Serco Group plc (SRP) Earnings Call Transcript & Summary

Ladies and gentlemen, thank you for standing by. Welcome to the [Audio Gap] [Operator Instructions] I must advise you the call is being recorded today, Wednesday, the 17th of June 2020. We'd now like to turn the conference over to your first speaker today, Rupert Soames, Chief Executive. Please go ahead.

Good morning, everybody, and this is Rupert here, and we have an unscheduled update with some good news, which is that the first half of trading looks to be better than we were expecting overall. And we now feel in a position to reinstate guidance for the year as a whole. Despite the considerable operational challenges of COVID-19, the business has performed very well. But I want to emphasize that the performance in the first half has actually not been greatly affected on a net basis by COVID-19 as the losses in some parts of the business have been largely offset by some gains in other parts of the business that has had additional work. But net-net, across the first half, COVID-19 has not had a significant impact on profits. I'd like to emphasize that this is the reporting period when 6 years of hard labor came together. It shows our confidence of our customers has been restored evidenced by high order intake even in these troubled times. And I would humbly say that across several jurisdictions, it's obvious that we are a go-to supplier in times of trouble. The OCPs have fallen away from GBP 42 million of OCP provision utilization in the first half of 2019 down to GBP 3 million in the first half of 2020. And we've had the unprofitable contracts such as COMPASS being replaced by the profitable follow-ons in the form of AASC. We've had powerful new wins in 2019 that were mobilized in 2019 and have now come into full production in the first half of 2020. We've had our acquisitions of delivering according to plan. And what is personally I find very chuffing is that the investments that we've made over the last 3 or 4 years in people and systems is delivering agility and operational excellence that has been quite remarkable. We delivered the U.K.'s first national test center in 2 days. We provided on 1 week's notice accommodation for 1,500 Australians returning from overseas into quarantine, and we have provided 10,500 tracers stood up and mobilized in a period of 4 weeks. Overall, we've recruited some 15,000 full and part-time people in the last 2 months. In terms of the first half performance, organic growth, very strong. We're expecting around 23% organic growth of -- sorry, 23% growth, of which 14% will be organic in the form of contracts like AASC, AHSC in Australia, FEMA in the U.S., and there's been about GBP 100 million of revenue of COVID-related work. We expect underlying trading profit of GBP 70 million to GBP 80 million against GBP 51 million last year. And of that increase, about GBP 10 million is coming from the acquisition of NSBU. CMS. Our CMS contract in the U.S. has been particularly strong in the first half of the year and has performed above our expectations. In terms of reinstating our guidance, I think that, that shows the resilience of our business model and the fact that we are -- our customers are governments, not businesses or consumers. We think we've got a -- well, we have got a strong order book, and we've got enough visibility to at least give some guidance. So I want to reiterate that the guidance is, I don't know, it carries a degree of risk that would be probably beyond normal due to the being big potential swings and roundabouts on it, but we -- they will be better to give some guidance rather than none. And at that stage, I'm going to hand over to Angus, who will talk you through the more detailed guidance, and then we will go to Q&A. Angus?

Good morning. Rupert talked about the first half. So we're looking at UTP, underlying trading profit of between GBP 75 million and GBP 80 million. And as we move towards the second half -- as we move into the second half, there is clearly a higher degree of uncertainty than there is normally. We could give our rationale for putting the guidance back on. But GBP 135 million to GBP 150 million for UTP for the full year is a broader range than we would normally give. But it's appropriate given the situation that we've had for the last 2 or 3 months. In terms of revenue, we've had about GBP 100 million -- we will have about GBP 100 million of COVID-related revenue in the first half, and we're looking at a similar number for the second half. And that takes -- largely explains the revenue guidance going from GBP 3.4 billion to GBP 3.5 billion, up to somewhere around GBP 3.7 billion. And as Rupert talked about, the strong organic growth in H1, that gives us about 9% organic growth for the year. Underlying trading profit. Our original guidance was GBP 145 million when we did the results in February. We're looking at the range, as I said, the GBP 135 million to GBP 150 million. Net finance cost, the effective tax rate at a similar level. And free cash flow, we still believe it will be broadly similar to '19 -- 2019, just over GBP 60 million. Now when we come to the end of the first half, we anticipate that the benefit that we've had from tax deferrals in the Americas and in the U.K., particularly in terms of the VAT deferral, which is meant to be out to March '21, will be about GBP 50 million of benefit to our net debt number. Now you'll see in the statement that rather than waiting to 2021, we believe our liquidity position is strong enough that we will repay. We anticipate repaying these tax deferrals during the second half of 2020. And from a liquidity perspective, we are in strong shape. We expect net debt at the half year to be around GBP 200 million and a similar number for the full year. One of the really encouraging things and credit to our government customers around the world is that despite all the challenges of getting payment invoices approved and making payment, our customers have continued to pay on time. And that's ensured that we have also paid our suppliers on time, and our supplier days are still around 30. Leverage. What this means for leverage is that we will be at the low end of our 1 to 2 target range. And with committed facilities of around GBP 500 million, our liquidity headroom will be at least GBP 300 million at the half year. With that, we go to questions.

