Serco Group plc (SRP) Earnings Call Transcript & Summary

Hello, and welcome to the Deutsche Bank Depositary Receipts Virtual Investor Conference, dbVIC. My name is Zafar Aziz, part of the DR team. I'm pleased to announce that our next presentation will be from Serco Group plc from U.K. Before I turn it speaker, a few points to note. Please submit your questions in the questions box below the slides. Once the Q&A session is ended, don't log out. You'll automatically be transferred into the Serco Group booth where you can continue to ask questions via chat and access shareholder material. On a final note, all of those presentations are recorded and can be accessed by the Deutsche Bank website, adr.db.com. At this point, I'm very pleased to welcome Paul Checketts, Head of Investor Relations from Serco, which trades on the London Stock Exchange under the symbol SRP, and in the U.S. on the OTC markets as SCGPY. Welcome, Paul, and over to you.

Hi, everyone. Good afternoon, and thanks for joining. My plan is, we've got about 30 minutes I think, so we'll do sort of 15 to 20 minutes. But I'll give you a bit of an overview of Serco, recent history and some thoughts on looking forward, and then I'll answer any questions you've got. If I -- I'm just going to jump to my first main slide of the disclaimer on 2, which I won't dwell on. But the first slide I'll pull up is, it gives you a picture of what our group looks like. It's an overview of Serco. We call it our bingo slide. And the way I would explain Serco to those for which it's new is, we -- our focus is entirely on providing services to governments. That is -- that's our narrow focus. There was a strategic decision several years ago to ditch the businesses that serve the commercial sector and to focus entirely on governments. Then within those parameters, we have diversification across geographies and across segments. And the logic of that is this, although we're focused on governments, we don't want to be too narrowly focused on any 1 government or any 1 segment because the nature of these markets is that demand can wax and wane over time. And if you have all the eggs in 1 basket, it can become problematic. So we like that diversification within those narrow parameters of doing government services. And you can see on the slide that the rough places that from -- we have -- our biggest region in terms of revenues is that U.K. and Europe, that's about half of our business. The Americas, which is primarily North America, is 25%; and Asia Pac is 17%; and the Middle East is our smallest region with 8%. And by segment, the defense segment is our largest with just under 1/3 of our revenues there. Citizen Services, which is a bit of a capture, but it does things like case management in core centers. That is 30% of our revenues. Then Justice & Immigration or prisons, we got immigration contracts there, that's 17%. Transport, where we do some rail work amongst other things; ferries, that's 12%; and health, where we provide services into hospitals is 9%. As far as to show that on a profitability perspective what you'd see is Americas is actually our largest region. It's about half of our profit now. That's a higher margin jurisdiction. And the Americas business makes higher margins in both -- it's defense segment, which is the largest part of it and it focuses primarily on the Navy, and also in Citizen Services where we do work for Obamacare on the case management side, that's broadly what the group looks like. People often ask, "How will that change over time?" It will depend on where the demand arises. It's a flexible model that can react quickly to we expect where demand waxes and wanes across the globe. Now there are 4 key areas of focus for us as a group, as a management team. Number one is revenue growth. The -- Serco, as a company, had a rough ride through 2012 for the following years. And a new management team came in under our Chief Executive, Rupert Soames, when it was in dire straits. And the first -- there were 3 stages to the strategy. The first 2 were essentially about stabilizing the business and making sure it was capitalized properly, and then the third part was in growth. And we've been -- since the second half of 2019, we've been in the growth phase, and that remains a key area for us driving revenue growth. I'll come back to it, but that's a key area of focus for us. The next is margin improvement. It's grown -- again, you'll see in a moment, but we've taken the margin up from circa 2% up to slightly north of 4%, and we think there's further progress made. That revenue growth, within our culture, it is all about profitable growth. It's certainly not about just growing revenue for the sake of it. It's about getting those margins and returns for that matter. And the third area is cash generation. Absolutely all those profit should be cash-backed. It hasn't always been the case in this company and the broader subsector, but that's really important for us. And on the whole, the cash characteristics are very