Computer Task Group Inc (CTG) 2005 Q1 法說會逐字稿

Ladies and gentlemen, thank you for standing by and welcome to CTG's first quarter 2005 earnings conference call. [OPERATOR INSTRUCTIONS] I would now like to turn the conference over to your host James Boldt.

Good morning. This is Jim Boldt. I want to thank you for joining us this morning for our first quarter 2005 earnings conference call. Joining me is our CFO Greg Dearlove. As to the format of the call this morning, Greg is going to begin with a review of our financial results, after his review I'll talk about the trends we saw in the first quarter plus what we anticipate in the second quarter of 2005, then we'll open the call for questions. Greg if you'd start us out please.

Thank you Jim and good morning to everyone. Before I begin I want to mention that the statements made in the course of this conference call that states the Company's or management's intentions, hopes, beliefs, expectations, and predictions in the future are forward-looking statements. It's important to note that the Company's actual results could differ materially from those projected. Additional information concerning factors that could cause actual results to differ from those in the forward-looking statements is contained in our press releases and from time to time in the Company's SEC filings.

For the first quarter of 2005 CTG's revenues from continuing operations were $68.7 million. Net income from continuing operations and net income were $0.5 million and net income per diluted share was $0.03. Our first quarter revenues from continuing operations were in excess of our expectations. Our net income from continuing operations and diluted earnings per share however were on the low end of our expectations due to higher than expected direct costs, increased recruiting costs due to the hiring of approximately 200 more employees than planned, and additional costs relating to our external audit primarily relating to Sarbanes-Oxley compliance.

Our direct profit percentage decreased to 24% in the first quarter down about 3% from the first quarter last year and operating our profits decreased from 2.3% last year to 1.4% in the first quarter of this year. Excluding the impact of the accounting change in 2002 this is the fifteenth consecutive quarter that the Company has reported profitability from continuing operations. SG&A increased by approximately $423,000 in the first quarter versus the same quarter last year and approximated 22.7% of revenue, an improvement of almost 2 percentage points from last year. Had we not experienced the unexpected hiring costs and additional audit fees SG&A would have actually decreased quarter over quarter in spite of the significantly higher headcount.

Revenues from IBM were $21.8 million in the first quarter of 2005 as compared to $14.2 million in the first quarter of 2004. Quarterly revenues from our European operations were $12.8 million in 2005 as compared to $10.2 million in last year's first quarter. On the balance sheet our days sales outstanding in receivables increased to 88 days from 72 days in the fourth quarter of 2004, and from 71 days in the first quarter of 2004. This increase reflects the timing of payments related primarily to our new business. We would expect the DSOs to improve significantly by the end of the second quarter.

On April 20, the Company closed on a new $35 million three-year revolving loan agreement with a new bank group therefore bank debt is now reflected as long term. Our debt was just under $12.3 million at quarter end up from $4.7 million outstanding at year end and up from the $9 million at the end of the first quarter of 2004. Our cash flows reflect cash used in operations during the quarter of approximately $6.2 million after recording depreciation expense of $709,000. We also made capital acquisitions of $1,846,000 during the quarter. Total employment in the first quarter was 3200 people of which approximately 87% were billable employees. Jim that concludes the summary of the Company's financial results for the first quarter of 2005.

Thanks Greg. We're obviously pleased with our first quarter performance as it represents the first quarter in a long time that CTG has reported at double-digit growth in revenue. As you know, we set a goal of having double-digit revenue growth for 2005 and a 12% increase in revenues in the first quarter of the year and a projected revenue increase of 22 to 25% in the second quarter of the year brings us a long way towards achieving that objective. The significant increase in our strategic staffing business that we announced with our fourth quarter earnings came on faster and stronger than we expected.

In the first quarter we were able to add 700, or 33% more billable staff to our headcount causing our total headcount to increase by 28%. That was 200 billable staff more than we had projected just a couple months ago which caused our revenues in the first quarter to be several million dollars greater than we'd anticipated. Most of the additional business that we picked up was in our strategic staffing group and while we're pleased with that business overall the initial direct profit margins were lower than we had originally projected. All in all we're pleased with our first quarter results as the 700 billable staff that we added puts us in better position at the start of the second quarter than we had expected.

