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Edited Transcript of SRP.L earnings conference call or presentation 31-Jul-19 9:45am GMT

Half Year 2019 Serco Group PLC Earnings Call

London Aug 1, 2019 (Thomson StreetEvents) -- Edited Transcript of Serco Group PLC earnings conference call or presentation Wednesday, July 31, 2019 at 9:45:00am GMT

TEXT version of Transcript

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Corporate Participants

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* Angus G. Cockburn

Serco Group plc - Group CFO & Director

* Kevin Craven

Serco Group plc - CEO of Serco UK & Europe

* Rupert C. Soames

Serco Group plc - Group CEO & Director

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Conference Call Participants

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* David Roux

BofA Merrill Lynch, Research Division - Associate

* Julian Charles Cater

Numis Securities Limited, Research Division - Analyst

* Paul Daniel Alexander Sullivan

Barclays Bank PLC, Research Division - Director & Analyst

* Stephen Joseph Rawlinson

Applied Value Limited - Director & Analyst

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Presentation

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Rupert C. Soames, Serco Group plc - Group CEO & Director [1]

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Welcome to the Serco 2019 Half Year Results. My name is Rupert Soames, and I am Chief Executive. And I know this is a very busy day for you all, so we're going to try and rattle through. But I do want to spend time, if possible, with Kevin Craven, who runs 40% of our business, runs the U.K. business, and he's going to give a specific section on the U.K. business.

So it's been a good first half, actually, pleased with the first half. It's been building on the inflection point that we saw in 2018, good trading and financial performance, revenue up 6% at constant currency, of which 4% was organic. This is the first period since 2013 that we've actually achieved some organic growth. Underlying trading profit of GBP 51 million, up 29% at constant currency or 25% excluding the beneficial impact of IFRS 16 on the UTP. Underlying EPS, up 35%. And free cash flow by a maths whisker turned positive again for the first time since 2014. But strikingly, a very, very strong order intake in the first half. GBP 3.3 billion of order intake and 2019 will, therefore, be the third year in a row that order intake has exceeded revenue. The order book has now increased by GBP 14 billion, and that's up GBP 12 billion from 6 months ago and GBP 11 billion, 12 months ago.

On NSBU, the acquisition of the Naval Systems business units that we announced earlier on in the year. We had, I think, had it in our mind that, that would close and complete the transaction sometime in mid-September. I'm glad to say that the regulatory consents have gone faster than we thought that they would. And we expect to complete that transaction imminently.

In terms of our balance sheet, it is not only robust, with underlying leverage at 1.37x EBITDA. It is also, I think, pretty clean. Adjusted net debt was slightly better than was expected at GBP 201 million on a pro forma basis. And in terms of a clean balance sheet, 87% of our U.K. suppliers are paid in less than 30 days, and 96% are paid in 60 days or fewer, which is very good for the industry. We don't use any working capital facilities. Our pension schemes are well funded, and there is no refinancing required in the near term.

Our revenue for 2019 remains unguided from -- unchanged from that, that we announced of our preclose update. And I'm delighted to say that the mobilization and transition of our 2 large new contracts that we won in the first half, being the Asylum Seekers contract in the U.K. and National Garrison Health in Australia, is proceeding very well.

If I can just put our guidance for GBP 105 million of profit for 2019, that's UTP after the impact of IFRS 16, into context. You'll remember one of my least favorite words, which was nadir. The nadir of our fortunes being in FY '17, when we made GBP 69 million of UTP and a margin of 2.3%. We increased that to GBP 93 million last year, but within that, and we were very explicit about this at the time, there was about GBP 10 million of nonrecurring trading items within that GBP 93 million. And on a like-for-like basis, with the GBP 69 million and the GBP 93 million, we think that we will make around GBP 100 million in 2019, or GBP 105 million after IFRS 16, and that represents a compound growth over that period of some 20%, which is kind of what you might expect of a company coming out of its bad times and beginning to grow again.

So despite an overall weaker market, our very strong order intake means that we believe that Serco will still be able to outperform for -- the market for at least the next 2 years. And we expect to achieve organic revenue growth of 4% in 2019, accelerating to 5% in 2020, as contracts such as Clarence, that's Grafton Prison, ASC and NGHS become fully operational. And as these become operational that should support margins continuing to increase. And therefore, the potential for further strong profits growth. Angus?

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Angus G. Cockburn, Serco Group plc - Group CFO & Director [2]

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Thank you very much. Good morning, everybody. Let me take you through the financial section of the interim results. Let's start with the income statement.

Revenue of GBP 1.5 billion is up 8% on a reported currency basis, which is 6% on a constant currency basis. The 6% comprises 4% organic growth and a 2% contribution from acquisitions, mainly Carillion Health in the U.K., which completed during the third quarter of last year.

The favorable currency impacts of GBP 20 million in revenue and $2.1 million in UTP arose primarily from the weakening of sterling against the U.S. dollar, from a first half average of 1.38 in 2018 to 1.30 in the first half of '19. All the rates are in the appendix, together with the impact of the ForEx sensitivities.

Both trading profit and underlying trading profit were GBP 50.6 million as the adjustments from the contract and balance sheet review were small and netted to GBP 0. On a comparable basis, to remove from UTP the GBP 1.6 million benefit of IFRS 16, the new leasing standard, UTP was GBP 49 million, representing growth of 30% in reported currency or 25% in constant currency. The UTP margin pre-IFRS 16 was 3.3%, a 50 basis point improvement, largely due to strong performance in the U.S.

Breaking down the revenue performance by division. The increase in revenue was driven by the Americas and AsPac. In the Americas, the 15% increase in organic revenue in the period was against a weak comp of a 12% decline in the first half of 2018, which back then was largely caused by the temporary market slowdown and ship modernization task orders. As you remember, our U.S. defense revenues improved in the second half of last year, and this momentum has continued through the first half of 2019.

