Description

Thesis

Computer Task Group (CTG, $4.80) is a quality staffing/consulting company that trades for 2.4x EV/LTM EBITDA and has a $40M enterprise value at the current market price. The thesis is:

(1)    CTG is cheap and has limited downside given that tangible book value per share is $5.03. Most of this book value is comprised of cash and the current surrender value of life insurance policies of $2.46 per share, $.20 per share in the Knox mansion that CTG has listed for sale in Buffalo, NY and the balance of the book value is comprised of receivables from large companies like IBM and Lenovo. You can buy CTG for an EV/IC of .7x and its ROIC is 14%.

(2)    Possible Catalysts: the company is undervalued and misunderstood for many reasons (micro-cap, little sell-side coverage), but largely because investors don’t realize that the actual outstanding share count is just under 16M, not 19M, as investors and analysts include the 3M shares held by the Stock Employee Compensation Trust (“SECT”) as economically outstanding. We believe the company is considering canceling the confusing SECT. If CTG ultimately decides to cancel the SECT, it would be like the company buying back 3M shares at no cost given that Bloomberg quotes the market cap and EV using the higher (wrong) share count.

(3)    Management has refocused the business on its higher margin healthcare consulting business (Solutions division) by doubling its sales force in that segment which has caused near term 2016 earnings to be cut materially, but we think the investment spending makes sense and will allow us to grow sales in the higher margin Solutions division, proving to ultimately be a good investment for the company. This Solutions division has strategic value as comparable companies have traded hands for >10x EV/EBITDA in recent transactions. In fact, while Solutions only generates 1/3 of company revenue it generates significantly more in EBITDA due to its higher margins than the commodity staffing business.

(4)    Reasonable capital allocation: CTG pays a 4.8% dividend and has been buying in ~3% of its shares annually for the last few years (although they did not buy any shares in the last quarter).  

Business Description

-          CTG has two divisions: Solutions (1/3 of revenues) and Staffing (2/3 of revenues). These divisions have very different margin profiles, with a typical Solutions business having 10%+ operating margins, while Staffing is a low single digit operating margin business. The ten year average margin is 4% (EBIT) for the consolidated business.

-          Solutions provides higher value add consulting and advisory for fixed duration projects that typically include installing and optimizing a complex software package. CTG is KLAS-rated in electronic medical record (“EMR”) software implementation. That high margin EMR business peaked in 2013 at ~$75M and has since declined to ~$25M per annum. CTG’s Solutions business is heavily focused in the healthcare area, but it does have engagements in other industries as well. Our research on the healthcare Solutions business leads us to believe that CTG has a solid position in this market, that while demand has weakened as EMR implementations have slowed (due to sequestration leading to hospital budget cuts), that the post-implementation optimization and advisory demand is beginning to accelerate. Recent acquisitions of Solutions businesses include:

o   CAN buys Sagacious for ~10x EV/EBITDA September 2015

o   HURN acquiring Vonlay for 10x EV/EBITDA and 1.5x EV/revenues May 2014

o   LDOS acquires MaxIT for 20x EV/EBITDA and 2.4x EV/revenues July 2013

o   LDOS acquires Vitalize for 15x EV/EBITDA and 1.9x EV/revenues July 2011

-          Staffing: CTG is a leading IT staffing company, with its two largest engagements being IBM (1/4 of revenues) and Lenovo (12% of revenues). IBM is a key customer in its Integrated Tech Services and Systems and Technology Group divisions. Lenovo bought IBM’s x86 server division and is now CTG’s second largest staffing customer. Our research suggests that CTG’s 50 year relationship with IBM (and also now Lenovo) remains strong, CTG provides reliable IT staffing to large tech companies.

Valuation

-          At its current price, CTG, a quality staffing and consulting company, trades for an EV of $40M which seems cheap for a company that has generated $300M of operating income in the last ~20 years.

