looking the goods, page-8

MikeMennel, Yes I do own TWO. If you refer to Post #:6234321 you will see that I had about 2.5% of my share portfolio invested in this company, which is a little less than half the size of some of my top ten holdings.

There was quite a lot of stock slopping around on the day the result was released, so I added to my position (inexplicably, someone was selling the stock, in relatively big licks, down to 151c on the day). I now have about 2.7% of my capital invested in TWO. i won't be buying any more, though.

Here's why:

Yes, the result was a good one, although it is difficult to discern to what extent the big kick-up in the DH in EBIT (DH10 EBIT:$4.7m, JH10:$3.2m, DH09:$3.3m) from Managed Services was purely organic, or to what extent it was soleley due to the contributions from the Zapper and Sugar Group, which were both acquired around this time last year (funnily enough, a big revenue kick - presumably from these acquisitions - appeared in the June half of 2010, but it was not matched with any EBIT uplift during the period...Managed Services EBIT actually went BACKWARDS in JH09 compared with DH08(!), and we know there isn't much seasonality in that business).

But the part of this result that warrants commentary, and might have caught some investors by surprise, is the poor margin performance in the Recruitment Business compared to recent pleasing post-GFC trends.

Recruitment Business EBITDA margins:
DH05: 13.3%
JH06: 12.1%
DH06: 10.6%
JH07: 10.4%
DH07: 8.5%
JH08: 7.5%
DH08: 1.4% (GFC starting to hit)
JH09: -6.9% (full force of the GFC)
DH09: 3.9% (demand starts to pick up again)
JH10: 9.0% (looks like we're heading to back to "normalised" double-digit margins)
DH10: 5.1% (Wham!)

Now, a large part of this will be due to the
additional 25% of consultants that have been added to the business in the half. This is clear from the Gross Margin that has barely flinched, DH10 vs JH10, and is still well up on JH09 and DH09:

Recruitment Business Gross Profit Margins:
DH05: 69%
JH06: 70%
DH06: 66%
JH07: 61%
DH07: 61%
JH08: 61%
DH08: 60%
JH09: 56%
DH09: 58%
JH10: 61%
DH10: 61%

So I wouldn't worry about this DH10 margin performance at all. Provided the additonal consultant headcount brings in incremental commensurate revenue, I expect EBITDA margins will get back to double-digit territory. And while the Revenue line for Recruitment Business was a little less robust than I had expected in the DH following a strong rebound post-GFC (Recruitment Revenues, JH09:$47.8m, DH09: $50.5m, JH10:$57.7m, DH10:$60.7m). I am confident the that with the deepening tightness in labour markets, that the revenue opportunity definitely exists.

All up I think analysts who follow TWO appreciate the cost drag contained in this result from the investment ahead of the revenue curve.

Normally I am wary of owning businesses where individual personalities dominate the boardroom (invariably, individual ego is mutually exclusive with shareholder value creation). However, in TWO's case I think that there is enough board oversight (four of the six directors are Independent)

I also beleive that the interests of the two critical executive personalities, namely Andrew Banks and Geoff Morgan, are appropriately aligned with those of minority shareholders, given they each own almost 30m shares (more than 40% of the business between the two of them) and are not overly remeunerated:

Andrew Banks, for his MD duties earns a mere $245k base salary (he must be one of the most poorly paid MD's for a listed company). True, he is deputised by a CEO, John Rawlinson, but even he is paid more ($425k basic salary, $600k including bonuses) than his boss.

And Geoff Morgan is the lowest-paid Non-Executive Director, at just $60k pa. It is also noteworthy that he hold no other directorships, an indication to me that he is focused on TWO and also that he is not a professionally boardroom parasite like many other "professional" company directors I know.

So all in all, I don't think TWO exists primarily for Messrs Morgan and Banks to line their pockets at the expense of minority shareholders. It is quite clear, in my mind, that their gain is mine, as so too will any shareholder value pain be shared equally around.

Finally, I think TWO is a 7.0-out-of10 investment opportunity. The reason I don't think it is a 9 or a 9.5 right now is because it is:

1) not overly cheap: FY11 P/E=23x, EV/EBITDA=8.1x and FCF yield on EV=6.9%, although I would argue that FY11 is not the most representative valuation year given some of the self-inflicted, and intentional cost distortions currently in the P&L. On FY12 metrics it looks far more attractive, but still not a table-thumping buy: FY12 P/E=13.7x, EV/EBITDA=6.1x and FCF yield on EV=9.2%

2) growing both by acquisition (a strategy of which I am never too enthuiastic) and by going international (the graveyard is full of the carcasses of companies that have come unstock because of a global foray. Yes, I do acknowledge that the probity checks and due diligence that these guys do appears to be more rigorous than most (this company is the only one I know that has in place an International Business Development Committee and an Acquisitions Committee, so the deals that arise aren't simply someone sucking the ideas out of their behinds... discussions seem to be documented, debated, and stress-tested in quite formal forums, something that you might see happening in large corporations, but very seldom in little $250m companies, which does provide some re-assurance that they aren't going to do anything dumb.) But still, compteting in the recruitment space in parts of Asia...I just don't see what competitive edge TWO brings to the equation; I think this is really a bit of a relationship-driven business, which is why they flourish here in Australia. Morgan and Banks are synonomous with personnel recruitment domestically, but in Asia or other emerging markets? The jury is not in. (For fuller context, in FY10, 73% of TWO's revenues came from Australia (down 1% on FY09), 16% from Asia (20% growth on FY09), and 11% from emerging markets ex-Asia(41% growth on FY09). So yes, its a growth business, but the growth is from what I would call more risky sources.)

In keeping with my exhortation to investors to not just look at all the blue sky potential, but also to be alert to the value-at-risk (in other words, "how much RISK am I taking on per unit of RETURN that I am expecting?"):
TWO is clearly a premium-rated stock which is fine if they keep delivering. but if they slip up, the de-rating will be severe.

Don't mean to be too gloomy; just wanted to provide a reality check in order the prevent any irrational exuberance. It's not a stock you can simply buy blind-folded; it has numerous moving parts that need to be closely watched. It is not a lay-down.


Cam