Capita: the writing was on the wall, but some missed the message

Experts have long been flagging the ailing health of outsourcing firms, which make their money by running services for central and local government as well as private companies that are trying to cut costs.

The recent collapse of Carillion, which had contracts with the government to provide services such as NHS cleaning, school dinners and prison maintenance, has intensified the spotlight on the sector.

Days after Carillion plunged into liquidation, the government was forced to deny that rival outsourcer Interserve was on the same path to oblivion, amid reports it was on a watchlist of troubled companies.

Serco, one of the largest outsourcing players, has been struggling to regain its financial stability since a 2013 scandal that saw it overcharge the Home Office for electronic tagging of criminals.

Now Capita has become the latest in the sector to suffer a major setback as its new chief executive Jon Lewis “kitchen-sinked” an array of bad news by releasing it all at the same time.

Shares in the firm tumbled 47.5% to a 15-year low, after Lewis slashed profit forecasts, announced plans to tap the market for £700m of investment and suspended a dividend that was worth more than £200m to shareholders last year.

Some industry observers saw the writing on the wall for the outsourcing sector long ago.

Tim Wainwright, an expert on outsourcing at global accountancy firm EY, said outsourcers have been squeezed by the need to provide services ever more cheaply, even as their costs have risen.

“The first time a government or company outsources, it’s relatively easy for someone to make savings, to do it more cheaply than that company could do themselves,” he said.

“When the contract comes up for re-tender, you have to bid cheaper than you did the first time you did it, so you get downward pressure on pricing. Meanwhile, you’ve got upward pressure on your cost base from things like the living wage, apprenticeship allowances and the cost of regulation.

“Clients in the private and public sector need to be realistic about the costs of running these contracts. To underbid is dangerous for the person winning the contract and the person taking it. There’s no winner here.”

Short sellers – City speculators who make money by betting a firm’s share price will fall – have also cashed in on the problems facing outsourcing firms.

Capita hasn’t attracted the volume of short-selling that Carillion did in the 18 months leading up to its demise.

But the percentage of Capita shares being sold short has surged since the end of November last year, and reached a peak in mid-January. Several hedge funds have made multimillion pound profits on this week’s share price plunge.

And yet, while a few savvy observers correctly read the runes, others have been completely wrong-footed by the decline in Capita’s fortunes.

Neil Woodford, who is regarded as one of the City’s star fund managers and stock market seer, said less than two weeks ago he was buying shares in Capita because he believed they were undervalued.

Referring to a financial update released by Capita in December, which prompted a 12% slump in its shares, Woodford declared the market’s reaction “very harsh”.

Of 14 City analysts surveyed by Reuters, only two recommended selling Capita shares before Wednesday, with nine advising clients to hold the stock, one suggesting buying more and two rating the shares a “strong buy”.

All of them will have some explaining to do to any clients who piled into Capita stock on the basis of this analysis.