Earnings Transcript for CTG - Q4 Fiscal Year 2021

Operator: Ladies and gentlemen, thank you for standing by. Welcome to the CTG Fourth Quarter and Year End 2021 Investor Call. As a reminder, today’s call is being recorded. I will turn the call now over to Mr. Craig Mahalik. Please go ahead, sir.

Craig Mahalik: Yes, thank you, John and good morning everyone. We certainly appreciate your time today and your interest in CTG. Joining me on the call are Filip Gyde, our President and CEO and John Laubacker, our Chief Financial Officer. We released our fourth quarter and full year 2021 financial results this morning before the market open. You can access that release on our website at ctg.com. After Filip and John’s formal discussion this morning, we will open the line for Q&A. Let me first just mention that as you are likely aware, we may make some forward-looking statements during the formal discussion as well as during the Q&A session. These statements apply to future events that are subject to risks and uncertainties as well as other factors that could cause actual results to differ materially from what is stated on today’s call. These risks, uncertainties and other factors are provided in the earnings release as well as other documents filed with the Securities and Exchange Commission. These documents can be found on our website or at sec.gov. During today’s call, we will also discuss non-GAAP financial measures, which we believe are useful in evaluating our performance. You should not consider this additional information in isolation or as a substitute for results prepared in accordance with GAAP. We have provided the reconciliation of non-GAAP measures with comparable GAAP measures in the tables in today’s release and our SEC filings. I will now turn the call over to Filip to begin. Filip?

Filip Gyde: Thank you, Craig and good morning everyone. We appreciate you joining us today. We had a very strong fourth quarter of 2021, with revenue up 11% and operating income increasing nearly 65% year-over-year. Importantly, this translated to strong bottom line performance, with GAAP earnings in the quarter of $0.58 per diluted share and non-GAAP earnings of $0.25 and excluding the reversal of the tax valuation allowance in North America and acquisition related costs. We ended the year with earnings of $0.92 on a GAAP basis and $0.64 per share from a non-GAAP basis. The non-GAAP EPS increase was 45% from 2020. Our results clearly demonstrate the significant progress we are making on our digital solutions and services strategy. Let me start today’s call by explaining our three business segments and how they relate to previous discussions we have had regarding disclosing financial information for solutions and staffing. The segments, including IT solutions and services, disclosed for each of North America and Europe represents our solutions revenue and higher margin IT staffing services. It is in these segments that we are making investments in business development resources, including solutions, sales, delivery and recruiting to grow both revenue and profit margins. The non-strategic technology services segment only includes a very low margin staffing business that we intend to disengage from over time. As you can see from our release, the revenue in this segment decreased 22% in the quarter and 15% for the year. Previously, when we discussed solutions, we included all of our solutions-based revenue, while staffing revenue represented all of our staffing revenue. With segments reporting, we are providing clarity around our strategy to segment the areas, where we are making investments, which is to North America and Europe, IT solutions and services business. Let me now turn to a discussion of the progress on our strategy. Our fourth quarter earnings results exceeded our expectations, primarily due to the disciplined execution by our team of a large training implementation and support engagement for a health system in North America. On this engagement, we collaborated with our clients on activities related to training, staffing and technical preparation for their government. This included providing over 140 Epic certified or credential trainers that assist us with curriculum development, updated training contents, supported Epic specialists, and provided training on how to personalize the new system. We also provided over 1,000 at the elbow support to the clients’ fees to ensure adoption and build confidence in the new system. This project was a tremendous success from all aspects, including planning and support to the logistics of quickly deploying such a large number of people in a short time period. At the end of the engagements, we have a very satisfied client. I continue to be impressed everyday by the many highly skilled people we have working hard to drive our solution strategy and provide tremendous service to our clients. This was a very significant engagement during the fourth quarter and was a large contributor to North America IT solutions and services revenue more than doubling year-over-year and generating 20% contribution margins. However, even if you excluded this engagement, our operating results in the quarter are excellent. As we continue to execute our strategy as a digital transformation IT services provider that is driving consistently better results. Large engagements occurring in either North America or Europe will directly affect any particular quarter’s contribution in the IT solutions and services segments. Accordingly, we have determined that it is best to provide the full year perspective on our outlook, while also giving some insight into how we see the next quarter playing out. During 2022, we will continue to disengage from lower margin non-strategic technology services. Additionally, we do not expect to have a large engagement that will be similar in size to the one we had in the fourth quarter of 2021. These items will provide a headwind of approximately $25 million to $35 million from 2022 revenue, resulting in our consolidated revenue expectation for the year of approximately $375 million to $395 million. Consistent with the shift in our business model, we expect earnings to grow at a greater rate than the revenue and are expecting non-GAAP diluted earnings per share in the range of $0.64 to $0.72 in 2022, which is about 6% growth from 2021 at the midpoint of the range. We do expect that our first quarter will be the softest quarter in the year and revenue will be down year-over-year. This is both due to the timing of engagements and lower utilization due to higher rates of illness from the impact that COVID-19 variant Omicron has had at the beginning of 2022 on our billable resources. For the long-term, our objective is to grow IT solutions and services revenue in mid to high single-digits organically and deliver contribution margins for these segments in the mid-teens. We expect this will enable us to achieve our goal over the next 2 years, with adjusted EBITDA margins increasing to 7% to 8% of revenue given the operating leverage inherent in the business and accelerating the pace of growth and increasing our margin profile through focused acquisitions. CTG is well-positioned to address the challenges our clients are facing in a constantly evolving digital landscape. Business performance decisions are driven by data, continuous innovation and enhanced customer experience are all critical business outcomes our clients need to derive their success. And our expertise is the reason CTG is often engaged to assist in their digital IT initiatives. We look forward to continuing to execute on our strategy, while also being the catalyst for digital transformation change for our clients. With that, let me turn it over to John to review our financial information. John?

