Serco Group Plc (OTCPK:SECCF) Q2 2022 Earnings Conference Call August 4, 2022 5:00 AM ET
Company Participants
Rupert Soames – Group CEO & Executive Director
Nigel Crossley – Group CFO & Director
Tom Watson – SVP, Defense Services Business Group
Mark Irwin – CEO, Serco UK & Europe
Conference Call Participants
Joe Brent – Liberum Capital Limited
Christopher Bamberry – Peel Hunt
Arthur Truslove – Citigroup
Oscar Mas – JPMorgan Chase & Co.
Paul Sullivan – Barclays Bank
Rupert Soames
Good morning. Good morning, everybody, and welcome to Serco’s Interim Results for the First Half of 2022. Let me do some introductions first. At the back is my Chairman, John Rishton, who — which is why I’m wearing a tie of course and actually. But on the top table here, we have Mark Irwin, who runs our UK&E business, joined Serco in 2013 and very successfully ran our Asia Pacific business before coming to the U.K. in 2020 and has since been running our largest business, which is the UK&E. And rather like John the Baptist, he came before me and has been a valued colleague ever since.
Tom Watson joined the company in 2018 and is CEO. We’re not quite sure whether it’s elect or designate or in waiting. But whatever, he’s taken over from Dave Dacquino, CEO of our highly successful North American business in September. So we’ve dragged him over here before he actually takes on executive responsibility and feel the full weight of that. And then, of course, Nigel, who you all know.
So I stand here in some trepidation because, of course, at our last results presentation, I couldn’t understand why in the full year results people were urgently looking at their iPads and iPhones and there was lots of scurrying going around. And it was in course I was presenting as Russia invaded Ukraine. For the interims, we’re hoping that the Taiwanese are not too nervous of current events.
But anyway, we live in difficult times, but the Serco has had a cracking good — a crackerjack of a first half, much better than we expected at the beginning of the year. This was to be the year when we were going to get the grayed slowdown after all the Test & Trace revenues. In fact, the rest of our business has performed amazingly well. And we’ve had in revenues, ex Test & Trace, we’ve had 12% growth in our revenues. And on UTP, we lost £25 million of UTP by a combination of Test & Trace and also AWE ending at the — in last June. And we’ve made that all back and more from the rest of the business.
75% of our UTP now comes from outside the U.K. And it’s not that we don’t love the U.K., but it just underlines how very broad our portfolio of countries is and how well that has played. This is the B2G platform, whether it’s diversification, its breadth and its agility, learn — actually, working in action and enabling us to go. And I mean, I remember when we announced that we were exiting AWE, people sort of thought it was at the end of the world, we’ll never make it up. Well, actually we have. And we’ve made it up through a whole — it’s not just 1 sector. It’s our Defense business has been very strong in North America. Also, our Citizen Services business and Case Management business in North America has been strong. Our Immigration business has been strong in Australia and in the U.K.
That would be a good idea. But I think — yes, thank you so much for reminding me because otherwise, we might have missed the disclaimer. That would be a terrible thing. Thank you for reminding that. I thought I was going to have to hit you.
Cash also has been incredibly strong with a conversion of over 100%. We’re now down to 0.5x leverage. We did actually do a small acquisition in the first half with Sapienza, but it’s very small, but we’ve got a decent pipeline. The order book, up £0.5 billion, which is not entirely shabby. Strong order intake despite it being a very slow period of time for rebids and extensions. And the — if you’ll remember from our Capital Markets Day, if you did the sums, you would have worked out that if we met our targets, we would get 15% dividend growth over the 5-year period. You will see this is 18%, and that’s the beneficial effect to the share buyback reducing the number of shares.
So we’re getting a dividend per share that is growing faster than our actual dividend payouts. And in terms of the guidance, we’ve given it a slight nudge off. It’s partly technical, which is FX and partly because we had — continues to have strong trading after the last update at the end of May.
We go — trying to get the slide present up. Maybe it’s because I’m pressing the wrong thing. There we go. Can you put that in the presentation though, please? So if you look — stand back and look at my favorite slide, which is the long-term growth of the business since 2017. We showed this at the Capital Markets Day. And what’s that basically saying is that even if we have UTP, that’s broadly speaking at the same level as last year in 2022, it will still represent a revenue CAGR of 8% from 2017 and a UTP CAGR of 27%.
Return on capital has dropped slightly because of the acquisition of WBB, but still is a very healthy 21%. And if you look at our cash conversion, it says there that we — it’s now consistently over 80%. That was the target that we put out at the Capital Markets Day. In fact, over the last 3 years, it will have averaged about 110%. And that is cash conversion without any funnies in this.
And on that happy note, I’m going to hand over to Nigel, who will talk you through the numbers and remember to advance the slides. Thank you.
Nigel Crossley
Thank you, Rupert, and good morning to everybody. So I’m going to start with the financial summary of the group’s performance and underline what Rupert just said, it has been a very strong set of results for the first half of the year. Overall, the group’s revenue has grown by 1% in the period. We’ve had higher activity on a number of contracts across our portfolio. And that’s partially offset the big negative drag that we’ve had of 10% from the ramp down of the U.K. Test & Trace contracts in quarter 1.
And in addition, we’ve had foreign exchange added about 2% and WBB acquisition added a further 2% to revenue. Underlying trading profit was £130 million, which is an increase of 6% on 2021 with a margin of 5.9%. And we expect to see higher margins in the first half of the year because of the timing of the volume work on contracts like CMS, the Obama Care eligibility contract. And this, combined with the U.K. COVID work in quarter 1, recovery from contracts that have previously been adversely impacted by COVID and higher volumes that are expected from on both Immigration and CMS have provided a hump to our profit margin and taking it to the top of our medium-term range of 5% to 6%.
