Over the past 12 months, outsourcing companies have become some of the market's most hated stocks. These companies have been hit by a toxic combination of rising costs and high levels of debt, which have eroded razor-thin profit margins.
With concerns building about the sustainability of the outsourcing business model, investors have dumped shares in Capita(LSE: CPI) and Interserve(LSE: IRV), sending them plunging to multi-year lows. However, after falling by more than 60% in the space of 12 months, the shares have started to attract bargain hunters, but is it worth taking a punt on these turnarounds or is it best to stay away ahead of further declines?
Two key problems
Capita and Interserve both face two primary issues. Firstly, these firms have been beset by rising costs on legacy contracts. For example, during the past year, Interserve has issued two profit warnings related to spiralling expenses on an energy-to-waste contract. Capita's turnaround is also being weighed down by these legacy contracts, which can be difficult to restructure and were agreed when costs were much lower.
The second issue these companies are having to grapple with is their weak financial position. Capita has a debt pile of more than £1bn to contend with, as well as a £381m pension deficit. Meanwhile, City analysts believe that Interserve's debt could hit £600m by the end of 2018, compared to its current market value of £107m.
To try and fix its balance sheet, at the end of January Capita announced a £700m rights issue and suspended its dividend until it can generate a "sustainable free cash flow." This highlights another problem with the outsourcing business model. Cash flow generation is generally very poor and managements has only exacerbated this issue over the past five years by pursuing unsustainable dividend policies, which have been funded by debt. For example, over the past five years, Interserve generated £175m in cash from operations but paid out £152m in dividends to investors, leaving little left over for debt repayment or funding capital spending. Capita's financial situation is similarly troubling. Over the past five years, the company has paid out around £700m more in dividends to shareholders than it has generated from operations after deducting capital spending and other investing cash outflows.
A better investment
These problems lead me to conclude that, despite the fact that these shares look cheap, the industry is still plagued by problems, and it will take some time for these companies to turn themselves around if they can convince their creditors to give them breathing space. Overall, the risk/reward ratio just does not look attractive here. Plenty could go wrong for Interserve and Capita as they struggle to return to growth and it may be many years before investors see a return. There are other better opportunities out there.
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Rupert Hargreaves owns no share mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.