FX and Labor Constraints Weigh on Europe IT Solutions and Services Segment
CTG, Inc. (CTG) reported mixed Q2 ‘22 results as further strengthening of the U.S. dollar and emerging labor market constraints in Europe weighed on revenue. On a more positive note, the North America IT Solutions and Services segment grew over 20% Y/Y, and the segment’s higher contribution to the revenue mix provided a boost to gross margin. Additionally, even with the aforementioned headwinds in Europe and CTG’s ongoing disengagement from less profitable customers in its Non-Strategic Technology Services segment, gross margins in both areas expanded sequentially and Y/Y, outpacing our assumptions. With operating expenses also coming in lower than we modeled, CTG beat our adjusted EBITDA and non-GAAP EPS estimates for the quarter, while meeting the higher consensus forecasts.
From a macro standpoint, FX will continue to weigh on growth for the remainder of the year since the Europe IT Solutions and Services segment comprises nearly half of revenue. Moreover, the combined impacts of high inflation, labor constraints and the war in Ukraine are also slowing pipeline conversion both domestically and abroad. As such, management reduced its FY ’22 revenue guidance from $360-$380 million to $330-$350 million. We estimate approximately $5 million of the change is attributable to FX and the remainder a function of elongating sales cycles. Along with the revenue reset, guidance for non-GAAP EPS was also reduced from $0.64-$0.72 to $0.56-$0.63. However, management reaffirmed its longer-term outlook for an adjusted EBITDA margin of 7%-8% by the end of FY ’23.
We reduced our revenue estimates for this year and next, primarily due to the impact of FX and labor constraints on the Europe IT Solutions and Services segment and a more gradual ramp up in the large North American digital solutions development contract won in Q1. Although an uptick in our gross margin assumptions and a slight haircut to our operating expense forecasts mitigated the impact to an extent, our estimates for adjusted EBITDA and earnings also move lower. Our price target declines in concert from $13.00 to $10.50 based on a FY ’23 EV/EBITDA multiple of 6x. We note that our prior target reflected a FY ’22 EV/EBITDA multiple of 8x but considering the current growth constraints and ongoing uncertainty in Europe, we expect multiple expansion to be limited for the time being. That said, CTG has demonstrated that its IT Solutions and Services segments can produce much higher margins than in the past. We therefore maintain our view that downside is limited, and shares could re-rate much higher as the company approaches an inflection point in its transformation.
Exhibit I: Reported Results Versus Expectations
Sources: CTG; K. Liu & Company LLC; FactSet Estimates
Q2 revenue of $82.8 million (-10.2% Y/Y) was below our estimate of $87.4 million and consensus of $89.9 million. Foreign currency fluctuations reduced revenue by $4.9 million relative to the prior year and growth was further impacted by emerging labor constraints in Europe. Of course, CTG also continued its strategy of disengaging from lower margin staffing customers. By segment, North America IT Solutions and Services revenue was $20.3 million (+21.3% Y/Y), Europe IT Solutions and Services revenue was $37.2 million (-15.6% Y/Y) and Non-Strategic Technology Services revenue was $25.3 million (-19.4% Y/Y). Relative to our model, the headwinds in Europe comprised the vast majority of the top line shortfall, and revenue in the North America IT Solutions and Services also came in lower as we had assumed a steeper revenue ramp following a significant contract win in Q1. Headcount at quarter-end was approximately 3,200, of which 90% represented billable resources, and was down from 3,650 last year and 3,250 last quarter.
Gross margin of 23.9% was above our 23.0% assumption as margins across all segments outpaced our expectations. By segment, gross margin was 34.8% in the North America IT Solutions and Services segment, 25.8% in the Europe IT Solutions and Services and 12.2% in the Non-Strategic Technology Services segment. Operating expenses of $16.6 million were below our $18.0 million forecast, which combined with the upside in gross margin resulted in both adjusted EBITDA of $4.2 million (5.1% margin) and non-GAAP EPS of $0.15 beating our estimates. CTG exited Q2 with $35.5 million in cash and no debt.
Reflecting further strengthening of the U.S. dollar and slower pipeline conversion, management cut its FY ’22 revenue guidance from $360-$380 million to $330-$350 million. Guidance for non-GAAP EPS also moved lower from $0.64-$0.72 to $0.56-$0.63. Despite the muted outlook for the remainder of FY ‘22, management reaffirmed its prior goal of a 7%-8% adjusted EBITDA margin by FY ‘23.
Exhibit II: Estimate Revisions
Source: K. Liu & Company LLC
We reduced our revenue estimates for this year and next to reflect the incremental impact of currency on the Europe IT Solutions and Services segment as well as more significant growth headwinds for the region. Our growth expectations for the North America IT Solutions and Services segment were also pared somewhat to account for a more gradual ramp in the large development contract secured in Q1 and a slower pace of pipeline conversion as projects come under increased scrutiny. Although the decrease in our revenue estimates was partially offset by higher gross margin assumptions, our adjusted EBITDA and EPS estimates also declined.
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