And underlying EPS is 7.7p. It’s a 14% increase on last year due to the strong trading profit performance, combined with slightly lower finance and tax costs and the ongoing benefit of the share buyback program. And free cash flow of £96 million results in a cash conversion of 101%. The strong cash flow contributes to the group’s leverage of 0.5x EBITDA at the half year. And this includes the cash outflow for the first £25 million of our £90 million share buyback program.
As Mark and Tom are here today, I’ll let them take us through the results for the UK&E — for U.K. and Europe and for the North America divisions. But the headline results in UK&E are strong, even though revenue was down 5%, this is after £220 million of lower Test & Trace revenue in the period, which has been largely offset by stronger performance across the rest of the U.K. business.
And the Americas revenue profit are both up significantly in the period from strong base business performance across the portfolio. The WBB acquisition has added further as well as some currency help, but Tom will provide more color on this when he gets up and speaks in a few minutes.
So moving on to Asia Pacific in a little bit more detail, who have delivered an exceptional profit performance in the first half of the year. Organic revenue growth was 3% due to higher volumes in the immigration services contract and in Citizen Services, where we’ve benefited from our agility to react at short notice through the changing needs of the customer. And in our health sector, we have seen lower revenue due to the reduction in scope in Fiona Stanley last year, albeit this has had a relatively small profit impact.
The underlying trading profit margin for the period has increased by 1.2 percentage points to 6.7% due to the increased volumes and mix of services and immigration and good margins on the shorter-term Citizen Services work. And order intake in the period was relatively light following the unsuccessful bids on Frankston Hospital and the vehicle licensing in Victoria. As those opportunities have dropped out, the pipeline for new business reduced in the period to just over £1 billion. But a particular focus for the region currently is the next generation of the immigration services contract, which will be rebid before the current contract comes to an end in December ’23.
The Middle East division’s results continue to reflect the impact of the Dubai Metro contract that ended in September 2021, which is a significantly greater impact on revenue than on profit due to its lower-than-average margins. Despite the lower revenues, profit increased 17%, and the profit margin almost doubled to 9.4%. The successful exit of the Dubai Metro has been accretive to margin, supported by further recovery in activity levels in airport services contracts as international travel continues to improve post-COVID. And going forward, we would expect to see the Middle East will operate at margins higher than what we’ve seen in recent years.
In terms of order intake, we have successfully rebid the Dubai Airport navigation services contract and we were successful winning a new contract for Facilities Management Services for the Riyadh International Airport. And we’ve also been pleased with some early progress on some smaller but higher-margin wins for asset management consulting services, particularly in the Kingdom of Saudi Arabia. And the pipeline, the Middle East continues to be healthy across all sectors, including opportunities for further consulting work, fire and rescue services and airport services.
So turning to cash. Free cash flow continued to be strong in the period and trading cash conversion was just over 100%, supported by flat working capital. Adjusted net debt of £164 million was reduced by £14 million since the year-end. And this is due to the strong free cash flow, offset by £25 million of share buyback, a £90 million final dividend in respect to ’21 and the negative foreign exchange impact from converting U.S.-denominated debt into sterling. And we’ve not used any financing facilities or efforts out of the ordinary to reduce the period end net debt. And in fact, our average daily net debt in the first half was only £35 million higher than our period-end net debt.
Leverage of 0.5x EBITDA remains below our 1x to 2x medium-term target, which provide a significant — which provides significant investment capacity. And this takes us on to capital allocation. Where the strong balance sheet enables us to fund all 4 rows of our capital allocation framework as we set out at the Capital Markets Day in December. Our first priority will always be to invest in the business to generate organic growth as this typically brings the highest return on invested capital. This has continued in the first half as we’ve invested in business development to support a healthy pipeline of £8 billion. We’ve had investments in IT, including the continued rollout of time to work and building enhanced capability and tools for asset management. We have also restarted our residential Oxford leadership and contract manager courses, including, for the first time, we’ve run a course specifically designed for women in leadership.
And second, on dividends, we’ve announced today our interim dividend for 2022 of 0.94p per share, which is an 18% increase on last year and follows the 15% increase that we had last year. And we remain on track to reduce our dividend cover towards 3x over the medium term.
And our third priority is to fund acquisitions. And in July, we completed a small bolt-on acquisition in Europe called Sapienza, which complements our European space business. And during the first half, we have continued with our disciplined approach of reviewing a broad range of acquisition targets and opportunities, knowing that we have the balance sheet strength available when the right opportunity comes along at the right price. And our final priority is to return surplus cash to shareholders, and we’re well progressed the share buyback program announced in February with £25 million of the £90 million completed by the end of June. We plan that the remainder of shares will be purchased during the calendar year. And as we present at the Capital Markets Day, the Board will continue to keep the strength of the balance sheet under review.
So finally, turning to guidance for 2022. And today, we’ve announced a small uplift to profit guidance compared to the May trading statement. This is partly due to foreign exchange benefit as sterling has weakened further as well as stronger volumes we’ve seen across the business in the second quarter. Our view of revenue and profit for the second half were unchanged since the May trading statement, which will be broadly flat to last year and a period when there will be no Test & Trace volumes compared to the £260 million of revenue in the second half of last year.
