When a profit warning causes a company’s shares to tank, there is always the temptation to view the event as a buying opportunity. That’s especially true for investors already committed to the investment merits of a company, who will in general be more susceptible to view a disappointment as a short-term, one-off setback rather than a more entrenched long-term issue. Behavioural scientists have even coined a term for this “look-on-the-bright-side” trait: confirmation bias.
So when trouble strikes, many old hands turn to the adage “profit warnings come in threes” as a necessary sanity check; best to get out quick, or stay on the side-lines, and wait for the rest of the skeletons to emerge from the cupboard. Most experienced investors will be familiar with the scenario of one warning following another until ultimately a company’s top brass throws in the towel – or has it thrown in for them – and a new broom comes in to deliver one final “kitchen sink” warning (see box) before things finally get back on track.
However, the reality is that while warnings do indeed sometimes come in threes, or other multiples, they can also sometimes be one-offs, and can indeed even prove buying opportunities (see the Bovis chart below). That means it is important for investors to have some ideas about how to distinguish between a profit warning that may prove a stand-alone event and ones that bear the hallmarks of being part of a series.
Is three the magic number?
Defining exactly what constitutes a profit warning can be nuanced, which means there is a dearth of reliable data on this important subject. Fortunately, consultancy EY has done detailed work monitoring warnings since 1999 and has run an analysis for Investors Chronicle to see just how frequently companies that warned on profits in the 12 months to the end of March 2017 did so more than once. Of 207 companies issuing warnings in the period, 30 per cent had made at least one other warning within a year of the one(s) during the period. The full breakdown can be seen in the accompanying pie chart.
While the data does not tally with the strict notion that three is the magic number when it comes to profit warnings, it certainly highlights how risky it can be to view a share price fall caused by a profit warning as a buying opportunity. What’s more, while the market does have a habit of over-reacting to bad news, even when a warning is a one off, there’s no certainty the shares will rebound from any fall (see BT graph below). Furthermore, the less at risk the company in question looks of running into further trouble, the less severe any share price reaction is likely to be. Conversely, when it is highly likely more bad news is to follow, share prices can be obliterated in one fell swoop, as has recently been the case with builder and supports services group Carillion (CLLN:68.3p) which the market thinks needs a balance sheet fix that will seriously damage the interests of equity holders.
In many ways the need for companies to issue serial warnings is understandable. Companies may be forced to warn before they know the full extent of the trouble they face given management’s duty to tell shareholders when it expects financial performance to fall materially (10 per cent) short of expectations. For example, if demand in end markets falls away, the realisation that trading is bad enough to warrant a warning may come at a point when a trend is developing rather than concluding. Often at the time it will not be possible for anyone to forecast how much worse things will get should the situation continues to deteriorate. Likewise, when a company finds it has an issue with a long-term contract, it may take lengthy investigation to understand how bad things really are and whether problems are widespread or a one off. What’s more, while management need to be mindful of giving an honest assessment of a situation, in the interest of all involved, they also have to avoid being alarmist.
The real danger for shareholders is to be lured into a “value trap” on the back of the seeming opportunity created by a share price fall, only to later realise things have continued to worsen (see NCC graph below). EY has identified three type of situations that tend to result in serial profit warnings. We’ve illustrated each of these with a recent example of a company whose warnings fit the bill. We’re also highlighting a number of companies that have recently warned on profits where there are grounds to think there could be more to come. AH
Three classic types of serial warnings
EY has identified three common characteristics associated with warnings that could be signs of entrenched problems. We outline these below along with an example of a company that recently has experienced such problems.
Contract problems
These often link into a more fundamental issue than one bad contract, such as poor management information due to a lack of IT investment and poor internal controls. It makes it less likely projects will remain on track and more likely that management won’t become aware of a problem before it becomes material.
Outsourcer Capita’s (CPI: 664.5p) share price dropped sharply last year after it issued a slew of profit warnings. The trouble started innocuously enough when management revised down organic revenue growth predictions in the half year report in July 2016, from “at least 4 per cent” to “around 4 per cent”, citing uncertainty following the EU referendum decision.
However, this was only the beginning. Delayed client decisions and led the group to warn in September that organic growth would be just 1 per cent, and underlying profit forecast were cut from £614m to £535-555m. When this was cut again to “at least £515m” in December, management announced plans to sell a number of businesses it judged to have lower growth potential. In February this year, the group announced it would impair £50m of assets and write down £40m of accrued income (recorded but not collected) following a contract review.
The creeping issues were somewhat glossed over in years up to the first warning by the group’s tendency to book high levels of ostensibly non-underlying charges, which flatter underlying earnings (see graph). When contract problems are to blame for a profit warning, they can have a tendency to link to a deeper problem than just one contract given the same teams and processes are often involved in bidding for multiple jobs. In these cases revisions and smaller warnings can come out in small, worsening updates before the full extent becomes clear in a “kitchen sink” update. This looks consistent with what has happened in Capita’s case.