AsPac revenue similarly maintained its strong second half performance last year into the first half of 2019. This was driven by several contact center and processing support contracts with customers such as the Department for Human Services, National Disability Insurance Service and the Victoria Police. The 3% organic decline in our Middle East division was largely due to the revenue reduction of this -- on the successful rebid of our MELABs contract.

Revenue in the UK&E grew 4%, with this growth comprising 5% from the Carillion Health acquisition, which continues to perform very well, partially offset by a 1% organic decline. Kevin will touch more on the UK&E later.

Overall, group revenue grew by 8% or GBP 109 million, with, for the first time since 2013, an element of organic revenue growth, which accounted for around half of the increase. This 4% or GBP 56 million of organic growth was supplemented by GBP 33 million of growth from acquisitions and GBP 20 million from ForEx.

Turning to the analysis of underlying trading profit. For the group as a whole, GBP 51 million of UTP represents a period-on-period growth of 29% in constant currency, or 25% excluding the GBP 1.6 million IFRS 16 effect. This growth was almost exclusively driven by our North American business, which had a very strong first half. We saw profit improvement across all our business units in North America, where the standout performer was the recently rebid CMS contract, which saw a rephasing due to the fixed price -- fixed unit price structure of the new contract and volumes weighted to the first half.

As we look forward, it's unlikely that the unusually high volume of variable work that we had in the first half will repeat in future years. The new contract is more fixed price in nature, and we have reduced costs materially through the introduction of robotic automation, a large element of which benefits the customer in terms of materially lower transaction costs. This performance has led the underlying trading margin in North America to grow from 6.3% in the comparable period to 10.1% in the first half of 2019, but we expect it to swing back to around a 6% margin in the second half. UTP in AsPac was modestly down, which included the mobilization and transition costs associated with our national garrison health contract, which successfully went live on the 1st of July. Similarly, in the U.K. division, where the profit growth arising from the Carillion Health acquisition was diluted by the transition and mobilization costs of ASC as well as a slightly lower level of profit from AWE.

In the Middle East, as previously flagged, underlying trading profit and margin reduced significantly. In large part, due to the margin reset arising from scope changes in the MELABs contract. Corporate costs grew by GBP 2.8 million, which reflects both timing and also some ongoing investment in areas such as IT and compliance and assurance. Overall, group margin improved from 2.8% in the first half of '18 to 3.4% in the same period in '19, maintaining the margin momentum we saw for the first time in 2018.

Turning to the bottom of the income statement. The increase in net finance costs was due in large part to the GBP 2.2 million increased interest payable arising from the adoption of IFRS 16. This was compounded by the GBP 1.9 million reduction of interest receivable as a result of the repayment of the Intelenet Loan note last autumn. The blended cost of our private placement and bank debt was 4.9%, similar to the 4.8% of the prior period. The underlying tax cost was GBP 9.8 million, down from $10.6 million in the prior period. This reflects a decrease in the underlying effective tax rate from 34% in the first half of '18 to 24% in '19. The effective rate is lower due largely to the improved profitability and mix, including a lower level of U.K. losses which we are not yet able to take a tax credit on, which is why the effective rate still remains higher than our blended country corporation tax rate. However, given the improving outlook in terms of U.K. profitability, as we work through our loss-making contracts, there is GBP 20 million of deferred tax asset already recognized with a further GBP 131 million of contingent tax asset, which we can recognize in the future as the outlook for U.K. profitability improves. Further detail in tax is given in Appendix 7.

I will cover exceptional items in a separate slide in a moment.

Underlying earnings per share grew by 42% from 1.84p to 2.62p, reflecting the reported 35% increase in underlying trading profit and the lower effective tax rate. Reported earnings per share, which reflects non-underlying items and exceptionals, was a loss of 0.15p compared to a profit of 1.30p in the prior period. The weighted average number of shares in issue was slightly higher at 1,146 billion, given the timing of the NSBU-related share placing.

As previously indicated, the board has not declared an interim dividend for 2019. The board remains committed to resuming dividend payments when it's prudent to do so, which will take into account the appraisal of future financial performance in terms of profit, leverage and cash generation as well as the prevailing market outlook. It is worth noting that full year 2019 is the last year of significant OCP and exceptional cash outflows, and that the board keeps the dividend policy under careful and regular consideration.

In terms of exceptional items, these were a net GBP 31 million as compared to GBP 11 million in the prior period. The biggest element related to the Serious Fraud Office investigation, which concluded with a deferred prosecution agreement, under which Serco will pay a fine and costs totaling GBP 22.9 million. This has been charged to the income statement in H1 as a post balance sheet event and will be cash settled in H2. The restructuring costs of GBP 5.4 million that were incurred relate to the elements of the final year of our transformation program, notably, the outsourcing of elements of our procurement process. With respect to the full year, we expect restructuring costs to be around GBP 15 million. Going forward, focus will move from transformation to operational excellence and delivering efficiencies in the contracts from the implementation of workforce management and improved procurement.

The exceptional costs related to the NSBU acquisition were GBP 1.7 million in the first half. The cash outflow related to exceptional items was GBP 12 million. In terms of the full year, we expect exceptional cash cost in the region of GBP 50 million, around half of which will relate to the conclusion of the SFO investigation.

Turning now to cash flow. We have, for the first time in my tenure, a positive, as Rupert said, albeit barely registerable free cash flow inflow for the first time of GBP 0.4 million. You notice, we didn't round that number. We gave you the bullet -- the point. This compared to an outflow of GBP 31.6 million in the first half of 2018, which has an IFRS-related restatement of GBP 5 million for the capital repayment of finance leases, which were previously recognized below free cash flow. For half year 2019, the cash flow has some new IFRS 16 lines to it. There is GBP 29.4 million of depreciation and impairment of newly recognized lease right-of-use assets. There is then the row that's titled Capital Repayment of Lease Liabilities, which, together with a finance element running through net interest paid, represents the actual cash flow on all these liabilities, i.e., finance and operating leases together. It is worth remembering that despite all these IFRS 16 items. It is absolutely 0 impact on net cash flow, and it's merely a presentational change. The shift to positive free cash flow was generated through improved profitability as well as lower working capital and OCP-related cash flows. Utilization of receivables financing was 0, and we no longer have a receivables financing facility. Also, we don't use any form of payables factoring.

