Description

We believe that Computer Task Group (CTG), trading at ~5-6x EBITDA and ~10-11x earnings despite a clean balance sheet and a credible path to capital-light high-single-digit or even double digit earnings growth, represents one of the most attractive risk-rewards in our investment universe today. In our view, the main challenge / risk (which constrains our position size) is simply extreme illiquidity rather than anything fundamental. 

Computer Task Group was written up on VIC by andreas947 in May 2021 at a price of $9.80.  Andreas provided a compelling thesis: under CEO Filip Gyde, CTG has successfully transitioned from a staffing business to one that derives most of its profitability from higher-value “Solutions” offerings in the field of digital transformation (modernizing legacy applications, implementing and maintaining new software such as Microsoft 365, etc.)  Utilizing its strong profitability and “Ft. Knox” balance sheet, the company has thoughtfully acquired complementary businesses with new solutions (such as applications testing) at accretive multiples.

Despite another year of progress, CTG today trades below the price at the time of Andreas’s writeup, at a mid-single-digit trailing and forward EBITDA multiple.  We believe this is reflective of the market’s continued perception of the business as a low-margin, low-value staffing bodyshop, rather than as a company that has a strong reputation in a solidly-growing industry with an increasing proportion of higher-margin, more-recurring revenues. 

We think that over the next 5-10 years, CTG can grow its EBITDA / free cash flow at a high single and possibly even double digit rate.  As a people-based capital-light business, substantially all cash flow can be returned to shareholders or used for accretive acquisitions that strengthen its competitive position and diversify its offerings.

We are not going to discuss the staffing-to-solutions transition, as Andreas already covered this in detail and we have nothing to add.  We highly recommend that you first read Andreas’s writeup (and the associated message board) if you are unfamiliar with the story.  Instead, based on our due diligence, we’d like to go deeper into three complementary issues:

-        The broad reasons this industry is attractive, which we have followed (through peers to CTG) for several years now.

-        CTG’s brand/reputation, the specific nature of CTG’s product offerings and their value proposition to customers, based on our discussions with former CTG employees as well as competitors / peers (we also did some work on Mastech (MHH), recently written up on VIC as well)

-        The company’s governance and capital allocation.  

1: Digital Transformation

We have followed the digital transformation space for quite a while, including an open investment in Software AG (SOW) and a closed one in Magic Software (MGIC), both of which have been written up previously on VIC.  We wanted to try to break the buzzwords and big growth projections down into the understandable, approachable qualitative elements.  If anyone has further insights on this issue (whether in agreement or contrary), we’d love to hear them on the message boards – is there anything we are missing here?

Summarily, there is a large gap between consumer perception of how advanced technology is (slick UIs such as Netflix, modern smartphone apps, etc) and how modern the back-end actually is.  Many companies still rely on legacy systems that are decades old.  In addition to being inefficient and costly to maintain, not to mention slow / limiting business capabilities, there is meaningful risk here as sometimes there are only a handful of employees who are able to run these systems. 

Even if you find new talent familiar with the antiquated languages they are programmed in (still sometimes COBOL or Fortran), they may not know the nuances of the specific system, or be able to work with it with limited / incomplete documentation that often exists.  One account manager we spoke to highlighted that the “Great Resignation” during and following COVID has exacerbated this issue, as companies are increasingly worried that the key employee(s) who can run these systems may one day decide to simply quit, putting those parts of their IT infrastructure at risk.

The imperative to do business faster, with access to more data from more sources, is leading companies to increasingly invest in modern IT infrastructure.  A good analogy is the famous saying “the future is here; it’s just not evenly distributed.”  Although many technologies exist, few companies have fully adopted them – and given enough time, all will.

One industry participant we talked to estimated that we’re currently only in the “middle innings” of digital transformation and that there is a decade-long runway for continued strong growth.  Short of a severe recession, he didn’t name any risks – even though we repeatedly pressed him – that would lead to a meaningful contraction in spending. 

