Capita restructuring and contract delays spark wider concerns

Outsourcing group Capita has shelved its dividend and plans a rights issue this year, alongside select disposals as new boss Jon Lewis finds the business "too complex", inflexible and indisciplined in structure and "short-term" in focus.

Since December's pre-close update, where several restructuring and one-off accounting charges were kitchen-sinked into the full-year numbers alongside a subdued outlook for public sector outsourcing contracts, Capita has continued to experience delays in customer decision making and weakness in new sales.

There is now predicted to be a significant negative impact upon profits from contract and volume attrition, the dropping out of one-off items including contract and supplier-related profits which were reported in 2017 and increases in some cost items, which are particularly expected to hit private sector partnerships.

As such, 2018 underlying pre-tax profits, before significant new contracts and restructuring costs, expected to be between £270-300m. With £389m forecast for 2017, this would represent a decline of 23-31%.

Two months after taking charge, chief executive Lewis said his initial review of the FTSE 250 group found plenty to be positive about. Having made a "prudent" budget for 2018, Lewis said he had now "decided to invest in people, sales and our transformation programme for the long-term benefit of the group",

But the ex-Amec man said the immediate priority was to strengthen the balance sheet through a combination of "cost savings, non-core disposals and new equity". Non-core units set for the axe were identified as ParkingEye and Constructionline.

Net debt at the 2017 year-end is expected to be in the region of £1.15bn with a receivables financing balance of £110m, with the with the rights issue as part of bringing the leverage ratio down from its current 2.25 times EBITDA to a new target of 1.2x. The precise quantum of the rights issue still to be determined but standby underwriting currently in place for up to £700m.

Lewis said "significant change" is required for Capita’s next stage of development as the group was "too widely spread across multiple markets and services, making it more challenging to maintain a competitive advantage in every business and to deliver world class services to our clients every time" and that "Capita is too complex, it is driven by a short-term focus and lacks operational discipline and financial flexibility".

His initial review of the cost base highlighted "significant scope" for cost efficiencies across a number of areas but also a need to spend more as Capita had underinvested in the business put "too much emphasis on acquisitions to drive growth".

For 2018 there will be a free cash outflow, with £215m of "known" commitments, plus a £260m cash outflow split equally between the final normalisation of seasonal cash management and the continued reduction in deferred income, reflecting the ongoing low level of new business.

MARKET AND ANALYST REACTION

Capita shares crashed almost 40% after an hour of trading on Tuesday to 210p, the lowest since late 2002.

Following the recent demise of Carillion, and with Capita also highly exposed to government contracts, including army on-boarding, teachers pensions, Pensions Regulator, HSE, DWP, Cabinet office, MoJ and many more, Mike van Dulken, head of research at broker Accendo Markets, said investors will be quite rightly wondering whether the floodgates are steadily opening to cast light on the risks of government reliance on public-private partnership.

Wednesday saw fellow contractors Serco down 3.75%, Babcock down 3.2%, Mitie and Kier 2% lower, but G4S losing less than 1%.

Van Dulken said the update was "about as ugly as it gets" and said the issues "rather echo what we’ve heard from elsewhere in outsourcing land of late".

"However, it’s more likely that the remedies identified to fix the ship are the real culprits of today’s share price plunge, with an attractive (but hitherto questionably sustainable) 6%+ dividend yield suspended until positive and sustainable cash flow returns, a £700m rights issue (sure to be highly dilutive to strong-arm shareholder participation) planned to bolster the balance sheet and non-core disposals announced to simplify the group."

While the update may have been a painful one, with the shares a fraction of their 1,350p high from 2015, van Dulken said "it may yet prove a case of honesty being the best policy and short-term pain being necessary to ensure a successful turnaround and deliver long-term gains for loyal shareholders who’ve had it tough to say the least".

Neil Wilson at ETX Capital added: "Too complex, too diverse and just haemorrhaging cash – no we’re not talking about Carillion, but fellow outsourcer in a spot of bother".

He said the new CEO's clear-out to fix the business before it heads the way of its erstwhile peer seemed wise as many outsourcers have suffered from the same scattergun approach.

"Similarities with Carillion are all too clear but action, however painful, is better than fudging numbers. A rights issue to shore up the balance sheet – up to £700m, or about a third of the market cap before today – should certainly help."

Robin Speakman at Shore Capital said the probability and requirement for such restructuring had been discussed in the City for some time and so he welcomed the news, but acknowledged Capita "still faces significant challenges in its core UK market on contract pricing and with continuing hiatus in public sector services, in our opinion".

He said the new guidance of £270-300m for underlying PBT compared to his forecast of £375m.