Computer Task Group (CTG)
This is an introductory writeup to Computer Task Group as I think the idea is interesting and I’d love to get some discussion going surrounding the next 12-24 months. Interestingly, the stock keeps getting cheaper despite what I’d view as very strong execution, with management basically delivering on what they said they’d do in terms of strategic maneuvering a few years ago. I like situations where ‘at a glance’ financials don’t tell the whole story, perception is set to change over time, and where I think the market is slow to react to something significant. CTG may fit the bill. There are some things I believe holding them back, on par with most microcaps, but by and large they’ve been doing a solid job and fundamentals remain strong.
Share Price: $6.75
Shares Out: 16.8mm (includes approx. 1mm options outstanding)
Market Cap: $113mm
Debt: $0 ($12mm capital leases)
EV: $88mm ($100mm incl. leases)
FY22 EBITDA: $17.2mm
FY22 FCF: $11mm (ish)
FY22 EV/EBITDA: 5.2x
2023E EBITDA: $23mm ($18-19mm ex-SBC)
2023E EV/EBITDA: 4.6x
Computer Task Group is the leading IT solutions and services partner for organizations seeking to accelerate digital transformation. What does that mean? It means that CTG helps companies implement their technologies in a more streamlined and efficient way. CTG provides business process solutions, which include strategic advisory, data strategy, digital workplace, enterprise platforms, information disclosure, and regulatory and compliance services. The Company also provides IT and other staffing services, including managed staffing, staff augmentation, and volume staffing services.
CTG has three operating segments which they just started disclosing separately: North America IT Solutions and Services (26% of revenues, 40% of gross profit), Europe IT Solutions and Services (46% of revenues, 46% of gross profit), and Non-Strategic Technology Services (Staffing Services, 28% of revenues, 11% of gross profit). North America and Europe It Solutions and Services make up over 80% of contribution profit (segment operating income before corporate allocations) and are also the two higher margin segments that CTG is driving toward making 100% of the business. The remaining staffing solutions segment (Non-Strategic Technology Services) is low margin and unattractive and will be run off over time (with negative top line impact, but a net positive in terms of value creation). CTG also acquired a company called Eleviant in 2022 which I will touch on briefly. Eleviant results are now reflected within the North America IT Solutions and Services segment. Staffing services businesses aren’t the greatest businesses, and I wouldn’t be interested in CTG if that was all that was on the table here, but digital IT solutions is an attractive space, as it’s a secular grower and offers the potential for higher margin projects and services. Within this realm, CTG has what I’d call a ‘shallow’ moat, with the typical things like reliability, reputation and talented employees. Basically, CTG has become very good at digital solutions within their verticals and as a result can outperform competitors by being faster, more efficient and with less mistakes. A client who has never implemented a cloud-based software program would turn to CTG who has likely done it numerous times. They have a strong competitive position. As a result, CTG can price for some margin and doesn’t have to be the cheapest service available, while also being able to participate in higher end solutions projects with better economics. This is partly why I think EBITDA margins can expand over time. Certainly 5-7% EBITDA margins aren’t indicative of any real moat, however it’s most likely CTG’s current scale as opposed to any business specific issues holding them back. If they can actually increase margins, then we could see operating leverage etc. etc.
As of FY22, the US represents 52% of revenues, while a combination of Belgium, Luxembourg and Other Countries make up the remaining percentage. Additionally, CTG has done a great job of diversifying their business mix within some very attractive end markets, and currently services six main verticals made up of Technology Service Providers (22.5% of revenues), Healthcare (18.1% of revenues), Financial Services (15.9% of revenues), Manufacturing (15.5% of revenues), Energy (5.8 of revenues) and General Markets (22.2% of revenues). Contracts are accounted for using Time and Material (76.1%), Progress Billing (19.1%) and Percentage of Completion (4.8%) methods. Europe was an early bright spot in the company’s digital transformation, growing fast and contributing a large chunk of contribution profits. The segment was led for years by the now CEO, Filip Gyde who is implementing his approach across the entire business.
CTG was founded in the 1960s and for most of their history was an IT Services business until around 2015 (or most likely 2018) where they gradually transformed the business from the staffing services model to one focused on digital IT solutions, bringing better growth, higher margins and more resilience. COVID and work from home accelerated some of these trends, but you wouldn’t know it by looking at the top line or trailing financials (until very recently) and I believe the market is still pricing this business as a lower margin staffing services company despite clear inflection toward digital solutions, and margin expansion. This is partly management’s fault, which I will get into, as messaging has been a bit mixed, and disclosures could be better. You’ll notice that revenue declined from 2021 to 2022, as lower margin staffing services (Non-Strategic Technology Solutions) contracts expired and were not renewed as the company allowed them to roll off in line with their strategic plan. However a look at gross profit and operating margins would reflect positive developments, as expected. All in all, the transition has been largely successful and I’d say we are 80-90% of the way there in terms of the ultimate business mix.
Recently, gross margins, operating margins and EBITDA margins have expanded around 100 basis points since 2020, with further room to move.
As touched on in valuation, management is targeting 7% EBITDA margins for 2023, and if their transformation continues, especially as North America IT Solutions grows, I’d argue there is room for margins to approach 9-10% over time.
CTG cites the global digital transformation professional services market to grow mid-teens through 2026 to reach nearly $300 billion, according to IDC and Fortune Business Insights, with tailwinds in the form of increased adoption of digital transformation plans and the majority of businesses outsourcing cloud migration efforts. Gartner is also very bullish on digital business transformation and CTG as mentioned has the expertise in a number of industries and verticals to capture some of that growth over time. I like the digital transformation theme and the industry given it’s somewhat lack of reliance on the economy being great, providing decent tailwinds for CTG over time.