John Laubacker: Thank you, Filip and again good morning everyone. Thank you for joining us on today’s call. As Filip mentioned, consolidated revenue in the fourth quarter grew to $112.4 million or 11% compared with the prior year period. Despite having intentionally disengaged from nearly $22 million in non-strategic technology services revenue through the year, we still had revenue growth of 7% for 2021. Fourth quarter revenue growth was heavily influenced by the engagement Filip discussed and resulted in revenue in our healthcare vertical increasing to 36% total revenue in the quarter, while also driving North American revenue 63% of our total revenue. By reporting our revenue in three segments, we have clearly identified our lower margin non-strategic technology services business, which totaled 31% over 2021 revenue. We will continue our efforts to strength this part of the business as we in turn invest in our solutions and services business in both North America and Europe to support our growth plans. IBM revenue was $16.7 million or 14.9% of total revenue in the quarter and $74.8 million or 19.1% of total revenue for the year. The large engagement represented greater than $20 million of revenue in the fourth quarter. For our Europe IT Solutions and Services segment, foreign currency translation had a negative impact of $1.6 million on revenue in the fourth quarter of 2021. Excluding foreign currency, revenue would have declined about 5% in the quarter for this segment, which loudly reflects lower utilization resulting from a higher level of downtime around the holidays, and from illness from the COVID-19 Omicron variant. Consolidated gross margin expanded 100 basis points in both the fourth quarter and full year period to 22.3% and 22% respectively. Both periods reflected the increased mix of higher margin IT solutions and services revenue. Of note, our fourth quarter SG&A expense as a percentage of revenue decrease 40 basis points to 17.7%. Despite our continued investment in solutions and business development resources in support of our digital solutions and services strategy, the results of the improved revenue mix and operational leverage we saw measurable improvement on our consolidated operating and bottom line performance. Operating income for the fourth quarter increased 55% with a margin of 4.6%, an increase of 130 basis points over the prior year quarter. When excluding approximately $211,000 of acquisition-related expenses, non-GAAP operating margin in the fourth quarter was 4.8%. For the 2021 full year, operating margin expanded 70 basis points to 3.2% and on a non-GAAP basis increased 50 basis points to 3.6%. We achieved net income of $8.7 million or $0.58 per diluted share in the fourth quarter, which included a $5.1 million or $0.34 per diluted share reversal of evaluation allowance against deferred tax assets in the United States. Excluding the tax valuation allowance reversal and acquisition-related expenses, non-GAAP earnings per diluted share were $0.25, up $0.11 or nearly 80% from the year ago period. This level significantly exceeded our prior guidance largely due to the margin improvement during the quarter. For the full year 2021, we delivered net income of $13.7 million or $0.92 per diluted share and on a non-GAAP basis was $0.64 per diluted share, which was 45% higher than the prior year period. Adjusted EBITDA margin improved $0.90 basis points to 5.8% in the quarter and for the full year was 4.6%, up 30 basis points. CTG’s headcount at year end was approximately 3,450, of which approximately 90% was billable. This compares with a 91% billable rate at the end of 2020. Turning to our balance sheet and cash flow, cash and cash equivalents were $35.6 million, up $2.7 million or 8% since year end 2020. Full year net cash provided by operations was $7.4 million and was used in part to fund capital expenditures of $1.9 million. Also, at the end of the year, the company had no outstanding balance on its revolving line of credit facility or any other outstanding debt. As Filip covered our outlook and guidance, I would like to reemphasize that we continue to work hard to advance our strategy by investing in the talent, skills and processes necessary to drive change. This means adding solution skill sets, reviewing how we source and approach opportunities and how we price our services. These investments and activities reflect the continued execution of our digital IT solutions strategy. In the end, we believe we have the skills, knowledge and expertise to provide differentiated quality services in the high-speed pace of digitalization within any enterprise. That completes our prepared remarks. John, could you please open the call for questions?

