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CTG > SEC Filings for CTG > Form 10-K on 26-Feb-2014All Recent SEC Filings

Show all filings for COMPUTER TASK GROUP INC

Form 10-K for COMPUTER TASK GROUP INC


26-Feb-2014

Annual Report


Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations

Forward-Looking Statements
This annual report on Form 10-K contains forward-looking statements made by the management of Computer Task Group, Incorporated (CTG, the Company or the Registrant) that are subject to a number of risks and uncertainties. These forward-looking statements are based on information as of the date of this report. The Company assumes no obligation to update these statements based on information from and after the date of this report. Generally, forward-looking statements include words or phrases such as "anticipates," "believes," "estimates," "expects," "intends," "plans," "projects," "could," "may," "might," "should," "will" and words and phrases of similar impact. The forward-looking statements include, but are not limited to, statements regarding future operations, industry trends or conditions and the business environment, and statements regarding future levels of, or trends in, revenue, operating expenses, capital expenditures, and financing. The forward-looking statements are made pursuant to safe harbor provisions of the Private Securities Litigation Reform Act of 1995. Numerous factors could cause actual results to differ materially from those in the forward-looking statements, including the following: (i) the availability to CTG of qualified professional staff, (ii) domestic and foreign industry competition for customers and talent, (iii) the Company's ability to protect confidential client data, (iv) the partial or complete loss of the revenue the Company generates from International Business Machines Corporation (IBM), (v) risks associated with operating in foreign jurisdictions, (vi) renegotiations, nullification, or breaches of contracts with customers, vendors, subcontractors or other parties, (vii) the change in valuation of recorded goodwill balances, (viii) the impact of current and future laws and government regulation, as well as repeal or modification of such, affecting the information technology (IT) solutions and staffing industry, taxes and the Company's operations in particular, (ix) industry and economic conditions, including fluctuations in demand for IT services, (x) consolidation among the Company's competitors or customers, (xi) the need to supplement or change our IT services in response to new offerings in the industry, and
(xii) the risks described in Item 1A of this annual report on Form 10-K and from time to time in the Company's reports filed with the Securities and Exchange Commission (SEC). Industry Trends
The market demand for the Company's services is heavily dependent on IT spending by major corporations, organizations and government entities in the markets and regions that we serve. The pace of technology advances and changes in business requirements and practices of our clients all have a significant impact on the demand for the services that we provide. Competition for new engagements and pricing pressure has been strong. In 2011, we experienced an increase in demand for our services, primarily in the healthcare provider solution and general IT staffing businesses. While demand in our healthcare vertical market remained strong in 2012, demand for our IT staffing services was modest which limited revenue growth for these services in 2012 as compared with 2011. During 2013, however, the demand for our services softened from prior years as demand from our healthcare clients was down, as were requirements for personnel received from our largest staffing customer.

The Company operates in one industry segment, providing IT services to its clients. These services include IT solutions and IT staffing. With IT solutions services, we generally take responsibility for the deliverables on a project and the services may include high-end consulting services. When providing IT staffing services, we typically supply personnel to our customers who then, in turn, take their direction from the client's managers. IT solutions and IT staffing revenue as a percentage of consolidated revenue for the years ended December 31, 2013, 2012 and 2011 is as follows:

              2013      2012      2011
IT solutions  39.4 %    41.0 %    37.9 %
IT staffing   60.6 %    59.0 %    62.1 %
Total        100.0 %   100.0 %   100.0 %

The Company promotes a majority of its services through four vertical market focus areas: Healthcare (which includes services provided to healthcare providers, health insurers, and life sciences companies), Technology Service Providers, Financial Services, and Energy. The remainder of CTG's revenue is derived from general markets.


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CTG's revenue by vertical market as a percentage of consolidated revenue for the years ended December 31, 2013, 2012 and 2011 is as follows:

                              2013      2012      2011
Healthcare                    31.4 %    32.7 %    29.6 %
Technology service providers  27.9 %    31.2 %    34.3 %
Financial services             6.8 %     6.1 %     6.7 %
Energy                         6.1 %     6.0 %     6.0 %
General markets               27.8 %    24.0 %    23.4 %
Total                        100.0 %   100.0 %   100.0 %

