Profit warnings

Citation

(2001), "Profit warnings", Property Management, Vol. 19 No. 4. https://doi.org/10.1108/pm.2001.11319dab.024

Profit warnings

Profit warnings

According to business advisers Ernst & Young's quarterly Analysis of Profit Warnings, published April 2001, downgraded profit forecasts from UK-quoted companies for Q1 2001 (January to end-March 2001) rose dramatically on the previous quarter by 77 per cent, and 136 warnings beat Q4, 1998's high of 126 (the highest recorded figure since Ernst & Young began its analysis of profit warnings in 1998).

Slowing world growth is the biggest culprit. But this quarter's sharp rise on the last is due to the apparently interminable troubles of the Software & Computer Services sector – and now foot and mouth. Together they account for 22 per cent of the total number of Q1 warnings. And the outlook is none too bright, according to Alan Bloom, Head of Corporate Restructuring at the firm: "Alarm bells continue to ring as Ernst & Young's analysis shows that mid-tier companies are now bearing the brunt of the economic slow-down. Last quarter it was the smaller companies who were affected. This echoes 1998, when both trailed a downturn in performance of the large corporates over succeeding quarters." The number of warnings from mid-sized companies – with turnovers of between £200 million and 1 billion – rose from 11 to 31 (23 per cent of warnings overall).

For a fifth quarter Software & Computer Services generated the largest number of warnings – 11 per cent of quoted companies in the sector and 14 per cent of the total. No surprises here – IT spend accelerated sharply before Y2K (and the effects of overvaluation during that high-growth period are still being felt); the risk of recession continues to depress company sector spending which includes, of course, IT; investment in the Internet sector has not turned into convincing revenues and its suppliers are suffering from depressed demand in turn; investors continue to lick their wounds, of course – as indiscriminately as some went in, they are leaving the sector as indiscriminately; and the supply chain ripples from the depression of major US players are starting to work their way through Europe.

Ernst & Young believes that many well-regarded TMT companies will probably issue warnings in the coming months as US orders are delayed, reduced or evaporate. Others – especially the bold and creative but young and inexperienced – will use this excuse to mask their own systemic management and planning failures. Some may not survive to make further warnings, says John Harley, a partner and specialist in the sector in Ernst & Young's corporate finance division: "The survivors will be those who can demonstrate productivity in areas that will save their customers money – like e-enablement and outsourcing. Venture capital and corporate investors are more cautious these days but are, in our experience, still interested in innovative technologies that can be seen to improve productivity."

He adds: "Nevertheless, TMT could be in for a much longer period of retrenchment than we expected. High numbers of warnings from Software & Computer Services are likely to feature until the year-end as demand falls, and we are certainly witnessing a sharp correction in over-optimistic growth estimates. However, future profit warnings may be distinguishing companies with losing applications from those with winners."

Advancing communications through telecoms infrastructures has proved a risky business, too, of course. Pricing pressure on international routes, the consumer's less-than-intense interest in high-capacity data services, and third-generation mobile phone technology (3G) sapping funds with no revenue stream in sight for years, have all contributed to the current spate of sector warnings. To sustain investment in 3G, 3G investors are already cutting their expenditure on their 2G (existing) networks and their suppliers will issue profit warnings in consequence. Says Harley: "As with the TMT sector as a whole, strong players now have the opportunity to buy weak ones and lower valuations will lead to consolidation through significant M & A activity in the coming quarters".

The means by which equipment manufacturers sell products to Internet providers and related customers – by investing in their business or lending them money – has turned from a driver of demand into a serious liability for some. As sales of equipment grew, so did the vendor's exposure to risk. Now the customer may have difficulty paying up. Richard Coates, Head of Ernst & Young's "Turnaround" team – which is involved in averting the slide of companies whose underlying proposition is sound – believes that companies with such exposure through vendor financing or other forms of corporate venturing could be candidates for profit warnings over the next few quarters. "The problem, of course, is difficult to estimate, because the deals are not always reported on balance-sheet as debts, but itemised as sales or revenue in kind. Client experience, however, gives us cause for concern. The increasing incidence in profit warnings from vendor financers could lead their customers to escalate the delivery of a loan commitment in full. Vendor financers in a downturn may, in turn, be reluctant to lend again or see a covenant through to its full term."

Coates says that future vendor financing deals must be more cautious in the current market if over-exposure is to be avoided. Those borrowing through these deals must also look at their ability to continue to draw on existing lines of finance as well as existing and future covenants for more money. "The worst – and most common – thing we encounter when we are called in to turn round companies is that they have banked on one solution that has failed, with no contingency plan, or they have kept their heads down because a decline seemed inexorable. Two things are critical. One: communicate with your vendor financer just as you would your other stakeholders. If your business plan is robust and you can reset achievable milestones in a difficult climate, you'll maintain the confidence of your lender and liquidity. Two: plan for contingencies in the light of these harsh market conditions. Anyone not planning for a substantial downturn in the technology arena should be. You must have a plan B. If you don't, your company could fail unnecessarily."