As to the individual business units our strategic staffing business obviously had a good first quarter. We incurred a considerable amount of transition costs in the first quarter and some, of these costs, such as the retention bonuses, will continue for several quarters. We see our strategic staffing group continuing to grow and its profitability increasing as the transitional costs subside. Our healthcare group also had a good first quarter and continues to benefit from the two large multiyear implementation engagements that began in mid-2004. Our healthcare business grew at a double-digit rate in the first quarter of the year and we expect to see that kind of growth continue throughout 2005.

Revenues from our financial services vertical declined in the first quarter of 2005 due to the termination of a large AMO engagement in mid-2004 with a customer that was in liquidation over the last six months we've introduced new offerings into both the financial services and life sciences practices. The offerings are being well received and we expect to see both financial services in life sciences revenues increase as the year progresses. Our European revenues increased by 26% in the first quarter of 2005 versus the first quarter of last year. Of the 26% increase approximately 6% was related to exchange gain while 20% related to growth in services revenues.

The areas that stood out in the first quarter of the year in Europe were our healthcare, life sciences, and testing offering, we also saw excellent results from the investments that we made in 2004 particularly from our Sarbanes-Oxley offering. That business did very well in both the fourth quarter of 2004 as well as the first quarter of 2005. Once a Company has initially complied with Sarbanes-Oxley the Company is then subject to the quarterly testing requirements. As such we've recently added a quarterly testing offering to our Sarbanes-Oxley practice.

As you know we believe that the staffing side of our business returned to a more normal market mid last year in order to be ready for an upturn in the solutions market we rehired Mike Colson at the start of the year to be our Senior Vice President of Solutions Development. Mike had previously worked for CTG but left in the late 90s to become the CEO of a venture capital firm specializing in the creation and launching of technology companies. Mike has already introduced several new offerings since returning to CTG, one area that he's particularly focused on is the payor side of the healthcare market. As you may know, while we have a fairly large healthcare practice most of our offerings are for the provider side of that market. We've already rolled out several new offerings for the payor market and at the beginning of the second quarter of 2005 we began several engagements with new healthcare customers. We believe this market is a perfect adjunct to our existing business with excellent growth potential.

As to the second quarter of 2005 we're forecasting revenues in the range of 72 to 74 million. As you know we had 65 billable days in the first quarter. One billable day equates to about 1 million 60 thousand of revenue and we'll have 64 billable days in the second quarter of 2005. As I've previously mentioned the 72 to $74 million range for the second quarter should give us revenue growth versus the second quarter of 2004 of 22 to 25%. Given our revenue forecast we believe earnings to be in the $0.03 to $0.05 per share range in the second quarter of 2005.

As I mentioned before we still have some start-up costs associated with bringing on this new staffing business which will continue to constrain our profitability in the second quarter. Those transition costs should diminish over time and as they do our profitability should improve. We're returning to a growth mode and we see the continued strength of our staffing business and vertical practices combined with the expansion of higher margin solutions offering as a sound and achievable route to increasing CTG's profitability. With that, I would like to open the call for questions if there are any. Operator, would you please manage our question-and-answer period.

Certainly. [OPERATOR INSTRUCTIONS] Your first question comes from the line of Rick D'Auteuil from Columbia Management. Please go ahead.

I think that's pronounced Dotay. Hey, Rick, how are you.

Just so we can better understand these transitional costs can those be quantified? It's -- we're finally achieving some top line here and always thought there was likely to be leverage in that and so far clearly we haven't seen any and I don't know if you're getting surprised by the cost side or I hate to throw out the prospect but perhaps you took on very poor margin business. Can you give us anything that would, I guess disprove the statement that we did some break-even business here with the IBM business.

Okay. That's actually we redid the first quarter without the transition cost so I can give you the percentages in the various areas. We essentially looked at this almost like an acquisition where often you curl out expense up front once those expenses go away it then becomes profitable for you. If you took our first quarter and took the transition costs out our direct profit margin would go from 24 to 24.7. So it's up seven-tenths of a percent. And a big component there is our retention bonuses of some of the people that were transitioned. I'll talk a little bit more about that in a minute.