In the second half, we do expect profit and margins to be lower than the first half as the U.K. Test & Traces ended, volumes on the CMS contract are weighted to the first half, aspect immigration volumes will likely reduce and will fund the one-off payment to frontline workers. These reductions will be offset in the second half by the ramp-up — sorry, partially offset in the second half by the ramp-up of new contracts, including DWP restart, the defense infrastructure organization contract and recent wins in North America defense.
Both net finance costs and the effective tax rate are expected to be slightly better in the year. Net finance costs benefited from lower borrowings and pension costs, which will more than offset the higher interest rates. And on tax, the release of a tax provision will throw into a lower full year rate. This is a one-off. And the effective tax rate in future is still expected to be around 25%.
Our free cash flow guidance has improved by £20 million to £140 million as some of the strong first half performance benefits the full year. Net debt reduced accordingly, albeit with some negative foreign exchange impact from the stronger U.S. dollar. And leverage at the end of the year is forecast to be below 1x EBITDA unless there are significant M&A opportunities in the second half.
So on that point, I will now hand over to Tom.
Tom Watson
Thank you, Nigel, and good morning, everyone. To begin with, I want to tell you how excited and honored I am to be assuming the role as CEO of the division from Dave Dacquino. Dave has been a fantastic leader and has done an outstanding job leading our division — our business for over 5 years. I’ve been working side-by-side with Dave for 4 years in my current role as Head of U.S. Defense And have been directly involved in many of the key aspects of the division such as developing the strategy, integrating our acquisitions and growing the pipeline. These are big shoes to fill, but I’m highly confident we have a successful and orderly transition, and I will look forward to leading the incredible team and continuing us on a path of sustained growth.
The American Division reported strong revenue. Let me make sure I got the slide. Here we go. The American Division reported strong revenue growth of 18% in the period, driven by the acquisitions of WBB and a strong dollar. Organic revenue was 3%.
Our Citizen Service segment saw the strongest revenue growth in the region, benefiting from higher case management volumes on CMS and post-COVID recovery activities on the Ontario driving examination contract. Defense includes revenues from WBB acquisition. Excluding which, there was a small organic decline due to reduced volumes on 1 large but low-margin ship integration contract.
Underlying trading profit was £76 million to increase the profit margin by 140 basis points in the year to 12.2%. The CMS contract continued to be a good driver of margins, benefiting from both higher revenues and further operational efficiencies.
Order intake was very strong with a book-to-bill of 138%. Now a particular note is that around 60% of the wins came from new business. Our most significant new business awards so far this year was a 280 million ship, Navy ship acquisition program management contract, which is now mobilizing following the successful resolution of a protest. We also received a new and very exciting 60 million award — £60 million, excuse me, award to provide ship design and build services as part of the no manning required ship program, which we call NOMARS. In addition, since the period end, we have been notified that we were successful in the rebid of our U.S. Navy SEA21 contract. The new contract is expected to be worth around $340 million over 5 years, which will help reduce risk to our 2023 [Technical Difficulty] is operating across the U.S. and in many countries abroad who cover the delivery spectrum from analysts and engineers to technicians and welders. All of our work on the government side and mission aligned and provides a full life cycle offering that includes upfront acquisition program management through engineering, modernization and sustainment. Our defense portfolio has experienced around a 9% organic growth CAGR over the last 5 years with total growth of around 26% when accounting for acquisitions.
Now we have completed 3 acquisitions in the past 4 years, BTP systems, which added SATCOM & RADAR engineering sustainment capabilities; Alion Naval Systems, which doubled our Navy business while key naval architecture and engineering capabilities; and WBB last year, which doubled our business in both the Army and the Air Force while giving us new customers such as the Office of Secretary Defense and the Missile Defense Agency while significantly adding to our technical capabilities.
Defense domain is to sustain moderate growth across the portfolio. In particular, for the Navy, the largest of our customers, we will continue to invest and steadily growing this business organically. We will do this by taking advantage of the scale and full life cycle capabilities that heavily leverage our investments in BTP and the NSBU we acquired while continuing the current momentum of key takeaway wins. We also plan to further diversify our portfolio into other services, namely the Air Force and Army, Space Force and other DoD agencies in commands. Our desire is to double both our Army and our Air Force business in the next 5 years, which will leverage adjacencies from our Navy market and the investments from WBB.
Finally, we plan to further develop our end-to-end life-cycle capability offering by expanding our technical capabilities in key growth areas such as cyber and autonomous unmanned systems, which our recent NOMARS win is a really great example of. We will further leverage these capabilities into other regions to support growth in our other divisions. Now 2 good examples of these are our International Maritime campaign, which is bringing U.S. capabilities to other markets; and our space campaign, which is actually bringing U.K. capabilities to the U.S. So we are very excited about the future of our U.S. Defense portfolio and with sustained growth in the budget, Serco is well positioned to maintain strong momentum in this market over the long term.
I’ll now turn this over to my U.K. colleague, Mark Irwin. Thank you.
Mark Irwin
Tom, thank you, and good morning to everyone. In the absence of our slides being up on the screen, could I please direct your attention to Page 20 in our booklet. We’re back. We’ll see if we can get this working.
For the U.K. and Europe business, at a headline level, revenues for the division declined 5% compared to the same period in 2021 due to the end of the U.K. Test & Trace work that reduced revenues, as you heard from Nigel, by £220 million or 20% at the level of the division.
Excluding the impact of the COVID support contracts, revenue is, however, up more than £170 million year-on-year, benefiting from the ramp-up of restart an employment services contract for the Department for Work and Pensions and higher demand in our Immigration Services business in the U.K. Our U.K. Immigration Services contract for accommodation and support services for asylum seekers is now the largest contract by revenue for the group.
