Computer Task Group, Incorporated
Q3 2020 Earnings Call Transcript

Published: 20 Oct 2020

[Operator:]

Ladies and gentlemen, thank you for standing by. Welcome to the CTG Quarterly Investor Call. [Operator Instructions]. And I'd now like to turn the conference over to our host, Chief Financial Officer, Mr. John Laubacker. Please go ahead, sir.

[John Laubacker:]

Thank you, Laurie, and good morning, everyone. Joining me on today's call is Filip Gydé, CTG's President and Chief Executive Officer. Before we begin, I want to remind listeners that statements made during the course of this conference call that state the company's or management's intentions, hopes, beliefs, expectations and predictions for the future are forward-looking statements. It is important to note that the company's actual results could differ materially from those projected. These forward-looking statements are based upon information as of today, Tuesday, October 20, 2020. The company assumes no obligation to update these statements based on information from and after the date of today's conference call. Additionally, information concerning factors that could cause actual results to differ from those made in the forward-looking statements is contained in today's earnings press release as well as the company's SEC filings. In addition, the company's press release and management statements during the call include discussions of certain adjusted non-GAAP measures and financial information. These financial measures and reconciliations of GAAP to non-GAAP results are provided in both today's press release and the related Form 8-K. With that, it is now my pleasure to turn the call over to Filip for his opening remarks.

[Filip Gydé:]

Thank you, John. Good morning to everyone on the phone and connected via webcast. We appreciate you joining us on today's call. While much of the world and most businesses, including CTG, continue to work through the unique challenges associated with the global pandemic, I'm pleased to report that our team's focus and commitment to disciplined execution resulted in another quarter of sustained progress and strong operating performance. Both operating profit and net income increased year-over-year, primarily driven by the growing contribution from higher-margin solutions business and strong utilization of available resources despite the lower total revenue in the quarter. As part of our decisive actions taken earlier this year, the majority of our employees and contractors continue to work remotely. We've experienced no loss in productivity since initiating the transition. And in fact, have realized increased efficiencies and sustained higher utilization as time previously consumed by business travel is used to produce incremental work. Importantly, we have continued to meaningfully advance the company's rapid transformation towards high-margin digital solutions. Our strategic initiatives aimed at the expansion of CTG's solutions offerings gained notable momentum in the third quarter, with solutions revenue increasing 3.7% sequentially and 6.5% year-over-year to represent nearly 40% of total revenue. We are continuously working to expand our solutions portfolio with new and complementary offerings, including incorporating robotic process automation and artificial intelligence capabilities. With our continued focus on the expansion of our solutions offerings and the resulting increase in the revenue contribution from this business, we remain committed to making the necessary investments to strategically scale and staff our solutions organization. Additionally, we are actively taking steps to position the company for success in both our existing and expanded solutions offerings across our targeted end market verticals. Consistent with these objectives, we recently hired Phaedra Divras, an accomplished executive with valuable experience delivering cloud transformation consulting and managed services. We are pleased to welcome her to CTG and believe she will be an important addition to our growing solutions team in North America. As evidence of our growing solutions engagements, during the quarter, we secured a multi-million dollar contract with a large state hospital system to provide Epic MyChart help desk services for two West Coast health care facilities in the U.S. Also during the quarter, we drove increased business development activity and meaningfully advanced our pipeline of engagements for CTG's recently launched testing solutions offerings in North America. As a reminder or for those new to CTG, testing solutions has been an important contributor to the success of our solutions business in Europe, and we are now seeking to replicate that success in North America, while also leveraging the unique crowd testing capabilities we acquired through our purchase of StarDust, a leader in testing and quality assurance services earlier this year. Our team remains actively engaged in the sourcing and submission of new proposals. Even though the issuance of new requests for proposals, and also the potential awards of new contract wins continue to be delayed due to ongoing uncertainty associated with the pandemic. Travel restrictions continue to limit face-to-face meetings, which are often critical for cultivating trust with prospective new clients. In response to these temporary obstacles, we have increased business development activities with CTG's existing client base. As a result of these efforts, during the quarter, we meaningfully expanded the previously awarded go-live implementation with a healthcare system clients in the northeastern U.S. Additionally, our team successfully maintained the significant amount of at-risk business in Alaska, following the sale of a client's business unit to another company. It has been particularly rewarding to see the significant financial progress we have made over the past 7 quarters. Our GAAP operating margin has increased from 1.2% in the first quarter of 2019 to 2.1% in this past quarter. While our non-GAAP operating margin has increased from 1.5% to 2.7%, in that same time period. Additionally, our earnings and EBITDA have also increased in a meaningful way over the past 7 quarters. Considering that all of the economies in which we provide services, have been severely impacted throughout most of 2020 by the pandemic, we are pleased with our performance this year and remain encouraged about the opportunities ahead. I'm very proud of what our team has accomplished to date, especially given the unique challenges resulting from the pandemic. However, there is still more work to be done. We have only begun to realize what I believe can be CTG's full potential. In addition to demonstrating progress on our existing strategic objectives, we will continue to take incremental steps to build upon and accelerate the continued momentum in our solutions business. As we look ahead and begin positioning the company for 2021 and beyond, I believe it will be important to be agile and quickly adapt to both rapidly changing market trends and clients' needs. Our team has done an excellent job of adapting to our new norm, while remaining highly efficient and executing well a predominantly remote working environment. Recognizing both the necessity and opportunity to evolve our strategy and expanded offerings to best meet our clients' needs, we are confident that our continued focus on delivering value-add solutions that enable clients' digital transformation will also result in increased profitability and significant long-term value for our shareholders. I will now turn the call over to John for a detailed review of our third quarter results and outlook for the remainder of 2020.

