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Profit warnings hit 7-year high

Monday, 14 April 2008

Research by Ernst & Young reveals that profit warnings reached 114 in the first quarter of 2008.

This is the highest first quarter figure since 2001 and up 11 per cent from Q1 2007.

Painful readjustment

Keith McGregor, restructuring partner at Ernst & Young, said that profit warnings remained above the 100 mark for the second quarter in a row, driven by the deepening impact of the credit crunch and a record number of retail warnings.

The last time UK firms issued more than 100 profit warnings in consecutive quarters it was 2001, when the end of the technology-led boom meant painful readjustment.

“The hangover from the credit-boom could be equally severe especially as some sectors are warning on current poor trading but may have failed to factor in the impact of a sustained downturn in demand,” McGregor warned.

The highest warning sectors were general retailers with 18, equalling their record peak of Q1 2007, support services with 14, software and computer services with 13 and media and general financial with eight.

Retail more in distress

The general retail sector has 18 warnings this quarter equalling the record number that were recorded in Q1 2007.

Retail profit warnings usually peak in the first quarter, when retailers provide Christmas and January sale post-mortems.

It is clear this year, however, that the sector is in more distress than at the start of 2007. The 12 months to the end of March 2007 saw 26 per cent of the sector issuing a warning.

By comparison a remarkable 42 per cent of FTSE general retailers had issued a warning to the year to date ending March 2008.

Andrew Wollaston, restructuring partner at Ernst & Young, said that it would be reasonable to expect more of the same, if not worst, for the rest of 2008 - yet, retail sales showed resilience in February and March.

“Looking behind the figures it is evident that food and seasonal items drove most of the sales growth. Other sectors such as household goods saw a decline highlighting that consumers are cutting back their spending on big ticket purchases and is evidence that the pressure is beginning to build,” Wollaston added.

Individuals to increase savings

He warned that the credit crunch will become real and personal to borrowers this year, especially the two million mortgage holders coming off fix-rate deals.

The base rate is expected to continue to fall gradually in 2008, but the same inflationary pressures that will limit the ability of the Bank of England to lower rates, will also eat into the benefit of any rate cut for the consumer.

Wollaston said that the period of economic uncertainty may even persuade individuals to increase savings from their historic lows, leaving retailers with even less of the disposable income pie.

There have already been ten notable retail administrations in this quarter and the outlook looks bleak for the second quarter and beyond.

The early Easter and far chillier spring than we enjoyed in 2007 will hit like-for-like figures. Retailers will need more than good weather to compensate for consumer frailty and their own rising costs.

Media sector coping

There were eight profit warnings in the first quarter of 2008 from media companies and although this is down from ten in the last quarter of 2007 difficult times may lie ahead for the sector.

The economic slowdown, and the consequent cut in marketing budgets, is already affecting some of the smaller media players.

Wollaston noted that the effect the current economic slowdown will have on the wider UK media landscape, especially the bigger players, would become clearer in the next two quarters.

For the time being, the sector appears to be coping with only some smaller players missing their earnings targets.

Wollaston said that the possible effects of the credit squeeze should not distract, however, from the real long-term challenge facing the media industry – the shift online.

“Only the companies that successfully manage this change will be able to compete effectively in the medium to long term,” he added.

Limited and more expensive credit to continue

Ernst & Young believes that consumer-facing industries will undoubtedly continue to suffer distress as the UK is weaned, perhaps abruptly, off its credit addiction.

Those companies linked to the house building cycle as well as ‘big ticket’ retailers are going to be especially vulnerable in the coming year.

Although they have lowered their expectations for growth this quarter, it might not be enough to prevent further profit warnings along the housing chain if the swift withdrawal of mortgages and confidence from the markets prompts a sudden housing downturn.

Credit contraction will also have a wider impact on investment and discretionary spend, keeping business-facing companies under pressure.

McGregor warned that limited or more expensive access to credit will continue throughout 2008 and perhaps into 2009.

“Lenders’ balance sheets will not return to health overnight. This credit constraint will make the “crunch” personal and painful for consumers and companies and we expect elevated levels of profit warnings in the year ahead,” he concluded.

Underperforming companies that have warned this quarter are being harshly punished in the current economic climate and evidence of this can be seen in the near 20 per cent drop in share price, Ernst & Young’s research found.

McGregor pointed out that this, and the increased volatility in equities, bonds and loan pricing could mean that 2008 represents the start of the next investment cycle for distressed players – and many have built teams and raised funds in anticipation.

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