclays]

I was wondering if you could update us on your thinking around M&A and the degree to which potentially you could leverage M&A to help fill in some of the gaps or address some of the challenges that have come out of the geopolitical situation you find yourselves in.

[Arkadiy Dobkin, Chief Executive Officer and President]

I think approach for M&A didn't change for us much. Very similar like in the past M&A for us, it's additional capabilities. Sometimes, beginning of the growth in some region. But from the point of the current delivery platform and the delivery locations, we already feel pretty comfortable, these all foundations which we have. I don't think M&A will be specifically important for this part. So we are sourcing in traditional agent capabilities in consultant market and industry expertise and maybe sometimes, in new locations, but again, it's not critical for us because we already established a pretty good footprint with growth.

[Ramsey El-Assal, Barclays]

Okay. And then my follow-up is just on a question around sort of the macro resilience of the business. And again, I'm not referring to Eastern Europe and the military conflict there. I'm referring more to just the economic environment more broadly. Can you talk about how you think about EPAM in the context of dealing with cyclical pressures, recessionary pressures?

I think typically, historically, IT services has been somewhat cyclical. I think some of the digital tailwinds today may provide sort of a secular tailwind that might help quite a bit through a recessionary period. But I'm just curious, Ark, your view about how the business fares during a hypothetical recession.

[Arkadiy Dobkin, Chief Executive Officer and President]

So I think we do have experience in the past. It's always difficult to predict how experience from the past is applicable for the future and how different the next recession going to be. But in the past, we usually were practically left for two, three quarters and then started to grow again. I think in general, that's what we are mentioning as well. In our industry, with all what's happening, I think we will be able to kind of tune headcount for a couple of quarters, and all kind of challenges in 2020, 2021. And specifically, 2022 make us actually much more resilient and much more adaptive to address potentially necessary adjustments.

So I think, and again, we already talked about it today about that we feel ourselves much more comfortable, much more prepared for some elements of unknown. And we probably during these last couple of years, we talked about it in Investor Days, not only about this war, it's about situation in Belarus during the last couple of years, trained and prepared better than anybody else on the market right now, for recession as well, if it would be happening.

[Operator]

Our next question comes from Puneet Jain of JPMorgan.

[Puneet Jain, JPMorgan]

Good quarter, guys. I have like a question on gross margins. Given that your delivery profile is changing, can gross margins go back to the prior pre-war 35%, 36% levels? Or maybe like the new locations, the pricing dynamics, labor dynamics there might result in like a different gross margin profile over the medium term compared to what it used to be before this invasion?

[Jason Peterson, Chief Financial Officer]

Yes. So this is Jason. And so from the standpoint of gross margin, I think gross margin in Q2 came in somewhat better than we had expected due to our ability to continue to deliver at certain locations and just kind of manage demand. We are expecting a bit of an improvement in gross margin between Q2 and Q3. And as we've talked about, we think there's a temporary impact as we shift people into new geographies, some of which are more expensive than the geographies in which they're leaving.

And so there will be a temporary impact that we expect to largely address by the time we enter 2023. But there could be a little bit of compression on margin relative to the very high levels that we were running at when we were running at 18% IFO or something, right? And so when we talk about kind of our return to profitability, we are really sort of thinking more about the traditional 16% to 17% range.

We continue to see good efficiency from an SG&A standpoint. And so again, I think I probably would sort of guide us towards the adjusted IFO and just assume that we'll have to manage it between the two components. But again, feel good about our ability to head back towards the higher levels of gross margin. But they could be slightly lower than they've been during the particularly hot quarters of 2021.

[Puneet Jain, JPMorgan]

Understood. And then, obviously, you mentioned macro remains healthy and all the good comments there. Has there been any change in client priority in terms of the type of projects they execute? Like have you seen any changes in type of projects or any changes in sales cycles or the speed at which they award new projects at all?

[Jason Peterson, Chief Financial Officer]

We -- I noted some people are talking about maybe an eventual shift towards efficiency or cost efficiency. We have not seen that at this time. So we still see the traditional drivers, application modernization, cloud migration, data, and then all the platform engineering that EPAM is well known for. And so we still see those as underlying drivers. And part of the reason why I think we feel comfortable guiding towards sequential growth both in Q3 and as we talked about it and expected in Q4 as well. But does that answer that question or?

[Operator]

Our next question comes from Arvind Ramnani of Piper Sandler.

[Arvind Ramnani, Piper Sandler]

I just wanted to ask about your kind of -- your ahead -- kind of roughly maybe six months looking at these new geos and kind of taking a closer look at scaling operations and input in geos across the globe. As you kind of digest what you've looked at in terms of local talent in markets, which goes outside say, Belarus and Ukraine and Russia are looking kind of promising to kind of scale up as you look out over the next two -- couple of years?

[Arkadiy Dobkin, Chief Executive Officer and President]

I think it's difficult to add something substantial in a couple of minutes answer versus what we shared already during our Analyst Day in May. And I think when we went actually to some level of details. And I can only repeat that, for example, what's happening during the last six months, in some respects, was prepared during the previous like years. We were specifically talking about how we were growing in India. And during the last couple of years, it's become one of the fastest talent growing market for us, and we continue to do this.

