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CTG > SEC Filings for CTG > Form 10-Q on 23-Jul-2014All Recent SEC Filings

Show all filings for COMPUTER TASK GROUP INC

Form 10-Q for COMPUTER TASK GROUP INC


23-Jul-2014

Quarterly Report


Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations for the Quarter and Two Quarters Ended June 27, 2014 Forward-Looking Statements
This quarterly report on Form 10-Q 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 the most recently filed Form 10-K and from time to time in the Company's reports filed with the Securities and Exchange Commission (SEC). Industry Trends

The Company operates in one industry segment, providing IT services to its clients. These services include IT solutions and IT staffing. 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 it serves. The pace of technological change and changes in business requirements and practices of the Company's clients all have a significant impact on the demand for the services that we provide. Competition for new engagements and pricing pressure has been and, management believes, will continue to be strong.

IT solutions and IT staffing revenue as a percentage of total revenue for the quarter and two quarters ended June 27, 2014 and June 28, 2013 was as follows:

                          For the                          For the Two
                       Quarter Ended                      Quarters Ended
              June 27, 2014     June 28, 2013    June 27, 2014     June 28, 2013
IT solutions        40.2 %            39.5 %             39.7 %          39.3 %
IT staffing         59.8 %            60.5 %             60.3 %          60.7 %
Total              100.0 %           100.0 %            100.0 %         100.0 %

The Company promotes a significant portion 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 Company focuses on these four vertical areas as it believes that these areas are either higher growth markets than the general IT services market and the general economy, or are areas that provide greater potential for the Company's growth due to the size of the vertical market. The remainder of CTG's revenue is derived from general markets.


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The Company's revenue by vertical market as a percentage of total revenue for the quarter and two quarters ended June 27, 2014 and June 28, 2013 was as follows:

                                                  For the                          For the Two
                                               Quarter Ended                      Quarters Ended
                                      June 27, 2014     June 28, 2013    June 27, 2014     June 28, 2013
Healthcare                                  31.2 %            32.3 %             30.7 %          32.1 %
Technology service providers                25.8 %            28.7 %             25.4 %          29.4 %
Financial services                           7.6 %             6.3 %              7.9 %           6.4 %
Energy                                       6.1 %             6.1 %              6.1 %           6.1 %
General markets                             29.3 %            26.6 %             29.9 %          26.0 %
Total                                      100.0 %           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. The Company's competition varies significantly by geographic region, as well as by the type of service provided. Many of the Company's 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). Regularly, new IT products and services are introduced which may render our existing IT solutions and IT staffing services obsolete. The economic conditions in the markets we serve are continuously changing and may negatively impact our business if we can not adapt to negative conditions as they occur. Finally, our healthcare clients have been effected by the U.S. government sequestration cuts which began in 2013 and have lowered their reimbursements. There can be no assurance that CTG 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 collectability of the amount 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 as per the proportional method of accounting using an input-based approach whereby salary and indirect labor costs incurred are measured and compared with the total estimate of costs at completion of a project. Revenue is recognized based upon the percent complete calculation of total incurred costs to total estimated costs. The Company infrequently works on fixed-price projects which 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.

During the 2013 second quarter, the Company performed under a contract with a customer that provided for application customization and integration services, specifically utilizing one of the software tools the Company has internally developed. As the project included significant modification and customization services to transform the previously developed software tool into an expanded tool that meets the customer's requirements, the percentage-of-completion method of contract accounting was utilized for the project.


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The Company's revenue from contracts accounted for under time-and-material, progress billing and percentage-of-completion methods for the quarter and two quarters ended June 27, 2014 and June 28, 2013 was as follows:

                                                  For the                          For the Two
                                               Quarter Ended                      Quarters Ended
                                      June 27, 2014     June 28, 2013    June 27, 2014     June 28, 2013
Time-and-material                           86.2 %            89.9 %             86.8 %          89.7 %
Progress billing                            11.5 %             8.2 %             10.7 %           8.1 %
Percentage-of-completion                     2.3 %             1.9 %              2.5 %           2.2 %
Total                                      100.0 %           100.0 %            100.0 %         100.0 %

