1st Mar 2006 07:00
1 March 2006Serco Group plc - 2005 Preliminary ResultsOutstanding year with firm foundations for revenue and margin increases goingforward 2005 2004 Revenue ‚£2,260.3m ‚£1,636.9m up 38.1% Profit before tax and amortisation ‚£91.5m ‚£71.2m up 28.5% Earnings per share before amortisation 14.09p 11.46p up 22.9% Profit before tax ‚£77.9m ‚£64.0m up 21.7% Earnings per share 11.66p 10.11p up 15.3% Dividend per share 2.97p 2.63p up 12.9%Further strong growth * Organic revenue growth of 19.4% and organic PBTA growth of 13.1% * In 2005, contract wins and extensions of ‚£2.6bn secured and appointed preferred bidder on contracts valued at a further ‚£2.4bn * Continued win rates of over 90% of rebids and over 50% of new bids * Acquisitions of ITNET and RCI added ‚£333.9m to revenue and ‚£23.6m to PBTA (‚£10.3m after funding costs) * Group EBITDA to cash conversion of 90% contributing to Group free cash flow of ‚£73.8m (2004: ‚£55.8m) Rapidly developing capabilities and markets * ITNET and RCI have added new skills and capabilities and taken us into new and growing markets * Leveraging Group-wide capabilities to win large and technical contracts - Cyclamen (‚£100m) and Small Business Service (‚£125m) * Increasing range of drivers expanding our markets around the world High visibility of future revenue * Forward order book at a record ‚£13.4bn at 31 December 2005 * 91% of planned revenue for 2006, 77% for 2007, 64% for 2008 * None of our ten largest contracts due for rebid before end of 2010 * Encouraging start to 2006 - appointed preferred bidder for ‚£1.0bn Marine Services rebid Continuing positive outlook * Unprecedented range of market opportunities * In excess of ‚£21bn of opportunities identified across our markets * Selective bidding, portfolio management and efficiency will contribute to increasing margins * Confident of double-digit growth for the foreseeable future Note: Organic growth excludes the impact of acquisitions and disposals, asincluded in the Finance Review.PBTA is profit before tax and intangibleamortisation. Group EBITDA is earnings from subsidiaries before interest, tax,depreciation and intangible amortisation. Cash conversion is the ratio of Groupoperating cash flow to Group EBITDA. Group free cash flow is from subsidiariesand joint venture dividends and is reconciled in Section 4 of the FinanceReview.Commenting on the results, Kevin Beeston, Executive Chairman of Serco, said:"2005 was an outstanding year for Serco. Markets continue to grow, primarilydriven by governments' needs to control spending and improve the quality ofpublic services. Our public service ethos and commitment to partnership enableus to win more than 90% of rebids and 50% of new bids. This success is built ona firm foundation: consistent, high quality service to satisfied customers. Ourbalanced portfolio, spread across our chosen sectors and international markets,allows us to target the best opportunities. The forward order book stands at arecord level and none of our ten highest revenue contracts are due for rebidbefore the end of 2010. We remain confident of continuing double-digit growthand increasing margins." - Ends - For further information please contact Serco Group plc: +44 (0) 1256 745 900Richard Hollins, Head of Investor RelationsGraham Capper, Head of Media and Public RelationsDominic Cheetham, Corporate Communications Directorwww.serco.comPresentation and Conference CallA presentation for investors and analysts will be held at JP Morgan Cazenove,20 Moorgate, London EC2R 6DA, at 9.30am.A conference call for investors and analysts will be held today at 14.30 UKtime.Participants outside the US should call: +44 (20) 7019 0810US participants should call: +1 210 795 0466The passcode for the conference call is `Serco'Copies of the presentation slides will be available from 12.00 UK time fromwww.serco.com.Outstanding year with firm foundations for revenue and margin increases goingforward2005 was an outstanding year for Serco. We grew revenue by 38.1% to ‚£2,260m,with organic growth of 19.4%.Profit before tax and intangible amortisation (PBTA) also increased strongly,by 28.5% to ‚£91.5m, with organic PBTA growth of 13.1%. Earnings per sharebefore intangible amortisation grew 22.9% to 14.09p. After intangibleamortisation, profit before tax grew 21.7% to ‚£77.9m and earnings per shareincreased by 15.3% to 11.66p.The recommended final dividend of 2.06p per share gives a total for the year of2.97p, an increase of 12.9%.Our cash performance remains strong, with Group EBITDA to cash conversion of90% (2004: 93%) contributing to a Group free cash flow of ‚£73.8m for the year(2004: ‚£55.8m).We have continued to retain existing contracts and win new work. We maintainedour win rate at more than 90% on rebids, demonstrating the quality of servicewe deliver to satisfied customers. With the Docklands Light Railway and MarineServices rebids at preferred bidder, none of our ten largest contracts byannual revenue are due for rebid before the end of 2010.As in previous years, in 2005 we won more than 50% of new bids, showing thestrength of our reputation, our ability to be selective in targeting new workand our innovative solutions. In total during 2005, contract wins andextensions were valued at ‚£2.6bn and we were appointed preferred bidder forcontracts totalling ‚£2.4bn.Our two largest acquisitions - ITNET (now Serco Solutions) and RCI (now part ofSerco Inc) - had the anticipated positive impact, adding ‚£333.9m to revenue and‚£23.6m (‚£10.3m after funding costs) to PBTA. The new skills and capabilitiesthey have brought to the Group are already delivering benefits. For example,Serco Solutions was instrumental in winning the ‚£125m Small Business Servicecontract from the UK Department of Trade and Industry.We are leveraging the benefits of our increasing scale and achievingefficiencies by centralising the purchasing of materials and developing ashared services facility for our back office functions such as finance andadministration. We have streamlined our management structure, removedunnecessary bureaucracy and begun the implementation of a SAP financial system.These initiatives - together with selective bidding and continued management ofour business portfolio - will benefit our PBTA margins in 2006 and beyond.Visibility of future revenue remains excellent. At 31 December 2005, ourforward order book stood at a record ‚£13.4bn and we had visibility of 91% ofour planned revenue for 2006, 77% for 2007 and 64% for 2008.At the same date we had contracts valued at ‚£2.6bn at the preferred bidderstage and a further ‚£2.7bn of bids where