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Executives

James Culligan – Director, IR

James Boldt – Chairman, President and CEO

Brendan Harrington – SVP and CFO

Analysts

Matthew McCormack – BGB Securities

Vincent Colicchio – Noble Financial Capital Markets

James Friedman – Susquehanna Financial Group

Computer Task Group, Inc. (CTGX) Q3 2011 Earnings Call October 25, 2011 10:00 AM ET

Operator

Ladies and gentlemen, thank you for standing by. Welcome to the CTG Third Quarter Earnings Conference Call. At this time, all participants are in a listen-only mode. Later we will conduct a question-and-answer session; instructions will be given at that time. (Operator Instructions). As a reminder, this conference is being recorded.

I would now like to turn the conference over to our host Director of Investor Relations Mr. Jim Culligan. Please go ahead.

James Culligan

Thank you, Greg, and good morning everyone. We certainly appreciate your time and your interest in CTG. On the call today, we have CTG’s Chief Executive Officer, Jim Boldt, and Brendan Harrington, Senior Vice President and Chief Financial Officer. Jim and Brendan are going to review the results for the third quarter of 2011 and then update you on the company’s strategy and outlook. We’ll follow with an opportunity for Q&A. If you don’t have the news release discussing our financial results, you can access it at the company’s website at ctg.com.

Before we begin, I want to mention that statements in the course of this conference call that state the company’s or management’s intentions, hopes, beliefs, expectations and predictions for 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 earnings release as well as in the company’s SEC filings. You can find these at our Website or the SEC’s Website at sec.gov. Please review our forward-looking statements in conjunction with these precautionary factors.

With that, I’d like to turn it over to Jim to begin the discussion.

James Boldt

Thanks, Jim, and good morning, everyone. This is Jim Boldt. I want to thank you for joining us this morning for our third quarter earnings conference call. As you read in our earnings release, in the third quarter of 2011 we were above our guidance for revenue and at the high end of our guidance for earnings per share. For the full year at the midpoint of our revised guidance. We anticipate a revenue increase over 2010 of 19% and an increase in EPS of 37%. Our revenue and earnings continue to grow as demand for our services expand both as a result of the continued need in the United States for staffing services and as the healthcare industry invests in electronic medical records and other initiatives required in IT support.

I’m going to talk more about our results and what we see for the 2011 fourth quarter and the full year, but first I’m going to ask Brendan to start us off with the review of our financial results. Brendan.

Brendan Harrington

Thanks, Jim. Good morning everyone. For the third quarter of 2011, CTG’s revenue was $101.1 million, an increase of $16.7 million or 20% compared with the third quarter of 2010. On a sequential basis compared with the trailing second quarter of 2011 revenue increased 2.8% and was 4% higher per billing day.

Solutions revenue in the third quarter of 2011 was $38.8 million an increase of $10.4 million or 36% compared with last year’s third quarter. As a percentage of total revenue, Solutions revenue was 38% compared with 34% a year ago. The improvement in our business mix was mainly driven by revenue growth from more profitable healthcare projects.

Continued strong demand from our clients increased staffing revenue on a quarter by $6.3 million or 11.2% to $62.3 million. Third quarter revenue from IBM, our largest customer, was $30.8 million compared with $27.2 million in the same period last year. Although, the total revenue from IBM increased as a percent of total revenue, IBM decreased to 30.4% in the 2011 third quarter compared with 32.2% of total revenue in the third quarter of last year.

Revenue from our European operations was $16 million, a 16.2% increase from the $13.8 million recorded in last year’s third quarter.

The effect of foreign currency fluctuations during the third quarter of 2011 increased consolidated revenue by approximately $1.3 million or 1.3%. The recovery in Europe continues to lag out of the U.S. as indicated by the lower growth rates of our European business which was 6.6% on a local currency basis as compared with the third quarter of 2010.