The working capital outflow in the period was GBP 7.5 million, and our average working capital days were broadly unchanged. Capital expenditure for the half year at GBP 12 million was lower than the GBP 18 million in 2018, but we still expect CapEx to be in the region of GBP 30 million for the year. From a net debt perspective, there are added complications of the equity placing and IFRS 16.

Net debt at the end of the first half is presented on a pro forma basis to exclude the GBP 139 million net proceeds of the placing, as these will flow back out again in the second half on completion of the NSBU transaction. We have also introduced a new measure, called adjusted net debt, to exclude all lease liabilities, including previous finance leases as IFRS 16 makes no distinction between finance and operating leases.

The prior period numbers have, therefore, been restated to exclude the GBP 20 million of finance leases that were previously included in net debt. Pro forma adjusted net debt at 30th June '19 is GBP 201 million, which is similar to the GBP 205 million in June '18. The increase from GBP 173 million at 31 December '18, reflects the previously discussed exceptional cash outflow of GBP 12 million as well as a GBP 9 million acquisition outflow in respect of our 10% shareholding in the SPV for the Clarence Correctional Facility in Australia, formerly known as Grafton. Daily average adjusted net debt for the period of GBP 219 million was GBP 26 million higher than in '18, very similar to the movement since the year-end. Peak net debt during the period was GBP 277 million, which was GBP 16 million higher than the prior period in 2018. Our debt covenants remain in a pre-IFRS 16 basis, and therefore, are calculated based on the previous GAAP definitions of finance and operating leases. Post the covenant adjustments highlighted in Appendix 10, our net debt-to-EBITDA leverage ratio is 0.43x, which includes the proceeds of the equity placing. On an underlying pro forma basis, which excludes the OCP net releases in the second half of '18 and ignores the impact of the placing, leverage was 1.37x. By the end of the year, we expect underlying leverage to be closer to 1.5x, which will include the impact of acquiring NSBU. This number is in the middle of our target range of 1x to 2x.

Okay, the slide that everybody's been waiting for: IFRS 16 on leases. We set out in February the background and estimated effect of adopting IFRS 16. You should, therefore, already be familiar with the top 2/3 of the slide. However, the first point I'd like to highlight is that the estimated impact on our 2019 result remains broadly unchanged from what we said in February. That is UTP and net finance costs will each increase by around GBP 5 million, and therefore, approximately net out. In terms of the first half, there was a GBP 1.6 million benefit to UTP and a GBP 2.2 million increase in net finance cost. It is also worth reiterating that the property leases associated with ASC, will have a bigger impact as we go through the second half and most particularly in 2020. And we will give further details as the lease portfolio takes shape. As if IFRS 16 wasn't complicated enough, when you add OCPs into the equation, it takes on a life of its own. For example, with respect to Caledonian Sleeper, the right of use asset that would have been recognized during the first half for the first tranche of our new trains was immediately impaired by GBP 12.6 million, because the profits in this contract couldn't support the asset value. This impairment took the form of an accelerated utilization of the OCP, meaning that the remaining OCP is smaller but there is now a new lease liability of the same amount. Importantly, it should be borne in mind that this does not change the cash profile associated with the Caledonian Sleeper contract, with the cash outflow previously associated with the OCP now being against both the remaining OCP as well as the capital elements of the lease liability and associated interest.

It's probably worth saying at this point that if you want more on IFRS 16, professional Nigel Crossley at the bank and his finance accounting team are very happy to run tutorials at the end of this session.

Now if like me, you crave for a set of Serco results where there's no mention of the 2014 balance sheet review and OCPs, the good news is that we're almost there with a remaining OCP balance of GBP 26.7 million at the half year. However, as we just discussed, there are IFRS 16 impacts on OCPs totaling GBP 25.9 million, and that is the combination of the GBP 13.3 million opening adjustment and the GBP 12.6 million accelerated utilization in Caledonian Sleeper. Adding this 26.7 -- adding this GBP 25.9 million to the GBP 26.7 million of the remaining OCP means that from a future cash outflow perspective on loss-making contracts, there's still GBP 50 million to GBP 55 million to go. Of that, GBP 15 million to GBP 20 million will occur during the second half of this year, a further GBP 15 million in 2020, and an aggregate of GBP 15 million to GBP 20 million thereafter. Overall, the good news on our loss-making contracts is that having started with GBP 447 million of liability and cash drag, we're within sight of the finishing line.

Finally, let's look at the outlook and modeling assumptions. The guidance on this slide excludes any benefit from the completion of NSBU, other than the impact of the acquisition price on adjusted net debt. All conditions have recently been met that enable the acquisition to complete imminently, and we expect approximately 5 months of NSBU revenue and profit will be included in the year-end results. We expect revenue for the year to be around GBP 3 billion, partly reflecting a small favorable currency movement based on current exchange rates. We continue to expect UTP of around GBP 105 million, which includes the GBP 5 million benefit from IFRS 16, which is broadly offset by higher net finance costs. As we head into the second half, we must bear in mind that growth will be muted, given the H2 benefit we had last year of one-off nonrecurring trading items such as end of contract settlements, as well as the impact of not having CMS variable work that we had in first half, with profit and margin reverting back to more normal levels. We expect net finance costs to be around GBP 20 million, which includes the estimated GBP 5 million from IFRS 16. In terms of tax, we expect an effective rate just below 25%. The weighted average number of shares on issue was expected to be 1,145 billion. As a result of the NSBU placing, an additional 111 million shares were issued in May, which increases the weighted average number of shares on issue for 2019 to 1,200 billion.