we were shortlisted to the final twoor three bidders. None of our ten largest contracts by annual revenue are duefor rebid before the end of the decade.Our identified pipeline of further opportunities exceeds ‚£21bn.Balanced portfolio and service excellence deliver strong growthWe have seen excellent growth across the Group during the year, both in the UKand internationally.The key developments in each of our markets are discussed below.Civil GovernmentRevenue increased by 28% to ‚£803.6m, representing 36% of Group revenue in 2005and making it our largest segment, encompassing home affairs, health, regionaland local government, education and consulting. Growth benefited from theinclusion of Serco Solutions from 3 February 2005.In home affairs we secured our first major civil resilience contract win - aten-year contract valued at around ‚£100m to provide solutions that detect theillicit importation of radiological substances at UK borders. This programme,known as Cyclamen, is central to the UK Government's counter-terrorismstrategy. In October we won a five-year contract valued at around ‚£30m toprovide electronic monitoring of offenders across Scotland. We now manage threeof the six electronic monitoring contracts in the UK.Among notable developments in health, our joint venture with Equion Ltd, adivision of John Laing plc, was appointed preferred bidder for a 35-yearagreement worth around ‚£1.2bn to support three Leicester hospitals as part ofthe Pathway private finance initiative. In managed healthcare, we acquired adoctors `out of hours' business in Cardiff and we have since won othercontracts in Oxford and Cornwall. The acquisition has provided a platform fromwhich we have won contracts to provide healthcare services to Feltham YoungOffenders Institute & Remand Centre and HMP Cardiff, and to improve care forpatients with long term-illnesses in the London Borough of Newham.In local government, the expertise gained in our long-term strategic contractswith councils in Winchester, Canterbury and Woking led to us being appointedpreferred bidder for a ten-year streetscene contract valued at around ‚£45m withRestormel Borough Council, and to our securing an environmental servicescontract with Welwyn Hatfield Council.We work in partnership with two local education authorities in the UK - Walsalland Bradford. In January 2005 the Office for Standards in Education (Ofsted)declared Bradford's services to be `satisfactory', and Walsall's to be `highlysatisfactory', significant turnarounds for what were once two of the poorestperforming authorities in the country. While there is still a considerableamount of work to be done, both Walsall and Bradford have continued to improveat rates faster than national trends in all indicators.Since its formation in 2003, our consulting business has grown rapidly and nowemploys around 80 consultants. It aims to raise awareness of Serco and enhanceour reputation by providing high-value advisory services. During 2005, we wonnew contracts with customers such as the Department of Health, the Home Office,and the Environment Agency, as well as two global investment banks and onemajor UK retail bank.DefenceRevenue grew strongly during the year, increasing by 52% to ‚£565.6m,representing 25% of Group revenue. Growth in the year was both organic andthrough acquisition, with the RCI element of Serco Inc included from 21 March2005.Significant wins in the year included the 23-year Defence Academy CampusIntegrator contract, valued at around ‚£400m, to deliver a world-class academiccentre of excellence for senior military and civilian personnel for the UKMinistry of Defence (MoD). Serco will manage the existing buildings, integratethe design and building of new premises and integrate IT systems. The contractbuilds upon the Joint Services Command and Staff College contract, which wealso manage at the same site.Serco was also appointed preferred bidder for a strategic partnership with theUK Defence Science and Technology Laboratories (Dstl). This contract, wortharound ‚£400m over 15 years, will see us manage the design and build of newfacilities and provide IT and support services across the Dstl estate.In August 2005, Serco Sodexho Defence Services - our joint venture with SodexhoAlliance - renewed and expanded its contract with the Australian Defence Forceto provide garrison support services in the Sydney West South region of NewSouth Wales. The contract is valued at around AUS$200m to Serco over a term ofup to nine years.In February 2006, we became preferred bidder for the MoD's Future Provision ofMarine Services contract. This 15-year contract, valued at around ‚£1bn, is todeliver marine support at major UK naval bases.TransportRevenue increased by 59% to ‚£548.7m, representing 24% of Group revenue. Growthwas driven primarily by the first full year of Northern Rail, our largestcontract to date, which we run as a joint venture with NedRailways.Since we began operating Northern Rail, passengers have benefited fromsignificant enhancements to performance, with train punctuality improving inall but one of the reporting periods during the year. Punctuality is now at itshighest level for four years.Our Merseyrail service, also run as a joint venture with NedRailways, continuesto prove itself to be one of the UK's best performing train operatingcompanies. In the January 2006 National Passenger Survey, Merseyrail's overallsatisfaction rating was 86%, 6% above the national average, with itspunctuality consistently over 92%.In urban transportation, the key development was our appointment as preferredbidder to continue operating the Docklands Light Railway (DLR). The newcontract is valued at around ‚£400m over a period of up to nine years. Serco hasoperated the DLR since 1997, winning National Rail Awards for six consecutiveyears including an award for Outstanding Achievement in the rail industry inSeptember 2005. In the last seven years, Serco has consistently improved DLR'sperformance and it is currently achieving passenger satisfaction scores closeto 95% and reliability scores of over 97%.We operate the National Traffic Control Centre, which helps travellers inEngland plan and complete their journeys by providing real-time trafficinformation, including alternative routing advice, direct to the media and thepublic via a website and interactive phone service. Achieving fullimplementation has taken longer than envisaged and we are now finalising theimplementation phase with our client, the Highways Agency.ScienceRevenue increased by 18% to ‚£342.4m, representing 15% of Group revenue.The key development in our science