Capita may be no Carillion, but it’s still not one for your “buy” list

It’s not every day that a major company loses almost half of its market value in a single day.

It’s a particularly impressive achievement in the middle of a rampant bull market.

But then, not every company is in the outsourcing sector.

A belter of a profit warning

Outsourcing group Capita issued a major profit warning yesterday. Firstly, profits are going to be lower than expected this year (that’s why it’s called a profit warning, after all).

The dividend was scrapped. It’ll sell businesses in order to simplify itself. And, as the cherry on top, it’s going to have to raise £700m in a rights issue.

No wonder the shares ended the day down nearly 50%. This would be an ugly state of affairs at the best of times. And in the wake of rival outsourcer Carillion going bust, it’s natural for everyone to think the worst.

So what’s gone wrong?

Capita has a “short-term focus”. It lacks “operational discipline and financial flexibility”. It has been far too reliant on buying growth in through acquisitions.

Those aren’t my words – that’s the chief executive commenting on the company he runs.

And this does give you some clue as to why this probably isn’t another Carillion (although that doesn’t mean it’s worth investing in, I hasten to add).

You see, Capita has a new man at the helm. The reason that Jonathan Lewis, the CEO, can be so scathing about the company is that he’s only just taken the job. He’s been in post for eight weeks, and he was hired precisely because of his credentials as a “turnaround specialist”.

So he’s spent that time kicking the tyres, wandering around the chassis, issuing the occasional “tut tut” under his breath and shaking his head grimly as he does so. This profit warning is his way of turning around to investors and saying: “Which bunch of cowboys did this to your motor? I can fix it – but it’ll cost you.”

“New boss” profit warnings are a little different to most profit warnings. Existing managers are reluctant to issue profit warnings, because it’s basically all their fault. That’s why they tend to be tentative and understated.

Indeed, Capita’s former boss, Andy Parker, was forced out in March last year after one too many profit warnings of his own (he was responsible for three of them – this is the fourth).

But a new guy has every incentive to make the company look as awful as he can get away with – it’s called “kitchen sinking”. That makes it easier for him to then turn around and say that he’s “saved” it at some point in the future.

So if nothing else, this is a more “controlled” situation than Carillion.

Just because a company isn’t Carillion, doesn’t mean it’s a “buy”

At the same time, however, that doesn’t mean that it’s “one and done”. When Warren East took over Rolls-Royce in 2015, for example, he kicked off his tenure with an epic profit warning and then followed it up with another belter a few months later. It wasn’t until then that the company hit a bottom in share price terms.

And as Lex in the FT points out, Rupert Soames (formerly of temporary power specialist Aggreko) jumped ship to sort out Serco, another outsourcing group, back in 2014. He pulled a lot of similar moves (Soames raised £500m) and the company didn’t share Carillion’s fate – but the share price hasn’t exactly sparkled since then.

I have to say, I’ve never been keen on the outsourcing sector. Every asset has its price, but outsourcing is a sector that is particularly difficult to analyse.

As an investor, you should beware complexity. That makes it very easy for a company to hide its sins. You should also be wary of over-acquisitiveness – that’s a sign of a company trying to buy in growth, which makes you wonder why it can’t just achieve that by being in a decent line of business in the first place.

Also – perhaps most importantly – beware of debt. Debt is the enemy of equity. The creditors get fed before you do. If there are too many of them and not enough to go round, then, as an equity owner, you get nothing.

All of these problems exist in the outsourcing sector in spades. So you can turn these companies around, maybe even convince investors to back them again. But fundamentally, is this a good line of business to be in? I don’t think so.

The lack of transparency, the long-term nature of the contracts, the sprawling scale of these businesses – all of those mitigate against this being an attractive line of business.

But the biggest issue is the political risk. About half of Capita’s business comes from the public sector. Outsourcing of all types has always been rife with political risk – it tends to be done by companies who want to shed jobs.

But public sector outsourcing is on another scale. It’s always easy to write an “evil private sector” story about services in the public eye, so any mistakes can rapidly spiral into headline news stories. And try building a good reputation while you attempt to collect the BBC licence fee or manage traffic wardens, as Capita does.

And it’s only getting worse. Now that the Labour party under Jeremy Corbyn has decreed that both Tony Blair and Gordon Brown were in fact Tory prime ministers, there is no ideological backing for outsourcing at all on that side of the political fence. As for Theresa May, outsourcers are just another in a long line of headaches she doesn’t have a lot of time to worry about.

It’s not easy to turn around a company at the best of times. Doing it when politicians are competing with one another to be more outraged than the next is even harder, as Lionel Laurent points out on Bloomberg.

In short, Capita is probably not going to end up going the same way as Carillion. But that’s not exactly a ringing endorsement. And it’s certainly no reason to buy.


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