REG - Serco Group PLC - Final Results <Origin Href="QuoteRef">SRP.L</Origin> - Part 3

SercoAnnouncement

12/03/2015 07:02

- Part 3: For the preceding part double click  ID:nRSL2478Hb 

for asylum seekers, we have to work closely with Local
Authorities to gain permissions to house asylum seekers in their areas. Local Authorities have a statutory responsibility
to provide and fund healthcare and education services for asylum seekers in their areas from existing budgets. Accordingly,
gaining Local Authority agreement to allow asylum seekers to be housed in their areas can be challenging and takes time. If
we have large numbers of additional asylum seekers we find ourselves having to provide accommodation for large numbers of
asylum seekers in hotels rather than houses, which is much more expensive. 
 
·      Volatility in the number of service users has also become a major issue; as the system has come under strain from
increasing numbers, so the numbers the Home Office instructs us to take can change rapidly from week to week, whereas
procurement of properties takes a much longer timescale. On occasions, we have been instructed by the Home Office to take
large numbers of service users with only a few days' notice and this inevitably causes increased costs and operational
strain on the system. Similarly, where there is a sudden drop off in numbers of asylum seekers this can lead to a surplus
in unoccupied rented housing, which also creates additional costs. 
 
·      Given recent volume growth we have reassessed our forecast volume assumptions. Based on historic numbers and trend
analysis, we have assumed an average growth rate of 1.46% per month in the North West and 1.49% in Scotland and Northern
Ireland.  This produces forecasts of significantly higher numbers of asylum seekers towards the end of the contract, and as
a result the projected losses are far larger than were previously anticipated. 
 
As a result of these factors, a provision of £112.3m has been recognised to cover anticipated losses over the remaining
five years of the contract (including the two extension years), and there have been asset impairments and other charges of
£3.0m.  This represents our current best estimate of the likely outcome, although the losses on the contract are closely
linked to volume of asylum seekers, which is not in Serco's control and the range of potential outcomes is wide, given that
there is no contractual cap on the total number of service users that could be assigned to Serco. 
 
As the triggers for these charges have been the recent significant changes in volumes and the consequent activation of the
volume price reduction, we have concluded that the charge is a change in accounting estimate in 2014, and not a prior
period error. 
 
Future Provision of Marine Services (FPMS) contract.  Total impairments and provisions: £65.6m 
 
The FPMS contract, which has a 15-year duration, provides marine support services to the UK Ministry of Defence (MOD)
dockyard ports of Portsmouth, Plymouth and Faslane as well as support to military exercises and training and to the Raasay
Ranges.  Serco has been delivering services to the MOD under the FPMS contract since its inception in 2007 and operational
performance against key performance indicators has remained consistently strong. 
 
The contract has specific tasks that we are required to deliver in return for a fixed fee.  Additionally, variable revenues
are recognised for extra tasking (as instructed by the MOD and other third parties), and from time to time through the
chartering of vessels to third parties. 
 
The contract was profitable in the early years.  However, a reduction in fixed fee revenue resulted in losses in 2011 and
2012.  In 2013 the contract returned to profit as the Group secured a large number of extra tasking requests and third
party charters, with the reduced fixed fee revenue also being offset to some extent by a cost reduction programme.  During
2014, the contract again lost money as there were few opportunities for third party chartering revenue and additional
tasking requests also ran at a lower level than previous years. 
 
It has become clear that there is significant uncertainty about our future ability to generate third party chartering
revenue.  In addition, recent cost reduction measures put in place by the customer are likely to limit the volume of
variable revenue opportunities in terms of extra task orders.  Furthermore, a review of the contract during the second half
of 2014, based on latest cost estimates, considered the on-going cost base to deliver the contract.  This review covered
the required resourcing, repairs and maintenance spend and sub-contractor agreements and concluded that, despite efforts in
recent years to reduce the cost base, Serco is likely to lose money on the fixed fee element of the contract. 
 
As a result of these factors a charge totalling £65.6m has been taken, comprising a provision of £50.2m to cover
anticipated future losses over the remaining eight years of the contract and £15.4m of asset impairments and other charges.
 As the triggers for this adjustment were the significant and unexpected reduction of variable revenues from chartering and
task orders in the year, which could not have been foreseen, together with the findings from the contract review, we have
concluded that this is a change in accounting estimate in 2014, and not a prior year error. 
 
Prisoner Escort and Custody Services (PECS) contract.  Total impairments and provisions: £26.9m 
 
This is a contract with the Ministry of Justice (MOJ) for the provision of prisoner transportation between courts and
prisons and for the management of prisoner welfare when at court.  The seven-year contract was awarded in 2011, with three
one year extension options at the customer's discretion. 
 