business was the expansion of work at theAtomic Weapons Establishment (AWE) sites at Aldermaston and Burghfield in theUK, which we operate as a joint venture with BNFL and Lockheed Martin.In July 2005, the MoD announced plans for a necessary upgrade to skills andfacilities at AWE, in order to provide continued reliability and safetyassurance. As a result, the MoD signed an amendment which increased its fundingfor the project. The additional investment organically grows our business andis valued at around ‚£350m to Serco over three years, further enhancing ourposition as a key player in the nuclear industry.Our track record with the MoD means that we are in a good position to bid fornew business. We secured a ‚£13m contract to supply the MoD's Integrated SensorManagement System. This intelligent network is designed to detect nuclear,chemical or biological attacks. The technology behind it gives us transferableopportunities to other sectors.We see potential for strong growth in the nuclear market, in particularfollowing the formation of the Nuclear Decommissioning Authority in the UK. Ourposition here has been further strengthened by the transfer of around 60 staff,together with an associated income stream, from BNFL Magnox Electric to Serco.The staff are predominantly highly qualified experts in the nuclear field.The European Space Agency (ESA) provided us with two successful rebids in 2005,for ESA's Earth observation programme - a contract worth ¢â€š¬14m over three years- and for engineering support at ESA's technical centre in the Netherlands,worth around ¢â€š¬20m over an expected five-year period.Acquisitions deliveringThe acquisitions of ITNET (now Serco Solutions) and RCI (now part of Serco Inc)are delivering the benefits we expected.The additional skills, capabilities and customer relationships of ITNET and RCIare providing significant opportunities for the Group in new markets andenabling us to compete for larger and higher value contracts in markets wherewe are well established.Since its February 2005 acquisition, Serco Solutions has contributed ‚£190.6m torevenue and ‚£14.3m to PBTA, at a margin of 7.5%.Throughout the year, Serco Solutions secured important contract extensions andadditional work with local government and commercial clients. We were delightedto win a place in a consortium shortlisted to bid for the UK Government'se-borders project, which, if successful, could be worth around ‚£360m to us. Aswell as being instrumental in our securing a contract worth up to ‚£125m toprovide web-based information services to the UK's small businesses on behalfof the government, Serco Solutions was chosen by IBM as a sub-contractor toimplement Bradford Council's IT platforms and services. The ten-year programmeis worth ‚£158m to the consortium.However one of the key opportunities in this area is the outsourcing of UKlocal and central government shared services. This has been slower thananticipated in coming to market. We have invested in enhanced capacity andcapability to prepare for the expected rapid expansion in this market.RCI expanded our position in the world's largest service contracting market,the US federal government. Since the acquisition was completed in March 2005,RCI has contributed ‚£143.3m to Serco Inc's revenue and ‚£9.3m to PBTA, at amargin of 6.5%.The RCI business continues to grow strongly, receiving numerous new task ordersand expanding or extending existing contracts. Among its key wins was the rebidfor the US Army's Career and Alumni Program. Valued at around $16m per year, wehave held this contract for 17 years - an exceptional achievement in US defencecontracting. In November 2005, we were awarded a contract to provide 102embedded recruiters for the US Army Recruiting Command (USAREC). The basecontract is for one year, with two one-year options. Each contract year couldbe worth up to $5m.There are significant opportunities for further growth, as the US Department ofDefense continues to turn to the private sector for support, and as over timewe extend our skills in other markets, such as transport, into North America.Market developmentOur opportunities for growth are created by two principal drivers: thenecessity for central and local governments to control their spending and theirneed to respond to social pressures for improved public services.Our balanced portfolio, spread across different sectors and geographic marketsaround the world, allows us to target our resources towards the bestopportunities.In the UK, the home affairs market is driven by the change in government focusfrom implementing initiatives to the delivery of outcomes - reducing crime andthe fear of crime. We estimate that this market is worth ‚£2.5bn per annum andgrowing fast.We have created a new position in healthcare, which is among the largest andfastest growing areas of UK Government spending - some ‚£89bn in 2005/6. TheGovernment spends ‚£70bn on education and we see opportunities in children'sservices and information and communications technology after the recentEducation Bill. In science, the formation of the UK's Nuclear DecommissioningAuthority has created a market worth around ‚£2bn per annum. Most areas of thepublic sector are experiencing budget pressure and in response are changing theway they work. In UK defence, we expect our addressable market to double to ‚£8bn per annum by 2010, as the MoD focuses resources, continues to civilianiseand seeks cost savings.A similar pattern is emerging in North America. The market is estimated at$2,000bn per annum, of which around one third is at the federal level and theremainder with state and local governments. The annual US defence budget isnearly $400bn and rising. Some market segments are looking at private sectorservice provision for the first time and more established markets such asmunicipal services and transportation are moving to more sophisticated,performance-based contracting, as the emphasis shifts from lowest cost to bestvalue, a trend which plays to our strengths.We also see exciting prospects in parts of Europe - notably Germany, whereeconomic and political conditions are accelerating the trend towards publicprivate partnerships - and the Middle East, in particular the United ArabEmirates. In Asia Pacific, the Australian defence and transport marketscontinue to offer good potential, while the opening of our Shanghai, Chinaoffice in May 2005 positions us to explore opportunities as the regionalgovernment pursues its ambitious public service objectives.Dedicated professionalsPeople are at the heart of our business. Throughout 2005, the dedication,expertise and