letter to the chairman

Fellow SKE shareholders,

I started acquiring SKE shares sometime eafter the announcement of the Strategic Review. I have a view that this is really a $500m company trapped in the confines of a $200m market cap today, due to an underperforming management team, and especially the CEO & MD, and the board.

Fortunately, this management incompetence has been recognised after a long and painful period of value destruction, and a board and management overhaul is underway, paving the way for the restoration of shareholder value (which is why I am now a shareholder).

To that end, I have drafted a missive to the current, but soon-to-retire chairman of the board, in the hope and anticipation that it serves as a record of shareholder expectations for the edification of the incoming Chairman, Independent Directors, and MD & CEO.

For the possible benefit of other shareholders who have an interest in shareholder activism, I have copied the content of the letter on this post. However, all the charts and tables [Figures 1 to 13] are obviously impossible to replicate.

Should any investors be interested in receiving the full letter in Microsoft Word format, it can be requested by sending an e-mail to [email protected].


Herewith follows the body of the letter:


Mr Ken V Loughnan AO
Chairman of the Board of Directors
Skilled Group Limited
Level 15
380 St Kilda Road
Melbourne
VIC
3004

Dear Mr Loughnan,

FINANCIAL PERFORMANCE OF SKILLED GROUP

I write to you about the unsatisfactory performance of our company over the past 12 months.

Specifically, I wish to highlight several critical areas that I believe represent unacceptable outcomes for shareholders, namely:

Cost Control and Margin Management
Capital Management
Free Cash Flow
Solvency Metrics
Shareholder Returns
Apparent Management Mindset

But before these topics are discussed, I think it would be instructive to sketch the backdrop against which we find our company today. The equity market, accepted conventionally as the ultimate long-term arbiter of the financial health of listed entities, indicates strongly that our company is ailing, as Figure 1 implies.

This table compares the share price changes of our company (SKE) over one-, two-, and three-year time periods, respectively, with those of some of its listed peers operating in the human resources outsourcing sector, namely Programmed Maintenance Group Limited (PRG), Spotless Group (SPT), and Chandler Macleod (CMG).

[Figure 1: Relative Share Price Movements]

While the members of this group of companies have all been adversely affected by the Global Financial Crisis (GFC), it is clear that SKEs share price reaction has been the worst over all timeframes.

The reason for this bottom-ranking share price performance is not hard to see. Figure 2 compares our company with its peer group based on changes in relevant financial parameters over the period of the GFC period, namely financial years (FY) 2008 to 2010, using FY2008 as the base period. (All data is presented excluding non-recurring items.)

[Figure 2: Changes in Financial Parameters]

In FY2010 SKEs Earnings Before Interest, Tax, Depreciation and Amortisation (EBITDA), Earnings Before Interest and Tax (EBIT), and Earnings Per Share (EPS) were, respectively, 34% 45% and 72% lower than FY2008. This is not only unequivocally poor in absolute terms, but in relative terms, our company has lagged well behind its peer group.

Disconcertingly, our company is the only company in this comparator group that has failed to achieve a recovery in operating profit (EBIT) to pre-GFC levels. In fact, it hasnt come close!

Worse still is the outcome on the important EPS measure. For our company to now be generating only a little over one-quarter of the EPS level recorded at the start of the GFC is an unambiguously disappointing outcome for shareholders, especially when other companies in the sector have been able to manage the slowdown inordinately better in EPS terms.

[Note: PRG is a March year-end entity, so in the interests of analytical convenience, PRGs March half results have been matched with June half results for June year-end companies, and PRGs September half results are matched with December half results for companies with December interim financial periods.)
 
MARGIN MANAGEMENT

Having studied our companys December 2009 and June 2010 financial statements in some detail, I have formed the opinion that there is inadequate management focus and effort being brought to bear on reducing the companys cost base in response to the lower level of revenues currently being generated.

I quote our Managing Director and & Chief Executive Officer (MD & CEO) from the 2009 Annual Report: In early 2008 we began preparing for a downturn and our focus moved from acquiring complementary businesses to ... taking costs out of the business. We reduced discretionary spending on consultants, marketing and travel, and closed or merged branches...

