Why are profit warnings triggering record share price falls?

This week’s Capital Agenda Blog comes from Alan Hudson, Head of UK Restructuring.

What price a profit warning? In Q3 2018 the average answer was 21% on the day of warning – the highest fall we’ve recorded since Q3 2008. In fact, we’ve only seen this high level of investor reaction a few times before – and it’s usually just before or during a recession.

So why are investors moving so decisively?

In this week’s Capital Agenda Blog, I want to share our thoughts on why we’re seeing crisis-level reactions to profit warnings and what companies should be doing to build resilience and confidence with stakeholders.

How extraordinary are these falls?

The 21% average share price fall of the day of warning in Q3 2018 is shy of the 22.5% peak set ten years ago in Q3 2008. The median fall of 21.2% is by hundredths just above the previous record set in 2001.

We normally use the median when analysing the share price fall on the day of warning because it’s less prone to being skewed by outliers. It’s the measure we provide on our Profit Warning Console, where you can search by quarter and sector. So, by any measure, these figures are extraordinary – especially outside of a period of severe economic distress.

Median share price fall on day of warning1

So extraordinary, in fact, that we ran some extra checks. We wondered if companies issuing profit warnings were just falling in line with their markets. Market volatility did rise last quarter. But, when we checked to see how much companies’ share prices had moved relative to their index, we still found an average fall of over 20% on the day of warning.

And, whilst the nature of equity trading is of course very different today to 2001 and even 2008; algorithmic trading has been around for some time without us seeing falls of this kind. So, we have to ask…

Why now?

To answer that, I think it helps to look at our EY Profit Warning Stress Index, which measures the relative percentage of UK quoted companies warning in the last 12 months. This index hit 72 in Q3 2018 – the joint-highest level for two years. The index has only moved over 70 on two prior occasions: during the global financial crisis in 2008-9, and in 2015-16, when the shock of oil price fall, geopolitical tensions and the EU Referendum triggered continuous waves of profit warnings.

PW Stress Index Q3 18 2

The last year hasn’t brought a similar shock; but we have seen a relentless build-up of pressure in the consumer side of the economy. In the year to end of Q3 2018, a third of FTSE General Retailers and a quarter of FTSE Travel & Leisure companies have issued profit warnings. Squeezed disposable incomes – coupled with rising operational costs and an increasing challenge from disruptive competitors – continues to leave consumer-facing companies vulnerable to warning. For example, if the weather doesn’t ‘behave’.

PW increasing overheads1

This stress didn’t let up in Q3 and, to this mix, we added two elements: 1) increasing cost pressures – from rising wages to a four-year high in oil prices; and 2)  the spread of warnings back into manufacturing and financial sectors. Investment services companies are feeling the pinch from increasing regulation, competition and capital outflows. Meanwhile, manufacturing companies are no-longer in the global growth and sterling sweet-spot that kept profit warnings exceptionally low in 2017 – as underlined by today’s CBI figures.

Balance of pressures2

This increasing spread of warnings meant that by the end of Q3 2018, a far greater percentage of companies had warned in the prior 12 months (15.6%) compared with a year ago (14.4 %).

How does higher stress translate into record share price falls?

This higher level of stress had already put investors on high alert – even before the ratcheting up of tensions this summer. The average share price fall on the day of warning has been elevated throughout 2018 – as you can see above and via our console.

And, if companies are already struggling, it’s logical for investors to ask how they’ll cope with what lies ahead. Not just with regard to Brexit; but also the rise in protectionism and increase in geopolitical tensions. With so much still on the line, investors want to be backing the fittest and most agile companies. And, by the same token, they’re more likely to exit weaker stocks on the first warning on the basis that a worsening outlook will trigger more.

Companies warning for the first time* have seen their share prices fall by over 19% in 2018 – up from around 15% in 2017.

*Companies that haven’t warned in the last 12 months

There are other factors that might increase investor reaction to profit warnings. Until recently, low yields elsewhere may have convinced more investors to stay put. This is changing very slowly  as interest rates and bond yields creep up. But, whatever the reasons – and whatever the mechanism for selling – investors are moving quicker and size and status offer little protection. In 2018, FTSE 350 companies saw average falls of around 17% on the day of warning against 11% in 2017.

 

What can companies do?

Directors can’t predict the path of every storm that lies ahead. But they can build a strong and agile company that has the reliance to flex in stronger headwinds. Companies that have flexible operating and cost structures, contingency plans that address their biggest pinch points, localised footprints and strong liquidity will be better placed to ride out any storms that do arrive – and benefit from any upturn. Clear plans and resilience can help build confidence amongst investors and other stakeholders.

In terms of Brexit…

An agreed deal could improve confidence in the short-term, but leave long-term anxieties.

If a no-deal scenario starts to look more likely, there will be a variety of moving parts – the interaction of which will be hard to predict. The likely sharp drop in sterling would raise inflation, fuel prices and import costs. Fragile consumer and business confidence would take a further blow. A lower supply of EU workers would hit hospitality, health, agriculture and construction, potentially raising wage costs.

Should we get to the point of regulatory and tariff disruption, this would affect sectors like automotive, airlines, aerospace, and consumer products including food, pharma and chemicals. In preparation for border disruption, companies who need to cover additional inventory and warehousing would find greater demands on their working capital.

Companies need to watch their own health and the health of their supply chains too.

But through all this, companies also need to keep their eyes on the horizon. It’s impossible for businesses to retreat completely into their shells – however risky the world seems.

The pace of change means that if companies aren’t going forwards, they risk going backwards at an alarming rate.

 

Download the full Q3 2018 Profit Warning report, find out more about profit warnings in the retail and travel & leisure sectors, and run your own searches using EY’s profit warning console

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