Case study july 2011 illustrative script 1 ICAEW

Appendices The candidate has included two Appendices:  Appendix 1: Review of WW‟s performance in the year ended 30 June 2011  Appendix 2: Proposed price for acquisition of Mustang‟s

FIRST 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 Second Illustrative Script and full Examiners‟ Report for this session

Examiners’ comments – overview

This script was well within the top 25% of all assessed scripts It is a clearly-presented report dealing with many of the key issues, offering sound commercial advice where applicable, and of about

average length The content is highly focused, addressing the case requirements as presented

without introducing irrelevant material A particular feature is the inclusion of the candidate‟s own derived figures to illustrate key arguments e.g WW‟s existing receivables days ratio in relation to the proposed PQR / Funtimes invoice terms: it would have been better still if the workings for these had been provided!

Good grades were earned for the executive summary and for all three main topics, as well as across the four areas of Professional Skills In essence, this was a well-balanced script The candidate went

a long way towards success by the simple technique of dealing with all the main components of

Requirement 1 (including KPIs) and Requirement 3 (including ethical issues and the „matters for

consideration‟) Most areas of Requirement 2 were also tackled but coverage of underlying

assumptions was relatively brief

Terms of reference and executive summary

Overall, the executive summary was good, admirably serving the purpose of distilling the key issues and drawing the audience into the report itself – just what an executive summary is supposed to do It addresses the main points covered in the body of the report on Requirements 1 and 2, restating the key figures and conclusions, but is briefer on Requirement 3 Overall, it is longer than the guideline 10% of the total script, but not unduly so It could have achieved even better grades by covering the ethical issues (there are marks available for ethics under three of the four skills headings) and being more balanced across the requirements

After appropriate terms of reference (and a helpful listing of key abbreviations), the executive summary begins with a neat series of sentences setting out the main findings under the three case requirements

It then goes on to address each in turn

On Requirement 1, the candidate comments on all the principal areas (including KPIs), and gives both

£ and % figures Mention is made of the largest clients and Quinto, and the margin changes are

explained by reference to cost areas The section ends with two pertinent recommendations

Similarly under Requirement 2, the candidate addresses all the key elements and applies sound

professional scepticism towards the data provided, including Mustang‟s KPIs It also makes the

sensible commercial recommendation to offer part of the consideration in a contingent form

In contrast, the key points at Requirement 3 are made quite tersely, and there is no reference to the ethical issues This perhaps suggests that the candidate was running out of time towards the end of the

executive summary, although (unlike in many scripts) there is a clear recommendation here – not to

tender

An irritating feature throughout is the use of the past tense ( “KPIs were analysed and found to be mixed ”; “we advised thorough due diligence ”); an executive summary is contemporaneous with the

report of which it forms a part and so should be written in the present tense

Analysis of Watchwell’s financial performance [Requirement 1]

This part of the report achieved a large number of competent grades It is set out clearly with an

introduction and then a section dealing in turn with each of the main captions from the exam

requirements It gives due emphasis to key clients and the 2010 acquisition Quinto, making judicious reference to industry issues where relevant It would have done better still by including more about margins and underlying costs.

The commentary on revenue comprises an overall comparison with the prior year, with industry norms and (for large clients) with forecasts, and an analysis of the two business streams The section on key contracts goes into an impressive amount of detail, including (in relation to Quinto) the sensible

recommendation to “carry out thorough due diligence on acquisition targets in order to avoid

overpaying for contracts in future”. On the client Jonas, the candidate suggests that it offers further scope for growth; in fact, revenue is more likely to decline as its work on Olympics accommodation must necessarily soon end The section on public sector clients sets their decline in revenue neatly in its PEST context, with a well-researched quote from a senior industry figure

However, despite such detailed coverage, this script misses out on further competent grades by not considering revenue per hour, whether overall or by client, and indeed it does not mention hours here

at all.

