2023-05-29 07:07:01 ET
Summary
- CTG is a consulting firm that specializes in digital transformation.
- The company is strategically divesting from their staffing segment in favor of their higher-margin core business. The results are mixed.
- Macro headwinds such as high interest rates should limit companies' CapEx spending, which will hurt CTG.
- I think there is some upside, but there is limited margin of safety.
- All things considered, I rate this company a hold.
Investment Thesis
Computer Task Group ( CTG ) is a consulting firm that specializes in aiding companies in their digital transformations. They have a team of IT experts who can advise a company on what tools are needed for their digital transformation and provide them aid in implementing said tools into the company's operations.
The stock is down almost 70% over the last ten years and is trading at around a 110 million dollar market cap. As a contrarian value investor, this ticker caught my eye.
The company has several things going for it. For one, the digital transformation industry is growing at over 20% CAGR and is expected to continue until 2030. Over 70% of company leaders say they are focused on digital transformation.
CTG is also in the process of a margin-expanding strategic divestment from its staffing segment. My projections show that this should have a non-negligible impact on the bottom line.
However, the headwinds are too strong. Interest rates are high, which is bad for stocks generally speaking, but should hurt CTG uniquely as CapEx spending, like hiring a digital transformation consultant, falls during periods of high-interest rates. On top of that, this is a cutthroat industry, with competition from other consulting firms and internal IT staff.
While I think CTG possesses some upside, the uncertainty is too great, and the valuation does not provide enough margin of safety for me to rate a buy. For that reason, I assign CTG a hold rating.
Digital Transformation Industry
As you might expect, the digital transformation industry has grown significantly in recent years and is expected to continue.
We live in a digital world, and companies that do not adapt will get left behind. However, I am not sure how much this macro trend will help CTG.
Skeptical about impact on CTG
Covid dramatically accelerated digital transformations, pushing the entire globe's trend towards digitization ahead by 7 years, according to a report from McKinsey . Covid aside, there has been a massive surge in demand for digital transformations. A sample survey from CTG found that 72% of decision-makers accelerated digital transformations in 2021, and 74% plan to increase that effort in 2022. However, this didn't seem to hit CTG as you would expect.
Even in 2021, which should have been the year to see the impact of covid, when people were working remotely, and companies were scrambling to adapt, revenue fell 2 million short of the 2019 figure.
The problem that CTG and other consulting firms had was that companies aren't hiring consulting firms for their transformations and instead opt to train current talent or hire new talent.
Only about 30% of companies choose to look outside the company, and only 20% partner or contract, the category that a consultant like CTG would fall into.
It is worth noting that only about 1/3 of attempted digital transformations are successful, and this is especially true for companies that are not obviously tech adjacent. The inability of companies to effectively implement these policies on their own without consultants' guidance could lead to more companies turning to professionals in the future. While I couldn't find any success rates on CTG specifically, there are a lot of case studies available on their website across many industries documenting their ability to carry out these transformations successfully. It is highly likely that consultant-aided transformations are more likely to succeed than similarly situated peers.
Divesting From Staffing
CTG currently operates in two segments, which can be broadly explained as their consulting segment and their staffing segment. The consulting segment is what I was talking about in the previous paragraphs and constitutes their core business, and their IT staffing segment is what it sounds like. They provide high-quality IT talent to teams that need it.
Over the past three years, they have begun divesting from their IT staffing to focus on their higher-margin core business. Broadly, this seems to be working. Here is a look at their gross margins in that time frame.
Now let's look at the numbers and see what is happening behind the scenes.
In April of last year, they had total revenue of $89 million. About 30% of that, or $26.5 million, came from their non-strategic technology segment ((NSTS)), which they are divesting from. Same quarter this year, revenue declined 12.5% to $78 million, driven almost entirely by a decline in NSTS. This quarter, only 19% of their revenue was from the said segment, marking a strong decrease YoY.
