Case study july 2011 illustrative script 2 ICAEW

The candidate opens with two paragraphs summarising WW‟s growth in revenue and profit.. “Additional training will reduce revenue per man hours” or clumsily worded e.g.“The 2012 Olympics

SECOND ILLUSTRATIVE SCRIPT AND EXAMINERS’ COMMENTS

The commentary below follows the order and numbering of the script, with reference to the topics in the marking key It should be read in conjunction with the review of the First Illustrative Script and full Examiners‟ Report for this session

Examiners’ comments – overview

This script failed the exam The candidate has produced good answers to Requirements 1 and 2

(over 50% of competent grades for each) – in both cases with full appendices – but a shallow

executive summary and a very brief Requirement 3, suggesting either a lack of ideas or time pressure (or both) – common problems among failing candidates

As illustrated more clearly below, throughout the script there are passages containing irrelevant or rambling sections that earn few if any competent grades Time spent on these could have usefully been reallocated to the rest of the script so as to produce a better balance

Terms of reference and executive summary

The script opens with appropriate terms of reference and a key to some of the abbreviations used This is followed by the executive summary, which comprises an introduction and a section for each of the three main requirements

The introduction sets out the context clearly, making neat reference to some of the major issues

affecting the company (e.g competition, compliance) and then providing a short summary of the main findings from each requirement

Under „Review of performance‟, the candidate offers some concise headlines about the income

statement, including costs, but omits two significant areas – revenue by key client and KPIs For

„Acquisition of Mustang‟, the candidate provides the key number (proposed price) and makes a series

of other relevant points, but overall, with only four sentences, the section is too brief: it refers to only one of Mustang‟s divisions and has nothing on the assumptions underlying the valuation Finally,

under „PQR tender‟, there are only three sentences! Again, the points made are all relevant but too

few to earn much credit Overall, the main content of the executive summary lacks suitable breadth and depth of coverage

Analysis of Watchwell’s financial performance [Requirement 1]

This is a good section It deals with the major elements of the requirements – comparison with prior year, gross profit, operating profit and KPIs – and is supported by a helpful appendix (see below) The main shortcoming lies in its failure to address the points listed under „Implications of financial analysis

on revenue‟ within the marking key at Applying Judgement This in turn is primarily the result of a failure

to consider revenue per hour for the large clients

The candidate opens with two paragraphs summarising WW‟s growth in revenue and profit

Unusually, the focus here is on operating margin, where the candidate makes effective use of a press article from the AI (Exhibit 12c) that most others overlooked (S)he goes on to a survey of revenue, setting out the overall increase; the same figure adjusted for Quinto („like-for-like‟); and movements in the two business streams The like-for-like analysis is useful, but only to a point: it is a feature of

WW‟s business that the client portfolio is constantly changing, and so it is of questionable benefit to exclude Quinto but not also, for example, to adjust for the large growth in Ardwicke business, or the impact of the prior-year acquisition, Tyro Indeed, the candidate hints at this when commenting on WW‟s success in tenders in the fourth paragraph

The passage on tenders shows good awareness, but it is quite speculative Moreover, it is twice as long as the preceding paragraph, which deals with performance of individual clients and which could and should have been expanded considerably All that the candidate has done here is compare the

total forecast for manned guarding with the actual total, mentioning only the two largest clients in

passing with no attempt to review them in any detail or discuss other clients (e.g the decline among the public sector bodies) There is no mention of hours at all The last paragraph on revenue also goes off on a tangent and takes up more space than necessary at the expense of further potentially valuable numerical analysis

For gross profit, the candidate identifies the overall absolute movement as well as the change in

margin % The latter is broken down by business stream so that the figure for manned guarding can

be compared with industry norms (as given in the AI) – an effective piece of analysis This is followed

by a review of wages The candidate has failed to calculate the rise in headcount and thus the

explanation for the rise in wages is partially flawed Only one other underlying cost caption is selected for review – training The analysis here is somewhat rambling for what is not a significant element of the income statement

The section headed „Operating profit‟ is deceptively long It in fact deals mainly with KPIs and

contains very little on operating profit at all After setting out the headline margin change, it identifies the change in three expense captions, but for only one of them (legal costs) is there an attempt at explaining the change All six KPIs are then discussed, in more detail than in many other scripts, but with some muddled thinking: it is hard to follow the logic of “although Greg has addressed the training days, staff morale is down, this in turn affects our competitive advantage to utilise our reputation to charge higher prices to maintain future GP margins” or “revenue per man hour and wages have also moved in adverse directions effecting growth and profitability as less cash flows in and more out.”

