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COMPUTER TASK GROUP INC - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations for the Quarter and Two Quarters Ended July 1, 2011(Edgar Glimpses Via Acquire Media NewsEdge) Forward-Looking Statements This management's discussion and analysis of financial condition and results of operations contains forward-looking statements by management of Computer Task Group, Incorporated ("CTG" or "the Company") 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, among other factors, the following: (i) industry and economic conditions, including fluctuations in demand for information technology ("IT") services and the deterioration in market conditions generally and for our targeted vertical markets, (ii) the availability to us of qualified professional staff, (iii) domestic and foreign industry competition for customers and talent, (iv) rate and wage inflation or deflation, (v) risks associated with operating in foreign jurisdictions, (vi) the impact of current and future laws and government regulation, as well as repeal or modification of same, affecting the IT solutions and staffing industry, our targeted vertical markets, taxes and the Company's operations in particular, (vii) renegotiations, nullification, or breaches of contracts with customers, vendors, subcontractors or other parties, (viii) consolidation among the Company's competitors or customers, (ix) the partial or complete loss of the revenue the Company generates from International Business Machines Corporation ("IBM"), (x) the need to supplement or change our IT services in response to new service offerings in the industry, and (xi) the risks described in Item 1A of the Company's most recent annual report on Form 10-K filed with the Securities and Exchange Commission ("SEC") and from time to time in the Company's other reports filed with the 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. The Company has responded to these challenging business conditions by focusing on its two main services, which are providing IT solutions and IT staffing to its clients. IT solutions and IT staffing revenue as a percentage of total revenue for the quarter and two quarters ended July 1, 2011 and July 2, 2010 are as follows: For the For the Two Quarter Ended Quarters Ended July 1, July 2, July 1, July 2, 2011 2010 2011 2010 IT solutions 37 % 32 % 36 % 32 % IT staffing 63 % 68 % 64 % 68 % Total 100 % 100 % 100 % 100 % 14 -------------------------------------------------------------------------------- Table of Contents The Company promotes a significant portion of its services through four vertical market focus areas: Technology Service Providers, Healthcare (which includes services provided to health care providers, health insurers, and life sciences companies), Energy, and Financial Services. 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. The Company's revenue by vertical market as a percentage of total revenue for the quarter and two quarters ended July 1, 2011 and July 2, 2010 are as follows: For the For the Two Quarter Ended Quarters Ended July 1, July 2, July 1, July 2, 2011 2010 2011 2010 Technology service providers 35 % 37 % 35 % 35 % Healthcare 29 % 27 % 28 % 27 % Energy 6 % 7 % 6 % 7 % Financial services 6 % 6 % 6 % 7 % General markets 24 % 23 % 25 % 24 % Total 100 % 100 % 100 % 100 % 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). 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 and Cost 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 that include significant amounts of material or other non-labor related costs which could distort the percent complete 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. 15 -------------------------------------------------------------------------------- Table of Contents The Company has entered into a series of contracts with a customer that provides for application customization and integration services, as well as post contract support (PCS) services, specifically utilizing one of the software tools the Company has internally developed. As the contracts are closely interrelated and dependent on each other, for accounting purposes the contracts are considered to be one arrangement. Additionally, as the project includes significant modification and customization services to transform the previously developed software tool into an expanded tool that will meet the customer's requirements, the percentage-of-completion method of contract accounting is being utilized for the project. Total revenue and costs were recognized equally until completion of the application customization and integration services portion of the project. The remaining unrecognized portion of the contract value is being recognized on a straight-line basis over the term of the PCS period. 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 July 1, 2011 and July 2, 2010 are as follows: For the For the Two Quarter Ended Quarters Ended July 1, July 2, July 1, July 2, 2011 2010 2011 2010 Time-and-material 90 % 93 % 91 % 92 % Progress payment 8 % 5 % 7 % 5 % Percentage-of-completion 2 % 2 % 2 % 3 % Total 100 % 100 % 100 % 100 % Results of Operations The tables below set 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: July 1, 2011 July 2, 2010 (amounts in thousands) Revenue 100.0 % $ 98,327 100.0 % $ 81,142 Direct costs 78.9 % 77,594 78.1 % 63,350 Selling, general, and administrative expenses 16.3 % 16,056 17.6 % 14,303 Operating income 4.8 % 4,677 4.3 % 3,489 Interest and other expense, net (0.1 )% (48 ) (0.1 )% (71 ) Income before income taxes 4.7 % 4,629 4.2 % 3,418 Provision for income taxes 1.8 % 1,799 1.9 % 1,513 Net income 2.9 % $ 2,830 2.3 % $ 1,905 For the Two Quarters ended: July 1, 2011 July 2, 2010 (amounts in thousands) Revenue 100.0 % $ 194,236 100.0 % $ 159,631 Direct costs 79.1 % 153,706 78.2 % 124,831 Selling, general, and