-          CTG trades for a forward EV/EBITDA of 4.2x and an unlevered FCF Yield of 12%. Note that forward EBITDA includes $2-3M of incremental investment spending to double the company’s Solutions division sales force. Excluding this investment spend, EV/EBITDA is ~3.5x 2016E.

o   CTG traded off significantly over the last few quarters on weakness in its earnings, largely due to declining Solutions segment revenues and weak 2016 guidance. We think investors who are able to look beyond the 2016E guidance may understand the following:

§  As CTG is hiring ~10 sales heads in its Solutions division, each head will generate $3-4M of sales and each head will cost ~$200-300K p.a. in base and commissions. The gross margin on Solutions is ~30%, so the incremental sales from the newly hired sales heads will be $35M, at a 30% GM= $10.5M of incremental GP $s less $2.5M of variable selling expenses for a $8M lift to operating income at the mid-point. We won’t see this contribution until Q3/Q4 2016 and let’s assume that the low end of the range for each and we get a $6M lift to operating income/EBITDA, putting CTG at 2.0-2.9x EV/EBITDA.

-          CTG last year ended the year with over $40M of cash. It also had ~$30M of life insurance policies financed by high cost debt. The new CEO, Cliff Bleustein, had the company use its cash to pay off this high cost debt and now CTG owns the life insurance policies and can borrow up to $17.5M against them for <2% on a new $40M credit line. These life insurance policies will pay CTG $39M of cash tax free as former executives pass away. The CEO also used the cash balance to terminate an early pay program that was costing the company ~$.4M of annual operating income to be paid early by IBM. We now have gone back to 60 day payment terms (cash has gone down as we have self-financed a higher AR balance), but in the process recovered $.4M of annual EBIT. Lastly, the company owns (but does not occupy) the Knox mansion in Buffalo, NY and has it listed for $3.95M.

-          CTG’s staffing peers trade for significant premiums on EV/EBITDA; you are effectively creating the Solutions segment for ~1xEV/EBITDA if you assign the staffing division a 4x EV/EBITDA multiple (see next page for our estimate of division EBITDA- the co. does not segment divisions)

Catalyst

-          We believe that management may cancel the SECT, optically reducing the share count by 3.3M shares at no cost. Note that Bloomberg, Yahoo Finance and the sell-side value CTG using the wrong share count of 19.3M which includes the 3.3M shares owned by the SECT, which does not receive dividends and are not economically outstanding. The company incurs a nominal expense annually to maintain the SECT.

o   In fact the company treats the shares as treasury shares and excludes them from GAAP shares for the purposes of calculating earnings per share.

o   The company states in its most recent 10-K: “As if December 31, 2015, all shares remaining in the SECT were unallocated and, therefore, are not considered outstanding for purposes of calculating earnings per share.”

-          We believe that if CTG were to segment its business, its current Solutions division EBITDA is $12M and worth $90M+ in a strategic transaction (comparable transactions are generally >10x). We assign a low multiple to the staffing business (4x) given the commodity nature and low growth of this business. The point here is that the company/private equity/strategic acquirer could realize significant value for CTG shareholders at some point by splitting these businesses. We doubt this happens soon, but it’s worth noting:

-          We think that recent sales force expense investments, successful or not, will subside or payoff by later this year, so 2017 earnings should see a nice lift, either from sales heads being cut, or revenues accelerating and generating an incremental $6-8M of EBIT (see above).

Management

-          Board and management own 11% of the company, and the new CEO recently purchased $185,000 of common in the open market.

-          We think highly of Cliff and believe he has made the right tactical and strategic moves since joining the company 12 months ago.

-          Management and Board own 10% of the shares.

Why is CTG so cheap?

-          Confusing share count and valuation due to SECT shares.

-          Illiquid.

-          Weak recent earnings.

Risks

-          Staffing is cyclical and high customer concentration with IBM/Lenovo.

o   IBM relationship is the foundation of the business and a 50 year relationship.

-          Sales force investment does not work out as planned.

o   Management should reduce these variable expenses in late 2016 if they don’t pan out.

-          Company uses cash balance to fund bad acquisitions.

o   We think if the company did use cash to do any deals they would be small.

Catalyst

+Cancellation of SECT

+CTG breaking out the segments of its business