Direct costs as a percentage of revenue were 79.3% in the quarter compared with 79.5% in the third quarter of 2010 and 78.9% in the trailing second quarter of 2011. SG&A expenses as a percent of revenue decreased to 16.2% from 15.8% in the third quarter of 2010. This improvement reflects the operating leverage from higher revenue and continued discipline in controlling costs.

Third quarter operating income expanded at a greater rate than revenue and was $4.6 million, up $1.5 million or 47% year-over-year reflecting the favorable effect of operating leverage and our higher margin Solutions work.

Compared with the trailing second quarter of 2011, third quarter operating income decreased 101,000 or 2.2%. Operating margin in the third quarter increased to 4.5% of revenue, an 80 basis point improvement from last year’s 3.7% due primarily to an increasing in the profitability of Solutions projects, cost controls and the additional operating leverage.

Operating margin declined 30 basis points compared to the second quarter 2011, reflecting one less billing day and the seasonal effect of the increased vacation time used by billable employees in the summer months of the third quarter.

Net income was $3 million in the quarter, an increase of 48% from $2 million in the third quarter of 2010 and a 5.7% increase from the second quarter of 2011. On a per diluted share basis net income was $0.18 for the quarter, a 38% increase from the third quarter 2010 and $0.01 higher or 5.9% as compared with the 2011 second quarter.

The 2011 third quarter results include equity compensation expense of approximately $0.02 per diluted share net of tax while equity compensation expense in the third quarter 2010 was approximately $0.01 per diluted share.

The tax rate for the 2011 third quarter was 35.3% compared with 34.1% in the 2010 third quarter. We expect the tax rate for the full year 2011 to be between 36% and 38%. We added approximately 50 employees in the third quarter with total headcount rounding to 3,700, the same as at the end of the second quarter 2011. Off the 3,700 employees at the end of the third quarter 2011, 90% were billable resources.

CTG’s financial position continues to be strong. At the end of the third quarter 2011 we had no long-term debt and $12.6 million of cash on the balance sheet. Both the third quarter 2011 and 2010 ended on a U.S. parole day. Our day sales outstanding was 61 days at the end of the third quarter 2011, the same as of the end of the third quarter 2010 and down one day compared to the end of the second quarter 2011.

Cash provided from operations in the third quarter of 2011 was approximately $2.8 million as compared with cash provided from operations of approximately $928,000 in the third quarter of 2010. In the quarter we had $463,000 in capital expenditures and recorded depreciation expense of $649,000. We repurchased approximately 187,000 shares of CTG common stock during the third quarter of 2011, bringing the total repurchases to approximately 281,000 shares for 2011 through September 30. During this most recent self-imposed blackout period prior to releasing our earnings, we repurchased approximately 19,000 shares under our 10b5-1 plan.

As of today, our repurchase authorization is for approximately 900,000 shares. Because it remains accretive to our earnings, we intend to continue our repurchase program during the fourth quarter of 2011. Jim?

James Boldt

Thanks, Brendan. In aggregate, our Solutions business which is more profitable than our staffing business increased by 36% in the third quarter 2011. The growth in Solutions work is primarily coming from EMR projects and is continuing to drive margin expansion. Overall, our healthcare business was up 32% over the third quarter of last year.

On our conference call at the end of July, we mentioned that we bid on an RFP for an electronic medical record project, which the hospital had not decided what IT services firms would be awarded the project. Since that call, we were notified that we had won that project.

When we started the third quarter 2011, we had 17 active EMR projects. During the third quarter, we started the project that I just mentioned, and one project came to an end. That means that at the end of third quarter 2011, we once again had 17 active EMR projects.

As the sizes of the new projects we’ve been winning are significantly larger than the sizes of the engagements ending, we remain very optimistic about our EMR business. Add to that the two RFPs for EMR projects we received in the third quarter, which clients have not yet selected an IT services firm, and the engagements that our sales forces are still pursuing and you can see why we have every expectation our EMR business will continue to grow.

