We are initiating coverage of CTG, Inc. (CTG) with a price target of $8.00, representing a FY ’20 EV/EBITDA multiple of 8x. We believe the long-established provider of IT staffing and solutions services is effecting a strategic transition in its business by de-emphasizing lower margin staffing opportunities and focusing instead on higher margin, higher recurring revenue engagements part and parcel to its solutions business. New President and CEO Filip Gydé has already executed a similar shift within CTG’s European operations over the past two decades and has filled key executive roles with leaders possessing deep roots at the company, leaving us confident in management’s ability to deliver strong earnings growth for years to come. Near-term, the company’s willingness to walk away from low value staffing mandates is likely to limit top line growth, but we expect both margin expansion and earnings growth in FY ’20 with further acceleration in the ensuing years. Given that CTG trades at just 5.3x our FY ’20 adjusted EBITDA estimate, we see limited downside in shares even prior to accounting for the value of the company’s owned headquarters and life insurance policies. In short, we believe the stock makes for a compelling investment.

Investment Highlights

Shifting to Solutions. In 2017, CTG’s IT Solutions segment comprised 30% of revenue. Between acquisitions in each of the past two years and a concerted effort by management to focus the company on solutions growth, the mix of solutions revenue has increased to over a third of the base in short order. We believe the shift from staffing to solutions is significant given the combination of higher recurring revenues and higher margins inherent in engagements for the latter. More specifically, gross margins across the company’s primary solutions offerings hover in the mid-20% range versus our estimate of a gross margin in the mid-teens for more commoditized staffing services. Recently, management has conveyed its willingness to walk away from low margin, resource intensive staffing engagements to pursue more lucrative solutions opportunities addressed by CTG’s Application Advantage, Enterprise Information Management (EIM) Advantage, and burgeoning Testing services. We expect this to further accelerate the mix shift towards solutions, which in turn should boost shares of CTG given relatively higher valuations afforded to IT solutions providers. Of note, this thesis has been borne out before in the company’s own stock performance as meaningful use requirements drove significant demand for electronic health record implementations in the early 2010s, propelling CTG’s solutions growth, solutions mix, and share price to record highs. While the drivers of solutions growth will be different this time around, and perhaps arise from more diverse sources, we see a similar benefit to CTG’s growth trajectory, margins, and valuation.

Resuscitating Health Solutions. The Health Information Technology for Economic and Clinical Health (HITECH) Act was one of many measures included in The American Reinvestment & Recovery Act (ARRA) enacted in February 2009 and catalyzed significant adoption of electronic health record (EHR) systems. As one of the few highly rated IT service providers capable of implementing EHR systems at large hospitals with over 1,000 beds, CTG rode the wave created by federally mandated initiatives to drive meaningful use of electronic health records, which culminated in solutions comprising 41% of revenue at the company’s peak in 2012 and CTG shares garnering a forward EV/EBITDA multiple in the low double-digit range. Of course, all projects ultimately come to an end, and as the company’s large implementations concluded, there were few engagements of similar scope to fill the void. As such, revenue from the Health Solutions group and the IT Solutions segment at-large declined in the ensuing years before stabilizing and inflecting higher in 2018. Today, the healthcare vertical accounts for approximately 17% of revenue, roughly half the level at CTG’s peak but reflecting positive growth once more. We expect Health Solutions growth to accelerate as payers, including the government, promote initiatives to move towards value-based care and population health in order to reduce healthcare expenditures while improving overall outcomes. In our view, new regulations and at-risk models featuring both incentives and losses will require providers to do more with their systems and data, creating significant opportunity for CTG’s Application Advantage and EIM Advantage offerings. Separately, large EHR systems vendors like Epic are pushing new software updates to customers at more frequent intervals, creating higher demand for application testing services. CTG boasts many application testing customers across Europe and has focused its U.S. testing business on Epic release management. With this in mind, we believe the company’s strong foundation in healthcare will serve as a launchpad for the IT Solutions segment.

Expanding Solutions Across the Organization. In addition to Health Solutions, CTG is also investing in growth abroad and to scale in other verticals like energy where the company has a foothold. In Europe, CTG expanded into France, which boasts a $40 billion IT services market, with the acquisition of SOFT COMPANY in 2018. That acquisition was followed by the purchase of Tech-IT in Luxembourg, adding complementary capabilities focused on data center infrastructure design and implementation. Given its broader regional coverage, management sees significant cross-sell opportunities throughout its European operations and is also leveraging its overseas capabilities to land new business in North America. Anecdotally, CTG successfully bid for additional work with an energy customer in Alaska by relying upon the expertise of its counterparts in Europe. Management believes the sharing of knowledge across the organization, expansion of the salesforce, and incentives to encourage cross-selling will enable the company to scale its solutions business in verticals such as energy and financial services, expand regionally in the U.S. to lucrative markets like California and Texas, and sustain strong growth in Western Europe.

