“What price to pay for predictability?” is an age-old question that shareholders have debated for centuries. Certainly, reliable and consistent returns cut a company’s cost of equity, pushing up the price that investors are willing to pay for it compared to the rest of the market. But as with anything, it is still possible to overpay, even for a top-notch business.
Capita Group (LSE:CPI), tipped as a BUY by Panmure Gordon
Take Capita Group, which reported half-year results this week. It is Britain’s largest provider (with a 22% share) of outsourced services. It offers call centre, administrative, recruitment, financial, IT and property consultancy services split evenly across public (eg, Birmingham and Southampton Councils) and private (Prudential and Resolution) sector organisations.
The basic idea is for customers to outsource their non-core operations to Capita, who in turn streamline their processes and integrate them within its larger activities. This results in cost savings for the client and improves overall customer service. For instance, one of its blue-ribbon contracts is to administer the BBC’s TV licensing obligations. This is a win-win situation for both parties and as a result Capita expects its top line to continue growing at double-digit rates, especially after just snapping up IBS OpenSystems for £78m, and being awarded a prestigious £60m contract by the Department of Health to develop the NHS’s online presence. Clearly, things are going well – but I suspect much harder times are just round the corner. Here’s why.
Firstly, although outsourcing is an expanding market, it is becoming crowded. There’s a plethora of first-class suppliers, including Serco, IBM, Accenture, Bunzl and even aggressive new low-cost entrants (eg, Tata) from India. What’s more, the whole sector is also exposed to serious risks. In particular, delays in signing new agreements, the mispricing of services, cost over-runs, negative press coverage (eg, Jarvis’s role in the Potters Bar rail tragedy) and/or the loss of a major customer – all of which could seriously damage a stock’s credibility in the Square Mile. For example, in October Capita was hit when it lost its flagship contract to operate London’s congestion charging scheme. It will now have to hand the project (worth around £60m a year) over to IBM in November 2009. The group has also been outmanoeuvered on other high-profile deals with Glasgow city council (by Serco) and the BBC (by Eaga).
For 2008 the City expects sales and adjusted earnings per share of £2.4bn and 32.6p respectively, rising to £2.7bn and 37.4p in 2009. Given the risks and comparative de-rating of other equities, I would value Capita on a forward p/e of about 15, or 490p – which is around 30% lower than current levels. As such, I believe the share price is vulnerable to a sharp pullback – especially if the British economy slows and its juicy operating profit margins of over 12% come under attack from aggressive rivals and rising costs.
Recommendation: TAKE PROFITS at 669p
• Paul Hill also writes a weekly share-tipping newsletter, Precision Guided Investments