Amazon And Microsoft Partnerships Will Advance AI Efficiency Amid Risks

Key Takeaways

• Capita's investment in AI aims to enhance efficiency and market position, improving operational margins and competitive stance in business process services.
  
• Strategic restructuring and focus on tech partnerships, cost optimization, and exiting low-margin units are expected to boost profitability and revenue growth.
  
• Declining revenues and competition pressure threaten Capita's profitability, while ambitious cost-saving targets and cyber incident costs pose risks to financial stability.

Catalysts

Operates an outsourcer that supports clients across the public and private sectors in the United Kingdom and rest of Europe.

• Capita's significant investment in AI and technology transformation aims to create a more tech-enabled, efficient, and lean organization, which is expected to increase operational margins and improve competitive positioning in the business process services market.
  
• Efforts to optimize cost efficiency and reduce the operational cost base, including a target of EUR 250 million in annualized savings by the end of 2025, are anticipated to improve net margins and support a sustainable cash flow profile.
  
• Expansion and enhancement of service offerings, particularly in AI and digital solutions, leveraging partnerships with hyperscalers like Amazon and Microsoft, could accelerate revenue growth and increase market share in tech-driven service delivery.
  
• The restructuring of the business, with a focus on exiting non-core operations and improving segmental profitability (such as exiting low-margin closed book life and pensions business), is anticipated to enhance overall earnings quality and align resources with higher-margin activities.
  
• A strategic drive to improve sales effectiveness and win rates, with a pipeline of approximately $11 billion, including $5 billion related to tech and AI innovations, could foster revenue growth and drive profitable contract wins, leading to stronger earning potential.

Capita Future Earnings and Revenue Growth

Assumptions

• Analysts are assuming Capita's revenue will decrease by 0.7% annually over the next 3 years.
• Analysts assume that profit margins will shrink from 3.2% today to 2.9% in 3 years time.
• Analysts expect earnings to reach £71.5 million (and earnings per share of £0.62) by about May 2028, down from £76.7 million today. However, there is a considerable amount of disagreement amongst the analysts with the most bullish expecting £82 million in earnings, and the most bearish expecting £61.1 million.
• In order for the above numbers to justify the analysts price target, the company would need to trade at a PE ratio of 7.2x on those 2028 earnings, up from 2.7x today. This future PE is lower than the current PE for the GB Professional Services industry at 22.3x.
• Analysts expect the number of shares outstanding to grow by 0.11% per year for the next 3 years.
• To value all of this in today's terms, we will use a discount rate of 12.56%, as per the Simply Wall St company report.

Capita Future Earnings Per Share Growth

Risks

• The decline in group revenue by 8% due to prior year contract losses and delayed mobilizations presents a challenge, negatively impacting both revenue and future cash flow stability.
  
• Significant headwinds in the contact center sector contribute to operating losses, exacerbated by a decrease in volumes in the telecoms vertical, which undermines profitability and will likely continue to affect net margins.
  
• Free cash flow was a negative outflow of EUR 122 million, reflecting costs from a cyber incident and cost efficiency program, indicating potential threats to net earnings if such incidents recur or if cost savings are not realized as planned.
  
• Exposure to high competition and a need for continuous cost reductions to remain competitive suggests margin pressure and could hinder Capita's ability to sustain profitability improvements if not managed effectively.
  
• The dependency on achieving ambitious cost-saving targets and the uncertainty over the full realization of these savings could pose risks if the expected efficiencies are not delivered, affecting operating margins and earnings.

Valuation

• The analysts have a consensus price target of £3.2 for Capita based on their expectations of its future earnings growth, profit margins and other risk factors. However, there is a degree of disagreement amongst analysts, with the most bullish reporting a price target of £3.75, and the most bearish reporting a price target of just £2.85.
• In order for you to agree with the analyst's consensus, you'd need to believe that by 2028, revenues will be £2.5 billion, earnings will come to £71.5 million, and it would be trading on a PE ratio of 7.2x, assuming you use a discount rate of 12.6%.
• Given the current share price of £1.83, the analyst price target of £3.2 is 42.9% higher. Despite analysts expecting the underlying buisness to decline, they seem to believe it's more valuable than what the market thinks.
• We always encourage you to reach your own conclusions though. So sense check these analyst numbers against your own assumptions and expectations based on your understanding of the business and what you believe is probable.