POL00028491
POL00028491
4
tat Han
POST OFFICE BOARD: 20 July 1999 POB(99)47
IN STRICTEST CONFIDENCE [-
IMPLICATION ON THE POST OFFICE OF
THE 24 MAY 1999 HORIZON AGREEMENT
Purpose:
The Board must decide by 31 July 1999 ifit can and wishes to terminate or sign the
revised contract with ICL for the automation of post offices. The signing of the
contract will commit Post Office Counters Ltd to significant financial undertakings. In
addition, the Government has informed The Post Office that it intends to move all
benefit recipients with bank accounts to ACT from 2003 to 2005. This paper outlines
the impact and seeks Board approval to the signing of the contract with ICL.
Strategic implications:
The implications aré:
¢ significant additional costs of the Horizon infrastructure;
¢ a fall in benefit payments business following the promotion of, or compulsion to,
ACT;
© potential force majeure closures of between 2,000 and 7,000 offices impacting both
POCL’s nationwide network and RM and PFWW’s universal service obligations;
that continuation (with ACT) supports Network Bank aspirations;
¢ the lack ofa benefit card, together with ACT, damages Government Gateway
strategy, making it only marginally positive over 10 years;
loss of footfall, reduction in office numbers and an increase in costs due to Horizon
have a significant adverse impact on Royal Mail and PFWW.
Costs/benefits:
Impacton POCL Impact on PO
NPV (Em) NPV (Em)
Scenario No. SYear 10 Year SYear 10 Year
Continue 1 -189 “161 134 AS
Continue 2 278 487 319 672
Continue 3 443 674 484 859
Terminate 4 1011-1310 1098 1540
Terminate 5 654 = -1002 a7 16
Continuing with Horizon is least bad.
Recommendations:
The Board is asked to agree to: Than mal WAPEC pradue
the signing of the revised contract with ICL; WA
interim project funding of £11.03m until a formal MaPEC in September; and
to agree that work should continue on: E
stopping or delaying the move to ACT; IN ~ ie
reducing the ongoing cost of Horizon;
°
°
¢ reviewing channel strategy; pcan
¢ persuading Government to ring fence the Horizon costs; and (WW
°
how the Government could subsidise the nation-wide network. bow
Sponsor: Stuart Sweetman Author: Tim Brown
MD POCL POCL Financial Controller ao 2
IN STRICTEST CONFIDENCE pe kw 1
POL00028491
POL00028491
‘
a
IN STRICTEST CONFIDENCE
POB(99)47 POST OFFICE BOARD €
IMPLICATION ON THE POST OFFICE OF
THE 24 MAY 1999 HORIZON. AGREEMENT
1, Background
Heads of Agreement with ICL on the future of Horizon were signed on 24
May 1999. Detailed codification of these Heads into a contract are expected
to have been completed by 16 July 1999 prior to the Board’s consideration of
its terms on 20 July 1999. The signing of the contract will commit Post Office
Counters Ltd to significant financial undertakings. In addition the
Government has informed The Post Office that it intends to move all benefit
recipients with bank accounts to ACT between 2003 to 2005.
2. Purpose of the paper
This paper outlines the impact of the new contract and seeks Board approval
to the signing of the contract with ICL.
3. Context e€
The original contract with ICL was signed in May 1996. Thé Horizon
business case was approved on the basis of protecting benefit payment >
income by the automation of the network and the introduction of the benefit
payment card. The contracts between POCL and BA, and POCL and ICL
were back to back. Recognising that benefit business was expected to decline
after the end of the contract with the Benefits Agency in 2005, POCL
developed a new vision. As part of the vision it was envisaged that the
counter network would be automated and that future business could be built
on the benefit payment card. The commercial strategies identified,
particularly Network Bank and Government Gateway, depended on an
automated platform and the development of a smartcard.
