Two weeks is a very long time in economics: profit warnings continue to rise despite a growing economy

I thought you said things were going well?

Two weeks ago, EY’s Capital Confidence Barometer reported increased economic confidence amongst UK businesses. Last week, the EY ITEM Club forecast strong UK economic growth in 2015, especially post the election assuming business investment recovers after the end of political uncertainty. This week, EY’s latest analysis shows more companies issued profit warnings in Q1 2015 than the same period last year. How can we reconcile these conflicting results?

It is certainly the case that profit warnings are higher than we would expect given the level of GDP growth in the UK economy. A level of about half the current rate would be more usual for the stage in the cycle.  Given the improving economic outlook therefore, it’s tempting to make the oil price the chief culprit for this year-on-year rise – particularly as one in five warnings cited its dramatic fall. However, there’s more to this story and we need to dig into the details to understand what is happening.

It is true, there are some challenges out there.

UK quoted companies issued 77 profit warnings in Q1 2015, three more than the same period of 2014, but sixteen fewer than the previous quarter.  Overall, 5.5% of UK quoted companies issued profit warnings in Q1 2015 – the highest first quarter percentage since 2009.

Yes, the rapid fall in oil price at the end of 2014, contributed to 16 profit warnings in the first quarter. This includes a record eleven warnings from within oil & gas sectors and five from elsewhere, primarily the FTSE Industrial Engineering sector.But it’s not all about oil. The FTSE sectors leading profit warnings in Q1 2015 were Oil & Gas Producers (8), Support Services (8), Software & Computer Services (7) and General Retailers (6): a wide sector spread.

When we delve into the reasons cited for profit warnings, it becomes clearer that the problems businesses are encountering go beyond a falling oil price.

EY’s analysis found that:

  • Increasing competition and pressure on prices contributed to 22% of profit warnings in Q1 2015. This includes most retail profit warnings.Rising consumer spending power helped to keep retail profit warnings in single figures, despite deepening price deflation. But, the constant fight to keep prices low and meet rising consumer expectations continues to create a testing retail environment.
  • A quarter of profit warnings cited contract delays or cancellations in Q1 2015, highlighting the impact of rising market uncertainties and just how little room companies have for manoeuvre. The FTSE Support Services sector is geared to the economic cycle and contract cycles. This leaves it well placed to benefit from the upturn, but also open to election uncertainties. Over 50% of the sector’s profit warnings blamed contract delays or cancelations in Q1 2015.
  • Volatile exchange rates and the strong pound continued to complicate the forecasting environment, contributing to 10% of profit warnings in Q1 2015.  This is down on last year’s high, as companies adjust and sterling eases against most currencies, although not the Euro.

A fresh look

Profit warnings matter: the median share price fall on the day of warning was 10.8% last quarter. In  this maelstrom of change and volatility, it’s imperative that companies take a fresh look at their strategies, business models and portfolios. There are significant benefits for companies who can build a business that has the capital, market, operational and stakeholder resilience to can meet the challenges of this recovery and implement more effective planning and decision-making. Not least because companies can now expect a greater interest in how they perceive the future from activist stakeholders and regulators.

Accurate, scenario based forecasting is crucial. Let’s consider outsourcing as an example. The aftermath of the 2010, election created contract uncertainty and increased margin pressure to the sector, as the new Government reassessed existing contracts. We recorded 30 profit warnings citing election related delays or ‘austerity’ related issues in the year after May 2010 – 13 from FTSE Support Services companies. The chief concern in 2015 – for both the public and private sectors – is the potential for a drawn out process that stalls contracts and creates indecision in the wider economy. Now is the time to make sure plans are in place for alternative scenarios to avoid an unpleasant time 6 or 9 months down the road.

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