professionalism of Serco colleagues around the world werecritical to our performance. Notwithstanding their daily achievements inbringing service to life, their wholehearted response to the tsunami insouth-east Asia, the London bombings, the hurricanes in the Gulf of Mexico andthe Pakistan earthquake, epitomised the spirit that defines Serco.BoardSince his appointment as a non-executive director in April 2000, Ralph Hodgehas played a vital role in shaping the direction of our business. As heprepares to step down from the Board, we would like to place on record ourgratitude for his contribution. We wish him a long and healthy retirement.We are in the advanced stages of discussions in appointing a successor toRalph.Continuing positive outlookGovernments around the world are continuing to face significant pressures toprovide better public services at lower cost and our market opportunities areunprecedented. In the UK, our growth is being fuelled by the development of amixed economy, which incorporates the private sector in the delivery of publicservices, and our ability to deliver customers' desired outcomes, which enableus to develop long-term relationships which in turn drive our organic growth.The Group has identified in excess of ‚£21bn of opportunities across ourmarkets. The breadth of these opportunities together with our approach toselective bidding, portfolio management and efficiency will contribute toincreasing margins. We are confident of achieving double-digit growth for theforeseeable future.Finance Review1. Introduction2005 is the first year the Group has reported its results under InternationalFinancial Reporting Standards (IFRS). Explanation of the impact of adoptingIFRS was provided in the Group's announcement `Transition to InternationalFinancial Reporting Standards', which was released on 31 August 2005. Allcomparatives throughout this report have been restated under IFRS. Effectivefrom 1 January 2005, the Group adopted IAS 32 `Financial Instruments:Disclosure and Presentation' and IAS 39 `Financial Instruments: Recognition andMeasurement'.2. Financial performanceThe Group continued to generate strong organic growth during 2005. We alsobenefited from the contributions of ITNET plc (ITNET) and RCI Holding Corp(RCI), which we acquired in February 2005 and March 2005 respectively.The Group's income statement for 2005 is shown in Figure 1. This includes theresults of our joint ventures, which have been proportionately consolidated.Figure 1: Income statement 2005 2004 Increase ‚£m ‚£m Revenue 2,260.3 1,636.9 38.1% Gross profit 325.0 242.6 34.0% Administrative expenses before (214.3) (166.2) 28.9% amortisation Investment revenue and finance costs (19.2) (5.2) Profit before tax and intangible 91.5 71.2 28.5% amortisation Intangible amortisation (13.6) (7.2) Profit before tax 77.9 64.0 21.7% Tax (23.5) (19.5) Profit for the year 54.4 44.5 22.2% Minority interest (1.0) (1.0) - Retained earnings 53.4 43.5 22.8% Effective tax rate 30.2% 30.5% Basic earnings per share before 14.09p 11.46p 22.9% intangible amortisation Basic earnings per share 11.66p 10.11p 15.3 % Dividend per share 2.97p 2.63p 12.9% 2.1 RevenueRevenue increased by 38.1% to ‚£2,260.3m. Excluding the effect of ‚£337.2m ofrevenue from our acquisitions in 2005 and ‚£26.0m of disposals in 2004, ourorganic revenue growth was 19.4%.Joint venture revenue increased by 109.8% to ‚£536.1m, primarily reflecting afull year of operation of the Northern Rail franchise, which began in December2004, and continued growth at AWE.2.2 Gross marginGross margin - the average contract margin across our portfolio - was 14.4% in2005.2.3 Investment revenue and finance costsInvestment revenue and finance costs totalled a net cost of ‚£19.2m (2004: ‚£5.2m). Included within finance costs was ‚£13.4m of interest on the debt used tofund our acquisitions, the net interest on the assets and liabilities of ourdefined benefit pension schemes and interest on our underlying net debt, whichhas reduced compared with 2004.2.4 Profit before tax and intangible amortisation (PBTA)PBTA increased 28.5% to ‚£91.5m (2004: ‚£71.2m), representing a net margin of4.0% (2004: 4.3%). Excluding the profits generated by the acquisitions andtheir associated funding costs, organic PBTA increased by 13.1%.2.5 Intangible amortisationIntangible amortisation was ‚£13.6m (2004: ‚£7.2m). The increase resultsprincipally from the amortisation of intangible assets acquired with ITNET andRCI, together with the additional amortisation of pension-related intangibleassets arising from the rights to manage and operate certain of our contractsand franchises.2.6 Profit before taxProfit before tax increased by 21.7% to ‚£77.9m (2004: ‚£64.0m).2.7 TaxThe tax charge of ‚£23.5m (2004: ‚£19.5m) represents an effective rate of 30.2%,broadly similar to 2004.2.8 Earnings per share (EPS)Basic EPS before intangible amortisation increased by 22.9% to 14.09p. BasicEPS increased by 15.3% to 11.66p.EPS before intangible amortisation and the effect of acquisitions increased by15.6% to 13.25p, and on a post-amortisation basis increased by 10.4% to 11.16p.EPS is calculated on an average share base of 458.1m during the year (2004:430.1m). The majority of the increase resulted from the issue of 30.4m sharesin part consideration for the acquisition of ITNET.3. DividendsOur policy is to increase the total dividend per share each year broadly inline with the increase in underlying earnings. The proposed final dividend of2.06p per share represents a 13.2% increase on 2004. The total dividend for theyear is 2.97p, an increase of 12.9%. The dividend will be paid on 17 May 2006to shareholders on the register at 10 March 2006.4. Cash flowOur cash performance in 2005 was strong, with a Group free cash inflow of ‚£73.8m, an increase of ‚£18.0m compared with 2004.The Group's cash flow is analysed in Figure 2. The presentation is consistentwith our analysis in previous years and is designed to show the true cashperformance of the Group - the cash flows generated by Serco's subsidiaries,plus dividends received from joint ventures. It therefore differs from theconsolidated cash flow presented on page 22, in which the cash flows of jointventures have been proportionately consolidated. The adjustment line in Figure2 reconciles the movement in Group cash to the consolidated cash flow.Figure 2: Cash flow 2005 2004 ‚£m ‚£m Operating profit excluding joint ventures 62.4 43.5 Non cash items 45.2 32.1 Group EBITDA 107.6 75.6 Working capital movement (11.2) (5.3) Group operating cash flow 96.4 70.3 Interest (15.7) (3.8) Tax (1.0) (1.5) Expenditure on tangible and