Tuesday, 28 August 2012

Capita (CPI) … it’s very bouncy

I’ve shorted Capita.

I had a look back over the notes I’d made when Capita announced an equity raise in April last. Its share price fell by 18% in the weeks that followed from its pre-announcement price. It’s since bounced back by 18%. It’s very bouncy.
My main concerns then and now are as follows:
  1. April’s cash call came shortly after it arranged a new £285m 2 year loan in February 2012. On my maths, that tallies up to a raise of c. £562m from its banks and shareholders during H1.
  2. Prior to its equity raise, Capita had suggested that it would likely reduce its acquisition spend during 2012, relative to previous years. Indeed it acknowledged this in the accompanying statement to its equity raise. It subsequently concluded that the “current acquisition environment continues to offer a rare opportunity to broaden its business”. That seems to me to be a bit of a “flip-flop” approach.
  3. In its equity raise statement, Capita also suggested that “its clients value Capita partly because of its financial strength.” This would be reflected through keeping its net debt to EBITDA level within its targeted range of 2-2.5x (2011: 2.5x). However, in the light of the company spending £1.3bn on acquisitions since 2005, and £733m since Jan 2010, a more welcome outturn would be to see these acquisitions begin to provide a greater input into the reduction of net debt, as opposed to a cash call. I note that my estimate of its free cash flow shows it has not risen since 2009 (in fact it seemed to have halved in 2011 – see below), while the net debt to EBITDA ratio has risen. To me it appears as though prior acquisitions have not helped with the group’s financial strength. So I don’t see why further acquisitions should do either.
  4. Total annual spend on acquisitions has been increasing while the valuations attached to those acquisitions appear to have remained high and the margins bought appear to be getting lower. On my estimates, acquisition spend has been c. £175m, £181m, £311m, £341m in the years 2008-11, while (again on my estimates) the average EBITA margins of the acquired businesses has fallen from low double digits in 2008, to single digits in 2011. Further, despite lower margins associated with acquisitions and the difficult trading backdrop across the market, valuations paid appear to have remained relatively sticky at c. 9x EBITA.
  5. Its net debt has risen from £258m in 2005, to £1.33bn in 2011. This declined to £1,201m in June 2012; however, excluding April’s cash call, net debt would have risen to £1,477m. Meanwhile, on my estimates, CPI’s free cash flow more or less stalled in 2008-10, at £209m, £239m, £240m, and then halved to £121m in 2011.
  6. The Deferred Annual Bonus Plan criteria appear to have been steadily falling. In 2009 the criteria for 33% to 100% vesting was for the company’s EPS growth to fall in the range of RPI + 6% pa up to RPI +16% pa. In 2010, this was brought down to a range of RPI + 4% pa to RPI + 14% pa. In 2011, this was again brought down to a range of RPI + 4% pa to RPI + 12% pa. Over the past two years the upper boundary for vesting has fallen from RPI + 16% to RPI + 12%. That is against the grain of management’s rhetoric on record pipelines.  
  7. Operating lease commitments rose significantly in 2011. Future minimum rentals payable under non-cancellable operating leases rose from £265m in 2010 to £379m in 2011; by 43%.
So for the reasons above, I have gone short.
Capita share price
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