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Why I’m sticking with Capita plc for now

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I’m sticking with my investment in Capita (LSE: CPI), despite last week’s shock profit warning which wiped more than £1bn off its market capitalisation.

Why? There are two key reasons. First, Capita’s share price reaction is partly driven by the fear that the company could soon follow in the footsteps of Carillion, a scenario that seems very improbable to me. Second, a potential turnaround at the company could deliver serious upside for shareholders, given its current valuation.

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Capita isn’t Carillion

I hope it’s not confirmation bias that has driven me to think Capita is not another Carillion, as there are some very noticeable differences between the two companies.

Firstly, Capita’s balance sheet is in much better shape than Carillion’s was a year ago. Although both had big debts and pension deficits running into the hundreds of millions, Capita’s financial liquidity is much more robust, as the company has more than £1bn in cash at the bank. Moreover, it also plans to raise £700m in fresh equity to further strengthen its balance sheet and to starve off a liquidity crunch.

Secondly, Capita is a different kind of outsourcer to Carillion. It isn’t involved in the sort of construction contracts that Carillion tripped up over. Instead, Capita offers services such as collecting the TV license on behalf of the BBC and helping private sector clients manage back office tasks.

Turnaround prospects

Capita has had similar problems to Carillion, such as relying too heavily on acquisitions and bidding too low to win contracts, but it’s in much better shape to deliver a turnaround at the business.

There’s still value in the outsourcer’s contracts, with Capita still set to generate between £270-300m in underlying pre-tax profits in 2018. There’s a plan to simplify the business, by selling non-core assets, and I reckon it has the right person at the helm of the company. CEO Jonathan Lewis is a well-respected turnaround specialist, having previously taken on the job of troubleshooting Amec Foster Wheeler.

Analysts at HSBC suggest a turnaround scenario could over time lead to a doubling in its share price, although it reckons it is too early to factor that into the valuation right now.

A better turnaround play?

Another turnaround play that may be worth a closer look is Petrofac (LSE: PFC), the mid-cap oil services company that’s been embroiled by a corruption investigation by the Serious Fraud Office (SFO).

Shares in Petrofac took a tumble this week as the company warned its shareholders that the SFO was deepening its investigation into alleged bribery, corruption and money laundering. If Petrofac is found to be guilty, it could face the prospect of a multi-million pound fine, which could greatly hurt its balance sheet and its ability to win new contracts.

New orders

So far, though, its higher counterparty risk has done little to hurt Petrofac, as it continues to secure new business at a robust pace. The company secured $5.2bn worth of new orders in 2017, bringing its order backlog to a total of $10.3bn, which reflects an impressive recovery from a year ago.

This demonstrates its strong underlying fundamentals, which is underpinned by its focus on the Middle East, where the relatively low costs of production in the region have shielded the company from the savage cuts to capital spending in the oil & gas industry.

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Jack Tang has a position in Capita plc. The Motley Fool UK owns shares of Petrofac. 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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