Both appear to be tenuous attempts to introduce pre-prepared analysis

In the final sections, the candidate sets out a conclusion and a series of recommendations These are both quite brief but they make a number of relevant points.

Assessment of proposal for Mustang acquisition [Requirement 2]

This is a reasonable section It comprises an introduction followed by „benefits of contract‟, „risks‟,

„conclusion‟ and „recommendation‟ The candidate has chosen to use own headings rather than the wording from the exam paper ( “factors to consider in appraising Mustang‟s client contracts and profile

of business activities”) This approach has not been successful as a number of key issues – especially

in relation to the appraisal of client contracts – have been omitted Indeed, the headings „benefits‟ and

„risks‟ should instead have appeared in the answer to Requirement 3!

The introduction covers a wide range of issues, making excellent use of facts from the AI: problems with previous acquisitions (including KPIs); WW‟s acquisition criteria; and WW‟s strategic objectives This has enabled it to obtain good grades under „Assimilating and Using Information‟ It then states the calculated contract price, with appropriate caveats

Under „benefits of contract‟, the candidate looks at some qualitative aspects of the proposed deal – but not very commercially For example, (s)he believes that the opportunity to take on a security

consultancy business will be an overnight success – the opposite extreme from the caution shown by most candidates (S)he also sees merit in Mustang‟s presence in Alpha, Bravo, Charlie despite the problems that it has experienced there, which in turn seem to vindicate WW‟s „no-go‟ policy In

mentioning the time system, the candidate again gives the impression of introducing prepared material without any convincing attempt to link it to the requirement

The section on risks is too brief and too preoccupied with diversification (seemingly another pet topic of this candidate), though it does make the valid point that Mustang‟s staff should be vetted

As for Requirement 1, the closing „conclusion‟ and „recommendation‟ sections have earned competent grades These include the advice to include some deferred consideration, and to request Mustang‟s ACS report This candidate suggests excluding contract 3 on the grounds that it is earning too low a margin The real issue – and reason why this contract might be excluded – is the uncertainty over its

future and that it could become loss-making on a re-tender (see commentary to Appendix 1 of First Illustrative Script)

Most of the analysis for this requirement is provided in the detailed Appendix 2 – see below for

commentary The candidate has failed to build on this analysis in the body of the report and so has missed the chance for further competent grades under „Structuring Problems & Solutions‟ and

„Applying Judgement‟ Thus there is no discussion of the additional revenue or margin for mobile security; Mustang‟s dependence on Peter Ross; or the differences between the two companies in charge rates and pay rates

Evaluation of PQR / Funtimes tender [Requirement 3]

This part of the report was the shortest and by far the weakest, with minimal content under most of the headings Inevitably, this has also meant that Corey‟s „matters for consideration‟ and the ethical issues are barely covered

The section begins well by identifying the size of the existing PQR contract relative to WW‟s revenue

as a whole, as well as referring back to WW‟s original success and to two other past tenders from Exhibit 10: Hyacinth (mistakenly shown as Ardwicke) and (indirectly) Tower

The script then moves on to the crux of this requirement – „commercial aspects‟ and „strategic

aspects‟ These are both subdivided into „pros‟ and „cons‟ (corresponding to „benefits‟ and „risks‟ per the wording of the exam paper) Unfortunately, the candidate has listed only three „pros‟ and two

„cons‟ under „commercial‟ and only one of each under „strategic‟ To make matters worse, only some

of these are relevant to the issues at hand, and in general they are illogical (e.g “Additional training

will reduce revenue per man hours”) or clumsily worded (e.g.“The 2012 Olympics is a lucrative

contract and will provide good source of revenue as security in forefront of peoples [sic] minds ”)

