Profit warnings to play big part in the ‘new normal’
It has been a strange week for holders of stocks. Champagne corks popped on Wall Street as the Dow Jones burst through the 20,000 point mark for the first time, but closer to home shareholders were being treated to some unpleasant surprises.
Investors in the Irish-Swiss baked products group, Aryzta — which owns the Cuisine de France brand — received quite a jolt when a profit warning was issued through the stock exchange, causing the share price to tank by 36%.
Nor was this the first time. The group issued another such warning in October and has in fact issued several.
Over at British Telecom, or BT, last Tuesday, investors got more of a shock when the company issued a profit warning — its first in a decade — along with an admission that an accounting scandal at its Italian operation was much larger than first suspected.
The company’s shares promptly tumbled by 21%, wiping out all the gains amassed over the three-year reign of chief executive Gavin Patterson.
The company was also hit by a slowdown in its government business, over Brexit uncertainty.
Stock price meltdowns of such scale are unusual events, but profit warnings are not.
Strictly speaking, a “profit warning” is a warning declaration by a listed company to investors, through the stock exchange, that profit in the coming quarter will be down significantly on the same quarter a year ago.
In practice, such warnings are aimed at analysts who have been led by the company to believe that profits would be higher than they will now turn out to be (or that anticipated losses would be lower).
Accountancy body Ernst & Young (EY) has pointed out that in the year to the end of last March, 312 public companies warned analysts that their profits would be lower than anticipated, the highest number to do so since 2008. Fifty warnings were issued among Britain’s top 350 public companies over a six-month period.
Like zoo animals, profit warnings come in all shapes and size. In some cases, they amount to little more than good communications and the markets will react accordingly. They are particularly common in sectors such as aviation which are prone to big swings in fortune.
Ryanair has, on occasions, issued so-called downward guidance statements. In October 2013, for example, Ryanair signalled that full-year profits would be around €70m to €75m below analysts’ expectations adding that the revised guidance “remains heavily dependent on no further weakness.”
After the Brexit vote, the airline was quickly out of the traps warning analysts again. A similar warning was issued by the other airline most likely to be impacted by the prospect of British exclusion from the single European aviation market, Easyjet.
Elsewhere, a year ago, following a sharp decline in the price of oil, Royal Dutch Shell warned that its fourth quarter profits would be down 40%, yet the company’s share price rose on the day.
There are many serial offenders in the profit warning space. One half of the companies that sounded the alarm, last year, had done so before.
In other words, do not assume that the issue of a profit warning is the same thing as the successful cleaning of a dirty stable. In many cases, the unearthing of dark stuff should be taken as a signal that more of the same is lurking nearby in the undergrowth. On occasions, however, the brown stuff simply hits the fan with devastating effect.
Last week, a Swedish biometrics company, Fingerprint Cards, was forced to announce that its former chief executive had been arrested on suspicion of aggravated insider trading ahead of a profit warning following a house search carried out by the country’s Economic Crime Authority.
Last October, Apple’s Korean rival, Samsung, was quickly forced into a stock market announcement after some of its Galaxy Note 7 smart-phones started exploding. There was clearly no opportunity for management to release the bad news in stages.
Frequently, but by no means always, the CEO, or even more commonly, the CFO (chief financial officer) will walk the plank around the time the bad news is conveyed.
Inevitably, question marks hang over the futures of Aryzta boss, Owen Killian, and BT’s Gavin Patterson, who had to confirm that a write-down in the Italian business would be £530m and not £145m as previously signalled. In the case of the once-vaunted publishing plc Pearson the story of decline has so far been set out in five ‘warning’ chapters.
Marjorie Scardino, chief executive since 1997, was garlanded in plaudits when she stood down from the top job, five years ago. Her successor, John Fallon, has stumbled from crisis to crisis — a victim, in large part, of shifts in the world of publishing over which he has little or no control. Pearson has been forced to cut thousands of jobs while selling off its coveted stakes in the Financial Times and The Economist.
It took a huge bet on the higher education publishing business only to be hit by a big switch on the part of students from print textbooks to digital offerings, rented at much lower cost. The sheer pace of technological change added to events such as Brexit, which have shaken currency markets, means that profit warnings can expect to remain commonplace.
However, in many cases, such stock market announcements owe as much to shoddy corporate governance, managerial complacency and incompetence on the part of auditors. In other cases, as noted, good old-fashioned fraud lies at the heart of the unexpected deterioration in perceptions about a business.
In the case of BT, the auditors are in the eye of the storm following the revelations of huge losses in the Italian business, revelations which also arguably raise question marks about the wider Italian economy.
In an article in the Canadian Journal of Administrative Science, academics Claude Francoer and Isabelle Martinez have established that there is an inverse relationship between the frequency of profit warnings and governance mechanisms which align the interests of managers and directors with the long-term interests of shareholders.
US businessman Warren Buffett is singled out for praise as “one of the few CEOs who regularly warn shareholders and markets when overvalued conditions prevail.”
Mr Buffett is contrasted with those managers who “engage in a spiral of actions to maintain the illusion of growth.”
