This week’s Capital Agenda Blog comes from Alan Hudson, Head of UK Restructuring.
Profit warnings have grabbed the headlines, but the headline number is actually pretty average for the time of year. What’s extraordinary is the detail behind the profit warnings we saw in an eventful first quarter – and what these warnings say about the rapid reshaping of a large part of the UK economy.
In this weeks’ blog we’ll share the main messages we think companies, their stakeholders and investors should take from our profit warning data and how we think the picture might change.
UK quoted companies issued 73 profit warnings in the first quarter – just one more than average for the time of year. If the pace felt higher, it’s perhaps because profit warnings have moved higher in public consciousness – and up the news agenda – given their role as an early warning sign in high-profile restructurings. The other big factor in their prominence is the fact that many more profit warnings in 2018 have come from high-street names – and that the high street is in trouble.
All shopped out?
It probably won’t surprise you to learn that profit warnings from Consumer Services sectors in general and FTSE General Retailers in particular hit a seven-year high in Q1 2018. It has been a torrid year for restaurants and high street retailers in particular, culminating with a string of restructurings at the end of 2017 and into 2018. I think what’s made this more shocking is that consumer spending, whilst growing at a slower pace, isn’t dipping – as it was back in 2011.
Although, it’s never just about how much consumers have to spend. It’s also about how and where they spend it.
In 2011, a combination of an income squeeze and changing shopping habits – in particular the rise of online and supermarket non-food lines – triggered a rise in high street distress. In 2018, the latest fall consumer spending, whilst dramatic, is arguably just an exacerbating factor for distressed retailers caught on the wrong side of structural change. The basics of retail are still the same, but the technologies companies (and their competitors) have at their disposal to analyse, predict, deliver and personalise the consumer experience have changed the game almost overnight. Investment is essential, but in a tight market, difficult for many to commit or raise – amplifying the divide. More than half of General Retailers profit warnings cited cost and pricing pressures in Q1 2018.
This is retail’s reinvention, not demise. But, there is unsurprisingly a strong focus on renegotiating rents and realigning portfolios in this environment, with a knock-on impact on landlords that we discuss in more detail in the Q1 paper. Company Voluntary Arrangements are very much in evidence and they obviously have a role in stressed situations. But, they’re no panacea, which is why we have unfortunately seen so many companies move from CVA to administration. We expect more restructuring and distressed deals in 2018 as the pace of change in consumer sectors accelerates.
The ‘B’ word
Brexit’s fall-out is now too complex and bound up in other issues to factor on its own in profit warnings. That’s not to say that’s its influence isn’t there in rising cost and price pressures (32% of warnings) and in the ten profit warnings citing adverse exchange rates in Q1 2018 – a post EU-Referendum high. Sterling has recovered some ground, but its weakness still has bite under new currency hedges. On the other side, we have the FTSE Industrial sector, which issued its third lowest number of warnings since mid-2011 – when a weaker pound also helped exporter benefit from a global economic revival.
The Brexit transition deal has eased fears of a cliff edge, which could have triggered more profit warnings in 2019. But, there’s a great deal of negotiation and news flow to come between now and then – and not just from Brussels.
This global recovery seems more entrenched now than in 2011; but there are signs that it’s losing momentum. Plus, there’s the obvious escalation in market and geopolitical risks. It was interesting to see that UK manufacturing output unexpectedly fell 0.2% in February – the first decline in almost a year after zero growth in January. No-one can take anything for granted in 2018. As we’ve seen before, increasing uncertainty hits contract reliant sectors in particular – e.g. Support Services, Software & Computer Services, and Construction & Materials. Watch out for more here in 2018.
We’re not in 2017 any more
It’s worth underlining again just how much has changed at the start of 2018. It’s the end of the long-running sweet spot of low-risk, rising growth and ultra-low interest rates. Trade war concerns, talk of tighter regulation for technology companies, uncertainty about the path of the US dollar and rising geopolitical tensions – including recent sanctions – have added to an adverse market mix.
This need not spell disaster. Uncertainty and volatility are normal. The problem is that investors built considerable market consensus around this sweet spot and many have strayed into unaccustomed corners of the market in search of yield. This raises the risk of a painful adjustment if a trigger pushes investors to exit crowded areas of the capital market on mass. As we saw to an extreme extent in 2007, changing circumstances can rapidly change investors’ risk equations and force them to shine a brighter light on their positions. Increased investor reaction to profit warnings since mid-2017 reflects rising volatility; but it’s also a signal that investors are reacting to structural, rather than one-off events.
Earnings expectations are more subdued. This may lower the pace of profit warnings, but it doesn’t to ease the pressure on struggling companies and it may focus closer attention on those who fail to meet lower forecasts.
The SmallCap Squeeze
In the last six months we’ve also noticed a sharp rise in profit warnings in the FTSE SmallCap, mostly in consumer facing sectors and mostly in reaction to rising costs. Investors are also voting with their feet. The average on-the-day profit warning share price fall was 19.5% for the FTSE SmallCap in Q1 – higher than AIM. I think this is symptomatic of the squeeze on mid-market companies in almost every sector. Moreover, the gap between companies able to adapt to the new economy and those left behind will grow as the pace of change accelerates. Stronger companies with access to capital to invest in their own businesses – and to make strategic acquisitions and alliances – will find themselves in an increasingly advantageous position.
You can read more about profit warning trends in our latest paper.