Underlying trading profit of £38 million was down £18 million versus the prior year. Positively, Immigration Services volumes, the commencement of the DWP restart program and the operationalization of our joint venture, VIVO, helped to reduce what otherwise would have been a £25 million trading profit headwind. The margin of 3.8% was down 160 basis points, with the end of AWE of note where the reduction in profit is not associated with the reduction in Serco reported revenue due to the structure of the joint venture. Margins in the period were also impacted by the immigration contract seeing higher utilities cost during the period. The indexation for this contract in the period were also impacted by the immigration contract seeing higher utilities cost during the period. The indexation for this contract takes effect in the second half of 2022, and we’ve now also hedged utilities through to early 2024.
You may recall that VIVO has been awarded 3 significant contracts by the U.K. defense infrastructure organization. Service to the DIO built estate commenced in February, service for defense housing went live in April, and service for the U.S. visiting forces support will commence towards the end of the year.
Our U.K. defense business has historically provided operations and technical services as well as asset management support in the air, space and maritime domains. Through VIVO, we now have taken a meaningful position in the land domain as well. At maturity, we expect that VIVO will generate revenues in excess of £400 million annually at the joint venture level.
We’ve also made progress in the development of our European business, where we’ve diversified our defense portfolio from the management of defense spaces into the maritime domain through the acquisition of Clemaco in July 2021. Last month marked the first anniversary of our ownership of this business. The business is now fully integrated into our European operations, is identified as Serco Belgium Marine and is providing in-service technical and maintenance support for the Belgian and Dutch mine hunter class of ships.
You may recall also from our Capital Markets Day presentation in December, we highlighted the work we do for the European Space Agency and other national agencies in the civil space sector. Through the acquisition of Sapienza, which we closed last month, we welcomed 160 new colleagues who support 50 space missions for 30 clients across 5 European countries and also extends to the U.K.
More broadly, our order intake in the period was robust at around £1 billion, including the successful bid for HMP Fosse Way, the group’s largest contract win in the first half. Leveraging our B2G platform has also seen us more recently in the second half announced as the preferred bidder for the Home Office to provide manned freight search capability at 3 border crossing locations in France. Our U.K. Justice and Immigration team developed and will support the implementation of the technical solution, but the services will ultimately be delivered by Serco France. We see this as an important first step into the immigration and border protection sector for our European business.
In terms of other key bids and rebids in particular, the outcome for FPMS will be known in the fourth quarter of this year, while the Skynet outcome has now been delayed into the first quarter of 2023. Overall, the pipeline for the division remained strong, exceeding £3 billion at the half year.
And just before I conclude, I wanted to acknowledge the 24,000 members of my team who continue to show unwavering commitment to our purpose and values. On our side, we are working hard every day to assure their safety and well-being, to enable an environment that is underpinned by equity and inclusion and where the success of our business translates into personal development and economic and career opportunities for all of our people.
Thank you for your attention, and I’ll now hand back to Rupert.
Rupert Soames
Well, thank you, Mark. Are we back online again, do we think? Webcast back up? Good. Apologies for those of you on the webcast who had — we lost a part momentarily, but we’re back again.
Okay. So usual slide, highlights and lowlights. Well, clearly, it’s been a bit of a crackerjack of the first half as we’ve done the performance has been strong UTP, cash order book, 12% revenue growth ex Test & Trace. Very pleased with all that. I’m also delighted to see that all 4 elements of our capital allocation model are creating value, investing in the business, increasing dividends, a bit of M&A and returning excess cash to shareholders.
Within strong new business wins, I can’t emphasize too much that the 94% book-to-bill would have been — if we had a normal level of rebids and extensions, that would have been way over 100%. But they come, and they go in terms of the timing of them. And we had strong new business. And I particularly want to just point out what the shape and the NOMARS bids. I mean these are really, really core contracts right at the top of — in the center of the U.S. Navy’s business. The shaping we are helping the U.S. Navy with the project management procurement of the submarines, and on NOMARS, it’s also, I think, our first contract that we’ve had with DARPA, which is the defense projects research — advanced projects research agency, which is a real plus up for us. And there’s no way we would have got these contracts without the acquisition of the Alion business now METS and also with the help of WBB in our portfolio.
And the second half win of SEA21, this was a very large core METS contract that was awarded to a competitor. We protested. It’s been a long and bloody fight, but actually we won. And our protest was upheld, and we’ve now been awarded that contract that will be a valuable bedrock to our business in the U.S. over the next 5 years.
Pipeline is very healthy. It does — you know it goes up. And now it’s up 40% year-on-year. But it’s down on the first half. Because it’s so narrowly defined, which is only new business, and because Actually, we’ve signed a lot of new business, it’s gone down a bit. We’ve had some bid losses, bid roads in Australia, Frankston, which was a hospital. And we’ve also withdrawn from the fleet solid support competition having completed the first 2 phases of it. So all that has served to reduce pipeline. But at £8.1 billion, frankly, it’s still very helpful — very strong.
So Mark paid tribute to the 24,000 people he’s responsible for across the business. We’ve had strong operational delivery despite really difficult conditions in many of our contracts in terms of the labor markets and waves of COVID and like. It’s been difficult.
I also want to draw attention to the progress we’ve been making on diversity and inclusion and how important this is to us. I actually think back to 2017 and see the number there that there was 17% — only 17% of our senior management team of 330 people where women. We’re now 33% and rising. I should think we’ll be 34%, 35% really quite quickly. So that is getting — we have taken swift action to try and get that more balanced, and it’s working really well for our business. Likewise, disability and people with declared health conditions, the number has doubled within the business. We’re now at 5%. And also the gender pay gap has reduced from 13% to 7%, all of which is important.
