2023-03-24 14:15:20 ET
Summary
- CTG provides IT consulting services. The industry is very competitive, and labor represents the highest cost center.
- CTG was slow to adapt to the competitive threat represented by India's low-cost labor. Today, the company's labor costs are twice those of INFY and five times India's IT average.
- Without a competitive advantage, the company is unable to grow revenues. It has improved profitability by focusing on higher-margin businesses, but that profitability engine is exhausting.
- I do not find a reason to justify the company's 17x multiple on earnings. It is a high premium that should be justified on competitive advantages, management quality or macro tailwinds.
- I do not believe CTG is an opportunity at these prices.
Computer Task Group ( CTG ) is an American-European IT consulting services and staffing provider.
The company has suffered for much of the past decade, losing revenues and profits. This was caused, in my opinion, by competition from India, a trend that CTG's management does not seem to have reacted to.
CTG has realized a strategic shift towards IT solutions from a previous concentration on IT staffing. I believe this is not enough because the Indian competitors also excel in this segment at a fraction of the labor cost of CTG.
Although the company's prospects are not bright, and the company's history is one of underperformance, the stock trades at a multiple of expected earnings close to 17x.
In my opinion, the stock does not represent an opportunity.
Note: Unless otherwise stated, all information has been obtained from CTG's filings with the SEC .
Business description
IT consulting and staffing : CTG offers companies to take care of their digital transformation and implementation projects. These include migration to the cloud, mobile application development, etc. Today, that segment represents approximately 70% of CTG's revenues, evenly divided between Europe and the U.S.
Before and until 2018, IT staffing represented 70% of revenues. IT staffing is a similar business because the clients require the services of IT consultants to develop a specific project.
A decade of underperformance : CTG was a rising company until 2013, when the business started drying up. The company could not adjust its fixed cost structure, and with already relatively thin margins, profits collapsed.
The drain continued until, in 2018, the company decided to focus on the IT services side of the business against the IT staffing segment. Revenues have not moved much, but gross margins did and with them, the slim operating margins.
India's rise : CTG's business segments are competitive because IT implementations are relatively commoditized. CTG does not own the technologies that are being implemented, and any other company can compete on the same basis.
Companies compete on how well they can organize their human resources for the tasks required by the client. Labor costs represent over 80% of CTG's costs because IT employees are scarce and therefore have bargaining power.
I believe it is in labor costs that CTG lost the competitive battle, mostly against Indian competition. It is no news that India has become a global service powerhouse, especially in BPO, CX, and IT services. Examples abound, the most famous one being Infosys ( INFY ).
The strength of the Indian competition in this realm is the low cost of their workers. According to sites like Glassdoor or Payscale, the average and median yearly salary of an Indian IT consultant is $12 thousand.
Indian IT consultant salary data (Glassdoor (above), Payscale (below))
CTG was slow to recognize the advent of Indian competition. The company opened its first Indian office in 2016 , and its salary costs are still multiples of the Indian average. We have several examples. Below are CoGS over total employees for CTG and Infosys, with the latter being half of the former. Infosys 20-F indicates that over 90% of its CoGS is labor costs .
Another example is the CEO pay ratio to the median worker's pay, reported by CTG on the executive compensation section of its latest 10-K. The CEO's compensation of $2.5 million was 40 times the median worker's compensation, yielding $62 thousand per worker, five times above the Indian average.
Competing in a cost-based business is difficult if your costs are much higher than your competitors.
Financing is strong but not incredible : CTG has no debt and $25 million in cash reserves. However, the company comments on its 10-K that those reserves are located in its foreign subsidiaries and are required as working capital. Therefore, they cannot be used for share buybacks or opportunistic acquisitions.
Cash earnings are no better : Some readers might point to CTG's cash-flows being higher than its net income. Indeed that is true, but only because of stock-based compensation, depreciation, and amortization.
Although amortization ($1.5 million per year) could be considered a cost of acquiring a business (a representation of its already generated value) and not a cost of doing business, the adjustment would not change the equation too much.
High taxation : Like many global companies, CTG cannot match costs generated in one jurisdiction against profits generated in another jurisdiction. The company has averaged an effective tax rate of 40%.
Valuation
CTG generated $6.7 million in net income in FY22, with an upward tendency that was considered above. Below I show pre-tax income to avoid the effect of the revaluation of tax allowances.
With $7 million in net income last year, and a market cap of $117 million, the company trades at a TTM P/E ratio of 16.7x.
The company's operating history does not clearly link economic conditions and revenue. Its projects require long sales cycles and years to finish, so it seems unlikely that revenues would be affected by medium-term economic difficulties. We optimistically assume that the company can maintain its profits or grow them.
On the other side, CTG has been unable to increase its business, and most of its profitability improvement has come from increasing the portion of revenues generated by the higher-margin IT services segment. It is unclear how much the situation can continue improving now that IT services represent 70% of revenues, from 30% in 2018 .
Once this engine of cost improvement is over, I do not find that CTG has a specific competitive advantage that would allow it to increase the business further when even the margins of a giant competitor like INFY have been under attack.
The company's management, most of whom have been with the company since the 1990s, was also very slow in realizing the enormous 'move East' trend in their own market, which makes me doubt that they will be able to spot the next one.
I believe that the 17x multiple is not commanded by company quality, managerial quality, or a prospect of macroeconomic or sector-specific tailwinds. I cannot justify the company's stock carrying that multiple.
Conclusion
CTG is a company that has lost business for most of the past decade. It has improved its profitability by shifting its focus towards higher margin segments, albeit revenues have remained stagnant.
I believe CTG's problems were caused by Indian competition in an industry where labor costs are the main competitive focus. It seems that the company could either not perceive that threat or face it properly.
Today, the company's stock trades at a substantial premium to both accrual and adjusted cash profitability. I do not believe the company commands such a premium on quality (it is not the lowest-cost producer), managerial ability (the Indian competition trend was not managed well), or macroeconomic or sector-specific tailwinds.
For that reason, I believe CTG is not an opportunity at these prices.
For further details see:
Computer Task Group Can't Seem To Compete With Lower-Cost Labor