administrative expenses 16.1 % 31,254 17.7 % 28,222 Operating income 4.8 % 9,276 4.1 % 6,578 Interest and other expense, net (0.1 )% (85 ) (0.1 )% (118 ) Income before income taxes 4.7 % 9,191 4.0 % 6,460 Provision for income taxes 1.8 % 3,533 1.7 % 2,769 Net income 2.9 % $ 5,658 2.3 % $ 3,691 16 -------------------------------------------------------------------------------- Table of Contents In the 2011 second quarter, the Company recorded revenue of $98.3 million, an increase of 21.2% compared with revenue of $81.1 million recorded in the 2010 second quarter. There were 64 billable days in both the 2011 and 2010 second quarters. Revenue from the Company's North American operations totaled $81.0 million in the 2011 second quarter, an increase of 21.4% when compared with revenue in the 2010 second quarter of $66.7 million. Revenue from the Company's European operations in the 2011 second quarter totaled $17.3 million, an increase of 20.3% when compared with revenue in the 2010 second quarter of $14.4 million. The European revenue represented 17.6% and 17.8% of 2011 and 2010 second quarter consolidated revenue, respectively. The Company's revenue included reimbursable expenses billed to customers, which totaled $3.1 million and $2.2 million in the 2011 and 2010 second quarters, respectively. In the first two quarters of 2011, the Company recorded revenue of $194.2 million, an increase of 21.7% compared with revenue of $159.6 million recorded in the first two quarters of 2010. There were 129 billable days in the first two quarters of both 2011 and 2010. Revenue from the Company's North American operations totaled $159.8 million in the first two quarters of 2011, an increase of 24.2% when compared with revenue in the first two quarters of 2010 of $128.6 million. Revenue from the Company's European operations in the first two quarters of 2011 totaled $34.4 million, an increase of 11.1% when compared with revenue in the first two quarters of 2010 of $31.0 million. The European revenue represented 17.7% and 19.4% of 2011 and 2010 year-to-date consolidated revenue, respectively. The Company's revenue included reimbursable expenses billed to customers, which totaled $6.3 million and $4.1 million in the 2011 and 2010 year-to-date periods, respectively. The revenue increase in the 2011 second quarter and first two quarters as compared with the corresponding 2010 periods is due to strong demand for both the Company's IT solutions and IT staffing services. IT solutions revenue increased 36.7% and 35.3% in the 2011 second quarter and year-to-date period, respectively, as compared with the corresponding 2010 periods. The IT solutions revenue increase was primarily driven by an increase in the electronic medical records work from providers in the Company's healthcare vertical market. IT staffing revenue increased 13.7% and 15.2% in the 2011 second quarter and year-to-date period, respectively, as compared with the corresponding 2010 periods. The Company's headcount was approximately 3,700 employees at July 1, 2011, which was an increase of approximately 300 employees from 3,400 at December 31, 2010, and an increase of approximately 500 employees from 3,200 at July 2, 2010. The increase in revenue in the Company's European operations in both the 2011 second quarter and first two quarters as compared with the corresponding 2010 periods was partially due to modest strength in the Company's European IT staffing business. This revenue increase was supported by the strength 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 2011 second quarter as compared with the 2010 second quarter, the average value of the Euro increased 13.0% while the average value of the British Pound increased 9.4%. 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 2010 second quarter to the 2011 second quarter, total European revenue would have been approximately $1.9 million lower, or $15.4 million as compared with the $17.3 million reported. In the first two quarters of 2011 as compared with the first two quarters of 2010, the average value of the Euro increased 5.6% while the average value of the British Pound increased 5.9%. If there had been no change in the exchange rates from the first two quarters of 2010 to the corresponding 2011 period, total European revenue would have been approximately $1.8 million lower, or $32.6 million as compared with the $34.4 million reported. 17 -------------------------------------------------------------------------------- Table of Contents In the 2011 second quarter, IBM was the Company's largest customer, accounting for $29.5 million or 30.0% of consolidated revenue as compared with $25.6 million or 31.5% of revenue in the comparable 2010 period. In the first two quarters of 2011, IBM accounted for $58.1 million or 29.9% of consolidated revenue, compared with $48.2 million or 30.2% in the comparable 2010 period. During the 2011 second quarter, the Company's current National Technical Services ("NTS Agreement") contract with IBM was extended for three months from June 30, 2011 to September 28, 2011. 