What a week for the Capita (LSE: CPI) share price! It’s up a stunning 46.79%. That kind of performance turns heads.

Thousands of investors will be thinking the same thing: why on earth didn’t I buy Capita last week? There’s a reason for that, of course.

Capita shares have been hopeless for ages. Over one year, they’re still down 24.84%. Over five years, they’ve crashed 81.7%. Investors have lost a lot more money on Capita than they’ve made. So what went wrong?

Capita is an outsourcing specialist and for many people, that will be explanation enough.

A troubled stock

Following the collapse of outsourcer Carillion, a Parliamentary committee “found that the Government’s overriding priority for outsourcing is spending as little money as possible while forcing contractors to take unacceptable levels of financial risk”.

Capita shares peaked at 795p in July 2015. Even after this week, they trade at just 20.26p. Last year’s massive cyberattack didn’t help. Capita has been through a lot.

Its latest results, published in May, did little to revive the share price, with adjusted revenues falling 9% in the four months to 31 April, due to local public service losses and reduced contract activity in defence and education. Capita is good at winning contracts, with a 77% success rate (albeit down from 80% in 2023). It’s not so good at making money from them.

Lift off began after Capita announced the renewal of its contract with the Cabinet Office to administer the Royal Mail Statutory Pension Scheme (RMSPS) on Tuesday, for an additional six years from 2026. An option to extend for a further two years would lift the contract’s total value to £48m.

But the real kicker was the news that it’s selling its public sector software business Capita One business for £200m to Orchard Information Systems, a subsidiary of MRI Software. First, it will bank a £4.8m cash dividend.

The board decided Capita was a non-core operation and the money raised would boost its balance sheet, pay down debt and fund its “transformation journey”.

Too risky for me

The news has applied rocket boosters to the share price, but I’m not sure it will continue to fly. Full-year 2023 results were a sluggish affair, with adjusted revenues up just 1.3% to £2.6bn.

Free cash flow was negative at £154.9m. Net debt was £545.5m, so the Capita One sale won’t clear all of that. It will still be large for a company with a market cap of £341m. No wonder the board is desperate to cut costs, targeting £60m of annual savings. 

The outlook isn’t that exciting, as the board expects 2024 revenue to be broadly in line with 2023, with only a “modest improvement in operating margin”. The company has made a pre-tax loss in three of the last five years. Revenues have fallen too, as my chart shows.

Another danger is that after the recent spike, investors could take their profits (or cut their losses). I suspect investors have had their fun for now. I can think of a heap of growth stocks I’d rather buy first.

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The outsourcing giant has rocketed in value after announcing a transformative asset sale. But at 18.8p per share, it still trades on a rock-bottom forward price-to-earnings (P/E) ratio of 6.4 times.

So should I add the shares to my portfolio today?

Big sale

The small-cap company provides a wide range of outsourcing and professional services to the private and public sectors. These services include operating call centres, executing human resources and accounting functions, providing sofware and IT infrastructure, and supplying business consultancy.

Its share price surged on Tuesday after it announced the sale of its Capita One software business for £207m. The division chiefly provides local authorities and housing associations with the tools to maximise revenues collection and cut costs from their operations.

The sale to MRI Software is expected to complete towards the end of August, before which time Capita will receive a £4.8m dividend from Capita One.

Capita said that the disposal “follows an evaluation of certain activities… that are not core to the group’s future strategy“. This includes standalone software services such as those provided by its soon-to-be-divested unit.

Under pressure

The sale will give the balance sheet a big boost and help it better meet its revised growth objectives. The business — which has a market capitalisation of £316m — had net debt of £545.5m as of December.

Capita’s been a disaster zone for investors over the past decade, its share price tumbling 98% in that time. It collapsed following the onset of Covid-19, and has failed to reclaim its previous heights.

The firm’s been a victim of surging costs as it’s become larger and increasingly inefficient. It was also hit by a massive cyberattack last March that saw hackers obtain customer data from around 90 organisations.

As well as causing reputational damage, the attack resulted in £25m worth of costs that pushed Capita further into the red. On a pre-tax basis, it swung to a loss of £106.6m in 2023 from a £61.4m profit a year earlier.

High risk

Last year’s rude awakening has prompted it to embark on a huge transformation programme. It set a £100m cost-cutting target in March. And last month it announced a large restructuring that will see it concentrate on areas like public services and contact centres.

Judging by broker forecasts, these steps could make the business one of the London stock market’s hottest growth stocks. Earnings are tipped to leap 74% year on year in 2024. And rises of 33% and 23% are predicted for 2025 and 2026, respectively.

