This week’s Capital Agenda Blog comes from Alan Hudson, Head of UK Restructuring and Kirsten Tompkins, UK&I Transaction Advisory Services Content Editor.
The Capital Agenda Blog usually starts the year with predictions for the 12 months ahead…but where do you start? The only thing we can predict is unpredictability – not least because Brexit isn’t the only variable.
Which is why it makes sense to start 2019 by looking at our latest profit warning data, where uncertainty is writ large and we can see where the biggest pinch points in the economy lie.
What happened in 2018?
In profit warning terms, we saw
More profit warnings – 88 in Q4 2018, 287 in 2018
The most since 2015 in both cases
A higher percentage of UK companies warning – one in six in 2018
The second highest percentage since 2008
More ‘new’ companies warning – 74% in Q4 2018
The highest number in eight years
It’s this last point that I want to focus on here, because I think it explains some of the underlying trends behind the latest peak in warnings and tells us most about what might come next.
From the ‘usual suspects’…
Profit warnings have peaked so high in recent in recent years that our EY Stress Index has hit recession-like levels. The oil price drop in 2015 and unexpected EU Referendum result in 2016 obvious triggered several warnings, but levels have still been relatively high in what is essentially still a recovery.
Underlying this data has been structural problems and changes that have made companies vulnerable to issuing profit warnings. The high level of profit warnings in consumer-sectors in 2016-17 was in part driven by the pressure of rising inflation, but they hit hardest where companies were struggling to adapt to changes in consumer behaviour. Similarly, increased costs hit FTSE Support Services, but these were felt keenest where companies were caught on the wrong side of onerous contracts.
Companies caught on the wrong side of a trend or contract often ended up warning multiple times. Our EY Profit Warning console shows that in Q1 2018, 48% of companies warning had already warned in the last 12 months, the second highest figure we’ve recorded since the start of 2007. Four companies warned for the fourth time in 12 months, 14 companies warned for the third time.
…to new warnings
These structural challenges remain, but at the end of 2018 something significant happened. This ‘multiple’ warning figure dropped to 26% – the lowest in eight years.
To put it another way, in Q4 2018, 74% of companies warning hadn’t warned in the last 12 months compared with 52% in Q1. And this wasn’t because the number of profit warnings had dropped – far from it. Profit warnings actually hit their highest level since 2015.
Some of the greatest concentration of ‘new’ warnings came in areas of existing stress. Five of the seven General Retailers warning in Q4 2018 hadn’t warned in the last 12 months. But warnings also spread to some new areas. Technology Hardware & Equipment warnings had been low until this final quarter of 2018, when they suddenly leaped to decade high.
So, what happened?
The price of uncertainty
In Q4 2018….
50% of General Retailers warnings cited weaker consumer confidence, up from 25% in 2017.
31% of profit warnings cited contract delays or cancellations, the highest percentage in ten years.
UK consumer confidence held up after the EU Referendum, driving economic growth. But it dipped significantly at the end of 2018, hitting its lowest level for five years, according to GfK. This fall had a widespread impact across consumer sectors in Q4, triggering more profit warnings including warnings from new companies in previously robust areas, like online retail and ‘experience’ spending. This took consumer services warnings, including retail, media and travel & leisure sectors, to even greater highs.
UK business confidence has been subdued for a while, but the increase in global uncertainties and fears of a global slowdown shook confidence again in existing areas of stress and new areas, especially those exposed to China. The FTSE Technology & Hardware sector issued the highest number of contract-related profit warnings in Q4 2018, when its warnings hit a decade high. All but one of the companies warning hadn’t warned before in the last 12 months.
Uncertainty has another price too. In Q4 2018, we saw a record 22.6% average drop in share price on the day of warning. By a fraction this is even higher than Q3 2008. Of course, the stress in the domestic and global economy was much greater a decade ago; but it’s a measure of how febrile the markets have become. Investors, awaiting trouble – and fearing the end of the bull market – are positioning themselves in the fittest looking companies.
Rising uncertainty wasn’t the only reason why profit warnings spread in 2018. The weather continued to confound normal seasonal patterns. Regulatory issues came increasingly to the fore, such as the changes to diesel regulation in the automotive. But, uncertainty is a pervasive force and the unpredictable climate has certainly exacerbated existing pressures, spreading profit warnings into new areas.
We can’t predict exactly what happens next. The final Brexit outcome will have very specific impacts on companies and sectors, depending on trade, labour and capital outcomes. But this profit warning data does give us some indication of what happens if uncertainty fails to lift – or deepens.
Profit warnings have triggered even higher average share price falls in the first few weeks of Q1 2019 than Q4 2018. Investors are moving very quickly on even the first warning. Sectors exposed to falls in consumer confidence – even parts that have shown prior resilience – are looking increasing vulnerable. Areas exposed to the impact of global economic and trade uncertainty – especially China-related, like technology and luxury goods – are now in the spotlight. Uncertainty invariably hits contract renewals, so we’ll be looking out for more issues in Support Services and other contract-heavy sectors.
But the biggest issues are always where issues collide. Where we see regulatory, structural, economic pressures all mount. And no-where is this more obvious than in automotive and retail- two sectors we cover in detail in our latest paper.
We may not see profit warning number rise overall if expectations adjust to the current level of uncertainty and pressure. But we expect further distress where structural and cyclical pressures continue to collide.