Yet the margins subsequently delivered by our company bear no relation to the MD & CEOs prior assurances. On the contrary, operating profit margins have for the past three financial reporting periods, been stuck well below their long-run averages (refer Figure 3). In my view, this is in no small part testimony to a lack of proactive management attention to some of the key drivers of profitability.

[Figure 3: SKILLED Group EBIT Margin]

Investors can accept modest margin pressure being unavoidable during severe business downturns for one, or possibly two, successive financial periods. However, for margins to almost halve, and for a sustained period, suggests corporate complacency, or a management inability to restore profitability.

Alarmingly, our company is alone in its dismal trend in EBIT margin. The comparator companies have in most recent financial results reported margins close to, or better than, pre-GFC levels, as Figure 4 shows.

[Figure 4: Comparative EBIT Margins (Post vs Pre-GFC)]

The realised margin outcomes are also at stark odds with the cost control assurances put forward by our companys MD & CEO at the time of the significant capital raising undertaken some twelve months ago, specifically: ...while we believe the worst is now behind us we have prepared detailed plans for addressing any further market weakness. Our cost base remains highly flexible and therefore were able to manage circumstances that other businesses would find very difficult.

The market weakness for which the detailed plans were prepared did indeed subsequently eventuate, without our company demonstrating any of the cost base flexibility, proffered by the MD & CEO.

CAPITAL MANAGEMENT

Working Capital
On the management of the companys working capital, too, sub-standard results are evident.

In August 2009 our companys Chief Financial Officer opined, we continually try to improve working capital management but the scope for further major improvements is limited given we anticipate stronger revenues. In fact we hope that we have to increase working capital as it would show that we were returning to a growth environment.

Well, the CFOs "wish" for higher working capital levels have been granted, with working capital increasing by 12% in DH2009 and a further 18% in JH2010, as Figure 5 illustrates. However, this has not been matched by the concomitant increase in revenues, which were down 4% on DH2009 and essentially unchanged (a mere 0.9% rise) in JH 2010. In aggregate, nominal working capital has risen by a significant $30m over the past twelve months.

So, working capital between JH2009 and JH2010 jumped over 33%, but revenues were 3% lower. As a shareholder, I consider this an inconsistent, and therefore unacceptable, set of outcomes.

[Figure 5: Changes on Prior Period in Revenue and Working Capital]

Among its peers, SKEs JH2008 ratio of Working Capital-to-Sales is now not only the highest at 7.1%, but it is also the only company that has recorded deterioration in its working capital ratio (from 5.2% and 5.5% in the respective previous corresponding periods). [Refer figure 6]

[Figure 6: Working Capital Management]

Juxtaposed against the apparent tardiness in our companys approach to working capital management, the comparator companies have all improved working capital ratios on emerging from the GCF. (Because its Working Capital-to-Sales ratio was zero for JH2010, SPT is not represented on the chart in order to avoid distortion of the Y-axis. But SPT, too, has improved its ratio, down from 1.7% in JH2008).

Equity Raising
Our company has undertaken one of the most significant issuances of new equity during the GFC (Refer Figure 7). Disappointingly, compared to its peer group companies, this has occurred at by far the greater discount to the prevailing share price at the time of the raising, with the attendant highest level of dilution for non-participating shareholders. The one company that raised proportionally more new equity than our company, namely CMG, has recorded significant share price appreciation since the raising.
So, our company was the subject one of the largest raisings, at the steepest discount, and with subsequent disastrous share price performance, to boot.

[Figure 7: Relevant Features of Equity Raisings over the period of the GFC]

In addition, I find it disappointing that the capital raised by our company occurred on terms that were most prejudicial to minority shareholders, as Figure 8 indicates.

[Figure 8: Equity Raising Mechanisms During the GCF]

In this context I draw your attention to the Publications - Policy Statement section of the Australian Shareholders Association website: (http://australianshareholders.com.au/asa_site/). Clause 3.2 of Statement 16 clarifies shareholder expectations in relation to the raising of additional equity, to wit:
Shareholders expect that the raising of additional equity capital will be done through methods (such as renounceable rights issues) that allow existing shareholders to preserve their level of equity in the company. Moreover, shareholders expect appropriate methods to be included in the fundraising arrangements that will enable them to receive the residual value of their entitlements, where those entitlements lapse for any reason.