Our SG&A expense would go from 22.7% to 22.2% and the operating margin would go from 1.4% to 2.5% so the earnings per share in the first quarter, it actually ends up being right at 5.5%. It would have rounded up to $0.06 or about double what we recorded, if we didn't have the transitional costs. And the transitional costs are relatively easy for us to identify. One of the things that we had to do was to guarantee that we could maintain continuity of some of the employees, actually all the employees that we took on, and this is very unusual in this particular market but we gave the employees retention bonuses. The bonuses go for nine months from the time that you come on the CTG, so the people who would have started on January 1, those retention bonuses and for our profitability increases at the end of September, somebody that was brought on at the March they could go through the fourth quarter and retention bonuses, there are many components but retention bonuses is a particularly large piece of these transition costs so that we'll see some improvement as we go along in the margins but the real improvement will happen in the fourth quarter, I'm sorry fourth quarter this year and first quarter next year is when we'll see those retention bonuses really end.

Is there a risk that they are no longer tied up after the retention bonuses roll off, and therefore you get turnover and have to I guess, put them back in place to replace them or to keep them onboard?

It's the same risk that we have with all of our employees. I suspect the retention bonuses will cause lower turnover when they're in place. But it's certainly possible that -- some people will decide to leave. Now we believe that the people currently are paid at market so these retention bonuses were just an additional assurance that we could retain the people and actually probably get lower turnover than the staffing business industry in the U.S. usually has.

If, in fact, the retention bonuses are a fact of life to sort of keep them in place, then we probably took on break-even business. In which case it wouldn't make sense to revisit that down the road.

I don't think so because we pretty much know what market is in those cities and we know that the people are paid at market so the retention bonus really is above market.

You're saying that you don't think you'll need to reinstate those to keep them in place when the time period rolls off?

No. Well, this is 500 people, we have, you know, thousands more people, and for nowhere else that I'm aware of. Certainly no one in CTG and nowhere that we've seen in the industry since the late 90s have people been giving out retention bonuses so we survey the markets that we're in probably every six months. We have a pretty solid feel we believe for what market is and we really don't see that as a problem.

If we look at Q2 in your guidance, is that drag to -- 1.1% drag to operating margins is that a comparable number, or percentage in Q2?

It's probably a little bit less than 1.1 because there are some costs we incurred in the first quarter that do go away. And as people, even with the retention bonus decide to leave obviously the retention bonus goes away. The person we rehire doesn't get a retention bonus. I think if you look at the midpoint for instance of our range we're going from 1.4 to 1.8. A little of that improvement is actually coming from the -- some of the transitional costs ending so there is some in that. Right now, based upon the business that we have, though, if the retention bonuses go away we would think that our margins would be around 2.5%, operating margin.

Okay. And I missed this. I got on probably a minute or two late, but you're saying in Q2 you expect about a 1.8% margin?

Yes. I'm sorry, we had given out guidance for the next quarter -- let me make sure I reread what I read last time. The revenue range was between 72 and 74 million. You touched that, but I didn't know that you had mentioned specific margins. Well, if you actually kind of rework the midpoint of the range, of that 73 million, in order to achieve that you'd have to have about a 1.8% margin to get to $0.04.

Also you made a reference to solutions business that came in at initial lower profits than you expected.

There was the staffing business. That was the large component of staffing business.

So that's this IBM business.

Yes.

It's not a solutions?

No. It was absolutely tied to this staffing business.

What's the -- what are the prospects on the solution side? I guess healthcare is good right? And beyond that, outside of healthcare, other --.

In general, the solutions business hasn't returned but it's an area where it depends on what niche you're in. We tried to pick niches years ago like healthcare that would grow. Demographics are aging so the country has to spend more on healthcare and pharmaceutical which is why we picked life sciences and healthcare to get into beginning. So in the healthcare area double-digit is not a problem. Sarbanes-Oxley, the first quarter was very good. We think the quarterly testing of company's controls, because we think that many companies will hopefully outsource that -- that will be a good annuity business for us. That's a very attractive area at the moment.

We also think testing. We do a lot of testing in Europe. In Europe they tend to have their testing separate from the applications development historically in the U.S. they kind of merged them together. As companies are sending work offshore they want to make sure that it's correct before they roll it -- in a production here in the United States plus, you can actually improve your quality and decrease your costs studies have proven by doing separate testing, independent testing, so that also is an offering that we've introduced in the United States within the last six years -- I'm sorry, within the last six months. We've had it in Europe for quite some time and that offering, too, is getting a lot of attraction. So if you create an offering, for instance, Sarbanes-Oxley that we introduced in the second quarter of last year which is a government requirement, you can see very good growth. In the general solutions business we're not seeing that.

