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What to do about profit warnings

Selling after the first profit warning is often the right thing to do but sometimes opportunities are created by them
What to do about profit warnings

It’s the moment that all shareholders dread. They turn on their computers in the morning to find out that one of the companies they own shares in has said that its profits will be less than people had been expecting – a profit warning. Profit warnings are painful experiences but can they be avoided and what should an investor do when they happen?

Why profit warnings are so painful

Share prices are based on people’s expectations of a company’s future profits. These expectations are reflected in professional analysts’ forecasts for measures such as pre-tax profit, earnings per share (EPS) and free cash flows. In theory, the value of a company and its share price is the sum of all its future profits discounted to a present value in today’s money.

In reality, short-term share prices are driven by what profits are likely to be in the next year or two. Beyond that, profits get more difficult to estimate for most businesses. This means that investors spend a lot of time focusing on near-term profits. 

When a company realises that its profits will fall short of analysts’ or its own previously stated forecasts it has to inform the stock exchange as soon as possible. This is known as a profit warning.

Profit warnings represent one of the major risks involved in owning a share. If you own shares in a company that issues a profit warning then don’t be surprised to see the value of your shareholding plummet on the day it is announced. Forecasts will be revised downwards as will the estimate of the amount of future profits a company can make.

It goes without saying that every investor wants to avoid a profit warning. Avoiding losses is one of the keys to successful long-term returns from a share portfolio. A share that halves in price has to then double in price to get back to where you were. The trouble is, it doesn’t usually turn out this way and the losses often continue.

The fear of a profit warning may also explain why people are currently prepared to pay high valuations for companies that have a track record of stable and growing profits. This in turn is increasing their risk of disappointment if those expectations cannot be met.

But there are signs that an investor can look out for to ward off danger before it strikes. Very few shares are bulletproof, and even very good businesses can come a cropper every once in a while.


Profit warnings on the rise in 2019

Ernst & Young does some really interesting and useful work on the profit warnings issued by UK companies. It has compiled its own profit warning stress index which measures the percentage of companies issuing profit warnings in the prior 12 months against previous quarters. A stress index value of 100 can be a sign of big problems. At the end of the second quarter of 2019, it stood at 91 – the highest for second-quarter profit warnings since 2008.

Source: Ernst & Young

This does not necessarily mean that the UK economy is heading for a recession or the stock market is about to crash. The stress index was high in 2015 and 2016 without either happening but the current trend is something that should not be ignored in my view.

During the second quarter of 2019, 69 companies warned on profits with the median share price fall of 20.9 per cent on the day of the warning recorded – the second biggest since the start of 2007 and more marked with smaller companies. Of the companies warning, 52 per cent had also warned during the past 12 months, adding weight to the conventional wisdom that profit warnings are rarely a one-off event.

By far the biggest cause of profit warnings was a shortfall in sales or a delayed or discontinued contract, which accounted for more than two thirds of all warnings. Given that most businesses have quite high levels of operational gearing in the short term, a sales shortfall can have devastating effects on profits. (See my column in last week’s magazine to read more about the importance of understanding operational gearing).


Identifying sources of profit warning risk

So how do you go about staying clear of companies that might issue profit warnings? The go-to method in recent years has been to invest in the shares of highly profitable companies with a track record of predictable profits and cash flows and resilience in good times and bad. These are known as bond proxy stocks because their profits are deemed to be bond-like in their predictability.

The problem with this approach is that investors are being asked to pay seemingly ever higher prices for perceived safety and even then it’s not guaranteed to protect them. This week’s profit warning from AG Barr (BAG) is a case in point. Soft drinks businesses are seen as pretty dependable but a misjudged pricing policy on its products has seen weak sales and full year profits are expected to fall by up to 20 per cent. Before the announcement, AG Barr shares were valued at over 26 times forecast earnings. Paying up for safety has not worked here.


The veiled profit warning

Companies often issue what are known as veiled profit warnings. This is where they try and hedge their bets and explain that profits are a bit sluggish at the moment but they might get better as the year progresses. This is often wishful thinking as a full blown profit warning often follows shortly afterwards.

You should pay attention to certain words or phrases in a company’s trading update. This is one issued by Restaurant Group (RTN) in early 2016 after a strong trading performance in 2015:

“It has become apparent from much of the recent data from the retail sector and the wider economy that the trading environment for many consumer facing businesses has been tougher in recent months than it was earlier in 2015. This has caused like-for-like sales growth to trend lower and accordingly we are more cautious than previously on the outlook for 2016. A possible referendum on the UK's continued membership of the European Union, National Living Wage implementation and global uncertainty are all additional issues that we are conscious of going into the new year.”

The share price fell on the back of this statement and then collapsed later on in the year when it issued a full blown profit warning.

Other well known phrases that should be treated with caution are things such as “profits will be second half weighted”, which can be interpreted as meaning things are not going as well as expected but hopefully everything will be okay in the end.

Deteriorating like-for-like sales trends

One way of spotting trouble ahead is to examine trends in like-for-like sales and look for signs of a slowdown. The information to do this is usually readily available with retailers and consumer goods companies.

Quite often a company will give you like for like sales for different periods of time for its financial year. What it might not tell you is the trend between two different dates. Returning to Restaurant Group in 2016, an examination of its sales trends told you that trading was getting much worse.

Like-for-like sales for the first 10 weeks of its financial year were down by 1.5 per cent and then after 17 weeks were down by 2.9 per cent. This is clearly a worsening trend which isn’t good but it didn’t tell the whole story – the like-for-like sales between week 10 and week 17.

You can work out for yourself how quickly sales have deteriorated with a clever little bit of maths. You can do this for any company that regularly discloses like-for-like sales information. We know that like-for-like sales were down by 1.5% after 10 weeks.