The General Retailers sector did well in and around Christmas – but not clothing. Nine of the 11 profit warnings issued by General Retailers in Q1 2001, came from those with some involvement with clothing and six of these nine were from discounters – or "value based" retailers. Despite reasonable consumer spending over the last year with only some decline in consumer spending growth of late, there are just too many retailers and too little money to go round, says Ernst & Young.

As far as the discounters are concerned, middle-market operators such as BHS have been squeezing the value players, winning back the price-sensitive customer with low prices. The power of a long-standing national brand and, in some instances, a more attractive and efficient in-store environment, may be giving the middle market the edge. This quarter's profit warnings indicate, then, the beginnings of a competitive response from the mid-market sector.

According to Simon Brooker, partner and retail specialist at Ernst & Young: "Middle market retailers are recognising that the middle ground is dangerous ground. There has, over the last few years, been a huge polarization of merchandise and quality in which many wardrobes feature discount clothing as well as the latest Armani. And that is how many consumers shop these days. They are not looking for middle market or middle-of-the-road clothing with promises of quality or value. Quite often they are finding that they can get it cheaper or better elsewhere and discount or 'value-based' these days doesn't necessarily mean cheap or poor quality." Brooker says that there will be more profit warnings from that part of the clothing sector that does not recognise the need for the change. "They will be left behind as various mutations take place as the more aggressive and more imaginative retailers decide which niche they will dominate."

Five of the ten Food Producers & Processors warnings are attributable to foot and mouth, shows Ernst & Young's analysis. While 11 only of the 136 warnings related to the epidemic this quarter, Ernst & Young believes that the impact of the disease could drive more profit warnings in the coming quarters. Beyond the punishment being suffered by the tourism industry and dairy, livestock and meat producers now, a host of suppliers and service providers to the agricultural and tourism industries remain vulnerable, says the firm. The ripples go beyond the obvious supply chain. Movement bans on animals have affected road hauliers, the rural housing market may be hit, mobile and electricity companies have been unable to carry out activity on quarantined land. Ernst & Young is, therefore, urging every company to examine its position in its supply chain, upstream or down, for foot and mouth-related effects and to assess their financial implications now.

Says Alan Bloom, "The economic effects of the epidemic will not die as foot and mouth fades. Confidence – one of the intangible but nonetheless powerful dynamics in business – has taken a big hit in tourism and agriculture. Together they consume large numbers of services. Time will be required to recover from psychological blows as businesses in and around those sectors go bust, some decide to throw in the towel or others divert or suppress investment as risk aversion naturally sets in. We see the effects spilling over into many sectors into 2002."

Warnings to peak next quarter at around 150

Most pundits believe that the UK will weather the US storm but world trade growth is slowing, so more profit warnings will occur in the following two quarters. Depending on the progression of foot and mouth, Ernst & Young believes that warnings could peak at around 150 next quarter with a levelling out the next, and a modest decline into the first quarter of 2002.

As warning companies saw a share price decline of 22 per cent on the first day of trading following the downgraded profit forecast announcement, Bloom warns again of the dangers of not managing City expectations. "It doesn't like surprises. Over-valuation of shares is not always the fault of a given company and herd instincts about sectors can be powerful and sometimes misdirected as we have all seen with the dot com craze. Common sense dictates that reality on behalf of investors and those attracting investment seems to be the best policy. This is predicated upon a company's ability to predict effectively its sales forecasts, of course, and with nearly one-third of warners this quarter having done it at least once before over the last 12 months, too many are clearly not learning from past mistakes."

"While current economic and environmental problems are contributing to forecasting failures, the high number of warnings also exposes the underlying fragility of many companies and tests their ability to respond effectively in a crisis", according to Bloom.

The Ernst & Young Quarterly Analysis of Profit Warnings for Q1 2001, can be viewed on our Web site from Monday 30 April (ey. com/uk). Electronic copies are available from fgreig@cc.ernsty.co.uk during office hours. Additional hard copies are available from Fiona Greig during office hours or can be collected after the press office officially closes at 5.30 p.m. from the 24-hour security office at the rear of Ernst & Young's Becket House offices (opposite St Thomas' Hospital, Westminster Bridge) from Thursday 26 up to and including Monday 30 April. Readers can obtain free copies of Ernst & Young's Analysis of Profit Warnings for Ql, 2001, from Alison Smithie. Tel:’0207 951 9912 or by e-mailing asmithie@cc.emsty.co.uk

The profit warnings analysis is undertaken quarterly by Ernst & Young's corporate restructuring division.