Profits warnings and how to predict them

When I began writing this article, I had in mind ugly profit warnings from Pearson, Next and Bovis Homes. There have been lots more over the past few months, of course, which provide relevant case studies for investors interested in avoiding vulnerable companies.

But, as pen hit paper, BT Group topped them all with a corker of a warning, which perhaps should not have surprised the City at all.

Back in October, BT told shareholders about problems at the Italian operation. The UK company talked about "inappropriate management behaviour" which would cost the company £145 million. Little was made of it at the time. Perhaps it should have generated more concern.

Now, we hear that accountants and BT chiefs got it horribly wrong. Those in charge of the company now warn it will cost around £530 million, news which sent BT shares racing to their lowest since summer 2013. Add that to its problematic pension scheme and surging cost of rights to major sporting events, and one can understand why big buyers are leaving BT shares alone.

Frankie & Benny's owner Restaurant Group warned again this week. Its problems have been well-flagged for over a year and a warning at the end of 2015 that it was "more cautious than previously on the outlook for 2016", proved a big red flag for shareholders.

Chiefs were right to be cautious, and further warnings wiped out well over half the company's value in less than four months. Even after the latest update, experts are wary. "Too early to buy," says Panmure Gordon analyst Mark Irvine-Fortescue ahead of full-year results in March.

Predictable weakness

Braemar Shipping's core shipbroking business may be doing well, but its technical division isn't. Again, we've known about this for ages - the unit did a lot of work for the struggling oil and gas industry - so share price weakness was predictable, although a crash to levels last seen during the financial crisis looks grim.

High street bellwether Next set the tone for 2017, waiting just 24 hours into the new year to warn that profits will fall, and keep falling. It's part of a cyclical slow-down in spending on clothing and footwear. The weak pound will also force Next, already under threat from rising inflation and anticipated consumer squeeze, to raise prices by 5%.

Pearson lacks diversification now that it's offloaded the FT and a stake in The Economist, which is an issue if you don't understand your core market.

Net revenue at its North American higher education courseware business plunged by 30% in the fourth quarter, an "unprecedented" decline, said Pearson. Clearly, it didn't predict a switch in behaviour to renting textbooks, or a drop in enrolment as Americans shunned higher education to take jobs in an improving economy. Overstocking was costly. Is selling Penguin books really the way to go?

Some profit warnings are pretty obvious to predict - there are serial offenders. But many are not

Elsewhere, serial warner Mitie is at it again, rising costs and fewer supermarket multi-buy promotions whacked recent bid target Premier Foods, while unfavourable bets dumped jilted bride William Hill.

Essentra has also just issued a third warning in under a year. Owners of shares in the cigarette filters maker will groan when reminded of comments made last summer that "the company remains fundamentally strong". The shares are down over a third since.

Don't worry, I haven't forgotten Bovis Homes, Cobham, Foxtons and smaller players like Spaceandpeople and Flowtech Fluidpower.

There will be more, and talks with market makers confirm that prices tend to get market down by around 20% on a profit warning. Then they'll "see where the buyers come in." But how can investors spot a warning before it happens?

Some profit warnings are pretty obvious to predict - there are serial offenders - or at least fear. But many are not.

Accountants EY point says watch out for big macroeconomic shifts, like Brexit, or a spiral of falling profit and capital. Fixing problem contracts is a major issue, too, with significant risk for management teams unable to do so.

Red Flags

Companies don't like telling shareholders, let alone the wider public, that things are going badly. Call it pride, but it can be greed, too. Highly-paid directors with huge egos do not have failure in their DNA. And mismanagement doesn't just ruin reputations, it hits directors in the pocket, too, with fancy bonus packages invariably linked to share price performance.

Admitting your business is in trouble has repercussions. Suppliers might decide to demand cash up front, putting pressure on cash flows, and if customers get a whiff that something's up, your bargaining power is compromised.

But when a listed company expects profits to miss City forecasts, directors are bound by stock exchange rules to issue a profits warning. Sometimes they don't, like Marconi during the dotcom boom, which is when shareholders have a real problem. Director selling after any update should definitely set alarm bells ringing.

That's why a quality management team is crucial to protecting your capital. You can check out the directors on the company website, often with a lovely photograph attached. They'll tell you a lot about the individuals, and where they've come from and their track record. You can quickly spot a weak team.

It's important the company is generating plenty of cash. If it isn't and it breaches strict covenants, the banks will eventually take over

Most company websites also have videos, and you can attend the annual general meeting, too. Make sure you turn up with plenty of questions for top brass.

If you're happy with who's running the business, find out if the company has a track record of disappointing the market.

And, what's the competition like? We highlighted the supermarket sector a few years ago, suggesting "trouble could be lurking." It was.

And that's one of the big giveaways. Look either at the peer group, or other companies that are exposed to similar earnings drivers. If one has warned that profits are struggling, it's likely others are in the same boat. That's why it's important to check out any change in the rhetoric.

Changes in management can also be a giveaway. Sure, it could be for a number of reasons, but a sudden departure is rarely good news.

Watch out if it's the chief executive. The new man won't want to take the blame for the previous guy's mistakes, so there's a tendency here to "kitchen sink it." That means getting all the bad news that's been brewing out of the way in one big warning. They all do it.

Of course, while the numbers might not tell the whole story, there are things to look for. Is the company growing sales? If they are, at least it means people like the product. If margins are decent, it will make good money, too.

And don't forget to see if the company is stretching itself by over-borrowing. Check that the net debt figure doesn't make you wince - net gearing near 100% or higher can be a bad sign. Interest payments can quickly get out of hand, especially when interest rates rise and bank facilities come up for renewal. That's why it's important that the company is generating plenty of cash. If it isn't and it breaches strict covenants, the banks will eventually take over.

What are the chances?

Research shows that about three-quarters of companies that announce a profits warning will issue a second. Another, often more severe, slump in the share price is inevitable after an initial indication to the market that all is not well. There can be more, of course, and fixing a business can take years. There's also significant execution risk, and some companies are just beyond saving.

An old saying in the City has it that the "first cut is the cheapest". All too often it is.

Here's a tip from Warren Buffett: "If you get in a lousy business, get out of it".

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.