[John Laubacker:]

Thank you, Filip, and again, good morning, and thank you for joining us today. As reported in our press release earlier this morning, consolidated revenue in the third quarter was $88.6 million compared with $89.1 million in the second quarter of 2020 and $97.2 million in the third quarter of 2019. The small sequential decline in total revenue for the quarter primarily reflected our continued transition away from select lower margin staffing business as well as the typical seasonality associated with the calendar third quarter. The year-over-year decline was in part due to the impact from the COVID-19 pandemic on client demand and the previously mentioned an ongoing transition away from lower-margin staffing business. Currency translation had a positive impact of $1.8 million on revenue in the third quarter of 2020 compared with a negative impact of $800,000 in the second quarter of 2020 and a negative $1.6 million in the year ago period. Total billable days in the quarter were 63 compared with 64 days in the second quarter of 2020 and 63 days in the year ago third quarter. Solutions revenue in the third quarter of 2020 increased $1.3 million or 3.7% sequentially to $35.1 million and expanded to nearly 40% of total revenue. This compared with $33.8 million or 38% of total revenue in the previous quarter. Solutions revenue also increased $2.1 million or 6.5% year-over-year compared with $33 million or 33.9% of total revenue in the third quarter 2019. In addition, the solutions representing a larger portion of our overall revenue, the gross profit margin from solutions improved 280 basis points year-over-year to 29.8% of revenue. Revenue from IBM in the third quarter was $18.6 million or 21% of total revenue compared with $18.9 million or 21.2% of total revenue in the second quarter of 2020 and $21.3 million or 21.9% of total revenue in last year's third quarter. Subsequent to our second quarter conference call, our master services agreement with IBM was further extended to November 27, 2020, as we continue to discuss general business terms and conditions of a longer-term arrangement. No other client represented more than 10% of revenue during the third quarter of 2020 or in recent comparable periods. Cost of services as a percentage of revenue were 77.9% in the third quarter of 2020 compared with 79% of revenue in the second quarter of 2020 and 80.7% of revenue in the year ago third quarter. GAAP operating margin in the third quarter of 2020 was 2.1% compared with 2.1% in the second quarter of 2020 and 1.6% in the year ago quarter. Non-GAAP operating margin in the third quarter of 2020 which excludes approximately $600,000 of acquisition-related expenses, was 2.7% compared with 3.2% in the second quarter of 2020 and 2.4% in the year ago quarter. The third quarter GAAP operating margin was flat sequentially but increased 50 basis points year-over-year, while the non-GAAP operating margin was 50 basis points lower sequentially, yet increased 30 basis points year-over-year. Both measures reflect the increase in the mix of solutions revenue within our total revenue and our continued efforts to improve the execution and delivery of our services. The effective income tax rate in the third quarter of 2020 was a negative 31.2% compared with 43.7% in the second quarter of 2020 and 33.5% in the year ago third quarter. The negative effective tax rate in the third quarter of 2020 was primarily the result of implementing newly enacted legislation that allows the exclusion of certain high tax income associated with the Global Intangible Low Taxed Income or GILTI regulations. This change in legislation resulted in a onetime tax benefit of $1.1 million or $0.08 per diluted share during the third quarter. GAAP net income in the third quarter of 2020 was $2.8 million or $0.20 per diluted share, which included a net $200,000 of nonoperating income or $0.02 per diluted share comprised of a gain from nontaxable life insurance, partially offset by acquisition-related expenses. Non-GAAP net income for the third quarter of 2020 was $2.6 million or $0.18 per diluted share. Additionally, note that both the GAAP and the non-GAAP net income for the third quarter of 2020 included the previously discussed tax benefit of $0.08 per diluted share associated with the change in legislation occurring during the quarter. For comparison, GAAP net income for the second quarter of 2020 was $1.8 million or $0.12 per diluted share, which included a net benefit of $0.02 per diluted share, comprised of gains from nontaxable life insurance and the sale of a building, offset by severance and acquisition-related expenses. Excluding these items, non-GAAP net income for the second quarter of 2020 was $1.4 million or $0.10 per diluted share. GAAP net income for the third quarter of 2019 was $879,000 or $0.06 per diluted share, included approximately $500,000 in acquisition-related expenses. Non-GAAP net income was $0.10 diluted share in the year ago third quarter. For the trailing four quarters ended September 2020, net income on both a GAAP and non-GAAP basis was $7.4 million or $0.52 per diluted share, which includes the previously mentioned tax benefit of $0.08 per diluted share related to the change in legislation. Adjusted EBITDA for the trailing 4 quarters was $14.9 million. CTG's total headcount at the end of the third quarter was approximately 3,750 compared with the 3,700 at the end of the second quarter of 2020 and 4,350 at the end of the year ago third quarter. The change in headcount compared with the prior year primarily reflects a reduction in personnel outside of our solutions business as we continue to transition away from select lower margin staffing services. Approximately 91% of our third quarter 2020 headcount was billable. Turning to our balance sheet. Cash and cash equivalents at the end of the third quarter were $33.4 million. The company's outstanding long-term debt was $6 million at quarter end, reflecting the paydown of 50% of the previously outstanding balance on the company's revolving credit facility during the quarter and resulted in net cash of $27.4 million at the end of the quarter. Capital expenditures in the third quarter of 2020 were $685,000 compared with $493,000 in the second quarter of 2020 and $583,000 in the third quarter of 2019. Looking forward, given the dynamic business environment and challenges associated with quantifying the potential impact of the COVID-19 pandemic on CTG's clients, we've chosen to not provide quantitative guidance for the fourth quarter and full year 2020. That said, we are very encouraged by our sustained progress and the success of our solutions initiatives as well as the corresponding increase in the company's gross profit margins in the third quarter of 2020. We also continue to be committed to our strategy of making appropriate focused investments in solutions for the remainder of 2020 as part of positioning the business for the year ahead, while also seeking to further enhance the long-term value of CTG. Before we open up the call for questions, I want to briefly address the filing that 2 of our investors made yesterday. Our Board and management team have seen the letter and are reviewing it. The focus of today's call is to discuss our quarterly results and we will not comment further on the filing at this time. Laurie, could you please initiate and manage our question-and-answer session?