Guidance for exceptional restructuring costs is around GBP 15 million, as we conclude the final year of the transformation stage of our strategic plan implementation. We expect to generate free cash flow of between GBP 30 million and GBP 40 million compared to GBP 16 million in 2018. In February, we guided to adjusted net debt of around GBP 200 million, which, consistent with our covenants, excludes newly recognized IFRS 16 lease liabilities. As stated at the time of the NSBU acquisition, we now expect adjusted net debt to be around GBP 250 million, with underlying leverage increasing to approximately 1.5x, of which was -- some 0.2x is due to the impact of NSBU.

With that, let me hand back to Rupert.

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Rupert C. Soames, Serco Group plc - Group CEO & Director [3]

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Okay. For those of you who are aware of my past as a disc jockey you'll be aware that one of the great secrets of the art is segueing smoothly from one mood to another. And on that basis, I'm going to start with the low lights first before segueing into the highlights. But you will notice on our low lights page that the acreage has had to change somewhat. We used to be about 50-50 low lights and highlights, but we're now down to 1/3 low lights. I will start, as always, with them.

First low light referred to is that we've obviously had some quite severe difficulties with the delay in the introduction of our new sleeper rolling stock. I have to say that the actual rolling stock itself is magnificent. But it has been like going in a single leap from a Bakelite phone to an iPhone. There's much, much more technology in it. The trains were delivered late. And we went into service probably too early. Anyway, it is now running well on the Lowlander and we are achieving very good punctuality on that, and those people who are traveling on the new trains are really enjoying it. So I am confident that, that over the next few months will get better as we roll out the Highlander and we've got that back under control.

Staying in Scotland, we have been beset by continued difficulties around some 300 Compass overstays, that's asylum seekers, who we have been looking after way after the Home office Support has continued. I'd have to say, this is an example of the road to hell being pathed with good intentions. What started as us giving a few asylum seekers a few months extra, after they've had their claim refused, to go and make alternative arrangements and find their way back to their home countries has turned into some 300 people over staying, of whom the average stay -- overstay is now knocking on a year. It is an intractable and difficult problem, but we will work our way through it. We are taking various elements of action to reduce that number. And over time, it will reduce. But it is, politically, very difficult and highly charged.

We still see continued very high levels of prison violence in the U.K. It is striking how different the levels of violence in the U.K. prisons are from the Australian ones. But I am glad to say that in the recent MOJ, Ministry of Justice, rankings of prisons are -- private prisons as a whole, and particularly the Serco prisons came out very well out of that. There are some indications that the trend in violence is beginning to reduce. But again, this is a problem that will take some time to resolve.

In terms of the delivery of our -- the new Icebreaker to Australia, we're now very tight on the delivery of that. I don't think -- see that as having any great financial consequence for us because we are on a fully pass-through basis with the manufacturer. But they are struggling to keep up to the time scales, and we will have to see how fast we can sail from Romania down to Hobart when the ship is finally delivered.

There's a very tight labor market in the U.S. I know there's been a lot of chat about the U.K., but in the U.K. we're, yes, it's quite tight, but it's fine. Kevin can talk more about that. But in the U.S., we're into the kind of stage now where welders are being paid like investment bankers or should I say analysts. The very tight labor market, particularly for key skills. And as you'd expect, the Navy is very busy. The implication for us is more that we could grow our revenues faster, if we can get a hold of more labor because a lot of our contracts there are in the -- our cost-plus rather than one being easing our margins. But we -- as I said, key skills are hard to come by.

The pipeline now is down to GBP 3.2 billion, which is not really unexpected, since we have taken GBP 3.3 billion of order intake in the first half. And I think we will replenish it quite strongly in the second half. We got quite a lot which is on the verge of the pipeline. But we want to see it start to grow. And in the U.K., you'll all be aware of the political situation. We -- clearly, the government is now highly focused on Brexit and getting Brexit done. All the government is a phenomenally powerful machine when with all the fish point in the same direction, and they are now all pointing in the same direction. So this continuation of having to focus on one particular theme and finding it difficult focus on others, is, I think, going to continue for a while. And as Kevin will explain, we're actually not badly placed in that environment because, actually, we do non-discretionary stuff. It's more of the discretionary projects that are being delayed.

Right. In terms of the highlights, we've talked about the UTP progress and the acquisition of NSBU. I would say it was particularly pleasing that when we did the equity placing, it was one of those rare birds, where we placed at a 5% premium to the previous night's close. And I'm glad to say that everybody who bought stock in that, everybody has gone away from that party with a balloon because we are nearly 11% up since the placing price. So that's good news.

In terms of the order intake, we talked about the asylum seekers and the defense garrison health care. But I would also point out that there's been a lot of other action: the U.S. Pensions Guaranty Corporation, in terms of providing what is the equivalent of the institution that handles and administers failed pensions operations in the U.S.; the U.S. Tririga Air Force next-gen IT, which is highly technical asset management for the Air Force. We've won another prison in the form of Adelaide Remand Centre, and we are now picking up -- or shortly, we'll be picking up Her Majesty's and the former Prime Minister's dustbins, since we are doing environmental services in Windsor and Maidenhead. And there's been a lot else, in particular, our contract with FEMA, the Federal Emergency Management Administration, where when there's floods or hurricanes, some other natural disaster in the U.K. (sic) [U. S.], we have a section of the country that we look after. And that is now ramping up very significantly, the business there. And I'm delighted to say that yesterday, we announced a further contract for rebid for some GBP 100 million of the traffic camera services in Australia. So there's still momentum behind that. Angus has talked about the OCPs being on track with some GBP 50 million to GBP 55 million left to go against the GBP 447 million. That's GBP 50 million to GBP 55 million of cash outflow, against the GBP 447 million that we announced in 2014. So as he says, we can see light at the end of the tunnel.

The U.K. government has tried really hard. And actually, they've done -- been extremely diligent and have done a good job in recognizing that the ground rules for contracting the public sector needed to be changed. There's a new playbook. It's early days yet, very early days. It will take some little -- it'll years to properly get implemented and become a way of life with government, but the intention is there.

