Over the last decade and a half, Capita saw revenue grew from £897m to £4,909m. An impressive feat which propelled the outsourcer into the FTSE 100.
But the share price collapsed has meant it got demoted from the FTSE 100 earlier this year.
Now, the share price is at their lowest since the great financial recession.
This post isn’t about the right time to buy Capita’s shares. It is identifying factors and the reasons for their share price collapse. That is important because if another company were to show similar symptoms to Capita you would be able to avoid it like the plague and not have your money go down the drain!
For those disappointed about whether Capita is a buy, it will get coverage in my next post! So, stay tuned!
Focus on sales rather than efficiencies
Since 2002, Capita achieved accumulative sales growth of 447%, as turnover approaching £5bn. It looks impressive until you realise Capita spent £4bn to achieve a £4.2bn sales increase.
But back to their profit and loss account. The first problem appearing on the radar is administrative expenses. Sure, Capita grew by 447%, but admin. Expenses outpace that to record accumulative growth of 670%.
Within the administrative expense, a big cost factor is employee and Capita, being the outsourcer requires a lot of it. The problems with having a lot of employees are worrying about the high staff turnover, high costs and staff morale. All this plays a big part in the success of winning contracts and implementing these contracts effectively. One way to measure efficiency is to use sales per employee. For Capita, this fell from £78k in 2007 to £65k today.
It means the average employee is £13k less productive, otherwise, revenue should be closer to £6bn, rather than £5bn! You can say the government finances are either tight or Capita isn’t efficient.
If we use a stricter metric like normalised profits per employee. Then, the deterioration in their internal operations goes much deeper. We see a fall of 50%.
This is also reflected upon in the market, as the market value each employee below £50k per person. The lowest level since 2002.
If one takes account of net debt, the enterprise value per employee would have fallen to £83k per person.
Magical combination coming together
This is a little outside the box but makes sense for “employer-based” companies. If you take the market capitalisation per employee and divide it by the normalised profit per employee, you get multiple. That ratio shows you the trend in when to buy and when to sell Capita.
Next, let’s start assessing their debt.
Capita has too much debt vs. sales
If you think administrative growth was excessive, then you haven’t seen anything yet. Capita’s net borrowings grew by 1,176% since 2002, compared to sales growth of 447%.
That is two and a half times quicker than sales!
Net borrowings have now accounted for 42% of total sales, compared to a conservative 18% back in 2002.
The cause of Capita debt increase
Some of this debt increase is down to covering dividends and cash interest payments.
Since 2002, net operating cash inflow totals £5bn. Then, you got your capital expenses (outflows) broken down into two parts:
That totals to £4.1bn.
Subtract £5bn from £4.1bn gives Capita £900m to play with.
The equity dividends paid totals £1.675bn, while net cash interest totals £470m. Add it together you get £2.1bn, leaving Capita with a cash deficit of £1.2bn.
Since total borrowing rose from £160.5m to £3,146.8m, slightly below £3bn increase.
So, why did Capita need £1.8bn?
First, any inflows from financing would affect the cash balance. Since we can’t identify Capita’s cash balance in 2002, let’s assume its zero. That means £1bn of debt went into their cash account, as cash and cash equivalent stands at £1bn.
But, where did the remaining £800m go?
£400m went into other investments, which includes insurance, hedges, currency swaps, FX and interest rate swaps. The biggest portion went to currency swaps.
The rest went to unit trusts and other types of investments.
Moving to total liabilities.
For those who want to erase most doubts on accounts manipulation, then use this metric: Total liabilities/Revenue. The idea here is to maintain a stable ratio, if not a steadily declining ratio.
Since we know debt has outshined revenue, it’s no coincident that total liabilities outpaced sales by 2 to 1, as ratio rose from 0.5 to 1.1.
Another efficiency measure is the Total Liabilities/Normalised profits ratio. Like sales, normalised profits growth is even slower, as liabilities outstrip it by 3 to 1.
What we have is the accumulative build-up of liabilities that EXCEEDED the growth of REVENUE and NORMALISED PROFITS. Capita saw increased financial risk, as operational performance falls short.
The increasing inefficiencies mean that competition looks fierce as bidders tend to lower their price to secure contracts.
So, what other things have contributed to the demise of Capita share price?
Other Attributing Factors Dragging Capita Down
There are so many financial and non-financial factors that are left out of my analysis, which I will address below.
These are the unfortunate events which played a part in the share price declining:
1). Exceptional Charges; – The reason why reported EPS collapsed from 35.5 pence in 2014 to 5.5 pence in 2016 was the write-down of contracts and assets. That level of write-downs has totalled £740m in the past two-and-a-half-years.
2). Not fulfilling contracts obligations; – The London congestion charge cost Capita £25m, as they are unable to meet a deadline to install a system. There are delays in registering qualified GPs in the NHS, which resulted in GPs being sent home after getting hired.
3). Contract delays due to governmental budgetary constraints; – That is due to the delay in military contracts and missing out on a large pensions deal.
4). Falling profits led to questions over goodwill valuation; -Goodwill makes up a good chunk of total assets. It amounts to £2.15bn or 30% of total assets. In the event of falling profits, there is pressure on management to write-down Capita’s goodwill to reflect reality.
Capita downfall (regarding its share price, not business) is a mixture of total liabilities and administrative expenses outpacing sales.
The fall in profits was due to the lack of improvements seen in Capita internal costs control (notably employees).
Also, investors didn’t take the news well when key contracts are delayed and failure to win.
All this is forcing management to make costs saving and force the sales of assets. It will (hopefully) result in the increase of margins and much-needed cash proceeds.
Capita’s market capitalisation currently stands at £3.7bn. Does this represent an opportunity to buy or do we hold? That will be my next analysis post on Capita.
Hope this article helps to identify key factors that led to the 70% share price decline. Remember, you can apply this to other businesses that are in a similar situation as Capita.
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