Success of Solutions Initiatives Boosts Q3 Results; Raising Price Target from $6.25 to $7.25

CTG, Inc. (CTG) reported strong Q3 ’20 results, surpassing Street expectations as renewed growth in the IT Solutions segment provided a meaningful boost to margins. The sequential and Y/Y increase in CTG’s solutions business reflected the combined benefits of management’s strategic initiatives, higher utilization rates coinciding with reduced business travel and favorable currency fluctuations. Of course, growth in solutions also translated into a more favorable mix of high margin revenue. In any event, both the IT Staffing and IT Solutions segments exhibited meaningful gross margin expansion from the prior and year-ago quarters, providing another indication that initiatives to reallocate resources away from lower margin staffing engagements and hone-in on opportunities around application services, information management and testing have borne fruit. Even with operating expenses running above our model, both adjusted EBITDA and non-GAAP EPS beat our estimates and consensus. Similar to last quarter, GAAP EPS exceeded the adjusted figure as CTG realized another gain from non-taxable life insurance proceeds.

Consistent with its approach throughout the COVID-19 pandemic, management refrained from providing guidance due to the associated uncertainty. That said, commentary pertaining to the pipeline sounded encouraging as management highlighted a meaningful advance subsequent to the introduction of testing services in North America. However, sales cycles with new customers remain extended, prompting CTG to focus more of its business development efforts on existing clients. Of note, these efforts yielded an expansion of an existing go-live implementation contract to include value-add support services in Q3. Management also plans to invest further in scaling and staffing the solutions business going forward. To that end, CTG announced the hiring of Phaedra Drivas, an experienced executive with a track record in delivering cloud transformation consulting and managed services.

On the whole, CTG’s performance during the pandemic has held up better than we initially feared and its strategic shift towards solutions has progressed at a faster pace than we anticipated. We therefore fine-tuned our assumptions for Q4 and FY ’21, which include an uptick in our growth expectations for the IT Solutions segment and a corresponding bump to gross margin, partially offset by higher operating expenses. The net effect was an increase in our revenue, adjusted EBITDA and non-GAAP EPS projections for this year and next. Applying an unchanged FY ’21 EV/EBITDA multiple of 5x to our higher estimates yields an increase in our price target from $6.25 to $7.25. We continue to see considerable upside in shares as CTG makes further strides in its transition to delivering higher margin services.

Exhibit I: Reported Results Versus Expectations

Q3 revenue of $88.6 million (-8.8% Y/Y) easily exceeded our estimate of $83.9 million and consensus of $84.2 million. The upside relative to our estimate reflected an earlier than anticipated return to growth in the solutions segment, which more than offset a modest shortfall in the staffing business. Specifically, IT Solutions revenue of $35.1 million (+6.5% Y/Y) surpassed our $30.0 million projection, while IT Staffing revenue of $53.5 million (-16.7% Y/Y) was just shy of our $53.9 million estimate. Consistent with recent quarters, demand for help desk services related to online patient access and the shift to remote work drove another solid showing in the solutions business. Conversely, the staffing segment continued to exhibit declines due to fallout from the pandemic and management’s strategic decision to reduce exposure to lower margin staffing engagements.

As IT Solutions comprised nearly 40% of revenue compared to 38% last quarter and 34% last year, gross margin expanded by over 100 basis points sequentially and by nearly 300 basis points versus the year-ago period to 22.1%. We were assuming gross margin of 20.5% on an IT Solutions mix of 36%. By segment, IT Solutions gross margin was 29.8% and IT Staffing gross margin was 17.0%, up from 27.0% and 15.3%, respectively, in Q3 ‘19. Management noted that the reduction in business travel amidst the pandemic has produced incremental work hours, resulting in increased utilization and efficiency within the solutions group. While revenue in the staffing segment has continued to decline, margins have increased as much of the downdraft has arisen from management’s prior decisions to cease lower margin engagements. Selling, general and administrative expenses of $17.7 million were above our $16.5 million estimate due to ongoing investments in business development as well as the end of some government reimbursements for furloughed employees late in the quarter. Regardless, the combination of higher revenue and better than anticipated gross margin resulted in adjusted EBITDA of $3.4 million (3.9% margin) and non-GAAP EPS of $0.18, both of which exceeded our estimates of $2.2 million and $0.04, respectively. We note that non-GAAP EPS included a $1.1 million income tax benefit that was not factored into our projection, but still would have beat our estimate by $0.06 on an apples-to-apples basis.

Exhibit II: Estimate Revisions

Management again refrained from providing any guidance due to the ongoing pandemic. However, management stated that the progress made thus far in transitioning to a more solutions-oriented business has been very encouraging and appeared cautiously optimistic in sustaining that success going forward. Between management’s commentary and an increase in the number of billable days, we continue to expect sequential gains from both a revenue and margin perspective in Q4. We raised our estimates for the quarter slightly to account for an uptick in our growth and margin assumptions for the IT Solutions business. Similarly, our revised projections for FY ’21 reflect a higher mix of solutions revenue partially offset by higher expenses.

Our report with model and disclosures is available here.

Disclosure(s):

K. Liu & Company LLC 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.