Operator: Certainly. And first from the line of Josh Vogel with Sidoti & Company, please go ahead.

Josh Vogel: Thanks. Good morning, Filip and John. Hope you guys are doing well.

Filip Gyde: Good morning, Josh.

John Laubacker: Hello, Josh.

Josh Vogel: Good morning. So, obviously tremendous success with the health system engagement, I was just curious is there any sort of residual business whatsoever that will fall into 2022, maybe just from like a support standpoint?

Filip Gyde: That’s a very good question, Josh. Yes, this is exactly the type of client and the type of projects we want to continue doing in the future, because it creates stickiness. We have been a tremendous value to the client. They are really very satisfied. And even while the Go-Live was going on we were already working and talking about support afterwards. There is a small kind of tail to the project with a separate smaller, go-lives and there will be continuation with the support afterwards. So yes, the short answer.

Josh Vogel: Great. And obviously, an engagement of this scale and the success there, maybe it’s too early to tell, but are you seeing it open any other doors or prospects or opportunities for other clients?

Filip Gyde: Well, this wasn’t the first of this kind of go-live supports that we have been doing. And actually, I am not doing it justice with using the word Go-Live, because it is really the end of through digital transformation project for those health systems. It’s changing the whole way they are working from start to finish. So, we have a track record of delivering the reliability that CTG is known for and the acceleration that we are bringing to their Go-Lives. We have done this before and we are looking at opportunities as we speak, in our pipeline that are in the same direction. Yes, this is a really great reference in the market.

Josh Vogel: Alright, great. Thank you. And looking at the guidance and just kind of using midpoint to some of the numbers, kind of implies 6% organic growth baked in for 2022. And I was curious how much of that number – of the numbers you gave out, would you classify as recurring that where you have the visibility versus new business that you are expecting to fill the pipeline?

Filip Gyde: Okay. Well, answer the question high level and then refer to John for more color. And from normal business as usual, kind of work, CTG has a high percentage of recurring business. We have a lot of loyal clients who have stayed with us for more than decades. So those clients generate ongoing business. These projects as we have done, that health system creates other opportunities at the same client. So, that is only increasing. John, that there anymore color you can give to that?

