Business Transformation Produces Margin and EPS Upside Despite FX Headwinds
CTG reported mixed Q1 ’22 results as strong growth in the North America IT Solutions and Services segment and tight operating expense controls drove upside on the bottom line despite a shortfall in revenue. The top line performance was primarily impacted by the strengthening U.S. dollar, which reduced revenue growth by over 300 bps Y/Y. In addition to the FX headwinds, the Europe IT Solutions and Services segment was also negatively affected by lower utilization early in the quarter due to Omicron, and to a lesser extent, by the insourcing of a client project. As expected, revenue from the Non-Strategic Technology Services segment declined Y/Y as CTG disengaged from lower margin staffing engagements. Reflecting the strong solutions growth in North America and the reduced contribution from non-core services, gross margin expanded significantly from a year ago and outpaced our assumption. Between the gross margin upside and lower operating expenses, both adjusted EBITDA and non-GAAP EPS beat our estimates and consensus.
Heading into Q2, CTG continues to see pipelines expanding and throughput improving from a year ago. Worth noting, the company secured the largest digital solutions development contract in its history in North America during Q1, a five-year award that should provide a foundation for solid growth moving forward. Utilization rates in Europe are also set to improve as COVID-related absences abate. However, the U.S. dollar has also continued to strengthen and with no signs that recent trends will reverse, management reduced its FY ’22 revenue guidance by $15 million from $375-$395 million to $360-$380 million. The decrease is solely attributable to FX and still reflects an anticipated decline in non-strategic services of $25-$30 million. Despite the revenue haircut, higher bill rates associated with the growing solutions business should drive margin expansion. Management therefore reaffirmed its prior FY ’22 non-GAAP EPS guidance of $0.64-$0.72 as well as its long term outlook for mid- to high-single digit organic growth in the IT Solutions and Services segment and an adjusted EBITDA margin of 7%-8% by the end of FY ’23.
We reduced our revenue estimates for this year and next, primarily reflecting the impact of FX on the Europe IT Solutions and Services segment. For FY ’23, we also lowered our estimate for Non-Strategic Technology Services revenue to reflect continued disengagement from lower margin services. Although much of the top line decrease was offset by higher gross margin assumptions, our adjusted EBITDA estimates also declined slightly. Our price target remains $13.00 based on an unchanged FY ’22 EV/EBITDA multiple of approximately 8x. CTG continues to transform its own business at an accelerated pace and with signs of traction in its core IT Solutions and Services segments, we see potential for shares to re-rate higher as the growth in higher margin services becomes more apparent.
Exhibit I: Reported Results Versus Expectations
Sources: CTG; K. Liu & Company LLC; IBES Estimates
Q1 revenue of $89.4 million (-7.9% Y/Y) was below our estimate of $93.8 million and consensus of $93.6 million. Foreign currency fluctuations reduced revenue by $3.1 million relative to the prior year and growth was further impacted by CTG’s decision to disengage from lower margin staffing services. By segment, North America IT Solutions and Services revenue was $20.4 million (+10.7% Y/Y), Europe IT Solutions and Services revenue was $42.5 million (-7.7% Y/Y) and Non-Strategic Technology Services revenue was $26.5 million (-18.9% Y/Y). Growth in North America reflected strong demand for application development services, particularly those leveraging Agile and DevOps principles. As mentioned earlier, CTG secured a five-year contract to assist an existing client with modernizing its technology and business processes, which should support continued strong growth moving forward. Growth in Europe was of course dampened by FX headwinds as well as lower utilization rates arising from omicron-related illness. Lastly, ongoing declines in non-core services revenue remained consistent with management’s prior guidance for a $25.0-$35.0 million reduction in FY ’22. Headcount at quarter-end was approximately 3,250, of which 89% represented billable resources, and was down from 3,700 last year and 3,450 in Q4.
Gross margin of 23.0% was above our 22.2% assumption due to strong growth in the North America IT Solutions and Services segment, which boasted a gross margin of 33.6% versus 24.7% and 12.3% in the Europe IT Solutions and Services and the Non-Strategic Technology Services segments, respectively. Operating expenses of $17.4 million were below our $18.5 million forecast, which combined with the upside in gross margin resulted in both adjusted EBITDA of $4.3 million (4.8% margin) and non-GAAP EPS of $0.16 exceeding our estimates and consensus. In Q1, CTG generated $4.3 million in free cash flow and ended the quarter with $38.8 million in cash and no debt.
Reflecting the stronger U.S. dollar, management reduced its FY ’22 revenue guidance from $375-$395 million to $360-$380 million. However, prior guidance for non-GAAP EPS of $0.64-$0.72 was reaffirmed as higher margin IT Solutions projects are expected to contribute to a strong 2H performance. Management also reaffirmed its longer term outlook for mid- to high-single digit revenue growth in its core IT Solutions and Services segments and a 7%-8% adjusted EBITDA margin by FY ‘23.
Exhibit II: Estimate Revisions
Source: K. Liu & Company LLC
We lower our revenue estimates for FY ’22 and FY ’23 to reflect the impact of currency on the Europe IT Solutions and Services segment. The reduction in our revenue estimate for next year also incorporates a similar rate of disengagement from non-core staffing services as anticipated in the current year. We had previously assumed a moderating rate of decline in non-strategic services. Although the decrease in our revenue estimates is mostly offset by higher gross margin assumptions, our adjusted EBITDA estimates decline slightly for this year and next. We note that our FY ’22 EPS estimate actually increases by a penny due to a reduction in our estimates for non-cash depreciation and amortization and stock-based compensation expenses.
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