In discussing gross margin, the candidate again makes good use of industry context by noting: “While these are only slight decreases and the gross margin still exceeds the industry average, they may be a sign of trends to expect for future years.” (S)he cleverly rationalises the fall in gross margin by stating

the average hourly pay rate – albeit without showing how this was calculated – and links this to KPI 1 Similarly, the paragraph on operating margin focuses on payroll expense However, the candidate fails

to realise that the % rise in head office staff numbers is almost the same as in their costs and, as a

result, in the next sentence explains why it is not the same! The same sentence mentions some other

cost headings (e.g recruitment) but only in passing and so fails to state that they have risen sharply or

to give reasons why

The section on KPIs covers all six (as set out in Exhibit 13), with the correct figures for the two that had

to be calculated (KPI 1 and KPI 2) The candidate makes comparisons with industry averages but omits

to refer to WW‟s own targets The figures for staff turnover, sickness days and training days are all astutely linked to the overall question of WW‟s reputation The increase in utilisation is explained as being due to synergies in mobile security, but this is flawed as all the KPIs relate just to manned

guarding

The candidate concludes with three „key recommendations‟ – all sensible and all logically derived from the foregoing analysis

Assessment of proposal for Mustang acquisition [Requirement 2]

This was also answered very well The candidate again begins with a brief introduction before going on, within a section headed „Valuation‟, to summarise the results of his/her calculations in a table that clearly shows the maximum and minimum values of each division and for Mustang overall This is immediately followed by a note of caution that Mustang‟s figures may be unreliable The candidate correctly draws on WW‟s poor experience with other recent acquisitions and uses this to advise WW on the starting-point for its negotiations on price

However, there is insufficient scepticism applied to the figures for any of the three divisions The

assumptions are dealt with in Appendix 2, where the candidate gives a range of values for each

division, but they are not then developed in the main narrative part of the report Thus for mobile

security, there is no questioning of the new £30k revenue or the reduced margin; and for security consultancy, there is no commentary on the likelihood of achieving Peter Ross‟ projections

The last paragraph of this section covers Mustang‟s KPIs – something that many candidates omitted to

do As at Requirement 1, the KPIs are benchmarked against industry standards, with appropriate scepticism being applied

The script then deals with the rest of the scenario under the heading „Strategic considerations‟

Although this does address many of the key points, it would perhaps have been safer to use headings closer to the wording of the exam paper ( “factors to consider in appraising Mustang’s client contracts and profile of business activities”) The candidate lists five advantages and three disadvantages of the

acquisition These are mostly relevant and well-expressed, especially the last two disadvantages, where the candidate adopts a very pragmatic approach towards (i) the problematic Alpha, Bravo, Charlie districts and (ii) the fee dispute, showing excellent „thinking outside the box‟ However, this section does also have a number of shortcomings:

 The first advantage estimates the extra annual revenue that would arise (£789k), but this is not supported by a calculation or otherwise apparent from the figures at Appendix 2

 The third advantage falls into the same trap as in many other scripts by treating the 50%-female workforce as a plus point, not recognising that Mustang was much smaller and so when converted

to an absolute figure this percentage would have little impact on WW

 Also in line with many other scripts, the first disadvantage fails to recognise WW‟s inherent

existing competence in security consultancy through its Packryte tender and through the directors‟ wider knowledge of the industry

Coverage of Requirement 2 ends with a section headed „In conclusion‟, where the candidate

succinctly brings together the main output from the earlier analysis

Overall, the script achieved another good set of CC and SC grades here It would have done better still by more challenging of the assumptions and by saying more about security consultancy generally

Evaluation of PQR / Funtimes tender [Requirement 3]

This was another good section that gained over 50% of competent grades, spread across all four skills areas The candidate has made many key relevant points

After another concise opening paragraph, the script moves straight into describing the benefits and risks of tendering, making reference as it goes along to Corey‟s „matters for consideration‟ It begins by estimating the likely size of the enlarged contract, focusing on the number of hours involved This is somewhat ironic, given that hours are not mentioned at all in the answer to Requirement 1, where there was more to say about them In dealing with two of Corey‟s „matters‟, the candidate refers back to WW‟s experience with the police in relation to the client Hyacinth (Exhibit 10) and also – this time with the correct focus – discusses female staff quotas

In addressing the risks, the candidate develops a series of good points about training; invoicing;

seasonality; TUPE; licensing; and the reputational impact of the Funtimes riot In all cases, the points are well thought through For example, the proposed change in invoice terms from 30 to 45 days is linked to WW‟s existing receivables days ratio (albeit that this is yet another figure for which no

workings are given); the reference to „peaks and troughs‟ shows an understanding of utilisation; and the question-mark over Logos‟ accreditation is supported by another pertinent quote from a senior industry figure

The analysis is followed by an „In conclusion‟ paragraph, which advises WW not to tender While this was not the majority view, the candidate has backed up the advice with sound judgement and an

excellent final sentence encapsulating WW‟s commercial dilemma: “Entering a price war with Logos will

only damage WW’s margins as well as their reputation for quality guarding services.”

