Capita plc: Transformation complete - growth next

Capita is a consulting, transformation and digital services business listed on the premium segment of the London Stock Exchange. The company is a constituent of the FTSE All Share index and has a market capitalisation of approximately £355m.

Full year results to 31 December 2021 were published on 10th March and we were delighted to have Stuart Morgan, Director of Investor Relations present and talk about the company’s prospects. A recording of the webinar is available here.

Stuart opened the presentation with the message that the transformation started in 2018 was now complete despite the challenges of the Covid backdrop. The resulting business is now clearly separated into two business units: Public Service and Customer Experience. The Public Service division is further ahead in its transformation and the Experience division is probably 18 months behind but has plenty of opportunity. The business model in place should also create opportunities for further margin progression. A number of business units have been sold and over £700m of proceeds have been received ahead of expectations providing the required liquidity for the group and improving the balance sheet. The pension fund is also now in accounting surplus and there will be further disposals during the current year and depending on the pace of disposals debt will be materially lower at the end of the year.

In terms of the 2021 results for the first time in 6 years revenues grew, albeit not by very much, but more encouragingly the value of contracts won increased by 31%, the order book grew by £260m and the pipeline of potential new business now stands at £9.4bn. The goal of positive FCF is targeted in 2022 which would mark an impressive turnaround.

Whilst the transformation is complete there is still a lot of work to be done and there is now a platform in place to achieve this. Their two divisions operate in large markets growing at 5% and Capita enjoys market leading positions, being the number 1 supplier of software and IT to the UK government and the number 1 supplier in the customer experience market in the UK and Ireland. Capita also had good digital expertise and are more client focussed around appropriate market verticals.

Stuart then walked through the financial slides in more detail and highlighted a few points. Although it was only a small increase revenues grew for the first time in 6 years despite the Covid headwinds. Travel and Leisure didn’t really recover to the extent they hoped for and Enforcement was also slower. Net Debt came down by almost £200m helped by total disposal proceeds of £483m offset by pension deficit payments of £156m and repayment of deferred VAT of £104m.

Key in the revenue growth was contract losses reducing at half the previous rates and a good performance from new wins, especially the Royal Navy Training Contract and the job entry targeted support scheme in Scotland.

In terms of profits, margins on new business are not offsetting lost contracts as those lost contracts tend to be slightly more mature and therefore higher margin. There were significant benefits from the £123m of cost savings including early benefits from the new corporate cost structure. Overall profits increased from £5m in 2020 to the £94m in 2021.

At the Divisional level Public Service grew both revenues and profits whilst Experiences is going the other way. Portfolio improved a little bit and this is hoped to improve further in 2022.

Cash from operations decreased due to the working capital unwind and there were some below the line payments which also negatively impacted cash flow. There were further payments into the pension scheme, a restructuring charge and the 2020 VAT deferral unwound in 2021. These cashflow headwinds are expected to abate in 2022 such that there should be just under a £300m improvement from 2021 to 2022.

The balance sheet and liquidity position improved in 2021 and will continue to improve through 2022. The timing of disposals will mean that the majority of the net debt reduction will come through in the second half of the year.

Stuart then went through the guidance provided to the market both for 2022 and the medium term. Capita is expecting revenue growth this year but margins will have another small downward year due to the loss of a couple of specific contracts, a change in the Army recruiting contract and the costs of recuring and hiring new people. Cash conversion is expected to improve and net debt to ebitda is expected to fall. In the medium term the company expect mid single digit revenue growth, high single digit EBITDA margins, mid single digit margins at the operating level, cash conversion of 70-80% and 1x net debt/EBITDA.

Capita today is a long way from the pre transformation Capita. In essence, the things that are being achieved now were simply not there at the start of the process: namely receiving good net promoter scores from clients, good governance, disciplined bidding and a stronger balance sheet.

Key to future success will be continued delivery for clients and pleasingly 99% of SLA’s were met in 2021 and the client Net Promoter Score increased by 13pts. The cash improvement on failing contracts improved by £100m and they are now winning new business from existing clients on generally better terms that before. In total £3.8bn of new business was won during the year and trading momentum has continued into 2022. Bidding has been disciplined at an average net margin of 10% and they have walked away from business which doesn’t meet their risk reward criteria. 2022 revenue is underpinned by a strong order book, a good book of framework contracts, transactional revenue steady at 12% of total sales and a good pipeline of new contracts. The BBC renewal has already been won and more contract announcements are expected in the near term.

Cost savings have been key to profit improvement and over £425m of costs have been removed since 2018. Further cost improvements under pin their medium term margin outlook. This will be from a smaller property footprint, lower overhead, fewer legal entities and less intercompany charging. On top of this the shift towards more digital mix of services offered should provide higher margins.

Contract structures mean Capita is broadly protected from the impacts of inflation as 66% of contracts have index linked escalators, 22% are fixed with indexation assumptions and 12% transactional with regular repricing. Where there has been an issue though is with people costs which have risen at higher rates compared to inflation. The recruitment market is tight and IT talent has been particularly in demand. Employee net promoter scores were also lower than hoped for and some effort has gone into improving the employee value proposition – more training, work at home flexibility and higher pay scales.

Moving onto the two divisions, Capita Public Services restructured earlier and has had a good year. The business is positioned in a large market estimated at £12.5bn growing at 5%. They are the no.1 supplier in the UK market organised around 5 verticals: Justice, Central Government and Transport; Defence, Fire and Security; Local Public Services; Health and Welfare; and Education. They are wining business because they understand customer needs in these areas. They are also moving up the value chain. As an example working for Transport for London they conducted the largest cloud migration program in Europe last year executed on time and on budget.

The Experiences market tends to be a more global market and Capita is competitive in the UK with strong positions also in Germany and Switzerland. The overall market is growing 5% and digital is growing 30% and only 1/3 is outsourced which presents further opportunities for growth. A couple of recent Fintech wins were highlighted.

Looking at the non core Portfolio division, they have successfully disposed of over £700m of businesses through 2021 and the cash proceeds have almost all been received. Trust Mark was sold in 2022 and there remain businesses with a combined turnover of £338m remaining to be sold. This will largely be completed in 2022 but the timeline for Travel and Leisure will be impacted by its recovery this year. As a result of these disposals there will be a significant reduction in net debt by the end of the year.

The presentation concluded with a summary: As at the end of 2021 the transformation has been done, the business is performing in a more reliable and consistent way, there is a platform in place for financial improvement, there is a much simplified structure, revenue growth is coming through in 2022 and beyond, further efficiencies will drive margin improvement and additional portfolio disposals with strengthen the balance sheet. Importantly there will be positive sustainable cash flow delivered in 2022. In response to a questions, a return to the dividend list might be considered from 2023.

This transformation has taken more time than anticipated to complete and there have been a few bumps in the road along the way. Capita though now has a much stronger balance sheet and two well positioned divisions. As confidence in the £3bn revenue line improves and mid single digit margins are achieved the valuation gap that currently exists is likely to close over time.

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

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