[Operator Instructions] The first question we have comes from the line of Paul Sullivan from Barclays.

Just a few for me. Firstly, your full year, could you just maybe help us quantify the full year revenue and margin impact from the COVID work? And I don't know if you can isolate the COVID rate impact. I know you talked about GBP 100 million to GBP 200 million or GBP 200 million for the full year. That sounds fairly conservative. I'm just trying to get a sense of how conservative the guidance has been struck, particularly around that COVID-related work. And can you talk about the margin implications from that, too? Secondly, could you sort of isolate how much you've taken from the furlough schemes? And do you think you're going to repay that in the second half? And how -- and is that factored into guidance? And related to that, how should we think about the second half or full year dividend?

Okay. So Angus, if you take the full year revenues and margins and COVID impact, and I'll take the furlough and the dividends.

Yes. Paul, as we've said, we will have about GBP 100 million of COVID-related revenue in the first half of this year. The big pieces are around the track and trace and then the testing plus work we've done in Australia in terms of our system services business out there, some of the shielding work in the U.K., some of the extra contact center work. So about GBP 100 million in the first half. We are looking at a similar number for the second half. Clearly, we don't have visibility on what will happen as we go forward. If contracts were to be extended, then the revenue would be a bit more. But we've made a judgment based on our best knowledge at this point. In terms of margin, it's lower. The COVID work is generally lower margin for obvious reasons. And we recover our costs and make a small margin, but less than our target margin, the normal margins.

Okay. As far as furlough is concerned, we've got about 2,400 people on furlough at the moment, of whom about 2,111 are in our leisure business where, as you can imagine, all the leisure centers and swimming pools have been shut down, and the cost to the government have -- is running, in our case, about GBP 1.6 million a month. And I want to emphasize that nearly all these service -- these people concerned are being furloughed with the express intention so that they can come back to work and these leisure centers can open as quickly as possible at the end of the crisis. Now it's all when lockdown eases sufficiently. It's too early to make a judgment as to whether we will repay some or all of it. I think that -- and it is not factored into our guidance that we would repay all of it because, frankly, we're doing what the government has asked us to do, which is to keep people on standby so that they can come back to work immediately. But we will make those judgments in the summer months. Now as far as dividends and bonus deferrals and liquidity, I think we take the reasons why we deferred dividends and bonuses was because we were receiving liquidity support, and we thought that, that was a wise thing to do. And as Angus has said, I think we take -- we would have taken about GBP 50 million of that at the first half. I think in terms of the thinking about the dividends that the pre-close is not the time to take a decision on future dividends, but clearly, the Board will look at it at the interims and again towards the end of the year. I would think it is extremely unlikely that the Board would consider it wise to declare an interim dividend having so recently deferred the 2019 final dividend. However, that decision will need to be revisited during the end of the year and when the trading outcome is more certain. If, as we expect, we've been able to have repaid all the government liquidity support that we will have received, that will clearly be a factor that the Board will want to consider.

Great. But no sense you're going to repay the furlough money?