Following extensive reviews by Government, BA withdrew from the Horizon
project on 24 May 1999, ending its need for a benefit payment card. The
Board agreed that POCL would continue with the project on new commercial
terms subject to the agreed codification of the Heads of Agreement signed on * C
24 May 1999 (with an option that if codification was not agreed, POCL could
terminate with the payment of £150m to ICL), and the use of £480m of gilts to
fund payments to ICL. The codification process ended on 16 July 1999
without any material disagreement allowing termination.
The key elements of the new deal are:
¢ functionality consists of Electronic Point of Sale (EPOS), automated
payments, local feeder systems and the Order Book Control System (OBCS:
bar-coded order books);
¢ additional functionality, such as Network Banking and Government
Gateway, will be possible at an extra cost of c£120m;
the system will be rolled out by March 2001 (based on a roll out rate of 300
offices a week);
« the contract will terminate on 31 March 2005;
¢ payments will be made as follows:
IN STRICTEST CONFIDENCE 2
IN STRICTEST CONFIDENCE
¢ Capital sum of £480m to be paid, less a 25% retention, over the next
two years (retention to be paid over subsequent four years);
¢ a payment of £68m to be made on acceptance;
following roll-out, operating payments to be made of c£95m p.a.;
© operating costs are 61% fixed, 32% variable with number of outlets
and 7% variable with volume;
¢ in addition POCL will have to bear the cost of unrecovered VAT;
¢ termination options available are:
* system fails acceptance, and no payments toICL; ..
¢ for convenience, with payments in the order of £450m.
Currently there is no new deal with BA to cover the existing manual benefit
payment and the new OBCS. BA is holding firm to a negotiating position
agreed with its Secretary of State, which is worse for POCL than the .
modelling done for Treasury at the time of the decision. Currently, POCL
and BA are some £265m NPV apart (the attached financials take a mid point
position). Discussions have been held with the McCartney Working Party on
how to un-block BA’s negotiating position. This would enable POCL to reach
a satisfactory commercial arrangement based on BA contributing to the cost
of automation in line with its share of business volumes.
4, Evaluation of impacts
In evaluating the new contract, the following scenarios were examined:
1. Horizon continues with increasing drift to ACT.
2. Horizon continues with heavy promotion of ACT.
3. Horizon continues with compulsory ACT from 2003 to 2005.
4. Horizon is terminated and an alternative automation is introduced, with
compulsory ACT.
5. Horizon is terminated and no alternative automation is introduced, with
compulsory ACT.
All scenarios have a negative NPV. The least bad scenario, Horizon and ACT
drift, has significant negative cash flows and losses over the next four years.
In all other scenarios the cash flows are negative and POCL incurs losses for
the next ten years.
The consequential impacts on Royal Mail and Parcelforce Worldwide, and
the loss of interest on the £480m of investment, further worsens the Group
position. Some benefit may be available from tax relief from capital:
allowances.
A summary of the cash flow and profit and loss position is at Annex A. In
NPV terms the relative positions are as follows:
IN STRICTEST CONFIDENCE 3
POL00028491
POL00028491
POL00028491
POL00028491
—
.
IN STRICTEST CONFIDENCE .
Impact on POCL Em Impact on PO Em
‘5 Year 40 Year ‘S Year 40 Year €
[Scenario I "NPV ] Ave. I NPV Iave. profit] [NPV ] Ave. I NPV ave. profit
profit (2rd 5 years) profit Grd years)
Bus. Plan al 5a] 166] [wa I ma I na Wa
1 189) 82) -161 6 134] 72) -115) [)
2 -278I -108] ~487] “47 319] -122I 672 -117I
3 443} -150] -674) “53 ~484) 164) -as9 123
4 1011] -166] I -1310} -9i] I -1098] 187] -1540) 161
5 654) _-94}_-1001 149) -777I__-124}_-1336 -257I
The differences between the impact on POCL and PO are the impacts on
Royal Mail, PFWW and Group (interest and tax).
