Earnings season is still ahead of us but profit warnings among UK companies are already starting to mount up, with Kingfisher, S4 Capital and Redrow just the latest to to issue them.
Judging by the extreme share price reactions, such warnings retain the power to shock and damage company valuations. But profit warnings are nothing new in the corporate landscape and are often misunderstood. Sometimes they reflect an underlying problem with a company, UK PLC, or economy – or they could be a more mundane re-evaluation of a company’s short-term prospects.
Coded Language
Let's start with the basics.
The words "profit warning" are rarely found on stock exchange announcements because companies don't want to deliver bad news to investors. When they do they tend to use euphemisms. This week’s example, advertising challenger S4 Capital, lost 22% of its value in one day after warning on profits and releasing loss-making figures for the half year.
"Following slower-than-expected trading over the summer months, including August and current client activity levels, full year expectations have been revised further," the company said (author's emphasis).
Effectively, at the halfway point in the financial year, S4 Capital said its revenues will be lower than anticipated, as will "operational EBITDA", a measure of profitability. Investors are being told here that revenue and profits will fall short of expectations. So this was a revenue warning. Media reports bundled this double bad news as "profit warning" – an easy-to-understand shortcut for investors.
Often sales and revenue fall in lockstep together, by the very nature of how companies make (or lose) money. Another recent example is housebuilder Redrow, which also "guided" for lower sales and profits for the full financial year.
EY Parthenon, which has been monitoring profit warnings since 1999, defines them thus: "a profit warning is an official statement to the stock exchange from a publicly-listed company that says that it will report full-year profits materially below management or market expectations."
Like Buses, But Why?
Not all profit warnings are equal. Just as bad news tends to be cumulative, so it appears do profit warnings: some companies are serial "warners" and are treated differently by the stock market. Fast fashion chain ASOS (ASC) is a familiar such company: the first of two last year, on June 16, pushed shares down 20%. There was another one in September that year and that followed warnings in 2021, and 2019. Morningstar analysts now think ASOS shares are significantly undervalued. They are currently priced at £3.92 but Morningstar's fair value estimate is £19.10.
Do profit warnings attract more profit warnings? It certainly seems to be the case. But an unexpected profit warning from a previously-star stock can also unsettle investors as much as a serial warner. Even Apple, which was the first firm to reach a valuation of $3 trillion (£2.4 trillion), warned on profits in 2019, a mere 17 years after a previous warning. It can happen to the best of companies too.
To get back to first principles, it might be worth asking why they occur?
Clearly there’s a mismatch here between what investors expect to happen and the guidance companies are giving. Part of this is down to the nature of quarterly and half-yearly reporting, a state of affairs demanded by investors and one that keeps public relations specialists and journalists busy four times a year.
Accounting is also inherently backward-looking, and a lot can change in between preparing and presenting results. Like all financial forecasts, earnings predictions are based on extrapolations and assumptions that can change dramatically. In recent years companies have blamed a "deteriorating macro environment", amid a global pandemic, industry slowdowns, and spikes in inflation.
There's plenty outside a company's control too. But there's also an element of "over promising" built into the reporting by listed companies: they want to present the best-case scenario to investors, which includes fund managers who decide whether to shares on your behalf! On the flipside, profit upgrades can be rewarded too: this year Rolls-Royce shares are up more than 128%. July saw a big leap higher when it upgraded its full-year forecasts.
As we've seen of late, half-year results can be a key moment for warnings. By then a company can roughly tell how the rest of the year is going to pan out, and what has changed since the predictions were last made.
Are Markets Efficient?
Trainee fund managers and analysts are taught the "efficient market hypothesis", which posits that all possible (publicly available) information is priced in to shares. You could argue profit warnings vindicate this idea, that the market is adjusting its expectations of the company via the mechanism of the shares. But for the company to be worth, say, a quarter less than it was worth yesterday because it will make less money seems a stretch.
Should companies stop making forecasts? That could be one solution to the profit warning carousel, and one that happened in the pandemic. Firms cited the uncertainty over the outlook, which made them unable to make forecasts for the full year.
For the contrarians among us, share price overreactions after profit warnings help short sellers. You'll see that this week when we publish our quarterly look at the most-shorted shares on the FTSE 100. Shorting companies that issue punishing profit warnings is meat and drink to the short seller.
And what of the bigger picture? According to EY, in the second quarter of 2023, profit warnings increased again on a year-on-year basis, the longest run of rises since the financial crisis. There are structural factors at work, from low economic growth to rising debt costs.
All that means investors will await the next earnings season with greater interest than ever.