But -- no, I don't -- the other answer, Paul, is we haven't made up our mind yet. I think it will depend. And the people -- the vast majority of people, as I say, on the furlough scheme are working for businesses that genuinely otherwise would close. I think we may take a closer look at those places where the businesses themselves are fundamentally profitable. We may take a look at those payments, but it's too early to say, whereas I think that we have more confidence in terms of the liquidity support are being to say that we do expect to be able to repay that on an accelerated schedule by the end of the year.

The next question today comes from the line of [ Joe Leatherland ].

Is that Joe Brent? Hello?

Joe Brent. Sounds like -- that sounds like Joe Brent to me.

It is. Very good. Three questions, if I may, and if I could take them in turn. The first question is, clearly, you're playing a key role in helping government address some of its challenges. Do you think that sort of helps the relationship going forward?

I'll take that. Yes, undoubtedly. I think that there are relationships being formed now, which are similar to battlefield relationships. I mean people have come to us to help, and we have mobilized at extraordinary rates. And we are working as seamless teams with government to do extraordinary things. I know we saw -- there was -- we came in for a bit of [ press agro ], but mobilized 10,500 tracers in 4 weeks from -- between us and our supply chain was a huge achievement, I think government recognizes that, and likewise in Australia, to be able to get and look after all the quarantined Aussies. So I think that it is building a -- I mean provided that we deliver operationally a -- it is certainly, I think, helping our reputation with a government as somebody that they can turn to and who is -- who's going to react appropriately and be able to deliver services on the sort of scale that government needs on a great speed. So I am -- I have no doubt where we will come out of this with stronger and deeper relationships with the government than we went into it.

The second one, if I may. I think there's quite a hit on the new terms on the franchises. When will these terms revert to normal post COVID? Any idea what the time scale might be?

You're talking about the rail franchises?

Correct. Yes.

No, I don't think we do have a view on that. We -- I mean we've got limited exposure to that because our franchise is actually different. They're not the normal franchise. We've got the Caledonian Sleeper, which is a bilateral agreement with Transport Scotland, and they have been very supportive of us to enable us to keep those services running on a lifeline basis. We then have Merseyrail, which is a more complicated situation because Merseyrail was actually profitable for us. And is now, we're now having to negotiate with Merseyrail. What happens now, it is loss-making. I don't think there will be any major implications for us in terms of our -- I mean the arrangements that we have in the long term across those 2 contracts, in the longer term, I think they will revert back to normal, which would be our working assumption. And in Dubai where we've got the Metro, we've kept the Metro running throughout. We've been working very closely with the Dubai albeit that volumes are much lower. We don't take farebox risk in Dubai.

And the final question for me. It is probably a stupid one, so apologies in advance. Why are you repaying the tax deferrals? Is there any interest on it? Are there restrictions attached, strings attached? Does it affect your basis capital dividend? Is it just a PR? Just why do we pay that money?

Well, look, the money was put there for a reason to support companies that had liquidity issues. If we don't have liquidity issues, we don't particularly see the need to hold on to that government money. You can't just say be hard-nosed about it, but we do see the liquidity support being a different issue from the furlough support. And if we've got a strong balance sheet, it will not be a huge amount of liquidity. But given that we're going to be down at a leverage -- right at the bottom end of our leverage anyway, sitting, if I say, gratuitously on VAT and other stuff doesn't really seem to be in the spirit of a government that has given massive liquidity support to companies. Many of whom really need it, but we're, I think, going to be in a happy position but we don't.

The next question today comes from the line of David Brockton from Numis.

Can I ask 2 questions? And I apologize, I know you've just given guidance -- just reinstated guidance for 2020, but I had a 2021 and beyond question. I just wondered if you can give us firstly an update on rebid risk. You've had quite a bit of success already this year in terms of some contract extensions such as Fiona Stanley. That's the first question. The second question just relates to the pipeline. Clearly, governments have been rather preoccupied with dealing with the pandemic. I just wondered if you can give us an update in terms of sort of some of the longer-term contracts that might come out, whether you've seen sort of a natural slowing there and whether we can see a pause in activity as we work our way towards the year-end.