John Laubacker: Thankfully, Josh, as you know, we don’t – we haven’t put out specific numbers around recurring revenue at this time. And we continue to have not done that. But we see the amount increase really from quarter-to-quarter pretty consistently. As Filip answered, so far, this engagement itself well, in itself was a large engagement has now led to some follow-on support work, which is what exactly what we are trying to drive with these types of engagements. And so we see that more and more often. I would also like to reiterate with what Filip just said that our client base we have such a great loyal client base, recognizing that we are providing consistently high level of quality services, the amount of renewals and extensions and continuation of new projects that we get across our portfolio from whether it be North America or Europe tends to be very, very high.

Josh Vogel: I appreciate the color there. And two more quick ones and I’ll let others hop on. Can we expect any other valuation allowances as the U.S. business continues to post profits? Is that something that we could see, the Q3 or Q4 in the future kind of like what we saw this year or in ‘21? Sorry.

Filip Gyde: John, I believe that’s a question for you.

John Laubacker: Yes, I don’t – it’s a great question, Josh. And I believe the answer is no, I don’t anticipate any other reversals of valuation allowance. The actual valuation allowance, that we $0.34 in the fourth quarter was reversal of all of the valuation allowance against all of the U.S. deferred tax assets. We are really actually very excited about obviously, it’s cash pickup within the financials itself. But what it demonstrates on a long-term basis is that the North American business is improving that there is a confidence level within the business itself to generate income and earnings have offset those deferred taxes over time. And we felt now for a number of reasons in the fourth quarter primarily driven in part by this large project, which generated income in Q4. But looking at the prospects going forward, we felt now is the right time. So, it’s not just the event of reversing the valuation allowance and adding the $0.34 to the results in the fourth quarter ‘21. It does present a positive outlook that says the company feels really good about its future prospects in that area. That gives us the competence to do it now.

Josh Vogel: Okay, great. Thank you. And just lastly, I just want to make sure I’m looking at it correctly, based on your EBITDA margin guidance, that’s 7% to 8%. That’s a Q4 exit rate target. Am I thinking about that correctly for 2023?

John Laubacker: Correct. That’s exactly right. So as we exit 2023, our target is to have 78%, consolidated, whole company EBITDA margins.

Josh Vogel: Perfect. Well, thanks for taking my questions and congrats on the great performance last year.

John Laubacker: Thanks, Josh.

Filip Gyde: Thanks, Josh.

Operator: Next question is from Kevin Liu with K. Liu & Company. Please go ahead.

Kevin Liu: Hey, good morning, guys.

John Laubacker: Good morning, Kevin.

Filip Gyde: Good morning, Kevin.

Kevin Liu: In terms of the Omicron impact, you have touched about how that impacted utilization in the fourth quarter, and also we’ve seen some impacts here in the first quarter. Just curious, that’s primarily on existing projects, where you just weren’t able to build some of those hours or whether there is any sort of impact in terms of sales cycles or RFP processes you are currently going through.

Filip Gyde: Alright. Yes, well, looking at how COVID affected us in the fourth quarter, Omicron, as you know, was extremely contagious, and I’m happy that I’m using the word was maybe a little too fast, but it looks like it. It was very contagious. It wasn’t causing a lot of severe illnesses among our workforce, but it was kind of like the effects of fluids. So we had a lot more people not available because of illness. So you utilization went down. But luckily, as you correctly put Kevin, it was mostly on the existing projects that we couldn’t build, because people were sick. It didn’t really affect the pipeline and the closing of the business. As a matter of fact, we’re seeing now that a large number of opportunities, we’re seeing solid win rates. And we’re seeing throughput on the pipeline improving where before it had lacked for some time, during defendants.

Kevin Liu: That’s helpful, and maybe along those lines, can you talk a little bit about the pipeline today? And what you’re seeing – for instance, is it concentrated in any particular verticals or geographies? And maybe, how does it compare in terms of what you were saying pre pandemic?