CTG is led by Filip Gyde, a long-time CTG executive who was responsible for leading the European IT solutions segment. He has been CEO since early 2019, and while working on European operations, oversaw growth and profitability improvements throughout the last several years. Until recently, Europe was the more profitable segment of the business as a major part of the strategy was to focus on higher-margin, more value-added IT solutions services. Under Filip’s leadership, Europe experienced 10 consecutive years of profitable growth. US appears to have the same opportunity. Despite his insistence to rant sometimes, I’ve found him to be smart and capable. The board isn’t great, and lacks technology expertise, but this isn’t a situation where I believe one has to be worried about governance. Comp is fair, SBC has been tolerable and earnings quality seems to be strong. I haven’t yet spoken to management as we’ve had to reschedule multiple times but will get something on the books after earnings.
Due to both business mix shift as well as fast growing and much improved European operations during Filip’s time as leader of Europe, total adjusted EBITDA grew from around $7mm in 2017 to $17mm as of FY22. I think these guys can do between $20-23mm in adjusted EBITDA (ex-SBC) during FY24 (incl. SBC), which would put the multiple (excluding cash build) at 4.0-4.5x. Cheap on its own, but even cheaper for a growing, asset lite, cash flow generative digital solutions business with expanding margins. Capex is minimal and there is no debt other than leases, so EBITDA converts fairly well to FCF. Large cap IT services businesses trade at mid-teens multiples of EBITDA, while pure-play staffing businesses trade around 8-9x. Mastech Holdings (MHH), written up on MCC as well and also undergoing / underwent a strategic shift from pure staffing to a faster growing, higher margin data and analytics segment, trades at 9x NTM EBIT (and seems to be hurting a bit from economic slowdown, but I don’t know it well). A multiple somewhere in that range on FY24 EBITDA would mean 100% upside from here. If there is no re-rate, you’ve got a nice >10% FCF yield, a net cash balance sheet and buyback/M&A optionality. One other thing to note which I have not yet confirmed with management is the receivables balance could be a large source of capital over time. I don’t know what % of these are from the staffing business, or how they will be released over time, but even if it’s $15-20mm of excess cash, that’s significant buyback/M&A firepower (assuming they don’t do anything stupid).
For FY23, management is guiding for $300-350mm in revenues and 7% adjusted EBITDA margins, or $23mm adjusted EBITDA using the mid-point of that guide. You’ll notice that revenue of $325mm would be flat in terms of year-over-year growth from FY22. Management’s outlook for FY23 includes a reduction in revenue of $35 million to $40 million from the prior year as a result of the intentional disengagement from the staffing solutions segment. Outside of this, or when the dust settles, I think they can grow revenues mid-single digits (organic), maybe more over time. EBITDA should grow at the same rate as they scale. As mentioned, the top line doesn’t paint the full picture here given that as the company completes its transformation into a digital IT solutions business (already >80% of revenues), ditching low margin revenue from staffing services will continue to affect the top line, but margins will benefit due to the improved business mix. Having said that, the market hasn’t yet re-rated this thing. In fact, the stock is down -10% in the last month around -8% YTD, and -30% since this time last year.
Aside from the typical things, microcap stock, $100k daily volume, two smaller-shop analysts, I can point to a few things that I haven’t yet confirmed as reasons for the cheap valuation. I think it’s a trust issue (my guess). First, during 2022, CTG acquired Eleviant Tech, a digital transformation business with $10mm in revenues. They paid $17.2mm or 1.8x revenues, significantly higher than previous acquisitions. It’s tough to analyze given I haven’t spoken to management, but I’d imagine there are both synergies here and relationship benefits, while hoping that Eleviant has higher margins than CTG. I will confirm when I can. The point is, I don’t know if this was the deal the market was hoping for, and I think the headline multiple spooked investors.
Second, within the Q4 / FY22 results presentation, the 2023 outlook included an $8-10mm investment in CTG’s ERP capabilities, a project that seemed to come out of the blue, despite its necessity. Management also spoke about removing these costs from GAAP results, indicating that backing them out means they aren’t necessary costs? There was also no discussion surrounding the return on this investment, cost-savings or other. So in the midst of this organic growth, margin expansion story, a fairly large ERP investment comes out of the blue, with no attempt by management to brace shareholders for the project. They’ve called it a two-year project, and the quite obvious risk here is that the implementation is a disaster and there are cost overruns etc. Now once the project is finished, the costs are non-recurring, but only in microcaps do you see something like this where during a critical inflection point, GAAP earnings and FCF are set to decrease slightly due to an unexpected internal investment. I think the market is punishing these guys a bit as a result. However, management has been largely honest up to this point, there are few ‘bad’ adjustments/add-backs to EBITDA so if you are able to look out past a few quarters (raising my hand) the business case hasn’t been impaired.
It’s important to keep in mind that the business has improved by all measures over time, while the valuation has decreased. Usually a good situation to step in front of. Mitigating the above points, and to summarize, this looks like a fundamentally attractive situation, independent of macro factors (the digital / cloud shift is happening), the industry is growing, and the business transition has already been successful (not a turnaround), with the opportunity for continued margin expansion and capital allocation optionality. Open to hearing the bear case!
Inability to execute
Doing something stupid with excess cash
Lack of proprietary IP
Severe economic downturn
Project internalizations (getting rid of outsourced IT, although no evidence of this yet)
Europe has hit a bit of a pause
Companies cut IT spend across the board (most projects are maintenance vs. new implementation)