Capita and fear of The Unknown

Capita kitchen sinks (again)

Capita has become another lightening rod for misgivings about outsourcing and public-private finance. Shares in the FTSE 250 stock crashed 45%—wiping out £1.3bn of value—after ‘kitchen sink’ announcements on profits, the dividend and a rights issue.

New CEO Jonathan Lewis said on Wednesday: "We cannot continue to focus on the incredibly broad array of disparate businesses…The strategic review we're undertaking will cause Capita to shrink, cause Capita to focus.” The comments were no big departure from the board’s strategy of the last several months. However, the group was signaling willingness to grasp the nettle more firmly. The £700m rights issue planned, disposal of some assets and scrapped pay-outs will stabilize its balance sheet. Leverage is anticipated to fall to 1.2 times core earnings compared to 2.25 times level at present. A signal on pension deficit reduction is also welcome.

Capita is not Carillion

An important difference between Capita and Carillion though is that the latter’s problems are linked to under-bidding on major contracts but Capita’s originate in routine services. Capita specialises in IT solutions for banks, the National Health Service, retailers and other sectors. Its string of profit warnings over the last few years stems from clients delaying new deals after Britain's vote to leave the European Union. Consequently, the group has been forced to undertake a painful process of simplification. It had previously depended on acquisitions as the main driver of revenue for years.

Another key difference between Capita and Carillion is that Capita generates lots of cash. It ended its last full year with £408m. On that basis, insolvency does not beckon for Capita. However the group is still subject to the same concerns as Carillion. Namely low- (or even zero) margin for contracts for increasingly cautious businesses amid political risk.

The ‘unknown’ could assail Capita as savagely as Carillion too. Most of its non-current assets were intangibles at the end of 2016 and two-thirds were ‘goodwill’ linked to acquisitions. These were the last reliable accounts of assets and liabilities before the group began a root and branch review.

Banks won’t ‘sell-out’ but more investors will

So, to be clear, Capita’s lenders will remain on side whilst it keeps generating cash and staying within leverage limits—as it has done to date. Beyond those limits, its future is uncertain. For that reason, we think stock price support will be less evident for Capita than selling interest for the foreseeable future. With 4% of shares out on loan, according to FCA data, Capita is a big short. Flimsily positive news could trigger a rush for cover, and an upward spike. The stock is down 84% in two years, near 15-year lows, and certainly oversold. However, we still expect any bounces to be sold, until the group can offer more clarity on growth and profits.