And there are other things that I'm pleased about. It looks like Serco, dare I say, is becoming something of a talent magnet. We decided to introduce a graduate program in the U.K. We had a 1,000 people apply onto our website, 600 people went through and did the test. We had some 75 people who exceeded on the test the level required for Treasury Fast Track acceptance and all this for 12 places. So I think that we are an attractive employer, particularly for young people, and what they see is our commitment to making a positive difference in public services.

In terms of operational excellence. If I should die, think only this of me, that Serco, by the autumn, will have a core SAP, ERP system on latest version running in the cloud and a complete Office 365 implementation worldwide. And that is, I have to say, most companies don't get anywhere near that. Most are treading, as we were, treading on versions 7, 8 years old, and we by the end of the year we'll be -- have as absolutely current version of SAP. And I think that, that puts us in good stead in terms of being able to run the systems clearly and efficiently.

And finally, I'm delighted to say that we were able to draw the veil over our issues with the Serious Fraud Office and come to a settlement of that. But clearly, we are continuing to maintain the very, very high degree of compliance assurance that you would expect for a company such as ours. And we also came to an amicable settlement with the Ministry of Defence around our DFRMO dispute.

A few words on the order book and pipeline progress. So if you just look at that top graph, you'll see that we've got an order book of GBP 14 billion, which is -- compares to GBP 13.6 billion that we had in FY '13. The difference is that within the GBP 13.6 billion of FY '13, there was over GBP 3 billion of contracts that subsequently turned out to be unprofitable. Whereas we believe other than a stub of remaining OCPs within our current order book, which is mainly sleepers and the DES in Canada, that our GBP 14 billion represents contracts that we expect to be profitable. I'm sure there's some in there that will turn about sometime in their lives, but it's a much healthier position. And it is a large order book relative to our revenues.

In terms of the pipeline. The pipeline represents only about half of our order intake over -- that we get. Because we define it the [forward] definition of pipeline is extremely strict. As I said, it generates about half of our order intake. But we need to rebuild it, but I think that we will be able to do so in the months ahead in the second half.

Just to remind about the NSBU acquisition for $225 million, it's got world-class capabilities and ship and submarine design, production, engineering in service support. It takes us right into the core of U.S. Navy design at a time when the U.S. Navy is committed to a significant increase in the number of ships in the Navy. And we also -- I have to say, our colleagues around the world both in the U.K. and in Australia are very keen to start using the skills that we have in [a line].

And on that point, I'm about to -- going to hand over to Kevin Craven. Kevin joined the business in September 2014. I think you're about my first recruit, pretty much. And he's had vast experience in the turnaround. He has taken the heat and burden of the day of the biggest turnaround in our business, where some of the most -- issues were the most intractable. He started running our central government business, and in 2017, he took over the whole of our U.K. business in terms of the local government. So Kevin?

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Kevin Craven, Serco Group plc - CEO of Serco UK & Europe [4]

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Thank you, Rupert. And may I say, what good judgment you showed in hiring me 5 years ago. Good morning, everyone.

So I'm very pleased to say that this is the year that the division begins to look like a proper business, both growing and delivering positive cash. I know you're relieved by that, but not as much as I am.

To remind you of the size of the business, in 2018, we were at GBP 1.3 billion of revenues. Our shares in joint ventures added around a further GBP 370 million. Those revenues together delivered about GBP 40 million of underlying trading profit at 3% margin. The majority of the business, as you would expect, is in large contracts. 75% of the revenue in just 35 contracts, and we had some 24,000 employees. You already know most of our client base and can see some of them on the screen. So I'll just pull out a couple of them that are further up the technical value chain.

For the European Space Agency, we do both space operations and data analysis. For CERN, the nuclear Research Facility on the Franco-Swiss border, we do the maintenance on the cryogenic operations. They're essential to the successful operation of that facility. We also do pathology and laboratory services at King's and Guy's Hospitals through our Viapath JV. And of course, the technically very difficult and challenging prison operations, where I'm very pleased to say, as Rupert mentioned, that we were awarded, either good or very good across all of our English prisons in the MOJ annual prison performance announcement last week. Also pretty good strategically was our first European defense contracts last year in Italy and Belgium, only small, but we will be bidding a further 5 military bases in Belgium soon.

So as you can see from the pie chart, the mix of the business across the 6 business units, 5 sectors, and we manage Europe as an additional geography, is pretty evenly spread, with defense, including AWE, the biggest, and Europe, the smallest.

So turning to the half year results, we have had a strong operational performance, and we continue to improve on the financial. The year is clearly an inflection point for us, as we start to outpace the drag from the onerous contracts that have dominated previously. Some revenue growth, GBP 23 million up, mostly from our successful health care acquisition, but some organic, such as our new Basingstoke and Deane environmental services contract and the employment and skills win, but offset by the exit from the OCP contracts and East Kent Hospitals and the onerous elements of the Anglia Support partnership, which we disposed of.

Underlying trading profit was up by 3%, and we've held the margin flat, despite continuing to invest in our skills, capability and compliance. We had expected some reductions in this first half, particularly from AASC, now in full mobilization and transition mode, and the 3-year pricing period for AWE. But those have been offset by the Carillion contracts and other health care improvements as well as our ongoing efficiency programs.

So the OCP utilization was down by about GBP 7 million at half year and is expected to be only GBP 40 million at the full year, then further reducing to less than GBP 15 million for next year. So tremendous progress given the GBP 80 million worth of pain we had in 2015.

So we are expecting the second half of the year to be much stronger and shifting to positive organic growth, with something like a 4.5% margin in the second half, which should get us to around 3.5% for the year and, therefore, up 50 basis points year-on-year. So I do like this slide. At 41% of the group, 45% if we include Europe, we have a material impact on the numbers. This slide shows us returning to being a significant contributor to the group's fortunes.