good. We're dealing with governments where the credit risk is minimal, and they tend to pay after 30 days. So there's no reason why that cash generation shouldn't be good. And the fourth area of the function for us--and this has become an increasing area and is likely to become more of a feature over the next few years--is M&A where you'll see coming up the balance sheet is in decent shape now and acquisitions where we think they can generate shareholder value will be an important part of the strategy. So I'll just give you an overview of the last few years and what we're expecting going forward. So you can see, we went through a period of decline as the portfolio was tidied up and problem contracts were exited. And since 2019, we've been delivering top line growth, 8% organic growth in '19, 16% last year. Then for this year, we're expecting 4%. And our medium-term aspiration is to be doing mid-single-digit organic revenue growth. The second area of focus, of course, is margin improvement, and you're seeing our profit has more than doubled in recent years, and that is because not only we had the revenue growth, but we see we've driven up that margin, gone from the 2.3% in '17 to 4.2%. We've seen a 33% CAGR over the last period. And again, our marginal aspiration is the 5% plus in the medium term. We're expecting it to be stable this year, which I'll come back to it. But we think, in the medium term, we can get to 5% or north of that through a variety of means, which include workforce management, operational leverage. We've got a very scalable cost base now. There will probably be some acquisitions into the mix that we can get both leverage on in the Navy at higher levels, and we have centralization of procurement program that's being rolled out over the next few years. On cash generation. This is a -- you can see the volatility of that. And the background to that is the business was hamstrung by onerous contracts when the current management team came in. In total, there was GBP 400 million of provisions for onerous contracts, and they were a big hand break on cash generation. They are now nearly -- virtually gone. We have less -- we have about GBP 10 million of provisions on the balance sheet now for onerous contracts. And what that means is the profits that we are generating will be converted cash. You see, 2020 is a slightly unusual year due to some tax breaks related to coalition governments and also because we had some catch-up on particular contracts where the billing have been slowed to begin with, and there's a bit of an unwind in that '21 number. But from an ongoing perspective, we would expect 80% to 90% cash conversion of the profits that we make. Acquisitions, in total, Serco in the last year has made 4 acquisitions, one of which was done through equity to buy a business called NSBU in the U.S., and that really bolstered our position in the Navy market. Then there were some health care assets that came out of Carillion [indiscernible]. But more recently, we've made 2. So at the end of 2020, we brought a business called FFA, Facilities First, in Australia, that's a cleaning business. That was designed to broaden our range of services, which would improve our success -- potential success rate on a rapid upcoming work. So it'll improve our credentials in that. It relates to army base FM work, which could be worth several billions of Aussie dollars in the next few years, relatively small acquisition, but it was capability building. Then a larger one, which we completed, I think 3 weeks ago now, is WBB in the U.S. And this really broadens out our defense business in the U.S. It strengthens our position in Air Force and Army. So a slightly less Navy-centric now, and we think it's both revenue and cost energy opportunities for that business is really plug it into the Serco group. And I expect some more acquisitions in the coming years. I think we left a moment on the year just passed because it was certainly an interesting one. We saw -- I mean despite all -- everything that was going on with COVID, it ended up being a really strong year for Serco. So you can see, in total, we did revenue growth of 20% and organic revenue growth of 16%, and our profits in the same period grew by 37%. COVID had brought some big operational challenges, but overall, it was positive for the group. We had large moving parts in both the negative and the positive side, the negatives were we won some leisure centers. So that's gyms in the U.K. Airports were closed down. We were in Mercy rail, which is a transport line, a commuter line into Liverpool. That was a very profitable business for us historically, and that was clearly hit hard. And our health care business was impacted severely with one of the biggest impacts being that we had high sickness rates amongst our staff. It got north of 30% at one point. So we had to cover for those with agency staff. So those 3 parts were the largest negatives. And we also have air traffic control work in the Middle East. So what we surprised