Capita Stock Purchase – A risky business at a low enough price (margin of safety).


Capita is a company I have been following for a while now. I was first tempted to purchase the stock in the wake of Brexit where the share price fell over 20%. But even though Capita fell with the broad market to 848p and it did look like a value stock at the time, I was worried that a price of 848p was still too high as it did not factor in all the risks surrounding the company. At the time, I marked down a price of 700p where if the stock were to fall to this price, it would provide a big enough margin of safety for me to be happy to part with my money and make a purchase.

Unfortunately, the market quickly roared back in the weeks after the Brexit vote and the price of Capita surged with it to reach 1046p. In hindsight, me missing out on the initial buying opportunity has turned out to be great as Capita issued a shock profit warning on 29 September which has seen its share price crash by over 27%. Ouch!

Although the share price drop seems to be overdone, it could be entirely justified. There are many risks surrounding the business right now including its high debt levels, the transport for London contract, new contracts stalling and even talk of the possibility of the company conducting an equity raise. But by far and large, the biggest problem facing the business right now is the reduction in the return on equity margins over the years. Having said this, I bought 172 shares in Capita last week as I do believe that it is now trading at levels where the risk is worth taking. There is now a big enough margin of safety for me to warrant a purchase.




Increasing Earnings Per Share and Low Returns on Invested Capital

For anyone familiar with my stock purchase decisions, they know that the Return on Invested Capital (ROIC) is by far the most important number when it comes to assessing the quality of a business and its earnings.

The return on invested capital (ROIC) is the percentage amount that a company is making for every percentage point over the Cost of Capital.

To keep it simple, a company that has a high ROIC will generally be able to have consistent high profit margins and be able to grow its profits at a faster rate than a company with a low return on equity figure.

The return on invested capital figure distinguished a wonderful business from an average business. Just have a look at the stocks that have provided high returns for investors over the past 20 years – Aaple, Alphabet (Google), Altria, British American Tobacco, Colgate Palmolive, Microsoft, Sage – all of these companies have high returns on Invested Capital.

On the other hand, a falling ROIC is usually a problem. Just look at what happened to Tesco. Although it kept increasing its earnings per share figure over the years, its ROIC figure kept decreasing. Investors where cheering the higher earnings by pushing the stock higher and higher. Only astute investors, Terry Smith for instance, recognised the fact that Tesco’s return on invested capital figures kept decreasing over the years and it eventually led to the crash in its share price.

What happened to Tesco, appears to be happening to Capita as well. The outsourcing giant has managed to grow its earnings per share from 43.9p to 70.7p over the past 5 years but during this period, its ROIC has dropped from 40% to 10%. Just have a look at the figure below.

capita-eps-vs-roic

Although Capiit’s Earnings per Share have increased over the years, its Return on Invested Capital has been decreasing. This is very worrying for the company and management needs to look at ways to turn this around.

 

By having a lower ROIC, Capita is becoming more inefficient. It somehow needs to boost this figure again in order for it to continue the stellar growth it has had over the past 10 years.

So this begs the question, why am I buying Capita even though its ROIC is dropping. The answer is the share price. Capita’s share price is low enough enough right now to warrant a purchase. It appears that the risks surrounding the business including the low ROIC figures are already priced into the stock. This is why it so cheap. To me, at current valuation levels, the stock has an inbuilt margin of safety. It is trading below its intrinsic value so to speak.

Capita is currently valued as if its business model is broken. Although it has encountered issues in a couple of its divisions and with a couple of contracts, it still remains a highly cash generative business. During the first half, the proportion of profits converted into cash increased to 112% from 104% cent in the previous year. This are excellent figures which support its acquisition strategy.

Sure Capita could issue further profit warnings but this appears to already be baked into the price. On the other hand, any good news coming out of Capita will send its share price rocketing. Capita looks like a good long-term play and a decent addition to my portfolio.




Capita Stock Purchase

I bought 172 shares of Capita at a price of £6.95 (695) each. Sure, the share price has fallen even more since my purchase but I am happy with the levels at which I bought my ownership stake.

One big pitfall individual investors have is that they have this temptation to wait for the stock price to go ‘even lower.’ I for one have experienced this. I missed out on purchasing wonderful businesses such as Glaxosmithkline (GSK) and Unilever (ULVR) as I was waiting for the stock price to go even lower during the crash of August 15.

I now have a rule that if a stock goes below my intrinsic value calculation, I will place a buy order. I will not wait for the stock to go lower. Sure, I will miss out on buying the stock at a cheaper price but what’s even worse is missing out on the stock altogether.

With my purchase of Capita, I am adding £55 in dividends to my portfolio. Even with the profit warning, Capita still has a dividend cover of 2. A yield close to 5%, a dividend growth rate of 10% and a dividend cover of 2, this is great for a business considered to be in turmoil.

Although the financial press is currently berating Capita and the prospects surrounding the company appear gloomy, the situation looks a little different for a long term shareholder. The company currently has a very appealing valuation, offers a chunky yield and has decent growth prospects going forward. I am sure that one day in the future when I am looking back at this purchase, I will be smiling at the fact that I bought shares in the outsourcer at such a troubling time in its history. Shares that will shower me with dividends for many years to come.

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