intangible assets (31.6) (23.4) Dividends from joint ventures 25.7 14.2 Group free cash flow 73.8 55.8 Acquisitions (281.7) (9.1) Other financing 269.4 (7.6) Dividends paid (12.5) (10.4) Group non recourse debt financed assets (15.6) (25.2) Group net increase in cash and cash equivalents 33.4 3.5 Adjustment to include joint venture cash impacts 4.1 12.8 Net increase in cash and cash equivalents 37.5 16.3Note: Group EBITDA is earnings from subsidiaries before interest, tax,depreciation and intangible amortisation.4.1 Group operating cash flowThe Group operating cash inflow for the year was ‚£96.4m (2004: ‚£70.3m), anincrease of 37.1%. This represents a conversion of Group EBITDA into cash of90% (2004: 93%). The Group's cash conversion is particularly notable given thelevel of organic growth, which typically results in a working capital outflowequivalent to one month's incremental revenue.4.2 TaxTax paid in 2005 was ‚£1.0m, compared with ‚£1.5m in the previous year. The levelof tax paid in 2005 reflects a number of factors, including our continuedprogress in closing previous years' tax returns, with a refund of ‚£8m in theyear, as well as residual accelerated capital allowances and other timingdifferences. Tax paid in 2004 benefited from a repayment of nearly ‚£7m, as wewere able to utilise tax losses in subsidiaries which were previously jointventures. From 2006, we expect our tax paid to be close to the tax charge inour income statement.4.3 Expenditure on tangible and intangible assetsExpenditure on tangible and intangible assets was ‚£31.6m (2004: ‚£23.4m). Thisrepresents around 1.8% of revenue excluding joint ventures. Included withinthis is ‚£7m of cash spent on designing and building our new SAP accountingsystem and shared service centre. This programme of expenditure will continuethrough 2006 and 2007.4.4 Dividends from joint venturesDividends received from joint ventures during 2005 were ‚£25.7m (2004: ‚£14.2m).This is equivalent to 101% (2004: 78%) of our share of joint ventures' profitafter tax. The high level of conversion reflects dividend payments made byjoint ventures from reserves retained in previous years. We expect a conversionrate in the range of 70% to 80% going forward.4.5 AcquisitionsThe cash outflow in 2005 of ‚£281.7m primarily relates to the acquisitions ofITNET and RCI. The other significant acquisition during the year was ourpurchase of the outstanding 50% of Defence Management Holdings Limited (DMHL)for ‚£5.9m. DMHL, which owns the special purpose company for the Joint ServicesCommand and Staff College PFI, was previously a joint venture.4.6 Other financingOther financing of ‚£269.4m primarily relates to the net draw down of loans tofund the acquisitions of ITNET and RCI.4.7 Group non recourse debt financed assetsThe ‚£15.6m outflow is the net of expenditure on PFI assets under construction,the movement on non recourse loans and changes in other PFI balances.Over the life of each PFI contract, we expect these movements to offset eachother.5. Net debtAt 31 December 2005, Group recourse net debt was ‚£264.0m (31 December 2004: ‚£15.3m). Further analysis is provided in Figure 3.Figure 3: Net debtAs at 31 December 2005 2004 ‚£m ‚£m Group - cash and cash equivalents 210.0 173.9 Group - recourse debt (453.1) (168.4) Group - obligations under finance leases (20.9) (20.8) Group recourse net debt (264.0) (15.3) Joint venture recourse net cash/(debt) 18.0 (4.6) Total recourse net debt (246.0) (19.9) Group non recourse debt (326.8) (256.5) Joint venture non recourse debt (22.4) (47.1) Total non recourse debt (349.2) (303.6) Total net debt (595.2) (323.5)Included within Group recourse net debt is ‚£16.8m (2004: ‚£15.3m) of cashsecuring credit obligations in relation to PFI and other project companies.5.1 Group recourse net debtThe strength of our cash flow resulted in a reduction in Group recourse netdebt in the second half of the year, from ‚£315.2m at 30 June 2005 to ‚£264.0m atthe year end.The net increase in the Group's other loans during the year reflects the debtfunding for the acquisitions of ITNET and RCI. These loans have covenantsconsistent with our private placements and allow sufficient headroom to fundknown commitments and working capital requirements.5.2 Group non recourse debtGroup non recourse debt, which we have utilised to fund PFI assets and theacquisition of the DES franchise, increased during the year to ‚£326.8m (31December 2004: ‚£256.5m). This was the result of our acquisition of theremaining 50% share of DMHL. Since the acquisition, we have consolidated 100%of DMHL's non recourse debt in our balance sheet. The increase was partlyoffset by the scheduled repayments of debt across all our non recourse debtfunded projects.The Group's debt is non recourse if no Group company other than the relevantborrower - typically a special purpose company for a PFI - has an obligation torepay the debt under a guarantee or other arrangement. The debt is excludedfrom all of our credit agreements and other covenant calculations, andtherefore has no impact on the Group's ability to borrow.6. PensionsTo assist understanding of the complexities of accounting for pension schemesunder IFRS, we have provided an overview. Further detail was provided in ourannouncement `Transition to International Financial Reporting Standards', on 31August 2005.The total pension cost included within PBTA for 2005 was ‚£55.6m (2004: ‚£39.5m).At the year end, the net amount included in the balance sheet arising from ourobligations in respect of defined benefit pension schemes was ‚£149.9m (31December 2004: ‚£124.7m). Further analysis is provided in Figure 4.Figure 4: Defined benefit pension schemesAs at 31 December 2005 2004 ‚£m ‚£m Group schemes - non contract specific (200.4) (164.6) Contract specific schemes - reimbursable (84.9) (56.0) - not certain to be reimbursable (21.3) (22.3) Net retirement benefit liabilities (306.6) (242.9) Intangible asset arising from rights to 19.0 21.2operate franchises and contracts Reimbursable rights debtor 84.9 56.0 Deferred tax asset 52.8 41.0 Net balance sheet position (149.9) (124.7)Under IFRS, Serco has three main types of scheme which are accounted for asdefined benefit pension schemes. Each type has its own accounting treatmentunder IAS 19 `Employee Benefits'. These are: * Schemes which do not relate to specific contracts or franchises - principally the Group scheme. For these schemes, the actuarial gain or loss for the period is charged to the consolidated statement of recognised income and expense (the SORIE) * Schemes relating to specific contracts or franchises, where the deficit will