Stockwatch: A classic turnaround is evolving here

by from interactive investor |

Does a transformation strategy and successful rights issue now tip risk/reward positively for shares in support services group Capita (CPI), or might balance sheet and industry risks hold it back?  

Over three years, the shares have slumped from 1,325p to a recent low of 123p, lately testing 160p, which accords with Citigroup's near-term price target as new management hones a group with a reasonably solid revenue base.  

Its analysts contend: "The early stages of the turnaround narrative should encourage investors and draw attention to a discount to the business services sector, based on 2020 forecasts."  That implies a speculative tag as yet for the stock, and volatility may persist until Capita delivers an audited turnaround.  

Meanwhile, it's tricky to discern a benchmark for value between forecasts based on EBITDA (approximating to operating profit) and an intangibles-heavy balance sheet, with no dividends for the foreseeable future.  But the narrative is certainly improving and Capita merits interest as a decent quality, medium to long-term speculation.  

Fresh management as a first transformation step 

Jonathan Lewis became effective as new CEO on 1 December, with a background in energy/turnarounds, most recently at Amec Foster Wheeler from 2016, which was then acquired by Wood Group for £2.2 billion later in 2017.  He has strong credentials as a turnaround professional – this being his fourth overall - despite IT/administration contracting not featuring in his commercial record.  He bears a consistent belief with turnarounds, believing "You should anticipate more to be done than might be shared when you start the process." 

Last January he appointed a chief transformation officer and formed an executive committee to drive change, having identified significant scope for cost efficiencies plus areas of under-investment and some quality operations deemed non-core, to be sold. 

It comes across as attractive yet realistic turnaround potential, despite the 2017 results showing a £513 million reported pre-tax loss as various non-underlying items, asset impairments and provisions totaled £851 million – the classic "kitchen sink" exercise.  

That underlying pre-tax profit reportedly rose 43% to £383 million suggests plenty worthwhile to work with however. Mind that figures are currently all over the place according to perspective, e.g. the Company REFS table reckons on a £264 million normalised loss for 2017.  It's another reminder the stock may remain volatile until the restructured group shows what it can earn.

Rights issue has improved perception of risk step 

This is the second element of a classic turnaround.  A 3 shares for 2 offer was declared with prelims and instigated over late April to late May, raising £701 million gross.  It came in context of the end-December 2017 balance sheet showing a £930 million deficit partly due to £1,722 million financial liabilities (generating £64.4 million net finance costs, covered 7 times by operating profit) and there was also £1,812 million intangibles - hence the persistently negative trend in net tangible assets (see table) that’s been over 200p per share.  

Yet the board has declared the share issue as creating a "sustainable" capital base to support its clients and operations, and some £300 million proceeds are also expected from non-core disposals this year.  They backed their words, buying a total 285,063 additional shares at 180p on 23 April, then taking up all their rights, the new CEO buying 138,500 shares initially i.e. £250,000 worth.

Short sellers thus no longer see Capita as a play on balance sheet risk: early this year the percentage of stock on loan spiked from 3% over 8%, but since the rights issue it has collapsed under 1.8% - chiefly a 1.6% short by AQR Capital Management, itself on a reducing trend.

Better cash flow profile ahead, and responsible dividends

The extra funds are intended variously: to cut debt to a target leverage ratio of net debt as 1.0 to 2.0 times EBITDA, achieve annualised cost savings of £175 million by end-2020 and invest up to £500 million over to upgrade key infrastructure also differentiate key offerings to drive growth.  

The overall target is for at least £200 million sustainable post-tax free cash flow in 2020, whereas 2017 saw £197 million generated from the ongoing operations (down from £620 million), leaving £11.2 million in terms of net cash flow after investing activities.  Showing how support services groups have irresponsibly paid dividends to placate shareholders, £217 million went out in 2017, although the current board has suspended payments until Capita generates enough sustainable free cash flow.

The balance sheet also shows an 18% rise in "Employee benefits" i.e. pension deficit, to £406.8 million, under non-current liabilities.  Even though it resulted mainly from an actuarial loss, new management declares "a matter of good corporate responsibility" to reduce the deficit. 

Capita - financial summary              
year ended 31 Dec           Consensus estimates  
  2013 2014 2015 2016 2017 2018 2019
Turnover (£ million) 3,896 4,378 4,837 4,909 4,235    
IFRS3 pre-tax profit (£m) 215 292 112 74.8 -513    
Normalised pre-tax profit (£m) 314 325 396 323 -264 392 421
Operating margin (%) 8.9 8.2 9.1 7.6 -4.8    
IFRS3 earnings/share (p) 26.7 35.5 7.9 5.6 5.6    
Normalised earnings/share (p) 41.6 40.1 50.3 43.0 -53.2 26.4 21.0
Earnings per share growth (%) -11.0 -3.6 25.3 -14.6     -20.3
Price/earnings multiple (x)         -2.6 5.8 7.3
Historic annual average P/E (x)   26.6 29.8 19.4 13.2    
Cash flow/share (p) 68.2 74.2 75.8 84.7 23.8    
Capex/share (p) 22.0 22.2 29.9 23.2 20.6    
Dividend per share (p) 24.3 27.4 30.1 32.3 31.7    
Dividend yield (%)              
Covered by earnings (x) 1.7 1.5 1.7 1.3 6.2    
Net tangible assets per share (p) -227 -267 -321 -352 -210    
Source: Company REFS          

PE multiple sub-8 times and 4.5% yield, potentially

Admittedly, some guesswork is involved and a glass half-full mindset.  Yet an order book over £8 billion and a re-organised structure offer scope for Lewis and his backers to get lucky.  Capita's five principal markets will henceforth be: software, human resources, customer management, government services and IT services – all with an increased focus on customer management.  

Citigroup estimates software could generate over a quarter of group profits with contact centres and human resources together contributing over a third; while UK central & local government services (nowadays seen as risky) may represent only 10-15% of profits.  A sixth division, specialist services, will include those peripheral or early-stage that may in due course be scaled up. 

Management targets a double-digit EBITDA margin for 2020 compared with an operating margin of 8-9% in recent years.  It has guided for underlying pre-tax profit of £270-300 million for 2018 so I'd be careful of consensus estimates - supposedly three brokers as of 4 May - for £392 million normalised pre-tax profit, as shown in the table.  That earnings per share (EPS) supposedly then declines from 26.4p to 21.0p despite profit up £421 million, reflects a rise in the average number of shares issued for 2019.  

It’s probably wiser not to get hung up on specifics: if Capita's turnaround is broadly successful then profits over £400 million (adjusted for depreciation etc) and EPS of 20p do look reasonable targets for the medium term; i.e. at 153p currently the stock is on a sub-8x PE and, if about a third of those earnings are distributed, then an implied 4.5% yield ought to constitute support.  

So, if updates convey the new strategy as "on track", then the stock may rise even if its near-term EPS outlook looks modest.  Such is the interplay between sentiment and fundamentals in turnarounds.

Political and sector-specific issues likely easing step 

Support service stocks have been under a cloud due to serial blow-ups - culminating in Carillion - and a sense that at best, pressures on government spending limit growth, and at worst a Corbyn/McDonnell government would take business away from subcontractors.  

But unless the Brexit outcome discredits the Tories enough to mean another general election before May 2022, sentiment has likely passed "peak fear" and Capita may prove a leader in turning sentiment more positively.  Speculative buy.

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