I’m not convinced by these electrifying estimates, however. And neither is the market, which in turn explains the low valuation on Capita shares.

It’s not a good sign that revenues dropped 9% during January-April due to contract losses and weaker contract activity. The fallout of last year’s data breach could be significant. And there is still much uncertainty over Capita’s transformation plan.

So on balance I’d rather look for other value stocks to buy right now.

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To find out, I took a close look at the company’s operations and financial statements. Here’s what I discovered to inform my decision.

The risks I see

Capita shares really started to crash in 2016. This was largely due to it reporting a net loss of £58m for that year. In 2017, the firm reported even worse negative earnings of £117m.

The company’s revenue has also decreased from $4.7bn in 2015 to £3bn for the last 12 months. Therefore, it’s safe to say it’s not growing!

In April 2023, Capita admitted that it had client and staff data stolen in a cyber attack, thought to cost the firm up to £25m. This came at a time when it had lost £68m for the first half of that year.

To recover from such an incident takes more than just cash, however. It also takes reputation salvaging, particularly over its cyber security approach. The event may have also affected investor sentiment over its shares for the worse in the long term.

The valuation

Capita has a price-to-earnings (P/E) ratio of around just 3.4 at the moment. That ratio is very competitive with the wider business services industry, where the median P/E ratio is around 17.

Over the last 10 years, Capita had a P/E ratio of around 15. Therefore, it’s also cheap compared to past valuations.

So, does this mean the shares are worth me buying? I would say not necessarily. The reason is that sometimes a P/E ratio can be very low because investors at large have lost faith in the company.

With Captia’s revenues so steeply in decline and its earnings results quite volatile, I’m hesitant to see this as a viable value investment for me.

Maybe a turnaround opportunity

While I don’t think the shares look like the most compelling investment at this time, even given the lower-than-usual valuation, the company is restructuring in an effort to strengthen its operations and financial results.

Following its transformation completed in 2021, notable results included improving revenue, turning a previous year’s loss into a profit, and achieving positive free cash flow. Also, it reported increased customer and employee satisfaction.

Therefore, there’s evidence to suggest that the company could be able to generate better results from here on out. However, it’s not guaranteed by any means, and I think there might be much more reliable investments for me to consider elsewhere.

Not on my watchlist

Capita isn’t a perfect business, and the problems it has faced in the past and its long-term revenue trajectory make me sceptical about becoming a shareholder.

Warren Buffett taught me from his public speeches that investing isn’t just about value. He says it’s also about buying a portion of great businesses. Capita doesn’t seem to fit the latter description for me, so I’m passing on the shares, even with the low valuation at the moment.

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Outsourcing services

Capita is one of the largest outsourcing businesses in the country. It helps public and private sector businesses with their operations across a range of tasks and duties.

As I write, Capita shares are trading for 18p. They’re currently trading at all-time lows! Over a 12-month period, they’re down 35%, from 28p at this time last year to current levels. Looking back further, over a five-year period they’re down 83%, from 112p to current levels.

I reckon Capita shares have struggled in recent years due to declining performance financially, as well as contracts being harder to come by. Plus, rising debt levels have concerned investors around the firm’s balance sheet. On top of that, a data breach last year didn’t help.

However, an announcement to cut 900 jobs and review around the overall strategy and direction of the business could set it on a better course ahead.

To buy or not to buy?

The Capita share price dropped sharply when the news of the data breach broke. Plus, it could present challenges winning contracts moving forward too as its reputation will have been harmed. The news last month that 5,000 pension holders will be suing Capita due to retirement savings data being hacked won’t help investor sentiment. A hefty financial penalty could be on the way too.

Next, the sheer size of Capita is astounding, with over 43,000 colleagues. No wonder it’s hard to keep an eye on efficiencies, and I’m not sure 900 job cuts will be the end to help drive improvements in this area.

However, it’s worth mentioning that Capita has still been performing well recently. A pre-close update for the 11 months ended 30 November released just before Christmas made for good reading. Revenue grew by 2.1% and new contract wins increased by 47% compared to the previous year. Margin levels also look to be increasing.

Moving on, what I personally like about Capita’s business model is its exposure to the public sector, where it makes half of its revenue. Usually, contracts with central and local governments are longer-term and can provide stable income streams. The private sector is not as secure, or long-term, generally speaking.

Finally, Capita’s current valuation on a price-to-earnings ratio of just three makes the shares look dirt-cheap, at least on the surface of things.

My verdict

Despite Capita trading on a rock-bottom valuation, and its most recent update showing promise, I’m not going to buy any shares today.