to know was also severely impacted. But it was more than offset by us being asked to help out our government customers in their response to COVID. So in total, the net impact on revenue, a positive impact of GBP 390 million of sales, with the biggest part of that being the U.K.'s test and trace team that has been commented on widely in the press, but that, in reality, is a great success and has improved our position with our e-customer. And overall, on the profit side, there was a GBP 2 million benefit. So a much smaller benefit from that of the big moving parts, largely even they eat other out. Regionally, U.K. was strong. Americas, top line was flattish, but we grew the profits well; as PAT, strong top line, but margin is down a bit due to some of the impacts. And the Middle East is the region that was hit hardest. Our order intake slowed in the year, and that was as COVID pushed -- that meant, decisions were being pushed to the right. But on the flip side of that, our pipeline has increased. It went from GBP 4.9 billion at the end of '19 to GBP 6.4 billion at the end of '20. So there's quite a large pipe of potential work to be awarded in the coming months. And the cash flow was strong. Our leverage ended up coming in sort of 0.6x EBITDA at the end of the year, and our typical range is 1% to 2%. And that's just one of the key reasons in us reintroducing a dividend. If I was to look forward, into 2021 and 2022. We probably give very fair guidance for the upcoming year. And from a 2021 perspective, we're expecting profits. Organic sales were 4%, so we're expecting profits to go from GBP 163 million last year to GBP 185 million. So strong -- still strong growth despite coming off a real period of high growth, and we're expecting cash flow to be strong as well. We think that the leverage will be in the sort of middle part of our 1 to 2x range at the half year, which is when we will have paid for our WBB acquisition. And then enter 2022 has been a hot topic because we're facing some headwinds, primarily the main ones are: we had a contract with the atomic weapons establishment, which is being taken back in-house. That will happen at the end of June this year and be a full year drag in '22. It will knock out about GBP 14 million from our profits. Then the COVID work that we did will come to an end, hopefully, for everyone's sake next year, but that was always going to be a femoral work. And at some point, it will drop out. And then the last part is that we -- there's a smaller impact, but we were running the Dubai metro, and that's moved to a different provider. So that's up about GBP 4 million of our profits. They're the headwinds that have been an area of question. And then on the flip side, the tailwinds that we'd expect recovery in the parts of the business that were impacted by COVID. We won relatively large contracts with the government in the U.K. in the last few weeks with the Department of Work and Pensions to get people back into work after COVID and then I mentioned that the pipeline of potential new work. The conversion of that will be as we go into 2022. And that takes me to [Technical Difficulty] on capital allocation. So amongst everything else last year, we refinanced our debt. So cash flow ended up being stronger than expected last year, and we refinanced some of our U.S. private placements. So we've taken out relatively long maturities. It goes between 5- and 12-year terms, and we feel pretty happy with our finance facilities at the moment. And then from a capital priority perspective, we don't want to have too much debt. We feel like in this industry, you should be relatively unlevered. And for us, the right number is between 1 and 2x net debt to EBITDA. And as long as we're in that -- within that range or for that matter, the lowest, then our capital priorities will be, in the first instance, to invest for organic growth will be our top priority. After that, it would be to fund bolt-on acquisitions. Then it would be to pay a dividend. While having introduced it last year, we would like to hedge that up over time. And if we are below -- after all, assets were below 1x, then we'd return that cash to shareholders. We did a small buyback -- we're doing a small buyback at the moment. But in -- we prefer to be doing accretive M&A, where that's good for our shareholders. But if we can't, we'll return the money. And then my summary slide for you is, it's been a really strong period over the last 2 years to Serco. We've seen 33% compound growth in our profits. Margins have increased significantly. The pandemic was very difficult operationally, but it really has proved the systems that have been put in place over the last few years. There was significant investment into IT and the infrastructure group, and that was shown itself able to be very agile and responded to wherever government demand is with speed. The culture that is important as we have what we refer to as niche-type structure, which is essentially that you give relatively high levels