Regarding their margins, here is a chart from their recent 10-K.
We can see that at least their North American IT solutions boast substantially higher contributing margins at 20.8% vs. NSTS at 9.6%. Their European segment's contributing margin is between the two at an even 12%, partly due to currency exchange rates.
So we have established that their revenue mix is shifting towards their IT solutions. What does this do to their profit?
Full-year 2022 results show that despite making up 28% of the revenue, the non-strategic segment only made up 20% of the profit. (Numbers in thousands).
For 2023, if we look at their conference call , we can see that they have projections of $325 million in total revenue, a midpoint of $275 million from strategic tech, and 50 million from non-strategic. They don't break down the split between US and EU revenue, so I will use the 65/35 split that we saw last year.
As you can see, despite revenue numbers staying constant, the profit increases by $2.2 million. I used the same margins we saw last year. The real numbers could be slightly higher, as SG&A is expected to decrease due to headcount reductions, which I will discuss now.
Here is a line from their 10-K .
The Company's total headcount was approximately 3,200 at December 31, 2022, which was a 7% decrease from approximately 3,450 at December 31, 2021... The decrease in headcount is in large part due to the significantly declining revenue in the Company's Non-Strategic Technology Services segment.
From 2021 to 2022, their SG&A decreased from $73.9 million to $68.1 million. This number is somewhat misleading, and the actual decrease is probably higher, as there were some acquisition-related SG&A expenses in 2022.
As you can see by their income statement, the vast majority of their gross profit gets eaten up by SG&A. If this continues decreasing, shareholders can expect an increase in the bottom line.
Risks/Downside
As with any investment, risks are associated, but in this case, I think the risks are enough in number and severity that they erode the margin of safety.
While the divestment from their NSTS segment will likely bolster margins, their top line is set to decrease substantially. Their largest contract is a staffing agreement with IBM that they plan to let expire. While the margins were lower, this is still a profitable segment for the business. If they fail to lower SG&A costs enough to offset the loss in revenue, divesting could lower the net income.
On top of that, there is the chance that their consulting business does not grow at all or as fast as they are expecting. I already mentioned the unfavorable macro environment, with high-interest rates putting downward pressure on enterprise capital expenditure, but there are also industry-specific risks. This is a low to no-moat business where you compete with other firms, many of whom utilize outsourcing to lower costs, as Tomas Andrade Campanini pointed out, and in-house IT staff, which seems to be the predominant choice amongst corporations.
I also worry about the long-term sustainability of this business model. There will come a day, likely not even a decade into the future when all of the companies that are going to undergo a "digital transformation" have already done so. In the same way that hardly anyone today is making the switch from a landline to a cell phone, there will come a time when corporations won't be navigating that massive paradigm shift that is digitizing much of the core business.
Valuation
It does appear that CTG is trading at a cheaper valuation in almost every single metric relative to its peers. I don't think this is a sufficient enough reason to buy the company.
For one, the peer group that Seeking Alpha is using is the IT sector. While I do agree with the classification, companies in this sector command some of the highest valuations in the market due to their massive YoY growth. CTG doesn't have that and is expected to remain stagnant.
I will also note I am skeptical of some of these FWD figures, as the FWD PE uses a number that beats even the company's own projections.
I would assign a price target of $8 per share to the company, giving them about a 15% upside from current prices.
Conclusion
As reflected in my price target, I do think that their margin expansion initiative could be good for the company long term. I also think they are consultants in an area that desperately needs consultants, as fewer than 1/3 of company digital transformations achieve the desired result.
That being said, we are headed into an environment where companies are even less likely to hire digital consultants than they would be in a low-interest-rate environment, and they didn't hire that many then.
All in all, the margin of safety is not big enough for me to pull the trigger, so for that reason, I will be staying on the sidelines for the foreseeable future.
For further details see:
Computer Task Group: Headwinds And Tailwinds Cancel Out