Contingent liability, UK SFO investigation, risks and uncertainties, viability statement assumption

Serco Group plc – Annual report – 31 December 2018

Industry: support services

29. Contingent liabilities (extract)
As we have disclosed before, we are under investigation by the Serious Fraud Office. In November 2013, the UK’s Serious Fraud Office announced that it had opened an investigation, which remains ongoing, into the Group’s Electronic Monitoring Contract.

We are cooperating fully with the Serious Fraud Office’s investigation but it is not possible to predict the outcome and timing. However, disclosed in the Principal Risks and Uncertainties in this Report is a description of the range of possible outcomes in the event that the Serious Fraud Office decides to prosecute the individuals and/or the Serco entities involved.

Strategic Report (extract)
Principal Risks and Uncertainties (extract)
SFO investigation
We remain under investigation by the UK Serious Fraud Office (“SFO”) which commenced in December 2013. We are cooperating fully with the SFO’s investigation, but it is not possible to predict the outcome and timing. No conclusion has yet been reached. However, in the event that the SFO decides to prosecute, the range of possible adverse outcomes is any one or a combination of the following:

• that the SFO prosecutes the individuals and/or the Serco Group companies involved, who may defend the action successfully or be convicted. This may result in significant financial penalties, an impact on existing contracts and Serco being subject to a period of discretionary debarment from future contracts with government entities; or
• that the SFO and the relevant Serco entities enter into a deferred prosecution agreement (“DPA”) – which may result in significant financial penalties, a potential impact on existing contracts and a period of discretionary debarment from future contracts with government entities. Such debarment would be discretionary in the sense that a contracting authority may consider it not to be relevant to a given bid or re-bid, or that Serco has provided sufficient evidence that it has addressed any issues identified in a DPA or be limited in time under the terms of the Public Contract Regulations 2015.

Upon any such conviction or DPA, the amount of additional work given to the Group may be reduced, and the Group may be subject to enhanced scrutiny with respect to its other contracts and further actions beyond those being implemented under the Corporate Renewal Programme may need to be taken.

If the Group faces any criminal convictions, debarment consequences or enters into a DPA, any such outcome could result in significant fines, a potential impact on existing contracts and have a material adverse impact on the Group’s ability to contract with the government and on its reputation, which would, in turn, materially adversely affect its business, financial condition, operations and prospects.

In addition, a criminal conviction of a Serco entity or of one or more of the Group’s current or former employees would in certain circumstances allow the Ministry of Justice to re-open the £64.3m settlement agreed and paid in 2013 in respect of certain issues arising under the Electronic Monitoring Contract. In those limited circumstances, the UK Government may seek additional payments from Serco.

We will continue to cooperate with the SFO’s investigation.

Viability Statement
In accordance with provision C2.2 of the UK Corporate Governance Code published by the Financial Reporting Council in April 2016, the Directors have assessed the prospects of the Group over the three-year period to 31 December 2021.

The Directors believe that a three-year period is appropriate since it reflects the fact that:

• The Group has limited visibility of contract bidding opportunities beyond three years.
• Approximately 50% (2017: 58%) of the current year revenue relates to contracts where the contract term potentially comes to an end within three years.
• There is currently significant political uncertainty in the United Kingdom, United States, Saudi Arabia, Qatar and Australia.

The strategic plan set out in March 2015 significantly changed the direction of the Group as explained in previous shareholder communications. This plan is still being executed with the Group preparing an updated five-year business plan each year to establish whether it is on target to achieve its long-term goals. However, the financials for the last three years of this period are largely extrapolations of key assumptions used in the budget process. Given the difficulties of forecasting over a long time period it would be inappropriate to draw conclusions on the future prospects of the Group and for developing sensitivities and mitigation strategies. Therefore, whilst the Five-year business plan continues to be developed, it remains a goal for the Group and is a not a forecast based on known assumptions; this makes assessing the longer term viability a challenge.