[Operator:]

[Operator Instructions]. Our first question from the line of Josh Vogel with Sidoti & Company.

[Josh Vogel:]

So my first question is health care has proven to be a strong market for you. You're seeing some nice success there in signing new business, expanding existing business. I was just wondering if you could talk about the general pipeline today, maybe what's changed in how you engage with and help these clients and prospects relative to pre COVID?

[Filip Gydé:]

Good question, Josh, certainly. Looking at our pipeline in health care is strong, is growing in a number of areas, I think when COVID sat in, we saw that our business in some areas, not only in health care but also they are increased in some areas. For instance, the help desk operations, where we had additional work and still have additional work in response to an increase in demand, think about patient access to online medical record, think about all of the employees working from home, having different kind of problems, different kind of questions to their help desk. We've also helped in setting up remote work capabilities, and that goes from laptop, phone systems, but also to more collaboration software processes and installations that are now becoming more robust because it's taking a longer time. So we see a lot of demand in that area. We also see a growing pipeline in our testing business, as I said during my remarks, and that is a business that was very strong, still is very strong for us in Europe, and we're now replicating it in the states. And with the increased software implementations, with the increased new releases and updates of software and the speed in which beginning of COVID, everything had to be changed. There's a lot of robust testing needed to make sure that the systems are without bugs, without faults. So all in all, in a number of different areas, we see good and solid potential still in our healthcare business.

