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This FTSE 250 stock is down 45% in 2 days. Here’s what I’d do now

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If you were holding shares in outsourcing group Capita (LSE: CPI) when its share price crashed by 45% this week, then you have my sympathies.

Let me explain why I think the shares have collapsed and what I’d do about it. Is this a stock to avoid? Or should you back chief executive Jon Lewis to deliver on his forecast of revenue growth in 2020?

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What’s gone wrong?

Capita employs more than 60,000 people globally on a wide range of outsourcing contracts. Examples of the firm’s activities include managing London’s Ultra-Low Emission Zone, running fire stations for the Ministry of Defence, and providing outsourced IT for large organisations.

Investors had been expecting the company’s 2019 results to show some improvement after they supported Capita’s £700m rescue fundraising in May 2018.

Unfortunately, improvement is taking longer than expected. The group reported a pre-tax loss of £62.6m for 2019, a big drop from its 2018 profit of £272.6m. Worse still, Capita’s net debt rose from £466.1m to £790.6m last year.

Lewis admitted that transforming Capita was proving “a complex challenge”. He says it will require “more investment than we had expected in 2018”. That sounds like bad news to me. I think there’s a risk this company could need another injection of shareholder cash to survive.

Why is performance so bad?

I’ve taken a look at Capita’s accounts and each division of its business remains profitable. I think that the problem is the amount of money that’s being spent to transform the business.

Last year’s accounts show costs of £69m relating to discontinued businesses, plus restructuring costs of £159.4m.

Back in 2018, the firm’s plan was to spend a total of £500m on new technology, training, and infrastructure. This was paired with £220m of planned spending on restructuring and cost cutting.

Lewis has already spent £649.5m of the planned £720m and now expects the total spend to be “nearer £800m”. Despite spending more, results are expected to be more modest. The firm previously forecast free cash flow of £200m in 2020. Capita has now cut this guidance to £160m.

Are the shares cheap enough to buy?

If I was a shareholder, the question I’d ask is would I buy the shares today? I’d only keep the shares now if I’d still be happy to buy them after this week’s news.

It’s not for me to offer investment advice. But based on this week’s figures, I don’t find Capita a very attractive investment. I don’t think the shares are especially cheap, either.

There are two reasons for this. The first is that it’s not clear to me how much more Capita will need to spend to complete its restructuring and deliver stable, sustainable profits.

The second reason is that I think the company’s debt levels are uncomfortably high. The 2018 rights issue doesn’t seem to have fixed Capita’s balance sheet. If I was a shareholder, I wouldn’t be in a hurry to pump in any more cash.

On balance, I think the outlook is uncertain for shareholders in Capita. I think there are better options elsewhere in this sector, so I’d avoid this one for now.

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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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