The section ends with a set of „ethical considerations‟ This mentions one of the two issues (insider information) introduced at the foot of Corey‟s letter but ignores the other (bribery) The candidate

gives the right advice here, albeit by a roundabout route Although this passage appears brief, the candidate has earned some good grades for ethics by dealing with some of the other ethical matters arising on the tender earlier in the section

Overall paper

The script is generally well written Apart from the style of the executive summary (see above), it is marred only by inconsistency in treating „WW‟ as singular or plural and inelegant punctuation of

„however‟ clauses‟ Overall, it has met the requirements, is balanced across the main topics and demonstrates a strong, commercial understanding of the case scenario

Appendices

The candidate has included two Appendices:

 Appendix 1: Review of WW‟s performance in the year ended 30 June 2011

 Appendix 2: Proposed price for acquisition of Mustang‟s contracts (from 1 October 2011)

Appendix 1 tabulates the key figures used for Requirement 1, including revenue by key client

measured against both prior year actual figures and current year forecasts Throughout, variances are given in both absolute £ and % terms Two additional features are (i) that industry averages are shown against WW‟s KPIs and (ii) that average cost per man hour has been calculated Both of these have enhanced the narrative at Requirement 1 in the body of the report Some further analysis – of

revenue per hour by key client – would have further enhanced both the Appendix itself and the main

report

Appendix 2 sets out clearly the calculations for the three divisions of Mustang and overall, with

workings to show how figures have been derived and what assumptions have been made For two of the divisions – and then for the business as a whole – the candidate has indicated both a „high‟ and a

„low‟ figure The added value in this Appendix lies in (i) a column showing the gross profit margin for each manned guarding contract and (ii) the asterisked footnotes reflecting the assumptions made about each of these contracts The first two footnotes are sensible, but the third is questionable: it shows contract 3 being retained at a loss, but it is more likely that Mustang would not re-tender in such a circumstance

ILLUSTRATIVE SCRIPT

REPORT

TO: The Board of Directors, Watchwell Ltd

FROM: Rosslyn Chartered Accountants

DATE: 27 July 2011

SUBJECT: Analysis of Watchwell‟s performance in the year ended 30 June 2011, and evaluation of options for

expansion

PRIVATE + CONFIDENTIAL

Terms of Reference:

This report has been prepared for the Board of Watchwell Ltd in the light of two potential new acquisition

targets: the contracts of Mustang and a merger between PQR and Funtimes It deals with the following matters: 1) Analysis of Watchwell‟s performance for the year ended 30 June 2011

2) Evaluation of the proposal to acquire contracts from Mustang, including calculations on suggested

prices

3) Consideration of the benefits and risks involved in re-tendering for PQR‟s contract now that they have

merged with Funtimes

The report is based on Watchwell‟s management accounts for the y/e 30 June 2011, which have not been audited, and upon information provided by Mustang, PQR and Funtimes, which has not yet been verified The report has been prepared solely for the use of Watchwell‟s directors and is not for external distribution Abbreviations used:

WW – Watchwell Ltd

SIA – Security Industry Authority

ACS – (SIA) Approved contractor scheme

Executive Summary:

The report‟s analysis of WW‟s performance this year is, on the whole, encouraging, although some areas are highlighted for the directors‟ attention in future years

The evaluation of the proposed acquisition of Mustang includes several potentially significant disadvantages, but overall seems to warrant further negotiations and work on the acquisition

The evaluation of the opportunity to re-tender for PQR, newly merged with Funtimes, raises some serious questions for the directors of WW, and suggests that WW should not proceed with the re-tender

Details covered in the main body of the report were as follows (See also figures in appendix 1)