of autonomy to the divisions but with a centralized management oversight. And that, again, has meant that we can react very quickly in a way that gives the customer excellent service, but still return to sort of uniformity and gets us good operational leverage. On the acquisition side, we're happy to do 2. And I think that -- one of the things about that, as I've shown, the cash generation now is going to be able to finance further deals if there's one that makes sense. And from a strategic perspective, the decision was made a few years ago to be really focused on government services but to be international. And we think that, that has relatively controversial at the time, and we think the last few years have demonstrated, and the last year, in particular, demonstrated the strength of that area of focus. And then the last thing is that from a longer-term perspective, we're going to give Capital Markets Day at the end of the year. But one of the key areas that we've talked about previously is that we think governments are under great pressure to deliver more for less for their population. And that will be exacerbated, we think, by COVID. They're going to see high levels of debt, but we're still seeing increasing levels of expectations of services and quality of those and a difficulty often to be able to finance those through extra taxation. So there's a -- you can more for better for less. And that's where we think we can help our customers. And within that, we still feel happy talking about the business being able to deliver mid-single-digit organic revenue growth and to drive margins up to 5% or more in the medium term. So I'll end it there from a presentation perspective. I can see a few questions. So I'll -- if anyone else has any, keep on sending them in. Otherwise, I'll just work through the ones we've got.

Our projections for '21 is one of the questions. I'll give you a quick overview. Maybe that's just worth giving a little more color on 2021. So we've given this quite explicit guidance of this year, a sense of dual precision. But of course, within that, there's some big moving parts. The areas that are clearly harder to project are, what happens with the COVID-related work. Our assumption for 2021, overall, is that the COVID work ends up being quite similar to 2020. And the biggest parts of that are the testing that we do in the U.K. There's a rebid out there at the moment. Serco provides about 25% of the testing capacity in the U.K., and it's expected that there is some capacity that has kept through the rest of this year, even if it's at a lower level. And then we also do some placing work around cases in a minute that's pretty quiet because the cases have dropped. These people are potentially going to be used for other purposes, including some, basically, people who have come back from overseas. So that -- yes, and we may see COVID work continue through the rest of the year. So we're expecting that to be relatively flat. But overall, profits to be increasing, which is partly due to the acquisitions and then partly due to some new work ramping up. The WBB contract, I mentioned, actually will be loss making in '21 and profitable in '22. The reason -- what is the reason for the increase in net debt in 2021? That is because with the WBB acquisition we've made, where it was paid for in about 3 weeks ago, and that cost us around about GBP 200 million. Well, that is -- that's the entire reason for the increase in the net debt. A fair question would be, why is your free cash flow reducing in '21 versus 2020? There's a couple of reasons. One is 2020 wasn't really a normal year, partly because there are some tax deferrals that were extended to various corporates, and we tried to pay most of those back last year because the balance sheet was in good shape. But some in the U.S., there was no mechanism for us to pay them back early. So that's one area of it. And the other was that we had phenomenal cash collections last year in the Americas related to a contract around federal emergency work. And in the Middle East on some older debt that our new CFO did a great job of getting in. So there was a catch-up on some older debts last year that's sort of one-off, if you like. But from a cash conversion perspective, excluding those 2 factors, we'd expect to be in the 80% to 90% range. The next question is, when you talk about Citizen Services' business, is it COVID related? Or is the growth sustainable? I say, it's both, is the answer. Last year, the test and trace work in the U.K. amounted to GBP 350 million of revenue. And our revenue in 2019 was GBP 3.2 billion. So you can see it went from -- it became a GBP 300 million to GBP 400 million business from scratch, which, as an aside, was made possible because of the investment in IT over the last few years. Remember, we got rapidly scaled up the business. We went from -- that business previously had 3,000 heads in the U.K. And it went to 13,000 in a matter of 6 weeks. So there's an element of the work that we would