In terms of pay, our pay has increased fast — way faster than we budgeted. But we’ve also introduced a one-off payment of £9 million going to 30,000 or 40,000 people. It’s an average of about £200 each, which is not a pay increase. This is above pay increases. This is just to say we recognize everyone is working: a, very hard; and b, actually, everybody is going to face a tough September and October. So we have — we’re putting a bit of money into people’s pockets, particularly the low pay, as we go into the autumn because frankly, we can afford it. We think it’s the right thing to do.
In terms of the lowlights, if you read my meanderings and musings in the annual report, this — the word concatenation is not often used with black swans, but we sure had it. And if you think of the Russian invasion of Ukraine 2 years ago, almost exactly within 2 weeks or 2 years later — I’m sorry, we think COVID, almost 2 years later to the day, not quite to the Russia invasion of Ukraine, these are 2 black swans nobody foresaw. But what is shown is the resilience and agility of our business.
It continues to be hard to recruit and retain staff, but I sense that’s getting a bit easier. I sense that people are seeing that particularly when their energy bills and inflation starts to hit more people coming back into the labor market and people a bit less willing to jump jobs. Repeated COVID waves has been a real nightmare. And you all know this from your workplaces where people are still catching it and it’s been going in waves. That’s made difficult.
Inflation. We’re well protected from a contractual point of view, but it does make life more complicated. And particularly, dare I say, this sort of inflation where 6 months ago, we were at 2%. Now we’re at 9%, and we’re forecast to be back at 2% at the end of ’23. I mean how do people plan their lives and resource. And on energy and stuff, when do you fix prices going forward? It makes — brings complexity into the business.
UTP is going to be lower in the second half than first. It nearly always is. And a lot of that is driven by the CMS contract in the U.S. where we get the open enrollment in the first part of the year. Clearly, we had a little — some benefit of Test & Trace in the first half in Q1. That’s now completely gone. We got higher labor costs. And we think that we’re going to have lower volumes probably in Australian immigration.
Other lowlights, the rapid increase in the number of people we’re looking after on the asylum seeking contracts in the U.K., we’re coping. But it is difficult to find people. There are still — and we weren’t responsible for the Afghan program. I still think there are 7,000 Afghan people still in the hotels. There’s large numbers of people — It’s hard to find additional accommodation because lots of people are still arriving. And in Acacia Prison in Australia, we had a disturbance, a large disturbance or a small riot. But it has caused damage to a part of the infrastructure there, and that has reduced our capacity, what is the now the largest prison in Australia shortly, followed by Clarence, which is running. So those were some of the lowlights. But basically, the business performed, we think, really, really well and better than we expected in the first half.
Just reflecting a bit on the Capital Markets Day that we gave last December. Our management framework, the Business-to-Government platform that we have and the advantages that this brings us one. And all these were on show in the first half. The agility, the ability to go after business to switch sectors and to switch countries. I mean if you’ve taken any one of our businesses and said you were just in a single jurisdiction. It would be a very different business with a very different risk exposure. The breadth of what we are able to offer from leisure centers to defense to and frontline work on defense, but also the design and development of advanced ships. The reach that we have in terms of our global footprint, way different from our competitors, driving efficiency that enable that we get from volume, but also making the business very resilient.
And this ability to — of breadth and reach and agility is summed up in the words that you see happening in the first half called follow the money. And when the Test & Trace falls away, we’ve got other parts of our business clients to help us make money and deliver value for governments and for our shareholders and employees.
The key messages you’ll remember from the Capital Markets Day that our markets are large, diverse and liquid private expertise is going to be valued. And I think in a world in which governments are ever more pressed for cash there, all the 4 forces that we talked about, they are larger than ever were in terms of government debt. The government are going to be keenly interested in using the private sector to deliver value for money outputs. The fact that we’ve had a consistent track record of delivery, that we have a strong and differentiated and defensible position that’s very hard to imitate, competitors can’t just stand up. And it’s taken us 25 years to build a business with the international footprint that we have.
And the powerful and scalable Business-to-Government platform, the fact that we’ve still got a lot more work to do, this business is far from performing as well as it could. There’s more that we can do. And that over the last few years, we’ve developed relationships of being a trusted and a valued partner of governments.
So at the CMD, we said that we expected our revenues to grow at 4% to 6%, which was a market growing 2% to 3%. Now when inflation comes in at 9%, that obviously gave them changes that calculus a bit. And one of the things we’ve said in the — on the RSA, we don’t expect our revenues to grow twice as fast as government revenues. If government revenues are growing at — sorry, government is growing at 5% or 6% because we won’t grow at 10%, obviously. But we will grow faster than the market. we expect our profits to grow faster. But actually, we’ve got to the margins are at the top end of where we thought they were anyway. So I think we just have to take a long-term view.
We’re not chasing margins in this business. What we are chasing though is a cash conversion. And as I said, we’ve achieved over 100% over the last 3 years. And we are showing that our returns to shareholders can grow faster than profits.
And on that happy note, thank you for your attention. Apologies for the power outage in the middle of the webcast, but we’ll now go over to Q&A, and we’ll start in the room, and then we’ll go over to the webcast. So I’m going to step down and we will take the first question.
Question-and-Answer Session
A – Rupert Soames
Who wants to go first? Mr. Joe Brent. Joe? There’s a microphone coming your way. No, no, Joe in the front here, please. We’ll come to Arthur in a moment.