1) It was noted that impressive revenue growth of 33% had been achieved this year, largely thanks to the

growth of Ardwicke stores, PQR, Jonas and Quinto contracts Caution was deemed necessary with the public sector clients whose revenue had fallen below forecasts because of public sector cuts

Profit margins appeared to have held up: decreasing only slightly in the face of higher wages and administrative costs The gross profit margin fell from 22.4% to 21% and the operating margin from 12.1% to 10.3%

KPIs were analysed and found to be mixed: utilisation and training days were both improved on 2010, with utilisation of 90% being particularly impressive given the industry average of 85% The directors should aim to maintain this

Staff turnover and average sick days were both up, however Turnover from 21% to 24%, and sick days from 7.1 to 8.2 While still lower than industry averages, the increases in these KPIs may indicate problems with staff morale The directors were advised to investigate and try to solve any problems found, as poor morale will threaten WW‟s reputation if it leads to poor client service

Key recommendations included:

– to monitor margins carefully as rising costs and pressure on charge rates threaten to reduce

profitability

– to diversify services where possible, as WW is currently very reliant on manned guarding and upon one client, Ardwicke

2) The valuation of Mustang was calculated based upon WW‟s usual multiples of expected gross profit

The valuations were then amended, using different assumptions (see appendix 2) to give a more prudent estimate

The range of values produced was from £352k to £451k, a significant variance We advised the

directors to start negotiations with the lower amount, especially as there is some doubt over Mustang‟s figures

We advised thorough due diligence work be carried out on Mustang‟s information especially as some of their reported KPIs seemed unusually high: staff turnover of 17% and utilisation of 93% We advise scepticism towards these KPIs until due diligence work has been carried out

Non-financial factors were also considered:

The key advantage was a good strategic fit, with female staff, a good approach to staff training and strong historic growth making Mustang an attractive acquisition target

Disadvantages were noted, most importantly pertaining to question marks over the future viability of the security consultancy division without any of Mustang‟s directors, as well as questions over whether WW are prepared to accept the increased risk of operating in deprived high crime areas Alpha, Bravo and Charlie

Our recommendation was to proceed with due diligence work but to consider offering part of the

consideration in a contingent form, depending on the future performance of the contracts

3) The PQR / Funtimes tender was felt to offer certain advantages:

– Revenue growth of £1,789k depending upon charge rates

– An opportunity to benefit from increased security needs during the Olympics

– Opportunities to work with local police

However, the risks involved were serious:

– Potential threats to WW‟s reputation as staff inherited from Logos are not all SIA licensed –

possible loss of ACS approval would be fatal for WW

– Reputational risks arising from a recent riot at a Funtimes festival

We therefore recommended WW not to proceed with this re-tender and to accept the loss of PQR‟s contracts if necessary

1) Performance Analysis

Overall this has been a positive year for WW, with revenue growth continuing, in line with the stated strategic objective of increasing the company‟s income Analysis of the financial statements does however bring to light some warning notes which are discussed in more detail below

Revenue

Total revenue has increased by £4,660k to £18,924k (33%), While this does not yet bring WW into the league of the Infologue.com Top 20 firms, it represents significant growth; far higher than the 2-4% predicted per annum from 2011-2015 for the manned security market as a whole

Manned guarding has committed more to this growth than mobile security, having increased by 34% compared

to 6% (see appendix 1) This is in line with expectations given WW‟s historic focus upon manned guarding, however may indicate a need to devote more attention to expanding the mobile security division and so

diversifying WW‟s range of services

In terms of revenue mix, as discussed above, the mobile security division has fallen behind manned guarding, now making up less than 5% of total revenue compared to 6% in prior years

Within manned guarding, the revenue growth witnessed this year is largely down to 3 factors:

1 An increase in revenue from Ardwicke stores of £2,304k or 63% to £5,980k This is in line with expectations

as Ardwicke have opened new Quickfood stores in 2010/11 While there is the opportunity of further

expansion, outside Dorset, WW should be wary of relying too heavily upon this one contract which

comprised nearly 32% of total revenue in 2011

2 Increases in revenue from PQR and Jonas Construction totalling £1,169k Again this was in line with expectations, as both clients were expanding their operations during the year Unlike Ardwicke, these two clients have generated revenue which meets or exceeds that forecast for 2011 by WW This makes them valuable clients for future years and WW should be careful not to neglect their contracts while focusing on expansion

