QUALIPORT
Capita Fails To Make The Grade

By Maynard Paton (TMFMayn)
October 28, 2002

Capita (LSE: CPI) has probably the best profit record on the London stock market. Over the past ten years, the outsourcer has generated earnings per share (EPS) growth of about 30% per annum. What's more, at a time when most other companies are doing their best just to maintain profits, brokers currently anticipate Capita increasing EPS by 40% this year and by 20% in 2003. Although the company obviously has some operational strength, the Qualiport will not be investing. Here's why.

History

This is Capita's five-year record:

Year to Dec 31st           1997    1998    1999    2000    2001

Turnover (£m)             172.9    237.8  327.2   453.3   691.2
Operating profit (£m)      16.6     26.6   35.7    54.4    76.0
Pre-tax profit (£m)        18.1     26.8   36.3    51.3    71.4

Earnings per share (p)      2.1      2.9    4.0     5.4     7.3
Dividend per share  (p)     0.7      0.9    1.3     1.7     2.3

The table doesn't really do justice to Capita's illustrious history. The company was formed in 1984 as a subsidiary of the Chartered Institute of Public Finance & Accountancy and was subject to a management buy-out three years later. In 1989, Capita floated on the Unlisted Securities Market at a value of £8m. Two years on, Capita moved to a full listing, at which point annual sales were running at £25m. A decade or so later, Capita is valued at £1,460m and generates an annual turnover of £691m.

Growth

Capita's hyper-growth stems from its involvement in the business process outsourcing (BPO) market. The company focuses primarily on white-collar support services, encompassing a wide variety of administrative activities. Customers are mainly local authorities, Government agencies, education establishments and private businesses. Capita's recent interim results stated the potential market for its services was estimated to be worth £65b per annum, about six times the value of the actual BPO market at the moment. With a 19% industry share, Capita is the sector's leading light.

As well as the great growth potential, Capita also has the benefit of long-term contracts. At present, contracts average 7-10 years in length. Such revenue visibility underpins Capita's estimate of £875m revenues for 2002 (27% higher than 2001), made in February. Customers obviously appear happy too, with the company reporting a 95% client retention rate during 2001. 

A rapid growth market, long-term contracts, happy customers; they're the pros. So what about the cons?

Cons

For starters, it's difficult to pinpoint exactly Capita's competitive advantage, and, importantly, whether that advantage is truly sustainable or not (remember Buffett On Growth).

A sound corporate reputation, experienced management and a decent bid price must all play a part in winning contracts. But as to which is uppermost in the mind of the client, and where Capita scores particularly well, is hard to judge for an outsider. With bidding processes inherently covert affairs, it's tricky for the ordinary investor to get an understanding of how the awarding of outsourcing contracts is decided. There is a risk that rapid industry growth hides the fact that rivals are catching up with Capita.

It's important to determine Capita's competitive advantage because operating margins of 10-12% don't readily indicate a business 'franchise'. If margins were 30%, then perhaps outside investors could take for granted there was some sort of wide, operational moat in existence (albeit unidentifiable).

However, with just average margins, prospective investors need to be careful. Capita obviously incurs pricing pressures somewhere in its activities. It's certainly likely to occur from traditional outsourcing requirements (e.g. a payroll department), whereby excessive profits will be hard to come by. Clients, all of whom tender contracts to save money, must know the present cost of the operations to be outsourced. Bids above that cost are unlikely to be successful.

Diversity

With lower margins to be had on conventional business, Capita has gradually moved towards more varied and complex contracts. Large deals involving TV licensing and congestion charging in London were among the many diverse contracts awarded to Capita last year. On the contract win front, Capita's 2001 highlights included:

* Administering the back office activities of Abbey National's (LSE: ANL) general insurance operation;
* Signing a strategic partnership with Blackburn with Darwen Borough Council, for the 'delivery and modernisation' of support services;
* Providing financial and accounting services to NAAFI;
* Providing BAA's (LSE: BAA) IT resourcing requirements;
* Administering and marketing a national youth card;
* Providing loss-adjusting services for Norwich Union, and;
* Managing the IT support services contract for the National Criminal Intelligence Service.

Furthermore, Capita acquired the following during 2001:

* A provider of trust and administration services;
* A provider of employee share plan administration software;
* One of the UK's leading loss adjusters;
* Two share registration businesses;
* A specialist call centre recruitment business, and;
* A teacher supply agency;

So, there are plenty different activities going on, all of which can be loosely described under the outsourcing umbrella. However, the long-term question is whether Capita's continual broadening of its outsourcing capabilities will eventually result in an operational mishmash. Is there a synergy in administrating TV licenses and running a teacher supply agency?

Summary

After some thought, Capita has failed to make the Qualiport watch list. Looking through the current watch list, the durability and scale of Capita's competitive advantage is simply not as obvious as, say, those firms involved in tobacco, radio, share trading facilities and seaports.

Long-standing management and corporate reputation must play a part in contract wins, but neither looks a tough barrier for those playing catch-up in the attractive BPO market during the years to come. Furthermore, in an effort to be all things to all clients, there's a risk that Capita could overstretch itself logistically. While Capita could well continue its great long-term buy and hold form, the Qualiport is comfortable watching from the sidelines.