We were starting to focus in on Latin America before war happened. And we are pretty impressed with the level of talent there. And a number of countries across Western, Central Asia, which we started to focus in 2020, 2021. And some of them like after the war, we seeing as a good potential as well. That's why again already was answering several times today.

We're pretty comfortable that we will be able to scale with the talent outside of our traditional locations. And don't forget that we're still growing pretty significantly in Central and Eastern Europe, which we have very strong experience and complement all of these locations with people who decided to relocate. And this is abysmal number of people too. So basically, we have advantage of being an EPAM DNA and EPAM experience in new ups for us.

[Arvind Ramnani, Piper Sandler]

Terrific. And just one quick follow-up. Just in terms of your gross margin, clearly, it's been impacted by this transition. Are you able to provide some color on how much of the impact was due to utilization in Russia versus the transition to higher cost geos?

[Jason Peterson, Chief Financial Officer]

Let me think. There's -- whenever we sort of give you a description of the impact, there's a whole series of different things that are impacting profitability. And so, I don't know, the change into the new geographies is probably having at least the impact or more so than the Russian utilization. And what it is going to -- we're going to continue to move people into new geographies, we did that in Q2. We're going to do that in Q3. And so you're going to see some accumulation of people who are still sort of in a holding pattern, waiting to get rate increases even though their costs have gone up.

So that's why I think that you'll see profitability in Q3 and Q4 being more similar rather than an increase in profitability between Q3 and Q4. But again, we're working through it, Arvind. And again, I think we feel relatively comfortable that we're making good progress with clients around appropriate rates for the geographies. And then we continue to have the same menu of options we've always had and that we also have relatively lower cost centers in Central and Western Asia, India, other. And so we offer a full range of opportunities for clients.

[Operator]

Our next question comes from David Grossman of Stifel.

[David Grossman, Stifel]

I just wanted to follow up a couple of things you said earlier in the call. The first was, I think you said you expect about 30% of your delivery capacity to come from the impacted regions in the back half of the year, and that's down from 60%, I believe, at the end of last year. So when you look at that change, is that the way to think about the distribution of work? And secondly, it seems about half of that decline came from closing down Russia. I just want to make sure that I got those numbers right.

[Arkadiy Dobkin, Chief Executive Officer and President]

Yes. At the beginning of this year, we were a little bit under 60% between three countries. Right now we're at about 40%. By end of the year, we expect to be closer to 30%. And this is approximately clearly present distribution of work as well, yes.

[David Grossman, Stifel]

Well, I was -- it looks like about half of that decline, of that 30% change, 15% of that was shutting down Russia. I just wanted to -- it seems like the math works that way.

[Arkadiy Dobkin, Chief Executive Officer and President]

That's right.

[David Grossman, Stifel]

Okay. And then the second question I had was just about the new geographies that you open -- that you're opening. Is the percentage of employees that are being paid in U.S. dollars, is that changing at all with the opening and expansion of the new geographies?

[Arkadiy Dobkin, Chief Executive Officer and President]

So it's a mix, and we still have not moved geographies which will be denominated in USD, which make it clearly the whole story a little bit complicated when you try to calculate it. But it's still going to be a factor, because in some new locations, which we enter in, especially in west -- specifically in West and Central Asia, we will be paying in -- salaries in USD calculation.

[Jason Peterson, Chief Financial Officer]

Yes, David. So it's mixed. But the Russian population -- the Russian employees were paid in rubles. And some of them are going to end up in countries that are paid in local currency and some of them are going to end up in countries where we are using a U.S. dollar as the currency for compensation.

[David Grossman, Stifel]

Any idea of just of your cost of goods, what percentage is in USD?

[Jason Peterson, Chief Financial Officer]

I can't do that off the top of my head, David, and it would also be hard for me to do it, but let me see what we can do to provide information to the market. But I think we've historically talked about -- actually, want to some -- I can't do that off the top of my head, so let me try to provide some information on that later.

[Operator]

I'm showing no further questions at this time. I'd like to turn the call back over to Arkadiy Dobkin, President and CEO, for any closing remarks.

[Arkadiy Dobkin, Chief Executive Officer and President]

Thank you, operator, and thank you, everybody who joined us today. As always, if you have any questions, David is available to help. And in general, I think we're doing better than we would expect like four, five months ago. And we're still in challenging time. But again, we see that we kind of stabilizing and now we're much more comfortable to say that we know how to redesign like our delivery platform, and it works. Thank you.

[David Straube, Head of Investor Relations]

Valerie, before we close out the call, I'd like to acknowledge, we experienced some audio quality issues with the management commentary portion of the call. We have posted a copy of our prepared remarks in the Q2 quarterly earnings section of our Investor Relations site on epam.com. So please go there if you need further clarifications on our prepared remarks.

[Operator]

Ladies and gentlemen, this does conclude today's conference. Thank you all for participating. You may now disconnect. Have a great day.