The IT services industry is extremely competitive and characterized by continuous changes in customer requirements and improvements in technologies. Our competition varies significantly by geographic region, as well as by the type of service provided. Many of our competitors are larger than CTG, and have greater financial, technical, sales and marketing resources. In addition, the Company frequently competes with a client's own internal IT staff. Our industry is being impacted by the growing use of lower-cost offshore delivery capabilities (primarily India and other parts of Asia). There can be no assurance that we will be able to continue to compete successfully with existing or future competitors or that future competition will not have a material adverse effect on our results of operations and financial condition. Revenue Recognition
The Company recognizes revenue when persuasive evidence of an arrangement exists, when the services have been rendered, when the price is determinable, and when collectibility of the amounts due is reasonably assured. For time-and-material contracts, revenue is recognized as hours are incurred and costs are expended. For contracts with periodic billing schedules, primarily monthly, revenue is recognized as services are rendered to the customer. Revenue for fixed-price contracts is recognized per the proportional method of accounting using an input-based approach. On a given project, actual salary and indirect labor costs incurred are measured and compared against the total estimated costs of such items at the completion of the project. Revenue is recognized based upon the percentage-of-completion calculation of total incurred costs to total estimated costs. The Company infrequently works on fixed-price projects that include significant amounts of material or other non-labor related costs which could distort the percent complete within a percentage-of-completion calculation. The Company's estimate of the total labor costs it expects to incur over the term of the contract is based on the nature of the project and our past experience on similar projects, and includes management judgments and estimates which affect the amount of revenue recognized on fixed-price contracts in any accounting period.
From 2011 to 2013, the Company performed services for a customer under a series of contracts that provided for application customization and integration services, specifically utilizing one of the software tools the Company has developed for internal use. These services were provided under a software-as-a-service model. As the contracts were closely interrelated and dependent on each other, for accounting purposes the contracts were considered to be one arrangement. As the project included significant modification and customization services to transform the previously developed software tool into an expanded tool intended to meet the customer's requirements, the percentage-of-completion method of contract accounting was utilized for the project.
The Company's revenue from contracts accounted for under time-and-material, progress billing, and percentage-of-completion methods as a percentage of consolidated revenue for the years ended December 31, 2013, 2012 and 2011 is as follows:

                          2013      2012      2011
Time-and-material         88.8 %    90.3 %    91.0 %
Progress billing           8.8 %     7.9 %     7.3 %
Percentage-of-completion   2.4 %     1.8 %     1.7 %
Total                    100.0 %   100.0 %   100.0 %


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Results of Operations
The table below sets forth percentage information calculated as a percentage of consolidated revenue as reported on the Company's consolidated statements of income as included in Item 8, "Financial Statements and Supplementary Data" in this report.

Year Ended December 31,                        2013      2012       2011
(percentage of revenue)
Revenue                                      100.0  %   100.0 %   100.0  %
Direct costs                                  78.8  %    78.4 %    78.7  %
Selling, general and administrative expenses  15.3  %    15.8 %    16.4  %
Operating income                               5.9  %     5.8 %     4.9  %
Interest and other income (expense), net      (0.1 )%     0.2 %    (0.1 )%
Income before income taxes                     5.8  %     6.0 %     4.8  %
Provision for income taxes                     2.1  %     2.2 %     1.8  %
Net income                                     3.7  %     3.8 %     3.0  %

2013 as compared with 2012
The Company recorded revenue in 2013 and 2012 as follows:

Year Ended December 31,        % of total       2013        % of total       2012       Year-Over-Year Change
(dollars in thousands)
North America                       81.6 %   $ 341,924           83.8 %   $ 355,805               (3.9 )%
Europe                              18.4 %      77,112           16.2 %      68,610               12.4  %
Total                              100.0 %   $ 419,036          100.0 %   $ 424,415               (1.3 )%

Reimbursable expenses billed to customers and included in revenue totaled $11.8 million and $13.4 million in 2013 and 2012, respectively.