Currently we see our new offerings for ICD 10 in accountable care organizations, known in the industry as ACOs, is our next major revenue growth opportunity. Our ICD-10 offering supports conversions in the U.S. from ICD-9 the current U.S. standard for diagnostic codes to ICD-10, the international standard which the federal government is requiring providers and payers to adopt by October 1, 2013.

We currently have one ICD-10 remediation project for a payer underway and are working on an ICD-10 assessment for a hospital. Our ACO offering supports the formation of accountable care organizations to improve the quality of care and reduce unnecessary costs the concept conceived as part of healthcare reform.

Going forward we believe the mix of our offerings we are selling will begin to change. Hospitals need this type of ICD-10 conversion projects or they will not be ready to go live with the new codes on the October 1, 2013 conversion date. While some hospitals will being their ICD assessments in 2011, we believe that in 2012 and 2013 a larger part of our revenue growth will be derived from ICD-10 projects as hospitals begin implementing the changes they need in their environments to accommodate the ICD-10 codes.

As we’ve talked about before and other trend we see emerging it has to do with the small hospitals. As you know, we’ve been focused on the 500 bed to 2,000 bed hospital market and have not been marketing to the 100 bed and less hospitals which constitute approximately half of the hospitals in the U.S. Unfortunately most of those hospitals have been slow to implement their EMR projects due to their limited capital. In general, these smaller hospitals often lack the financial resources to implement EMRs or to fund the ICD-10 conversion and do not have adequate capital structures to form their own accountable care organization.

Recently some of our clients have begun acquiring smaller hospitals and while we had finished the EMR work for the larger hospital system, we’ll be engaged by these clients to implement EMRs at their newly acquired hospitals. As such, we’re beginning to access the smaller hospital market without having to go through the normal sales cycle.

As the dates approach for the EMR penalties and the ICD-10 conversion, we expect to see more of the smaller hospitals be acquired by the larger hospital systems. And as a consequence, there is a potential for more EMR work at multi-hospital organizations where we’ve already completed their initial implementation.

Longer term we believe medical informatics will be a major opportunity for growth in serving the healthcare industry. We have a solid head start in this opportunity having already developed three solutions for the healthcare market that employee medical informatics to identify ways to improve the quality and efficiency of healthcare delivery. These offerings are now commercial and we’re actively marketing them.

Having covered healthcare, I’d also like to talk about the other three vertical markets on which we focus. Demand from the technology service provider market was good, although moderating during the third quarter 2011. As to our financial services and energy verticals, we depict those businesses as stable and improving and we’re optimistic that they will continue to do so in the future.

Turning to our staffing business, which generates most of its revenue from the technology service provider market, it increased by 11% in the third quarter 2011 when compared with the third quarter of 2010. As you know since the beginning of 2011, we’ve been expecting our staffing revenue growth to slow, although still at a double digit growth rate of 11% in the third quarter, staffing revenue growth began slowing in the quarter. Longer term, we expect our staffing business to grow in an 8% to 10% annual pace.

As was mentioned in our news release, IBM has informed CTG that it has been selected to continue as the supplier under the NPS agreement for the next three years. CTG expects the NTS agreement to be executed during the fourth quarter of 2011.

While there are changes under the new agreement, in aggregate we expect that the new agreement will put us in about the same position in terms of the IBM business as we were under the old agreement.

Looking at the fourth quarter, we’re forecasting total revenue to be in the range of $100 million to $102 million or a 16% increase from the midpoint of our guidance over last year’s fourth quarter. We’re forecasting earnings per share in the fourth quarter of 2011 to be in the range of $0.18 to $0.20 per diluted share, or a 19% increase in the midpoint of our guidance over the fourth quarter of last year.

For the 2011 full year, we expect a revenue range of $395 million to $397 million, or a 19% increase from the midpoint of our guidance over 2010. Based upon our revenue forecast and the anticipated mix of business, we expect net income per diluted share in 2011 will be in the range of $0.70 to $0.72 or a 37% increase from 2010 at the midpoint of our guidance.

