Encouraging Q4 Performance Leads to Strong Outlook for Core IT Solutions and Services Segment
CTG reported Q4 ’22 results ahead of our estimates and consensus. Relative to our model, strong sequential revenue growth in Europe offset a higher rate of disengagement from non-strategic services than we had anticipated. The highlight of the quarter, however, was a material expansion in gross margin driven by the recent acquisition of Eleviant and a strong performance in North America. In fact, margins across all segments outpaced our assumptions. As operating expenses (excluding acquisition-related and severance costs) were only marginally above our estimate, the upside in gross margin drove a strong beat on both the adjusted EBITDA and non-GAAP EPS lines. Worth noting, CTG’s adjusted EBITDA margin was a touch above 6% in Q4, leaving the company well positioned to achieve management’s goal of a 7% margin exiting FY ‘23.
Although management acknowledged that macroeconomic headwinds remain, we were encouraged to hear that there are a large number of opportunities within the pipeline and throughput actually improved in Q4. Management further noted that win rates remain solid, while renewals and project extensions are occurring at a high rate. Given these dynamics, CTG’s revenue guidance for FY ’23 assumes high-single digit organic growth in the core IT Solutions & Services segment along with continued strong growth for Eleviant. We note that even with the rate of disengagement from Non-Strategic Technology Services expected to exceed our prior assumption in FY ’23, the strength in the core business still puts the midpoint of guidance for both revenue and non-GAAP EPS above our estimates heading into the print.
We fine-tuned our revenue estimates for this year and next, but our projection for FY ’23 is essentially unchanged and increases modestly for FY ’24. That said, we now model a higher mix of revenue from the core IT Solutions & Services segment going forward, resulting in a meaningful uptick in our gross margin assumptions. Although we also raised our operating expense estimates somewhat to align with our higher growth expectations, our adjusted EBITDA and non-GAAP EPS estimates increase slightly. In accordance, our price target rises from $9.25 to $9.50 based on an unchanged FY ’23 EV/EBITDA multiple of approximately 6x. CTG has made steady progress in transitioning more of its business to higher margin digital solutions over the past few years, and the acquisition of Eleviant appears to be accelerating the company’s transformation. Shares remain attractively valued, in our opinion, and should re-rate higher as investors come to appreciate the potential for a dramatic improvement in CTG’s underlying growth and margins moving forward.
Exhibit I: Reported Results and Guidance Versus Expectations
Sources: CTG; K. Liu & Company LLC; FactSet Estimates
Q4 revenue of $77.9 million (-30.7% Y/Y) was in line with our estimate of $77.5 million and above consensus of $76.2 million. The revenue decline was primarily attributable to the completion of a large healthcare engagement that generated over $25 million in revenue in the year-ago period and the disengagement from $9.3 million in lower margin staffing services. By segment, North America IT Solutions and Services revenue was $22.9 million (-29.6% Y/Y), Europe IT Solutions and Services revenue was $37.0 million (-7.6% Y/Y) and Non-Strategic Technology Services revenue was $17.9 million (-34.1% Y/Y). Relative to our model, revenue from North America was in line with our estimate, while upside in Europe offset lower revenues from non-strategic services. Headcount at quarter-end was approximately 3,200, of which 86% represented billable resources.
Gross margin of 27.6% was well above our 25.3% assumption, primarily due to significantly better than anticipated gross margin in the North America IT Solutions and Services segment. That said, gross margins in each segment were ahead of our assumptions. Specifically, gross margin was 43.9% in the North America IT Solutions and Services segment versus our 39.0% assumption; 24.3% in the Europe IT Solutions and Services segment compared to our 24.0% assumption; and 13.6% in the Non-Strategic Technology Services segment versus our 12.4% assumption. Operating expenses of $19.1 million ran higher than our $17.1 million forecast but was only a shade above our estimate when excluding the impact of acquisition-related and severance costs in the quarter. Reflecting the strong gross margin performance, adjusted EBITDA of $4.8 million (6.2% margin) exceeded our estimate and consensus of $3.9 million. Non-GAAP EPS of $0.14 also beat our projection of $0.11 and consensus of $0.12.
In Q4, CTG used $0.6 million in cash from operations and had $0.7 million in capital expenditures. The company exited Q4 with $25.1 million in cash and no debt.
Management’s FY ’23 guidance includes revenue of $300.0-$350.0 million and non-GAAP EPS of $0.56-$0.68, comparing favorably with our expectations heading into the print. Prior to revisions, we were projecting revenue and non-GAAP EPS of $320.6 million and $0.58, respectively, while consensus stood at $324.3 million and $0.65. More importantly, embedded in management’s revenue guidance is an assumption for IT Solutions and Services revenue of $245.0-$290.0 million, representing growth of 15.4% Y/Y at the midpoint. We were previously projecting core IT Solutions and Services revenue at the low-end of management’s guidance. The strong growth in higher margin solutions services should offset an expected decline of $35.0-$40.0 million in Non-Strategic Technology Services and enable CTG to achieve a 7% adjusted EBITDA margin exiting the year. We note that CTG’s non-GAAP EPS guidance for FY ’23 excludes $8.0-$10.0 million in expenses related to a global ERP system implementation, which is expected to span two years.
Exhibit II: Estimate Revisions
Source: K. Liu & Company LLC
Our FY ’23 revenue estimate remains unchanged, but we increased the underlying mix of revenue from CTG’s core IT solutions and services segment. Also worth noting, we shifted some revenue from Q1 into the later quarters, primarily reflecting automatic increases in compensation for employees in Belgium and Luxembourg. Per management, the higher costs may result in clients reassessing budgets for a stint but should ultimately be passed through within a quarter or two.
Our FY ’24 revenue estimate increases slightly and also reflects a favorable mix shift towards CTG’s higher margin revenue segments. Reflecting the higher mix of solutions revenue, we increased our gross margin assumptions for both FY ’23 and FY ’24 and raised our operating expense estimates slightly. As a result, our adjusted EBITDA and non-GAAP EPS estimates increased for both years.
Our report with model and disclosures is available here.
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