When Serco (SRP) and G4S (GFS) were hit by contract scandals and a deluge of provisions three years ago, Capita (CPI) seemed like the last of the UK-listed outsourcing giants still standing. In fact, in 2014 Capita posted its highest level of organic growth since the financial crisis. However, a profit warning just over a week ago means full-year earnings expectations have been cut.
Underlying pre-tax profits are expected to be between £535m and £555m for the 12 months to December, compared with a consensus £614m expected at July's half-year results. Problems have arisen during the second half, some of which were flagged during the summer, including referendum-related delays to client decision-making. This includes planned work to install a new IT system for Transport for London, the delay to which has led to one-off costs of £20m-£25m. More concerning are the troubles in its IT enterprise services division, particularly its technology reseller business and specialist recruitment in its workplace services division. A slowdown here means full-year profits from these businesses is predicted to be £30m lower.
The shares fell 30 per cent on the announcement on 29 September and now investors may ask whether this fully prices in the risk, or is suggestive of longer-term problems.
Organic growth, which management expects to fall to 1 per cent this year, has been inconsistent during the past decade (see chart below). The group has been heavily acquisitive during this time and when organic growth has slumped, bolt-on purchases have ridden to the rescue. A slew of acquisitions mean the group's divisional structure has been subject to several changes during the past two years, in particular. This makes like-for-like comparison of performance from year to year difficult - or almost impossible - on a divisional basis.
Exceptional charges, particularly relating to business disposals and goodwill impairments, have also been steadily rising. For instance, the group took a £110m impairment on goodwill and other assets last year after exiting non-core and low-growth businesses. Panmure Gordon analyst Michael Donnelly believes goodwill relating to IT services may be at risk of being written down, resulting in further exceptional charges on the balance sheet.
"My concern is that the value paid for these businesses was too great and will need to be corrected in the balance sheet," he said.
Capita has always been highly cash-generative, which has supported its acquisitive strategy. During the first half, the proportion of profits converted into cash increased to 112 per cent from 104 per cent in the previous year. Numis's head of support services research, Julian Cater, said this still works very much in the outsourcer's favour.
Mr Cater upgraded his rating for Capita to buy from hold. "The business has been valued as if the business model is broken," he claimed. "It has encountered issues in a couple of its divisions and with a couple of contracts, but I don't think that is indicative that the Capita business model is broken."