In 2013 Serco identified misreporting of its Designated Ready and Available for Court Time (DRACT) performance measure, and
in late 2013 an outline agreement was reached with the MOJ that Serco could retain the contract in return for making
service improvements, at Serco's cost, and forgoing any future profit.  During the course of 2014 Serco and the MOJ worked
together to determine the detail of this agreement and the consequent level of investment required by Serco. Discussions
were at an early stage at June 2014 and are now concluded.  This has allowed us finally to determine the transformation
activities necessary, and as a result in the second half of 2014 we took the decision to extend our transformation
programme into 2015, at an additional estimated cost of £6m.  The crystallisation of these obligations has also allowed us
to refine our assessment of the future level of resources which will be necessary within the contract to sustain our
service at the agreed levels for the remainder of the contract term. This resulted in a significant increase in expected
future costs. 
 
The total onerous contract provision at 31 December 2014 is £14.1m, to cover future anticipated losses over the remaining 3
years and 8 months of the contract, with asset impairments and other charges of £12.8m.  The principal factors driving our
estimate are the extent and speed of our ability to reduce the level of staff overtime and the requirement for short-term
agency resource through planned operational improvements. 
 
This adjustment is a direct result of the discussions concluded in the second half of 2014, and consequently the adjustment
is considered to be a change in accounting estimate in 2014, and not a prior period error. 
 
Ashfield prison.  Total impairments and provisions: £18.8m 
 
The HMP Ashfield PFI contract commenced in 1999 and runs through to 2024.  In 2013 the operational role of Ashfield was
changed from a Young Offender Institution to an adult male sex offenders' prison resulting in a changed cost base.  Such
changes are normal in the life of a 25-year contract, and there is an established process for agreeing resultant price
changes.  However, since the change of operational role of the prison the MOJ has imposed on us a level of pricing which we
dispute, and which would result in substantial losses over the remaining life of the contract.  We remain in negotiation
with the MOJ but progress has been slow and agreement has not yet been reached.  Should we continue to be unable to reach a
resolution with the MOJ, we will have to invoke contractual remedies, including the dispute resolution mechanism under the
terms of the contract. Since the outcome of any such process is uncertain, we judge we need to take an onerous contract
provision of £15.3m to cover anticipated future losses, as well as impairing certain other assets totalling £3.5m, making
an aggregate charge against the contract of £18.8m. 
 
As the adjustment is the result of the failure to resolve pricing in 2014, the adjustment is considered to be a change in
accounting estimate in 2014, and not a prior period error. 
 
Other Onerous Contract Provisions Charged to Trading Loss 
 
Total other onerous contact provisions charged to Trading Loss for future year losses of £105.9m, related to contracts
which each had cumulative future year trading losses of up to £15m.   These contracts were individually reviewed as part of
the Contract and Balance Sheet Review by EY and management and arise from one or more of the following factors in the
second half of 2014: a change to the strategic direction of the business, a reassessment of the likely outcome of disputed
items, and adverse operational results arising from external factors leading to a reassessment of the future profitability.
 These factors led to these contracts becoming onerous and provisions being recognised at the lower of the net costs to
fulfil contracts and, where applicable, the costs to end contracts early.  In each case, it was concluded that as the
triggering events arose in 2014, these provisions were changes in estimates. 
 
Onerous Contract Provisions Projected Utilisation 
 
Projecting the future utilisation of the onerous contract provision is not easy given the inherent uncertainties of
predicting future contract performance, particularly when the performance on a number of key contracts depends on future
service demand and volume which are factors we do not control.  It is hard to forecast, for example, the number of asylum
seekers entering the United Kingdom.  However, given the fact that projected utilisation correlates with the estimated cash
impact of these future contract losses, we have estimated the projected phasing below. The projected utilisation reflects,
where the impact was significant, discounting of the future contract losses and this has reduced the total provision on the
balance sheet by £21m. Clearly, we will in future years review our contract performance regularly and update our estimate
of onerous contract provisions and associated projected future utilisation. 
 
                                     2015 £m  2016 £m  2017onwards£m  Total £m  
                                                                                
 Projected provision utilisation*    139      83       225            447       
 
 
*including exceptional items for UK frontline clinical Health and provisions included in held for sale liabilities 
 
The projected provision utilisation represents our current understanding of the contracts' future financial outturn.
Depending on various factors, as outlined below, the extent of actual losses and cash flows is likely to vary from these
estimates over the coming years. 
 
