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Capita profits warning spooks investors

This morning’s announcement by government outsourcer Capita of a potential £700m rights issue, a suspension of the dividend and a profits warning had the entirely predictable response of seeing the share price nosedive by over 40% to their lowest levels since 2003. Since 2013 the company has seen is market cap drop from £6.9bn to £1.3bn now.

This is a bold move by new CEO Jonathan Lewis and the fact that he thinks that this sort of restructuring is necessary, speaks volumes to the current sentiment around the outsourcing industry in the wake of Carillion’s insolvency.

Concerns over debt levels and pension deficits, along with the over-diversification of the business appears to have prompted this significant slim lining approach.

We’ve already seen the company raise £888m by spinning off Capita Asset Services to Link last year, and the company expects to effect further disposals by selling off ParkingEye which it purchased for £57m in 2013 and ConstructionLine which it paid £35m for in 2015 in order to raise extra cash in order to reduce its medium term leverage ratio to around 1-2 times net debt to EBITDA.

At the end of 2016 it was around 4.5 times while last year’s sale of its asset services division cut that number to 2.7, with the goal to getting the number down to 2.25 by the end of the 2017 fiscal year.

The pension deficit is a particular concern in 2015 it stood at £188m, and was estimated to be £381m as of June last year, with management undertaking to set aside an extra £21m in 2018 to get this number back down. In light of the problems exposed at Carillion the big jump in this number is a particular concern and exposes some particularly uncomfortable truths about shareholders holding management to account.

Does the current accounting and regulatory environment invite a conflict of interest in shareholders looking at short term returns to the exclusion of the long term health and sustainability of the business and its pensioners?

While todays share price decline is brutal, the fact that CEO Jonathan Lewis has taken steps to address the company’s weaknesses is to his credit, and while it may invite short term pain, the long term effects could well ensure the survival of the business in the long term. This is important given that Capita is the biggest supplier of local government services in the country, by some distance, according to data supplied by Tussell.

If Capita were to fail the ensuing political fallout would make Carillion look like a tea party.

It was a lesson Balfour Beatty took on in 2013 and something Carillion bosses really should have addressed two to three years ago.

In acting decisively now CEO Jonathan Lewis appears to be getting out in front of a problem that should never have been allowed to get this far. Time will tell whether today’ s actions will be enough to satisfy longer term investors, however if today’s price action is any guide investors aren’t in any particular hurry to get back in.

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