Results of Operations
   The table below sets forth data as contained in the condensed consolidated
statements of income with the percentage information calculated as a percentage
                            of consolidated revenue.
For the Quarter Ended:                           June 27, 2014            June 28, 2013
                                                         (amounts in thousands)
Revenue                                      100.0  %   $ 100,331     100.0  %   $ 107,117
Direct costs                                  78.8  %      79,133      78.8  %      84,470
Selling, general and administrative expenses  15.7  %      15,728      15.2  %      16,248
Operating income                               5.5  %       5,470       6.0  %       6,399
Interest and other expense, net               (0.1 )%         (55 )    (0.1 )%        (106 )
Income before income taxes                     5.4  %       5,415       5.9  %       6,293
Provision for income taxes                     2.2  %       2,182       2.1  %       2,238
Net income                                     3.2  %   $   3,233       3.8  %   $   4,055


For the Two Quarters Ended:                      June 27, 2014            June 28, 2013
                                                         (amounts in thousands)
Revenue                                      100.0  %   $ 198,242     100.0  %   $ 215,612
Direct costs                                  78.8  %     156,112      79.1  %     170,366
Selling, general and administrative expenses  15.7  %      31,185      15.1  %      32,665
Operating income                               5.5  %      10,945       5.8  %      12,581
Interest and other expense, net               (0.1 )%        (152 )    (0.1 )%        (215 )
Income before income taxes                     5.4  %      10,793       5.7  %      12,366
Provision for income taxes                     2.2  %       4,394       1.9  %       4,254
Net income                                     3.2  %   $   6,399       3.8  %   $   8,112


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The Company recorded revenue in the 2014 and 2013 periods as follows:

                                                                      Year-over-
For the Quarter Ended:    June 27, 2014          June 28, 2013       Year Change
                                 (amounts in thousands)
North America           80.2 %   $  80,513     82.6 %   $  88,502       (9.0 )%
Europe                  19.8 %      19,818     17.4 %      18,615        6.5  %
Total                  100.0 %   $ 100,331    100.0 %   $ 107,117       (6.3 )%

There were 64 billable days in both the 2014 and 2013 second quarters. Reimbursable expenses billed to customers and included in revenue totaled $2.6 million and $3.1 million in the 2014 and 2013 second quarters, respectively.

                                                                           Year-over-
For the two Quarters Ended:    June 27, 2014          June 28, 2013       Year Change
                                      (amounts in thousands)
North America                79.5 %   $ 157,662     82.4 %   $ 177,593        (11.2 )%
Europe                       20.5 %      40,580     17.6 %      38,019          6.7  %
Total                       100.0 %   $ 198,242    100.0 %   $ 215,612         (8.1 )%

There were 126 billable days and 127 billable days in the 2014 and 2013 year-to-date periods, respectively. Reimbursable expenses billed to customers and included in revenue totaled $5.1 million and $6.2 million in the 2014 and 2013 year-to-date periods, respectively.

On a consolidated basis, IT solutions revenue decreased 4.8% and 7.0% in the 2014 second quarter and year-to-date period, respectively, as compared with the corresponding 2013 periods. Also on a consolidated basis, IT staffing revenue decreased 7.4% and 8.8% in the 2014 second quarter and 2014 year-to-date period as compared with the corresponding 2013 periods. The Company's headcount was approximately 3,800 employees at June 27, 2014, which was a 3% decrease from approximately 3,900 employees at June 28, 2013, and a 3% increase from approximately 3,700 employees at December 31, 2013.

In North America, the revenue decrease in the 2014 second quarter and the 2014 year-to-date period as compared with the corresponding 2013 periods was due to a decrease in demand for the Company's IT staffing business. This decrease was primarily due to the reduction in requirements from a large IT staffing customer that began late in the 2013 second quarter. Additionally, in the Company's IT solutions business, the Company had more electronic medical records (EMR) projects end in the 2014 second quarter and year-to-date period than were started. The Company also began a data analytics IT solutions project in the 2014 second quarter which is scheduled to end in December 2014. In total, the Company's data analytics projects added approximately $1.7 million and $0.06 to our second quarter revenue and net income per diluted share, respectively, and they are estimated to generate approximately $6 million and $0.18 of revenue and net income per diluted share, respectively, in all of 2014.