Under „ethical standards‟, the candidate appears to be fast running out of time as there is little more here than a restatement of the two issues mentioned in Corey‟s footnote Similarly, the sections headed „Conclusions‟ and „Recommendations‟ are extremely short Perhaps the best that can be said about them is that they do advise WW on whether to proceed with the tender

Overall paper

This script is poorly written, characterised by clumsy touches (e.g wrong date on cover page), poor spelling ( „resiliant‟ for „resilient‟, „lead‟ for „led‟) and inelegant grammar, epitomised by the opening of

the executive summary: “Lack of product diversification or geographic diversification have not had a material detrimental effect on the prior year‟s performance Despite recession and competitive

environment, WW has produced good growth results.” Other examples are highlighted under

Requirement 3 above

Appendices

The candidate has included two appendices, one each for Requirements 1 and 2

Appendix 1 sets out the movements (both £ and %) across the income statement The revenue figures are split by business stream and also identify the like-for-like position by showing Quinto separately The KPIs are also clearly set out, and benchmarked against industry norms and WW‟s own targets As well as revenue and margins, the candidate has selectively included some of the cost captions (something lacking in many scripts) This should have enabled them to be discussed in the body of the report but, as noted above, the candidate has not made best use of the calculations here There is no data at all on individual clients – whether overall revenue or revenue per hour – and this weakens the quality of the main report

In Appendix 2, the candidate has set out the calculations for Mustang, following the Tyro template from Exhibit 11 This is a very comprehensive appendix, including all the main figures (including a list

of Mustang‟s KPIs, again alongside industry norms and WW‟s targets) and the assumptions applied (including those affecting the valuation multiples)

The manned guarding table includes an extra column to show the gross margin earned on each contract, which the candidate uses effectively in the body of the report It is also accompanied by two footnotes The first states the basis on which other costs have been adjusted; but the second is a throwaway comment on what is the crux of the whole matter: “Projections are on forecast figures, do not know if they have been audited – advice [sic] professional scepticism.”

For mobile security, the candidate has included suitable figures but has failed to adjust for the fall in margin and has also made a simple casting error (the table adds to £114k not £144k) For security consultancy, (s)he has taken the unusual step of reducing the growth assumption to 30% for 2012, resulting in an adjusted gross profit of £44k (Most candidates opted for 0% or 100% growth.) The profits for each division are then brought together in a table where the total price is computed by applying chosen multiples (The overall result of £464k is higher than in most scripts because the errors on mobile security are compounded when the multiple of 2.0 is applied.) Below this table, the candidate succinctly explains the basis for the multiples used

ILLUSTRATIVE SCRIPT

DRAFT REPORT TO THE BOARD OF DIRECTORS OF

WATCHWELL LTD

JULY 2010

BY – OSSIE FORDHAM

TERMS OF REFERENCE

The purpose of this report is to analyse WW‟s performance for the year 30/06/11, evaluate the potential

acquisition of Mustang and discussing the possible tendering of PQR‟s enlarged business following acquisition

of Funtimes

This report has been prepared as a draft solely for the Board of Directors of Watchwell Ltd

It contains sensitive and confidential information and is intended for internal use only

NB – WW – Watchwell Ltd

– All numbers + calculations denominated in £000

EXECUTIVE SUMMARY

Watchwell Ltd is a reputable security firm providing a premium, SIA accredited manned guarding and mobile security service

Lack of product diversification or geographic diversification have not had a material detrimental effect on the prior year‟s performance Despite recession and competitive environment, WW has produced good growth results

Other wider overall issues include the need to grow organically and through acquisition to achieve strategic long term objective of being included in top 20 Infologue.com list whilst continual compliance with all new and

existing laws including SIA, minimum wage act and TUPE

2011 saw many changes including the acquisition of Quinto

The effect of these changes on WW performance for 2011 is calculated in appendix 1 and discussed in part 1 The acquisition of Mustang offers opportunity to address the lack of product diversification and simultaneously achieve long term growth target of £24m This is further discussed in part 2, with supporting appendix 2

Regarding the proposal from PQR, to tender for additional Funtimes business ahead of tender renewal date raises some concerns including ethical issues This is discussed in part 3

(1) REVIEW OF PERFORMANCE

Overall revenue achieved was £18,924 up 32.7%

This was due to the acquisition of Quintos in early 2011

The growth strategy through acquisition has proven to be a good way forward to achieve top 20 status Gross profit increased to £3970, up by 24%, despite margins down to 20% in 2011