Shareholders accept that entitlement issues might be uneconomic where, for example, the amount to be raised is small in relation to the existing level of shareholders' funds, or where equity needs to be raised quickly. In such circumstances private placements of equity would be reasonable. Shareholders expect any discount from the market value in a private placement will be limited to the extent of the costs of a general entitlement issue relative to the amount such an issue would raise, but that it will not exceed 2.5% unless existing shareholders are given the opportunity to subscribe for additional shares on the same terms.

That our company needed to undertake a significant, steeply discounted capital raising with an overwhelming non-entitlement component is at odds with mainstream shareholder expectations, and suggests to me an element of desperation on the part of management at the time.
 
The irony should not be lost on shareholders and management that a full thirty cents of every dollar of the new equity raised went into funding the subsequent $30m working capital blow-out. I am sure you can understand criticism that some might level at the apparent lack of respect our companys board and senior management seem to have for the scarcity of equity capital.

On the other hand, what should have occurred was a more proactive management of operating costs, working capital and cash flows that would have obviated the need to raise fresh equity to the extent that was considered necessary.
Raising equity capital successfully is not an achievement to be lauded; on the contrary, avoiding the need to raise equity through astute, judicious management of the companys capital resources, is. Shareholders expect the latter.

FREE CASH FLOW

A striking feature of our companys recent financial performance is the sharp deterioration in FY2010 in the rate of conversion of Revenue to Free Cash Flow (defined as Operating Cash Flow Less Net Payments for Property, Plant and Equipment and Payments for Intangibles), as can be seen in Figure 9.

[Figure 9: Free Cash Flow as a % of Revenue]

It is disturbing to contemplate that almost out of almost $1.7bn in revenue, a mere $19m reported as Free Cash Flow in FY2010.

Our company has gone from enjoying from one of the highest conversion rates of Revenue into Free Cash Flow, to the lowest in the past financial year.

I consider this to be a shameful result, especially in the context of several management statements during the year that implied the disciplined management of costs and capital resources. Clearly, quite the opposite is in evidence.

SOLVENCY METRICS

Net Interest Bearing Debt/EBITDA
The combined effect of inadequate margin control, and poor cash flow management, is sustained pressure on the balance sheet. Figure 10 shows that Net Interest Bearing Debt (NIBD) as a Multiple of EBITDA is higher in the most recent financial period than it was preceding the GFC.
Alarmingly, this deterioration has occurred despite the significant quantum of new equity capital injected into the business in the intervening period, as well as managements numerous claims over the past year of a focus on closely managing the companys capital resources.

[Figure 10: NIBD/EBITDA Ratios]

Interest Coverage
Net Receipts (Net of Tax)-to-Net Interest Payments are disconcertingly low, at a little over two times, as Figure 11 illustrates. Again, it is deeply concerning this is lower than prior years even after the major intervening recapitalisation exercise.

[Figure 11: Cash Interest Coverage Ratios]

Our company went into the GFC with the most favourable solvency and interest coverage ratios among its peer group. Yet, despite undertaking one of the largest proportional equity raisings, our company has emerged from the GFC with the most challenged solvency and interest coverage metrics! I consider this to be inexplicable and totally unacceptable.

Note, too, that some of the peer companies did not apply all of the proceeds from newly-raised equity to reduce gearing. PRG and SPT applied not-insignificant portions of their additional equity capital to the undertaking of acquisitions. This makes the resulting adverse trend in interest coverage for our company relative to its comparator group remarkably worse, in my view.

SHAREHOLDER RETURNS - DIVIDENDS

I consider the suspension of dividends to be the closest thing one can get to a cardinal sin for listed corporations, especially those that are the No 1 industry player. Yet, that is exactly the fate that has befallen our company. Shareholders will not have received a single cent in return from our company for at least 18 months; instead shareholders have been called upon to put money into the business.

An eminent investor once said, An investment grade company is one that puts money into shareholder pockets, not take it out. Based on this definition, with which I believe most self-respecting and prudent investors would identify, our company is failing the investment grade test.

The inability to declare dividends in respect of the past two successive reporting periods is something of which I believe our board should feel ashamed.