3 The newly acquired Quinto contracts have generated £1,077k of revenue this year However this was lower than forecast as WW had expectations based upon information which turned out to include inaccuracies While Quinto‟s new revenue is valuable to WW, the poor performance against forecast (10% lower

revenue) is a warning that WW must carry out thorough due diligence on acquisition targets in order to avoid overpaying for contracts in future

The only really negative area of revenue this year is in respect of the public sector clients Dorset Hospital, Soton College and Granville University The revenue from these has fallen by £173k to £3,229k, a decrease even greater than was forecast (see appendix 1) This appears to be because of public sector cuts resulting from the Coalition‟s spending review

WW should expect further cuts to follow, and while this may lead to outsourcing opportunities (as police

numbers are cut), the mood of austerity may also spread to the private sector David Mundell, the Group Sales director of an Infologue.com Top 20 firm, recently noted at a security seminar that „the current market for

guarding solutions is “the most price driven” he has ever witnessed WW should be prepared for further

pressures on their charge rates and revenues

Margins

Both the gross margin and operating margin have increased this year by £775k to £3,970k and £226k to

£1,946k respectively This appears to have been driven by revenue growth (Ardwicke, PQR, Jonas and Quinto) rather than cost-savings, however, as the company‟s margins have decreased the gross profit margin has fallen from 22.4% to 21% and the operating profit margin from 12.1% to 10.3% While these are only slight decreases and the gross margin still exceeds the industry average, they may be a sign of trends to expect for future years Gross margins appear to have been reduced by higher wage costs; the average hourly pay rate has risen from

£6.89 to £7.05, and wages as a proportion of revenue from 78% to 79%

Operating margins have been squeezed by an increase in all administrative expenses, but most notably head office salaries, which have gone up by £313k to £1,082k (41%) This is very high even given the increase in head office staff from 24 to 33 It seems likely that the company‟s rapid expansion is requiring more

management time and effort in terms of working on advertising, recruitment and in professional fees relating to potential acquisition targets

KPIs

Revenue per man hour worked is up from £11.73 to £11.91 which is good, however it is necessary to absorb the higher staff costs; as discussed above, wages as a proportion of revenue have increased from 78% to 79%

Utilisation has increased from 89% to 90% which is very encouraging, especially as the industry average is 85% This reflects WW‟s efforts at achieving synergies, especially within the mobile security division WW should continue to strive for high utilisation as this impacts directly upon the company‟s profit margins

Training days also represent an encouraging measure of WW‟s performance this year; they have increased from 4.3 to 6.9, reflecting additional compulsory courses attended by staff this year WW should aim to keep this KPI high, as well trained staff are critical to the company‟s reputation and thus its success

The only really discouraging KPIs relate to staff morale: staff turnover has increased from 21% to 24%, and sick days from 7.1 to 8.2 While the turnover figure is lower than the industry average these are worrying trends, as poor staff morale may lead to issues with employees and so to poor client service This will damage WW‟s reputation and eventually cause them to lose business

Key recommendations

 WW needs to remain vigilant regarding its margins to ensure that these are not squeezed unduly by lower contract prices and rising wage costs

 WW should consider diversifying its product range and client base to avoid becoming too reliant on key contracts

 WW should investigate the reasons behind its falling staff-related KPIs and attempt to resolve any issues Otherwise it risks future problems with employees and potential damage to its reputation

The opportunity to acquire Mustang‟s contracts has recently come up, and is attractive in terms of revenue growth However, WW need to ensure that they pay a fair price to reflect the value of the contracts, as well as to consider the wider implications of the acquisition upon WW‟s business strategy

Valuation

Appendix 2 shows various valuations based upon certain assumptions and using WW‟s standard multiples of gross profit The values of the 3 different divisions have been assessed separately, and in each case,

assumptions have been altered to produce a maximum and minimum potential value

These are summarised as follows:

