The premium rating that shares in outsourcing giant Capita (CPI) have long enjoyed is coming under pressure after some high-profile contract losses and a squeeze on its profit margins. Capita's acquisition-led growth has also left the balance sheet saddled with lots of debt and goodwill, which could hinder future returns. True, the share price has recovered from a surprise share placing earlier in the year, and organic growth will return in the second half. But Capita's cash flow is falling and the whole outsourcing sector is increasingly coming under the microscope, so we think investors should not hang around until Capita's next trading update on 13 November.
- New contracts coming through
- Near-term organic growth
- Falling profit margins
- Working capital strain
- Outsourcing under the microscope
- Premium rating to sector
Outsourcing offers tantalising up-front savings to both the public and private sector. The theory goes that whatever an organisation can do in-house with a department of, say, 100, an outsourcer - due to its sheer scale - can do with fewer people. Then it hands back the savings, while skimming some profit for itself. Equally important, there is a promise that the quality of service is maintained or even improved.
During times of austerity this offer is often too good to refuse. The problem is that the savings promised are sometimes also too good to be true. Capita is no stranger to the occasional contract hiccup - there was a failure to renew the London congestion charge contract, and it had to cough up £50m after the City regulator fingered it in the 'Arch cru' investment scandal. And this year Capita lost the renewal of the Criminal Records Bureau contract. When Capita bid for the contract ten years earlier they said it would cost £250m. Everyone was happy as its bid was around £100m less than the nearest competitor. However, the elation was shortlived, as a scathing report by the Public Accounts Committee into the debacle reveals. The contract was delivered seven months late, was plagued by IT failures and ended up costing £395m. The failures highlighted in the report were basic: a lack of proper planning, unrealistic assumptions and poor communication between contract partners.
However, Capita has far more successful partnerships, as its growth over the past 20 years attests. Given these successes and the need to cut costs, outsourcing will continue to grow. In its latest annual report, Capita estimates a target market of £117bn, of which only £8.1bn is currently outsourced. So austerity will help grow Capita's share of its market, but austerity cuts both ways - it will also make the market smaller. Robin Speakman, an analyst at broker Shore Capital, says: "Outsourcing's share of the pie is growing, however the pie is shrinking".
CAPITA (CPI) | ||||
|---|---|---|---|---|
| ORD PRICE: | 726p | MARKET VALUE: | £4.75bn | |
| TOUCH: | 726-727p | 12-MONTH HIGH: | 788p | LOW: 600p |
| DIVIDEND YIELD: | 3.5% | PE RATIO: | 14 | |
| NET ASSET VALUE: | 119p | NET DEBT: | 151% | |
| Year to 31 Dec | Turnover (£bn) | Pre-tax profit (£m) | Earnings per share (p) | Dividend per share (p) |
|---|---|---|---|---|
| 2009 | 2.69 | 258 | 30.8 | 16.8 |
| 2010 | 2.74 | 310 | 38.4 | 20.0 |
| 2011 | 2.93 | 303 | 39.2 | 21.4 |
| 2012* | 3.33 | 426 | 52.2 | 23.5 |
| 2013* | 3.64 | 463 | 54.0 | 25.5 |
| % change | +10 | +9 | +3 | +9 |
Normal market size: 3,000 Matched bargain trading Beta: 0.7 *Shore Capital estimates (profits and earnings are not comparable with historic figures) | ||||
This will bring profit margins under pressure as competition increases and Mr Speakman thinks there is another dynamic at work - clients' expectations have changed; previously they just wanted to ensure the work got done, now the focus is on the cost. At the half-year stage, Capita's operating margin slipped 0.3 percentage points to 13.5 per cent, and Mr Speakman feels that, as contracts are re-bid, there is a risk margins will fall from double digits to high single digits.
Capita's free cash flow is also falling - from £280m in 2009, £241m in 2010, and £157m last year - as new contracts absorb working capital. Capita won a record £2bn in new contracts and renewals last year and implementing them resulted in a cash strain. In addition, Capita's debt-to-equity ratio is high, especially as behind shareholders' funds of £793m there is £1.9bn of intangible assets, mostly goodwill from acquisitions. Capita says there is no reason to suggest any impairment of that goodwill, but, should growth slow, that could change.
