Capita – significant upside
Pitch Capita to a roomful of investors these days and you are likely to empty it pretty quickly. So let me get to the numbers straight away:
Capita’s market cap is currently £360 with £270m debt on a pro forma basis.
The turnover of its two continuing business units is around £2.6 bn and I think they should achieve around 6% operating margins on this. After tax, this is around £120m of net profit.
This translates into a 3x P/E. If I am right about the debt and Capita’s normalised earnings, then this is cheap. So let’s look at those two things.
Net debt (excluding lease debt) was £430m as of 31.12.21. Since then, they have received £210m in proceeds on 2 further disposals. I estimate the remaining businesses they have slated to sell will fetch around £200m – in aggregate these have £338m of turnover and £27m profit before tax.
This leaves £20m net debt, to which I make some adjustments of my own.
First, pensions. They are currently in accounting surplus and have agreed reduced contributions of £30m p.a. for 22/23 and £15m pa for 24-26 for total of ~£100m. I believe the pension surplus will only increase, as increases in the discount rate following interest rate rises will more than offset the effect of increased inflation on the pension liabilities.
Second, working capital unwind. They have a very big deferred revenue balance. This is because on contracts where they are doing upfront ‘transformation’, the client funds the upfront costs but this cash is booked as revenue over the contract life. As older transformative contracts have not been replaced as quickly by newer ones in recent years, this balance has been unwinding, however they are forecasting that this has largely run its course mainly because they are winning more new business. In 2021, the working capital outflow due to deferred income unwind was around £130m and they forecast ‘half that’ in 2022 and improving beyond that. I have no idea what the right number is but let’s say there is £150m further unwind to come.
Putting all the above together gets to £270m net debt pro forma. Note that this is the number I am using for valuation purposes and that their actual debt position for covenant purposes will be better than that.
What other nasty surprises might be lurking to increase that number? The big unknown with contractors is problem contracts. But Capita has been in restructuring under turnaround CEO Jon Lewis for over four years now and say these are now dealt with. That seems plausible. It also seems plausible that contracts agreed since he took over won’t have these problems. Why? Firstly, they have centralised bidding decisions to an investment committee that he oversees. Secondly, there has been less competition, as public sector contracts in particular have become unattractive since the various failures for eg Carillion, rail franchises, etc but also because the Government actively disqualifies unsustainable bids.
I am not saying there will be no further nasty surprises - I have no idea. It is why I never buy shares in contractors and think them suitable only for private equity where you can diligence the contracts properly. But, 1. I think this risk is much less likely now, and 2. If you believe the normalised earnings (to follow, below), then there is significant margin of safety to absorb any further nasty historic liabilities.
What are Capita’s normalised earnings?
Capita has a significant market position in both its core businesses
Capita operates in the UK only and is the largest player in both its continuing segments, ie Public Service and Experience, which are both in large and growing markets.
Public Service (£1.4 bn turnover 2021): Despite the various scandals and difficulties amongst government outsourcers from Carillion to rail franchises in recent years, Governments need outsourcers and have always relied on the private sector to provide services. There is also a rational expectation within government that they must make a reasonable profit. Capita’s order book and pipeline are holding up and now back to growing. It continues to be the largest supplier of business process services to the UK Government and it continues to win and renew business.
Customer Experience (CX) (£1.2 bn turnover 2021): Capita has been in the business of outsourced customer service - call centers typically - for over 40 years and is the largest provider in the UK, with the market forecast to grow at 5% p.a. Its revenue retention rate was 97% in 2021 and it is winning new business with existing and new clients. It compares very favourably to peers as judged by industry analysts.
Peers currently earn higher margins
Capita’s current margins are not a good indication of its potential. Capita earned around £75m in operating profit in 2021 on continuing operations, £98m in public sector on turnover of £1.4 bn, £69m in ‘Experience’ on turnover of £1.2 bn, less £52m corporate overhead and less £38m to adjust operating profit for lease costs, as I am using pre IFRS-16 numbers (adding back right-of-use depreciation and subtracting lease interest and capital payments). That equates to an operating margin of 3%. Not all that operating profit was cash profit because of the deferred revenue unwind, which I dealt with above in ‘Debt’.
Let’s instead look to peers to see what its potential is over the medium term:
Serco, the number 2 behind Capita in UK government BPO but a little further along in their restructuring journey, is currently earning 5% operating margins and targeting 6%. It only does public sector work that is typically less transformative, complex work than Capita, so this should be a floor for what Capita can achieve in its Public Services business. Capita itself said in its most recent earnings call that it is earning 10% EBITDA margins on newer public sector contracts, which would translate into 8% operating margins post capex.
Peers in Customer Experience in the same quadrant as Capita (see above) earn double digit operating margins - 13% for Teleperformance, Concentrix and Majorel, the latter being most comparable to Capita in scale.
Let’s assume in the next few years Capita gets to 5% operating margins in public sector work and 8% in Customer Experience, on current turnover levels that would equate to a blended margin of 6.4% and operating profit of £165m.
What could Capita be worth?
Serco now trades at just over 8x EV/EBIT and peers in the CX space trade anywhere from 12x EV/EBIT for Majorel to 22x EV/EBIT for Teleperformance. Let’s assume a 8x multiple for Capita’s public sector business and 10x for customer experience with for the sake of simplicity a 50:50 split, yielding 9x blended multiple.
9x EBIT of £165 per the above, less the pro forma debt of £270m yields an equity value of around £1.2 billion, which is 3.4x the current market cap. Put another way, that is a margin of safety of 70%.
This also assumes no growth in revenue and that Capita is underearning vs peers.
Let’s assume it takes 3 years to work out, ie for the market to wake up to this and rerate the shares accordingly, that’s still a 50% p.a. return.
Let’s assume they achieve only £100m in disposal proceeds instead of £200m and that the working capital unwind is £250 not £150. That 's still a 2.8x money multiple.