Has UK plc lost its earnings compass?

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

UK quoted companies issued 89 profit warnings in the first quarter of 2019. This is the highest first quarter total since 2009. Indeed, our EY Profit Warning Stress Index has only been higher twice before – both times during the last recession.

In this week’s Capital Agenda Blog, I’m going to ask why so many more companies are losing their way when it comes to forecasting earnings – and how they might navigate the rest of 2019.

Beyond retail

The biggest thing that initially struck me about this latest rise in profit warnings is their spread across a wider variety of sectors. A year ago, in Q1 2018, one-in-four profit warnings came from a retailer. In Q1 2019, this had dropped to less than one in seven.  

This isn’t because profit warnings from retailers – or consumer services sectors in general – have dropped dramatically. But profit warnings from manufacturing, financial and technology sectors have risen in the last year, as this chart and data on our EY Profit Warning Console shows.

Lost in uncertainty

So why have more companies – and a wider range of companies – been forced to adjust their forecasts at the start of 2019? Why is our Stress Index at recession levels? 

The UK economy isn’t contracting, but UK companies are now subject to an unprecedented range of pressures. Our data shows rising uncertainty – or, more accurately, an increasing and broader range of uncertainties is a big part of the problem.

Why uncertainty matters
A company issues a profit warning when it no longer thinks it will meet its previous forecasts or market expectations. When we see rapid dips in economic activity or when demand is in a greater state of flux, profit warnings rise. A greater range of uncertainties means more companies are at risk of warning.

During the first quarter of 2019, UK plc was not only contending with the rising threat of a ‘no-deal’ Brexit, but also rising geopolitical and trade tensions, increased market volatility and rising concerns over the outlook for the global economy. Last week we saw increasing speculation that the Federal Reserve may cut interest rates – when just a few months ago, they looked set to increase in 2019.

This growing hum of uncertainty looks to have had a wide-ranging impact, on ‘big-ticket’ consumer spending, contracts and investment by the end of the quarter. Profit warnings linked to delayed contracts, weaker consumer confidence, geopolitical worries and Brexit have all risen since 2017.

What about Brexit?

What role has Brexit played in this rising uncertainty? The number of profit warnings citing Brexit rose to 10% in Q1 2019, haven risen steadily since the second quarter of last year. Thus far in 2019, 12% of warnings have cited its impact – including 30% in Q2 to-date.

The 12% figure for 2019 overall might seem relatively low given Brexit’s domination of the news cycle, its prominence in UK companies’ list of concerns and the extent and cost of ‘no-deal’ preparations. But, it could reflect the fact that Brexit is a substantial, but not isolated challenge for UK plc. Companies may find it difficult – or may be reluctant to – separate out this concern. Its impact is also not universal. Stockpiling has increased activity in some sectors, in others the impact of delayed spending may take some time to show.

Brexit profit warnings

Three FTSE sectors – General Retailers, Travel & Leisure and Financial Services – account for 50% of Brexit-related warnings in the last 12 months. All areas where a stall in activity would cause an immediate impact.

Therefore, whilst a Brexit extension may remove some immediate anxieties, this may not have much impact on overall profit warning numbers. An unwinding of stockpiles could even trigger warnings in some areas. Meanwhile, underlying uncertainty remains over the UK’s long-term relationship with the EU, whilst a whole host of other geopolitical and growth concerns remain. The UK economy also has issues beyond Brexit, including uneven regional growth, low productivity, high debt and weak business investment – exacerbated by recent events.

Underlying it all…

But does this heightened uncertainly alone explain the exceptional number of companies warning at the start of 2019? If we look back across the last two years, our EY Profit Warning Stress Index has remained relatively high in pretty benign conditions.

What’s underlying this increase in profit warnings – and restructurings – is the acceleration of technological and structural change. Companies are finding that their core markets can be disrupted and turn sour incredibly quickly. The need to keep up is relentless. The tension caused by this increasing struggle to invest and keep up often amplifies other issues, especially in sectors with tight margins.

Around one in every ten profit warnings now regularly cites the need for additional investment, but this is only part of the picture, with companies also facing new entrants and routes to market. Competitive issues rank more highly in today’s profit warnings than 2-3 years ago – as do pricing pressures. We’ve also started to track the number of companies warning based on the need to change their product mix – 9% in Q1 2019.

The impact of innovation

A recent IMF report showed that a recent corporate increase in market power has been concentrated among “a small fraction of dynamic – more productive and innovative – firms”.

Industries that make the most of technology are more susceptible to dynamics where the winner takes most of the spoils.

The most-represented sectors in the top decile are information and communication, financial and insurance activities, manufacturing, and utilities.

The Rise of Corporate Power and its Macroeconomic Effects – IMF, 3 April 2019

In this regard, we come full circle with the recent fall in business investment – from its previous low base – potentially storing up problems down the line for UK plc. We’ve seen in troubled sectors such as retail and support services how balance sheet restructuring can buy breathing space. But, unless companies invest to adjust to new sector dynamics, they soon hit the buffers again.

Navigating uncertainty

It’s this combination of challenges that makes it so much harder for companies to keep their earnings bearings. But, given that uncertainty and structural change are now a constant, what can companies do to get their earnings and forecasts back on track? The stakes are certainly high, with first-day share price falls now consistently averaging over 20%.

Companies can’t proof their business against every uncertainty. But, they can mitigate the impact by getting a firm grip on their own business-critical risks, opportunities and assumptions. Armed with these insights, they will be in a better position to identify emerging issues earlier and move more quickly to fine-tune their profit guidance, should the need arise. Continuous performance and cash flow management are more vital than ever in these turbulent times.

Companies with contingency plans that address their biggest pinch points and that have flexible operating and cost structures will be better placed meet the demands of 2019 – and benefit from any upturn. Companies may need to be prepared for greater demands on their working capital to cover additional inventory and warehousing – and to be sure that their supply chain is prepared too.

In the face of unpredictability, companies also need to find the balance between being prepared and battening down the hatches. It’s impossible for businesses to avoid taking risks – however risky the world seems. Companies that have invested and innovated have outrun the competition in the last decade. The pace of change is such that if companies aren’t going forwards, they risk going backwards at an alarming rate. 

You can see more of our profit warning data on our EY Profit Warning Console, which allows users to search and compare by quarter, sector and FTSE Index.

You can also download the full EY Analysis of Profit Warnings paper, which includes an in depth look at FTSE Financial Services and General Retailers, which are also featured on in the sector insights portion of our web site.

Edited by Kirsten Tompkins