Joe Brent
Three questions, if I may. Firstly, on your Concatenation, I’m not going to say it black swans. You have those as a lowlight. COVID, you made money. And arguably, Ukraine has been positive for your defense business. So hard to manage, but actually profitable arguably. So interested in your thoughts on that.
Secondly, for the year, I think consensus has pointed about 8% organic growth. But in your thoughts as to how much of that is volume and how much is price in the light of what you’re saying about inflation. And then thirdly, just interested in why you withdrew from fleet solid state support?
Rupert Soames
Right. So I’m going to ask Mark to answer about fleet solid support. In terms of black swans, well, I mean, it depends on the type of black swan. I mean they’ve not been good for the world. They have disrupted. The fact that through our agility, we were able to get on the back of Test & Trace, and I don’t think it’s a general case. The black swans are good for our business. And certainly, we’ve not had a lift from Ukraine from our Defense business. If anything, we are getting a lift in the Defense business more from the focus of the North American Navy in responding to Chinese aggression in Taiwan, and that is driving that. But I don’t think that this is a — If you go to my former business at Aggreko, we loved a swan but not so much in Serco. You want to talk to about the volume and price?
Mark Irwin
Yes. So when we — just to remind everybody, when we look at our business, we think we’ve got good inflation protection. About half our contracts are — have got indexation in them. About 1/3 very short-term contracts are cost plus. And that’s about the 10%, 15% where we’ve got other kinds of protection backing us up against supply chains and other activities.
To actually really pin down what is the inflation impact of that, it’s quite difficult. It’s easy to pick up the indexation. The other bits are much more difficult to measure. So the bet I’m much more focused on is, am I seeing my revenue and my cost going out of kilter. And as we’ve gone through the first half, we haven’t seen that. We haven’t seen a dilution or an improvement in margins because of inflation.
And when we look at our forecast in the second half, there is an ever be a little bit of revenue upside from that from inflation. But we’re not seeing a divergence between our costs and our revenues. So I think the piece I take comfort for is that protection that we thought we had in our contracts is actually working and is working when interest rates are as extreme as they are at the — when inflation rates are as extreme as they are at the moment.
Rupert Soames
But I think it’s fair to say, and correctly, if it’s not, I know you will, the — but most of the 8% will be volume because it’s volume in CMS and its volume in immigration. That would be right. Mark, FSS?
Mark Irwin
Certainly, Rupert. So I think it’s important to note that the fleet solid support program had 2 parts. There was a design phase and in the manufacturing phase. We participated successfully in the design phase through our partnership with Damen with sound parent design and using our colleagues in Serco Canada Marine to advance that design. So we believe we had a robust technical solution for that.
In terms of the manufacturing phase, which is the phase that we have withdrawn from, the government’s requirement is that all 3 ships in the class be assembled in the U.K. That would require us relying on infrastructure that we believe is not yet ready to be able to do this and, therefore, translates to risk that we could not effectively manage. The optionality to build part of the fleet offshore is something that we could do. But to go to a whole of class effectively from an entry-level position in yards that may not yet be capable was risk that we felt was not appropriate for us or potentially even for the MoD. We do though — we do though have very strong interest to support the national shipbuilding strategy. We continue to work with our partners and look at what we can do for further programs as that capability develops in the U.K.
Rupert Soames
Chris?
Christopher Bamberry
Chris Bamberry from Peel Hunt. Could you give us a sense of the breadth and depth of the M&A pipeline just now in the pricing? And secondly, the field bids, Victoria Roads and Frankston, have you had any feedback on those yet?
Rupert Soames
Yes. If I take the — what was the first part of your question?
Christopher Bamberry
Just a sense of the breadth and depth of the M&A pipeline and pricing you’re seeing.
Rupert Soames
Oh, you right M&A, there’s a fair view. There’s a pipeline that our M&A team have put down in sporting life and are actually getting up from behind the odd thing around. But as you know, we kissed many frogs and we grow. But I think maybe what there’s a hope that in the current environment, there may be some companies out there that are near our expectations in terms of what we pay. But I think it’s — we’re okay on that. VicRoads was a huge bid for a 40-year franchise for to run vehicle licensing in for New South Wales. We have a really good run at it. But on these 40-year franchise deals, we were not involved in the financing or the equity raising. We had a partner. We were a subcontractor to a group called Plenary. And our consortium was comprehensively outbid by Macquarie. We’re not entirely — I’m hopeful that something may come of it some time. And Frankston Prison — again, Frankston Hospital was a PPP, and it wasn’t huge. We lost that. We always — if you don’t — if you’re not losing stuff, you’re not trying.
And I would say that just as with FSS, we swung the bat at it. It was — it’s one thing building on icebreaker for the Australian Government and other building 3 best-in-class in finding a shipyard in we had a really good design. And the interesting thing was how closely on maritime. People worked across them. We have a very good relationship with the MoD. And they, I think, appreciated us bringing an alternative design. But at the end of the day, we are not ourselves shipbuilders and so we needed to find a partner — All right? Okay.
So Arthur, do you want the…
Arthur Truslove
Arthur from Citi. Three for me, if I may. So firstly, [indiscernible] in the Americas business, which obviously is higher than average. Are you expecting this to result in a meaningful acceleration in organic growth? And can you give us an idea of roughly how much?
Second question. For the group as a whole, you had £2 billion of order intake, which 70% was new business. So that comes to sort of £1.4 billion. And I just wondered if you could tell us how both the 70% new business figure and the £1.4 billion of new business won compares with normal.