Since February, things have shown some signs of turning around, management announced the sale of the specialist recruitment business in June, then agreeing a sale of the asset services division a few weeks later for £888m, £65m higher than the consensus estimate. The slimmed down, focused business has now begun winning new contracts at an increased rate, securing £318m in the year to date and increased its win rate to one in two by value, compared with one in three previously. Management expects a pick-up in contract wins in the second half of the year, further boosting growth. TD
Less profit means less capital to invest to get back on the front foot. When NCC (NCC: 192.25p) first informed investors that business wasn’t going as well as previously hoped in October last year, the market could have perhaps foreseen the trouble that was to come. That first announcement – though not officially a profit warning – was succeeded by two forecast downgrades. The resulting share price collapse wiped £450m off the group’s market capitalisation in just six months.
Up until that first warning, NCC had been highly acquisitive. Its position in the fast-growing cyber security space made investors keen for a slice of the company and by December 2015 its strong share price momentum had seen it promoted to the FTSE 250. Capital raisings allowed the group to buy five new companies in 2014 and 2015 which led to rapid turnover growth and further demand for the shares.
But with the first signs of trouble, many investors jumped ship and NCC saw its share price plummet more than a third in one day. Two more official warnings later and it’s no real surprise that investors are less enthused by NCC, particularly given the sporadic way the bad news was released to investors and sudden departure of much of the senior management.
The shares may look cheap compared to this time nine months ago, but they are still not great value given the future prospects for the company and its reputation for mismanagement. NCC’s buy and build strategy seems to have hit a road-block due to the likelihood that appetite for further equity fund raisings, especially at the current price, would be limited. Without the access to capital it previously enjoyed, the group has found itself struggling to fend off competition in a very attractive market with significant research and development requirements. What has made the situation worse is that costs at cyber security division Assurance have risen faster than revenues. In recent full-year results the division reported a 35 per cent decline in operating profits to £9.2m even after accounting for positive foreign exchange movements. Plus, the major contracts lost at the end of 2016 have not yet been salvaged.
NCC epitomises the troubles that can befall a fast growing company which is forced to warn on profits. Its exit from the FTSE 250 stripped it of the access to capital it required to fund its previous acquisitive growth strategy, which has made it harder to rectify its problems. The new chief executive seems to have a plan, but in the increasingly competitive cyber security space, it seems as though it is going to be tough to revive past glories. MB
Macro or sector problem worsening quicker than expected and in stages
A host of negative factors contributed to steadily deteriorating trading last year at former sector darling Restaurant Group (RTN: 321.4p), which owns several restaurant chains including Frankie & Bennies and Garfunkels. Heavy expansion by rival “eating-out” businesses has meant increasing competition, while tepid wage growth in the UK is putting pressure on demand. Meanwhile, rising costs - from business rates, to minimum wage increases, and food price rises linked to sterling weakness – have added to pressures. As if this was not enough, changing consumer tastes and the growth in popularity of restaurants focused on fast-and-natural food with counter service seems to have caught Restaurant group on the back foot.
Restaurant Group has a number of characteristics that meant the trouble it has encountered has been particularly painful. A long-term track record of self-financed growth, strong cash generation and high returns meant the company’s shares were highly rated when trouble struck, leaving them with further to fall. After a key profit warning in April last year, the shares plummeted by more than a quarter.
Furthermore, the fact that the company operates a predominantly leasehold estate means it is locked in to ongoing fixed rent payments at many of its sites which works to exacerbate the impact of poor trading on profits. The way like-for-like sales are calculated also means restaurants that have yet to reach a mature state are included in the figures, especially when chains are expanding fast. When trading difficulties mean expansion has to slow, this can compound the impact on reported like-for-like sales.
Indeed, after like-for-like sales went negative during the financial year to January 2016, the group reported at the time of its full-year results in March that it had experienced a 1.5 per cent like-for-like drop in the first 10 weeks of its new financial year. Just over a month later, in April, trading had deteriorated so quickly the company had to issue a warning that like-for-like sales declines had reached -2.7 per cent over 17 weeks. The final quarter of the financial year saw a -5.9 per cent collapse in like-for-like sales. The declines moderated to -1.8 per cent in the 20 weeks to 21 May this year.
The problems at Restaurant group led to the departure of chief financial officer Stephen Critoph after 11 years at the company, and his replacement by Barry Nightengale, who previously held the same role at Monarch and oversaw the airline’s turnaround. But after 10 months on the job Mr Nightengale stepped down from the position in April, raising speculation that Restaurant Group was in worse shape than previously thought. A representative for the company said at the time that Mr Nightengale’s specialty was turnarounds and that phase is now behind the company, though this did not stop shares from falling 9 per cent on the day of the announcement.
The management team at Restaurant Group looks quite different since chief executive Andy McCue joined Restaurant Group in September last year. Senior hires from Costa, JD Wetherspoon (JDW) and Paddy Power Betfair (PPB) are tasked with restoring the reputation and profitability of the group. They have scrapped the previous management team’s strategy of rapid expansion and price increases, which saw pre-tax profits fall to £77.1m last year from £86.8m in 2015. Budget-friendly promotions and family-friendly menu options are now meant to encourage customers back into its restaurants, and customer data will be the base on which future decisions are made. A cost cutting programme is also meant to save around £10m per year at a one-off cost of £6m, and has already seen 33 restaurants close with another eight scheduled to be shut.
At 309p, the shares are hovering near their five year low. The Bloomberg consensus 13 times forward earnings looks cheap considering the 5.6 per cent dividend yield. The new management team has us encouraged that a real recovery could be on its way. JF