At present, the uncertainty around what efficiencies will look like and how they could impact Capita is putting me off investing. I need to see more results and updates before I decide to part with my hard-earned money. Plus the data breach in March last year is a huge red flag for me. Failures like these can have a lasting impact on current sentiment, and future prospects too.

To me, Capita shares don’t represent value for money just now. I reckon there are better stocks out there for my portfolio. Capita’s next update is due in early March and I’ll revisit my position at that time.

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Dealing with the red flags

Capita operate a fairly unique business model. It’s classified as a business process outsourcing and professional services company. In practice, it offers a wide range of services to a vast array of clients from healthcare to accounting.

It has contracts with both central and local government, as well as catering to the private sector. Revenue is about half from each sector.

Part of the share price decline over the past five years has come from being too big and too inefficient as an organisation. This is being addressed, with the firm announcing back in November that it would be cutting 900 jobs in order to boost profitability.

Another scare came last March with a large scale data breach. This become very public and damaged the reputation of Capita, with hundreds of thousands of people impacted.

These are just some of the red flags that have caused some investors to sell their holdings in the firm over the past year.

What the metrics say

Despite the share price tumble, the company is still profitable. Not only this, but it provided an up-beat assessment of finances in the latest trading update.

Given the last full-year profit, I can assess the relative value by looking at the price-to-earnings ratio. This compares the current share price to the earnings per share. A benchmark figure of 10 is what I use to say that a stock is fairly valued.

At the moment, the P/E ratio is 3.12. This is exceptionally low. There are two angles to look at this. On the one hand, this low figure could suggest that the share price is cheap and I should buy the stock. On the other hand, it could suggest that investors are so pessimistic about the company that they don’t want to invest at all.

What I’m doing

If I assume that the earnings per share figure for the full-year stays the same, then the share price would need to triple in value to have a P/E ratio of 10. This is the best case scenario I can see for the stock over the next couple of years.

The worst case is continued headaches, inefficiencies, and data problems. This could lead to the stock falling even further.

I’m not convinced that Capita is fundamentally in a great position right now, but I do find it hard to ignore the undervalued nature of the stock. That’s why I think I’m going to start pound-cost-averaging. This would involve purchasing a small number of shares each month for a long period, to build up to a larger holding over time.

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It’s incredible to think that only in 2015 the share price was close to 800p. So at current levels, does it make sense for investors to buy?

The reasons behind the fall

For the past five years, the company has been experiencing declining revenue. Contracts have been harder to come by, both from higher levels of competition but also from some poor delivery from the business.

Over the past year, the share price has struggled due to more unusual problems. For example, it was hit by a cyber attack in late March, with client data stolen. It has ultimately cost the business £25m to fix. This is an eye-watering number, especially considering the business posted a H1 loss of £67.9m.

In recent weeks, the fall can also be tagged to the exit plan from selling Agiito and Evolvi (the travel and event divisions). Both were profitable divisions and so I think some investors are concerned about selling areas actually performing well.

Looking forward, the main risks I see for the company are the revenue figures and also the operational inefficiency of the large sprawling business.

Look at the value

Despite the numerous headaches, I do think investors can find value in buying Capita shares now.

For a start, Capita is working hard to reduce debt levels. This has fallen from £710.4m a year ago to £544.6m now. The lower the level of net debt, the less worried investors will be about the company. This should help the share price to rally.

The selling of different divisions can also be seen in a positive light. Trimming the fat and becoming a leaner organisation should enable Capita to be more streamlined. With efficiencies comes cost savings. In this way, profit margins could grow.

Finally, the total contract value (TCV) at the end of H1 was £2.2bn, up 54% from the same period last year. This shows meaningful progress and growth.

The numbers are key

The falling share price has also helped to lower the price-to-earnings ratio. Using the last annual earnings per share figure, the ratio sits at just 3.27. Typically, any number below 10 represents a potentially undervalued stock.

For a stock to be trading at such a low multiple of earnings tells me a few things. It shows to me that investors don’t currently place much value on the business, or the future earnings. If they did, it would likely trade closer to 10x.

Yet isn’t this the basis by which value investors get excited? If everyone was expecting Capita to do well in coming years, there wouldn’t be much of an opportunity for a share price rally.

I’m not going to make out that the the share price is going to turn around today. Yet I do feel that if we revisit this article in a year, I’d be confident the stock would be trading higher than 21p.

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So, what went wrong for the consulting, transformation, and professional delivery services business? And is the share price slump a rare opportunity for me to buy a cheap stock, or a value trap?

Here’s my take.