(As a topical aside, we believe the transition from lumpy capex-driven on-prem implementation to more opex-driven, cloud/subscription/SaaS based implementations, has probably meaningfully reduced the historical cyclicality of IT spending, and this flows through to service providers such as CTG as their work becomes increasingly recurring / maintenance based as opposed to implementation / project based.)  

COVID has only served to accelerate these trends, as it resulted in step-change differences in usage of (for example) grocery delivery and videoconferencing, as well as a permanent shift towards remote work.  While many COVID trends will partially unwind, technology adoption has seen a permanent positive inflection.

Just as one anecdote from our coverage universe: a sizeable ($500M+) omnichannel brand we follow only recently (past 1-2 years) gained the ability to segment customers by what they purchased and when – which seems like a fairly basic, low-level necessity to run a brand in today’s age.  We have observed over the past 5 years that technology has become an “arms race” need-to-have rather than a nice to have – that is to say, investing in technology is non-negotiable.  If your customers aren’t demanding it, your competitors are gaining an advantage by using it.

Historical Comparisons

We all know that “software is eating the world” and that well-known SaaS companies often now trade for double-digit revenue multiples.  What we believe is still less obvious to the market at large is that the inevitable growth of sexy software, cloud applications, and so on drags behind a whole host of “unsexy” software and labor to integrate, maintain, and manage these new technologies. 

We have observed that many purveyors of these boring back-end services and software trade at bargain valuations  despite being benefited by the same macro trends as their sexier peers.  This is similar to how the providers of software and hardware for servers / the back end (think Dell, Microsoft, Seagate, etc) were left for dead in the early 2010s as they were perceived as secularly-declining consumer-oriented businesses.  It turns out that many of these businesses ended up doing well (some even spectacularly), and as a group have delivered very attractive returns to shareholders over the past decade.

As a more recent example, in 2018-2019, Magic Software (MGIC), a provider of integration and low-code focused software and services, traded at a low double digit P/E ex-cash.  Around the same time, its peer MuleSoft was acquired for roughly 16x revenues by Salesforce.  That is not to say that Magic is the same business or deserves the same multiple – but they did many of the same things, and have grown EPS at a solid double-digit CAGR (which has eventually led to a substantial rerating). 

We think CTG is a similar story to MGIC 3-4 years ago, but even cheaper.  As one example, as we understand it, they have a sizable Microsoft 365 practice.  We all know that MSFT’s current premium valuation is at least in part driven by the commercial success and rapid growth of the Microsoft 365 subscription offerings.  Obviously, the more businesses who implement and use these products, the more back-end management will be required by players such as CTG. 

We are obviously not arguing that CTG should trade at MSFT’s valuation (it is self-obviously a vastly inferior business), but it doesn’t seem to make a lot of sense that CTG trades at a no-to-negative growth ~5-6x EBITDA when the software companies whose products CTG is implementing and maintaining would be seen as very cheap at ~5-6x revenues.

Risk Factors

One key difference is that CTG does not have any proprietary software – only services (we will address its specific value proposition in a moment).  Their assets (people) go out the door every night (or, I guess, log out of Slack.)

It does, therefore, deserve a lower multiple, as well as more scrutiny – are they actually embedded in client organizations/processes, or can they be ripped out the second someone else offers to do it for a few dimes cheaper? 

There is also the risk of commoditization over time – technology services that used to be lucrative, such as EHR (electronic health record) or ERP (enterprise resource planning) application implementations are now much lower-margin.  So it is important to not be too reliant on any single technology and to always be moving to the vanguard of what is new / less competitive. 

Offsetting these risks is the inexorable growth of technology, and – equally importantly – the efficiency gains that typically accompany outsourcing, which is increasingly longer-term rather than just project-based.  No matter how large a company is, it will be the first time they implement or maintain any particular software – conversely, a third-party has done it dozens of times for other clients. 

