This week’s blog comes from Alan Hudson, EY Head of UK&I Restructuring
In 1999, when EY started to track UK profit warnings, the dot.com boom was full swing, the euro started trading and businesses were preparing for Y2K – the so called “millennium bug”.
Two decades and over 6000 profit warnings later, we’ve gathered a wealth of insight into corporate vulnerability to profit warnings; how capital reacts; and the changes in our economy that have created new sources of value.
Most striking of all are the results of a thought-provoking study we’ve undertaken into the impact of issuing three or more successive profit warnings. For a fifth of these companies, it is a case of three strikes and you’re out – and this is happening quicker than ever.
What it tells us about business….
No sector is immune from profit warnings. We’ve seen warnings in every FTSE sector from Aerospace & Defence to Tobacco since 1999. Nevertheless, it’s also fair to say that some sectors are more vulnerable than most.
FTSE Support Services – including outsourcers – has issued the highest number of profit warnings; whilst FTSE General Retailers has the highest average percentage of companies warning by quarter. Both are highly exposed to business and consumer confidence. But both have also issued high levels of warnings in relatively benign conditions. So, economic conditions can only be part of the story.
|Top sectors by number of warnings||Top sectors by percentage warning *|
|Support Services||General Retailers|
|Software & Computer Services||Oil Equipment and Services|
|General Retailers||Automobiles & Parts|
|Media||Technology Hardware & Equipment|
|Travel & Leisure||Leisure Goods|
*Average percentage of companies warning per quarter
These two sectors are amongst those most structurally vulnerable to profit warnings. Beyond falling sales and the difficulties of the economic cycle, contract issues are the most common reason for companies to warn. This helps to explain why we consistently see such high warning levels amongst outsourcing, construction and software companies. Meanwhile, retailers have been though the most the most incredible structural upheaval over the last 20 years. In 1999, just 13% of UK households had home internet access and the first smart phone is over ten years away. The speed and cost of technological and consumer behavioural change has left many retailers struggling to keep up.
That said, over the last 20 years, an average of 15% of companies have issued warnings each year. In our toughest year, 2001, it was 23%. Profit warnings can sometimes be unavoidable, for example after extreme economic or sector shocks, but they are not inevitable. The fact is: most companies don’t issue profit warnings.
If we look behind the numbers, many of the problem contracts triggering multiple profit warnings have flaws in their inception and execution, often exacerbated by a slow or insufficient response. Management teams that have weak visibility across their business and poor internal controls won’t spot problems early. Companies that don’t respond quickly to changes in their market increasingly risk falling into a negative spiral of falling customer and investor confidence.
|Top reasons for warning|
|Sales short of forecasts|
|Increasing costs and overheads|
|Exchange rate changes|
Thus, reliance, accountability, visibility and agility are vital armour against profit warnings.
What it tells us about capital….
For our 20th anniversary we’ve also carried out an analysis of “multiple profit warnings”, which shows that the third warning is often the final blow and capital is becoming ‘flightier’.
By “multiple profit warnings” we mean companies that issue a chain of three or more profit warnings in one year – with any further warnings issued within six months of the last added to the chain.
Using this measure, 18% of companies that have issued a profit warning in the last 20 years have gone on to issue multiple warnings. Most of these come from the sectors we’ve identified as being structurally vulnerable to warning, which also makes them vulnerable to multiple warnings – if they don’t get a handle on their problem.
|Sector||Multiple profit warnings|
|Software & Computer Services||
|Travel & Leisure||
|Media & Entertainment||
|Construction & Building Materials||
This 18% figure indicates that, despite the saying that ‘profit warnings come in threes’ most companies will just warn once or twice in a year. But there are good reasons why we remember the third warning.
A year after companies have issued a chain of three or more profit warnings
- 25% have had a covenant event*
- 20% of companies have delisted
- 10% have gone into administration
- 9% have recovered their share price
*breach or waiver
In total, around 18% of companies will experience a restructuring event (administration, CVA, debt restructuring or distress sale) within a year of issuing a chain of three or more warnings. Half will have lost their CEO and 40% their CFO.
All of which underlines why it’s so vital that companies don’t risk a value destroying chain reaction of multiple profit warnings.
More so today because capital is getting ‘flightier’ and companies are under increasing scrutiny. We can see this in the reaction to all profit warnings, with the average first day share price fall rising from 15% in 2015 to above 20% in 2019. But, if we dive deeper into our multiple warning data we can also see problems escalating quicker and investors and stakeholders reacting faster – quicker now than during the financial crisis.
Companies experiencing restructuring events after multiple warnings now do so in a median of 91 days – just about three months.
*Breach or waiver
What it tells us about the economy….
Shocks and recessions have triggered the biggest spikes in profit warnings since 1999. When companies have little-to-no time to adjust, either their operations or their forecasts, we see sharp jumps in warnings as per 2001, 2008-9 and to a lesser extent in 2015, when oil prices fell dramatically and the global recovery stuttered.
Large spikes in warnings are often followed by sharp drops – as we saw in 2003 and 2010. These extreme dips usually happen when the economic cycle turns ahead of forecasts. But this didn’t happen to any great extent in 2016. Indeed, in recent years profit warnings have stayed remarkably high with the percentage of companies warning in the last 12 months close to 2008 levels.
Why are so many companies warning? There are two significant drivers visible in our data. An unsettled geopolitical backdrop – of which Brexit is just a part – has created a steady hum of uncertainty, with increasingly contract disruption and opportunities for companies to be wrong footed by sudden changes in trade conditions or exchange rates. There is also huge structural upheaval in play due to technological disruption and its impact on consumer and business behaviour. This is most obvious in the rising number of profit warnings citing increasing costs – in particular, unexpected investment costs.
The price of keeping up is rising and some companies just don’t have the capital or capacity to reshape their businesses in time.
What this says about the future…
Companies will increasingly fail – and fail quickly – when they don’t respond speedily enough to shifts in their sector value chains. As capital moves faster, the time given by stakeholders to companies to reshape their results has also diminished.
Thus, even in relatively benign economic conditions, we have seen a high number of companies on the ropes. The next few months, in the UK at least, could prove to be anything but benign. Some companies have increased their resilience; but high levels of profit warnings suggest that many others lack the capital and capacity to ride out rougher seas.
If companies are forced to reforecast their earnings, it’s essential that they act boldly and quickly to grasp and address the fundamental issues behind their profit warning. Too often we see companies wait and hope that something will turn up. But, our analysis shows that companies and stakeholders need to act fast before the profit warning spiral deepens.
You can find out more about our 20 year anniversary analysis and access our console to search our profit warning data on our web site.