Is Capita the Ultimate Retirement Share?

LONDON -- The past five years have been tough for those in retirement. Portfolio valuations have been hammered, and annuity rates have plunged. There's no sign that things will improve anytime soon, either, as the eurozone and the U.K. economy look set to muddle through at best for some years to come.

A great way of protecting yourself from the downturn, however, is by building your retirement fund with shares of large, well-run companies that should grow their earnings steadily over the coming decades. Over time, such investments ought to result in rising dividends and inflation-beating capital growth.

In this series, I'm tracking down the U.K. large caps that have the potential to beat the FTSE 100 over the long term and support a lower-risk income-generating retirement fund (you can see the companies I've covered so far on this page).

Today, I'm going to take a look at Capita  (LSE: CPI  ) , the business-process outsourcing specialists with a strong presence in the U.K. public sector.

Capita vs. FTSE 100
Let's start with a look at how Capita has performed against the FTSE 100 over the past 10 years:

Total Returns

2008

2009

2010

2011

2012

10-Year Trailing Average

Capita

7.6%

3.8%

(4.9%)

(6.8%)

23.6%

14.5%

FTSE 100

(28.3%)

27.3%

12.6%

(2.2%)

10%

8.3%

Source: Morningstar. (Total return includes both changes to the share price and reinvested dividends. These two ingredients combined are what make it possible for equity portfolios to regularly outperform cash and bonds over the long term.)

Capita's 10-year average trailing total return shows that it has steadily gained on the FTSE 100 over the past 10 years, delivering a total return 75% greater than the leading index since January 2003. It's a solid performance, so how does Capita look as a retirement share?

What's the score?
To help me pinpoint suitable investments, I like to score companies on key financial metrics that highlight the characteristics I look for in a retirement share. Let's see how Capita shapes up:

Item

Value

Year founded

1984

Market cap (billion pounds)

5.1

Net debt (billion pounds)

1.2

Dividend Yield

2.9%

5-Year Average Financials

Operating margin

12.2%

Interest cover

10.0 times

EPS growth

12.4%

Dividend growth

18.9%

Dividend cover

2.3 times

Sources: Morningstar, Reuters, Capita.

Here's how I've scored Capita on each of these criteria:

Criteria

Comment

Score

Longevity

A relative newcomer in the corporate world.

2/5

Performance vs. FTSE

Pretty strong.

4/5

Financial strength

High levels of debt detract from the appeal of its strong margins.

3/5

EPS growth

Earnings have grown at a respectable rate.

3/5

Dividend growth

Dividends have outgrown earnings but remained amply covered.

4/5

Total: 16/25

Capita's main line of business is providing outsourcing services to the public sector, although it works in the private sector, too. Examples of contract wins in 2012 include a deal to manage all training across the Civil Service, a recruiting deal for the Army, a support services partnership to provide back office functions like payroll and HR for West Sussex County Council, and one of three regional contracts to carry out disability assessments for the new Personal Independent Payment, a new form of disability benefit.

This company has grown rapidly and strongly over the past 10 years, and much of this growth has been generated by acquisitions. In the first nine months of 2012, it acquired no fewer than 14 companies, and in 2011 it acquired 21. As a result, Capital has become saddled with a fair amount of debt, and in April 2012, the company was also forced to raise 275 million pounds through a share placing. Capita's shares slumped as a result but have since recovered and now look increasingly pricey, on a price-to-earnings ratio of almost 20, and with a below-average dividend yield of 2.9%.

Capita's dividend history is quite impressive -- the company has delivered at least 20 straight years of dividend growth. But although this is an impressive achievement, and a very desirable attribute in a retirement share, these dividends are beginning to look unaffordable. Capita's dividends have remained well covered by profits, but they have not been covered by free cash flow for at least four years (I didn't check any further back) and have simply been funded partially or completely by new debt -- a worrying trend.

My verdict
All of this leads me to conclude that Capita is a good business that's ready for a period of consolidation: I think that Capita's public sector outsourcing business model is solid and should have good longevity, but its combination of tightening cash flow, rising debt, and increasingly unaffordable dividends is one that worries me, especially when combined with a premium P/E rating.

One to watch, perhaps, but definitely not a retirement share for new buyers at the moment.

Top income picks
Doing your own research is important, but another good way of identifying great dividend-paying shares is to study the choices of successful professional investors.

One of the most successful income investors currently working in the City is fund manager Neil Woodford, who manages more money for private investors than any other City manager. Woodford's High Income fund grew by 342% in the 15 years to Oct. 31, 2012, during which time the FTSE All-Share index managed a gain of only 125%.

You can learn about Neil Woodford's top holdings and how he generates such fantastic returns in this free Motley Fool report. Many of Woodford's choices look like excellent retirement shares to me, and the report explains how he chose some of his biggest holdings.

This report is completely free, and I strongly recommend you download "8 Shares Held by Britain's Super-Investor" today, as it is available for a limited time only.


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