Fall from grace

Capita was once a FTSE 100 stock. Alas, those days are long gone. A few years ago the business ran into financial difficulty after successive bungled contracts, leading to a dividend suspension in 2018. It hasn’t delivered payouts since. Considering the company made a loss in H1 2023, I don’t expect this will change any time soon.

Data and IT outsourcing is the core of Capita’s business. It provides services to the public and private sectors in the UK, Europe, India, and South Africa. Most of its revenue comes from domestic sources. To its credit, the group’s worked on prestigious projects, such as London’s congestion charging scheme and Ultra Low Emission Zone (ULEZ).

However, recent financial results show the scale of the challenge Capita faces today. The group posted a reported pre-tax loss of £67.9m in H1 2023 — a move in the wrong direction after the threadbare £100k profit in H1 2022.

One reason behind the loss was a major cyber-attack launched against the company in March by the Black Basta ransomware group. The data breach resulted in the disclosure of personal information and passport images on the dark web. This culminated in a loss of up to £25m, which was higher than the group previously anticipated.

Beyond the immediate financial impact, the long-term reputational consequences are severe. Capita counts the military and NHS among its clients. These organisations can ill afford data breaches of this scale.

Future prospects

It’s tempting to write off the shares after these failures. However, the company’s making progress on some key metrics. Taking steps to repair the balance sheet, it reduced net debt by £165.8m to £544.6m. Additionally, it has accelerated its adjusted revenue growth for four successive reporting periods.

The company’s also secured valuable new contracts. The group landed a £250m contract to work on the Disabled Students Allowance framework with the Student Loans Company. Plus, as the preferred bidder for the Public Service for Functional Assessment Services, it expects to sign a £565m agreement with the Department for Work and Pensions in H2.

Whatever the future direction for the share price, the company will have to revive its ailing fortunes without CEO Jon Lewis at the helm. The Welshman has announced his intention to retire later this year. He’ll be replaced by Adolfo Hernandez, vice-president of global telecommunications for Amazon Web Services.

So can I get rich?

Although Capita shares look cheap today, I’m not convinced the company is my ticket to riches. The group still needs to make considerable progress and the reputational damage from the cyber-attack doesn’t fill me with confidence.

I’m avoiding this stock for now and looking elsewhere for shares with stronger growth prospects.

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Is it a no-brainer buy now, or would that be throwing good money after bad?

Outsourcing

Capita is billed as one of the country’s leading outsourcing firms. It has public and private business and has its fingers in a lot of pies.

The London congestion charging scheme, council tax, and 999 centres are among its government contracts. And it’ has’s involved in all sorts of construction contracts too.

But Capita was struggling even before Covid came along and stuck the boot in. It had grown too big, too fast. It stretched itself too far and had to rein things in.

Massive fall

In the days before the 2020 stock market crash, the Capita share price stood at around 150p. Today we can buy some for 28p. But things are even scarier than that.

At their peak back in June 2015, before the firm’s rapid growth turned round and bit it, the price was up at 800p. From then to today, that’s a humungous fall of 96.5%.

So should we fill our boots, or not touch this one with a bargepole?

On the face of it, I think Capita’s valuation looks attractive.

Low valuation

The company is profitable and its earnings are expected to rise in the next few years. Forecasts put the price-to-earnings (P/E) ratio at eight for this year, dropping to six by 2025.

Analysts even think the dividend will come back too, though only for a small yield of 1.5% by 2025. Still, even that could show some confidence in future cash flow.

FY22 results were quite a turnaround. The firm showed an adjusted pre-tax loss and a cash outflow in 2021. But it turned them round in 2022, posting £73.8m in pre-tax profit, with £116.5m of free cash flow.

Bargain buy?

So low P/E, back to profit, and upbeat forecasts. What’s not to like? Well, a few things.

Capita ended 2022 with net debt of £482m. That’s slightly more than the stock’s market-cap of £473m, and it makes that low P/E meaningless.

To buy the whole company and pay off the debt, a well-heeled investor would have to shell out for the equivalent of a P/E of 16. Perhaps not such a bargain.

I also fear for Capita’s long-term future.

Political change?

The current government has a history of outsourcing public business. But the chances of Rishi Sunak holding on to power in the next election don’t look great right now.

I doubt Sir Kier Starmer will be too keen to push on with the same policy. And public stuff accounts for around half of Capita’s sales.

What’s my take? No, I don’t see Capita as a no-brainer buy. But it’s not into bargepole territory for me either.

With the uncertain long-term future for public outsourcing, I can only rate it a ‘wait and see’. H1 results are due on 4 August.

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So, is the stock now a bargain?

A brief history

Capita is an outsourcing business. It provides a multitude of services to both the public and private sectors, including collecting council tax, operating 999 call centres and advising on large scale engineering projects.

