IGNITE LIMITED — Management Reports 2013

Feb 19, 2013

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20 February 2013
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MD on Outlook

Open Briefing interview with MD Kym Quick

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Clarius Group Limited Level 3, Suite 302 70 Pitt Street Sydney NSW 2000

In this Open Briefing[®] , Kym discusses:

• Signs market has bottomed, but timing of recovery uncertain

• Restructuring, cost reduction initiatives to contribute to second half

• Cash flow improvement, balance sheet strength

Record of interview:

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Clarius Group (ASX: CND) today reported a net loss after tax of $0.47 million for the first half ended 31 December 2012, versus net profit of $1.34 million in the previous corresponding period. Before one-off redundancy costs, net profit after tax was $0.14 million, which was a further decline from the second half of last year when underlying profit was $0.72 million, and reflects a further fall in demand for permanent placements as well as some weakening in contracting demand, which had until now held up reasonably well in the current cyclical downswing. What is the outlook for demand over the remainder of the year? Are you seeing any signs that demand is bottoming?

MD Kym Quick

It’s very difficult to predict what the remainder of the year holds in terms of external market conditions. We’d like to believe market conditions have bottomed but while there’s nothing we’re seeing that suggests there will be a worsening of conditions, there’s nothing that suggests there’s going to be a significant upswing either.

Sentiment plays a strong part in hiring decisions and world macro events have led to more scepticism and conservatism in the domestic market since the GFC. However, over the past few months a number of leading indicators have begun sending somewhat positive signals. The annualised growth rate of the Westpac Melbourne Institute Leading Index has increased from ‘well below trend’ to ‘above trend’ over the last six months, and many financial indicators, including funding costs, interest spread and equity prices have improved, suggesting a more positive outlook for economic activity in the medium term. However, while sentiment now appears to be stronger than we’ve seen for some time, it’s yet to translate into outcomes and results, but is a good forward indicator of some more positive demand in hiring.

So there are positive signs of improvement, however, I anticipate any recovery will be slow and customers will remain cautious off the back of several years of economic turbulence.

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You’ve indicated that restructuring initiatives in the first half have resulted in the removal of approximately $4 million of salary costs annually in the Australian business. Will the full

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benefits flow in the current second half? What is the outlook for earnings in the current half, assuming there is no further deterioration in the demand environment?

MD Kym Quick

We’ve done a lot of ongoing work around restructuring, and as a result we’ve taken significant costs out of the business over the last few years. We’ve also implemented a number of efficiency initiatives that will further reduce costs. Certainly, the salaries we took out of the business in the last half will flow through into this half and as long as the market doesn’t deteriorate any further this should translate to a more profitable result.

Given we’ve taken costs out of the business, shut down parts of the business that weren’t creating profits, and the fact that the investment in China will start to pay back this half, we are confident of a stronger half if market conditions do not deteriorate further.

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At the end of last financial year Clarius flagged its intention to reinvest in the business to improve payroll systems and associated IT infrastructure. What has been the progress in this program, what are the expected benefits and what are the implementation risks?

MD Kym Quick

We’re on track in terms of budget and timetable. We anticipate going live with the transitioning of our first brand to the new payroll system in the next couple of months. That should give us a good indication of how long the rest of the roll-out will take.

As we’ve mentioned previously, we’re expecting to get the full benefit of the implementation early in FY2014, but we should start to see some efficiencies as we roll each brand onto the system. The benefit will be two-fold: it will allow us to reduce our operating costs; as well as giving us significant scalability. Currently, if we add more than around 150 contractors onto the books, we have to add head count to be able to manage that. The new system will give us the capacity to add up to 800 new contractors before we need any increase in our cost base. If there’s one upside to the current market conditions it’s the timing around this implementation – it’s better to do an implementation when you have fewer contractors than when the market is in full swing.

With any IT infrastructure program, there’s always risk and we’re abundantly aware of that. Because payroll is our core business, we’ve got to be very diligent in making sure we’re ready to go live, and that’s helped by the fact that we’re able to stagger the implementation brand by brand. We’ve already put our own payroll on the system and that’s working effectively. The next brand that goes live will be one of our smaller businesses which will allow us to flush out the problems before we get to the larger and more complicated payroll systems.