[Josh Vogel:]

I appreciate the insight there. When thinking about the IT Solutions business, you have application solutions, operations, port testing, information management. It was a pretty impressive jump in the gross margin. And I guess, can we assume that you're seeing most of the traction today in the application solutions and testing work? And maybe just give a sense of where you're seeing most demand overall and what you anticipate over the next several quarters when we think about all of the offerings under IT Solutions.

[Filip Gydé:]

I think we see traction in all of the areas. We see mainly a lot of things happening in the area of cloud, cloud computing and platform and that is really positioned all over the spectrum of the solutions that we are offering. We see in all of the solutions. So if it is application development of implementation, if it is testing, if it is operations and support and infrastructure, we see a lot of progress in applying robotic process automation, artificial intelligence, testing, for instance, as we've launched it very recently this year, we can see the growing demand and also the growing demand not only for testing as such, but for test automation. And you see that most of the test automation software vendors are applying artificial intelligence in their tool sets, and that's also how we are focusing on the market. The amount of testing work that there is now, and there is going to be in the next several years is huge that it cannot be done manually. And economically, it doesn't even make sense to do that. So test automation is definitely an area where we see strong demand. But in the application side, same thing and then the service desk side, we also see those new digital technologies take more of the part of the opportunities in our pipeline.

[Josh Vogel:]

All right. And maybe a question around utilization of the billable resources in the quarter versus your initial expectations in late July. Was there perhaps less vacation time taken than expected? Could that potentially dampened utilization in Q4, if people finally do take some more time off? Could you just give some color around that?

[Filip Gydé:]

John, could you give some color on that?

[John Laubacker:]

Sure. It was actually different among different countries in which we operate. So in some of -- I'll start with Europe, some of the European countries utilization continued to be very, very high, and the vacation time taken was a bit less than we had thought it would be in Q3. So we do think that there'll be an impact there in Q4. But I want to say in most of the countries in which we operate, vacation holiday time taken was a little bit higher than it had previously been as expected, as we expected people to take a breath and take some time off. And as countries, at least at that point in time, in the third quarter, opened up a little bit, to some travel, people did take some holiday time and take some time off. So we did see that. In the United States, I think our utilization across the board was very, very strong. We did expect a tick up in time off and we did see that, but it wasn't really any higher than we had expected. So I would say as expected in North America.

[Josh Vogel:]

All right. Great. And just one last one probably for you as well, John. Just doing back of the envelope math, I'm kind of calculating a gross profit in staffing at about 17%, up from 15% in change a year ago. I was just curious how much more business are you planning to transition away from? Or when will that be complete? And then how should we think about the margin profile of the staffing business going forward from here?

[John Laubacker:]

It's a great question. Your math is good. And from our perspective, when we look at the staffing business overall and stepping away or disengaging from some of the lower margin staffing business, we've been pretty detailed and thoughtful about that process. And we go through sort of a long list of questions around who is the client? What is the opportunity? How hard is it to recruit? How hard is it to deliver? What are the future opportunities to maybe convert that to something else? And what does the overall client relationship look like? Just to name a few of the things that we think about. It would be our plan to absolutely continue to step away from the lowest margin staffing business, as we do that. There are opportunities, and you look at a number of our larger clients, not all the business is governed by, say, one contract or one relationship in one location. We've got multiple contracts and multiple relationships. And so as each one of these come up, we critically evaluate the work that we do in each one of those areas and decide if that's something we need to continue or want to continue or it's something that we might want to step away from. So I think you'll continue to see a progression away from the staffing, the lowest margin staffing business where it just isn't viable or instrumental to what we're trying to accomplish overall as an organization. So that is definitely going to continue. As far as margin profile, I would think that it's not going to go up rapidly from here, but I continue to believe that we'll continue to push that up incrementally as we step away from the lowest margin piece of that business.

[Operator:]

[Operator Instructions]. We'll go next to Kevin Liu of K. Liu & Company.

[Kevin Liu:]

You guys talked a little bit about the pipeline deals still moving a little bit slower given the current environment. I was wondering if you are seeing signs that, that is picking up. And for a number of these deals that have come into the pipeline related to testing in North America, do you expect those to be able to close in the near term? Or do you think these are opportunities more so for the coming year?

[Filip Gydé:]

I think we have kind of a spread in the pipeline. We still see that business opportunity, obviously, don't go through the pipeline as they did pre COVID. But we do see that our clients are, let's say, past that first phase where everybody said, okay, everything is going on hold. We're only doing quick fixes. The things we're discussing now are really the things for long term. We see that now they are in a situation where, well, the quick fixes probably need to be replaced by more structural, more robust solutions. And while they just can't wait until who knows when things are really better. So we see some pickups in activity, though it's still, like I said, not at the speed that we had before.