Outsourcing and Reputation

Although there are certain applications where it is cheaper to manage it in-house, most of the industry participants we talked to agreed that it is generally increasingly preferred by clients to outsource it on a “managed-service” basis.  This can be quite a lucrative business model with strong growth, if you look at the BPO (business process outsourcing) companies like Infosys, Wipro, etc, all have generally have displayed strong growth with attractive profitability.

An important component here is that with the transition to the cloud, companies are increasingly preferring to outsource much of their IT, which then tends to be fairly sticky.  Due to accumulated know-how and the risks associated with going with a new vendor, our understanding is that for “managed services” where a company such as Computer Task Group or Mastech, once you have the business it is sort of yours to lose – you keep it for a number of years until they replace the system or you screw up. 

Moreover, reputation and scale matter; our understanding is that it is hard to get onto approved vendor lists but substantially easier to win additional work once you have proved yourself (incumbency is an advantage).  We heard the classic “nobody got fired for buying IBM” quote from one former employee, who noted that it took him 18-24 months to get onto a vendor list for solutions offerings and then even more time from there to be trusted with big/important projects.  So the sales cycle is pretty long. 

To this extent, several former employees of CTG mentioned that the company’s staffing business actually serves as marketing because it gets their foot in the door with potential clients in a low-risk way, even if it doesn’t generate much margin directly.  This is a two-way street, however: it also means that CTG’s business with existing customers is somewhat more entrenched than might be obvious from the outside looking in.

Even though the industry is competitive, our takeaway from talking to industry participants is that the growth opportunity is so substantial that there is often more of a problem with supply than demand.  Although in part due to the current labor shortages that may not persist permanently, one account manager at a competitor said her biggest challenge was not getting new contracts, but rather the availability of talent to fulfill them. 

2: CTG Specifically

One challenge we always have with small companies is understanding their competitive positioning.  There is a vast array of public data on large companies such as Domino’s Pizza, Microsoft, or AerCap – it’s pretty easy to assess their brand and product and how it stacks up.  On the other hand, there are (literally) thousands of companies in the IT consulting space – so it’s all well and good to read securities filings, but we’ve found talking to people in the industry to be tremendously helpful.

As far as CTG goes, we consistently heard the words “reliability” and “talent” from former employees.  The company is not the cheapest in the market, but apparently generally does a great job and wins a lot of repeat business from customers.  They apparently have (or at least had, as of the time the former employees left) a lot of strong talent, particularly in the European market (note that this is the successful strategy that was run by Filip Gyde, who is now CEO of the whole business and porting it to America.) 

They’re also particularly good at project management.  They tend to do a lot of projects in the verticals they participate in (although they are expanding to new verticals as well), which helps as they then generate a strong reputation in that vertical even if they are largely unknown in the broader market.  For example, at one point, they were considered one of the gold standards in the EHR (electronic health records) market, although this turned out to be a double-edged sword (for reasons we’ll discuss momentarily).

On the staffing side, CTG does have a particular strength in “high-end” staffing (which has higher margins), wherein they find people who have unique skills and talents.  One former believed they might actually benefit from COVID-induced WFH in the long-term, as their reach might allow them to find better talent (for cheaper) across the country rather than only in a local market.

Your Assets Go Down The Elevator And Out The Door…

On the solutions side, the issue we investigated the most was the idea of proprietary IP.  We’ve made a number of investments in other business services companies, and one challenge is that your assets are often walking out the door.  In some cases (like Korn Ferry or McKinsey), it is clear that the brand name is valuable enough that clients are often buying the brand rather than the individual.  In the case of CTG, we wanted to understand exactly what it is that clients are buying.

In addition to the brand/reputation we mentioned above, the perception we got is that there is a “soft moat” here.  One thing we have observed for many businesses is that it is often harder (in practice) to replicate something that seems easy.  Take Chipotle as an example – what’s so hard about a buffet line of various meat/grain/veggie/sauce options?  Yet very few companies have achieved anywhere near a similar level of success, whether in a similar area (burritos/bowls) or a different one (noodles, pizza, etc).