On the back of successive governments looking to privatise more functions, the company grew rapidly and became a member of the FTSE 100 in 2006.

However, in 2018, not long after being appointed, its chief executive issued a profits warning, suspended the dividend, and embarked on a radical programme of cost cutting. Later that year, the company had to raise £700m. It now doesn’t make the FTSE 350.

The business had grown too quickly and become overly complex.

It therefore set about reducing the number of operating divisions from 10 to two, disposed of non-core assets to reduce its debt, and concentrated on “winning more of the right work“.

The directors believe they’ve now completed the transformation and stabilisation phases of the turnaround. And according to its latest update, the company is well positioned to grow once again.

Is it?

Future prospects

Investors appeared to like the company’s 2022 results. Capita’s shares rocketed by 46% during the three days following the announcement that it had made a profit of £74m, compared to a loss of £123m in 2021.

But its order book and sales pipeline are both flat, although there are big differences between its two divisions.

And the situation may not improve. A change of government could lead to more services being brought back under public control.

The company’s reputation will also have been damaged as a result of a cyber attack that took place at the end of March. It claims that only 4% of its servers were affected. But an investigation is underway to ascertain the full extent of the damage.

Time to buy?

I think Capita has probably turned the corner after its recent struggles. But I think it has a long way to go before it sees rapid growth again.

The forecasts of analysts covering the stock are usually a good guide, although not fool proof. The average of the predictions for 2023 revenue is £2.91bn (2022 actual: £2.85bn). And profit before tax is expected to be £93m (2022 actual: £74m). These are not much different from last year’s figures, although I acknowledge they’re going in the right direction.

However, the company’s shares trade on a price-to-earnings (P/E) multiple of around six.

This is on the low side and does imply that Capita’s stock represents good value, although I don’t think it’s in bargain territory.

The company hasn’t paid a dividend since 2017, which means — if I owned the stock — I’d be relying on capital growth to make a return.

Therefore, until its growth prospects become clearer, I’m not going to invest. I believe there are better opportunities elsewhere. However, I shall watch the company’s progress with interest.

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With the Capita share price near 25p, it’s dropped by around 47% over the past year.

In fairness, the markets have been terrible and many stocks have plunged. But the business has perhaps earned the poor performance of its shares. Nevertheless, it has turnaround potential now. And I think the opportunity is worth me exploring.

Rapid rise and fall

Capita was the UK’s leading player in creating and developing the outsourcing market. And the business grew at lightning speed after emerging as a standalone company back in the late 1980s. And it diversified its services both wide and deep in the public and private sectors.

Capita seemed to be everywhere. For example, it’s had contracts such as the running of the London congestion charging zone. It’s collected the BBC licence fee, and provided electronic tags for offenders. It’s recruited for the British Army and for the NHS. And it’s been involved in many primary support services for the NHS as well as many other diverse operations in both the public and private sectors.  

The share was a darling of the stock market — until it wasn’t. The company’s rapid expansion into a mind-bogglingly wide spread of services caused an apparent lack of focus. Contracts started becoming unprofitable. And worse still, Capita started mucking things up and getting things wrong with many of the services it was supposed to provide.

The day of reckoning came in July 2015 when the share price topped-out at around 800p. And that’s a lot higher than today’s 25p, which goes a long way towards telling the story of the decline of the business. Indeed, the earnings record over the past few years has been terrible. In 2016, the company posted annual earnings of just over 14p per share. But for 2022, City analysts expect a little under 4p.

Turnaround and debts

One of the outcomes of Capita’s history of ascendancy and decline is a huge pile of debt. It’s a big problem facing the current management team in their efforts to turn the business around. And the company is addressing it in part with a programme of asset sales.

One recent example is the announcement of the company’s intention to dispose of its Pay360 Limited business. And it also completed the sale of its two real estate and infrastructure consultancy businesses in September. All the money raised appears to be going towards debt reduction.

In August’s half-year results report, chief executive Jon Lewis said the company’s reputation for delivery and digital transformation services is increasing. And it’s secured “a series of important contract wins and renewals”. Meanwhile, City analysts predict an increase in earnings of around 34% in 2023 making the forward-looking earnings multiple about five.

Rising annual earnings haven’t been seen for around five years. So, this could be the beginning of a meaningful turnaround. But it’s early days. And the company has a lot of historical ‘baggage’ and debt to shift. Meanwhile, there’s no shareholder dividend.

I don’t think the Capita share price is a particular bargain when adjusting for the company’s debts. The valuation looks fair to me. And the company has much still to prove. So I’m watching from the sidelines for the time being.

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