Filip Gyde: Well, it looks like we’re getting closer to pre pandemic situation. Like I said, our pipeline is, is healthy in all areas of the business, there is no one specific industry or digital solution set that jumps out. Large number of opportunities, solid win rates, renewals and extensions continue at a very high pace. And what is encouraging is that throughput this improving, and that is the thing we’ve mostly experienced in the earlier phases of the pandemic, that the pipeline was still there, but the throughput was, was not as fast, not as good. And that is coming back and making us all very excited about what’s coming.

Kevin Liu: That’s great to hear. And then just on the non-strategic services segment that you guys are calling out now, can you talk a little bit about the pace at which you expect to disengage further work and does that accelerate kind of in ‘22, and ‘23, or should we think of it as kind of more moderate declines than what we have seen the late?

Filip Gyde: Well, as you have seen in the release, we have stepped away from $50 million in the last 2 years, intentionally. We are continuing the stepping away, or looking at it as fast as we possibly can do. But this segment is a combination of a lot of things, different number of clients, contracts, engagements, all with different maturity dates, and that makes moving away at one time or extremely fast, impossible. We must follow in contractual provisions, while supporting the clients. Some of those provisions prohibits immediately ending or sale of the engagements. And obviously, we also need to be mindful of the impacts from our organization. It is a very deliberate focus Kevin to only invest in the IT solutions and services area, and to disengage from the lower margin business as fast as we can, while respecting all of the boundary conditions around it.

Kevin Liu: Got it. And then, given the current environment in terms of kind of a tight labor market and signs of wage inflation, I was curious what sort of impact you are seeing on your business? Have you been able to improve your bill rates with claims on kind of new engagements or renewals? And then conversely, what are you seeing from a talent retention and wage inflation perspective?

Filip Gyde: While we are all seeing again, after a while, during the pandemic, we are now seeing the war for talent coming here again. Obviously, there is wage inflation. We have seen that I think first in Europe in the second part of the year, or we are seeing it a little bit everywhere. We are able to match our pricing accordingly, because pricing when you are pricing in solutions, where you are pricing to a deliverable or to a service level and it’s not so much is directly related to a cost rate and a bill rate anymore. We are focusing really hard on retention, because that is the best way of improving our margins. Each time you lose people during a project, and you need to re-hire, you have the hiring costs, you have the training costs, you have some overlap you have to provide. So, it all adds costs to the mix. And our retention that at this moment is still extremely good. I think we at the top of the market. And the fact that we are now for the first time in our history, great place to work certified in all of the countries where we are delivering business, in all of the countries that we are present, is definitely a contributor to that retention.

Kevin Liu: Alright. And just lastly, for me, could you talk a little bit about the opportunities you are seeing in your acquisition pipeline, and what you are seeing with valuations in this current environment?

Filip Gyde: Well, we are actively focusing on looking for acquisition targets. As you know, we have a very disciplined approach to that. We have a capital allocation framework. So, every target is looked at with our criteria in mind for definitely not going to take any risks or going to pay extremely foolish multiples. So, we have a very disciplined approach. We are seeing opportunities in the markets. And that’s where we are looking. We are always looking Kevin for what I call seeds for growth. So, we are looking at additional solution capabilities, or solution capabilities that are very close to the solutions we already have that correlate with what we already have. We are looking for offshore delivery capabilities and geographies or clients, but always from a very disciplined approach. So, we are not going to pay crazy multiples. And we haven’t done any acquisition in ‘21, I think that is a definite proof of our careful, but thorough approach today.

Kevin Liu: Got it. Well, thank you for taking the questions. Congrats on the strong ‘21. And good luck this year.

Filip Gyde: Thanks, Kevin.

Operator: And we do have another question that just came in from the line of George Melas with MKH. Please go ahead.

George Melas: Yes, good morning, gentlemen. Thanks for taking my question.

Filip Gyde: Hello.

