Profit warnings: who’s swimming against the tide?

Profit warnings are a measure of performance against expectation. So, given the overall upside surprise in 2016, it’s not surprising that the annual figure was the lowest for three years. But our data also tells a story of a growing gap between winners and losers. What’s creating such a great divergence, will it last and what does it mean for corporate prospects and forecasting in 2017?

multiple-warnings-q4-2016EY’s latest Quarterly Profit Warning Paper tells an interesting story. On the one hand, there were just 73 warnings in Q4 2016 – against 100 in the same quarter of 2016. The annual total for 2016 was also the lowest annual total since 2013. So far, so in-line with the positive official figures and surveys. But, of the companies warning in the final quarter, 49% had already warned in the previous 12 months – well above average. Also, we saw the highest percentage of FTSE Support Services companies warning in 2016 – higher even than 2008 – and the highest number of retailers warning since 2011.
So where is this divergence coming from?

Currency, currency, currency

Profit warnings citing exchange-rates ticked up during 2016, reaching 11% in the final quarter – and this with many pre-BREXIT currency hedges still running.  But it’s not just about the direct effect that matters, but the way that a falling pound transmits through the economy through prices, inflation, disposable income.

sterling-and-pw-q4-2016

Normally, we say that a strengthening pound is a greater shock than a weak one– as the chart shows – but such a dramatic fall has the potential to reshape the economy and create a strong divergence in performance. A five-year high in retail warnings comes as the sector sees its price and inflation holiday end. That said, obviously some parts of the economy benefit and in other sectors, the currency issue is not so much a tide as an eddy. Manufacturing  profit warnings dropped, but not dramatically. As we’ve seen in recent days, a record rise in input prices – boosted by weak sterling – has delivered a sting in the tail.

As for the rest of 2017, I’d watch for the impact of inflation but also the impact of sheer currency uncertainty and politicisation.  BREXIT and ‘Trumponomics expectations pulled the pound lower and the dollar higher. But the picture has got muddier of late. In BREXIT’s case by parliamentary oversight and growth upgrades . In the US by efforts to talk down the dollar and talk up other currencies. But what if EU negotiations don’t start well and US growth takes off? Overall, the strong dollar, weaker pound paradigm holds, but the outlook is fluid, adding to the forecasting and hedge fixing challenge.

Growth

Going back to price rises, some companies are obviously on the right side of these. Currency moves, rising US and global growth prospects – and OPEC’s oil supply cut have helped to cut profit warnings from FTSE Oil & Gas Producers and other basic materials sectors.  But there is still a high levels of warnings from companies serving the oil sector. Less so than the end of 2015, when the oil price shock contributed to a century of warnings, but we can’t assume that producers will throw caution to the wind on CAPEX.

ftse-350-since-brexit

That’s the thing about growth, it doesn’t float all boats. In fact, it can emphasise the gap between those best equipped and placed to exploit it and those who aren’t – especially when growth is geographically patchy and unevenly spread within sectors reshaped by technology. If prices are also rising, it’s also a matter of who can manage costs and exert pricing power without losing market share. Going back to retail, surveys show volumes growing to the end of the year. What we saw in profit warnings was primarily the initial impact of currency on prices and these warnings actually came from a smaller group of companies than 2015

Uncertainty

Over a quarter of warnings in Q4 2016 cited contract delay or cancellation,  a theme that’s carried through into 2017. Our data shows uncertainty hitting hit the contract dependent sectors hardest and quickest as businesses think twice about spending and the double-whammy of price rises on fixed price contracts kicks in.  So we saw high percentages of FTSE Support Services warnings in 2016 and we’re now starting to see more  FTSE Software & Computer Services warn in 2017.

Companies that have put bids together on thin margins are vulnerable to changes in the labour market and material prices. This obviously also puts FTSE Construction & Materials in the spotlight – and we feature the sector following a rise in warnings that saw as many companies warn in Q4 16 as they did in 2015. It can take time for sales pressures to feed through when pipelines are full, but what we see across all sectors when conditions toughen is that any misjudged contracts – either in inception or execution – come to the fore. Companies with a lack of internal transparency, accentuated by poor management information – due to a lack of IT investment and poor internal controls – tend to have more problems and tend not to spot them early.

Outlook and forecasting

So what next? If these trends persist we’ll see more divergence in and between sectors. We may also see more warnings. So far in 2017, we’ve seen profit warnings run around 20% higher than 2016, suggesting companies are finding it harder to forecast and manage expectations. To be fair, no-one is finding it easy to forecast at the moment – as recent economic forecast revisions demonstrate. There are so many imponderables and unpredictable elements, that it’s possible to think about multiple scenarios for where the UK – let alone the global – economy might end up. We could see warnings tail off if some of the adverse tides turn.

Therefore, companies will need to think and rethink and stress-test their forecasts regularly  and being agile, current, and responsive will help. It can also help to think about scenarios, especially when short term business performance is at the mercy of uncontrollable or volatile external factors such as commodity prices, foreign exchange and interest rates or where major contract slippage or project costs could derail forecast results. Companies should also run risk-based scenarios and consider the impact on their financial performance, liquidity and solvency.

It’s impossible to predict the future, but we can be more prepared for the unexpected.


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