Well, just for Angus delves into this, I can see lots of shuffling of paper going on the -- at his end. I'm just going to -- I think one of the -- clearly -- actually, our pipeline, we think our pipeline, we don't normally talk about it, but it will actually be quite strong as the half year. And we've had strong order intake in the half year. We think we'll be at or near 100% book-to-bill. But if I can give you a qualitative feel about it, what will be happening is some of the large procurements are going out, which is, on the face of it, bad news. But on the other hand, the good news is that if you are an incumbent, it means to say that the rebids are going out as well. So it tends not to have a huge impact because it all tends to be swinging, and roundabout is that we hold on to the rebids for longer. If the new stuff gets delayed, it's in terms not to be a disaster. But I think that there are some large programs coming along in the next couple of years where the government is going to be struggling to put together full-blown tender processes. But at the moment, it's not at the top of their mind, I don't think. But that would be my guess is that rebids, contracts that might have been retendered will tend to get extended if they run into trouble, and new business coming in may also go out to bid.

So we'll have the inverse, David, in terms of our rebids. Our rebids that were due in 2021 were about GBP 800 million. We've already secured Fiona Stanley, which was around about just over 10% of that number. And you look at some of the other ones, Acacia Prison in Western Australia. We have the Australian tax office. We've also got a naval support contract again in Australia. And continuing that Australian theme, our immigration contract, which still has another potential extension term to it, which we saw recently exercised. That comes up right at the end of 2021. And we've got a number of defense contracts in the U.S., ATFP and Goose Bay. So we've got about GBP 700 million at this point that's up for rebid in the way that Rupert talked about in terms of some of the new work perhaps slipping to the right a little bit that may well benefit us from a rebid perspective. We would say nothing unusual about the piece of rebids over the next couple of years. We've got GBP 800 million and now we dropped down to GBP 400 million in 2022 and then GBP 300 million in 2023.

The next question today comes from the line of Ed Steele from Citi.

Just one area to ask you about, please. The U.S., of course, had a very strong year last year. Could you talk a little bit about how the contracting process is felt through the first half? And any thoughts you have into the presidential election, please?

Presidential election, no. I think we have no thoughts whatsoever about the presidential election. In terms of contracting, I mean, broadly speaking, the -- it's still continuing. There are some delays on programs. But the U.S. machine -- contracting machine is continuing to run in its usual way of tenders followed by appeals, followed by protests, followed by eventual awards. So we're not noticing a huge difference on that, and they are keeping up the flow of new business in terms of the Navy, in particular. And in terms of performance of our NSBU, its profitability was in line with what we had in the acquisition model. Revenues are slightly down because of some delayed contracts that have been on -- under protest, but the margins have held up. And the CMS contract, I think that we -- that's been a lot stronger than we thought that it would be, and there's going to be, I think, some -- what we don't know yet is what the impact of having all these -- a number of people unemployed in the U.S. is going to have on demand for the federal health care programs, but we would expect it probably to be positive. But that won't flow through until the end of the year and possibly into next year. But it has been a very strong first half for CMS.

[Operator Instructions] The next question comes from the line of Christopher Bamberry from Peel Hunt.

A couple of questions, if I may. First of all, what are the key deltas within the GBP 135 million to GBP 150 million profit guidance range? And secondly, the year-end net guidance of GBP 200 million is based on change from before. Are there any movements within the constituent parts of that? I mean, obviously, there's no dividend payments expected this year. Any other kind of key movements on CapEx, working capital or whatever it may be?

I'll leave that to Angus.

In terms of the GBP 135 million to GBP 150 million, we've got -- I think there's a number of moving parts in terms of how we will end up on that. You've got to look at the, for example, in the COVID revenue, going back to the first question, will some of it extend on? We don't know beyond what we -- beyond our balance of probability. And then you got to look at areas like leisure. How is that leisure business going to open up? How many people can get into swimming pool, can get into a gym? We're losing significant amount of money in our leisure business, and that will continue in the second half, and we've got to wait and see how social distancing is going to work in that. Transport, in terms of how many users are we going to have at Merseyrail, the Caledonian Sleeper. And the health business, that's -- our team have done an unbelievable job in the way that we have supplied -- provided services right through this. And we've had very high level of absence for a period. It's now come back down to how is that going to develop in the second half. So these are some of the moving parts in terms of where we think we might end up for the year. And that -- and it is hard to predict right now, and that's why there is a bridge to the guidance. In terms of net debt, let's wait and see. We've got -- the first half is challenging from a working capital perspective because we've got so much of the COVID work just coming on stream now. So clearly, there's a working capital consumption with that. We've just got to see how it plays through the second half. I would say it's pretty much -- if you take the COVID element out, it's pretty much business as usual elsewhere around the circle world. So there's no major changes in that in terms of account.