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Clarius booked gross profit of $19.55 million in the first half, down from $24.27 million in the previous corresponding period, reflecting lower demand and margin pressure. To what extent is the margin pressure a structural trend as opposed to a cyclical one, and how are you responding? Can gross margin be maintained in the absence of demand growth?

MD Kym Quick

We’ve certainly seen cyclical pressure on margins during the downturn but some of the pressures we’ve seen aren’t just cyclical.

Generally, when skills are in extreme shortage, it’s advantageous for us to look to increase our margins. However, when you’re dealing with large clients, the expectation is that you meet their requirements on margin, and adapt your business model to enable that business to be profitable. We’ve done that over the last couple of years with the creation of our Major Accounts business, which has a very different delivery model, different remuneration model and different structure versus the more open market or retail parts of our business. Major

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Accounts is a profitable business for us, albeit at a lower margin than those other parts of the business.

We believe margins will recover as we see demand increase and the fight for talent begins to heat up again, but higher margins in large volume contracts is a thing of the past.

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The Candle brand, which specialises in information and communications technology recruitment has historically accounted for over 70 percent of your revenue in Australia, saw revenue fall to $76.22 million, down 21 percent, with EBIT falling to $0.96 million from $3.36 million. To what extent was the revenue fall attributable to margin pressure and to what extent to weaker demand? How do you reconcile the weaker demand with the perceived skills shortage in information and communications and how will this play out over the nearer term?

MD Kym Quick

The fall in revenue was driven by both weakening demand and margin pressure, but the biggest issue was the lack of demand. One of the more significant downturns was in Queensland, where we had a strong presence in the government sector, and on 1 July a large portion of those contractors were released. That left a very big gap in our revenue that we’re only starting to rebuild in that region.

This calendar year has started off a bit stronger in the IT space. In the industry, most of us are confident there’s going to be stronger demand this half than we saw in the last half, particularly in the December quarter.

In the IT sector, you can’t just look at the skills shortage sector-wide, you have to break it down into categories and verticals within the market. There are some areas with extreme over-supply and others with extreme under-supply. Moving forward, one of the big challenges in the IT market as demand increases will be that supply is unfortunately diminishing: recent intake into university IT and technical programs has dropped significantly.

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The Alliance brand, which specialises in administrative roles and accounts for nearly 20 percent of your revenue in Australia, performed relatively consistently versus the previous corresponding period, with revenue of $22.20 million, down 2 percent, and EBIT of $0.16 million, up from $0.07 million. What were the drivers of this performance and are they sustainable?

MD Kym Quick

Alliance felt the impact of the economic downturn very quickly, which is explained by the fact that administrative and support roles in an organisation are the first ones to be cut in a downturn. On the flip side, often they’re the first to return. The relative strength in Alliance gives us some indication that companies are hiring back that administrative and support function because they’re confident of growth and that they’re going to be able to get value out of those with that skill set.

Alliance has done a lot of work to strengthen the sales team, introduce clearer metrics around consultant productivity, and implement tighter cost controls. This internal work is ongoing, regardless of market conditions, so Alliance is in a better position with a stronger sales team and cost efficiencies going forward.

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Clarius’s smaller New Zealand and China businesses remained in loss in the first half but you’ve flagged improved performances in the current second half, with China expected to move to break-even before the end of the financial year and a break-even second half result in New Zealand. To what extent do the businesses now have the platform for profitable growth?

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MD Kym Quick

Our business in China is now performing strongly, with revenues at the highest level we’ve seen for several years. The business now has a strong platform for growth. Obviously we’ve invested there with the formation of an entirely new team of 65, so costs have increased but we’re very confident China will break even during the current half, if not generate a profit for the half. The Beijing office is profitable, and Shanghai is just getting to the stage where it’s profitable. Towards the end of this financial year we’ll be looking at setting up another operation in China to capitalise on some of the growth occurring outside the two major cities. The cost of setting up in regional cities is far less than in the major centres so we’d anticipate a regional office becoming profitable quickly with a higher return on revenue.