pass back to the customer or to the next contractor at the end of the relevant contract. For these schemes, the actuarial gain or loss for the period is charged to the SORIE, and a recoverable intangible asset is recognised on the balance sheet and amortised to the income statement over the contract or franchise life, and * The AWE contract, where there is a right of cost reimbursement, and where the pension scheme deficit and offsetting debtor are both included the balance sheet. The increase in net liabilities during the year resulted primarily from thereduction in the AA bond rate, which increased the liabilities on all definedbenefit pensions. These increases, together with the related deferred taxmovement, have been reflected in the SORIE.Figure 5 shows the approximate sensitivities of the liabilities on our definedbenefit pension schemes to movements in the discount rate, and to changes inour actuarial assumptions regarding the rate of inflation, the rate of increaseof scheme members' salaries and life expectancies.Figure 5: Pension assumption sensitivities Change in assumption Change in liability Discount rate +0.5% (10)% (0.5)% +11% Price inflation +0.5% +8% (0.5)% (7)% Salary +0.5% +3% (0.5)% (3)% Longevity Increase by one year +2.5% The main Group defined benefit pension scheme accounts for around two thirds ofour net balance sheet position. In recent years, we have taken action to managethe liabilities of the Group scheme. We have closed the scheme to new members,other than those joining the Group as a result of TUPE transfers. We increasedemployer contributions to the scheme from 2003, and employee contributions from2004. We have also introduced annual actuarial valuations, which ensure that wehave up-to-date information on the position of the scheme.During 2006, in conjunction with the scheme's trustees, we will furtherconsider the funding and risk profile of the Group scheme.7. AcquisitionsWe completed the acquisition of ITNET on 3 February 2005. The consideration of‚£245.5m comprised ‚£171.3m of cash and 30.4m shares worth ‚£74.2m. Theacquisition gave rise to goodwill of ‚£260.9m, including fair value adjustmentsand acquisition costs of ‚£28.1m. Intangible assets arising on the acquisitionhave been recognised at ‚£20.6m and will be amortised on a straight-line basisover their expected life of eight years. From the date of ownership ITNETcontributed ‚£190.6m to revenue and ‚£14.3m to PBTA.Our acquisition of RCI was completed on 21 March 2005 for consideration of ‚£116.3m in cash. The acquisition gave rise to goodwill of ‚£93.7m, including fairvalue adjustments and acquisition costs of ‚£7.0m. Intangible assets arising onthe acquisition have been recognised at ‚£2.2m and will be amortised on astraight-line basis over their expected life of five years. From the date ofownership, RCI contributed ‚£143.3m to revenue and ‚£9.3m to PBTA.Our other acquisitions during the year, principally the 50% of DMHL,contributed ‚£3.3m to revenue and ‚£0.8m to PBTA.8. PFIs8.1 PFI portfolioThe Group has a portfolio of 11 PFI projects. We have operating contracts forall our PFIs, and equity investments in ten. Following our purchase of 50% ofDMHL, we now own 100% of eight of our PFI projects.8.2 Accounting for PFI contractsIn March 2005, the International Financial Reporting Interpretations Committee(IFRIC) issued a draft interpretation on accounting for service concessionarrangements. These are arrangements such as PFIs, under which a government orother body grants contracts for the supply of public services - such as prisonsor hospitals - to private operators. The IFRIC is still working towards a finalinterpretation, which it expects to publish in the second half of 2006.In the absence of specific guidance within IFRS, from 1 January 2005 we haverecognised our PFI debtors at amortised cost, as defined by IAS 39. Thismaintains an accounting treatment consistent with UK GAAP and existing IFRS.The draft guidance from IFRIC, if it were issued in final form, could require anumber of changes to the accounting treatment of service concessionarrangements. This could result in a significant increase in the carrying valueof the Group's PFI debtors.9. Treasury9.1 Credit facilities and liquidity managementThe ‚£420m bank credit facility we used to provide funding for the acquisitionsof ITNET and RCI comprises a term loan facility and a revolving creditfacility. As at 31 December 2005, term loans totalling ‚£279m were outstandingand the revolving credit facility was undrawn. The bank facility has covenantsand obligations typical of these types of arrangement, is unsecured and expiresin December 2009. Loans drawn under the bank facility accrue interest at a rateof 50 basis points over LIBOR.Serco has also issued loan notes under two private placements. The first, for ‚£43.2m, matures in December 2007. The second, for ‚£117m, amortises evenly from2011 to 2015.9.2 Impact of IAS 32 and IAS 39The Group adopted IAS 32 and IAS 39 effective from 1 January 2005. Adopting IAS39 resulted in a reduction in our opening net assets of ‚£27.1m. Thisprincipally represents a fair value loss from marking to market the interestrate swaps we use to hedge the interest obligations of PFI special purposecompanies into fixed rate obligations, and the cross-currency swaps used tohedge long term loan notes.All designated hedges are highly effective and, as a result, the impact on theincome statement for the period was immaterial. Further details of the effectof applying IAS 32 and IAS 39 can be found in our announcement of 31 August2005, 'Transition to International Financial Reporting Standards'.Consolidated income statementFor the year ended 31 December Note 2005 2004 ‚£m ‚£m Continuing operations Revenue 2 2,260.3 1,636.9 Cost of sales (1,935.3) (1,394.3) Gross profit 325.0 242.6 Administrative expenses (214.3) (166.2) Other operating expenses - amortisation (13.6) (7.2)of intangibles Total administrative expenses (227.9) (173.4) Operating profit 2 97.1 69.2 Investment revenue 3 33.6 35.3 Finance costs 3 (52.8) (40.5) Profit before tax 77.9 64.0 Tax (23.5) (19.5) Profit for the year 54.4 44.5 Attributable to: Equity holders of the parent 53.4 43.5 Minority interest 1.0 1.0 Earnings per ordinary share (EPS) Basic EPS 4 11.66p 10.11p Diluted EPS 4 11.46p 9.99pConsolidated statement of recognised income and expenseFor the year ended 31 December Note 2005 2004 ‚£m ‚£m Net actuarial loss on defined benefit 8 (58.4) (29.4)pension schemes Actuarial gain on reimbursable rights 8 35.6 13.0 Goodwill previously written off, released - 0.2on sale of subsidiary Net exchange