Why are profit warnings breaking 2008 records?

This week’s Capital Agenda Blog comes from Alan Hudson, Head of UK&I Restructuring and Kirsten Tompkins, UK&I Transaction Advisory Services Content Editor.

In 2019, a higher percentage of UK quoted companies issued profit warnings than 2008.

We’re not facing recession. Insolvencies have risen in 2019 but are well below 2008 levels. This clearly isn’t as dire a situation as the peak of the financial crisis. But what 2019 does have in common with 2008 is unpredictability. What arguably makes it harder to forecast is the increasing pace of change and wider array of challenges companies face to earnings.

The UK economy isn’t in recession, but – because of these pressures – some sectors arguably are….

Worse than 2008? Really?

In 2019, 17.8% of UK quoted companies issued a profit warning, fractionally higher than 2008’s figure of 17.7%. We need to go back to 2001 to find a higher figure of 22.7%.

PWQ419 - % warning

Over a hundred more companies warned in 2008 than 2019. But, there were about a third more quoted companies in 2008, making this a slightly smaller proportion overall. The forces driving the fall in the number of quoted companies have also changed the composition of the market. But, as we explain in our analysis, today’s market contains a higher proportion of the top-warning sectors than 2008.

So, to really understand why such a high percentage of companies are warning now, we need to go back to basics. Profit warnings aren’t an absolute measure of company earnings. What they measure is how many times quoted companies say they’ll miss their profit expectations. Fundamentally, they measure how well companies can predict their future.

In those terms, 2019 was an exceptionally challenging year, combining protracted and widespread uncertainties with low levels of growth and ongoing rapid structural change across a wide range of sectors. It’s this combination that we believe drove warnings to such exceptional highs.

The price of uncertainty

We’ve clearly had testing years since 2008 – especially during the eurozone crisis. But did any year have as much protracted domestic uncertainty and geopolitical tension as 2019?

At home it was a Brexit-dominated year of long-drawn-out speculation, punctuated by high drama, but with little resolution in terms of companies knowing what comes next in EU-UK trade. Meanwhile, prolonged US-China trade talks, growing strains in international relations and rising numbers of popular protests – including the strikes in France and Hong Kong demonstrations – added to global uncertainties.

The impact of inventory build, delayed decision making, and consumer wait-and-see is writ large in our profit warning data. The chart below tells the story – particularly the build of pressure into the last quarter of 2019.

PWQ419 - reasons for warning

In Q4 2019, 35% of profit warnings cited contract delays or cancellations – a ten-year high. Over a fifth of warnings pointed directly to political uncertainty – domestic and global. This uncertainty obviously also had a broader impact on economic growth, which is likely to come close to decade lows at home and abroad.

The structural challenge

Compounding and fuelling this uncertainty is the ongoing and increasingly rapid structural change we’re seeing within and across industries.

Across our economy we’re feeling the consequences of a struggle to reconcile the impact of rapid and deep-seated change – in the political landscape, in our use of technology, in our respect for the environment and opinions on the purpose of corporations. The consequence is rapid paradigm shifts that are continuously redesigning industry landscapes, creating new business models – but undermining many more.

Companies need to invest time and capital to meet these challenges, which is more difficult in the current environment. A third of FTSE Retailers warned in 2019 for the second year in a row, even as disposable incomes grew, due to falling consumer confidence.

And retail’s issues go well beyond the pound in consumers’ pockets. Seismic structural change has seen entire business models virtually removed overnight by new technologies and changing consumer behaviour, with the sector experiencing recession-like levels of restructuring in the last three years.

PWQ419 - retail warnings

Sector recessions?

This is the crux of why we’ve seen such a high level of profit warnings – not just in 2019, but in the second half of the last decade.

Paradigm shifts are creating multifaceted challenges to corporate earnings. Companies are now accountable to much wider stakeholder groups, whose attitudes and behaviour are being shaped by technological change, but also by increasing concerns about sustainability and the role of corporations in society.

There are so many more horizons to watch today, with rivals coming from within and outside companies’ sectors. Social media has the power to accelerate a trend to the point where a product can become virtually defunct within weeks – or new a product can grasp the public’s imagination.

PWQ419 - super-sector warnings

In 2019, we saw the forecasting challenge spread and radiate out into industrial and financial sectors, whist warnings from already stressed consumer discretionary sectors rose again.

This was partly due to economic factors and the slowdown in manufacturing. But, it’s impossible to understand issues within the automotive sector, for instance, through a financial sense alone. Hence, why we believe that we’ll see more sector recessions almost independent of economic slowdowns.

Where does it hurt?

Our profit warning data shows several FTSE sectors where a third or more of the has issued a profit warning in the last year. We’re also watching other sectors, where profit warnings have risen two, three, even four-fold in a year.

Top ten FTSE sectors, by percentage of sector warning in 2019*

1 Technology Hardware and Equipment 56%
2 Industrial Materials 50%
2= Automobiles and Parts 50%
4 Telecommunications Equipment 40%
5 Household Goods and Home Construction 36%
6 Retailers 33%
6= Personal Goods 33%
6= Chemicals 33%
9 Leisure Goods 31%
10 Industrial Transportation 30%

*Excludes sectors with fewer than 5 members

We can see the pressure on the automotive and consumer supply chains, the impact of businesses and consumers holding back and the sustainability challenge here.

FTSE sectors with over a 100% year-on-year increase in profit warnings

1 Personal Goods 500%
2 Chemicals 400%
3 Banks 200%
4 Investment Banking and Brokerage Services 200%
5 Industrial Metals and Mining 150%
6 Construction & Materials 125%
7 Finance and Credit Services 133%
8 Technology Hardware and Equipment 117%

Corporate prospects haven’t entirely decoupled from economic growth. Insolvency levels are still well below 2008’s peak. The easing of domestic political tension, combined with additional fiscal spending, should still boost earnings in 2020, helping more companies to meet or beat what are now depressed expectations.

So, profit warnings fall in the short term. But not by much. The pace of warnings has eased into January; but underlying stresses remain, and ongoing uncertainties mean the pace could quickly rise again.

In response, companies need to remain flexible, agile and alert to changes on multiple horizons. This multiplicity of challenges means that a rising economy won’t float everyone’s profit boat.

You can read more of our analysis in our latest EY Analysis of Profit Warnings and explore our profit warning data further using the EY Profit Warning Console.