The next question comes from the line of Sylvia Barker from JPMorgan.

Just going back to the GBP 100 million of COVID-related revenue in H1 and H2, it seems like the 3 main elements, obviously, the track and trace, the testing in Australia, and I guess the U.K. wants the tracing revenue in particular. Obviously, it will be a lot higher in the second half. So do you basically assume that the other 2 kind of disappear pretty quickly? And what is the sensitivity around that assumption? And then around government customers repaying some of the extra costs, you will be obviously negotiating on that currently into the second half. But again, what sensitivity have you included within the guidance for the various outcomes of that?

I'll let Angus take that, please.

Well, we are talking to a customer about a number of the -- we've incurred significant extra cost in certain businesses. And we are -- these are commercial negotiations where our first instinct and the customer's first instinct has been to do the right thing and to make sure that when you're providing critical lifeline services, that has to be the #1 priority. And I think we've worked with all our customers really well and credit to the customer for the way that they have gone about dealing with what was a -- what is a really challenging situation. So there are a number of commercial issues. We've used our best judgment. Clearly, we're not going to go into any of the detail of it here. But again, we've given it our best estimate as to where we think we'll end up in this. But you can imagine the biggest areas will be around leisure, will be around health, will be around transport. In terms of what's happening, for example, in the Middle East, where Dubai Airport shut, Baghdad shut, Sharjah Airport shut, there's a number of conversations that we will be having. Remind me of the other question, again -- ah, COVID. In terms of -- yes, track and trace is clearly a large part of it. What you've got to remember with track and trace is a big piece of it really is being subcontracted. So the profit impact is significantly less than the revenue impact on that contract. We have taken the current contracts. And if they're extended, then that will help push us up the range. If they're not extended, then we'll be more exposed to areas like leisure, health and transport.

The next question comes from the line of Allen Wells from Exane.

Most of my questions have been answered, but just one quick follow-up. On the full year guidance, what exactly are you assuming in that range between top and the bottom on the leisure recovery, i.e., in one of those scenarios, I'm guessing -- you assume that the leisure business is out for the rest of the year. Just trying to understand how influential that is? And what the assumptions are around it on the business?

Angus, let me try that one, and if I make a hash, you can do. We've taken what you might call a middle road. We're kind of assuming that the -- that at least some of the leisure facilities will start opening, maybe at the end of July, early August. There are different things like -- but if you really want to get into the complexity of leisure services, there is a nightmare scenario where we have to open swimming pools, heat them, put lifeguards around and fill them with chlorine and then only allow to have 6 people in them. So it depends the pattern of reopening. I think that we've taken the view that they will gradually reopen in sort of July, August. But they're not going to be up to full swing. Remember, these are membership operations where people have to pay membership. They expect to have the full range of facilities. So the answer is we don't really know. And I think that the reason for the wide range is also because if furlough starts falling away, which it will do, we can't fully reopen our facilities. It could be quite a big hit in the second half. So it's really hard to tell. And I think that we would be very disappointed if we ended up below the bottom end of the range. And -- but it will be quite influential how those leisure centers do whether we -- where we end up above that. So we've taken the middle of the road. It could be worse, and it is quite a big swing item. Equally, on the other side of that, we've kind of assumed that the tracing contracts will run too for the life till September, but if they do renew, they renew at a very much lower rate. So there could be some upside on that, and that comes back to the whole argument. I'm really sorry, we're giving a very wide range because there is a wide range like it comes and some very big moving parts. I tend to take the view that they won't all go wrong simultaneously, but it's also day-to-day, they may do. Equally, I tend to say the view they won't all go right simultaneously. We won't get leisure centers opened and extensions of tracing contracts. So as I said, I think it's some big moving parts.

[Operator Instructions] The next question today comes from the line of Kean Marden from Jefferies.