In North America, the revenue decrease in 2013 as compared with 2012 was due to a reduction in demand from our healthcare customers and from our largest IT staffing customer. On a consolidated basis, IT solutions revenue decreased $9.2 million or 5.3% in 2013 as compared with 2012. The decrease was primarily driven by the sequestration that the U.S. federal government imposed during 2013, which, amongst other cuts, reduced Medicare reimbursements to hospitals and healthcare systems by 2% beginning on April 1, 2013. These cuts reduced revenue for many of our healthcare customers, causing them to reduce their expenses for much of 2013, including previously planned spending on IT projects. IT staffing revenue increased $3.8 million or 1.5% during 2013 as soft demand from our largest IT staffing customer was offset by strong demand from our other IT staffing customers.
The Company's European operations include Belgium, Luxembourg and the United Kingdom. When considering the year-over-year change in revenue in constant currencies, the revenue from our European operations increased 9.0%. This strong increase in year-over-year revenue was in part due to strength in the Company's European IT solutions services, and in part by the acquisition of etrinity which added approximately $2.8 million in revenue during the year. The revenue increase was supported by the strength relative to the U.S. dollar of the currencies of Belgium and Luxembourg, and slightly offset by the currency of the United Kingdom. In Belgium and Luxembourg, the functional currency is the Euro, while in the United Kingdom the functional currency is the British Pound. In 2013 as compared with 2012, the average value of the Euro increased 3.3%, while the average value of the British Pound decreased 1.3%. A significant portion of the Company's revenue from its European operations is generated in Belgium and Luxembourg. Had there been no change in these exchange rates from 2012 to 2013, total European revenue would have been approximately $2.3 million lower, or $74.8 million as compared with the $77.1 million reported.


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IBM is CTG's largest customer. CTG provides services to various IBM divisions in many locations. During 2011, the NTS Agreement with IBM was renewed for three years until December 31, 2014. As part of the NTS Agreement, the Company also provides its services as a predominant supplier to IBM's Integrated Technology Services unit and as the sole provider to the Systems and Technology Group business unit. This agreement accounted for approximately 92.3% of all of the services provided to IBM by the Company in 2013. In 2013, 2012, and 2011, IBM accounted for $101.0 million or 24.1%, $113.5 million or 26.7%, and $116.5 million or 29.4% of the Company's consolidated revenue, respectively. In 2012, IBM spun its retail business off to another large company. While CTG retained the work, this reduced our revenue from IBM in 2012 by $3.2 million. We expect to continue to derive a significant portion of our revenue from IBM in future years. However, a significant decline or the loss of the revenue from IBM would have a significant negative effect on our operating results.
In January 2014, IBM announced its intention to spin off its x86 server division to Lenovo. A portion of the Company's 2013 revenue from IBM was related to the x86 server division. The Company expects to retain a significant share of the revenue derived from the x86 server division despite the transition of the division from IBM to Lenovo.
The Company's accounts receivable from IBM at December 31, 2013 and 2012 amounted to $11.0 million and $12.6 million, respectively. No other customer accounted for more than 10% of the Company's revenue in 2013, 2012 or 2011. Direct costs, defined as costs for billable staff including billable out-of-pocket expenses, were 78.8% of consolidated revenue in 2013 and 78.4% of consolidated revenue in 2012. The increase in direct costs as a percentage of revenue in 2013 compared with 2012 was due to a shift in the Company's business mix to a higher percentage of IT staffing services, which has a higher direct cost as a percentage of revenue than our IT solutions services.
Selling, general and administrative (SG&A) expenses were 15.3% of revenue in 2013 as compared with 15.8% of revenue in 2012. The SG&A decrease as a percentage of revenue in 2013 as compared with 2012 is primarily due to lower levels of personnel incentives earned in 2013, and continued disciplined cost management.
Operating income was 5.9% of revenue in 2013 as compared with 5.8% of revenue in 2012. The increase in operating income year-over-year was primarily due to the lower SG&A costs as a percentage of revenue. Operating income from North American operations was $21.8 million and $21.3 million in 2013 and 2012, respectively, while European operations generated operating income of $2.9 million and $3.2 million in 2013 and 2012, respectively. Operating income in 2013 in the Company's European operations would have been approximately $0.1 million lower if there had been no change in foreign currency exchange rates year-over-year.