When you compare CTG to companies both in and outside of our industries, we had a strong third quarter in 2011. We’re expecting 2011 to be another excellent year for CTG with strong double-digit revenue and earnings growth.

With that, I’d like to open the call for questions, if there are any. Operator, would you please manage our question-and-answer period?

Question-and-Answer Session

Operator

Thank you, ladies and gentlemen. (Operator Instructions) Your first question comes from the line of Matt McCormack. Please go ahead.

Matthew McCormack – BGB Securities

Yeah, hi, good morning.

James Boldt

Good morning. Matt.

Matthew McCormack – BGB Securities

I guess just a point of clarification, I guess on the segments. The Solutions growing 36%, obviously very strong, but then your Healthcare segment only grew 32%, so I mean is there – is there some staffing in there? Or where else did you see very strong Solutions growth in the business?

Brendan Harrington

Well, we have Solutions – and there is no staffing in there to begin with. We have Solutions and a lot of the other verticals, Energy for instance is made up of a great deal of Solutions and even other which is all other industries, but before we breakup separately, there is Solutions in that business as well. So the other parts of the Solutions business just had a very good quarter.

Matthew McCormack – BGB Securities

Was there anything specific that you can point to?

Brendan Harrington

No there is…

Matthew McCormack – BGB Securities

There were other verticals?

Brendan Harrington

No. Energy definitely improved. Energy had been lagging and it definitely picked up in the quarter, but there is nothing specific.

Matthew McCormack – BGB Securities

Okay. And would it be possible just to get the breakout of the other verticals?

James Boldt

Certainly, sure. Brendan, do you want to that?

Brendan Harrington

Yeah. The Financial services was up 21%, Technology services providers was up 14%, other was up 19%, and Energy was up 4%.

Matthew McCormack – BGB Securities

Okay. Okay. And so obviously you’ve had a pretty good year, when you look out into ‘12, I guess could you kind of talk about the visibility that you have both on the Solutions and the Staffing side. I think you said you’re expecting Staffing to trend to the 8% to 10% long-term revenue growth rate. But so how should we look at that into next year given the economy and given what you said with your visibility right now?

Brendan Harrington

Right. If someone would definitively tell us what the economy was going to do that would be very helpful. We don’t actually have a forecast yet for next year. We definitely assume that long-term staffing is going to go back to about an 8% to 10% growth which is the growth rate that we grew at for the four years ended 2008. We also believe that our solutions business, particularly the healthcare solutions, are going to grow at a much faster rate than our staffing business. When we get to the February call we’ll probably be a little bit more definitive on our guidance but certainly right now that’s what we’re thinking.

Matthew McCormack – BGB Securities

Okay. And then what about the pricing environment both in light of the IBM agreement that was just extended and then also on the Solutions side?

Brendan Harrington

Well I’m going to break our business down because it’s very different and depending on which business you’re looking at. There definitely has been wage inflation in the healthcare business and that was true in 2010 and it continues in 2011 and it’s picking up to a great extent because of the shortage of people we have skills in healthcare. There is a shortage in the market, wages are going up and bill rates are going up as well.

In Europe because of some statutory regulations in some of the countries they were in by statured we have to raise wages once a year. We also raise our prices at the same time so Europe seeing about 3% or so increase in their bill rates versus a year ago. We’ve just started to see some inflation in the general staffing business. Well, I know unemployment is high overall in the United States I think it’s very different for people who have IT backgrounds. A lot of the employment – unemployment in the United States is tied to the construction industry. We in the last couple of years have seen a big change really in the availability of IT professionals. Before 2008 when we called a candidate, we usually find that they had a couple job offers they were considering. During the great recession in 2009 and 2010 by and large, we’re the only person talking to the candidates. We’re back now, we think to what the market was like in 2007, probably only a couple percent unemployment in the programmers and analysts in the United States. So we’re starting to see some, I wouldn’t call it significant, we’re starting to see some mild bill rate inflation in the staffing business in the United States as well.