I have 3, if I may. First of all, to what extent was profitability in the first half impacted by sickness and absence rates from your employees? And has that employee resourcing risk now substantially subsided? Secondly, on the Wellington (sic) [ Wellingborough ] and Glen Parva bids in the Alcatel standstill periods at the moment? And thirdly, on the OCP. The OCP is GBP 3 million in the first half. Does that suggest that your GBP 15 million to GBP 20 million guidance for the full year now looks a little bit toppy? And if so, which contracts have contributed towards the better than expected?

Okay. So I'll take the first 2, and I'll ask Angus to answer the OCP contract. Sickness and absence started off very high. It's now down to normal levels. In fact, in some bids in Australia, we actually got more people coming to work than normal. Yes, there would have been -- there was extra overtime and agency work, particularly in the health care space in the early weeks of the crisis that has subsided, but the cost of that would not have been enormous. I mean we might have been talking GBP 1 million or GBP 2 million either way. And then -- but then there are other costs that we're trying to recover. So I don't think that, that is -- I mean it's a good question, but I don't think that, that will have a material impact first half to second half. Wellingborough and Glen Parva are not in standstill because they haven't yet been notified of any award. So we don't know if they are in standstill. They're not in standstill with us, but we would have been told if we had loss. So that is not the case. And Angus, toppy OCPs in the second half, no?

Just [indiscernible] to comment. And no, what we're looking at for this year as a whole, Kean is, there's about GBP 5 million of OCP outflow. Why is it less than we expected? You'll have read that our -- COMPASS over [indiscernible] problem in Scotland is now sorted out, both via court and then by agreement with the customer to take them back. So that's done. And PECS, it's a side of our -- operationally, we've done a really good job in PECS. So we've put workforce management in, our rostering is better, and we're running the contract a lot more efficiently. So there is an OCP saving in that as well.

[Operator Instructions] The next question comes from the line of David Roux from Bank of America.

Perhaps just a follow-up question on that. Could you perhaps give us a bit more color on the free cash flow guidance? I mean operating profit is expected to be up quite strongly, probably about 20% if you look at the middle of your guidance, yet free cash flow is expected to be broadly stable year-on-year. And we've noted that OCP utilization has dropped off quite a lot. It seems like working capital absorption is under control. I'm just wondering what items are weighing on your -- or are expected to weigh on your free cash flow conversion this year.

In terms of free cash flow conversion, we've got -- I think it will get better as the year goes on. So a lot of the COVID work we have put on and we're going back and we are just getting to the contract stage now. So H1, you will not see a stronger conversion, I think, as you will see at the full year. So there'll be a bit of working capital on COVID. There's also some -- we're getting FEMA and King's. There are some structural challenges there that we're now getting ourselves sorted out. We understand the invoicing. On some of the U.S. defense work, with things like [ King's and Dick's ], you get 80% paid as you go through the contract. 20% is withheld till the end of the contract. And so because [ King's and Dick's ] was so busy last year in terms of the kickup in defense spending, that 20% will begin to come back to us in the second half of this year and then the first half of next year. FEMA, again, the volume was absolutely huge. The customer is now catching up, and we're going to have a really good June in terms of collections there. We anticipate that going through the second half. And as you're right, what you've got to remember the OCP is that not all the OCP last year was cash. Because of IFRS 16, there was about GBP 50 million on Caledonian Sleeper that moved out of OCP and into onerous lease. So the cash impact in OCP is GBP 15 million less than you think. But let's see, forecasting cash has never been our strongest point. So let's see where we are at the full year. But there's no fundamental issues at all in terms of working capital. CapEx is at the low level so -- and I think the big difference is below the line, and we're not booking restructuring provisions and there's not significant restructuring cash cost going out.

There are no further questions over the phone at this stage. Please continue.

Right. Well, thank you all very much indeed. And if anybody has any individual questions you need to ask of our team, you know how to get hold of Paul Checketts. If you want to speak to him, we'll be happy to respond. Thank you all very much indeed.

And feel free to call Nigel or Angus as well. Thank you very much, all.

Thank you very much. That does conclude the conference for today. Thank you for participating. You may all disconnect. Speakers, please stand by.