Capita’s lacklustre transformation

Order intake came in at £1.8bn last year, but the order book contracted from £8.2bn to £7.1bn. Contract losses worth £172m far outweighed £25m of contract wins, creating an uncertain outlook – around £60m came from early termination and insourcing. In government services (where the order book shrank by 18 per cent), the group is grappling with deteriorating local government demand for large, multi-year outsourcing contracts. Existing clients are ending contracts early and taking services back in-house, resulting in a £34m goodwill impairment charge in 2018. Ongoing contract attrition is expected to contribute to a £200m revenue decline in 2019. Although the business generates almost a fifth of group revenue, this translates to just 10 per cent of adjusted operating profits (which plunged by 56 per cent in this division to £35m last year). Margins are lower than the wider group, having almost halved to 4.7 per cent.

Capita is looking to technology to reignite growth – digitally-enabled services and software represent growth markets, include higher-value services and provide international opportunities. While software produces just 10 per cent of group revenue, it comprises 34 per cent of adjusted operating profit. It was the only division where margins increased in 2018 (by 0.6 percentage points to 28.4 per cent). However, despite new contract wins, product roll-outs in the US and offshoring to India, adjusted revenue fell by 1.3 per cent and operating profit was flat.

A rights issue raising £701m and disposals worth £408m reduced net debt from an unwieldy £1.1bn to £446m. But this is still worryingly high when coupled with recent cash outflows from the business. Peel Hunt forecasts that net debt will increase by almost 60 per cent in 2019 to £736m. With a £372m working capital outflow, free cash flow swung to negative £261m in 2018 (from £67m), making a dividend a distant prospect. Further disposals are planned in specialist services, but simply selling off non-core assets is insufficient – the group needs to reliably secure the higher-margin contracts it covets.

By the group’s own admission, the transformation programme is critical to future performance. Savings of £70m have come at a cost of £55m (expected to increase to £95m this year in order to get cumulative savings of £175m by 2020). Other 2020 targets include double-digit adjusted operating margins and £200m of “sustainable” free cash flow. But with the group adjusted operating margin squeezed from 10.9 per cent to 8.7 per cent in 2018 and worse-than-expected organic revenue decline triggering forecast downgrades, we remain doubtful.