The increase in revenue in the Company's European operations in the 2014 second quarter and year-to-date periods as compared with the corresponding 2013 periods was primarily due to modest increase in demand in our European IT solutions business. The revenue increase was supported by the strength relative to the U.S. dollar of the currencies of Belgium, Luxembourg, and the United Kingdom, the countries in which the Company's European subsidiaries operate. In Belgium and Luxembourg, the functional currency is the Euro, while in the United Kingdom the functional currency is the British Pound. In the 2014 second quarter as compared with the corresponding 2013 period, the average value of the Euro increased 5.1% while the average value of the British Pound increased 9.5%. A significant portion of the Company's revenue from its European operations is generated in Belgium and Luxembourg. If there had been no change in these exchange rates from the 2013 second quarter to the 2014 second quarter, total European revenue would have been approximately $1.0 million lower, or $18.8 million as compared with the $19.8 million reported. In the first two quarters of 2014 as compared with the corresponding 2013 period, the average value of the Euro increased 4.4% while the average value of the British Pound increased 8.0%. If there had been no change in the exchange rates from the first two quarters of 2013 to the corresponding 2014 period, total European revenue would have been approximately $1.8 million lower, or $38.8 million compared with the $40.6 million reported. Additionally, operating income in the second quarter and year-to-date period would have been approximately $25,000 and $62,000 lower, respectively, if there had been no change in the exchange rates year-over-year.


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In the 2014 second quarter, International Business Machines Corporation (IBM) was the Company's largest customer and accounted for $22.7 million or 22.6% of consolidated revenue as compared with $26.6 million or 24.9% of revenue in the comparable 2013 period. In the first two quarters of 2014, IBM accounted for $44.3 million or 22.3% of consolidated revenue, compared with $55.6 million or 25.8% of consolidated revenue in the comparable 2013 period. The National Technical Services Agreement ("NTS Agreement") with IBM extends to December 31, 2014. As part of the NTS Agreement, the Company provides its services as a predominant supplier to IBM's Integrated Technology Services unit and as sole provider to the Systems and Technology Group business unit. The Company's accounts receivable from IBM at June 27, 2014 and June 28, 2013 totaled $10.5 million and $10.0 million, respectively. No other customer accounted for more than 10% of the Company's revenue in the second quarter or first two quarters of 2014 or 2013.

In January 2014, IBM announced its intention to spin off its x86 server division to Lenovo. A portion of the Company's 2014 and 2013 second quarter and year-to-date revenue from IBM was related to the x86 server division. The Company expects to continue to retain a significant share of the revenue derived from the x86 server division despite the anticipated transition of the division from IBM to Lenovo.

Direct costs, defined as the costs for billable staff including billable out-of-pocket expenses, were 78.8% of revenue in the 2014 second quarter as compared with 78.8% of revenue in the 2013 second quarter, and 78.8% of revenue in the first two quarters of 2014 as compared with 79.1% in the corresponding 2013 period. The Company's direct costs as a percentage of revenue decreased in the 2014 year-to-date period as compared with the corresponding 2013 period primarily due to the percentage increase in solutions business in the Company's revenue mix, which has a lower direct cost. The decrease in direct costs resulting from the change in the business mix was partially offset by a significant increase in fringe benefit costs, primarily medical expense, in the 2014 second quarter. The increase in medical expense was due to much higher utilization of the Company's self-insured plan during the quarter.

Selling, general and administrative ("SG&A") expenses were 15.7% of revenue in the 2014 second quarter as compared with 15.2% in the corresponding 2013 period, and 15.7% of revenue in the first two quarters of 2014 as compared with 15.1% in the corresponding 2013 period. The increase in SG&A expenses as a percentage of revenue in the 2014 second quarter and year-to-date period as compared with the corresponding 2013 periods is primarily due to the loss of operating leverage from the decrease in revenue in the 2014 second quarter and year-to-date periods.

Operating income was 5.5% of revenue in the 2014 second quarter as compared with 6.0% in the 2013 second quarter, and 5.5% of revenue in the first two quarters of 2014 as compared with 5.8% in the corresponding 2013 period. The decrease in operating income as a percentage of revenue in the 2014 second quarter and year-to-date period as compared with the corresponding 2013 periods is due to the increase in SGA expense as a percentage of revenue, and the increase in medical expense in direct costs as previously noted. Operating income from North American operations was $9.4 million and $11.2 million in the first two quarters of 2014 and 2013, respectively. European operations recorded operating income of $1.6 million and $1.4 million in the 2014 and 2013 year-to-date periods, respectively.