And I will reject any rebuttal along the lines of the GFC forced our hand, because other similar businesses managed to maintain dividend payments throughout the crisis; or in the isolated case where dividends werent declared, they have subsequently been resumed, as Figure 12 shows.
Additionally, while shareholders in our company are probably uncertain as to when they might expect to receive dividends again, each of the comparator group has already announced increased dividends since the peak of the GFC.

[Figure 12: Dividend Performance During, and Following, the GFC]

Within this unsatisfactory context, I refer to the following management statements:

Were still focused on cash preservation and balance sheet management. In the current environment, we anticipate paying between 30 percent and 50 percent of NPAT in dividends. Once business conditions return to a more normal basis we expect to return the dividend back towards its historical levels.
- ASX Open Briefing, 24 August 2009

We expect to maintain a lower dividend payout ratio over the next 12 months in the order of a 30-50% of NPAT before returning to the historical 70-80% of NPAT.
- Investor Day Presentation, 11 November 2009.

That our MD & CEO, late in calendar 2009 was speaking in constructive terms about a dividend policy around the time the company was raising capital, only to have such utterances rendered null and void a mere three months later is an unacceptable sequence of events, in my view.

APPARENT MANAGEMENT MINDSET

At the risk of sounding presumptuous, as a retired investment professional who over almost two decades of studying some 4,000 annual reports of listed companies, I have come to back my judgment in gauging how well, or otherwise, a companys executive team is performing; how competently it is driving the business, and how in control it is of the critical issues.

In the case of our company, I am afraid to say that my judgment call is that there exists a lack of focus on, or ability in, managing some of the critical parameters of shareholder value creation, as discussed in this missive.

Driving the Business (as distinct from hoping for the economic tide to come in)

When I consider statements and comments made by management over the past 12 months, I am left with an overwhelming feeling of a management mindset that is largely passive and reactive. I have a regrettable sense that managements expectations are for shareholder value to be restored principally on the anticipation - and in the hope - of an improvement in the macroeconomic environment.
Various management briefings over the past twelve month are punctuated with this leverage-to-economic-recovery thesis:

History demonstrates a strong rebound on a return to economic growth
- ASX Announcement, 19 August 2009.

This capital management initiative will....position the business for growth in an imminent economic recovery.
- Equity Capital Raising Announcement, 19 August 2009.

SKILLED will benefit strongly from any upturn...
- Equity Capital Raising Announcement, 19 August 2009.

I would also note that as a business we have high leverage to any economic improvement...
- MD & CEO, Open Briefing, 24 August 2009

any improvement in business conditions will immediately flow through to the bottom line.
- Managing Directors Report, 2009 Annual Report, released 15 September, 2009.

...we are confident that as the economy strengthens our business will quickly rebound...
- Managing Directors Report, 2009 Annual Report, released 15 September, 2009.

Expect strong market growth to return with upturn and beyond
- Presentation, 2009 Annual General Meeting, 21 October, 2009.

Growth is returning to the business in the labour hire area expect this to become more broad based as the year progresses
- Investor Day Presentation, 11 November 2009

And then, inexplicably, and at stark odds with the indications to the contrary, the thesis of leverage to economic recovery is de-bunked during the profit warning issued a mere 15 business days later:

differing responses of SKILLED Groups business areas to an economic recovery that is still gathering strength
- Market Update, 4 December 2009

Cynical observers of our company would be forgiven for concluding that its management team is not on top of the business, and has an inability to enhance financial performance unless the macroeconomic planets are favourably aligned.

If the companys fortunes turn around when the demand for its services recover, then that will certainly be a good and a nice thing. But that shouldnt be enough for shareholders. A board and management team worth its salt should be able to proactively produce reasonably good financial outcomes irrespective of the macroeconomic conditions. Boards and management teams are not paid simply to hope and wait for better days, which is what it appears to me has been occurring with our company.

Again, from the 2009 Annual Report: In July 2009 we realigned our organisational structure to group similar businesses together: Staffing Services, Engineering and Marine Services and Business Services. This restructure will enable us to drive sales, share best practice across related businesses, streamline management decision making and ultimately maximise profit and shareholder returns.

Well, subsequent to the series of market updates in the December half, the economy has been recovering strongly, and still our companys earnings and cash flow remain under pressure, culminating in the suspension of dividend payments. Regrettably, not only have profits and shareholder returns not been maximised, but they have in fact evaporated.