Upping the Ante in Staffing. While CTG’s focus is clearly on the solutions side of the business, staffing will continue to represent the majority of revenue, at least through the medium-term. In this regard, management is cognizant of the impact to overall growth and margins arising from decisions to pursue (or not pursue) projects on the staffing side. We expect the company to be prudent in evaluating both its existing base of business as well as future opportunities. Per management, CTG plans to expand selectively in certain existing accounts, acquire higher margin customers in the mid-market, and prune non-core engagements that lack appropriate economics. The company is also on the hunt for opportunities to convert existing staffing customer to managed services relationships, which would result in stickier revenue and less price compression.

New Executive Team a Known Commodity. Although Filip Gydé has only been President & CEO of CTG since March 2019, he joined the company in 1987 and led the company’s European operations for nearly two decades. Of note, the European business has exhibited robust growth due to a concerted focus on solutions, a playbook Mr. Gydé is now employing across the entire company. John Laubacker was promoted to CFO in April 2017 but has been with the company for over two decades. Tom Niehaus, EVP Operations, North America was appointed in May 2019 to oversee sales, delivery, and recruiting across North America. Mr. Niehaus first joined CTG, which acquired a company he founded, in 1999, and he left in 2011. Prior to rejoining the company, he served as COO of Encore Health from 2012-2017 and was appointed CEO of Encore in 2017. Rob Barras, Vice President of Sales, rejoined the company in October 2017 after a stint at Advisory Board. He had previously served as CTG’s Health Solutions sales leader during the company’s heyday from 2009 through 2016. Given the leadership team’s deep roots within the organization and proven success in areas critical to its future, we believe CTG finally has the right management in place to execute on its strategic shift towards solutions.

Hidden Assets. CTG owns its corporate headquarters in Buffalo, NY as well as life insurance policies on 18 former employees whose average age is 76 years old. The life insurance policies have a gross cash surrender value of $29.5 million and a total death benefit of $37.6 million. CTG has outstanding loans and interest totaling $26.7 million against the policies, resulting in a net cash surrender value of $2.8 million and an expected payout upon the death of all remaining plan participants of $10.6 million after the outstanding obligations are repaid. Worth noting, proceeds from the loans were put towards a modified “Dutch auction” tender offer in which CTG repurchased over 1.5 million shares at a price of $8.85 per share for a total cost of approximately $13.5 million in April 2018. As for its headquarters, CTG listed the property for sale in 2018 at an asking price of $3.2 million, but ultimately chose to consolidate its local workforce at that location following the $1.8 million sale of a nearby administrative building.

Valuation. Shares of CTG trade at just 5.3x our FY ’20 adjusted EBITDA estimate, a significant discount to the average multiple afforded to both its staffing and IT services peer groups. We note that staffing firms trade at an average forward EV/EBITDA multiple of 7.5x, while IT services companies trade at an average forward EV/EBITDA multiple of 8.7x. We believe CTG’s highly discounted valuation limits the downside risk in shares and may also attract the interest of an acquirer. Regarding the latter, Assurance Global Services (AGS) sent an open letter to the Board of Directors in August 2019 revealing its submission of two non-binding proposals to acquire the company, the first of which was an offer of $5.50-$6.00 per share in May 2019 and the second an enhanced offer of $5.75-$6.00 per share. CTG rejected the proposal, stating the proposed price undervalues the company and expressing confidence that the company’s business transformation will create more value for shareholders. Our price target of $8.00 represents a FY ’20 EV/EBITDA multiple of approximately 8.0x.

Investment Risks

Acquisitions. CTG has completed several acquisitions in recent years and remains active on the M&A front. The company could overpay for an acquisition, face significant integration issues, or fail to realize expected synergies, which in turn could lead to earnings dilution and other negative outcomes.

Competition. The markets for both IT staffing and IT solutions are highly competitive with low barriers to entry. CTG competes with numerous vendors in both markets, many of whom have significantly more scale and resources at their disposal, as well as its own customers’ internal staff. CTG is also dependent upon qualified IT personnel to provide its services and faces significant competition in recruiting these resources.