Up at the top, we are showing the revenue profile. So managing this business declining by 36% over the years up to 2018 has been pretty hard and finding the headroom to invest in improving the much-needed systems, processes, capabilities and people was tough. But we got there and distinctly turned the corner last year, as you can see from the underlying trading profit margin on the bottom section. We are anticipating eventually getting closer to our 5% to 6% margin aspiration, which is a reasonable reward for what we do. More importantly, the middle section shows the profitability in pound terms improving and the OCP utilization reducing and visibly coming towards an end. It might be a little bit fanciful, but if you squint at these bottom 2 sections, it kind of looks like a smile, and it may be that I am slightly, ever so slightly biased.

Moving on to the operational [sharpens]. Rupert talked about the Caledonian Sleeper. We are making real progress on the new rolling stock implementation. And those of you who've been lucky enough to travel with us in the last couple of weeks on our Lowlander service will have enjoyed the real step change in facilities and comfort. As our passengers clearly have, since volumes are up 9% year-to-date versus last year. And continuing the trend since we operating -- we started operating the franchise, we are up 24% since the beginning of that franchise period. So as you know, the OCP increased in 2017 due to that delay in the rolling stock. However, it now drops significantly. We are trading within expectations and looking forward to April next year, when the losses will be much, much smaller and Transport Scotland will bear 50% of any of those remaining losses. It's probably also worth reminding you that in 2022, we can adjust our pricing to Transport Scotland. They can choose to accept those prices or we will exit. So if you haven't tried it, you should. It's a real experience now.

So talking of OCPs, Compass with an enormous OCP in 2014, is almost all over. We are in the middle of transitioning to AASC in the Northwest already, and we start transitioning the Midlands and East of England today. We'll be formally done with the Compass contracts, which have revenues of around GBP 70 million, losses of around GBP 15 million per annum, on the 30th of September when we hand over to Mears in Scotland and can concentrate on the new contracts. With double the revenues and 20,000 asylum seekers in around 5,000 odd properties, we will be the largest supplier in this marketplace going forward.

Importantly, the new contract has been improved, both for our service users, but also reduces Serco's risk with volume caps, greater gradation of volume charging bans and protections against surge events as well as much improved inflation mechanisms. Both of these are challenging complex contracts, but we are making good progress and are on track to deliver.

So I did want to pick up on 2 areas of operations that we don't often talk about. The first of these is space and security, where we have a range of capabilities and services, but also see quite a lot of opportunity as the sector grows on a global basis. That capability extends from Serco's very first contracted [filing deals] in the late 1980s, where we have supported both the Ballistic Missile Defense infrastructure, but also do the space traffic analysis. And over to the Copernicus Earth Observation satellite program for ESA, where we provide the data and information access services through a web portal called [Onde].

So this diagram shows some of the many touch points we have in this growing area and some of the opportunities. So over at Vandenberg Air Force base in California, that's where the U.K., Australia and Canada joined Forces with the U.S. for command and control functions integrating space and military operations. The U.K. version of that is the joint National Space Operations Center, and up the top at Scotland that Sutherland, you can see the site for the U.K. vertically launched Space port. These are the types of real and current opportunities that Serco is both qualified and ready to support. In the direct technology space, we have a small business that is, for example, supplying test equipment for the Luftwaffe amongst others. And finally, at the emergency planning college, this is a go code with the cabinet office, where we provide emergency and resilience training for the civil authorities. This is probably one of the few places in the U.K. that has benefited from Brexit thus far.

So finally, I wanted to touch on a little known gem inside Serco, the ExperienceLab. We separated this operation out from the National Physical Laboratory many years ago, and it designs people-centered services and digital solutions, both internally and for external clients including, I might add, Google and Facebook. But we have seen great outcomes in health, particularly where they have designed and delivered Serco Cares. This is a cultural change and patient support program that has been massively well received by our clients and frontline medical staff as well as impressing academia as the quote shows. This is Serco at its very best. And we think Serco Cares has huge applications in other areas of our business where we support vulnerable people.

They also had a hand in perhaps a more relevant example for organic growth at a contract level. So down below, we are looking at the new patient discharge suites, where we designed and built an extension at Norfolk & Norwich University Hospital that specializes in taking patients ready for discharge from the wards early and then manages the -- all the admin, medications and transport before they leave hospital. This enables the hospital to get back beds and staff much sooner, and alleviates a lot of the patient frustration in hanging around waiting for staff to support the discharge.

Just moving on to the pipeline. Currently, this is the externally defined pipeline, which is reasonably healthy and spread over all of our sectors. Just outside the pipeline, we mentioned prisons, where there are 2 new-build prisons, Wellingborough and Glen Parva, coming into the pipeline very soon. But we also have the Gatwick Immigration Receiving Center in J&I, which is a bid we are in the middle of right now. And we are in defense partnering with [NG] on a number of defense infrastructure opportunities, both in housing and base support. We also have a maritime infrastructure opportunity down in Portsmouth, and of course, health is generally a very liquid marketplace with a number of opportunities in [FM].

So this picture, obviously, excludes rebids and extensions. But probably worth noting the PECS contract, prisoner escorting, which is underway at the moment. It is currently an OCP contract, where the opportunity for cash and profit turnaround is similar, albeit much smaller than AASC. The contract value of that is around GBP 70 million for 10 years in the new contract.

So we are very much in good shape. Much of our transformation is complete, and we're now focusing very hard on productivity and continuous improvement. We are, every single year now, training 500 yellow belts and 60 green belts, and expect to have over 7,000 employees in our complex contract environment under the new workforce management system by the end of the year. I am somewhat less lugubrious than Rupert on the market and the environment. They do remain challenging, but we are seeing progress, both in relationships and policy. And I should say and support Rupert in mentioning that the outsourcing playbook was a big step forward for the government. And we are seeing visible signs in some of the tenders that we are dealing with at the moment of those changes. But there is real deal flow, as you can see out there. A lot of what we do is not discretionary. Patients will still need care in hospitals. The Royal Navy will still need to be towed out to sea and asylum seekers will still need housing.