And then third one, U.S. defense, obviously, the pipeline is up from 2.2 billion to 3.1 billion in the U.S. business. Would you say at this arises from sort of robust increases to U.S. defense spending in FY ’22? Or is it more a reflection of what might come in FY ’23?
Rupert Soames
So I’m going to ask Tom to answer the third question about defense budgets. But just be warned, after he goes to bed at night reading the defense estimates and it’s his joy and pleasure. I read diesel manuals. He reads defense estimates. So if I can take the 1 point for — I’ll take the 2, the book-to-bill and the 70%. Look, it is on the whole good news that we have our highest book-to-bill in our division that has the highest margins. Building out scale in the U.S., we’ve invested a lot of money in acquiring businesses in the U.S. So that’s good. But it evens out. I mean the Australian book-to-bill was way lower. And that’s coming back to this point of having a footprint. And most of that, though, remember that the thing about these book-to-bills is that to the extent that they are on contracts like SEA21 that last for 5 years, it’s actually reflecting long lifetimes on contracts rather than you in order to look at the annual contract value and not just the total contract value.
As far as the 70% being new business and less, yes, we did have a slightly above-average conversion win rate on the new business despite the rates and stuff like that. We had a higher than we would normally have. But we spent between 20% and 30%. I think we’re just fractionally above that. But it’s just timing on the flows because the pipeline that we publish is only new business, we don’t include rebids with — it’s a pretty narrow definition. So I think that one will just be in the west and we were not — and I’m pleased with it, but I’m not rapturous. Tom, do you want to just talk about what’s happened in the U.S. defense estimates if you’ve had a moment to think about it.
Tom Watson
Absolutely. So first of all, it’s — your first question, though, is related to the size of our pipeline, and is that more reflective of the size of the budget. And reality is it’s more reflective of our investments in the portfolio. So if you think about the strategic investments we made, particularly in the Alion Naval Systems business and in WBB, that, together with our existing business, when we put all that together, we do these things called synergy bids, right, where we’re taking adjacencies and capabilities from these businesses and as we put them together and integrate them, and that’s driving significant growth in our pipeline. So we’re able to go after bids that we were not able to go after before, and we’re having some success in that. And so that’s the result of kind of a multiyear strategy coming together. So super excited about that.
As far as the defense budget is concerned, I mean, the — we were surprised by a 22 increase. But as Rupert alluded to that, that is very much a result of China aggression and the war in Ukraine because we were actually expecting to see more domestic spending increases versus defense spending. So we would have expected more in the federal civilian side of the business. So as far as ’23 is what we’re seeing from a ’23 budgeting perspective, it’s hard to say. But they’re guiding toward between 5% and 10% growth in defense, which in any case, even if it’s flat, it’s still a very large number. But that would be beneficial to our pipeline of more opportunities, specifically within the Navy.
Rupert Soames
Okay. Oscar?
Oscar Mas
It’s Oscar from JPMorgan. I have three questions. The first one maybe for Nigel. It’s going back to wage inflation and indexation. You talked about most of the revenue growth being volume in H1. Can you just explain when indexation tends to kick in, in contracts and if there’s any benefit in the second half? Then the second question is on the U.K. immigration work. It’s been quite strong in the first half and also guided to in the second half. Can you just explain when you expect that to fall back down to normal levels and what’s really driving that growth?
And then the third one, again is in the U.K. You’ve talked about some wins with that are Brexit related. Are we starting to see some kind of declogging of the U.K. and the procurement pipeline? Are there more opportunities in the U.K.?
Rupert Soames
I’ll ask Mark to take those 2. But Nigel, why don’t you start on the inflation.
Nigel Crossley
So we do end up some time in the divergence between indexation is generally applied on the anniversary date of the contract. And we chop over a lot of people and their annual pay rise tends to be in a different data. So we do have — we can have differences. Some contracts we win, and on some contracts we lose. So our biggest contract in Australia, the indexation was applied at the end of quarter 1. Our biggest contract in the U.K., which is the both immigration contracts gets their indexation in October.
So we will see — we’ve taken a chunk of inflation costs in immigration in the first half, particularly in utilities, but in wages as well, and we’ll see the benefit of indexation come late. So on that one, there’s a lag before you get the indexation benefit. In Australia, I would say that the salary increase is generally tend to be at the start of the year, and we’ve got that indexation at the start of quarter two.
So Those are just illustrative of how they can run. So I think the message takeaway or some of win or some will lose as we go into inflation. If you win or lose, you’ll get the reverse as you come out of that high inflation period. So as we look at the moment, I don’t think there maybe is a little bit more lag when maybe getting the costs slightly ahead of as getting the index section. But I don’t think it’s a particularly big number that I’m worried about.
Rupert Soames
Mark?
Mark Irwin
In terms of the migration services volume, there were sort of a complex demand equation, but the 2 big drivers, one is arrivals. And the other is the speed at which the Home Office processes and assists the application. So we’ve seen both of those abnormally high. The level of arrivals as you would have read the press and then also the Home Office catching up on processing backlog. And so we are sort of tempering our view on volumes as we go to the end of the year as the Home Office catches up and is able to conduct all of these evaluations and process people. So we think we’ll be roughly where we are now. We have 32,000 service users in care, but we’ll see that potentially softening just a little bit as we go to the end of the year as the processing catches up.
Rupert Soames
And Mark, on Brexit, is the juxtaposed a sign of new stuff to come?