The Company's effective tax rate ("ETR") is calculated quarterly based upon current assumptions relating to the full year's estimated operating results and various tax-related items. The Company's normal annual ETR ranges from 38% to 40% of pre-tax income. The 2014 second quarter ETR was 40.3% and the 2014 year-to-date ETR was 40.7%.

The ETR was higher than the normal range in the 2014 second quarter and year-to-date period primarily due to the expiration of certain federal income tax credits as of December 31, 2013. The Work Opportunity Tax Credit (WOTC) and the Research and Development Tax Credit have not been renewed by the U.S. federal government as of June 27, 2014. Should these credits be reinstated during 2014, in accordance with current accounting guidelines, the Company will recognize the benefit of those credits beginning in the quarter in which such legislation is enacted.

The 2013 second quarter ETR was 35.6% and the 2013 year-to-date ETR was 34.4%. The ETR was lower in the 2013 second quarter primarily due to the Company recording a tax benefit related to its participation in the WOTC program offered by the federal government to companies who have hired individuals who have traditionally faced barriers to employment. The 2013 year-to-date ETR was below the normal range due to the recording of a tax benefit of the Company's 2013 research and development activities, the WOTC mentioned above, and the recording of a tax


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benefit for its research and development activities for all of 2012 in the 2013 first quarter, as required under current accounting guidelines. 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

Net income for the 2014 second quarter was 3.2% of revenue or $0.20 per diluted share, compared with net income of 3.8% of revenue or $0.24 per diluted share in the 2013 second quarter. Net income for the first two quarters of 2014 was 3.2% of revenue or $0.39 per diluted share, compared with net income of 3.8% of revenue or $0.47 per diluted share in the first two quarters of 2013. Diluted earnings per share was calculated using 16.3 million and 17.1 million weighted-average equivalent shares outstanding for the quarters ended June 27, 2014 and June 28, 2013, respectively, and 16.4 million and 17.1 million weighted-average equivalent shares outstanding for the year-to-date periods ended June 27, 2014 and June 28, 2013, respectively. The decrease in weighted-average equivalent shares outstanding in 2014 is due to approximately 0.4 million shares repurchased under the Company's share repurchase plan in the first two quarters of 2014, and a lessor dilutive effect of outstanding equity-based compensation grants.

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 condensed consolidated financial statements and accompanying notes. The Company's significant accounting 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 condensed consolidated financial statements. The Company identifies its 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 income taxes, specifically relating to the valuation allowance for deferred income taxes, and goodwill valuation. Goodwill Valuation
The Company has a goodwill balance of $37.6 million related to its healthcare vertical market recorded as of June 27, 2014. This balance reflects an increase of approximately $2.0 million in the 2013 first quarter 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 involve judgments and are based on currently available information, any of which could prove wrong or inaccurate when made, or become wrong or inaccurate as a result of subsequent events.
At the October 2013 measurement date the Company completed its annual valuation of the business to which the Company's goodwill relates. During 2013, the Company utilized the provisions under Accounting Standards Update No. 2011-08, "Intangibles-Goodwill and Other (Topic 350): Testing Goodwill for Impairment," which allows public entities to first assess qualitative factors to determine whether it is necessary to perform the two-step quantitative goodwill impairment test. Under this new process, an entity is no longer required to calculate the fair value of a reporting unit unless the qualitative assessment shows that it is more likely than not that its fair value is less than its carrying amount. From its internal qualitative assessment completed in 2013, the Company believes that although the fair value of the business decreased from 2012, it continues to be substantially in excess of the carrying value of the business. Additionally, there are no other facts or circumstances that arose during the 2014 year-to-date period which led management to believe the goodwill balance was impaired.
Income Taxes-Valuation Allowances on Deferred Tax Assets At June 27, 2014, the Company had a total of approximately $7.6 million of current and non-current deferred tax assets, net of deferred tax liabilities, recorded on its consolidated balance sheet. The deferred tax assets, net, primarily consist of deferred compensation and state taxes, offset by depreciation. The changes in deferred tax assets and liabilities from period to period are determined based upon the changes in differences


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between the basis of assets and liabilities for financial reporting purposes and the basis of assets and liabilities for tax purposes, as measured by the enacted tax rates when these differences are estimated to reverse. The Company has made certain assumptions regarding the timing of the reversal of these assets and liabilities, and whether taxable income in future periods will be sufficient to recognize all or a part of any gross deferred tax asset of the Company. . . .

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