Profit warning yo-yos and omens

This week’s blog comes from Alan Hudson Restructuring Leader UK & Ireland.

EY’s latest analysis shows UK profit warnings springing back from a seven-year low to hit 75 in Q3 2017 – well above the 62 average for a summer quarter and the biggest quarterly rise in almost six years. This week’s blog takes a look at why there has been such a dramatic profit warning yo-yo in 2017; why divergence is a growing theme; the rise in multiple warnings and how investors are reacting. In short: with less patience.

Yo-Yo

To understand 2017’s profit warning yo-yo we need to go back to basics. A profit warning is a statement from a UK registered quoted company that says its performance will miss expectations. It’s when the balance of these two elements – performances and expectations – get strongly out of kilter that we see big moves in overall profit warning numbers. And, when sectors also have fundamental structural issues, the impact of any adverse shift is often amplified even further.

Profit warning number to 2017

In the second quarter, better global growth, combined with a post-Brexit fall in earnings expectations, helped more companies to feel confident in their forecasts. Profit warnings hit a seven-year low, aided by a dramatic drop in industrial warnings that’s persisted into Q3.  The proportion of FTSE Industrials companies warning in the year to date was 22%, compared with 30% this time last year. But, in third quarter, earnings expectations also levelled off and the rise in domestic price and demand pressures, drove warnings back up. General Retailers and Travel & Leisure companies heavily cited cost & pricing pressures in their profit warnings – 39% and 59% respectively. Uncertainty and volatility added extra layers of complication that made forecasting difficult.

Industrial % of co warning Q3 17

Divergence

You can see that tied into this volatility is a growing divergence between sectors with high exposure to domestic pressures and those benefiting from improving overseas growth. The exceptions to the fall in industrial warnings – FTSE Construction & Materials and FTSE Support Services – help to prove the rule. Both are subject to the increasing domestic pressures that come out clearly in our data, including rising import and employment costs and less certain growth.

reasons for warning Q3 17

In both of these sectors there’s also the amplifying effect of structural issues, such as the number of tight-margin contracts. On the consumer side, inflationary pressure on consumers is obviously hitting discretionary spending, but there are also amplifying issues for airlines (overcapacity & impact of terrorist attacks), restaurants (overcapacity – especially in casual dining) and retail (price transparency & investment in multi-channel). So, when domestic pressures rise we’re seeing these amplified – driving that yo-yo.

We could see warnings drop back again in Q4 – as often happens after a peak in warnings – but I suspect that expectations have further to adjust. Sheer unpredictability in the economic and geopolitical climate is also causing increasing problems. And then there’s the potential changes to trade conditions on the horizon and – and more immediately – rising commodity prices, which means industrial sectors can’t rest on their laurels either.

Zombies

Of course, the picture is more nuanced at an individual company level. Companies warn for all kinds of complex reasons and most will feel – to varying degrees – some part of the positive and negative forces we describe above.  Moreover, what our data also highlights is that even between very similar companies, there can be big differences in performance according to how well companies manage to flex and stay on the right side of sector and economic trends. Even in 2008 – at the height of the financial crisis – 4 out of 5 companies didn’t issue a profit warning.

multiple warnings

In 2017, what we’re increasingly seeing is a group of companies issuing ‘multiple warnings’. In Q3 2017, 42% of companies had already warned at least once before in the last 12 months. In fact, nine companies warned more than once just in third quarter alone. The last time we saw something like that was Q4 2008. For me, this underlines the point about the rapid shift in expectations we’ve seen this summer – quicker than some companies can react. It implies that more companies are finding themselves on the wrong side of structural and economic changes in their market –  and they are struggling to forecast or even find a way back. Change is happening so fast that some companies just don’t have the capacity or capital to adjust.

Most companies issuing multiple warnings will recover, but it’s interesting to see this rise in multiple warnings coming at the same time as concerns over zombie companies grow. It’s a variation on the same theme of companies struggling and unable to invest sufficiently to stride forward, which has broader implications for the UK economy. The problem of low UK productivity and investment is a complex one with many potential causes, but the Office for Budget Responsibility recently commented that:

The abnormally low level of interest rates could also be weighing on productivity growth by allowing weak and highly indebted firms to survive for longer than they normally would, by alleviating the burden of servicing their debts. This would lower productivity both through a ‘batting average’ effect and by preventing the efficient reallocation of those resources to more productive uses.

 Omens

In terms of what all of this means for companies warning, our data also underlines how unforgiving the market has become when they get it wrong. In the FTSE 350, the average share price drop on the day of warning rose to 16.2% in Q3 compared with 7.5% in the previous quarter and the long-term average of around 10%. Why might this be? I think investors are reacting to growing pressures and forecasting uncertainties and higher levels of risk, which are also being reflected in higher levels of corporate stress and restructuring activity. When companies warn, investors are on their toes, less likely to hang around and wait and see because they’re more worried out the outlook.

Therefore, it’s vitally important for companies to forecast accurately. To do this in such a challenging environment, companies need fast facts to give them full visibility on underlying performance and a clear understanding of the key variables that may affect their profit and cash assumptions. In turn, this should allow them to respond quickly to mitigate adverse movements when these variables change and, when necessary, signal a timely change in profit guidance.

Failure to do so can come at a high price.


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