Why Capita plc is set to slump by 20%+

Updated: 
City and falling FTSE 100 share prices

Shares in Capita(LSE: CPI) have fallen by over 7% today after it released a profit warning. The outsourcing specialist has reduced guidance for the current year and for next year as a difficult operating environment continues to put its financial performance under pressure. However, there could be worse to come even though the company has announced a major overhaul of its operations today.

Disappointing performance

Since the company's last update in September, trading has remained challenging across a number of its divisions. Notably, the operating environment within its IT Enterprise Services segment has weakened. While it's expected to recover over the medium term, in the near term it's likely to act as a drag on the company's overall performance. In addition, cost saving measures implemented by Capita's clients have caused a general slowdown in its wider business, which is set to hurt its performance for the full year.

As a result of these challenges, full-year revenue is now expected to be £4.8bn. Underlying profit before tax is forecast to be at least £515m, excluding restructuring costs. The difficulties faced in 2016 are due to continue into 2017 and financial performance next year is therefore forecast to show no improvement versus 2016's figures.

A difficult outlook

In response to the difficulties it faces, Capita has decided to sell the majority of its Asset Services division, as well as a small number of other businesses. It will also seek to reduce costs in order to improve margins and create a more efficient business. This should improve the company's balance sheet and leave it better equipped to deal with what could be a tough outlook.

On the topic of future performance, the operating environment could worsen before it improves. Brexit is causing increasing uncertainty and businesses and government are clearly postponing investment decisions until they're better aware of what a post-Brexit UK economy will look like. In addition, cost savings are being sought across the economy, with outsourcing companies such as Capita likely to be hit harder than most in future. As a result, a further profit warning can't be ruled out, which could easily send the company's share price lower by 20% or more.

Hope for investors

Of course, a large number of companies have successfully turned around their performance following difficult periods. For example, life insurer Aviva(LSE: AV) is a good example of a company which was loss making just a handful of years ago, but which today offers a compelling investment case.

It has been able to turn its fortunes around thanks to a major restructuring and cost savings. Its decision to merge with Friends Life should also improve its future performance and lead to a more resilient and robust financial outlook as it leverages its dominant position within the life insurance business.

However, Capita is still in the early days of its turnaround. It faces sizeable headwinds and while over the medium term it has growth potential, it seems prudent to await a lower share price and evidence of improved performance before buying it.

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Peter Stephens owns shares of Aviva. The Motley Fool UK has no position in any of the shares mentioned. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.