Overall we have this problem that we have this very large AMO that ended in the middle of last year. If you took that out of last year's first quarter, our solutions business in total actually grew by around 5% in the first quarter of this year so we're starting to see it grow. In the areas that we're focused on, which is development and integration they grew by about 17% versus the first quarter of last year. So in niches you actually can grow and we plan on doing that. That's really the reason we brought Mike Colson back to begin to focus in on rolling out offerings that are hot.

And that AMO did that go off -- did that customer go offshore?

No, the customer unfortunately went into bankruptcy and then they went into liquidation and they brought it back inside as they're shutting it down.

I'll let others ask. Thanks.

Okay. Thank you. We have time for one final question. It comes from Bill Sutherland from Boenning & Scattergood. Please go ahead.

Hey, Jim.

Hey, Bill.

Giving you guys a short call.

Actually, operator, I think we need to leave it open for any questions that are out there.

DSOs, what were they? I got on a couple minutes late. I'm sorry.

DSOs at the end of the quarter, Bill, were at 88 days.

Okay. And that's a little up.

It's up significantly. I believe it was 74 days at the -- let me go back. It's in the low 70s in both the end of the year and the quarter before, and it's all due to our newer business primarily.

Is it just a cycle issue and it'll return to normal?

We believe that it had to do with the business and the percentage of subcontractor and it will decrease as the second and third quarter rolls out but we would see a significance decrease we believe in the next three months. It will return to more normal levels.

Positive cash flow is not going to be an issue is it?

No, I don't believe so.

Mix, between strategic staffing and solutions in the quarter? Do you guys calculate that yet?

Yes, actually, we -- I'll let Greg answer that. We actually calculate staffing versus solutions.

Yes. I meant all of staffing, yes.

In the quarter staffing is going to end up we believe around 70% and 30% in all other solutions work which would be application management and solutions.

And Europe was what percent of total?

Was about 12 -- 18%.

And, I'm sorry, IBM, and that's the last one I think I missed.

IBM was 31.8.

And is that about where you think it's going to run?

No, actually, we've probably gone back to where we were in the late '90s. The 700 people that we hired, for instance, in the first quarter they weren't billable for the entire quarter. That's one of the reasons that our revenue is going to go up in the second quarter. Second quarter if we hit our forecast IBM is probably going to be 36% of our total business which is fairly comparable to where it was in maybe '98.

And the tax rate? Is that 31 and change?

Bill, the first quarter is going to be impacted by a couple of things but we would believe that the effective rate as we go forward during the year should be around 41%. So it's impacted just somewhat in the first quarter because of earnings and some items that rolled through on a one-time basis but 41 is what we are thinking is the rest of the year.

Is that the rest of the year, or is that what the year should come to?

We would think that the year will be in the 40 to 41% one when it's all said and done.

And, Jim, looking at the mix, right now and then kind of making some assumptions for at least the near term, where does this -- you've set out some expectations or some goals for target operating margins, and based on a certain level of revenue scale, and I think that was a 50/50 staffing solution mix. If you were to stay weighted in staffing, would we be talking about different goals?

Yes, if we continue with this obviously our operating margins are going to be lower because of the staffing business in total has a lower average operating margin, about 5%, and the strategic staffing actually is below that. Our goal really is to get the Company back to 50% solutions and 50% staffing. We've said this goes back a couple years, that in a normal market we would expect it to yield about 7 or 8% operating margins, without the transition costs we're at about 2.5% so we've got a long ways to go.

I actually -- let me just give you an example, because it's sometimes hard to see that. I'll use the numbers that I gave out which are without the transition cost so we've got about a 25% direct profit margin and about a 22% SG&A. If we could add as much staffing business as we just -- I'm sorry, add as much solutions business as we picked up in staffing business recently, so let's say it's $50 million, our solutions business generally runs direct profit margins between 35 and 50% direct profit margins, and the incremental SG&A because we've already got corporate covered and we've got -- they'll be a little incremental in corporate but just people to process payroll, and we've got our delivery people at least the directorate level people out already in the field. So the incremental SG&A I always figure should be 15% or less.

So you add 15 million a year let's say and this is no easy feat, obviously, but that's 12.5 million a quarter, I'll pick towards the low end, a 40% direct profit, 15% SG&A percentage. When you add it to the our first quarter earnings again this is after we've taken the transition out -- costs out, we end up with about a 27% direct profit margin, a 21% SG&A and about a 6% operating margin and that's really the direction that we need to go in. I mean, we need to get our direct profit margin which now is around 25% without the transitional costs, back up to around 28%. Fortunately this additional volume has spread the overhead out so we're getting closer to the 21% that we need.

