Emphasis on Solutions Drives Upside Results and Guidance

CTG, Inc. (CTG) reported Q4 ’19 results ahead of our estimates, which we note also represent the consensus. The upside was attributable to robust growth in IT Solutions revenue. Recall that growth in the segment decelerated in Q3 due to a greater seasonal effect following the acquisition of Tech-IT, which prompted us to exercise greater conservatism in our Q4 estimate. Ultimately, both Tech-IT and the European business at large finished the year strong with management highlighting several large engagements spanning CTG’s capabilities in infrastructure and software deployments. With new and expanded engagements in the EU in hand and the first implementation of an automated testing solution secured in the U.S., the outlook for another year of double-digit IT Solutions growth appears promising, in our opinion. As expected, IT Staffing revenue declined on a sequential and Y/Y basis, albeit at a slightly higher rate than we modeled, due to management’s decision to transition away from several lower margin staffing engagements. The ensuing mix of revenue resulted in gross margin exceeding our assumption by over 100 basis points, which in turn led to both adjusted EBITDA and EPS comfortably exceeding our estimates.

Given management’s emphasis on driving solutions growth, the dynamics in Q4 are expected to remain in play throughout FY ’20, and guidance for the year was largely as we previewed. Specifically, CTG anticipates relatively flattish revenues for the year accompanied by higher margins and profitability than realized in FY ’19. While the midpoint of management’s revenue guidance matched our prior projection, we revised our forecast towards the lower end of the range as the outlook is somewhat back-end loaded, in part reflecting the progression of billable days this year as well as more aggressive actions to reduce the book of low margin staffing business to start the year. While the staffing portfolio remains under review, we believe guidance already contemplates the likely actions to be taken. We also note that CTG remains in negotiations with IBM, its largest customer, over a longer-term extension of an existing agreement. Turning to the bottom line, management’s EPS guidance was well ahead of our expectations, suggesting a higher mix of IT Solutions revenue and greater margin expansion than we had assumed. As such, our adjusted EBITDA and EPS estimates both moved higher despite the downtick in our revenue forecast.

All things considered, CTG’s strategic shift towards a solutions-oriented business remains on track. Recent efforts to consolidate the North American sales team and align incentives with solutions growth leave us optimistic that the progress exhibited in Q4 will accelerate further in FY ’20. Between the prospects for improving fundamentals and an outright sale of the company, we continue to see CTG as a compelling investment opportunity. Our price target remains $8.00 based on an unchanged FY ’20 EV/EBITDA multiple of 8x.

Q4 revenue totaled $99.3 million (+6.6% Y/Y), exceeding our estimate of $96.1 million. Management attributed the growth to the acquisition of Tech-IT and further noted that fluctuations in exchange rates represented a $1.3 million headwind to revenue, implying top line growth of 8.0% on a constant currency basis. By segment, IT Solutions revenue was $37.9 million (+26.8% Y/Y) and IT Staffing revenue was $61.4 million (-2.9% Y/Y). We were projecting IT Solutions and IT Staffing revenue of $33.6 million and $62.6 million, respectively. IBM accounted for $21.5 million in revenue during Q4, or 21.6% of the total.

Reflecting a higher mix of solutions, gross margin was 20.4% versus our assumption of 19.0%. Selling, general and administrative expenses of $17.7 million ran higher than our $16.9 million projection. However, the higher revenue and gross margin still resulted in adjusted EBITDA of $4.0 million (4.0% margin) and non-GAAP EPS of $0.14 exceeding our estimates of $2.9 million and $0.07, respectively.

Management’s initial outlook for FY ’20 includes revenue of $380.0-$400.0 million and non-GAAP EPS of $0.42-$0.48, comparing favorably with our prior expectations for $391.9 million in revenue and $0.35 in non-GAAP EPS. However, management’s guidance for approximately $87.0 million in revenue in Q1 was well below our estimate due to one fewer billing day than we had assumed and a more aggressive culling of the staffing business to start the year. That said, the expected mix of solutions revenue will still enable CTG to deliver growth of approximately 50% on the bottom line in Q1, implying non-GAAP EPS of $0.10 versus our estimate of $0.08. While the company’s FY ’20 guidance appears heavily skewed to 2H, we note that this is due in part to the progression of billing days anticipated over the course of the year.

We lower our revenue estimates for this year and next, primarily to reflect more conservative assumptions for the IT Staffing segment given management’s willingness to shed lower margin engagements despite the implications for the top line. We note that these reductions are partially offset by higher growth expectations in IT Solutions, which we expect to benefit from management’s efforts to focus the organization on CTG’s portfolio of offerings. The higher mix of IT Solutions also prompts an uplift in our gross margin assumptions, which is somewhat mitigated by an uptick in operating expenses to support further growth. We note that the increase in our non-GAAP EPS estimates appears more meaningful than the lift in our adjusted EBITDA projections as a lower estimate for depreciation and amortization had more of an effect on our model than our other adjustments.

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.”

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