Profit warnings on the rise: forecasting is tough in a changing economy.

I thought you said that things were getting better?

We all know that a week is a long time in politics, but what about economics? Only seven days after the EYITEM Club issued its upbeat Summer Forecast “The UK economy hits the sweet spot’, EY’s latest analysis shows that UK profit warnings reached their highest level for three years in the first half of 2014.  Surely some mistake? How can business decision-makers reconcile such apparently conflicting messages?

Well, some things are…but it is a complicated story…

The  EYITEM Club forecast set out the prospect of a balanced recovery in the UK with business investment surging and, in tandem with increased consumer spending, driving economic growth. With signs of moderation in the housing market, the UK economy is forecast to grow at over 3% in 2014 and prospects are strong for the following years.

However not everything is rosy: export performance, especially for goods, remains disappointing; real wages are not increasing in line with growth; and investment is still well below peak levels.   The UK economy is moving forward but has not yet recovered.

The UK economy is not just recovering, as I discussed previously, it is also changing. The low growth in real wages has undoubtedly helped to boost the numbers in employment but it has also changed the way in which consumers, especially those on lower incomes, approach their spending decisions. On the corporate side, as Chris Giles of the Financial Times so clearly explained (in a great set of graphics highlighting all the major economic changes since 2008), there has been a significant shift between sectors since 2008. Oil and the Extraction industries are down nearly 40% in real terms and Finance has fallen by around 15% but Professional Services are up close to 10%, the Communications sector has grown by 10%, Health by 15% and Administrative Services are 20% higher than in 2008.

…which helps to explain the rise in profit warnings…

When we delve into the detail underlying the EY Profit Warnings, the impact of the challenges and changes in the economy becomes clear.

Companies used three main reasons were used to explain why profit warnings were necessary:

  • currency movements were cited as accounting for 20% of all warnings in H1 2014;
  • competitive and pricing pressures, were the cause for 18% of all warnings in H1 2014 versus 5% a year earlier; and
  • increased expenditures on R&D and investment led to 10% of all warnings this year to date.

The key sectors making profit warnings were Consumer Goods and Services, Support Services and Industrials.

The UK economy’s strength has made life harder for exporters. Market expectations over a rise in interest rates, recognition of the improvements in the UK economy and the relative political stability of the UK have all combined to increase the rating of Sterling. The result has been a significant appreciation especially against many emerging market currencies such as those of Turkey, Thailand and India, and some gains against the US Dollar. The impact on the Consumer Sector and Support Services is clear as companies have found  their competitiveness under pressure, and even when they have been successful in their chosen markets, the conversion of international earnings into Sterling has been on less favourable terms than originally forecast.

Increased competitive and pricing pressures provide the perfect illustration of how the changing nature of the economy can impact corporate performance.

  • In the consumer market, a fall in real disposable incomes of something close to 10% since 2008 has partly been compensated for by more people in the workforce, reducing the impact on total consumer spending. However, lower real wages has been a significant factor in driving consumers to be more price conscious, which in turn has led to success for businesses targeting these segments.It is no surprise therefore to see  30 profit warnings from the Consumer sector overall in the first half of 2014.
  • We have also seen a large number of profit warnings from the Business to Business sectors this year to date, With a changing sectoral mix, the UK economy is now more weighted towards sectors with relatively lower value add per unit of output, consider Administrative Services compared to Financial Services as an example. In this changing environment, as in the consumer market, prices are subject to ever greater scrutiny and challenge and hence margins come under pressure too.

Finally, when we note that UK business investment slumped in the period after the financial crisis and is still 12% below peak levels according to EYITEM, it is no surprise that corporates are starting to incur increased costs as they increase output to respond to growing demand. The fact that these costs have been cited as reasons for profit warnings suggests they are short-term patches rather than long-term investment commitments.

…and provide a longer-term lesson

We can therefore reconcile an optimistic macro-economic outlook for the UK with an increase in profit warnings. The success of the UK economy is part of the reason for a strengthening pound and the changing nature of the UK economy, which is supporting the recovery, is creating new pressures on prices and costs. Nevertheless, there is also a case for arguing that business forecasting may not yet be fully attuned to the challenges of  a growing but changing economy. We have been through two distinct periods in recent economic history: up to 2008 when risk appears to have been underestimated; and 2009-2013 when risk aversion was the norm. As we move to growth mode, the challenge is to manage and price risk appropriately.

Companies require robust forecasts to support decision-making in the complex environment they are going to be operating in. This means:

  • an assessment of the external economic environment to identify the key trends and the potential scenarios which could impact how these key trends play out;
  • in-depth analysis of how the macro trends such as currency and real wage developments will impact their sector ;
  • mapping of the macro view to their business and financial models, using their own data to tailor the high level view.

Much has been made of  the potential of “Big Data’ but this may the moment when it really comes into its own. The companies with the best understanding of the complexities of the growing but changing economy stand to benefit most. The approach to forecasting and analytics will be a key building block of future success.

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