So really another way to look at it is the marginal operating profit on solutions would be ranging from 20% to 35%.

Yes, I think 35% is a little high but -- in the example that I used, it was 17%.

Okay.

And it's not a slam dunk but the reality is that we've hit multiple AMOs in our history that were $20 million a year in revenue, and I think that --.

That's at the lower end of the GP range.

That is at the lower end of the GP range. We have started to look for acquisitions, and we haven't found anything. That's a possibility. Hopefully the solutions business will get stronger.

Where would that possibly be? I guess acquisitions.

If we do acquisitions it probably will be to augment the verticals that we currently have. So -- and we don't need to do an acquisition to do this one but adding payors to our healthcare offering is a great adjunct to that particular offering. So it could be in the four verticals that we currently have. Well, three of the four verticals we're not going to do a company that focuses on technology service providers. We have the expertise that we need in that area. It could be that we'd go out and buy something in another -- to get us into a vertical. One area quite frankly, that would be attractive would be the government, particularly given anticipated spend that they're going to have on Homeland Security. We have a lot of high end information security people, a lot of them have had top secret clearances in the past, that would be perhaps an entree point for us to get into the government.

Do they seem like realistic acquisition prospects, just based on what you've seen?

They're pricey at the moment, unfortunately. They're very pricey. Historically, as you know, the government business tended to be a 5% operating margin, and half of revenues was probably a reasonable acquisition price. Now it's one times revenue or one to one and a half times revenue, that's what we've seen. If we did something that was that pricey it would have to be something where we immediately could bring an offering that we have to the government and obviously get more revenue out of it.

Okay. Thanks, Jim.

Thank you.

[OPERATOR INSTRUCTIONS] And we have a follow-up question from the line of Rick D'Auteuil from Columbia Management. Please go ahead.

Actually, Bill asked my question so I'm all set. Thanks.

Okay.

All right. And we have a question from the line of Ben Stetler, Private Investor.

Yes I had a question about those retention bonuses you referred to in the first quarter. Why do they continue in subsequent quarters and what are these other inefficiencies you refer to? Are they overhead or recruiters or what?

The -- generally when a company gives retention bonuses they will either pick an end date, so it could be you don't get the retention bonus unless you stay for nine months, or you get milestones, you might get part of your retention bonus for each of the next three quarters, and that's why it continues out for a couple of quarters because you're trying to incent the person not just to stay for this quarter you're trying to incent them to stay for a good part of the year.

Right.

They're a tremendous number of transition costs in the first quarter a lot of it was getting the overhead people in place before we actually hit the business. We had to open offices and hire recruiters even though we didn't have a tremendous volume for them to recruit, have account managers in place, et cetera. I really -- this is very specific to one customer. I actually have a list of what the transition costs are but I really don't feel comfortable going through those because most people, it's relatively easy to identify who the customer was and I don't think it's fair to them and also we have a confidentiality agreement with them that we won't disclose particulars about their account.

Will these be absorbed? How will these be absorbed over the following quarters?

Well, they impacted obviously our profitability in the first quarter. They also will in the second, third, fourth. As time goes on, I'll use retention bonuses as an example, as the person reaches the end of their receiving the retention bonus that expense just goes away and our profitability goes up.

And that's the main one?

That's a significant one.

Like the other overhead in that --.

That, over time, tends to go away, which is one of the reasons our margins have gone up in the second quarter because now we have more of the business that we've been anticipating.

So then you're anticipating in the third and fourth quarter to continue to improve from there?

Yes, but as I said before the retention bonuses, which is a big piece of this, don't -- if the people stay, for nine months, then if it started January 1, then we have those bonuses through September, and therefore profitability increases in the fourth quarter. If they were hired at the end of March, obviously those retention bonuses go to the end of the year so we should start to see them the most noticeable portion go away in the third and fourth quarters. Now, if somebody decides that they're going to leave, for whatever reason, I mean people move, et cetera, the retention bonus goes away immediately, we don't offer it to the person that replaces them.

So if that solutions business comes back which will raise your margins then that's going to have a tremendous impact on your profitability going forward.

Absolutely. And as I said before that's the reason we brought Mike Colson back in order to make sure that we had the right offerings.

All right. Thank you.

Okay.

We have no further questions at this time.

Okay. I'd like to thank you for your continued support and for joining us this morning. Have a great day.

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