[Kevin Liu:]

Understood. And just a couple of questions around the solutions gross margin. Obviously, you guys have made a lot of progress there. Does the mix of work you see in the pipeline and the projects nearing completion, does that point to any sort of changes in what you would expect for gross margin going forward? And then, John, maybe you could help us just in terms of the benefit you guys received from government reimbursement programs in Europe, whether you expect those to continue or if those start to taper off from here?

[Filip Gydé:]

Okay. Well, let me start with the solutions gross margins. We are obviously very happy with the continued progress of our gross margin and solutions. And I think what we see, Kevin, is a combination of 2 things. It's a combination of us focusing on a number of solutions and over time frame of more than a year now getting better and better because we're doing the same solutions, we're repeating the same solutions and getting more efficient in executing. So that obviously gives you a higher profitability. What we also see is that we're focusing more on subsets of solutions that yield higher profit margins. And there, you definitely come in the area of the more digital solutions that are more in demand and that yield the bigger -- a higher profitability. So it's a combination of those two factors. As we move forward in executing our digital solutions strategy, and we increased the mix of business towards a higher-margin dilutions, we are confident that our margins are going to continue to increase, though obviously, it's not going to be a linear straight-line going up, but the trend will definitely be on the increasing side. John, do you want to comment on the benefit?

[John Laubacker:]

Sure. Thanks, Filip. Kevin, it really is a different answer in each one of the countries in which we operate. For instance, for the most part, a lot of the subsidies diminished greatly or ended at the end of August. In some instances, they would continue for the rest of the year, we will take advantage of those where we can. But for instance, in Belgium, for the most part, those came to an end at the end of August. They continue on if you're a company that's in trouble today, and we're not. We're actually doing, as you know, exceptionally well. So the benefits that we previously received won't be available to us after August or weren't available to us after August, impacted September in Q3. Some of the other countries, those benefits do continue, but at a diminished level as time passes. So it will be reduced, the amount of benefit we get from the government in the other countries as time passes. So the impact in Q4 will be sustainably less than the impact was in Q3 and certainly in Q2.

[Kevin Liu:]

Got it. That's helpful. And then just on the staffing side, I know it's still kind of early days since IBM announced this, but with the spin-off that they're undertaking, I was wondering if you could comment a bit on just how much business you have with a portion that's being spun off versus the part that's remaining with IBM? And how you expect this to kind of affect the negotiations for a longer-term agreement or perhaps even shifting some of these engagements more towards managed services agreements?

[Filip Gydé:]

Sure. We have not as yet had a detailed discussion with IBM subsequent to their announcements. And obviously, we believe a certain portion of our business would move to the new company. But at this moment, nothing has been decided yet. As you know, our relationship with IBM is long-term and is outstanding. So we expect to continue that relationship even if some of that business would transition to a new company. John indicated it in his remarks, current contract has been extended to November 27. And the discussions with IBM on the terms and conditions of a new long-term deal are still continuing. So I'm not sure there would be a significant impact from that spin-off on those discussions. But like I said, we haven't had a detailed discussion with them yet.

[Operator:]

Our next question is from the line of Gary Hatton with Granahan Investment.

[Gary Hatton:]

I understand you're not here to talk about the filing, but I'm actually out-of-pocket and haven't had a chance to see what the filing even sanctioned. Are you willing factually just to say what they filed and said?

[Filip Gydé:]

John?

[John Laubacker:]

Our approach is that we're going to talk about financial results today, Gary, from the quarter in the press release. And so no, we're not going to address the filing that was made.

[Operator:]

And I'll now turn it back to management for closing remarks.

[Filip Gydé:]

Thank you, Laurie. In closing, I want to first thank the entire CTG organization for their dedicated work and collective contributions to the company's strong operating performance in the third quarter and year-to-date. I'm very pleased with our continued progress, including the growing momentum for our solutions business and offerings, especially during this challenging environment. As our strategic focus evolves further towards expanded, higher-margin solutions business that enable clients' digital transformation, I am confident we will be well positioned to capitalize on new long-term growth opportunities across multiple end market verticals and geographies. We anticipate this expansion of CTG's Solutions business will yield both increased profitability and significant shareholder value. Thank you for your continued interest and participation on today's conference call. Laurie, you may now disconnect the call.

[Operator:]

Thank you. Ladies and gentlemen, this will conclude our conference call for today. Thank you for your participation and for using AT&T conferencing service, and you may now disconnect.