Capita: A better business is taking shape

Capita is a modern outsourcer, helping clients across the public and private sectors run complex business processes more efficiently listed on the premium segment of the London Stock Exchange. The company is a constituent of the FTSE All Share index and at the current share price of 19.5p has a market capitalisation of £332m.

Half year results to 30 June 2024 were published on 2 August 2024 and we were delighted to welcome CEO Adolfo Hernandez and Deputy Head of Investor Relations Stephanie Little, to a Yellowstone webinar to talk about the company’s prospects. A recording of the webinar is available here.

Adolfo has been the CEO for 7 and a half months now and a lot has been achieved in this short time as they build a better Capita. In discussions with stakeholders it’s clear that Capita does a good job in many areas and really matters to society but this has not delivered the appropriate financial returns. Capita is now working to build a better company and deliver the required financial returns. Key components are becoming more efficient, using technology better internally and using technology to add more value to customers as well as more consistent delivery of contracts. Executed well this will result in a better company – better for staff, customers and shareholders. And of course this will deliver a significant improvement in financial performance – the targets are 6-8% EBIT margins; 65-75% operating cash conversion and positive free cash flow from 2025; and low-mid single digit sustainable revenue growth.

In the first half of 2024 Capita demonstrated good progress against their strategic priorities. Operating margins improved 45%, annualised cost savings of £100m have been delivered and the company is on track to deliver the £160m of targeted cost savings by June 2025. When Adolfo joined the company, the target was cost savings of £60m and he raised the target to £160m and Capita has already made good progress towards achieving this. Relationships with hyperscalers, such as AWS and Microsoft, have been re-established so that they are no longer simply customers but partners and can leverage each other’s strengths to develop new products and win new business.  Capita One has been sold for net proceeds of £180m moving the company expect minimal net financial debt by the year end (excluding lease liabilities). All of this couldn’t have been achieved without changes to the culture of the organisation and good progress has been made here too. At the half year the company confirmed it was on track to deliver full year operating margin, profit and free cash flow in line with expectations and reaffirmed medium term guidance as outlined during its Capital Markets Event in June.

In terms of the H1 financial highlights revenues fell 9.3% to £1,201.5m, operating profits grew by 32.5% to £54.2m and the operating margin increased 45.2% to 4.5% mainly as a result of the cost reduction programme. The free cash outflow was reduced to £51.9m aided by lower deferred income releases, lower pension costs and lower cash costs from the cyber incident which offset the costs to deliver the cost reduction programme.

New business won in the first half fell to £0.9bn, representing a book to bill ratio of 0.8x. This lower amount of new business partly reflects a more disciplined approach to only bidding at appropriate margins. The renewal rate improved to 95% but work still needs to be done on the new and expanded scope area where the win rate is only 34%. The 2025 bid pipeline is very strong at £5.7bn, is the highest it’s been for many years and management seemed confident in the pipeline for the  second half of the year. The company announced today the DCC renewal which is worth £135m over two years and said there were a number of other contracts signed which didn’t warrant an RNS, including winning back a contract previously exited with a more modern offer at improved margins. Interestingly green shoots are being seen in the Experience division which they expect to have an impact in 2025.

Guidance for the full year was reiterated: Group revenue is expected to see a low to mid-single digit percentage reduction; Operating margin is expected to show a modest increase on the 3.5% pro-forma 2023 margin as the benefits from the cost reduction program are realised, operating cash conversion of 60-70% with proforma free cash outflow of £90m to £110m including the £50m costs from the cost reduction program; and minimal net financial debt at the year end. Net financial debt at the half year was £166.4m, flat on the previous year. The completion of the disposal of Capita One after the period end will see Capita end the current year with minimal financial debt and lease liabilities will also continue to fall as the property portfolio is reduced (they have already reduced properties from over 300 to 140). Capita also confirmed they expect to be free cash flow positive from 2025.

Over a number of months Capita has been working on a project to understand how the market views the services Capita provides in terms of capabilities, differentiated position and margin profile. The results were first shared at the CMD in June and were presented again and place the service lines into 3 buckets. Star Positions account for c45% of FY23 revenues and comprise the service lines      that Capita delivers well, have good financial metrics and where customers rate the service provided. Examples would be the Royal Navy Training, Low Emission Zone Delivery and Pensions Administration. The second bucket comprises those businesses that have Transformation Potential and make up c30% of FY23 revenues. In these areas something is missed from the proposition, investment, process or technology and consequently the businesses are not performing as well as they could. However, they are in the right space and they provide good opportunities for improvement in both delivery and financial performance. Examples would be how they improve the Contact Centre experience through perhaps partnering with hyperscalers to improve automation. The third category is Manage for Value and comprises c25% of FY23 revenues and comprises a mix of businesses. In some cases the proposition can be improved through partnerships, in other cases more radical transformation is required, another option would be exploring exits. Examples would be the closed book life and pensions business and Capita One, the disposal of which was announced in July.

Cost efficiencies are an important part of the turnaround at Capita and £100m in cost savings were delivered by June with more progress in the last couple of months. These cost savings are creating a faster, more agile, more effective business and this work continues through the remainder of the current year and into 2025. Once the £160m target has been delivered, up to £50m will be reinvested in the business. Reinvestment will have a technology focus and enable Capita to participate in faster growing markets.

On the technology front, improvements are needed so that Capita can integrate the best technology with an understanding of business processes to provide better solutions for customers and thereby add more value. The hyperscalers have great technology and by partnering with them Capita can improve their offering and be more competitive. The other advantage is that no upfront capex is required and with all the technology hosted in the cloud on a “pay as its used” basis there is really good alignment between cost and revenue. A number of new products have been deployed in partnership with the hyperscalers and there is a lot more to come next year. Looking at a case study of the technology benefits already experienced, a cloud base contact centre using generative AI has seen first time resolution of complex queries reduce from 7-10 days to 2-3 days. This solution will be rolled out for multiple private and public sector clients going forward.

In conclusion, there was a recap of the Capita Investment case. Capita has strong foundations to build on, especially with customers and what Capita does really matters to them and is valued by them. The next step is translating this into better financial performance and this is beginning to happen. Cost efficiencies are key to the turn-around strategy along with investing in technology,  partnerships and making the most of those areas where Capita already excels. There is a lot of work to do but Capita knows what they need to do and importantly those in charge of making it happen have done it before.  The medium term targets in numbers are revenue growth of low to mid-single digit percentages, an operating margin of 6-8% and importantly, free cash flow to become positive from 2025 with operating cash conversion of 65-75%.

This was an upbeat presentation from Capita management and the first half of 2024 has seen material improvements and an acceleration in the pace of the transformation. They now appear much closer to profitability and positive free cash flow than they have been for a very long time.  No wonder the CEO, FD and other directors are investing in the shares of the company.

A recording of the webinar can be found on the Yellowstone Advisory YouTube channel or by clicking here.

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