This was driven by higher wage and training costs

This would be a limiting factor in this environment given that these have to be invested in to maintain competitive advantage to win tenders at favourable rates

(2) ACQUISITION OF MUSTANG

A historically poor performance of acquisitions (Tyro) has led WW to sought our help with Mustang

With a cash surplus available due to a prudent dividend policy a recommended price of £464 is proposed With recommendations of deferred consideration instead of up front cash

This will achieve the product diversification with Mustang‟s consultancy division that Tom is already

providing, and WW are seeking

(3) PQR TENDER

This is a good client who has been won on reputation without compromising price

Despite the negative press re Funtimes, WW should tender for this contract without compromising on ethical or cost standards

This gives them product diversification in CCTV, much needed as faster growing and will earn greatest revenue, much needed

(1) REVIEW OF WW’S PERFORMANCE TO 30/06/11

Overall the company has had a successful year with revenue and gross profit increasing, giving a healthy operating profit increase of 13% This puts them in good stead in a highly competitive market

This is positive given the difficult economic environment where clients seek lower rates and that 27% are making less profit, with 12% selling at a loss Please refer to appendix 1 for supporting calculations

REVENUE

Revenue has increased by £4,660 (32.7%) to £18,924 Like for like sales have also increased by £3,583 (25.1%) excluding Quinto

This is driven by increases in both the manned guarding and mobile security, 34% and 6% respectively The increase in business anticipated in Ardwicke and PQR have not materialised as forecasted, thus results were down by an immaterial amount (0.7%) compared to forecast revenue figures

WW seems to have a good strategy in place to achieve new tender & renew tender targets of 60% and 80% respectively The good internal control of debriefing lost tenders seems to be working In addition WW‟s high cost, high quality approach appears to pay dividends when pitching to target clients

In this economic recession, it can be seen that security is a buoyant market and firms place a greater emphasis and have budgets put aside for security This in turn helps WW to remain as a growing business and not be adversely affected, thus achieving its long term goal of revenue increase to £24m to achieve top

20 status

GROSS PROFIT

Gross profit has increased £775 (24%) to £3970 Margins are slightly down on 2010 to 20% in 2011, down

by 2.4%

This is driven primarily by reduced margins in manned guarding sector as this reduced to 19% in 2011 (2010: 20%); however still above industry norm of 15%

Gross profit margins in mobile security remained relatively stable, maintaining its high percentage

The increases in costs within man guarding was driven by increase of wage costs of £3779 (35%) to

£14,423 This was expected due to rise in tax and national insurance payments Addition of headcount also contributed to this increase

Training costs were also expected to increase as WW trains its new staff from Quintos This is a good investment into the future, help build our reputation as guards are our intangible asset They provide good service, which in turn helps to win referral at high prices and maintain growth, therefore achieving success tender targets

OPERATING PROFIT

Operating profit has increased by £226 (13%) to £1946

The good growth in gross profit has been offset by higher overheads namely advertising (71%), legal (78%) and impairment costs (71%)

The legal costs have to be further investigated, as it seems that the discrimination case has been settled This needs to be addressed with caution as it opens flood gates for other potential claims

Staff discontent is further seen in increase in staff turnover KPI‟s and sick days of 24% and 8.2 respectively the former way above our internal target of 20% but below industry target of 25%

As discussed staff are our key asset on which our reputation is built on, high t/o and sick days increase risk exposing us to reputation damage thus harm profitability

It seems although Greg has addressed the training days, staff morale is down, this in turn affects our competitive advantage to utilise our reputation to charge higher prices to maintain future GP margins Revenue per man hour and wages have also moved in adverse directions effecting growth and profitability

as less cash flows in and more out

On a positive note utilisation has improved to 90%, above industry average of 85% and closer to target of 92%

CONCLUSION

A resiliant performance in an economic downturn by WW

Revenue targets lower than forecast, however a good performance from existing clients

Increase in utilisation and gross profit, however offset by increases in wages, will need further

investigations

RECOMMENDATIONS

Continue to acquire company‟s with good strategic „fit‟ with WW to achieve growth targets and promote brand with existing clients