Customer Concentration. Year to date, IBM has accounted for 21.5% of CTG’s total revenue and has exceeded that threshold in each of the past five years. The company’s National Technical Services Agreement with IBM is set to expire at the end of 2019. While we anticipate an extension of its current agreement and see potential for the company to expand the scope of services provided, IBM has reduced the number of requirements and billable rates in the past. A similar recurrence in the current round of negotiations or any other negative developments pertaining to the relationship would have a significant impact on the company’s financial performance. While no longer a 10% customer today, SDI, a vendor manager for Lenovo, has also comprised a meaningful percentage of revenue historically and reductions in requirements there would negatively affect CTG’s growth and profitability.

Economic Conditions. Demand for IT staffing and IT services may decline amidst uncertainty or a downturn in the economy.

Industry Concentration. While CTG is focused on expanding its presence in several key verticals, the company currently has significant concentration with technology service providers (~32% of revenue), manufacturing companies (~17%), healthcare organizations (~17%), and financial services firms (~13%). Depressed conditions in any of the major industries served by CTG could weigh on the company’s results.

International Exposure. Over 37% of CTG’s revenue comes from Europe, exposing the company to foreign currency fluctuations, geopolitical conditions, regulatory compliance requirements, and other factors that may cause volatility in results.

Missed Expectations. Many of the company’s engagements with customers are on a short-term basis or cancellable without any financial penalty. As such, customers could decide to not move forward with projects, cancel existing projects, or change the scope of projects, all of which could cause the company to miss its guidance or consensus estimates. In addition, an inability to win new projects to replace completed engagements could also cause the company to miss expectations.

The Backstory

CTG was founded in 1966 by David Baer and Randy Marks. In 1978, the company moved into the Knox Mansion, a property in Buffalo, NY now over a century old that still serves as its headquarters today. CTG was listed on the NYSE in 1987 and subsequently established a North American healthcare practice serving providers, payers, and life sciences organizations. Expansion into Europe began in the mid-1980s and continued in the early 90s. In February 1999, CTG acquired healthcare IT service provider Elumen Solutions for $89 million, comprised of $86 million in cash and assumed debt and the issuance of 128,000 shares of CTG common stock. Elumen Solutions was combined with the company’s healthcare practice to form CTG HealthCare Solutions.

Jim Boldt was appointed President and CEO of CTG in 2001. Much like today, Mr. Boldt focused the company on driving solutions growth across five key verticals with healthcare receiving much of the attention. His tenure was highlighted by the years after the passage of The American Recovery and Reinvestment Act in 2009, an economic stimulus package that included significant incentives for providers to adopt EHR systems. In 2013, CTG acquired etrinity, a healthcare consulting firm based in Belgium. By then, the rush to implement EHR systems had crested, creating a headwind to the company’s growth in healthcare. Mr. Boldt passed away unexpectedly in October 2014, and Cliff Bleustein was selected as the company’s next President and CEO in March 2015. While Mr. Bleustein had experience in the healthcare IT space, his tenure was short-lived due to a poor culture fit.

Bud Crumlish, at the time a 26-year veteran of CTG and leader of the company’s strategic staffing business, was named President and CEO in July 2016. Under his watch, the company initiated its ONE CTG strategy to cross-sell a more clearly defined set of solutions across its existing customer base, entered the French IT services market with the acquisition of SOFT COMPANY in 2018, and completed a modified “Dutch auction” tender offer in which over 1.5 million shares were repurchased for approximately $13.5 million. Changes to the compensation scheme for management and the Board were also initiated to better align their interests with shareholders, and the company also put forth three-year growth and margin objectives. While CTG ultimately fell short of those targets, we believe the efforts made to align the interests of all company stakeholders and the overarching goals of ONE CTG left the company well positioned to return to prominence upon improved execution.

Coinciding with Mr. Crumlish’s retirement earlier this year, Filip Gydé was appointed as President and CEO. As mentioned earlier, Mr. Gydé is also a long-tenured CTG veteran with demonstrable success in driving both solutions and overall revenue growth within the company’s European operations. Just prior to Mr. Gydé formally taking the reins, CTG acquired Tech-IT, a Luxembourg-based IT consulting and solutions company for $9.7 million.

ONE CTG

CTG formally launched its ONE CTG initiative in Q4 ’16 to enhance collaboration across the organization. Through knowledge sharing and cross-selling, management sought to expand both the staffing and solutions businesses. As part of the effort, the company introduced Application Advantage and Enterprise Information Management (EIM) Advantage, both of which combine several existing services into a comprehensive solution. More recently, the company has also begun to highlight testing and validation services as an area of focus given numerous customer wins in Europe and a burgeoning opportunity around Epic release management in the U.S. Of course, the company also offers an array of staffing services, including staff augmentation, managed staffing, volume staffing, direct and permanent placements, and recruitment process outsourcing. Although sales efforts are primarily geared towards landing new solutions customers and cross-selling the solutions portfolio into the existing base, management plans to selectively target several strategic customers for expansion, focus more on the mid-market where margins tend to be higher, and move existing customers towards managed service provider relationships where possible.

