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Why I’d buy this top growth and income stock over Capita plc

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If you want an example of just how punishing the market can be, take a look at the recent share price performance of outsourcer Capita (LSE: CPI).

Down 34% since the end of June, the battered business dropped another 12.6% in value yesterday following the release of a less-than-encouraging trading update. It’s not exactly the start new CEO Jonathan Lewis — who arrived at the beginning of the month following the ousting of Andy Parker in March — would have been hoping for.

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While stating that trading over the year to date had been “in line with expectations” and that previous guidance of a “modest” rise in underlying pre-tax profits over H2 (before new contracts and restructuring costs) hadn’t altered, investors were clearly unimpressed with the reduction in the value of the company’s bid pipeline from the £3.1bn predicted in September to just £2.5bn. In addition to this, Capita also warned of a decline in profits from its IT Services and Digital & Software Solutions divisions.

While it’s plans to concentrate on markets that “offer the best growth prospects“, further reduce costs and “recharge” its sales performance in 2018 sounds great on paper, the fact that the £2.7bn cap already expects “a higher level of contract and volume attrition” in its Private Sector Partnerships division doesn’t exactly bode well for 2018.  

Following the huge drop in value, shares in Capita can now be picked up for just eight times forecast earnings. Although some investors may sniff value, its declining returns on sales and capital employed, worryingly high dividend yield (7.6%) and uncertain future make this one company I’d want to avoid.

A better option

Having already climbed 16% in 2017 before today, shares in specialist recruitment firm SThree (LSE: STHR) were up again in early trading following the release of a trading update to coincide with the end of its financial year.

As a result of strong performance in Q4, group gross profit for the year is now expected to climb 4% after foreign exchange fluctuations are taken into account. Broken down, the company saw strong growth in the US (up 18%) and Continental Europe (9%) over the last twelve months.

It wasn’t all good news. In addition to an 8% reduction in gross profit at its Permanent business, today’s statement also revealed that trading in the UK and Ireland continues to be “challenging” with year on year gross profit falling by 14% to £55.6m. That said, with 80% of profit now coming from elsewhere in the world (up 5% from the previous year), SThree appears sufficiently geographically diversified to cope with any adverse consequences arising from our EU departure.

All told, adjusted pre-tax profit for the full year to the end of November is now expected to be “slightly ahead” of current market expectations of £43.8m. 

Reflecting on the company’s outlook for 2018, CEO Gary Elden stated that the recent momentum seen in its Contract business (gross profit up 10% year on year) combined with its performance in the aforementioned markets left the company “well-positioned for growth” going into 2018.

Although more expensive than Capita, SThree’s stock currently changes hands for 13 times forecast earnings — a not unreasonable valuation. What’s more, the shares come with a near 4% yield, appropriately covered by profits. Factor-in a rock-solid balance sheet (net cash position of £6m) and consistently high returns on the capital it invests and the mid-cap looks a far better buy.

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Paul Summers has no position in any of the shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

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