£352k £451k

A key point to note at this stage is that no due diligence work has yet been carried out on the information

provided by Mustang Given WW‟s experiences with Tyro Guards and Quinto, they should therefore be wary of taking Mustang‟s figures and assertions at face value Rosslyn advise that we undertake thorough due diligence

on all of the information supporting the valuation, as far as is practically possible

We would therefore recommend WW to open negotiations with a low offer, in the region of £350k, in order to avoid overpaying for the contracts Subsequent findings from due diligence may affect the later negotiations, either reducing or increasing the value

At first sight, several of Mustang‟s stated KPIs seem very high: Utilisation of 93% compared to industry average

of 85% and staff turnover of 17% compared to industry average of 25% It may be that Mustang really is

achieving these impressive rates, however we would advise WW to be cautious in their approach to the

acquisition

Strategic considerations

The acquisition seems likely to bring many advantages to WW, both financially and strategically:

 Advances WW‟s strategy of revenue growth, bringing in an estimated £879k of revenue for the y/e 30 June

2012 This will help WW in their stated aim of entering the Infologue Top 20, although there are risks

involved in excessively steep growth patterns (see below)

 Nevertheless, this is a tried and tested means of growth for WW, and they have plenty of cash available to make acquisitions The directors should monitor cashflow carefully however, as the high initial investment in acquisition consideration and working capital could lead to liquidity problems

 Mustang seems to represent a good strategic fit with WW in that 50% of its guards are female This would benefit WW as certain of their retail clients such as Hyacinth prefer to have women guards for their female staff and customers

 Mustang also has a good attitude towards training its staff, with 6 days of annual training This should mean that staff attain a high level of professionalism and so enhance WW‟s reputation for high quality security guards

 Acquisition of Mustang‟s contracts would also make WW less reliant upon Ardwicke stores, which helps them to diversify their risk

There are also certain disadvantages to be considered, however:

 While the consultancy division represents good service diversification for WW, and is an area into which they have previously considered expanding, WW need to consider their current competencies As

Mustang‟s directors will not transfer to WW, there is a risk that expertise in the area of security consultancy will be lost This could lead WW to lose business, or even worse, to give inappropriate advice and risk facing legal claims from clients WW should try to include some training sessions from Mustang‟s directors within the acquisition negotiations, to enhance their own industry expertise

 Mustang appears to operate in areas (Alpha, Bravo + Charlie) which are considered dangerous and which

WW currently will not work in This brings additional risks of legal cases from clients as well as danger to employees, which will also drive up insurance premiums WW directors need to make a reasoned decision

as to whether they are prepared to deal with these risks

 Mustang is currently in dispute with a client over fees receivable WW should investigate whether they normally have problems with credit control on these contracts, as this would affect WW‟s liquidity They should also enquire from Mustang‟s lawyers (if given permission) whether there are any other disputes outstanding

In conclusion

The Mustang contracts certainly seem to warrant further investigation as they are potentially a good means of increasing revenue and market share for WW However, we would recommend:

 WW carry out thorough due diligence on Mustang‟s figures and to review their ACS certificate and latest ACS annual audit report

 To consider opening negotiations with a conservative offer somewhere around £350k

 To consider whether they have sufficient security consultancy expertise to keep this division viable

 To decide whether the levels of risk involved in accepting contracts in Alpha, Bravo and Charlie can be mitigated to an acceptably low level

This is a particularly important decision for WW as it not only involves the potential to secure new business but also involves the possible loss of one of WW‟s key clients, PQR

There are many obvious benefits available from the proposed contract:

 The PQR / Funtimes merger will double PQR‟s current guarding hours, from 146k to 292k Assuming charge rates remain the same; this would mean potential revenue growth of £1,789k, taking the combined contract to £3,578k [WW should ask for details of the mix of staff likely to be required by Funtimes (in terms

of security) in order to assess what charge rates will apply to the additional hours.] This represents

significant revenue growth for WW

 Funtimes‟ involvement in the 2012 Olympics gives WW an opportunity to take advantage of the extra business which will become available due to the high numbers of tourists expected to visit Weymouth

 Winning this tender would also avoid the loss of PQR‟s current contract, which, in 2011, was 9.5% of WW‟s total revenue (£1,789k) As PQR have plans to acquire more stadiums and venues across England, they represent a valuable client to WW; one which could lead to future expansion outside Dorset