*Source: CTG Investor Presentation, December 2019*

Application Advantage combines CTG’s strong application management outsourcing offering in the U.S. with the company’s service desk competencies in Europe, enabling the company to offer a comprehensive solution addressing all aspects of an application’s lifecycle. Key service lines include assessment and roadmap development, application management, and help desk support. The solution set is typically sold into the IT organization, and engagements tend to produce longer-term recurring revenue contracts in excess of $1 million on an annual basis.

EIM Advantage encompasses the company’s capabilities in managing all aspects of data. Engagements typically entail an assessment of a customer’s processes, resources, and tools to determine how data is being collected and consumed; advising on the appropriate data management strategy to ensure ownership, organization, and proper accessibility of critical data; and assisting in the development of reporting, dashboarding, and other visualizations that enable customers to glean insights from their data. EIM Advantage tends to be sold into the finance organization or to the C-Suite. Projects are typically short-term in nature with deal sizes in the low to mid six-figure range but may expand to involve multiple phases.

Competition for the company’s solution services ranges from large U.S.-based IT outsourcing firms like Accenture, Cognizant Technology Solutions and IBM to offshore IT services companies such as Infosys, Tata Consultancy Services and Wipro. Others like Capgemini tend to be seen more frequently in specific geographies and verticals i.e. Europe and financial services. In healthcare, CTG competes with other vertically-focused business process outsourcers such as emids Technologies, Impact Advisors, and Nordic Consulting.

The Healthcare Panacea

Throughout the company’s history, growth in CTG’s Health Solutions group has ebbed and flowed with demand cycles driven by new regulatory considerations. For instance, the company’s healthcare business generated growth in excess of 20% in the aftermath of the dot com bubble despite a depressed IT spending environment as the passage of the Health Information Portability and Accountability Act (HIPAA) in 1996 fueled demand for HIPAA compliance assessments. As mentioned earlier, the meaningful use cycle associated with the HITECH Act also enabled CTG to generate Health Solutions growth in excess of 20% and increase the mix of solutions revenue north of 40% for a spell. Demand for EHR system implementation services has since waned, but new opportunities to optimize existing deployments, provide service desk support, and test applications have emerged. With healthcare payers, particularly the government, intent on driving down costs while still improving overall patient outcomes, we believe it is only a matter of time before new reforms are enacted. At present, initiatives pertaining to value-based care and population health are increasingly moving to the fore, prompting providers to re-evaluate their requirements around systems and data.

A move away from fee-for-service towards value-based care represents a wholesale shift in how healthcare providers are incentivized. In lieu of payments for the volume of services provided, providers are rewarded based on patient outcomes, thereby better aligning the interests of payers, providers, and patients. The shift to value-based care also coincides with an increasing emphasis on population health, defined as the health outcomes of a group of individuals, including the distribution of those outcomes amongst the group. In considering population health, data pertaining to the determinants of health and the populations in question becomes paramount in concluding whether the overall health of the population is improving. New models combining value-based care with the concept of population health continue to be put forth and evaluated. Already, the Center for Medicare & Medicaid Services (CMS) is testing a broad array of service delivery and payment approaches for Medicare Advantage through its Value-Based Insurance Design Model, and is currently testing value-based insurance by condition, socioeconomic status, or both; enabling more impactful reward and incentive programs; allowing for telehealth services; and requiring better structured and timely wellness and health care planning programs.

As this new paradigm takes hold, CTG has already taken steps to align its solutions offerings with the evolving requirements of payers and providers. On the payer side, health plans currently leverage many analytical tools to determine the direction of their business and which contracts may be at risk but must now consider new models and whether their existing mix of tools are sufficient. In this regard, CTG’s expertise in data management and analytics leaves the company well positioned to assist in the assessment and adoption of new solutions. As for providers, many continue to be pressured to accomplish more with fewer resources, creating opportunity for CTG to provide a host of managed services whether to manage applications, provide help desk support, or assist in the testing of new or updated applications. Today, over half of the sales team in North America is focused on healthcare with more to come as management plans to double the North American salesforce in 2020. Whether value-based care ultimately becomes the cure-all for ever-rising healthcare costs remains in question, but CTG’s ability to realize strong demand from investments ahead of the upcoming cycle would garner shares a far healthier valuation in our opinion.