These projections may need to be revised or could prove to be incorrect due to various internal and external factors, such
as, (i) contract trading performance, (ii) the extent of actual losses, (iii) any re-negotiations of contract terms, (iv)
insurance or other claims made or disputes or litigations with customers or suppliers, (v) the impact of macro-economic,
social and political factors on the Group, such as economic recessions, changes to government policies and budgets and (vi)
changes to volume, such as, significant increases or decreases in the number of asylum seekers under the Group's existing
relevant contracts, (vii) changes to demand, such as, significant increases or decreases in the use of outsourcing services
by the Group's government customers, or (viii) changes to costs, such as, increases in the cost of labour or materials
employed by the Group. 
 
Other Impairments and Charges to Trading Loss 
 
Included in management's best estimate of outcomes from the accelerated review as announced in November 2014 were £187.8m
of charges to Trading Loss. A significant portion relates to £105.3m of provisions and accruals for contracts, property,
employee and legal related exposures.  An estimated future cash impact of these items is expected to be £72.5m and these
are all in relation to contracts that remain profitable, or for areas covering a range of contract or Group activity. 
These charges have arisen as a result of new information being made available in light of the changing risk profile of the
Group and changing direction of the business which has led to a hardening of positions taken by customers and other parties
where we have potential liabilities.  The impact of the changes in certain customer positions as a result of these
triggering events in the year has also led to a non-cash impairment of receivable balances of £61.9m. 
 
There are also non-cash impairments of intangible and tangibles assets of £20.6m, relating primarily to corporate assets
abandoned as a result of the strategy review.  The business has developed various IT systems and processes which we no
longer consider to be necessary to the future direction of the business, nor, therefore, is it appropriate to continue to
hold these assets. 
 
Impairment of Intangibles Arising on Acquisition 
 
As a result of the Strategy Review there are areas of the business where acquisitions were made but we will no longer be
pursuing opportunities, resulting in the abandonment of certain intangible assets, resulting in impairments totalling
£12.3m, some of which related to contracts with future losses.  As these are directly linked to the Strategy Review
concluded in the year, they represent changes in management's best estimate. 
 
Exceptional Items 
 
Exceptional items are non-recurring items of financial performance that are outside normal operations and material to the
results of the Group either by virtue of size or nature. After taking into consideration the reminder issued by the
Financial Reporting Council in December 2013, regarding the treatment of exceptional items, we believe that the items set
out below require separate disclosure on the face of the income statement to assist in the understanding of the underlying
performance of the Group. 
 
                                                                             Year ended 31 December 2014  Year ended 31 December 2013  
                                                                             Total £m                     Total £m                     
 Costs associated with UK Government review                                  (9.2)                        (11.6)                       
 Settlement amount relating to UK Government reviews                         -                            (66.3)                       
 UK frontline clinical health contract provisions                            (16.1)                       (17.6)                       
 Restructuring costs                                                         (32.7)                       (14.9)                       
 Provision for settlement relating to DLR pension deficit funding dispute    (35.6)                       -                            
 Other provision for legal claims                                            (20.1)                       -                            
 Impairment and related charges of Australian rail business                  (37.2)                       (9.6)                        
 Impairment of Global Services business transferred to assets held for sale  (39.2)                       -                            
 Impairment of goodwill                                                      (466.0)                      -                            
 Deferred consideration adjustment relating to prior year acquisition        -                            10.3                         
 Total other exceptional items                                               (656.1)                      (109.7)                      
                                                                                                                                       
 (Loss)/profit on disposal of businesses                                     (5.4)                        19.2                         
 Total exceptional items                                                     (661.5)                      (90.5)                       
                                                                                                                                       
 
 
Costs Associated with UK Government Reviews 
 
During the year there were exceptional costs totalling £9.2m (2013: £11.6m) associated with the UK Government reviews and
the programme of corporate renewal.  This reflected external costs incurred and included external adviser costs related to
these reviews and the Corporate Renewal Programme. 
 
UK Frontline Clinical Health Contract Provisions 
 
During 2014, there were additional exceptional provisions of £16.1m (2013: £17.6m), including an onerous contract provision
of £13.7m to cover the anticipated future year loss from the unexpected increase in patient volumes in 2014 on the Suffolk
Community Health contract.  The provisions relate to the re-evaluation of the forecast losses of the UK clinical health
operations, against which an exceptional onerous contract provision of £17.6m was made in the prior year and reflect the
Group's withdrawal from the front-line UK clinical health market, with the future focus of the Group on Healthcare being on
the provision of non-frontline health services.  This re-evaluation reflected reviews showing there are additional costs of
delivering improved service levels and meeting performance obligations through to the end of the contracts.  The Cornwall
out-of-hours contract is being exited early in May 2015 and Braintree Clinical Services was disposed of in March 2014.  The
third loss-making contract, Suffolk Community Health, is being run through to the end of the contract term in September
2015. 
 
Restructuring Costs 
 
As a result of analysis of the cost structures in the businesses and initial actions from the Strategy Review, an
exceptional restructuring charge of £32