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Accounting

Are profit warnings wake up calls or the beginning of the end?

Tuesday, 28 November 2006

Sometimes all profit warnings show is that the company is very bad at forecasting. But Hugh Thompson argues they more often show that something fundamental is going wrong with the business, especially if the profit warnings occur more than once in a year. For the last seven years, accountancy firm Ernst & Young has been publishing a quarterly analysis of profit warnings issued by the UK's 2000 quoted companies. This document is eagerly read by the markets, analysts, bankers, lawyers and shareholders, not least because of the detailed analysis the reports give of what these warnings mean.

Profit warnings are an all-embracing expression for the board giving notice that the bottom-line figures will not be in line with expectations. When such warnings are given, the accountants calculate that the shares fall by an average of 15 per cent in the first day, but in some cases the fall can be as high as 30 per cent. Not only are profit warnings highly embarrassing because they show the company is not totally in control of its data or its business, but they are expensive. It must be remembered that if the company is forecasting low returns then it is not doing much to excite the market or its share price.

For most of the past year, profit warnings have been running at about 50 per quarter that Ernst & Young feels is a good sign of a steady and benign economy. But when the warning levels top 70 per month, it is the time to start taking a more serious look at underlining trends in the economy. In the final two quarters of 2000 - as the dot-com boom turned into bust - profit warnings rose to 74 and 77 with a large number of software and IT companies being forced to broadcast bad news. Earlier in the year profit warnings had been running in the 40s per quarter, as now.

However, as Ernst & Young points out, there are several distinct categories of warning.

The first is market trend. Typically this was what caused the massive rash of profit warnings and worse in the 2000 dot-com bust. The markets and the economy had been racing ahead, optimism fed and fuelled further optimism and for a while many thought that the laws of economic gravity had been suspended. Nobody wanted to be left out and boards competed with each other to give the very best and most hopeful forecasts. As we now know, it ended in tears. It is not that boards lied or made up figures, just that at that time, forecasts were exaggerated anyway and everyone was going for the top-of-their-range forecast - not the bottom or the more conventional middle, but the very top. Today, not least chastened by those heady and eventually disastrous days, there is far more realism in the market and few would forecast at the top of their profit range.

The second identified category of warning is industry or market specific. In changing markets, problems are always presenting themselves. How a group of companies respond to their common problems not only differentiates them but also has a direct effect on their profit forecasting. Typically all the major tobacco companies have had to face the problem of declining demand in the West and the opportunity of increasing demand in the Third World.

It must also be remembered that companies may give profit warnings that have no bearing on the fundamentals of their business. An oil major may revise its forecast to between £10.3bn and £11bn. That would not make it a company in some kind of risk - but if that oil company issued repeated warnings, then its various stakeholders may start to wonder about the quality of its financial management. And change in markets, technology and consumer-behaviour is not only endemic and expensive, but companies are having continually to change to keep up or else see their bottom line suffer. The difference between those who keep continually abreast of changes and those who do not is ever widening.

The third category is adverse global or national shock. The most seismic of these, of course, was 9/11, but Sars, BSE, foot-and-mouth and the Gulf wars also ruined the most circumspect forecast. In fact the warnings happened very quickly after 9/11 with, not unnaturally, the insurance companies coming out almost immediately with their revised view of their balance sheets and airlines followed suit. Some 70 profit warnings were issued in October 2001 alone. It is easy to forget that 2001 was economically a fairly bumpy year even before the Twin Tower outrage: in the first quarter there were 136 warnings while in the three months after 9/11 there were 149.

Finally there is company-specific risk. Typically in this scenario one company receives a majority of its business from another. A major clothes manufacturer may receive half of its orders from one high-street retailer. The retailer cuts back and cancels the whole order and there is very little the manufacturer can do except adjust his forecast, though questions maybe asked of its management about why it did not see the cutback coming.

Ernst & Young looks at companies issuing profit warnings in terms of their sector, size and region, all of which can have a bearing on performance or trend.

For most, the first reaction to a profit warning is a change or restructuring. Companies may decide that the way forward is to restructure financially. It is common for companies in difficulty to swap their debt for equity as a way of relieving pressure on the balance sheet.

On the operational side, companies will often use a profit warning as a catalyst to move resources out of less profitable areas into the more profitable parts of the business. In the past three years, many companies that spent the previous decade acquiring all kinds of businesses in attempts to vertically or horizontally integrate have been divesting back to their core. At the heart of most quoted companies is, after all, a very real business.

Because of these kinds of actions and a more realistic attitude to forecasting, it is rare that companies make more than two profit warnings in a year. However, more than one warning is often a result of the company going into something like denial. While most see a profit warning as a good reason to look at themselves very closely, some boards cannot bear to go through such painful self-analysis and consequent change. From these companies the bad news just gets worse.

It is felt that the increased role of the non-executive directors could become crucial after a profit warning. For boards that are slow to react, the independent directors can insist on company doctors or consultants being brought in. With companies, as with houses, the sooner the corrective action is taken the less the damage and the more stable the structure.

So how much of an indicator is a rise in profit warnings? In the first quarter of 2004, profit warnings grew by one-third to 52, with software and retailing accounting for 20 per cent. Richard Coates, corporate restructuring partner at E&Y, said: "While a 37 per cent rise in warnings can hardly be good news for UK listed companies, it does not suggest a need to hit the panic button.

"The most appropriate term for the current underlying business conditions is stable, hardly an overused word during the political and economic turmoil since 2000. The economic environment remains arguably the most positive for three years, creating conditions in which businesses that get basics right will do well."

He pointed out that the software companies doing badly were the smaller market-value companies that did not have the resources of giants. And of course, once they had made a warning the market value shrunk yet further, making it harder still to raise additional resources.

Hugh Thompson has been a business writer for The Guardian, The Sunday Times and The Daily Telegraph. He has also edited the trade papers Publican, TV Weekly and Claims Professional and has recently run the 'Entrepreneur', 'My Big Break' and 'My Big Deal' columns for The Times. He has a background as a specialist marketing and media, personal finance, insurance and management writer.