gain/(loss) on translation of 8 6.9 (3.3)foreign operations Fair value gain on cash flow hedges during 8 6.1 -the year Tax credit on items taken directly to 8 2.0 5.6equity Net expense recognised directly in equity (7.8) (13.9) Profit for the year 54.4 44.5 Total recognised income and expense for 46.6 30.6the year Attributable to: Equity holders of the parent 45.6 29.6 Minority interest 1.0 1.0 46.6 30.6Consolidated balance sheetAt 31 December Note 2005 2004 ‚£m ‚£m Non-current assets Goodwill 544.5 177.4 Other intangible assets 107.8 75.0 Property, plant and equipment 103.0 96.2 Investments - 13.7 Trade and other receivables 459.8 390.6 Deferred tax assets 91.2 50.1 1,306.3 803.0 Current assets Inventories 36.4 26.9 Trade and other receivables 528.8 390.1 Cash and cash equivalents 240.7 200.5 805.9 617.5 Total assets 2,112.2 1,420.5 Current liabilities Trade and other payables (531.1) (417.0) Current tax liabilities (19.5) (5.8) Obligations under finance leases (8.2) (8.1) Loans (64.8) (46.4) Financial instruments (4.9) - (628.5) (477.3) Non-current liabilities Trade and other payables (5.0) (0.6) Obligations under finance leases (18.2) (18.2) Loans (744.7) (451.3) Financial instruments (30.8) - Retirement benefit obligations (306.6) (242.9) Provisions (26.3) (6.0) Deferred tax liabilities (92.1) (55.0) (1,223.7) (774.0) Total liabilities (1,852.2) (1,251.3) Net assets 260.0 169.2 Equity Share capital 9.4 8.7 Share premium account 269.5 191.5 Capital redemption reserve 0.1 0.1 Retained earnings 8 132.8 104.4 Retirement benefit obligations 8 (139.0) (124.4)reserve Share-based payment reserve 8 16.6 6.2 Own shares reserve 8 (16.4) (16.4) Hedging and translation reserve 8 (15.1) (2.6) Equity attributable to equity 257.9 167.5holders of the parent Minority interest 2.1 1.7 Total equity 260.0 169.2Consolidated cash flow statementFor the year ended 31 December Note 2005 2004 ‚£m ‚£m Net cash inflow from operating 6 140.8 87.6activities Investing activities Interest paid (47.6) (39.4) Interest received 32.8 35.0 Disposal of subsidiary and business - 3.2undertakings Proceeds from disposal of property, 0.4 0.4plant and equipment Proceeds from reduction in investment in - 1.8joint venture Acquisition of franchise - (4.1) Acquisition of subsidiaries, net of cash (281.7) (13.7)acquired Purchase of other intangible assets (13.1) (4.1) Purchase of property, plant and (22.3) (21.9)equipment Net cash outflow from investing (331.5) (42.8)activities Financing activities Dividends paid (12.5) (10.4) Repayment of borrowings (5.8) (0.8) New loan advances 272.0 10.2 Capital element of finance lease (8.4) (9.0)repayments Proceeds from issue of share capital 4.4 0.7 Decrease in non recourse loans (21.5) (19.2) Net cash inflow/(outflow) from financing 228.2 (28.5)activities Net increase in cash and cash 37.5 16.3equivalents Cash and cash equivalents at beginning 200.5 184.6of year Net exchange gain/(loss) 2.7 (0.4) Cash and cash equivalents at end of year 240.7 200.5Notes to the preliminary announcement1. General informationThe basis of preparation of this preliminary announcement is set out below.The financial information in this announcement, which was approved by the Boardof Directors on1 March 2006, does not constitute the Company's statutory accounts for theyears ended31 December 2005 or 2004, but is derived from these accounts.Statutory accounts for 2004 have been delivered to the Register of Companiesand those for 2005 will be delivered following the Company's annual generalmeeting. The auditors have reported on these accounts; their reports wereunqualified and did not contain statements under S237 (2) or (3) of theCompanies Act 1985.The preliminary announcement has been prepared in accordance with theaccounting policies adopted under IFRS for the first time with a transitiondate of 1 January 2004. The disclosures required by IFRS 1 `First-time Adoptionof International Financial Reporting Standards' concerning the transition fromUK GAAP to IFRS can be found in our announcement of 31 August 2005, `Transitionto International Financial Reporting Standards'.The financial statements have been prepared on the historical cost basis.The Group has adopted IAS 32 `Financial Instruments : Disclosure andPresentation' and IAS 39 `Financial Instruments: Recognition and Measurement'with effect from 1 January 2005. Derivatives are initially accounted for andmeasured at fair value on the date a derivative contract is entered into andsubsequently measured at fair value. The gain or loss on re-measurement istaken to the income statement except where the derivative is a designated cashflow hedging instrument.2. Segmental informationThis Group manages its business on a market segment basis and these segmentsare the basis on which the Group reports its primary segment information.Business segments Civil Defence Transport Science Total Government Year ended 31 December 2005 ‚£m ‚£m ‚£m ‚£m ‚£m Revenue 803.6 565.6 548.7 342.4 2,260.3 Result Segment result 37.5 33.3 25.0 31.4 127.2 Unallocated expenses (30.1) Operating profit 97.1 Investment revenue 33.6 Finance costs (52.8) Profit before tax 77.9 Tax (23.5) Profit for the year 54.4Year ended 31 December 2004 Civil Defence Transport Science Total Government ‚£m ‚£m ‚£m ‚£m ‚£m Revenue 629.1 372.3 345.8 289.7 1,636.9 Result Segment result 26.6 21.6 20.7 26.5 95.4 Unallocated expenses (26.2) Operating profit 69.2 Investment revenue 35.3 Finance costs (40.5) Profit before tax 64.0 Tax (19.5) Profit for the year 44.5Geographical segments United North Europe and Asia Total Kingdom America Middle Pacific Year ended 31 December 2005 East ‚£m ‚£m ‚£m ‚£m ‚£m Revenue 1,661.7 254.5 205.2 138.9 2,260.3Year ended 31 December 2004 United North Europe and Asia Total Kingdom America Middle Pacific East ‚£m ‚£m ‚£m ‚£m ‚£m Revenue 1,202.3 94.6 186.7 153.3 1,636.93. Investment revenue and finance costs 2005 2004 ‚£m ‚£m Interest receivable by PFI companies 26.7 31.8 Interest receivable on other loans and deposits 6.9 3.5 Investment revenue 33.6 35.3 Interest payable on non recourse loans (19.9) (23.6) Interest payable on obligations under finance leases (0.8) (0.7) Fair value adjustment on fair value hedges and non IAS 0.4 -39 designated hedges Interest payable on other loans (27.8) (13.8) Net interest payable on retirement benefit obligations (4.7) (2.4) Finance costs (52.8) (40.5)4. Earnings per shareBasic and diluted earnings per ordinary share (EPS) have been calculated inaccordance with IAS 33 `Earnings Per Share'. EPS is shown both before and afteramortisation of intangible assets to assist in the understanding of the impactof