Boom, Bust and the Path Forward

Given the discretionary nature of staffing and IT services, it should come as no surprise that CTG’s business tends to feel the brunt of a recession. Amidst the Great Recession, revenue declined 22% Y/Y to $275.6 million with EPS declining at a similar rate to $0.38. However, government incentives to drive adoption of EHR systems provided a meaningful benefit to CTG’s Health Solutions business, resulting in a CAGR in revenue of 15% between 2009 and the company’s peak in 2012. Much of the EHR implementation work in the ensuing years tended to be smaller projects associated with M&A activity, resulting in an inability for the company to backfill revenue as its largest engagements reached completion. This coupled with lower requirements at its larger staffing customers resulted in a CAGR of (7)% over the next five years. In 2018, revenue growth turned positive as CTG acquired SOFT COMPANY, which was expected to generate annualized revenue of approximately $30 million; delivered strong organic growth in Europe; and saw revenue from its largest customer rise.

*CTG’s SEC Filings; K. Liu & Company LLC*

Thus far in 2019, CTG has experienced similar trends as in the prior year. The acquisition of Tech-IT in February is expected to contribute approximately $20 million in revenue on an annualized basis, and the company continues to see solid organic growth in Europe and the broader IT Solutions segment despite a headwind from foreign currency fluctuations. In Q3, CTG generated $97.2 million (+7.7% Y/Y) in revenue, comprised of $33.0 million (+13.9% Y/Y) in solutions revenue and $64.3 million (+4.8% Y/Y) in staffing revenue. Gross margin expanded 100 basis points on a sequential basis and was up 10 basis points versus the year ago period. Adjusted EBITDA was $3.0 million (3.1% margin) and non-GAAP EPS, which excludes acquisition-related expenses, were $0.10 versus $0.06 in the prior year. Due to a strategic decision to walk away from a low margin staffing engagement, management reduced the high-end of its FY ’19 revenue guidance by $5.0 million for an outlook of $390.0-$400.0 million, but still increased its non-GAAP EPS guidance from $0.32-$0.38 to $0.33-$0.39.

*Sources: CTG’s SEC Filings; K. Liu & Company LLC*

*Sources: IBES Estimates; K. Liu & Company LLC*

Prior to the publication of our report, CTG’s consensus forecast included just one set of estimates. We have taken a more conservative approach with our projections for Q4 and beyond as we expect management to sacrifice top line growth in favor of securing higher margin revenue opportunities. This in turn should position the company for sustained double-digit growth on the bottom line over the long-term. Beyond 2020, we believe solutions growth could reach the high single-digit to low double-digit range with staffing likely to remain in the low single-digits, thereby producing an acceleration in top line growth as the revenue mix increasingly skews towards solutions. Specifically, our estimates for FY ’21 include a 3.6% Y/Y increase in revenue to $406.0 million, approximately 30 basis points of expansion in the adjusted EBITDA margin to 3.7%, and EPS growth of 13.3% to $0.40.

Valuation

Shares of CTG currently trade at just 5.3x our FY ’20 adjusted EBITDA estimate. On a historical basis, shares have peaked at a forward EV/EBITDA multiple just over 13.0x and troughed at approximately 4.0x over the past 10 years. We believe the current valuation reflects a lack of confidence (or perhaps a lack of awareness) that CTG is well positioned to shift its business mix towards higher margin solution services. Our price target of $8.00 represents a FY ’20 EV/EBITDA multiple of 8.0x.

Given CTG’s two operating segments and their disparate growth and margin profiles, we benchmarked CTG against both a peer group of staffing companies as well as a group of IT services companies. For our analysis, we excluded companies with a market cap over $5 billion given the substantial differences in scale and service offerings. As illustrated below, IT services companies tend to command a higher valuation relative to staffing companies, reinforcing our view that the company’s strategic shift to solutions should translate into a higher stock price. As importantly, however, CTG trades at a significant discount to the group median in both cases, which makes for a favorable risk/reward proposition in our view.

*Sources: Company Filings; IBES Estimates; K. Liu & Company LLC*

Our report with model and disclosures is available here.

Disclosure(s):

K. Liu & Company LLC (“the firm”) has received compensation from CTG, Inc. (CTG) in the past 12 months for “Sponsored Research.”

Sponsored Research produced by the firm is paid for by the subject company in the form of an initial retainer and a recurring monthly fee. The analysis and recommendations in our Sponsored Research reports are derived from the same process and methodologies utilized in all of our research reports whether sponsored or not. The subject company does not review any aspect of our Sponsored Research reports prior to publication.

Initiating Coverage of CTG