Interest and other income (expense), net was (0.1)% of revenue in 2013 and 0.2% in 2012. Net other income in 2012 primarily resulted from the receipt of life insurance proceeds totaling approximately $1.3 million for two former executives that passed away during 2012. This income in 2012 was partially offset by bank fees.
The Company's effective tax rate (ETR) is calculated based upon the full year's operating results, and various tax related items. The Company's normal ETR ranges from 38% to 40%. The ETR in 2013 was 35.6%, while the 2012 ETR was 36.5%. The 2013 ETR was lower than the normal range primarily due to the recording of approximately $0.7 million of tax credits related to research and development activities, and approximately $0.4 million of tax credits related to the Company's participation in the Work Opportunity Tax Credit (WOTC) program offered by the federal government to companies who have hired individuals who have traditionally faced barriers to employment. The tax benefit for these two items for both 2013 and 2012 was recorded in 2013 as required under current accounting guidelines, as the legislation extending these tax credits, the American Taxpayer Relief Act of 2012, was not passed by the U.S. federal government until January 2013. The benefit of these tax credits was partially offset by an increase of approximately $0.1 million in the valuation allowance associated with net operating losses incurred by certain foreign subsidiaries. The 2012 ETR was lower than the normal range due to approximately $0.5 million in tax expense related to non-taxable life insurance proceeds received during the year. In addition, in 2012 the Company recorded an additional $0.2 million reduction of state tax expense as a result of the recording of certain favorable provision-to-return adjustments associated with the Company's 2011 income tax returns.
Net income for 2013 was 3.7% of revenue or $0.92 per diluted share, compared with net income of 3.8% of revenue or $0.96 per diluted share in 2012. Diluted earnings per share were calculated using 17.0 million weighted-average equivalent shares outstanding in 2013 and 16.8 million in 2012. The increase in shares year-over-year is due to additional actual shares outstanding during 2013 as compared with 2012 due to a high number


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of stock option exercises by optionees in 2012 and 2013. This increase in the number of shares outstanding was partially offset by purchases of approximately 0.4 million and 0.3 million shares for treasury by the Company during 2013 and 2012, respectively.
2012 as compared with 2011
The Company recorded revenue in 2012 and 2011 as follows:

                                                                               Year-over-
Year Ended December 31, % of total       2012      % of total       2011      Year Change
(dollars in thousands)
North America                83.8 %   $ 355,805         83.1 %   $ 329,295         8.1 %
Europe                       16.2 %      68,610         16.9 %      66,980         2.4 %
Total                       100.0 %   $ 424,415        100.0 %   $ 396,275         7.1 %

Reimbursable expenses billed to customers and included in revenue totaled $13.4 million and $12.7 million in 2012 and 2011, respectively.

In North America, the significant revenue increase in 2012 as compared with 2011 was due to strong demand for the Company's IT solutions services. On a consolidated basis, IT solutions revenue increased $26.4 million or 17.9%, and was primarily driven by an increase in the Company's EMR work for providers in the healthcare vertical market in North America. IT staffing revenue increased $1.8 million or 0.7% as demand for these services significantly slowed due to challenging economic conditions in the United States.
The Company's European operations include Belgium, Luxembourg and the United Kingdom. The increase in year-over-year revenue in the Company's European operations was primarily due to modest strength in the Company's European IT solutions services. When considering the year-over-year change in revenue in constant currencies, the revenue from our European operations increased 10.9%. This revenue increase was offset by the weakness relative to the U.S. dollar of the currencies of Belgium, Luxembourg, and the United Kingdom. In Belgium and Luxembourg, the functional currency is the Euro, while in the United Kingdom the functional currency is the British Pound. In 2012 as compared with 2011, the average value of the Euro decreased 7.7%, while the average value of the British Pound decreased 1.2%. A significant portion of the Company's revenue from its European operations is generated in Belgium and Luxembourg. Had there been no change in these exchange rates from 2011 to 2012, total European revenue would have been approximately $5.4 million higher, or $74.0 million as compared with the $68.6 million reported.
As noted above, IBM is CTG's largest customer, and CTG provides services to various IBM divisions in many locations. During the 2011 fourth quarter, the NTS Agreement was renewed for three years until December 31, 2014. As part of the NTS Agreement, the Company also provides its services as a predominant supplier to IBM's Integrated Technology Services unit and as the sole provider to the Systems and Technology Group business unit. These agreements accounted for approximately 91.9% of all of the services provided to IBM by the Company in 2012. In 2012, 2011, and 2010, IBM accounted for $113.5 million or 26.7%, $116.5 million or 29.4%, and $102.3 million or 30.9% of the Company's consolidated revenue, respectively. In 2012, IBM spun its retail business off into another large company. While CTG retained the work, this reduced our revenue from IBM in 2012 by $3.2 million. The Company's accounts receivable from IBM at December 31, 2012 and 2011 amounted to $12.6 million and $12.8 million, respectively. No other customer accounted for more than 10% of the Company's revenue in 2012, 2011 or 2010.
Direct costs were 78.4% of consolidated revenue in 2012 and 78.7% of consolidated revenue in 2011. The decrease in direct costs as a percentage of revenue in 2012 compared with 2011 was due to a continued shift in the Company's business mix to a higher percentage of solutions services, which incurs lower direct costs as a percentage of revenue than the Company's staffing services. SG&A expenses were 15.8% of revenue in 2012 as compared with 16.4% of revenue in 2011. The SG&A decrease as a percentage of revenue in 2012 as compared with 2011 is primarily due to disciplined cost management and the effect of operating leverage resulting from revenue growth.


