Can Capita's growth continue and are the shares cheap?
Capital appreciation is surely the goal of many investors. One method of achieving that is to buy companies with steady earnings growth. If bought when the shares are cheap, two drivers could move the share price up:
- growth in earnings, and;
- an upwards P/E re-rating.
Highly successful fund manager Peter Lynch classified steady growers as 'Stalwarts', which he typically traded for 20% to 50% share-price gains. But whether buying for gains like that or holding for the longer term, we need to know if that steady earnings growth can continue, and whether the shares are cheap.
Seeking steady growth
Not all companies achieve steady earnings growth as you can see by the aggregate performance of those in London's premier FTSE 100 index (UKX), where the compound annual growth rate over the last five years has been just 0.7%:
| Year to June | 2007 | 2008 | 2009 | 2010 | 2011 | 2012 |
|---|
| FTSE 100 index | 6608 | 5626 | 4249 | 4917 | 5946 | 5571 |
| Aggregate earnings per share | 537 | 503 | 427 | 397 | 527 | 557 |
Steady earnings growth is a promising characteristic in today's markets so, for this series, I'm examining firms with annual earnings growth between 4% and 20%.
One contender is Capita (LSE: CPI), which is an outsourcing specialists working for public and private sector organisations. This table summarises the company's recent financial record:
| Trading year | 2007 | 2008 | 2009 | 2010 | 2011 |
|---|
| Revenue (£m) | 2073 | 2441 | 2687 | 2744 | 2930 |
| Adjusted earnings per share | 28.1p | 33.26p | 38.75p | 44.98p | 48.49p |
Earnings have grown at an equivalent 14.6% compound annual growth rate putting Capita in the Stalwart category.
Capita specialises in sorting out, and running, its clients' businesses. I like to think of the process of managing an enterprise, or organisation, as comprising two parts: strategic decision-making and execution. So often, the execution element is lacking. Capita has enjoyed considerable success, since its establishment in 1987, offering execution skills to organisations. So, clients outsource 'non-core' functions to Capita, like administration, ICT, HR and payroll, strategic development, and business process engineering. Capita then either takes the work directly, or comes into the organisation to introduce new, and better, systems and processes, and to train the client's staff to use them.
Mainly active in the UK, Capita reckons it's the market leader in Business Process Outsourcing (BPO) with a 23% market share. I like the way the company analyses its revenue according to market segment. Currently, the firm derives 20% of revenue from local government, 15% from health, 13% from education, 10% from central government, 8% from insurance, 7% from life and pensions, 4% from financial services, 3% from transport and 20% from other businesses in the private sector. So, well over half of revenues are from the public sector.
Capita pursues growth both organically and through acquisition.
Capita's earnings growth and value score
I analyse five indicators to determine whether earnings growth can continue and if the shares offer good value:
1. Growth: both revenue and earnings per share have been growing steadily. 3/5
2. Level of debt: net gearing is around 200% at the last count. 2/5
3. Outlook and current trading: recent trading and the outlook are robustly positive. 5/5
4. Enterprise value to free cash flow: historically high, at around 40. 1/5
3. Price to earnings: a historical 15 based on adjusted earnings per share. 2/5
Overall, I score Capita 13 out of 25, which encourages me to believe this stalwart may continue earnings growth that outpaces that of the wider FTSE 100, given the positive outlook and recent trading. However, I think the shares already price in future performance, which seems apparent when compared to the FTSE's price to earnings ratio of around 10 and the firm's growth predictions.
Foolish summary
Although the outlook and recent trading are both positive, Capita's cash flow has been feeling the squeeze due to demands made from working capital. This appears to be due to tough economic conditions affecting its clients' ability to pay quickly for services received. There's also a fair bit of debt on the balance sheet due to past acquisition activity.
Right now, forecast earnings growth is 7% for 2013, and the forward P/E ratio is around 13 with the shares at 730p. Considering that and the other factors analysed in this article, I think the firm is a good candidate for my watch list.
Capita is one of several steady-earnings-growing stalwarts on the London stock exchange, each with the potential to deliver significant capital appreciation when purchased at sensible prices.
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Further investment opportunities:
> Kevin does not own any shares mentioned in this article.