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. We expect the NTS agreement to be renewed in September 2011, and that the Company will continue to derive a significant portion of its revenue from IBM throughout the remainder of 2011 and in future years. However, a significant decline in or the loss of the revenue from IBM would have a significant negative effect on our operating results. The Company's accounts receivable from IBM at July 1, 2011 and July 2, 2010 totaled $15.0 million and $13.5 million, respectively. No other customer accounted for more than 10% of the Company's revenue in either the second quarter or year to date periods of 2011 or 2010. Direct costs, defined as the costs for billable staff including billable out-of-pocket expenses, were 78.9% of revenue in the 2011 second quarter as compared with 78.1% of revenue in the 2010 second quarter, and 79.1% of revenue in the 2011 first two quarters as compared with 78.2% in the 2010 corresponding period. The increase in direct costs as a percentage of revenue in the 2011 second quarter and first two quarters when compared with the corresponding 2010 periods is primarily due to an increase in employee benefit costs, mainly unemployment insurance. Additionally, the increase in direct costs in 2011 is due to a significant portion of the increase in the Company's IT staffing business being from the Company's lowest margin IT staffing business, which has significantly higher direct costs than the Company's IT solutions business. Selling, general and administrative ("SG&A") expenses were 16.3% of revenue in the 2011 second quarter and 17.6% in the 2010 corresponding period, and 16.1% in the first two quarters of 2011 as compared with 17.7% in the corresponding 2010 period. The SG&A decrease as a percentage of revenue in both the 2011 second quarter and first two quarters as compared with the corresponding 2010 periods is primarily due to disciplined cost management and the economies of scale associated with revenue growth. Operating income was 4.8% of revenue in the 2011 second quarter as compared with 4.3% in the 2010 second quarter, and 4.8% in the first two quarters of 2011 as compared with 4.1% in the corresponding 2010 period. Operating income from North American operations was $7.7 million and $5.8 million in the 2011 and 2010 first two quarters, respectively, while European operations recorded operating income of $1.6 million and $0.8 million, respectively, in the corresponding 2011 and 2010 periods. Net income for the 2011 second quarter was 2.9% of revenue or $0.17 per diluted share, compared with net income of 2.3% of revenue or $0.12 per diluted share, in the 2010 second quarter. Net income for the first two quarters of 2011 was 2.9% of revenue or $0.34 per diluted share, compared with net income of 2.3% of revenue or $0.23 per diluted share, in the comparable 2010 period. Diluted earnings per share were calculated using 16.9 million and 16.1 million weighted-average equivalent shares outstanding for the quarters ended July 1, 2011 and July 2, 2010, respectively. Diluted earnings per share were calculated using 16.8 million and 16.1 million weighted-average equivalent shares outstanding for the year-to-date periods ended July 1, 2011 and July 2, 2010, respectively. The number of equivalent shares outstanding increased year-over-year due to an increase in the Company's stock price which increased the dilutive effect of outstanding stock options, but was somewhat offset by the purchase of approximately 240,000 shares into treasury stock pursuant to the Company's share repurchase program for the twelve month period ended July 1, 2011. 18 -------------------------------------------------------------------------------- Table of Contents 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 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 most critical accounting policies are those related to income taxes, specifically relating to deferred taxes and valuation allowances, and goodwill valuation. Income Taxes - Deferred Taxes and Valuation Allowances - At July 1, 2011, the Company had a total of $7.3 million of current and non-current deferred tax assets, net of deferred tax liabilities, recorded on its consolidated balance sheet. The changes in deferred tax assets and liabilities from period to period are determined based upon the changes in differences 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. At July 1, 2011, the Company had deferred tax assets recorded resulting from net operating losses totaling approximately $3.0 million. Management of the Company has analyzed each jurisdiction's tax position, including forecasting potential taxable income in future periods, and the expiration of the net operating loss carryforwards as applicable, and determined that it is unclear whether some of these deferred tax assets will be realized at any point in the future. At July 1, 2011, the Company has offset substantially all of these deferred tax assets with a valuation allowance totaling $2.9 million, resulting in a net deferred tax asset from net operating loss carryforwards of approximately $0.1 million. The Company's deferred tax assets and their potential realizability are evaluated each quarter to determine if any changes should be made to the valuation allowance. Any change in the valuation allowance in the future could result in a change in the Company's effective tax rate ("ETR"). A 1% change in the ETR in the 2011 second quarter would have increased or decreased net income in the quarter by approximately $46,000. Goodwill Valuation - The Company has a goodwill balance of $35.7 million recorded as of July 1, 2011. As of the fiscal month-end October 2010, with the assistance of an independent appraisal company, the Company completed its annual valuation of the business to which the Company's goodwill relates. The valuation indicated that the estimated fair value of the business was substantially in excess of its carrying value by approximately 31%. Additionally, no facts or circumstances have arisen since October 2010 that have led management to believe the goodwill may be impaired. 