Strategic Review
I refer to the Strategic Review commissioned by the Board, on 29 April, 2010, with conclusions announced on 26 August, 2010. I have numerous objections to the manner in which this Strategic Review was conducted, as well as its recommended course of action.

Firstly, I fail to see why an investment bank needed to be appointed to lead The Review, given the attendant costs that would have been incurred. I think this is an especially valid criticism when the duration of The Review is considered.

Second, that scarce company resources were made available to an external consultant, which then took four months to conclude that borrowings needed reducing, should be offensive to all shareholders. Given the brief of the Strategic Review was to restore value to (SKILLED) shareholders and other key stakeholders through the consideration of a broad range of options, I struggle to believe that TOO MUCH DEBT is the optimal value-restoring conclusion to arise from the broad range of options.

Surely the board itself could have come to the collective conclusion that debt levels are too high? That sort of basic financial insight should, after all, be entirely within the job descriptions of the directors and senior executives of a company, in my opinion. The strategy of any company, including appropriate gearing levels, is for its board to set, and not to be subcontracted to a third party. If a board of directors has an inability to design and implement the right strategy for a company, then it should be replaced with one that can. It is one of the fundamental tenets of fiduciary duty, I believe.

Third, I have concerns about the involvement of the current MD & CEO at a senior level in the Strategic Review process. It should strike impartial observers as inconsistent that the executive that carries ultimate accountability for the unsatisfactory performance and the consequent negative impact on the Groups financial position of our company, should play an influential part in the conducting of the Strategic Review, or the implementation of its findings.

If the mutually agreed intention is for the current MD & CEO to step down from his role, then I believe that this should have occurred prior to the conducting of the Strategic Review. It is my contention that the outcomes of Strategic Reviews are far more logical and worthwhile when they are presided over by the new MD who would ultimately carry the responsibility of all actions taken as part of such reviews.

A new MD and CEO needed to be appointed as soon as possible in the interests of continuity and stability. Why has it taken so long to find a successor? Investors have a particular distaste for uncertainty and what we have had since April 2010 is uncertainty about the management structure of our company. It concerns me that the Board can be so nave as to overlook the negative perceptions this uncertainty induces among investors.

Fourth, I am astonished to learn that Swan Contract Personnel (SWAN) has been identified through the Strategic Review as the business that is to be disposed in order to repair the balance sheet. I fail to see how the discarding of a business described previously by management as a well established business, with a strong brand name and reputation, an excellent business, and a valuable contributor to SKILLED Group, could possibly go any way to restoring value.

On my calculations and modeling, under any reasonable price that might be received for SWAN, the disposal will be materially EPS-decretive. Even if SWAN is sold for double the amount for which it was acquired in 2007, I estimate the impact would be a 20% decline in per share earnings.

On my assessment, SWAN has grown its revenues by an average compound annual growth rate of almost 6% per annum since 2006, and today this business reports 22% greater EBIT than it did in 2006. Compare this to the broader SKILLED Group, whose FY2010 EBIT (excluding SWANs contribution) was 14% lower in FY2010 than FY2006. Moreover, SWAN currently operates at 5% EBITDA margins, when the broader SKILLED Groups EBITDA margin is a mere 3.6%.

In essence, SWAN is clearly an enhancer of our companys financial pedigree, and yet it is being put up for sale. This is the sort of businesses companies should look to be acquiring, not discarding in a state of semi-distress. I cannot help but feel that we are selling one of the jewels in the SKILLED Group crown, and I am left to conclude that the mismanagement of our company has caused it come to this.

Given the: a) latent upside in this business on the back of the recovering resources sector in Australia,
b) further shareholder value uplift likely in the hands of a focused management team, and c) capital gains tax liability that I expect will be crystallised, a truly handsome sale price for SWAN will need to be achieved. My concern is that this will prove to be a challenge given the current soft pricing environment for businesses and assets, and the ongoing rationing of credit available to prospective acquirers. I hope to be pleasantly surprised, but I somehow doubt it.

Finally, if the management structure is in need of remedial attention, as has been implied by recent company announcements, why was this not incorporated into the Strategic Review as part of the value restoration brief? Instead, the Strategic Review is now finalised after a lengthy period, yet several critical leadership uncertainties remain. I trust this wont be presented by management as the next excuse why financial performance in future periods falls short of expectations.

