Warnings within warnings

UK companies are still issuing a remarkable number of profit warnings, despite a substantial fall in earnings expectations at the end of 2015 – and the start of 2016. This week, we’ve picked out five things we learnt from this quarter’s profit warning data. We’re looking in particular at why some companies are still struggling to make their forecasts and why investors aren’t reacting in the way we might expect.

UK quoted companies issued 76 profit warnings in Q1 2016, down from 100 issued in the previous quarter, but on a par with the number issued in the same quarter of last year. That’s the headline numbers, but what lessons can we learn from the data – the warnings within the warnings, as it where….

1. VUCA requires resilience The three-year rolling average for profit warnings is 15% higher now than it was in 2010-13, the three years following the last recession .  We’ve been pondering the reasons for this for a while. Clearly expectations were well grounded back then by the global financial crisis – but they should be grounded now. Global growth has been – in the IMF’s words – ‘mediocre’, but this certainly a ‘known known’; something else must be complicating the picture.

We’ve turned to VUCA as an explanation – a concept we’ve used here before. It’s hard to think of a more apt description for 2016 than:  Volatile, Uncertain, Complex and Ambiguous. This maelstrom is expressed in a quarter of warnings blaming contract disruption, the pressure on pricing from rising competition and increasing investment. Keeping up with the disrupting Jones’ is expensive work. There is also obviously a high potential for misreads. But, we have to ask if companies could be doing better. UK plc needs to do more to adapt and build resilience into its operations and forecasts. The falling oil price has been an obvious driver of profit warnings – cited in 20% of alerts in 2015. But it was still being cited in 18% of warnings in Q1 16.

In oilfield services – and elsewhere – VUCA is the ‘new normal’.

2. More profit warnings are coming in twos and threes….and fours…. Most companies are adapting, growing in line with forecasts and not issuing profit warnings; but the percentage of companies issuing warnings is rising and when companies get it wrong, they are more likely to get it wrong again.

PW MultiplesAlmost half of the companies warning in the first quarter had also issued at least one warning in the last year – compared with just over a third in the same period in Q1 15.

Sixteen companies warning in the first quarter of 2016 had issued three or more warnings in the last 12 months – compared with nine in the same period in 2015.

Profit warnings clearly don’t always come in threes – as the old adage goes – but that pattern is becoming more common. This is most likely to happen in sectors vulnerable to contract loss and disruption, such as FTSE Support Services and FTSE Software & Computer Services – underscoring our VUCA point above – and in retail

3. Retailers are struggling – even in the “good” times.
We’ve seen two major retailers go into  administration in the last week, underlining the tough message for general retailers in our profit warning data. The last few years have been the best of times and – whilst not quite the worst of times – certainly very challenging times.

The consumer economy looks in rude health, with wages running well ahead of inflation and interest rates set to say at the lower bound until…well, who knows…but probably a long time hence. And yet, in the last year about 30% of the current FTSE General Retailers sector has issued a profit warning – 50% in the last three years. The first quarter peak in 2016 was the highest since 2011.

The problem for retailers is that rising operational costs and the hard bargain driven by the UK consumer have chipped away at the benefits of rising disposable income and demand. It’s a sector that is constantly disrupted by new entrants, new models and changing consumer behaviour. This year brings additional currency challenges as sterling weakens on Referendum uncertainties and the National Living Wage, where the benefits are less certain than the costs for the sector. This is before the expected fall in disposable income growth falls to 1.7% by 2017 from 2.7% in 2016.  As many retailers have also noted, consumers also seem more interested in spending on experiences over things. It’s a bigger, more expensive fight over a smaller pie and something has to give.

4. Numbers should drop…but there is (nearly) always something…

Profit expectationsStrong sterling and weak oil prices  have helped maintain profit warnings at a high level in the last two years and both are or should be waning out of the results in 2016. Exchange rates have barely figured in 2016. Oil prices remained a thorn in the side in the first quarter, but not thus far in the second. If markets and economies remain in relatively calm waters for the rest of 2016, our data suggests that profit warning numbers should drop  – especially since expectations are well grounded*.

Then again, if the last few years have taught us that in VUCA world, there is nearly always something with the potential for further misreads. Oil prices rose on Kuwait strike action as much as anything – and rising prices generally aren’t a good thing for profits and profit warnings! That’s the great conundrum here. Even if there isn’t a big shock, or one driver, we’re wondering about the capacity of low interest rates to drive demand any further. IMF economists recently argued that past demand windfalls had been driven by a falling oil price AND falling interest rates. In this cycle, interest rates were already low and global consumers are expressing their disgruntlement at the ballot box.

Low interest rates could also encourage consumers to save a bigger pot for retirement. Ostensibly, there’s no sign of that in the UK, but the low savings ratio won’t capture areas like buy-to-let – which covers an estimated two million landlords.

* A low level of profit warnings won’t necessarily signal rising earnings. In Europe, Thomson Reuters expect a 19% YoY fall in profits in Q2 – 12% excluding energy companies.

5. Investors are inured…or have run out of options
The average share price fall on the day of warning fell to 13% in the first quarter – compared with 15% in the final quarter of 2015. Share price falls among FTSE 350 companies warning were especially dramatic, down from 9.6% in Q4 15 to 5.4% in Q1 16.

This all seems somewhat incongruous in the context of the market volatility we saw in the first quarter. After the century of warnings last quarter, perhaps markets weren’t all that surprised. Maybe companies are getting better at tempering warnings with counter-measures.  Or could this just be a reflection of the low yields available elsewhere?