Investigate ways to improve staff morale and reduce sick days eg employee opinion surveys

(2) ACQUISITION OF MUSTANG

Historically WW has had a poor performance with respect to acquisitions, namely Tyro, where proper due diligence was not carried out and forecasted revenue for contracts were overstated

In addition KPI‟s were not appropriately vetted, this lead to lower gross profit thus questioning price paid for acquisition

A corporate agent has introduced Mustang to WW Mustang seems to meet the three requirements that

WW look for in an acquisition, namely proper fit, SIA accreditation and gross profit margins of 10-15% This will allow WW to address the lack of diversification, grow revenue without major changes in business model to achieve top 20 status

By reference to appendix 2, an acquisition price of £464 has been proposed

This is subject to limiting factors which include professional scepticism around the forecast figures

themselves, Edwin‟s professional qualifications and it is not known if these results are audited or not

In addition KPI‟s received are well above both industry and WW targets

This could be a cause for concern given the previous history with Tyro

BENEFITS OF CONTRACT

The contract offers a chance to diversify into security consultancy This is a known area that Tom has experience with, thus small learning curve, revenue would be earned instantly

Mustang also currently do mobile and man guarding, this will fit with WW, with little or no change required

to infrastructure, especially the 8 year old time recording system

Security firms are generally locally specialised The success of good reputation can be capitalised in Dorset There is also scope to micro geographically diversify into Alpha, Bravo and Charlie areas Thus opening a new market to increase revenue, previously avoided

Potential synergies could result in reduction in costs especially wages This could be particularly explored with mobile security, which gives historically higher profit margins

RISKS

WW seem to be staying in comfort zone, with no macro geographic diversification or product diversification Security firms that historically prosper are the ones that are product diversified

With the rapid increase in the Electronics market, not exploring CCTV, would have a detrimental effect on

WW long term going concern

Taking on new contracts always exposes WW to inherent risk of staff from Mustang not being properly vetted thus liable to financial and reputation damage, affecting profitability

CONCLUSION

WW has the surplus cash to invest in Mustang as it has had a prudent dividend policy

Acquisition seems a good fit with both strategic and ethical aspirations that WW have

This is a known model and it has proved to be successful

RECOMMENDATION

We recommend that WW request latest audited ACS results from Mustang, once these meet standards, and no further adjustments should be made

It would be worth finding out if it is possible to obtain only the projects making a GP margin of >10% thus excluding the 3rd one, or else a much lower price should be offered, with a marketability discount of approx 30% - 40%

In addition deferred consideration should be paid instead of cash up front

(3) PQR’S TENDER

PQR contributes 9.5% of 2010 revenue and contract was won on good reputation without having to

compromise on price

Previous good relationship with Police as demonstrated with Ardwicke will put WW in good stead should they want to acquire this tender

In the past Logos has been known to undercut on price and adopt unethical behaviour to win contracts PQR seem happy with the service to date, although the CCTV issue has not been yet addressed

If WW cannot provide CCTV this will limit scope to tender for 2012 Olympics

COMMERCIAL ASPECTS

Pros – PQR is an existing client, that is known not to compromise on costs Going forward an inflationary

increase could be added to maintain GP targets and margins

It provides WW with geographic diversity into Weymouth and Portland and at the same time expanding into CCTV

The 2012 Olympics is a lucrative contract and will provide good source of revenue as security in forefront of peoples minds

Cons – Contracts with Funtimes will reduce security staff in the future through decreasing profitability

Other contracts will have to be sought

The increase in payment period of 45 days will put pressure on our working capital cycle with a current disconnect with wages being paid weekly and suppliers invoiced fortnightly

STRATEGIC ASPECTS

Pros – Funtimes expansion into CCTV put company in good stead for the future

Cons – Additional training will reduce revenue per man hours

ETHICAL STANDARDS

As with junior staff being sent to PQR, Corey is discussing confidential info to gain a competitive

advantage

Unethical behaviour of bribing the WW Guards

CONCLUSIONS

This is a good opportunity to diversify both geographically and product

Apply for tender without cutting costs or resorting to unethical behaviour

RECOMMENDATIONS

Regular debriefs to be continued with contracts and current staff