expect to drop way, i.e., the COVID stuff, and then may be some residual responsive work on COVID. But we'd expect clearly test and trace over the next -- at least, in the next 18 months to disappear. But excluding that, that business has actually been a phenomenal source of growth over recent years. And it's quite interesting because when we had our last strategy review, McKinsey helped us with us and told us that we should sell the business because it didn't -- it was low barriers to entry, commoditized market, great competitor in terms of teleperformance that specializes in the area and have better scale. So they advised that we sold it, and we decided that, that wasn't really we wanted to go down. And in fact, it has seen great growth in AsPac. The Citizen Services business has got some great work with the Australian tax office with Services Australia, with Victoria Police. And really what's proven to be -- resonate with customers is when you have an established relationship with the government and then also you can be providing services to citizens, 3 things like call centers, and marrying up that relationship with the ability to execute on that has actually proved quite a strong combination. And elements of it make good money, make good returns. So Citizen Services, in fact, we'd like to try and broaden that business out a bit. And we think we've got some real skills that we can cross-sell across different regions. Next question is, a few years ago, Serco had a strategy to stabilize, transform and grow. It looks like you're in the final stage. What's next? Well, yes, that's totally right. When I joined about a year ago. So I deleted that slide because it ran out in 2020. So it's a bit longer than the 2, and we'll update later this year. It was -- we were intending to do it last year, but in the midst of COVID, it seems more sensible to take a pause and reassess when the fog has cleared a bit. The short answer is, we still think we can grow mid-single-digit top line and get the margins up. And then wrapped around that, it's -- and returns are really important for us and risk is really important for us. So those are sort of underpinning principles. And then there's going to be a question about, how do we accelerate growth in part of the portfolio? How do we drive the margins up? And a lot of that emphasis, I think you'll see will be on contract margins as opposed to central costs, trying to make those contracts more efficient without compromising the service excellence. And it hasn't really been touched so far, but that is something that's being worked on at the moment. Three things like workforce management, and that's been being -- beginning to being rolled out now. So I think it'd be about continuing to take market share, making sure it's profitable growth and enhancing our profitability through some of these efficiency programs. Dividend plans for 2021 have been asked about. I think -- we think we should always be on the relatively cautious end of the dividend cover deal. Because it really is more important that the balance sheet is in good shape than at any point getting stuck on a too high dividend, plus we started at a conservative level and we'd like to increase it for 2021 as long as things pan out as we're anticipating at the moment, and I'd expect that dividend cover over the next few years to be steadily reduced. And the last one that's on the list at the moment is saying, what do you expect in terms of order book growth during the first half of the year? I can't answer that at the moment. It's a more complicated calculation for me just to do on the back of a fag packet. But if I was to run through the moving parts. So the order book actually reduced last year, and that was because the order intake was lower. It's just a matter of burning through revenue more than we're adding in. The pipeline currently -- well, pipeline -- remember, last year, it was GBP 6.4 billion. So that had gone up from GBP 4.9 billion a year before, and we still anticipate -- we've won a big contract with the Department of Work and Pensions. That was GBP 350 million. Now we're going into the order book. We're close to that level. The U.S. business has been a chip of work. And then both in the U.K. and the U.S., there's a real backlog of award decisions. So we're anticipating quite a lot of work handed out over the next -- certainly over the next, say, '21 and then at the start of first half of '22. I'm not quite sure where the order book will land at the half year, but we've had a good win in DWP anyway. And the pipeline, we're pretty happy with it at the moment. It could end up being a pretty respectable year in terms of wins if some of the slowdown manages these as we go through the coming months. I think that's all the questions I have. We're pretty much out of time. Thanks again, everyone, for tuning in. If anyone want anything else from us, we'd try to be as helpful and transparent as possible to get in touch whenever you like and for the rest of the afternoon.