Operator

Your next question comes from the line of Vincent Colicchio from Noble Financial. Please go ahead.

James Boldt

Hey, good morning Vince.

Vincent Colicchio – Noble Financial Capital Markets

Good morning, nice quarter guys.

James Boldt

Thank you.

Vincent Colicchio – Noble Financial Capital Markets

Jim, you mentioned in your prepared comments about ICD-10 become more important. Could you give us a sense of how your pipeline of opportunities has changed, say, last quarter to now, have you seen a market change there?

James Boldt

Absolutely. A quarter ago or so we were talking only a couple of hospitals about doing assessments. Now we’re talking to between one and two handfuls of larger systems about doing assessments. Basically what’s happening a lot of the hospitals where we finish the EMR implementations, they kind of needed a breather. So if they finish it let’s say in the first or second quarter of this year, they needed to do some work that they just been postponing and now they’re to the point that they are talking to us about doing assessment. Some hospitals because depending on how their staff actually have started their own assessment and kind of select a IT services provider to help them with the remediation part because they don’t have enough people to do the remediation. So we’re definitely seeing the ICD-10 work pick up.

Vincent Colicchio – Noble Financial Capital Markets

And on the EMR side you’d mentioned that the project you had was bigger than the one that was say, where the delivery was completed. Can you talk to in order of magnitude how much bigger the new project was and also the two RFPs you have, order of magnitude how much bigger they are than your typical project you’re working on today?

James Boldt

Yeah. Just in general probably the hospitals that we’ve either won or looking at let’s say last two quarters have tended to be 50% larger to 100% larger than the hospitals that we’re ending. So the hospitals that we’re ending tended to be 800 to a 1000 bed and these hospitals tend to be around 1,400 to 1,800 beds and it is virtually linear. I mean it does cost about twice as much, almost twice as much to do an 1,800 bed hospital that does a 900 bed hospital.

Vincent Colicchio – Noble Financial Capital Markets

On the European business what are your expectations for growth there in the fourth quarter and does the nature of the type of business you do, does that somewhat insulate you from European economic issues?

James Boldt

Well it somewhat does yes. It absolutely does. We think that Europe will probably continue to grow at the same rate that it grew in the current quarter. So it is – even if you looked at in real terms that is growing when you eliminate the currency fluctuations most of our business in Europe is in Belgium and there the EU as you know is headquartered in Belgium. Literally they are building Washington DC 200 years later.

So every quarter new ministries will open up and they need IT support and we’re doing some of their IT support. So, well if we were in some of the countries in Europe I wouldn’t be as optimistic, being where we are in Belgium I think that we can continue to grow so that growth rate is going to be low single digits. And I think it’s going to be awhile before the European economy improves enough to have our general business grow.

There is one opportunity that we believe is coming but we can’t figure out exactly when it’s going to be and that has to do with electronic medical records. There are actually some hospitals in Europe now that are starting to look at U.S. software, not just for the electronic medical records, but software in general because some of the software in the United States, most of it actually, the epic Siemens software, is more robust than the software than the individual hospitals built themselves. So, we’re hopeful that once the United States proves that the EMR model works that all Europe actually will begin implementing because they’re experiencing the same cost pressures that the U.S. is with rising health costs.

Vincent Colicchio – Noble Financial Capital Markets

You’d mentioned that your medical informatics is attractive growth opportunity, could you give us more color there? Have you shown your products into most of your EMR clients, what type of feedback have you had and sort of when do you expect to see some significant traction there?