We’ve been in New Zealand for a long time, so the performance of the business has been disappointing. We’ve installed a new management team there. In Auckland the new team was in place last year and is starting to record good results. In Wellington we’ve had a revamp of management and the team, and we’ve got some good quality recruiters who are experienced in the market and who understand the IT space in New Zealand. We’re confident they will deliver a good result this half. We have good client relationships in New Zealand and think the business can achieve a steady result this year, and growth beyond that.

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Cash flow from operations was $3.34 million in the first half, a turnaround from outflow of $4.08 million in the previous corresponding period, reflecting stronger controls on debtors and the reduced number of contractors. What scope is there to further improve and maintain working capital disciplines, particularly as the business emerges from the current downturn?

MD Kym Quick

Our new CFO Anne Bastock has worked very hard to strengthen our controls around cash and debtors, and we’re probably in the best shape we’ve ever been in this area. One area of focus has been around ensuring we have arrangements in place with clients that provide incentives for them to pay on time. Another has been around introducing stricter internal controls around terms of business, for example, ensuring our consultants aren’t signing to non-standard payment terms. Obviously those initiatives are starting to pay off.

We see scope for improvement from the new payroll system. Given the payroll system is directly linked to our billing system, the more automated and efficient we are in getting timesheets processed, the quicker we can get invoices out. At present, there can be a week or a week and a half delay between paying a contractor and getting the invoice out. We should be able to materially reduce that gap once the new system is fully implemented.

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As at 31 December, Clarius had net debt of $0.37 million and gearing (net debt/equity) of 0.5 percent, compared with $1.76 million and 2.2 percent respectively six months earlier. What is the outlook for debt and what balance sheet capacity is there for potential acquisition opportunities?

MD Kym Quick

We’ve kept our debt level as conservative as we possibly could, and we’re in a good position to make acquisitions should an opportunity come about. We always consider acquisition opportunities that are presented to us but the challenge in this market is finding good quality acquisitions that have reasonable price expectations. We remain very disciplined in terms of the type of business we’re looking to acquire.

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Clarius booked goodwill impairments totalling $18 million after tax in the previous two financial years, but you’ve maintained the book value of goodwill as at the end of the first

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half. Considering market conditions remain weak, are further impairments likely at the end of the current year?

MD Kym Quick

We have two cash generating units that have goodwill attached to them: Candle and Alliance. Candle includes some minor acquisitions, but the bulk of its goodwill has come from the organic growth of the business. So there’s a reasonable amount of head room in the goodwill associated with Candle.

Alliance was formed out of a number of acquisitions over the years, so most of its goodwill relates to those. We’ve written down some of the goodwill in Alliance and the head room is fairly tight. Based on our forecasts, we don’t anticipate any further impairments in Alliance but we’ll be watching its performance very closely.

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Clarius will not pay an interim dividend, versus 1 cent per share paid for the previous first half. Under what conditions will the board consider a resumption of dividend payments?

MD Kym Quick

At the end of FY2012 we had retained losses on our balance sheet, and didn’t have the capacity to pay franked dividends. We’re now in a position where we can pay fully franked dividends but the resumption of payments that will come back to not only our cash flow, which has obviously improved, but also the sustainability of profitability of the business.

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Thank you Kym.

For more information about Clarius Group, visit www.clarius.com.au or call Kym Quick on +61 2 9250 8100.

For previous Open Briefings by Clarius Group, or to receive future Open Briefings by email, visit openbriefing.com

DISCLAIMER: Orient Capital Pty Ltd has taken all reasonable care in publishing the information contained in this Open Briefing®; furthermore, the entirety of this Open Briefing® has been approved for release to the market by the participating company. It is information given in a summary form and does not purport to be complete. The information contained is not intended to be used as the basis for making any investment decision and you are solely responsible for any use you choose to make of the information. We strongly advise that you seek independent professional advice before making any investment decisions. Orient Capital Pty Ltd is not responsible for any consequences of the use you make of the information, including any loss or damage you or a third party might suffer as a result of that use.

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