Steady Progress on Margins Despite Ongoing Revenue Headwinds
CTG’s Q3 ’22 results reflected management’s ongoing efforts to strategically shift the company towards higher margin digital IT solutions engagements. Despite revenue coming in below our estimate and consensus, gross margin improved meaningfully Y/Y and was consistent with our assumption. On the top line, revenue was again impacted by FX and the company’s disengagement from lower margin staffing services. However, we were pleased to see revenue in the North America IT Solutions and Services segment hold steady on a sequential basis and were even more encouraged by the sequential and Y/Y improvement of over 300bps in the associated gross margin. With operating expenses also coming in lower than we modeled, CTG delivered adjusted EBITDA in line with our estimate and consensus. Non-GAAP EPS were a penny below consensus and $0.02 shy of our forecast due to a higher than anticipated tax rate.
As for guidance, continued strengthening of the U.S. dollar since CTG last reported will further impact reported revenue in the Europe IT Solutions and Services segment, and management now anticipates disengaging from approximately $30 million in Non-Strategic Technology Services work. We had previously modeled a non-core revenue decline in the mid-$20 million range. Although the recent acquisition of Eleviant will offset this to a degree, management’s revised guidance for FY ’22 includes revenue and non-GAAP EPS of $320-$330 million and $0.52-$0.58, respectively, down from $330-$350 million and $0.56-$0.63 previously. Perhaps more importantly, however, management reaffirmed its outlook for an adjusted EBITDA margin of 7% by the end of FY ’23.
We lowered our revenue estimates for this year and next, primarily reflecting the higher rate of disengagement from non-core staffing services and the ongoing headwinds from FX and labor constraints on the Europe IT Solutions and Services segment. Although the acquisition of Eleviant and an uptick in our gross margin assumptions mitigated the impact somewhat, our estimates for adjusted EBITDA and non-GAAP EPS also move lower. As a result, our price target declines from $10.50 to $9.25 based on an unchanged FY ’23 EV/EBITDA multiple of approximately 6x. We believe CTG is navigating through the challenging economic environment as well as can be expected and is making solid progress on its own transformation. We continue to believe shares are attractively valued and could see significant upside as growth in higher margin solutions revenue begins to overtake the declines in lower margin staffing services.
Exhibit I: Reported Results Versus Expectations
Sources: CTG; K. Liu & Company LLC; FactSet Estimates
Q3 revenue of $75.0 million (-17.2% Y/Y) was below our estimate of $78.4 million and consensus of $78.2 million. Foreign currency fluctuations reduced revenue by $5.7 million relative to the prior year period, and growth was further impacted by CTG’s ongoing disengagement from lower margin customers in its Non-Strategic Technology Services segment, which decreased revenue by another $8.8 million versus last year. Adjusting for these two items, growth on a constant currency basis in the core IT Solutions and Services segment declined just 1.8% Y/Y despite ongoing labor constraints in Europe. By segment, North America IT Solutions and Services revenue was $20.3 million (-4.1% Y/Y), Europe IT Solutions and Services revenue was $33.3 million (-15.2% Y/Y) and Non-Strategic Technology Services revenue was $21.4 million (-29.1% Y/Y). Relative to our model, ongoing disengagement from lower margin staffing services comprised $1.9 million of the revenue shortfall, while lower revenue from the Europe IT Solutions and Services accounted for the remaining $1.4 million. We were encouraged to see revenues in the North America IT Solutions and Services segment hold steady on a sequential basis and come in relatively in line with our $20.5 million estimate despite more challenging economic conditions. Headcount at quarter-end was approximately 3,250, of which 88% represented billable resources, and included approximately 300 employees from the recent acquisition of Eleviant.
Gross margin of 24.3% was a shade higher than our 24.2% assumption as higher than anticipated gross margin in the North America IT Solutions and Services segment more than offset lower margins in the remaining segments. Specifically, gross margin was 38.0% in the North America IT Solutions and Services segment versus our 35.0% assumption; 23.7% in the Europe IT Solutions and Services segment compared to our 25.5% assumption; and 12.3% in the Non-Strategic Technology Services segment versus our 12.9% assumption. Operating expenses of $16.0 million were below our $16.5 million forecast, which combined with the strong gross margin resulted in adjusted EBITDA of $3.8 million (5.1% margin) meeting our estimate. Non-GAAP EPS of $0.11 was below our projection due to a higher tax rate than we modeled.
In Q3, CTG generated $9.7 million in cash from operations and had $0.5 million in capital expenditures. Additionally, the company paid $17.4 million in cash for the acquisition of Eleviant and exited Q3 with $26.8 million in cash and no debt.
Reflecting further strengthening of the U.S. dollar and a higher rate of disengagement from lower margin staffing services, management lowered its FY ’22 revenue guidance from $330-$350 million to $320-$330 million. Guidance for non-GAAP EPS also moved lower from $0.56-$0.63 to $0.52-$0.58. The revised guidance implies Q4 revenue and non-GAAP EPS of $73.1-$83.1 million and $0.10-$0.16, respectively, leaving our prior estimates and consensus at the high-end.
Exhibit II: Estimate Revisions
Source: K. Liu & Company LLC
We reduced our revenue estimates for this year and next to reflect lower levels of Non-Strategic Technology Services and the incremental impact of currency on the Europe IT Solutions and Services segment. In addition, we have moderated our FY ’23 expectations for growth across the IT Solutions and Services segments to account for increasing global economic uncertainty. Partially offsetting these reductions was the incorporation of Eleviant into our model, which we note assumes approximately $10 million in revenue on an annual basis along with gross and adjusted EBITDA margins of 50% and 15%, respectively.
We also introduced our FY ’24 estimates, which include revenue of $322.8 million (+0.7% Y/Y) and adjusted EBITDA of $20.4 million (6.3% margin). Worth noting, we expect CTG’s IT Solutions and Services segments to grow in the high single-digit range. We also assume the company exits FY ’23 with an adjusted EBITDA margin of 6.9% and exits FY ’24 with an adjusted EBITDA margin of 7.5%.
Our report with model and disclosures is available here.
Disclosure(s):
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