Therefore, in terms of relative positions, continuing Horizon is least bad.
5. Strategic responses
The evaluation has already taken account of a number of commercial
responses (NPV calculations based on Scenario 2):
¢ Network Bank, and the signing up of four of the top five banks by 2003,
which is based on value share and not commodity pricing. Work to date
indicates that Network Bank will contribute some £260m NPV over 10
years (with a terminal value of £420m). Although banks are interested, no
bank has yet signed up on this basis;
¢ Government Gateway, based on value share, contributing only £8m NPV
over 10 years (but with a terminal value of £192m). Support through the
McCartney Working Group will be needed if this position is to be
improved upon;
¢ cash and distribution work for the banks contributing £90m NPV (witha
terminal value of £45m);
¢ network closures contributing some £26m NPV over 10 years (witha
terminal value of £130m) depending on the level of compensation.
All these areas require investment over and above direct Horizon programme
costs (but included in the financial analysis), and are not without risk.
In terms of Royal Mail and PFWW, an investment decision in favour of Cc
Horizon has significant adverse consequences:
¢ lost revenue from reduced footfall and office closures, and the cost of
alternative channels, is estimated to be as high as £58m and £20m p.a.
respectively;
¢ in addition, under the inter-business contract, both RM and PFWW will
pick up a share of the costs of automation (£30m p.a. and £3m p.a.
respectively in steady state).
At these levels of cost, the network compares unfavourably with the
experiences gained from mail order and retail stamp sales. Royal Mail
considers there to be no viable options to recover or absorb these costs. There
could be a case to be made to a regulator that the additional costs are part of
the cost of the Universal Service Obligation (USO). If successful, and to cover
the costs to Royal Mail, a price increase of 2p/2p on the postage stamp stream
IN STRICTEST CONFIDENCE 4
POL00028491
POL00028491
G
sq
IN STRICTEST CONFIDENCE
would be necessary (i.e. excluding the “commercial” meters and pre-paid *
streams). The price increase would have to be in excess of 4p/4p to cover the
entire loss in POCL. Any increase in the price would worsen Royal Mail and
PFWW’s competitiveness. A price increase and “subsidy” to POCL would be
likely to have political consequences and would raise significant competition
issues.
The key elements to improving the financial impacts are:
¢ slowing the move to ACT;
¢ reduce the ongoing cost of Horizon (see Board paper POB(99)48 on
Accounting, Funding and Tax);
¢ reduce channel costs (through new channels and reducing network);
¢ ring fence the Horizon costs from other Post Office business; and
¢ Government commitment and subsidy of the nation-wide network.
5. Financial re-authority
Following the Board’s decision a business case will be produced and
submitted to MaPEC for formal authority for project expenditure. However,
the project will reach its Maximum Authorised Expenditure (December 1996)
by the end of July. The project requires additional project funds to cover the .
period to the end of September 1999. The project requires, therefore,
approval of payments to ICL and interim funding of £11.03m until formal
MaPEC approval.
6. Recommendations
The Board is invited to note:
(i) the impacts of continuing or terminating Horizon;
(ii) that continuing, while bad, is better than termjndtion.
on wr
The Board is asked to agree to:
(iii) the signing of the revised contract wjth ICL following a codification of
the 24 May 1999 Heads of Agreement, and the associated payments to
ICL;
(iv) interim project funding of £11.03m until a formal MaPEC in September.
The Board is asked to agree that work should continue on:
(v) stopping or delaying the move to ACT;
(vi) reducing the ongoing cost of Horizon;
(vii) reviewing channel strategy, including its cost, alternatives and its
impact on the universal service obligations of The Post Office;
(viii) persuading Government to ring fence the Horizon costs from other Post
Office business; and
(ix) how the Government could subsidise the nation-wide network.
Stuart Sweetman
July 1999
IN STRICTEST CONFIDENCE 5