Mark Irwin
We hope so. I think it’s a practical matter that when you put borders in place where you did not have processes, controls, systems, capability, resources then that will require support. And I think that support will be required faster than what the government can mobilize in its own right. Juxtapose is the first opportunity that we’ve seen a decision on we have decisions pending on other control facilities, not just for the Home Office but also for HMRC. And we do see building both administratively and, as I said, in terms of the physical entry points that need to be managed and monitored over the maturity now of Brexit taking root.
Rupert Soames
Okay. Yes.
Paul Sullivan
It’s Paul Sullivan from Barclays. Could you talk about the balance between conservatism and genuine risk when it comes to providing guidance, particularly into next year and particularly around the U.S. given the high margins we saw in the first half and other rebids or potentially high-margin contracts? Could you then talk about the political backdrop in Australia post the change in government? Any change to thinking of that? And then finally, thoughts on the contract backlog in the U.S., particularly relating to WBB, which seems to be holding back growth a little bit there?
Rupert Soames
Do you want to take the — your so-called conservatism?
Nigel Crossley
Yes. Thank you, Paul. We put our forecast together. And we know that when we go into the year that there are some ranges some outcomes on some different contracts and some things work out different from we expect, some of the better and some for the worst. And I think as we’ve gone into this year, on 3 of our biggest contracts, we’ve seen higher volumes than we expected and we saw last year. The two immigration contracts in Australia and the U.K. and the Obama Care.
So I think this year, we’ve had a bit of a pickup. Will that continue next year? I suspect the integration volumes in Australia will drop down. We expect the CMS volumes to drop down as you get more people in employment and less reliant on the state health insurance, U.K. migration, everybody can ask everybody in this room is immigration going to go up or down both people in the system and people have different things.
So actually trying to estimate that is quite difficult. So we look at ranges of where we think our — what the range is and try and pick points that are in the middle or middle to the slightly safe side of that. And that’s where we are with this year’s forecast, and that’s where we are when we look ahead to next year as well. But there have been some probably bigger movements of volume this year than we ordinarily expect. And trying to understand how they continue or how they unwind is what we’ll be doing as we go through the budget process at the end of this quarter.
Rupert Soames
So as far as Australian politics is concerned, I mean, one of the great things about Australia is there’s nearly always an election going on somewhere because you’ve got the state elections and the federal relations. I presume that you’re referring to the federal elections. We haven’t noticed anything different. There is bipartisan support for the immigration work — for doing that. I don’t think that there’s any question that they will wish to continue with operational sovereign borders.
There may be more opportunities like VicRoads where state governments see that they have paid for services that they can then go and monetize and to reduce the — I think that the makeup of the federal part is with the deals as I’m not sure that we see that having begun. But what we do see though is continued emphasis on defense. And the program and we are bidding for a large program based on a U.S. design of a landing craft at the moment for the — in mid bid on that.
So we’re not seeing any major policy shifts. There may be some labor legislation that makes it more difficult. They have taken some people from our call centers back into government service. But on the other hand, they then come back and said, but can you go and do this because there are other areas like passport where they are under pressure. So we’re not seeing any major issues on that.
In terms of the U.S., I’m going to let Tom talk a bit about what’s happening in terms of the dynamics of the volumes, in particular, that we’ve — the low value — the low-margin contracts that we have. As far as WBB is concerned, I mean, we’ve been very clear is that when we close that contract in April, we weren’t expecting a second COVID wave. There is no doubt that, that we’re really pleased with that acquisition. It’s doing very well. It’s not growing as fast as we thought it might because it’s been difficult to get — it was held back in the first but the value that it’s added to our business, and we’re about to do a reorganization of aligning the WBB business more with our verticals. So we’re perfectly active with the way that that’s again. Tom, do you want to talk a bit about the sort of…
Tom Watson
Yes, absolutely. And I’ll just piggyback on what Rupert just said. The value of WBB comes very much in the technology. It’s the technical capabilities that it brings that we’re going to infuse into other parts of the business, so that those adjacencies that we can bring in from those customers and what they’re doing today is quite remarkable. And so we’re really working to integrate that technology better into our overall pipeline.
The dynamics of our backlog, contract backlog — generally speaking, U.S. defense contracts kind of come in 2 flavors. you have your stand-alone multiyear contracts. Multiyear is defined in U.S. terms by about 5 years typically. And then you have your, what we would call, indefinite delivery contracts or framework contracts, as you guys would refer to them.
And we have both flavors. And so there’s a lot of variability mostly in those framework-type contracts from year-to-year. So a little bit of softness that we’re seeing this year is really related to the CANES program, Consolidated Afloat Networks and Enterprise Services. It’s a U.S. Navy IT contract that we are one of the principal providers of. And we’re just seeing lower volume on that contract relative to the Navy’s buying on it. So year-to-year, that ranges that goes up between 50 million, 60 million, 70 million every year and some years, it goes down. So it’s a bit cyclical on that contract, and we’re in one of those downturns on it right now.
Rupert Soames
We understand that contract, it’s mainly — it’s installing servers from Cisco and others on to ship is probably our lowest margin…
Tom Watson
It’s an integration contract where — very little labor, high material volumes. The material doesn’t come with any margin on it. So we buy a lot of material. We build it into the racks. We integrate it and then install it. So a fantastic system, but there’s very little labor and therefore, very little margin on it. So overall, it has not been dilutive to the margin of the business.
Rupert Soames
Cool. Are we done? Anybody online? No. Well, listen, thank you all very much indeed. And very nice to see you all. Thank you for coming. And of course, those that did would have got the whole glorious presentation and not the redacted version. Thank you.
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