This week’s Capital Agenda Blog comes from Alan Hudson, Head of UK Restructuring.
EY’s latest Analysis of UK Profit Warnings for Q2 2017 shows profit warnings hitting their lowest quarterly level in seven years. In this week’s blog we cover the main themes in five charts and explore the link with the other headline of the week – ‘shrinkflation’. Plus, we look at why the zombie company debate is back on the agenda. These are still relatively benign conditions for UK companies, but earnings risks aren’t all about the macro.
UK profit warnings in five charts
It was obvious from the start of the second quarter that we were seeing a fundamental shift in the pattern of UK profit warnings. The lowest April figure for over a decade set the tone and volumes didn’t move up much from there with just 45 warnings issued across the quarter. Indeed, the percentage of companies warning has only been lower ten times since 1999, when EY started tracking profit warnings – with most of those quarters in 2003 and 2009-2010.
The comparison with the period after the financial crisis is worth making. As we’ve discussed at greater length elsewhere, in 2017 – as in 2010 – two primary forces have reduced the level of profit warnings: a better than expected economic outcome for the UK and global economies – at least until recent months when UK GDP has stalled – and falling earnings expectations. You can see this most obviously in the FTSE Small Cap, which has less exposure to the upside in global trade than the FTSE 100.
There’s further evidence of this adjustment in the reasons given for warning, where the emphasis has shifted from external to internal factors.
There have been some background changes over the quarter, with the pound staging a mild recovery – helped by the dollar slipping back. But we can’t say that the pressures that previously drove warnings – currency, pricing pressures, competitive, investment needs, low oil price etc. – have entirely gone away. Companies have adjusted their forecasts and businesses models, but the stress is still there.
The biggest red flag in this regard is being waived by General Retailers, whose seven warnings equalled the post-crisis high for a second quarter. Here expectations hadn’t shifted enough – a bad omen for a consumer driven economy. The warm June weather helped sales, but the disposable income squeeze will catch-up with retail again, sooner or later. And we shouldn’t forget the structural pressures that have kept warnings high here – and elsewhere – whatever the macro outlook – as the list of FTSE sectors with the greatest proportion of companies illustrates.
|FTSE Sector||% warning YTD|
|Oil Equipment, Services & Distribution||64%|
|Automobiles & Parts||60%|
|Technology Hardware & Equipment||42%|
|Fixed Line Telecommunications||38%|
|Electronic & Electrical Equipment||26%|
Structural change in the oil sector is obviously prevalent, with companies now adjusting to the sustained low price – as opposed to the initial shock. As we highlight in the main paper, macro and structural changes are now colliding in the automotive sector. Regulatory change drove most of the warnings in non-life insurance. Contract issues are behind most warnings in FTSE Support Services, where tight margins often leave companies open to governance issues. Increasing geopolitical uncertainties have also hit here, as well as in industrial sectors.
‘Shrinkflation’ highlights tricky trends
So, where does this leave us? Companies have adjusted their forecasts to mixed macro experiences, but there are risks on the horizon and technological and behavioural change that may require more radical changes to business models. Which brings us to ‘shrinkflation’. An Office of National Statistics (ONS) report out this week confirms what we’ve all suspected: chocolate bars have shrunk. In fact, 2,500 consumer items have shrunk in the last five years, whilst only 614 have got larger. This trend pre-dates Brexit, so it’s not all down to the fall in the value of the pound. The price of sugar and cocoa has actually fallen in the last year.
What we’re seeing is manufacturers reacting to a much broader and longer-term issue: the increasing price sensitivity of consumers that outlasted the end of the last recession. Once manufacturers have cut costs to the bone, the next logical place to go is to trim the product itself. This trend is just one illustration why profit warnings might spring back up without the usual push from an economic downturn. The global – if not the UK – economic back drop is relatively benign, we’re seeing significant structural pressure in many sectors, be that from technological or behavioural change or structural changes in the market.
Credit risk is also rising up the agenda. The Bank of England isn’t alone in sounding a 2006-like alarm over unsecured consumer lending. Regulatory changes limit the systemic threat compared to last time; but, on the other hand, what room do central banks have to work in should anything go wrong? Very little. So, although there is little macro-imperative, major central banks are still talking about raising interest rates – and they have other reasons for thinking about normalisation.
Talk of rate rises has put ‘zombie’ companies – usually described as companies with interest cover at 1 or less – back in the spotlight again. An OECD report in January discussed how their survival congests markets and constrains economic growth and productivity by diverting capital to less productive areas. The Bank of International Settlements recently made a similar point. A report from Bank of America Merrill Lynch out this week found that 9% of European companies have very weak interest coverage– more than pre-Lehman. They suggest that this will tie central bank’s hands, but the OECD says the cure risks becoming toxic…
“….in the early phases [some policy initiatives] might have been useful in facilitating credit and preventing firm exit that would lead to mass layoffs. However, given the length of the crisis, the persistence of some of these policies may now be detrimental to productivity growth by distorting credit supply, especially given asymmetric information problems making it difficult to identify unviable firms, and curbing the potentially positive contribution of exit.”
This is always a tough call. Higher than usual levels of corporate survival created a shallower recession and kept more people in employment. Raising rates now still risks hitting these companies now. But, without a rise in productivity, it’s hard to raise living standards. Tough choices lie ahead.