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Operating income was 5.8% of revenue in 2012 as compared with 4.9% of revenue in 2011. The increase in operating income year-over-year was primarily due to the favorable change in business mix to more solutions services in 2012, and lower SG&A costs as a percentage of revenue. Operating income from North American operations was $21.3 million and $16.6 million in 2012 and 2011, respectively, while European operations generated operating income of $3.2 million and $2.7 million in 2012 and 2011, respectively. Operating income in 2012 would have been approximately $0.2 million higher if there had been no change in foreign currency exchange rates year-over-year.

Interest and other income (expense), net was 0.2% of revenue in 2012 and (0.1)% in 2011. Net other income in 2012 primarily resulted from the receipt of life insurance proceeds totaling approximately $1.3 million for two former executives who passed away during 2012. This income in 2012 was partially offset by bank fees. In 2011, partially offsetting net interest and other expenses which resulted from bank fees and a loss on intercompany balances settled or intended to be settled at year-end, was approximately $0.1 million resulting from a gain on a sale of property.
The 2012 ETR was 36.5%, and the 2011 ETR was 37.6%. The ETR in 2012 was lower due to approximately $0.5 million in tax expense related to non-taxable life insurance proceeds received during the year. In addition, the Company recorded an additional $0.2 million reduction of state tax expense as a result of the recording of certain favorable provision-to-return adjustments associated with the Company's 2011 income tax returns. The ETR during 2011 was reduced as the Company recorded $0.3 million of tax credits related to research and development activities, and $0.3 million of federal tax credits related to the retention of certain individuals hired during 2010. The impact of these credits was partially offset by an increase in the valuation allowance of $0.2 million associated with net operating losses incurred by certain foreign subsidiaries. The Company did not record a tax benefit for its research and development activities during 2012 as the legislation extending the tax credit related to these expenses, the American Taxpayer Relief Act of 2012, was not passed by the U.S. federal government until January 2013. As required under current accounting guidelines, the Company recognized a tax benefit of $0.3 million for these 2012 credits in the 2013 first quarter.
Net income for 2012 was 3.8% of revenue or $0.96 per diluted share, compared with net income of 3.0% of revenue or $0.71 per diluted share in 2011. Diluted earnings per share were calculated using 16.8 million weighted-average equivalent shares outstanding in 2012 and 16.7 million in 2011. The increase in shares year-over-year was due to the dilutive effect of incremental shares outstanding under the Company's equity-based compensation plans. This increase was partially offset by purchases of approximately 0.3 million shares for treasury by the Company during 2012.
Critical Accounting Policies
The preparation of financial statements and related disclosures in conformity with U.S. generally accepted accounting principles requires the Company's management to make estimates, judgments and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes. The Company's significant accounting policies are included in note 1 to the consolidated financial statements contained in this annual report on Form 10-K under Item 8, "Financial Statements and Supplementary Data." These policies, along with the underlying assumptions and judgments made by the Company's management in their application, have a significant impact on the Company's consolidated financial statements. The Company identifies its most critical accounting policies as those that are the most pervasive and important to the portrayal of the Company's financial position and results of operations, and that require the most difficult, subjective and/or complex judgments by management regarding estimates about matters that are inherently uncertain. The Company's critical accounting policies are those related to goodwill valuation, and the valuation allowance for deferred income taxes. Goodwill Valuation
The Company has a goodwill balance of $37.6 million related to its healthcare vertical market recorded as of December 31, 2013. This balance reflects an increase of approximately $2.0 million in 2013 due to the acquisition of etrinity, a provider of IT services to the healthcare market in Belgium and the Netherlands.
The balance is evaluated annually as of the Company's October fiscal month-end (the measurement date), or more frequently if facts and circumstances indicate impairment may exist. This evaluation, as applicable, is based on estimates and assumptions that may be used to analyze the appraised value of similar transactions from which the goodwill arose, the appraised value of similar companies, or estimates of future discounted cash flows. The estimates and assumptions on which the Company's evaluations are based


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