Computer Task Group: An Attractive Takeover Target Or Stand-Alone Investment

Summary

• Computer Task Group is an attractive takeover target for many reasons.
• The company is a strong standalone investment if no takeover or shareholder activism appears.
• Owners of Computer Task Group face a few unique risks, however, which should be considered before investing.

Introduction

Computer Task Group (NASDAQ:CTG) is a Buffalo-based corporation that provides IT services in North America and Europe. The company offers a variety of IT services to clients, including supplemental IT staffing and custom technology support solutions. CTG's customers span a variety of industries, including healthcare, life sciences, manufacturing, finance, energy, telecom, and government. The organization was founded in 1966 and has been publicly traded since 1988.

The stock first caught my attention in late 2014. At the time, the ticker had been falling for over a year after an excellent runup between 2010 and 2013. Adding to the organization's woes was the tragic and unexpected loss of its then CEO and Chairman, James Boldt, at age 62. Thus, in late 2014, CTG fit into the "contrary stock" category we look to for investment opportunities. In December 2015, Contra the Heard Investment Newsletter took a position in the organization at $6.46.

Since then, the c-suite has seen a number of CEOs come and go, and the stock has traded over $9.00, under $3.50, and everywhere in between. At times, management's actions have been baffling, but today the prospects appear more promising than in the past, and the stock possesses many attractive buyout characteristics.

CTG's Attractive Takeover Characteristics

In early 2019, long-time insider Filip Gydé took over as CEO, and since then the firm has started moving in the right direction. Shortly after Filip took the helm, he issued a letter to shareholders stating that CTG would focus on its higher margin "IT Solutions" business rather than its lower margin "IT Services" division. In December 2019, Filip's vision was expanded to include growth in Europe, balance sheet strength, and bolt-on M&A.

Filip and staff have been successfully executing on this vision. The higher margin IT Solutions division went from 32.1% of revenues in Q4 2018 to 39.6% in Q3 2020. Meanwhile, sales generated in Europe have climbed from 36.4% to 45.1%. CTG has also engaged in a handful of M&A opportunities in Europe since 2018, integrating Soft Company, StarDust, and Tech-IT.

These actions have improved margins, and in the latest quarter net income grew from $0.89 million to $2.83 million year-over-year. Going forward, the c-suite intends to continue growing the IT Solutions side of CTG's business. In short, any acquirer would be purchasing an organization moving in the right direction with a good runway ahead of it.

During this transition, management has maintained a clean balance sheet. In the latest quarter, the entity held $33.4 million in cash, $6 million in debt, and had ample working capital. Management has also managed to unlock additional value in other areas - for example, after many years of trying, CTG sold its headquarters building in Buffalo, resulting in a gain of approximately $0.8 million.

Source: CTG's valuation data via Morningstar.

A would-be buyer of CTG could acquire the organization on the cheap too. The so called "acquirer's multiple" (EV/EBITDA) is low at 6.6, meaning a buyer would be paying little for CTG relative to its EBITDA generation. Furthermore, the price to sales ratio is 0.25, the company is trading at just over book value, the price to earnings ratio is 12.7, and its price to cash flow ratio is a mere 3.1 times. These metrics look low regardless of how they are assessed. Compared with the index, for example, CTG is cheap, as the Morningstar data above suggests. This Seeking Alpha data also implies the stock is cheap relative to its peers:

Source: CTG's peer to peer valuation data via Seeking Alpha.

CTG's valuations are roughly aligned with the stock's 5-year averages, yet (as this article argues) the outlook today is better than it has been over the past 5 years. It does not appear as though the market has repriced CTG to account for its improving outlook.

On a side note, here at Contra the Heard Investment Newsletter, we prioritize assessing profitable enterprises trading around book value. Over time, we have found this is often a good indicator of future success, especially when profitability is improving as it is with CTG.

Prior to the pandemic, Assurance Global Services made two unsolicited takeover offers at $6.00 and $7.00, in August 2019 and January 2020 respectively. Nothing came from either of these approaches, but it does highlight how CTG is viewed as a valuable entity by a potential acquirer.

In summary, CTG is an attractive takeover target because its current management team is successfully growing the company's high margin business division while maintaining a strong balance sheet. Despite the improving results and business turnaround, the valuations remain low. Finally, in 2019 and 2020 an interested party (Assurance Global Services) approached CTG twice with takeover offers.

