Is Capita plc poised to deliver a monster turnaround?

Roland Head explains why he’s not buying Capita plc (LON:CPI) just yet.

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Some of my most successful investments have been turnaround stocks. But I’ve had a few that have fallen flat as well.

One thing I’ve learned is to look for businesses which have the potential to generate high returns when times are good. This is why I’ve recently been taking a look at Capita (LSE: CPI), whose shares have fallen by 85% from their July 2015 high of more than 1,300p.

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I’ll come back to Capita in a moment, but first I’d like to take a look at a turnaround I chose not to buy. Was I wrong to say no?

Operating profit doubled

Shares of construction and infrastructure group Balfour Beatty (LSE: BBY) were up by 3% at pixel time, after the firm released a much-improved set of full-year results.

Underlying profit from operations rose by 184% to £196m last year, thanks to a broad-based improvement in profit margins.

Balfour managed to achieve average net cash of £42m through the year, compared to average net debt of £46m during 2016. The group’s bank balance also received a year-end cash boost, thanks to the £103m received for a partial sale of the group’s stake in the M25.

Shareholders will be rewarded with a total dividend of 3.6p, a 33% increase. This may seem small compared to underlying earnings of 20.9p per share, but I believe chief executive Leo Quinn is right to be cautious.

No regrets

The group’s underlying revenue and profits are expected to be fairly flat in 2018, despite Balfour being “on track for industry-standard margins in [the] second half of 2018″.

However, the group’s results show an operating margin of just 1.3% and a return on capital employed of 3.9% in 2017. Both figures are better than in 2016, but they’re still low by most standards.

Although I expect further gains in 2018, I don’t think the firm’s forecast P/E of 15.4 and prospective yield of 2.3% are cheap enough to be attractive.

Is it time to buy Capita?

Troubled outsourcing group Capita is said to be planning to reduce its focus on UK government work under new chief executive Jonathan Lewis.

Mr Lewis is expected to unveil his strategy for the outsourcing firm next month, alongside details of a major fundraising.

All we know so far is that the company has already put in place underwriting for issuing up to £700m of new shares. That’s equivalent to 65% of the current £1.07bn market cap.

It’s probably fair to assume that the new shares will be issued at a discount to the current share price, so my estimate at this point is that the rights issue could double the number of shares in circulation.

I should stress that this is only a guess. But if I’m right, then this would mean that forecast earnings per share for 2018 would fall from 29.6p to 14.8p following the rights issue. Based on the current share price, the stock might trade at around 135p after the rights issue. That would give a 2018 forecast P/E of 9.1.

That seems high enough to me, until we know more about the outlook for the next couple of years. Shareholders often suffer when company debt gets out of hand. I plan to wait until after the rights issue before considering whether to invest in this turnaround stock.

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Roland Head 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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