Circumstances Surrounding the Sale of 4 Million Shares by the MD & CEO

No doubt much will have been said on this subject, so I wont labour the point, suffice to say that even though I dont believe there to be anything insidious surrounding these events, I can understand why criticism arises.

When the Outlook slide of the interim result presentation pack published in late February has five bullet points, four of which are unambiguously positive in tone, (and the fifth is merely of a qualifying nature), and this is followed a mere two months month later by a market update that reads: the rate of improvement in the businesses, after the normal seasonal slowdown in early 2010, has not resumed at the pace realised in late 2009, then investors are prone to be circumspect about the extent of managements grasp on the business.

But worse; when, at the midpoint of these two major communications by management with the market the first favourable, and the second adverse - the major shareholder and MD sells a meaningful quantum of his holding (for whatever legitimate reason), from a governance standpoint it will not be seen by most market participants in a positive light, in my opinion.
 
EXHORTATION TO IMPLEMENT STEPS TO RESTORE SHAREHOLDER VALUE

The outworking of what I consider to be the mismanagement of our company, and the resulting chronic financial underperformance, is that SKILLED Group now finds itself near the absolute top in a ranking of ASX200 listed companies on a measure of Revenue-to-Market Capitalisation, as highlighted in Figure 13.

[Figure 13: Revenue-to-Market Cap. for ASX200 Stocks (excludes Resources Companies)]

This is admittedly not a conventional measure of company standing among most capital market practitioners. However, it should be noted that there exists a strong correlation between companies that are much-maligned by investment markets for poor financial performance, and their position in Revenue-to-Market Cap rankings.

In common parlance, companies at the top of this ranking are companies who, relative to their size, generate significant revenues, but little of the revenues are translated into net profit.

For fuller edification, the top ten company names are listed below:
RiverCity Motorway Group
Photon Group
Australian Pharmaceutical Industries
PaperlinX
Centro Property Group
Singapore Telecommunications
Elders
Skilled Group
Coffee International
Sigma Pharmaceuticals

Even casual followers of the Australian financial markets and media would probably be aware of the tragic travails of most of these companies; such is the extent of the negative coverage they have received. I am certain that most experienced and respected investment practitioners would consider most of these companies to be characterised by either all or some of: dubious business models, poor management teams and boards, poor industry structures, or other structural flaws.

Frankly, to find our company included among some of these companies comes as a shock to me, and I suggest it should deeply concern the board, too.

Unlike many of these other companies, I do not believe the SKILLED Group business model to be broken, nor do I believe the industry structure in which SKILLED Group operates is remotely dysfunctional. Instead, I simply believe that SKILLED Group has been poorly managed.

As the No 1 industry player, our company should be doing inordinately better than it has been for the past several financial reporting periods.

I simply do not get any sense from within our company of a relentless drive for continual business improvement, or a determined pursuit of best practice. I do not see much evidence of the kind of corporate spirit, culture and character that makes good businesses excellent ones. And I believe our business should be one of excellence, creating value for shareholders, instead of destroying it.

I am therefore left with little choice but to apportion a significant quantum of blame for the value diminution experienced by all, but specifically minority, shareholders at the feet of the board. That our company is delivering financial results so far below par is an indictment on the way the business is being managed. In my mind, the facts speak unequivocally for themselves.

To that end, I welcome the early signs of board renewal, starting with the intention to appoint two Independent Directors, and the replacement of the MD and CEO.

It should not be lost on the SKILLED Group board and senior management that when Net Profit is a mere 0.77% of revenue, as it is currently, then converting of just a small slither of those substantial revenues to EBITDA translates into a substantial enhancement of Net Profit. I am hopeful that the incoming Chairman, Managing Director and Independent Directors will appreciate this fundamental financial arithmetic, for the sake of all stakeholders.

Accordingly, I am looking forward to travelling from Sydney to Melbourne to attend the AGM later this year, and am hopeful for the opportunity to learn more from our company management about how our company will be elevated along the value curve, and how the financial disaster of the past 12 months will be remedied.

Stakeholders deserve far better than the apparent mismanagement and chronic financial under-performance and that has plagued our company in recent times.

Yours Faithfully,