What If No Buyer Appears?

If no buyer emerges, the stock should continue to do well on its own, and if the valuations remain close to where they are today, we intend to continue holding it for a long time. The fundamentals are strong under Filip Gydé, the valuations are low as reviewed above, and the financials are sound.

Source: CTG's insider information via INK Research.

Insiders have recently been buying too. Over the past 52 weeks, officers and directors have purchased a total of $260,715 in stock and sold $19,592, for net insider buying of $227,048. This buying has not been confined to one individual either, which adds to the bullishness of the signal.

While a buyout may unlock value faster than it would materialize naturally, the ingredients are there for value to surface over time regardless of if the company is acquired. Therefore, investors in CTG should do well either way.

Risks

Computer Task Group is not without risks, however. Competition is stiff, the market could tank, and key employees could leave. Moreover, CTG has two unique risks that should be considered before investing.

The first risk is its revenue exposure to IBM. In the latest quarter, 21% of revenues came from Big Blue. Although this has declined since 2016 when it was 30.3%, it is still material. The majority of this business with IBM is wrapped up in a single contract called "The National Technical Services Agreement," which originally expired at the end of 2019 but has been extended several times now in increments of a few months here and there. The lack of clarity regarding the future of this contract suggests a lot of haggling. One way or another, this contract will resolve itself - in the best-case scenario it will be extended for years with healthy margins, or in a worst-case scenario it will be an albatross contract, to be extended with low or no margins. It's also possible that one of the two parties could walk away, which could be either good or bad for CTG depending on the contract's margin profile versus its other business.

In addition to the revenue concentration risk with IBM, CTG has a checkered past when it comes to buying back its own stock via tender offers. For a tender offer to maximize long-term shareholder value, its parameters must be tightly contained to dissuade short-term speculators from driving up the price. To do this, companies buying back shares in a tender need to limit the dollar amount dedicated to the endeavour, establish a tender price (or range), and set an expiration date. Many corporations do this well - one which I've written about here previously is Diana Shipping (DSX).

Unfortunately, CTG has a history of doing the opposite. On February 15, 2018, CTG issued a press release stating the organization would start a tender offer. The press release did not specify a dollar amount for the tender, and instead indicated up to 10% of outstanding common stock would be purchased. The press release did not set an end date or establish a tender price range, either. This created a perfect environment for speculation because traders knew the company would attempt to buy 10% of its stock, but the price and date were to be determined. In the weeks that followed, volumes jumped and the ticker rallied from $5.29 to $7.88 before CTG issued a second press release which finally set a termination date and named a price range between $8.05 and $9.00. In the end, CTG repurchased 1.53 million shares at or below $8.85 for a total cost of approximately $13.4 million.

There is no question that this action destroyed shareholder value, as the stock price following the tender's conclusion illustrates. If a price range had been established from the outset, shareholder capital could have gone significantly further, as it would have been possible to buy stock at a much lower price point than $8.85. Instead of buying low and selling high, this 2018 tender offer did the opposite.

Fortunately for today's owners, there is no inclination the current CEO has any plans to execute a similar strategy. This said, such an error of judgement cannot entirely be ruled out, and investors must be aware of this rather unique tender offer risk associated with CTG.

Conclusion

Computer Task Group is an attractive takeover target for many reasons, despite the risks associated with CTG's revenue dependence on IBM, as well as its checkered tender offer record. Its business is moving in the right direction under the leadership of Filip Gydé and it has a clean balance sheet, yet its valuations are still low despite the improved operating results. These features may explain why Assurance Global Services made two offers to purchase CTG prior to the pandemic. Though nothing came of these offers, Assurance may return in the future, or another bidder may emerge. A buyout would most likely unlock shareholder value relatively quickly, but the ingredients for long-term value creation appear to be there regardless of whether a buyer comes knocking, which means owners should be well positioned either way.

Disclaimer

The opinions expressed - imperfect and often subject to change - are not intended nor should be taken as advice or guidance. Contra the Heard Investment Newsletter is not an investment advisor or financial advisor. Contra the Heard Investment Newsletter provides research, it does not advise. The information enclosed in this article is deemed to be accurate and reliable, but is not guaranteed by the author.

Analyst’s Disclosure: I am/we are long CTG, DSX. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.