Good progress has been made on the strategic plan and the Directors expect this to deliver the growth targets which have been set. Although in the early stages of growth, the ability of the Group to harvest the benefits of the transformation are only just starting to be realised. We have previously highlighted the dependence on the external market and our ability to win new contracts whilst reducing the cost base. Market rates of growth have slowed in recent years and while we expect strong growth in the next two years due to our new contract wins and order book, thereafter revenue growth is more difficult to assess, but margins will increase from cost reduction and improved efficiencies. Importantly in 2018, we have refinanced the Group’s bank debt, and the new Five-year funding will provide the financial platform to continue to invest in the growth of the Group.

The Board and the Group Risk Committee continue to monitor the principal risks facing the Group, including those that would threaten the execution of its strategy, business model, future performance, solvency and liquidity. Management and mitigations of those principal risks have been taken into consideration when considering the future viability of the Group. The Group’s principal risk review, as set out on pages 52 to 63, considers the impact of these principal risks and the mitigating controls that are in place.

In assessing the prospects of the Group over the three-year period, the Directors have also considered the Group’s current financial position as well as its financial projections in the context of the Group’s debt facilities and associated covenants. These financial projections are based on a bottom up Budget exercise for 2019 and 2020 which has been approved by the Board, and an extrapolation to 2021 using higher level assumptions based on local market growth rates and identified opportunities.

The Group’s covenant net debt balance at 31 December 2018 is £181.5m. The Group’s base projections indicate that debt facilities and projected headroom are adequate to support the Group over the next three years. The Group’s financial plan has been stress-tested against key sensitivities which could materialise as a result of the crystallisation of one or a number of the principal risks, the objective being that the future viability of the Group is tested against severe but plausible scenarios. The sensitivities tested include a reduction in the win rates for rebids, extensions and the Pipeline of new opportunities, a delay in delivering margin improvements and a potential penalty arising from risks such as contract non-compliance, major information security breach or a material legal and regulatory compliance failure. A reverse stress test of the Group’s profit forecast has been completed using different assumptions of new business and rebid win rates and the Group’s profit margin. This analysis shows that the Group can afford to be unsuccessful on 50% of its target new business and rebid wins, or it can be unsuccessful on 25% of its target new business and rebid wins combined with a profit margin 100 basis points below the Group’s forecast, before the Group’s borrowing facility covenants are breached in 2021. As context, rebids have a more significant impact on the Group’s revenue than new business wins, as contracts accounting for 50% of total revenue are expected to be rebid in the next three years. The Group’s rebid win rate has been in excess of 90% over the last two years. While these sensitivities will change in line with Group’s order book and contract performance going forward, including the impact of new contract wins and losses, the ability for the Group to absorb sensitivities of this scale within its existing financing arrangements drove the assumptions below which the Directors felt appropriate to disclose in making this viability statement.

It is unlikely, but not impossible, that the crystallisation of a single risk would test the future viability of the Group; however, unsurprisingly, and as with many companies, it is possible to construct scenarios where either multiple occurrences of the same risk, or single occurrences of different significant risks, could put pressure on the Group’s ability to meet its financial covenants.

At this point, the Group would look to address the issue by exploring a range of options including, amongst others, a temporary or permanent renegotiation of the financial covenants, disposals of parts of the Group’s operations to reduce net debt and/or raising additional capital in the form of equity, subordinated debt or other such instruments.

Subject to these risks and on the basis of the analysis undertaken, the Directors have a reasonable expectation that the Group will be able to continue in operation and meet its liabilities as they fall due over the three-year period of their assessment. In doing so, it is recognised that such future assessments are subject to a level of uncertainty that increases further out in time and, therefore, future outcomes cannot be guaranteed or predicted with certainty. The Directors have made the following key assumptions in connection with this assessment:

• there is no significant unexpected contract attrition of existing work that becomes due for extension or rebid over the next three years;
• there is no significant reduction in scale of existing contract operations as a result of customer policy or other changes;
• there is no significant deterioration in new bid and rebid win rates from those anticipated;
• the Group is able to complete the execution of its strategy, including further transformation in 2019, and making progress to revenue growth and further margin improvement from 2019 onwards; and
• the Group is not subject to any significant penalties or direct and indirect costs and/or debarment from bidding for new contracts from the current SFO investigation, nor does the investigation adversely impact on existing contracts.