IAS 38 `Intangible Assets' on the Group financial statements.The calculation of the basic and diluted EPS is based on the following data:Number of shares 2005 2004 millions millions Weighted average number of ordinary shares for the 458.1 430.1purpose of basic EPS Effect of dilutive potential ordinary shares: share 8.0 5.3options Weighted average number of ordinary shares for the 466.1 435.4purpose of diluted EPS Earnings 2005 2004 Earnings Per Earnings Per share share amount amount ‚£m Pence ‚£m Pence Earnings for the purpose of basic 53.4 11.66 43.5 10.11EPS being net profit attributable to the equity holders of the parent Add back : Amortisation of intangible assets, 11.2 2.43 5.8 1.35net of tax Basic earnings before amortisation 64.6 14.09 49.3 11.46of intangible assets Earnings for the purpose of basic 53.4 11.66 43.5 10.11EPS Effect of dilutive potential - (0.20) - (0.12)ordinary shares Diluted EPS 53.4 11.46 43.5 9.995. Acquisitionsa) Acquisition of ITNET plcOn 3 February 2005 the Group acquired all of the issued share capital of ITNETplc for purchase consideration of ‚£245.5m comprising cash and the issue ofshares. ITNET plc is the parent company of a group of companies involved ininformation technology solutions. This transaction has been accounted for bythe purchase method of accounting. The goodwill arising is attributable to theanticipated profitability arising from new business and the anticipated futureoperating synergies from the combination. Book Fair value Fair adjustments value value ‚£m ‚£m ‚£m Net assets acquired Goodwill 12.8 (12.8) - Other intangible assets 0.6 20.0 20.6 Property, plant and equipment 9.4 (1.4) 8.0 Deferred tax assets 6.3 3.2 9.5 Inventories 6.0 - 6.0 Trade and other receivables 43.6 (4.1) 39.5 Trade and other payables (39.9) (7.4) (47.3) Current tax liabilities (0.4) (1.0) (1.4) Provisions (4.4) (19.2) (23.6) Loans (4.0) - (4.0) Retirement benefit obligations (11.5) - (11.5) Obligations under finance leases (5.8) - (5.8) 12.7 (22.7) (10.0) Goodwill 260.9 Total consideration 250.9 Satisfied by: Issue of Serco Group plc ordinary shares 74.2 Cash 171.3 Purchase consideration 245.5 Directly attributable costs 5.4 250.9 Net cash outflow arising on acquisition: Cash consideration paid in 2004 13.7 Cash consideration paid in 2005 163.0 176.7 ITNET plc contributed ‚£190.6m to revenue and ‚£14.3m to the Group's profitbefore tax and intangible amortisation for the period between the date ofacquisition and the balance sheet date.5. Acquisitions (continued)b) Acquisition of RCI Holding Corp (`RCI')On 21 March 2005, the Group acquired all of the issued share capital of RCI forcash consideration of ‚£116.3m. RCI is the parent company of a group ofcompanies involved in business process management for the US FederalGovernment. This transaction has been accounted for by the purchase method ofaccounting. The goodwill arising is attributable to the anticipatedprofitability arising from new business. Book Fair value Fair value adjustments value ‚£m ‚£m ‚£m Net assets acquired Goodwill 4.3 (4.3) - Other intangible assets 0.1 2.1 2.2 Property, plant and equipment 1.9 - 1.9 Deferred tax assets 1.0 0.1 1.1 Inventories 0.7 - 0.7 Trade and other receivables 35.3 - 35.3 Trade and other payables (13.7) (2.8) (16.5) 29.6 (4.9) 24.7 Goodwill 93.7 Total consideration 118.4 Satisfied by: Cash 116.3 Directly attributable costs 2.1 Net cash outflow arising on 118.4acquisition RCI contributed ‚£143.3m to revenue and ‚£9.3m to the Group's profit before taxand intangible amortisation for the period between the date of acquisition andthe balance sheet date.6. Reconciliation of operating profit to net cash from operating activities 2005 2004 ‚£m ‚£m Operating profit for the year 97.1 69.2 Adjustments for: Share-based payments 5.7 4.5 Depreciation of property, plant and equipment 30.3 22.2 Amortisation of intangible assets 13.6 7.2 Loss on disposal of property, plant and equipment 0.4 0.8 Loss on disposal of intangible assets 0.1 - Loss on sale of subsidiary undertakings - 0.1 Operating cash inflows before movements in 147.2 104.0working capital (Increase)/decrease in inventories (1.9) 2.3 Increase in receivables (47.2) (34.4) Increase in payables 44.6 31.7 Cash generated by operations before PFI asset 142.7 103.6expenditure Movement on PFI debtor 15.3 7.6 Expenditure on PFI assets in the course of (7.8) (16.3)construction Cash generated by operations after PFI asset 150.2 94.9expenditure Tax paid (9.4) (7.3) Net cash inflow from operating activities 140.8 87.67. Analysis of net debt At Cash Acquisitions Exchange Non-cash At flow / differences movements 1 ‚£m 31 January ‚£m disposals ‚£m December 2005 2005 ‚£m ‚£m ‚£m Cash and cash 200.5 32.5 5.0 2.7 - 240.7equivalents Non recourse loans (256.0) 20.5 (43.1) - 0.4 (278.2)(related to PFI assets) Other non recourse (47.6) 1.0 - (6.9) (17.5) (71.0)loans Other loans (194.1) (266.2) (4.0) (12.2) 16.2 (460.3) Obligations under (26.3) 8.4 (5.8) (0.2) (2.5) (26.4)finance leases (323.5) (203.8) (47.9) (16.6) (3.4) (595.2)8. Reserves Retained Retirement Share-based Own Hedging and Total earnings benefit payment translation obligations reserve shares reserve ‚£m ‚£m reserve reserve ‚£m ‚£m ‚£m ‚£m At 1 January 2005 104.4 (124.4) 6.2 (16.4) (2.6) (32.8) Fair value loss on (3.5) - - - (34.4) (37.9)hedges on adoption of IAS 39 Tax credit on hedges 0.5 - - - 10.3 10.8 Restated at 1 January 101.4 (124.4) 6.2 (16.4) (26.7) (59.9)2005 Dividends paid (12.5) - - - - (12.5) Net profit for the year 53.4 - - - - 53.4 Net actuarial loss on - (58.4) - - - (58.4)defined benefit pension schemes Actuarial gain on - 35.6 - - - 35.6reimbursable rights Credit in relation to - - 5.7 - - 5.7share-based payment Fair value gain on cash - - - - 6.1 6.1flow hedges during the year Net exchange gain on - - - - 6.9 6.9translation of foreign operations Tax charge on cash flow - - - - (1.4) (1.4)hedges Tax (charge)/credit on (9.5) 8.2 4.7 - - 3.4items taken directly to equity At 31 December 2005 132.8 (139.0) 16.6 (16.4) (15.1) (21.1)9. Joint venturesThe Group's interests in joint ventures are reported in the consolidatedfinancial statements using the proportionate consolidation method. The effectof the Group's joint ventures on the consolidated income statement is asfollows: 2005 2004 ‚£m ‚£m Revenue 536.1 255.5 Operating profit 34.7 25.7 Profit before tax 36.4 25.2 Tax (10.4) (6.3) Profit for the year 26.0 18.9 Minority interest (0.5) (0.6) Share of post-tax results from joint ventures 25.5 18.3Operating profit includes ‚£6.6m (2004 : ‚£nil) of costs incurred by Group. 1ENDSERCO GROUP PLCRelated Shares:
Serco