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Capita hostage to heroic assumptions

The outsourcing heavyweight is struggling in the face of entrenched industry problems
April 25, 2018

The ignominious collapse of Carillion, the UK government’s biggest outsourcing contractor, led to a joint parliamentary inquiry and further calls for the shake-up of the UK audit industry, particularly regarding the relationship between public companies and the leading audit firms: PwC, KPMG, EY and Deloitte. The extent to which auditors should be held to account for failing to flag the kinds of contractual issues that have bedevilled the outsourcing industry is open to debate. So in January – with the market on edge – a profit warning and dividend suspension by industry rival Capita (CPI) sparked a sell-off and reignited fears over systemic weakness in the sector.

IC TIP: Sell at 175p

However, this week saw the publication of the group’s full-year figures, which were well received. The bare bones: Capita revealed a 4.3 per cent fall in underlying revenues, although it was broadly flat once the effect of business exits was factored into the equation. Meanwhile, annual losses increased fivefold to £513m on the back of £851m in specific non-underlying items, including a £552m goodwill impairment.  

Net debt fell by 37 per cent to £1.12bn, and management is targeting a one to two times net debt to adjusted cash profits (Ebitda) multiple by the year-end. There was a £445m gain on the disposal of the Capita Asset Services businesses, but free cash flow came in at £37.7m, against £367m in the prior year, and is expected to be in negative territory this year. To bolster the balance sheet, Capita plans to raise £701m via a 3:2 rights issue at 70p a share; an effective 56 per cent discount to the group’s closing price on the trading day prior to the announcement.

That discount is indicative of the vulnerability of the business, but it could be argued that Capita’s central problem (recently highlighted by chief executive Jonathan Lewis) is the sheer complexity of its business arrangements. In an age that constantly demands more in the way of ‘specialisms’, Capita is trying to manage multiple long-term contracts across a range of devolved administrations, municipal authorities and public sector bodies.

Among a raft of problems, the group has been subject to a probe by the government’s National Audit Office (NAO) over the supply of a GP support system, and it was recently criticised for the technical shortcomings of a recruitment system supplied to the Ministry of Defence – the list goes on. Capita is by no means alone on this score; we’ve lost count of the number of underperforming legacy contracts that have dogged the sector, but as my colleague Algy Hall points out: “Even with all the safeguards and caveats lawyers can conjure, bids for complex, long-term contracts tend to require heroic assumptions about an unpredictable future. This can mean that the more emphasis a bidding process puts on price, the more the outcome is likely to favour (at least in the short term) and encourage companies that are prepared to be excessively optimistic”.

And there’s certainly been no shortage of this optimism in the UK. In a few short years either side of the millennium, the country, perhaps in the grip of some sort of ideological fervour, was transformed into the second-largest outsourcing market in the world behind the US.

A recent report from the NAO gives some idea of the extent to which successive UK governments have embraced private finance initiatives (PFI): UK taxpayers are on the hook for nearly £200bn for private contractors and services over the next 25 years. The NAO also found that with different economic assumptions, schools could cost 40 per cent more, and hospitals 70 per cent more, when undertaken through PFI rather than through conventional government agencies. 

CAPITA (CPI)    
ORD PRICE:175pMARKET VALUE:£1.17bn
TOUCH:175-175.2p12-MONTH HIGH:721pLOW: 128p
DIVIDEND YIELD:6.3%PE RATIO:NA
NET ASSET VALUE:*NET DEBT:£1.12bn
Year to 31 DecTurnover (£bn)Pre-tax profit (£m)Earnings per share (p)Dividend per share (p)
20133.9021527.126.5
20144.3829235.829.2
20154.841128.031.7
2016 †4.37-89.8-14.331.7
20174.23-513-80.111.1
% change-3---65
Ex-div:na   
Payment:na   
† 2016 restatement due to the adoption of IFRS 15. *Negative shareholders funds (including £1.81bn in intangible assets)