FTSE 350 Profitability: the direction is clear, but not the severity

Despite an avalanche of updates, it's still too early to gauge the full impact of the lockdown on corporate profitability

April 8, 2020

by Mark Robinson

Management priorities have shifted abruptly. The focus on marginal profitability has given way to liquidity and balance sheet strength. A few short weeks ago, equities analysts were debating whether average forward earnings multiples were unrealistic given underlying corporate profitability. That argument is now redundant.

We don’t know how long public policy will curtail normal commercial activity, but it seems unlikely that the government will ease restrictions until testing for the virus in the UK reaches a level that facilitates meaningful statistical analysis. The Health Secretary is guiding for 100,000 tests per day by the beginning of May, but government targets are usually given in hope rather than expectation.

If the lockdown – in its present form – stretches well beyond that date, the effect on the UK economy and corporate profits will be truly calamitous, a point borne out by the latest Purchasing Managers’ Index data covering the UK services sector – 34.5 at its latest reading.

Fitch Ratings expects that gross domestic product in the UK will fall by close to 4 per cent in 2020, assuming containment measures are unwound in the second half – beyond that it’s anyone’s guess. The Fitch analysis also points to “a sharp recovery in 2021”, although a cynic would argue that you might as well consult a clairvoyant as a ratings agency.

With so many variables at play, it is still too early to make an accurate assessment on the overall hit to UK profits. Around a fifth of the FTSE 350 constituents have issued definitive profit warnings, while a greater number have pulled guidance altogether. The initial wave of downgrades related to consumer-facing industries, but the breadth of the downturn has expanded as B2B supply chains begin to falter. It would be reasonable to assume that the current position probably falls well short of the proportion of negative outcomes through 2020. Suffice to say, markets are now getting hit everywhere.

While most of the FTSE 350 constituents have felt unable to provide definitive guidance, some companies have produced estimates based on historical trading patterns, which could shed light on a given sector.

Ergo Next (NXT), one of the first retailers to can its full-year dividend, a decision which, somewhat counter-intuitively, was well received by analysts and the market. On 19 March, the fashion group modelled three scenarios that forecast full-price sales losses of £445m, £820m and £1bn. The worst-case scenario, equivalent to a quarter of annual sales, has become more likely after it was forced to temporarily close its online, warehousing and distribution operations.

After a single percentage point fall in 2017, Next has been successfully rebuilding its gross margin, but it’s unlikely that the retailer will match last year’s 41 per cent rate through 2020 as sales volumes contract and the proportion of discounted sales increase. There would be little point in extrapolating from the scenarios outlined by Next for other sector constituents, but they do give some idea as to the scale of the reversal under way.

Other recent updates from the likes of BAE Systems (BAE), Saga (SAGA) and BP (BP.) also give clues as to the factors governing future profitability within their given sectors, such as the level of capital expenditure retrenchment, debt servicing, the ability to claw-back receivables and the level of dependence on discretionary spending. These types of vulnerabilities are always in evidence, but it’s hard to remember a time when the tide has gone out so quickly.

See below for our entire FTSE350 review:

FTSE350 profitability: the direction is clear but not the severity

FTSE350 Review: Coronavirus and the dividend dilemma

FTSE350 groups scramble for cash

Aerospace on the descent as defence stays on course