19 -------------------------------------------------------------------------------- Table of Contents Other Estimates - The Company has also made a number of estimates and assumptions relating to the reporting of other assets and liabilities and the disclosure of contingent assets and liabilities to prepare the consolidated financial statements pursuant to the rules and regulations of the SEC. Such estimates primarily relate to actuarial assumptions including discount rates and expected rates of return on assets, as applicable, for the Company's defined benefit and postretirement benefit plans, an allowance for doubtful accounts receivable, assumptions underlying stock option valuation, investment valuation, legal matters, other contingencies, and progress toward completion and direct profit or loss on contracts. As future events and their effects can not be determined with precision, actual results could differ from these estimates. Changes in the economic climates in which the Company operates may affect these estimates and will be reflected in the Company's financial statements in the event they occur. Financial Condition and Liquidity Operating activities used cash of $4.3 million in the first two quarters of 2011 ("2011 period"), and provided $1.6 million of cash in the first two quarters of 2010 ("2010 period"). In the 2011 period, net income totaled $5.7 million, while other non-cash adjustments, primarily consisting of depreciation and amortization expense, equity-based compensation expense, deferred income taxes, and deferred compensation totaled a net of $1.4 million. In the 2010 period, net income was $3.7 million, while the corresponding non-cash adjustments netted to $1.3 million. Accounts receivable balances increased $7.9 million in the 2011 period, and increased $7.5 million in the 2010 period. The increase in the accounts receivable balance in the 2011 period resulted from the 22% increase in revenue year-over-year and an increase in days sales outstanding ("DSO") to 62 days at July 1, 2011, as compared with 57 days at July 2, 2010. The increase in accounts receivable in the 2010 period resulted from the 13.1% increase in revenue year-over-year. Other assets increased $1.4 million in the 2011 period due to the timing of payment of insurance premiums prior to quarter-end in the 2011 period, and subsequent to quarter-end in the 2010 period. Accrued compensation increased $0.6 million in the 2011 period due to an increase in employee headcount of approximately 300, or 9% in the 2011 period. Income taxes receivable/payable decreased $1.5 million in the 2011 period due to the timing of estimated tax payments and excess tax benefits received from equity-based compensation transactions. Investing activities used $1.3 million in the 2011 period as compared with $1.1 million in the 2010 period. The cash used in the 2011 period primarily represented the additions to property, equipment and capitalized software of $1.2 million and net contributions to the Computer Task Group, Incorporated Non-qualified Key Employee Deferred Compensation Plan ("non-qualified Plan") of $0.1 million. Additions to property and equipment in the 2010 period totaled approximately $1.1 million. The Company has no significant commitments for the purchase of property or equipment at July 1, 2011. Financing activities provided $3.1 million of cash in the 2011 period as compared with a usage of $1.3 million in the 2010 period. The cash provided in the 2011 period primarily related to exercises of stock options under the Company's equity-based compensation plans. The Company did not have any amount outstanding under its revolving credit line, the term of which extends to April 2014, at July 1, 2011 or July 2, 2010. The Company borrows or repays its revolving debt as needed based upon its working capital obligations, including the timing of the U.S. bi-weekly payroll. During the 2011 period, the average outstanding daily balance under the Company's revolving line of credit was approximately $0.5 million, while the average outstanding balance under this line of credit was $2.2 million in the 2010 period. 20-------------------------------------------------------------------------------- Table of Contents The Company is required to meet certain financial covenants in order to maintain borrowings under its revolving credit line, pay dividends, and make acquisitions. The covenants are measured quarterly, and at July 1, 2011 include a leverage ratio which must be no more than 2.75 to 1, a calculation of minimum tangible net worth which must be no less than $39.2 million, and total expenditures for property, equipment and capitalized software can not exceed $5.0 million annually. The Company was in compliance with these covenants at July 1, 2011 as its leverage ratio was 0.0, tangible net worth was $49.8 million, and 2011 year-to-date expenditures for property, equipment and capitalized software were $1.2 million. The Company was also in compliance with its required covenants at July 2, 2010. When considering current market conditions and operating results, and the Company's current estimate of future operating results, the Company believes it will be able to meet its covenants, as applicable, for the remainder of 2011 and in future years. During the 2011 period, the Company used $1.2 million to purchase approximately 94,000 shares of its stock for treasury. At July 1, 2011, a total of approximately 1.1 million shares are authorized for future purchases. During the 2010 period, the Company used $1.7 million to purchase approximately 232,000 shares of its stock for treasury. The Company believes existing internally available funds, cash potentially generated from future operations, and borrowings available under the Company's revolving line of credit totaling $34.6 million at July 1, 2011 are sufficient to meet foreseeable working capital and capital expenditure needs, fund stock repurchases, and allow for future internal growth and expansion. Off-Balance Sheet Arrangements The Company did not have off-balance sheet arrangements or transactions in the 2011 or 2010 second quarters or year-to-date periods. Contractual Obligations The Company did not enter into any significant contractual obligations during year-to-date period ended July 1, 2011. 21-------------------------------------------------------------------------------- Table of Contents |