When it comes to Computer Task Group, what we learned is that CTG (and of course companies more broadly) develop specific practice areas / niches that they get good at over time.  In some cases, they may even develop their own proprietary tools (internal software) to make things go easier – not software that they are per-se selling to the client for a specific fee, but rather something that helps them do the implementation or maintenance faster/quicker/more accurately. 

As we referenced earlier, any client (no matter how large) has never implemented Microsoft 365 before, nor maintained it, whereas CTG has done both dozens of times.  Although we received conflicting answers on what is allowed and not allowed in the industry, we believe that some contracts also allow CTG to become more efficient by having employees work on whichever client needs support rather than sitting around waiting for a problem for one client if nothing needs to be done (essentially, the Uber model of cars always picking up riders rather than sitting empty.)

Margins

From a financial standpoint, we also dug into the margin differences between CTG’s solutions segment (targeting high single digit EBITDA margins in the near-term and much higher in the long-term) and its peers.  We got the impression from a few former employees that some of what they do is quite similar to Cognizant (albeit on a smaller scale and with less offshore resources).  Everyone attributed CTG’s lower margins to scale rather than anything structural about their business.

To this end, it's worth looking at a peer group of various IT consulting and/or BPO type companies.  None of these are perfect comps – for example, Charles River (CRAI) has a big expert consulting with niches such as antitrust expert testimony which are not comparable; similarly, Hackett Group (HCKT) has a data-driven benchmarking practice. 

Nonetheless, taken as a whole, you can see that all of these companies, with *gross* margins in the 20s to 30s, have EBITDA margins that are at least double digits (and often mid-teens plus). 

CTG has solid gross margins in its solutions segment that have bounced around 31 – 33% since they started breaking them out in Q1 2020.  So we think as they scale, their EBITDA margins will start to be more in line with the peer group as they leverage the significant investments they are making to grow their business.

In other words, as CTG grows, it’s not unreasonable to assume that they could increase their EBITDA margins by 50 – 100% from current levels, leading to substantial operating leverage.  CTG is early in many areas, such as – for example – leveraging cheaper offshore resources (in geographies such as India) to fulfill certain aspects of client projects. 

Management is also focused on “robotic process automation” and AI to increase their efficiency.  Calling back to one of our earlier points, note that these efforts should also extend their competitive advantage by requiring less human input to accomplish the same thing.  Our understanding from the industry calls is that depending on the specific contracts, often they will be required to share some margin savings with customers (for example, when they use offshore resources).  However, being able to provide a higher level of service at a comparable or even lower cost to competitors would obviously improve their position.

Filip J. L. Gyde, Computer Task Group, Incorporated - President, CEO & Director [9]

 Well, at this moment, we're using RPA and AI to mimic the actions and decision-making process of first-line service desk agents. This way, we automate the part of the process. We shorten the working ticket per -- working time per ticket for our agents. That way, the cost of the services decrease, and we provide an added benefit to our clients. At this moment, we have begun the use of RPA and AI in the proof-of-concept stage for 3 different clients and are excited about it's future potential and are going to remain at that route going forward.

[...]

 Filip J. L. Gyde, Computer Task Group, Incorporated - President, CEO & Director [15]

 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 2 factors.

Cross Selling

A final point (which transitions us nicely into our next section) is that everyone we talked to suggested that cross-selling new capabilities is apparently well-received.  One former noted that CTG had a strong position in testing – an area which they bulked up through their 2020 acquisition of Stardust in France – and they used this expertise in the testing niche to penetrate many new clients and subsequently sell other services.     

