Questor share tip: Sell Capita as returns fall

Capita
£11.38-22p
Questor says SELL

INVESTORS have been ignoring the warning signs at outsourcing group Capita [LON:CPI] as they chase returns and growth.

The FTSE 100-listed company’s return on capital - a measure used by value investors as a guide to whether growth is good for shareholders - has been falling for the past seven years, according to data from Bloomberg.

Warren Buffett put it best in one of his annual letters to investors in Berkshire Hathaway: “The primary test of managerial economic performance is the achievement of a high earnings rate on equity capital employed (without undue leverage, accounting gimmickry etc) and not the achievement of consistent gains in earnings per share.”

Capita has certainly delivered on rapid growth. Revenues have more than tripled from £1.07bn in 2003 to £3.90bn at the end of 2013, while pre-tax profits doubled from £117m to £215m in the same period. Earnings per share have soared from 8.9p in 2003 to a forecast 46p for the year ended 2014.

The shares have more than quadrupled in value as investors focus on growth in earnings per share.

However, Questor has concerns over the quality of that growth. Capita is certainly delivering more but at what price? The balance sheet has increased from £342m in 2003 to £835m at the end of 2013.

The problem is that Capita is using more capital to generate higher earnings per share, which means the returns they are generating from those assets are falling every year. As the capital base has expanded, the return on capital has slumped from a peak of 23.6pc in 2007 to 7.2pc at the end of 2013.

Another factor that needs considering is that the return on capital figure is an average, as such it will mask some investments that will be performing far worse than others.

Capita’s most recent annual results showed why return on capital is being dragged down so drastically. Last year the company saw pre-tax profits fall by a total of £260m, with £146.7m related to losses on disposing and closing businesses, and £113.3m to writing down the value of goodwill. This resulted in a huge gap between the £475m in underlying pre-tax profits and the reported £215m.

There are other warning signs for investors as well.

Capita managing director and chief executive Paul Pindar, who led the business for 22 years, stepped down in January. He was replaced by deputy chief executive and chief operating officer Andy Parker.

In 2012 the company launched a £274m fundraising when cash became strained due to taking on new contracts.

Capita has largely fuelled the rapid expansion through acquisitions funded by debt. Net debt has increased from £138m in 2003 to £1.46bn at the end of June 2014.

Because of these acquisitions, the largest asset on the balance sheet is the perceived worth of those companies, held within £2.55bn of intangibles.

There is no doubt that growth continues apace at Capita. The company secured £1.3bn of new contracts in the first half ended June 30 and the pipeline of new work reached a record £5.7bn.

Investors often end up paying a high price for growth when they myopically focus on earnings per share. Capita shares have a net asset value of 126p, yet the shares, at £11.51, are trading at more than 10 times that figure.

The shares are also trading on 18 times forecast earnings, falling to 16.6 times next year, and that premium looks unwarranted given the high debt levels, falling returns and warnings signs for investors. Sell