Royal Mail — Strictly Confidential
RMH(06)53
ROYAL MAIL HOLDINGS pic BOARD
REPLACEMENT OF HORIZON
Executive Summary
A;
Purpose of Paper
The purpose of this paper is to request RM Holdings Board approval in principle for
the replacement of the Post Office Ltd's Horizon Electronic Point of Sale system,
subject to securing long term funding. Approval of £25m interim funding is requested
in order to enable the programme to be continued. Any delay in this programme will
result in c £44m of irrecoverable benefits being foregone over the course of the
existing Horizon contract.
Background
2
Horizon has been in use in Post Office Ltd (POL) since 1998. It was developed, and
has subsequently been maintained, by Fujitsu Services. In 2002 the original contract
term was extended to March 2010 in exchange for significant cost reductions.
However, Horizon remains expensive to Operate and change, and lacks the agility
essential to respond to the ever changing marketplace. In 05/06 it cost £96m (c.8.7%
of turnover) and without this investment the cost as a percentage of turnover will
continue to rise as costs increase and revenues fall.
One of the biggest opportunities POL has to enhance profitability is by reducing the
costs of the Horizon system. A new deal has been negotiated with Fujitsu Services
that delivers significant cost savings on more favourable terms, in return for an
investment in new IT infrastructure and an extension to their contract until March
2015. None of the other options considered {including a competitive procurement)
provide similar benefits.
Benefits
4.
For an investment of £127m the proposed new deal delivers an incremental post tax
NPV of c.£90m over continuing with the current system / contract until 2015. The
scheme generates an IRR of c.39% and pays back in 4.5 years.
The Fujitsu supplied Horizon replacement represents the least cost option of all those
reviewed. The key drivers of the incremental NPV are: upgrading of the application
software and data centre systems to enable lower cost telecommunications links,
reduced maintenance and upgrade costs and the ability to use the pre-paid element
of the existing contract to fund the development of the replacement system.
Annual operating cost reductions, compared to existing contract terms, are circa £8m
pa in 06, rising to c.£60m pa by the end of the contract, as set out in Appendix 1.
These benefits are contractually locked in and are therefore guaranteed. The
percentage of variability in operating costs to cater for changes in POL business
needs is also increased from 23% to 50%.
The new technical architecture gives the flexibility required to evolve the size and
shape of the network, and it will be quicker and cheaper to change.
RMG00000043
m1G00000043,
RMG00000043
00000043
Royal Mail — Strictly Confidential
8. Fujitsu have agreed a number of incentives that will ensure that they continue to
deliver the benefits of emerging technologies and new industry practices. Provisions
for market testing mean that should these incentives fail, then the POL has a clear
route through to competitive industry costs, quality and practices. These potential
benefits have not been included in this case.
Why do it now?
g There are compelling reasons to do this now and to maintain the Programme on an
interim funding arrangement pending the long term funding deal:
i. A delay of six months will result in a re-deployment of the Fujitsu and POL
Project teams and a failure to meet key milestones for data centre migration,
resulting in a 12 month delay to the Programme. In addition we will not be able
to use and, thus will lose, the benefit of £5m of pre-paid services from Fujitsu
under the current contract this year.
This will worsen the P&L by £44m in the plan period as follows:
® Impact £m 06/0 I 07/08 I 08/0 I 09/10 I 10/1 I Tota
« 9 u Li
Lost benefits & increased (9) 1 (8) (26) (2) (44)
costs
This represents the difference between Table 16 and Table 17 in Appendix 1
ii. Further, the balance of negotiating power will have switched to Fujitsu as we
go beyond the time at which it is theoretically feasible to run a competition,
select an alternative supplier, develop and roll out a replacement system in
time to meet the end of the current contract in March 2010. At best this would
mean an extension of the current contract on its unfavourable terms and cost,
at worst Fujitsu could significantly increase the annual charges for any
extension which we would have to pay.
Recommendations
9 10. Approval of the Business Case (POL funded model — table 16) and agreement to
entering into a revised contract with Fujitsu Services, subject to funding issues being
resolved.
hae Approval of early release of up to £25m of capital (in addition to the £10m already
approved) from the overall submission to enable the continued development of the
Horizon replacement system to allow the cost savings in the POL business case to
be maintained.
12. Approval for Post Office Limited to conclude detailed contract negotiations with Fujitsu in
line with the business case financials. Post Office Limited will only proceed to full
contract once funding has been resolved. POL request that authority be delegated to the
order of the Investment Committee to sign the contract at that stage.
Alan Cook
April 2006
Rac00000049
Royal Mail — Strictly Confidential
ndix 1 — Financials
For an investment of £127m the proposed new deal delivers an incremental post tax
NPV of c.£90m over continuing with the current system / contract until 2015. The
scheme generates an IRR of c.39% and pays back in 4.5 years.
14. The proposed Fujitsu deal offers a replacement system at a significantly lower cost
than any of the other available options.
15. The incremental P&L impact is:
Assuming the project cost is funded over an extended period (Managed
service):
Current Contract (Extended)
Group PBIT (96) (97) (98) (101) (105) (109) (114) (119) (125)
1) HNG (Financed as Managed Service)"
Group PBIT (87) (89) (99) (73) (68) (67) (67) (68) (68)
HNG Managed Service Compared with Current
Inc. Group PBIT 8 i. {0) 28 37 At 46 51 57
“This includes a financing charge of £38m at a rate of 7.5% per annum and assumes
we can get third party funding via Fujitsu. This may require an RMG or DTI
guarantee.
16. Assuming the project cost is funded by POL:
Current Contract (Extended)
Group PBIT (96) (97) (98) (101) (105) (109) (114) (119) (125)
HNG (POL Funded)
Group PBIT (87) (89) (92) (66) (61) (61) (60) (61) (61)
, HNG Compared With Current
Inc. Group PBIT 8 ia 6 35 44 48 53. 58. 64
All numbers are quoted in £ millions
ae Impact of a 1 year delay in implementation (Project cost funded by POL)
Current contract : (96) (97) (98) (101) (105) (109) (114) (119) (125)
HIG (POL funded) group PBIT (97) __(89)_(100)__ (92) _——(63)_—(63)_——(83)_——62)__—(63)
HNG compared with current PBIT @ 8 @ 9 42 46. Ei 57 62