As far as the company’s relationship with IBM, this is staffing weighted so the revenue is less indicative of exposure than EBITDA (which we believe to be lower.)  Moreover, they seem to have a strong relationship and this is not one agreement with one stakeholder but rather a composite of multiple individual agreements, so while they might lose pieces of the business over time, we don’t think it’s likely that they would lose all of it at once (or that it would be tremendously impactful to their financials if they did).  It’s a risk, but not one that we’re going to lose sleep over given the valuation – even if IBM liquidated tomorrow, we think CTG would still be very cheap.

3: Governance and Capital Allocation

In addition to organic growth, CTG has an active M&A program.  Their internal targets (which we’re not modeling as achievable, though one can hope) are to achieve $250M+ in solutions revenue and $35M in consolidated EBITDA in FY2023, which they acknowledge would require inorganic investment.

One concern we always have with companies of this size – particularly ones with active M&A ambitions – is whether they will take a perfectly good cash-flowing business and do something stupid with it. 

We spoke to the Chairman, Jay Helvey, who (in our opinion) has a much more impressive background than one typically expects from an illiquid $100 million enterprise value company.  For anyone wondering, the reason he got involved is because CTG did an Epic EHR implementation at the Wake Forest hospital, whose board Helvey also sits on.  His bio is below.

Jay joined Cassia Capital Partners LLC as the founding Managing Partner in 2011 after a successful career at CMT Asset Management, Ltd., an international asset management firm with offices in Chicago, London, and Hong Kong, which he helped establish in 2005. As principal partner, he was responsible for Risk Management and Portfolio Construction which included allocating to hedge funds.

Mr. Helvey is recognized as a leader in financial risk management with extensive experience in trading cash, futures, and derivatives instruments, as well as 12 years of experience overseeing large investment portfolios. As a Managing Director at J.P. Morgan, Jay served as the Vice Chairman of J.P. Morgan’s Risk Committee and Global Head of Derivative Counterparty and Hedge Fund Risk Management.

Jay earned a master’s degree in International Affairs, Banking and Finance in 1984 from the School of International and Public Affairs at Columbia University in New York, where he was an International Fellow. He also attended the University of Cologne, West Germany in 1982 as a Fulbright Scholar

Mr. Helvey said all the right things about capital allocation – that the company is focused on ROIC and cost of capital, that being “accretive” isn’t enough given low interest rates, that they do think about buybacks given where the stock trades but they are thoughtful about liquidity, etc. 

It is of course easy to say the right things, but in micro-cap land, we think it’s rare to have a Board Chairman of a $100 million company that is this knowledgeable or focused on risk management and capital allocation.  We’re not saying this some sort of “Outsiders” story or anything – we’re simply observing that it’s good to know that there are “grown-ups in charge,” so to speak, and that the Board has a very risk-focused perspective and seems unlikely to do anything catastrophically stupid (which is all that we need, at this valuation).  A potential risk is that Helvey is not a technologist, but we think there is enough tech expertise within the company and that having a financial / risk perspective on the Board is a nice complement.

One historical note that we think is important relates to EHR implementations.  We dug in on concentration risk both due to the large books of business with e.g. IBM, and the fact that the company’s revenues declined precipitously from about 2013-2014 until 2017 (i.e. why will it be different this time?)  In the earlier part of the decade, CTG was heavily involved in EHR implementations that were mandated by the PPACA. 

Clients rushed to meet the 2014 deadline, which was subsequently delayed; nonetheless, once the deadline and follow-up work passed, CTG’s revenues fell by roughly 30% peak to trough, and EBITDA declined even further.  There was nothing wrong with doing this lucrative work while it was available, but we got the sense that few in the organization were really thoughtful about what happened after that.  We believe the company’s management and Board are now much more focused on having a diverse offering of solutions in a diverse range of verticals.

In terms of actions matching words, we ran the numbers on the company’s three acquisitions – SOFT company, Tech-IT (both in 2018), and Stardust (2020).  Based on their disclosures,  all of these transactions were done at 8x EV/EBIT or below, and all had strategic value. 

