There was a time when the market was in love with the outsourcing sector. And FTSE 100 giant Capita (LSE: CPI) was the poster boy. The company had notable institutional support, including from Neil Woodford, who liked the ‘asset light’ business model and impressive stream of dividends.
However, a few shrewd analysts began to question the underlying performance behind outsourcers’ multiple acquisitions, the way they booked revenues and the high debt and lack of tangible asset backing. They were right to do so, because these chickens came home to roost, most notably with the collapse of Carillion.
Huge turnaround potential
Back in January, I wrote that I’d sell Carillion at almost any price but I rated Capita a ‘buy’, albeit one with elevated risk. My optimism proved misplaced. The shares were trading at 410p at the time but are changing hands at around 160p, as I’m writing.
The fall of Capita from its high of over 1,300p has been spectacular, taking it down the FTSE 100 and into the second-tier FTSE 250. There are probably private investors who will never go near the stock again and with big FTSE 100 tracker funds no longer holding it and it also being unappealing for equity income institutional investors (the dividend has been scrapped for the time being), this has got to be one of the most unloved companies around.
However, because of some positive developments since my January article, I continue to rate Capita a higher risk ‘buy’ but one with huge turnaround potential from the now thoroughly depressed share price. Further management changes, a balance sheet bolstered by a £700m rights issue, progress on the disposal of non-core assets and the winning of new contracts all give me cause for optimism.
I believe the Carillion disaster should lead to outsourcing contracts being awarded more on a best value basis than simply to the lowest bidder. If Capita can make any kind of decent margin on its multi-billion revenues, which I believe it will be capable of, I can see the shares rising strongly in time, as the market regains confidence in the company.
Temporary setback?
Global medical products and technologies company ConvaTec (LSE: CTEC) was London’s biggest flotation of 2016. Its 225p-a-share IPO valued it at £4.4bn and its shares were trading at over 300p the following year. However, late in the year, the shares dived when the company reported some significant operational issues. The collapse in its market cap led to it being demoted from the FTSE 100 in December.
I viewed these operational issues as temporary and felt comfortable with management’s confidence in resolving them. In an article at the time, I wrote: “Given the growth and margin progress that was being made up to this point and the fact the shares have slumped so far (near to 180p), I see merit in buying a small stake in this higher risk/reward turnaround situation, perhaps adding on an improving outlook.”
The company has indeed made progress. In a Q1 trading update last month, it said: “We have delivered a solid start to the year, underlining 2018 as a year of stabilisation.” The shares have recovered to 215p at the present time and I continue to rate the stock a ‘buy’ at this level. I believe the business has a bright future in the attractive healthcare sector.