Capita crumbles to 10-year low as analysts warn of material risks

Having already more than halved since its September profit warning, Capita shares fell to their lowest in a decade after analysts at HSBC and RBC Capital Markets warned the shares had the potential to crumble yet further.

RBC cut its target price to 500p from 600p as a lack of growth, margin pressure and a stretched balance sheet was seen as the company's best-case scenario, with a worst case of further downgrades, change of management and an equity raise.

HSBC downgraded the stock to 'reduce' from 'hold' and slashed its price target to 450p from 1,020p, responding to many investors who had been asking if the shares have hit a trough by saying "we see a material risk that they have not".

Capita has high financial gearing, declining sales and a weak growth outlook, "a combination that seldom fuels investor confidence", while consensus estimates of a 1-2% decline in organic sales decline and 40 basis points expansion of operating profit margin for 2017 also now "seem optimistic", HSBC said, adding that its earnings per share estimates are 8-9% below the consensus, with dividend forecast 50% below consensus.

HSBC saw three strategic choices for Capita: a slow de-gearing that would hold back M&A and dividends, disposal of underperforming business, and/or a capital increase.

"A slow, organic de-gearing does not look like a realistic option to us. The UK public sector pipeline is weak, private sector contract awards and decision making have come to screeching halt post the Brexit vote, according to the company," analyst Rajesh Kumar said.

"The transactional businesses such as the recruitment business, the share registry, and the IT box shifting sales are unlikely to cyclically swing back to growth soon. If the decline in organic sales worsens further, financial de-gearing may not happen. A highly geared balance sheet in a weak demand environment may impede further long duration contract wins."

RBC's Andrew Brooke also noted that the UK outsourcing market is likely to remain under pressure as decision making has lengthened, discretionary spending is on hold and rebids are likely to result in margin pressure and/or greater risk transfer relative to first-generation outsourcing contracts.

Brooke said there were also "a number of Serco-esque red flags"; including a lack of growth, falling ROIC, increased exceptionals, significant acquisition spend, regular divisional reorganisations, increased amounts of accrued income and contingent liabilities, and no key external management appointments for a long time.

"Hence we believe there remains a risk of further write-downs, one-offs and a rebasing of expectations at some point."