James Boldt

Well, we – no. We haven’t shown it to most of our clients. Many of those products – our current healthcare business is more concentrated in hospitals than it is in payers or life sciences. About 70% actually of our healthcare revenues comes from the hospital or provider market. And a lot of the products that we’re talking about well they have – they definitely can be used in hospitals but they also have pay-offs or payers. We are very encouraged with the products that we have out there. We have very little revenue or any very little profitability in the third quarter in terms of our products but we’re getting to the point that we actually put some profitability in them in for the fourth quarter for the products that we’re starting to see them gain traction. So we’re optimistic about it in the fourth quarter, and if that happens we’ll probably talk more about it on the call on February.

Vincent Colicchio – Noble Financial Capital Markets

Okay. Thanks, Jim. Good quarter I’ll go back to the queue.

James Culligan

Thanks Vince.

Operator

Your next question comes from the line of James Friedman from Susquehanna. Please go ahead.

James Friedman – Susquehanna Financial Group

Hi. Thanks for taking my question.

James Culligan

Hi, Jim. How are you?

James Boldt

Good morning.

James Friedman – Susquehanna Financial Group

Good. I wanted to ask and if this is too specific move on, but do you have any view about the risks or opportunities in sequestration. So if I don’t have to explain that I won’t, but what I’m referring to is the Capital Hill process now where there is budget cuts that are going to be in force relative to especially health care and defense?

James Culligan

We don’t have any specific information as you know in the budget ceiling legislation. They put in there if this committee can’t cut the deficit significantly there’s automatically a 2% cut on CMS. We’re obviously concerned about that. I’ve talked to the president of at least one of the state hospital associations about it. They think that it’s probably going to be at least 2% of a cut. The way that the budgeting system works for the federal government that wouldn’t be expected until the fiscal year that starts October of 2011. So when a hospital is look at next year they’re looking at probably a cut in the fourth quarter.

It’s a concern; however, you have to bear in mind that most of the hospitals that we deal with are 500 bed – just about all of them, 500 bed to 2000 bed hospitals so the revenues are between $500 million and $2 billion. Most 1000 bed hospitals usually have 300 million to 400 million of cash on their balance sheet. So the clients that we’re dealing with have a much better capability of dealing with the government cut back than the smaller hospitals one. Also the hospitals that we deal with tend to have 2%, 3%, 4% operating margin.

Hospitals are obviously concerned about it. This is a cycle. The government has done this to them before. If you go back to the Balanced Budget Act of 1998 for instance they largely came out of hospital reimbursements and eventually the government had to fix that because the – we need hospitals in the United States that can’t continue to underfund them. I think the – what we’re focused on is where we see the opportunity really is that hospitals, the ACO, the payers everybody needs ways to reduce their cost. And if you look at healthcare just in general, for 30 years they under spent on Information Technology. Some of the offering that we’ve come out the fraud, waste, and abuse lets them cut their costs without actually cutting any service to their clients. Also the medical management tool that we have, that allows them to treat a patient better and at the same time lowers their costs.

So the product that we came out with we think will be very attractive, particularly to the ACO market where they’re going to be responsible basically for absorbing any cost overruns that they might have.

Operator

And at this time, there are no further questions.

James Boldt

Thank you. CTG is firmly established in healthcare, one of the fastest growing major U.S. industries. We have offerings for Electronic Medical Records, ICD-10 conversions, Accountable Care Organizations, and Medical Informatics, all of which are expected to be in strong demand for the next several years. We’re therefore very excited about CTG’s future growth. We believe the strength of our business, the growth opportunities in the healthcare market and our strategy and ability to execute well provides CTG with strong growth prospects for the foreseeable future. I would like to thank you for your continued support and for joining us this morning. Have a great day.

Operator

Ladies and gentlemen, this conference will be available for replay after 11.30 Easter Time today through October 29. You may access the AT&T teleconference replay system at any time by dialing 1-800-475-6701 and entering the access code 175415. International participants dial 320-365-3844. Those numbers once again are 1-800-475-6701 or 320-365-3844, with the access code 175415.

That does conclude your conference for today. Thank you for your participation and for using AT&T executive teleconference. You may now disconnect.

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