And finally, we are moving towards growth. We want to broaden our pipeline, we want to build on our global centers of excellence in J&I and Health. And we would love to leverage the NSBU acquisition in defense. We do see opportunity in Europe. And if we maintain our rebid and extension rates, we will continue to see organic development. In short, our market remains attractive. And we are well-established to play. Thank you.

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Rupert C. Soames, Serco Group plc - Group CEO & Director [5]

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Well done, Kevin, done a terrific job. So the first half of '19 has built on the inflection point that we delivered in 2018. Good trading and financial performance, very strong order intake and our order book at GBP 14 billion is a fine store of future value. Our NSBU acquisition adds materially to the scale both of our U.S. and our wider defense business, and we have a robust and a clean balance sheet.

2019 guidance for growth in both revenue and UTP remains as previously, and the mobilization of our large new contracts is going well. At which point, I will turn over to Q&A, which will be moderated by Angus.

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Questions and Answers

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Angus G. Cockburn, Serco Group plc - Group CFO & Director [1]

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Down in the front here, please.

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Paul Daniel Alexander Sullivan, Barclays Bank PLC, Research Division - Director & Analyst [2]

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It's Paul Sullivan from Barclays. Just firstly, could you just give us a bit more color on the range of opportunities within the pipeline and beyond that you see outside of the U.K.? And could you give us a sense of the sort of the average margin that you would expect, what you currently see it within the pipeline and maybe that settings beyond the pipeline. That is the first question. And then just sort of following on to that, in terms of progress and timing of reducing contract costs. I think that's the sort of next leg of the margin improvement story, a little bit more sort of color on where you see -- and where do you think you are on the road to 5% to 6% margin? And then just finally, post the U.S. acquisition, where do you now see the strategic gaps in the portfolio? And how ambitious do you think you'll be on M&A going forward?

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Rupert C. Soames, Serco Group plc - Group CEO & Director [3]

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So Kevin, do you want to talk about contract costs?

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Kevin Craven, Serco Group plc - CEO of Serco UK & Europe [4]

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Indeed, so as I mentioned, around the yellow belts and green belts workforce management, these are examples of some of the initiatives we're using to drive down those contract costs. I have set the team a target of a 1% margin improvement. I would expect to see that coming through in the next 18 months or so, depending on the contracts and the challenges we might have in those specifics. But as we build that operational excellence space, we get to 20% of the workforce being yellow belts, 5% being green belts. Each of those will produce a big difference.

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Rupert C. Soames, Serco Group plc - Group CEO & Director [5]

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I'll talk a little bit about the pipeline x the U.K. At the moment, it's mainly focused in the U.S. We have a large tender right to all the traffic control training for the FAA. We have numerous bids in with the Navy. And in particular, we have just won a place on what's called the 750 framework, which is a framework contract for doing work on ships equivalent to -- similar to the CANES contract that we already have. But we -- that is quite a big opportunity. In Australia, we have -- at least we see it coming down the pipeline, some more prisons coming up for bid. And there is a major rebid of our a [Tangata] contract of providing a [label] services in Australia. I think in terms of margin, they are where you would expect us to be. We try to bid in the sort of minimum of 5%. We occasionally shave a little bit beneath that. But from our point of view, it is an issue of risk and reward. I would say that there's quite a lot hovering just outside the pipeline, and in particular, Kevin mentioned the Prison Framework contract that others have taken into their pipeline. We haven't yet done that, but that will be quite a large value to come in. Angus, do you want to add anything to that?

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Angus G. Cockburn, Serco Group plc - Group CFO & Director [6]

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No. In terms of margin, where we are -- we were 2.3% back in '17, we added 100 basis points last year. The consensus says we'll add 30, another 30 this year. And we see that margin progressing next year as well. So are we going to suddenly hit a button and get there? No. But we are now on a progression where the margin is getting higher and heading towards that range.

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Rupert C. Soames, Serco Group plc - Group CEO & Director [7]

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In terms of M&A, yes, we still have an appetite for that. It was one of the reasons why we went and did a significant proportion of the NSBU acquisition with equity was to keep some dry powder, and there is still a flow of opportunities. I don't think you want to confuse us looking at stuff and actually doing stuff, over quite a broad range, ranging from Carillion Healthcare contracts to NSBU in the Navy, and BTP that we've done and others that we've looked at. I don't want to confuse that with being just being frivolous about it. Actually we have a broad spread of businesses. We look at quite a lot. But then we have quite a few businesses which could benefit from acquisition. So we have an appetite. We are very focused on integrating NSBU, but that will not stop us looking at other stuff. Does that do it?

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Angus G. Cockburn, Serco Group plc - Group CFO & Director [8]

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Next question. Yes.

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Unidentified Analyst, [9]

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(inaudible) from [DR Hamburg] I have a couple of questions focused on the U.K. After the outsourcing playbook favored by the government, are you seeing an improvement in terms from them or is it just dialogue at this stage? And have you seen an increase in propensity for local authorities to outsource? And lastly, has there been change in the competitive backdrop when bidding for contracts versus 3 years ago?

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Rupert C. Soames, Serco Group plc - Group CEO & Director [10]

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Kevin?

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Kevin Craven, Serco Group plc - CEO of Serco UK & Europe [11]

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Yes. I mean, on the first, as Rupert mentioned, the competitive outsourcing playbook will take time to bid in, and we are seeing a number of tenders where there is no sign of the changes that are encapsulated within that. But on the other hand, I could call out the MoJ, where we have seen some changes and the dialogue around the terms and conditions have been very much in line with the best principles in the outsourcing playbook. So it will depend on adoption by the individual departments and the pace at which it's appropriate for them to move. But I think it's a positive move, generally, for the market and generally welcomed by my colleagues in the industry. In terms of your second question, more propensity for local authorities. No, we are seeing a slight tendency towards more extensions but that is a feature, generally, of the U.K. marketplace at the moment in terms of capacity of government departments, whereby they perhaps are focusing on other things like Brexit, they will then take an easier route to extend contracts, then perhaps start a full-scale procurement. We are seeing that in the local authority marketplace as well, but not a greater share of outsourcing. I wouldn't say that is visible to us anyhow. And then in terms of the competitive environment, some of the things that we do are very difficult and challenging. The prison framework, for example, prison operator's framework, essentially over the next 10 years or so, there is a private sector prison that will be coming to market roughly at a pace of 1 per year. There are 6 places on that framework. 3 of those are current prison operators. So the competition has de facto become bigger in terms of the ability to operate and run those prisons in a challenging environment. I expect that the majority of those awards would go to current operators. But it will depend, as always, on individual competition and the appetite for people. We are confident that we have a robust proposition and hope to do well.

