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Capita is not Carillion – although there are echoes

Market watchers have been drawing some dark, if perhaps understandable, comparisons between failed outsourcer Carillion and struggling outsourcer Capita, which recently launched a £700m rights issue. While the businesses positions are very different, there are some subtle similarities.

26/04/2018

Andrew Williams

Andrew Williams

Investment Specialist, Equity Value

In the same way a driver will slow down only after they see a speed camera or a home-owner might take out insurance the day after a big storm has hit, so a high-profile company failure will always spur the market into trying to identify similarly exposed businesses.

As such, after Carillion went into liquidation at the start of the year, it was only a matter of time before dark mutterings were heard about the financial health of Capita.

Superficially, at least, it is perhaps not so surprising that parallels have been drawn.

For one thing, like Carillion, Capita is also a major provider of outsourced services to the public sector – although, while the former was more involved in construction and buildings maintenance, the latter specialises more in administration and IT projects for clients such as the BBC, the British army and the NHS.

For another thing, Capita has seen its fair share of bad headlines recently – most notably at the end of January this year when, after issuing a large profit warning, it cancelled its dividend and announced it was seeking to raise cash by way of a rights issue.

Then, only this week, it put some flesh on those bones – revealing it was looking to raise £701m by issuing new shares at a big discount after posting a £513m loss in 2017.

Capita is in a better financial state than Carillion was

Despite all that – and though it may be damning with faint praise – Capita is in much better financial shape than Carillion was and the financial dynamics of many of the businesses it operates are quite different.

We should be clear that we do not believe the company is in any danger of going bust.

Nevertheless, while the superficial parallels being drawn should be rejected, a deeper analysis does reveal Capita made a number of mistakes that also contributed to the problems of Carillion – and, as it happens, those of numerous other support services and construction groups that have got into difficulties in recent times, such as Balfour Beatty and Serco.

Echo 1 - Flattering amount of debt

Back in January, for example, Capita talked of taking a hit from the “normalisation of seasonal cash management” – which can be translated as no longer looking to flatter the appearance of how much debt it reported at its year-end by calling in all the money it was owed at the end of an accounting period while not paying any suppliers.

This is a common practice among construction and support services businesses – as evidenced by the fact Carillion’s year-end net debt was consistently much lower than its average net debt figure.

Capita’s new management team is doing the right thing and smoothing out these artificial intra-year cash movements, but doing so sucked cash out of the company in 2017 and will again this year.

Echo 2 - Use of factoring

Another similarity with Carillion – and one we looked at in more detail in Carillion’s collapse – is Capita’s use of factoring to further flatter its financial position.

While Carillion was taking the ‘reverse factoring’ route, however, Capita had stuck to common or garden ‘factoring’ – that is, signing its debts over to a bank, which would pay it the money (after taking an appropriate fee) and then go after the debts itself.

We should stress that the scale of these arrangements are much smaller inside Capita than they were at Carillion and that there is nothing wrong with these types of transactions per se.

Once more, Capita’s management are looking to unwind these legacy arrangements – although, again, doing so will drain cash from the business.

Echo 3 - Grow continually

A further echo with Carillion – and others – is the pressure Capita has been under from investors, the wider market and ultimately its own board to grow continually.

If that growth was not coming organically from within the businesses itself, then it had to be bought from somewhere else, which usually involves taking on debt and can store up further trouble for later.

From 2013/14, little of Capita’s growth was organic and the company’s debts rose to problematic levels – to the extent they are now having to be reduced with a rights issue and asset disposals.

In a similar vein, almost irrespective of what is happening at a public company, investors now seem to expect it steadily to raise its dividend each year in perpetuity.

Not doing so can be seen as really bad news by the market and companies can go to great lengths to avoid having to bite that particular bullet – thereby risking following the example of Carillion, which did not come close to covering its dividend for years.

Capita’s dividend had also grown for many years – and, while profits and cashflows were also growing sustainably, that was entirely reasonable.

There came a point, however, where it was no longer reasonable to grow the dividend – and arguably not even to sustain it.

In continuing to do so, therefore, Capita had to add more and more debt to its balance sheet, which – at the risk of repeating ourselves – can store up further trouble for later.

A recurring theme

A recurring theme here is putting off tough decisions to another day – a day Carillion, because of the growing pressures this placed on its finances, never saw.

Whether the rights issue will prove enough to help Capita recovery its former glory is up for debate – and further disposals do seem necessary to give its balance sheet a solid foundation.

While Capita may be the company in the headlines today, however, investors should remember it is just the most recent in a long line of similar businesses that have made a similar set of mistakes and destroyed a lot of shareholder value in the process.

Author

Andrew Williams

Andrew Williams

Investment Specialist, Equity Value

I joined Schroders in 2010 as part of the Investment Communications team focusing on UK equities. In 2014 I moved across to the Value Investment team. Prior to joining Schroders I was an analyst at an independent capital markets research firm. 

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