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Despite high profile casualties and Brexit concerns, the number of firms downgrading earnings guidance is below average
Thursday 03 Nov 2016 Author: William Cain

Research produced by consultants at Ernst & Young (EY) shows there has recently been a below-average number of profit warnings. You may think that sounds odd, given a spate of bad news from listed companies.

Results over the last four years in KPMG’s Profit Warnings report shows there are an average of 73 profit warnings every three months – more than one every trading day.

However, the third quarter of 2016 saw fewer than normal with ‘just’ 68 profit warnings.

The start of the fourth quarter may suggest Q3’s low result is merely a blip.

Profit warnings came thick and fast in October with some of the larger victims including Amec Foster Wheeler (AMFW), Berendsen (BRSN) and Capita (CPI).

Talking Point

Watch out for support service companies

While profit warnings are fairly common on the stock market according to EY analysis there are some trends within the data. Profit warnings at Berendsen and Capita are part of a wider theme of difficulties in the business support services sector, for example.

Thirty-eight companies in this section of the market delivered profit warnings in the past year, 27% of the entire sector.

‘Contract issues – slips, delays and cancellations – are a perpetual problem for the sector and feature in a quarter of business support services profit warnings in the last 12 months,’ says Lee Watson, restructuring partner at EY.

‘They’ve also been the catalyst for significant reputational damage, as we’ve seen in a number of high profile cases. Public sector contracts in particular have attracted high levels of scrutiny given their high profile position in the public domain and ongoing scrutiny of government spending.’

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Retailers also looking fragile

Retailers were another sector which struggled during a third quarter which also included the UK’s vote to leave the EU. Nine profit warnings issued by the sector was the highest since
late 2011 and the third-highest since 2008.

While sales are rising, pressure on margins is one of the main sticking points for many retail businesses.

‘Although Brexit wasn’t the main driver for profit warnings this summer, its secondary effects have the potential to tighten the margin vice even further as we move into 2017,’ said EY’s head of retail restructuring Jessica Clayton.

‘It’s this pressure on retailers’ margins that leaves them vulnerable to shocks like adverse weather conditions – and Brexit’s economic fallout looks set to tighten the vice even further. The impact of weakened sterling may be delayed by currency hedges but at some point something will have to give at the till – or further down the supply chain.’

Profit warnings losing strength

Not only were there fewer profit warnings in the third quarter, those which were delivered resulted in lower average share price declines than the three months to 30 June.

Average share price declines after a company reduced its profit expectations were 9.5% in the third quarter, down from 16.6% in the three months earlier. Over five years the average is around 10%.

Early indications are that profit warnings have been more severe during October, the first month of the final quarter of 2016, as witnessed by heavy declines at Laird (LRD), Capita and Amec Foster Wheeler.

But investors will need to wait until early 2016 before EY updates its data for the final quarter of 2016.

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Two thirds don't blame brexit

EY notes that only 30% of profit warnings in the third quarter cited Brexit. While the economic and commercial impact of the UK’s vote to leave the EU appears to have been limited so far, the report says the second half of 2015 was a low base for comparison. Investors should therefore treat the results with caution.

‘The 14% year-on-year third quarter fall in UK profit warnings needs to be seen in the context of last summer’s market turmoil and a year of plunging expectations,’ says EY’s report.

‘Profit warnings spiked last summer as the fall in commodity prices passed down the supply chain and worries over China’s growth and US interest rates amplified economic uncertainties.

‘Earnings forecasts were already falling, but fell sharply again as profit warnings reached a post-credit crisis high in summer 2015 and remained high into the final quarter. Those expectations continued to fall through into 2016 — albeit not as rapidly — creating a low earnings bar for companies to beat in the third quarter of 2016.’

Brace yourself for economic shocks

The report adds: ‘What happens next depends on how (Brexit’s) secondary effects spread through the economy. Many currency hedges run out in early 2017 and business confidence will be influenced by the complexities of working towards a bespoke trade deal with the EU and the cushioning provided by monetary and fiscal policy.

‘Given the extent of market volatility and the many unknowns, market expectations may swing too far either way, given us some peaks and troughs in the number of profit warnings.’ (WC)

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