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Rupert C. Soames, Serco Group plc - Group CEO & Director [12]

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I'll just add something to that. I mean, when you see the AASC procurement, the asylum seekers, which was a GBP 4 billion government procurement. There was only 1 new player came into that market. So my general view about the U.K. market is that the competitive intensity is probably less than it was, that there are people are being more choosy about what they want to bid for. But this is a sort of pendulum swinging, and we'll, I'm sure in time, come back and win people. If the companies, the market see other players being successful and making money serving the government, then that will attract new competition back into the market over a period of time.

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Angus G. Cockburn, Serco Group plc - Group CFO & Director [13]

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Thank you. Next question. David?

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David Roux, BofA Merrill Lynch, Research Division - Associate [14]

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David Roux from Bank of America. I've just got one question for Angus. On the free cash flow, free cash flow guidance for the year. That seems to be nudged up somewhat since we last heard from you. I was just wondering what's driven the change in expectations?

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Angus G. Cockburn, Serco Group plc - Group CFO & Director [15]

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It's small moves in areas like tax is probably a little bit less than we thought, working capital is looking a little bit better than we thought. There's nothing materially changed as we go through it, perhaps CapEx would be a little bit lower. So you're looking at GBP 2 million or GBP 3 million different in the whole series of different lines.

Julian?

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Julian Charles Cater, Numis Securities Limited, Research Division - Analyst [16]

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It's Julian Cater from Numis. A question for Kevin. When we talked about your U.K. business and the risk of a labor government, I think you were -- that was 2 or 3 months ago. And you were sort of relatively measured i.e. you thought that if you were involved in [more] power distribution, you'd be more at risk. You talk about delivering essential services, but even in some of your local authority for areas like waste management, there's a sort of statute backing to that. But if you look at the commentary from John McDonnell 2 or 3 weeks ago, talking about potentially having taking in collection in-house. Some of those are other sort of services. How is that perhaps shaping your thinking about what you're prepared to bid for in the U.K. over the next couple of years and how your sort of risk register has changed?

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Kevin Craven, Serco Group plc - CEO of Serco UK & Europe [17]

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So I mean, one of the things that John McDonnell said was that he won't cancel existing contracts, which, I think, is something that is worth dwelling on because many of our contracts, and particularly in the local authorities, are fairly long contracts. So it may be that, again -- and there's a question mark about whether that includes extensions. But I would expect that to protect us, to some extent, if there was a major political move in that space. And generally, my view on the political environment is that any government now will last 5 years. Typically, our average contract life is closer to 7. And if there was a major policy announcement around this stuff, then, of course, we would have some impact, but would it mean that we have no business? I don't believe so. So I am still reasonably sanguine about that. I think depending on how he takes an election platform into government and how easy it is to enact that policy will then depend on our response to it. We are fortunate in terms of our geographical spread. And therefore, I would expect Rupert to very quickly transfer some of my business development budget overseas, pretty rapidly.

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Angus G. Cockburn, Serco Group plc - Group CFO & Director [18]

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Stephen?

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Stephen Joseph Rawlinson, Applied Value Limited - Director & Analyst [19]

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Stephen Rawlinson from Applied Value. Two questions, if I may. Firstly, with regard to one of the slides, Page 75, you refer there to the inflationary nature of your cost increases you can apply. Could you just talk a little bit about the 4% organic growth in the first half? And how much of that might have been your ability to actually implement those inflationary cost increases, particularly given some of the competitive environments that you face. And secondly, with regard to rebids. It looks to me like over the next 3 years, the GBP 300 million, GBP 400 million and GBP 500 million of current contract work to be rebid. Just talk a little bit about whether it's your current intention to actually bid those contracts, and how you see that playing out.

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Rupert C. Soames, Serco Group plc - Group CEO & Director [20]

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So in terms of the -- I think there's a dynamic in our business around inflation and pay that is different to many others, including in our sector. In that, as Kevin said, most of our contracts are long-term contracts. And over 90% of them either have predetermined indexation in them, or price negotiations and things. But it's not as if, when we are competing each year to go and in a competitive environment to catch up labor costs. So I think that we are reasonably well protected. I don't off the top of my head know how much of our increase in revenue in the last 12 months came from indexation. But let's say, it will probably be, globally, somewhere around inflation. Because that's what we tend to get on our contracts anyway. Sorry, the second question about the GBP 300 million to GBP 500 million of rebid?

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Stephen Joseph Rawlinson, Applied Value Limited - Director & Analyst [21]

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(inaudible)

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Rupert C. Soames, Serco Group plc - Group CEO & Director [22]

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Yes, I mean, most of them, we will want to rebid. Some of them we don't, and a lot of this depends on the terms under which customers are -- that new contracts come out. But there are examples, and I won't go into them, won't name them, where we have not been able to come to an agreement with the customer about a fair way of contracting, and we have just said, right, we won't rebid. But the vast majority of them, we would.

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Angus G. Cockburn, Serco Group plc - Group CFO & Director [23]

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Any other questions? Well thank you very much.

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Rupert C. Soames, Serco Group plc - Group CEO & Director [24]

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Thank you all very much, indeed. Kevin is here to be tied to a post and interrogated, if anybody wants to. I'll hold him down while you kick.

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Kevin Craven, Serco Group plc - CEO of Serco UK & Europe [25]

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Sounds like fun, Rupert.