  • Multiply -1.5 by 10 to get -15.

After 17 weeks like-for-like sales were down by 2.7%.

  • Multiply -2.7 by 17 to get -45.9

To work out the like-for-like sales trend in the past seven weeks:

  • Take away the 10-week figure of -15 from the 17 weeks figure of -45.9 to get a figure of -30.9 and divide by 7, which gives a like-for-like sales decline of 4.4% for the past seven weeks.

At the time you should have asked if this figure gets even worse and leads to an even bigger downgrade in analysts’ forecasts? It often does and in Restaurant Group’s case it did.


Rising stock levels

Rising stocks as a percentage of revenues can be a sign of weakening demand for a company’s products. To turn these stocks into cash, a company might have to slash selling prices and accept much lower profits (or even losses). Hindsight is a wonderful thing, but Ted Baker’s (TED) stock levels have been rising for years which means that a significant profit warning has been a big risk for some time.


Peak profits on cyclical companies

Some companies such as manufacturers or housebuilders have profit cycles that tend to move in line with the general economy. Profit margins tend to peak near the top of a cycle. Predicting when the cycle will turn is never easy but looking at trends in profit margins can give you an indication if a company is nearer the top or the bottom.

With cyclical companies, it’s also worth asking if the company you are looking at has done anything to make itself more resilient since that last downturn. If it hasn’t then the trend in margins might be a useful guide.

At the moment, I think it’s quite reasonable to ask whether housebuilders’ margins have peaked as they are higher than the last cycle peak.


Beware of expensively valued companies

Highly valued companies contain significant risks for companies. This is because high valuations imply high expectations of future profits growth. If the company comes out and says it cannot meet those expectations the share price can come crashing down.

Recent examples of this are Craneware, (CRW) a highly rated software company which was trading on a forecast rolling PE ratio of 55 times at the start of this month. It then issued a profit warning which caused its shares to fall by more than 35 per cent on the day it was announced. It is still on a very demanding rating of 37 times at the time of writing.


AG Barr’s profit warning came from the base of a high forecast PE ratio of 26 times. Its shares fell by 28 per cent on the day of the warning. Both companies have seen price falls much higher than the 20.9 per cent cited in the Ernst & Young Q2 report highlighting the risks of owning highly valued stocks that issue profit warnings.


Highly indebted companies

Companies with lots of debt are known as highly geared. The interest on the debt has to be paid before shareholders can be paid. A fall in trading profits magnifies (gears) the fall in profits to shareholders as more of it is eaten up by interest payments.

This is why large amounts of debt is only really suitable for companies with very stable revenues and profits such as utility companies. A shortfall in sales has the potential to decimate profits.


What to do when a profit warning strikes

Do you sell or buy? This is usually the first question an investor asks when they find themselves having to cope with a profit warning. The answer is that it depends.

A profit warning that arises due to a weakness in trading conditions or a rise in competition is unlikely to resolve itself quickly and often leads to a second or a third warning further down the road. It can also be a sign that a company’s business model is broken and therefore selling on the first warning can be the right thing to do. Fashion retailer Superdry (SDRY) feels like a classic case of this.

Hanging on and waiting for a share price to recover can be extremely painful, especially when the foregone alternatives are taken into account. Long-term holders of Tesco (TSCO) who were on the end of a series of profit warnings in 2013 and 2014 are yet to recover their losses despite a significant improvement in its recent business performance.


Can profit warnings present buying opportunities for investors?

There’s an old saying that you shouldn’t try to catch a falling knife. But when you get a company that has issued a series of profit warnings, its shares can become so unpopular and so lowly valued that they become attractive to a corporate buyer or have formed a base to create big gains when profits do recover.

What should you be looking out for in a potential takeover candidate that has been going through a rough patch? Here are a few things you might want to consider:

  • Is is a strategic asset? Can the business fit in nicely to someone else’s and help it become better. In the case of Home Retail in 2016, Sainsbury’s clearly thought that Argos would help it compete better with the likes of Amazon and pounced after a series of profit warnings pushed down the share price.
  • Does it have strong finances? Companies with little or no debt can become targets for private equity companies which like to load companies up with debt, improve the profits for a few years and then sell the business. Argos had a debt free balance sheet but had a lot of hidden debt due to the fact that it rented its stores. High rent bills, high borrowings and large pension fund deficits can deter buyers.
  • Can the business recover? Some businesses just become weaker. The profit warnings show investors how that process plays out. But some businesses have just hit a rough patch and there is often potential for recovery. Some companies are inefficient and can be improved significantly leading to higher profits.
  • Are the shares cheap enough? Share prices can fall to very low and distressed valuations. If they can offer a high return to a buyer on current or recovered profits then they might just make a tempting takeover target or make lots of money for investors as profits recover. Housebuilders after the financial crisis are a great example of this. Many were priced as if they were going out of business and were valued at a big discount to their asset values, but turned into multibaggers as they stopped the rot and profits recovered even before Help to Buy was introduced in 2013.

This week’s profit warning from AG Barr is an interesting case. Is its profit warning a one-off? I find its comments about its pricing strategy and the effect it has had on sales quite concerning, whilst the problems associated with its Rockstar energy drinks and Rubicon juice drinks look as if they will take some time to fix. In short, this is a company that still looks to have some profit warning risk in it.

AG Barr is a good business that has proven to be very reliable, but its reputation has taken a big hit here. A 20 per cent downgrade to 2019 profit forecasts would still leave the shares on a forecast PE of 25 times at 642p a share. This is virtually unchanged from the pre-warning multiple. Given the damage to Barr’s reputation for dependability, a lower valuation seems warranted and therefore the risks to shareholders still seem quite high.