We discussed the testing angle with Stardust earlier; the acquisition of Soft Company allowed the company to gain traction with company headquarters in France rather than clients’ regional hubs in Luxembourg or Belgium, and also helped them build more of a presence in the finance vertical.  (Going back to something we mentioned earlier, it would have taken them much longer to build this presence organically.  Now that they already have a beachhead in this market, it is much easier to cross-sell their full base of solutions – so we think deals that bring them presence and reputation in new industries are valuable/accretive.)

They also seem to have handled integration well, as it seems these businesses have grown rather than seeing a mass exodus.

Valuation

We’ll keep this one rather simple.  The company’s Adjusted EBITDA in 2020 was a little under $16 million.  The company does not by nature need to invest a lot of capex to grow (people-based business) – peak capex has been about $3 million over the last few years.  The company has been successful in winning a number of large deals towards the end of 2021, some of which are one-time go-lives in late 2021 and some of which will lead to a growing base of more recurring revenue.

We think the company can comfortable grow its revenues at mid-to-high single digits annually on an organic basis.  Given the operating leverage we discussed earlier, we think the company’s investments will pay off and its margins in solution will expand over time by at least several hundred basis points, such that EBITDA / cash flow growth should be high-single-digits over time (achievably).  We believe that capital allocation will be favorable, as discussed, although we are not modeling it explicitly. 

The company trades at a market cap of about $130 million and an enterprise value of $100 million net of cash.  Putting it all together, if you assume 2022 Adj. EBITDA of say $18 million to $20 million, and subtract $5 million or so for capex and stock-based compensation, you get to ~$14 million in pre-tax cash flow and something like $10 million in post-tax free cash flow.

Maybe you want to model it more or less aggressively, but the point is that this is an asset that is clearly trading at no more than ~6x EBITDA or ~11x free cash flow, despite a credible path to grow revenues and margins at a nice clip.  It really doesn’t matter what happens to the price of oil or houses – this seems to be a reasonably macro-agnostic investment driven by a secular growth trend, with no obvious problems, trading at a bargain-basement price. 

We think that their specific end-state is less important here; as long as they grow even a bit, the stock is very cheap.  We see no reasons to expect that their business is at imminent risk of substantial degradation, which is more or less what it seems to be priced for.

We would suggest that, at a minimum, CTG should trade for $13-14 per share, or something in the neighborhood of 15-17x our estimate of 2022 earnings (plus the $2 per share of cash on the balance sheet).  Our internal valuation is higher ($17-18), although this is predicated on CTG achieving more aggressive revenue growth and milestones. 

We would encourage you to do the math yourself, although we would suggest that DCF modeling is (in this case) more useful than looking at near-term multiples.  Given the higher growth in CTG’s higher-margin Solutions business, as well as the operating leverage inherent in that Solutions business, we think that cash flow growth is likely to be much higher than revenue growth. 

Additionally, we think that when (not if) the company does another acquisition or two, they will very firmly and obviously become a higher-margin, Solutions-centric business, and hopefully garner the multiple they deserve rather than trading like a commodity staffing company.

Ultimately, while there are certainly some risks here, we think they are mitigated.  To summarize:

1)     As Andreas discussed in depth in his writeup, the company has already successfully transitioned from a Staffing business to a Solutions business.

2)     The industry that the company participates in should grow at a mid to high single digit rate, driven by a secular trend (technology adoption / modernization) that should largely be macro-agnostic.

3)     CTG should be able to expand its margins over time towards those of peers by growing in size, selling more solutions to existing customers, and more extensively utilizing offshore resources.

4)     The company has already demonstrated a history of acquiring, integrating, and cross-selling attractive assets at attractive multiples.

5)     The company sells at a no-growth multiple, with a “Ft. Knox” balance sheet.

We tried and failed to poke holes in the thesis through our due diligence, and are interested if anyone has any differing perspectives.

Catalyst

Continued growth in earnings