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Recovery stock Capita plc could gain 70%+ within 3 years

Public Domain.

Thursday’s results from outsourcing specialist Capita (LSE: CPI) showed that 2016 was a disappointing year. Its earnings fell by 30% on a per share basis and prompted a major turnaround strategy to be launched. However, the current CEO Andy Parker will not be around to see it through, since he announced on the same day as the results that he will stand down. While this may increase the uncertainty surrounding the company, now could be the perfect time to buy it for the long term.

Major change

Capita’s current strategy includes a plan to streamline the business and make it more efficient. For example, it will dispose of two of its businesses, Specialist Recruitment and Asset Services, while it will seek to create a simpler and lower-cost business model. While this could improve the company’s performance, the reality is that a new CEO is likely to go much further with changes in the company’s strategy.

A key reason for this is that a new person at the helm will have greater scope to make changes. They will not be bound by any previous decisions and will be able to consider the future of the business from an outside perspective. This could benefit Capita, since it seems to have lost its focus in recent years and has become somewhat bloated. Major change may mean great uncertainty, but it could also lead to rising profitability in the long run.

Growth potential

Capita is forecast to return to profitable growth in 2018. However, its bottom line is due to flatline in 2017 before rising by just 3% next year. In the meantime though, its shares could see their rating increase as a new strategy is announced and begins to take hold. In other words, low earnings growth in the next two years may not hold back Capita’s share price if it is able to prove to investors that it has the right ideas on how to boost its earnings.

The company’s shares currently trade on a price-to-earnings (P/E) ratio of just 9.1. This is lower than their four-year historic average P/E ratio of 16.4. If the company’s P/E ratio reverted to its mean, it could equate to a share price gain of well in excess of 70% within three years. This includes a margin of safety in case earnings forecasts are downgraded.

Sector inspiration

Of course, Capita is not the only support services company to experience a difficult period. Sector peer Serco (LSE: SRP) is around halfway through an ambitious plan to improve its financial performance. Its recent results showed that while it is not yet back to full health, its performance is gradually starting to show green shoots of recovery. Therefore, Capita could follow a similar path over the next few years.

With Serco trading on a P/E ratio of 41.6, it may appear overvalued at the present time. However, its bottom line is expected to increase by 45% next year, which puts it on a price-to-earnings growth (PEG) ratio of just one. Therefore, it appears to be a sound buy, although Capita’s lower rating could make it the stronger performer over the medium term.

Strong growth

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Peter Stephens owns shares of Capita Group. The Motley Fool UK has no position in any of the shares mentioned. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.