George Melas: Hello. The margin goal that you have 28% as you exit 2023, is a big improvement over the 2021 levels, which is at 4.6%? What are the major factors that are going to move the needle that much? And is acquisition part of that plan?

Filip Gyde: Thank you for that question, George. And there are mainly four main drivers to the realization of this vision. First, we are continuing to robustly invest in our sales, solutions, partnerships delivery, basically to drive our organic growth. Second, answering your second part of the question, yes, there is acquisitions involved. We have a focus on acquisitions that will grow and expand our IT solutions and services segments. Like I have said, disciplined capital allocation approach, and focusing on digital capabilities, offshore capabilities, client sets and geographies. Third, focusing on reducing our non-strategic technology services segments, which I went into a little more detail in the previous question. And fourth, focusing on lowering our delivery costs through our offshore delivery centers. Our new segments reporting is also providing greater clarity on where we do all of these investments. And we firmly believe that continuing the disciplined execution we have shown in the last 3 years, executing these four strategic points, we will drive the operating results towards those ‘23 goals.

George Melas: Okay. Great. Thank you for the clarity. Appreciate that. Looking at the margins of the two solutions businesses in North America and Europe, just over the last 3 years, which is the data you provided, Europe seems to have meaningfully lower gross margins and contribution margins than in North America. Can you sort of help us understand what explains that, and also, maybe what you are trying to do if you are trying to sort of improve European margins?

John Laubacker: Sure. We have had a lot of long-term success in Europe over the last couple of years, and we will do so in the future. But in 2021, we saw that we had some particular challenges, a couple on gross profits. Starting in the third quarter, we were impacted by lower utilization from more holiday time, as the COVID-19 pandemics diminished, people started to travel again. Fourth quarter, we had Omicron variant, that created a higher level of sickness. And made it impossible for people to build or to have the utilization we normally have. And finally, we are also impacted by the raising wage costs – the rising wage costs, that at times, we cannot always pass on to our clients. On the contribution profits level, and that’s part of the longer story. And also the story why we believe we will improve these numbers is that we continue to believe it’s necessary to invest internally in sales, in solutions, in recruitments to drive future success. We know we have work to do in Europe to increase these margins, but very confident by using those four levels – levers, sorry, that we will succeed going forward.

George Melas: Okay, great. And then maybe just one quick final question – two quick questions, maybe what are the NOLs that you have right now? And on the large health systems project, did you guys work on the Epic implementation, or did you really start getting involved in the go-live phase of the project?

Filip Gyde: As we were involved in that project, we were involved in the application managements of keeping the current – the older applications running, while the Epic implementation was going on. We were not directly involved in the Epic implementation, which makes it even more remarkable that we were awarded the go-live support, which I think is a merit to the references that the teams have built over the last couple of years. And they have added a wonderful new reference to that list.

George Melas: Okay. And just on the NOLs.

Filip Gyde: I am sorry about that. John, could you take that one?

John Laubacker: Sure. On the net operating losses, the NOLs we have, most of those that we have remaining at this point in time relate to operations, where we previously had operations or were companies with that were operations fed or led up into them. So, we have got some, we have got valuation allowance against those and I don’t see those changing in the future.

George Melas: Okay. Thank you. Thank you very much.

John Laubacker: Thank you.

Filip Gyde: Thank you.

Operator: And at this point, there are no further questions coming in.

Filip Gyde: Thank you, John. In closing, the fourth quarter marked another quarter of continued progress and execution on CTG’s digital solution strategy. Our achievements of year-over-year growth continues to validate that we have an effective strategy and the right team in place to deliver on business objectives. Near-term, we expect to deliver increased operating profits and bottom line results, further demonstrating the success of our strategy and the ongoing commitment building long-term value for all CTG shareholders. Moreover, we are confident that our previous repositioning of CTG as a catalyst for clients to achieve accelerated digital transformation will lead to realizing our longer term vision and financial targets for 2023. Thank you again for joining us today and your continued support of CTG. Tom, you may now disconnect the call.