How to predict a profits warning

Get it right and stock-picking can be a rewarding pastime, both financially and intellectually. When things go wrong, however, it becomes less fun and demands that investor make uncomfortable and incredibly difficult decisions. And those awkward moments have become more frequent in recent months. My colleague and resident stockpicker Edmond Jackson points out this week that US earning season has passed without major incident, but UK companies continue to fire out profit warnings at a rate of knots. Here's how to spot the dogs and avoid costly losses.

Wave of warnings

Demand might be improving for UK Plc, but businesses faced a trio of headwinds during the first half of 2014. Competition is fiercer than ever, margins are under pressure, and the strong pound is wiping out profits when overseas earnings are switched back into sterling. There were 63 profit warnings here in the second quarter, according to accountants EY, formerly Ernest & Young. That's the highest total for those three months in three years.

And those 63 - among them heavyweights like Standard Chartered, Serco and Drax have seen their share prices hammered harder than at any time since 2012. The median share price fall on the day of the warning leapt to over 12% last quarter compared with a more modest 9% in the previous three months. The average jumped to 16% - a two-year high. A City market maker once told me that they would mark the shares down by 20% on a profit warning and "see where the buyers come in."

Among the hardest hit have been the food producers. The household goods sector issued the most warnings in four years during the first quarter, says EY, amid an ongoing price war among the supermarkets. Both Morrisons and Tesco have already issued embarrassing warnings and on Friday, former golden-boy Waitrose admitted price cuts and heavy investment would damage its numbers.

All exporters will have suffered some currency impact, and while conditions have certainly improved, competition is intense and margins are tight. "The support services sector has proved vulnerable to lapses in accounting and operational controls in the past," says EY.

Interactive Investor's own research has revealed 16 profit warnings so far in the third quarter. With the conflict in Ukraine and tougher sanctions imposed on Russia, it could get worse - sportswear giant Adidas has already admitted it expects to sell fewer tracksuits and trainers there in the months ahead. Annual profits could be as much as €300 million (£239.34 million) lower, and it will shut more stores there, too.

Marconi: Case study

One is reminded of Marconi, the engineering conglomerate turned telecoms behemoth responsible for one of the most spectacular corporate collapses in British history. Fourteen years ago, at the height of the dotcom boom, the company was riding high and its shares changed hands for 1,250p each. Within a year, the £37 billion business had imploded and by 2003 was trading at less than 2p a share. By 2006, it had completely disappeared, swallowed up first by Ericsson then US private equity.

And there are clearly lessons to be learned here. An investigation into the disaster found that management had broken stockmarket rules. Only seven weeks before the shock profits warning, bosses told shareholders everything was fine. They clearly knew it wasn't but, perhaps in arrogance, thought they could put off the inevitable. By the time they owned up, the shares had already been suspended pending an announcement.

It all began when George Simpson took over from Lord Weinstock in 1996. Simpson decided to sell the family silver and spend over £4 billion of cash on fast-growing American telecoms businesses. But in 2000 the internet boom turned to bust, and with its cash resources drained, the company had little cushion. A paper in Business Strategy Review also points to Simpson's disastrous decision to "put all his eggs in one basket." But it was untested and a new basket. "More often than not major changes in strategy take a company into new areas that it does not really understand and the results end up being disastrous - as the shareholders of Vivendi and Enron will confirm."

Warning signs

Let's be clear, companies don’t like telling shareholders, let alone the wider pubic that things are going badly. There are a number of reasons, not least pride, and in many cases greed. Many successful and highly-paid directors have egos. Admitting failure is not in their DNA. But it doesn't just ruin reputations; it hits them in the pocket, too - these days, bonuses are invariably linked to share price performance.

Owning up to problems in the office can mean serious trouble for the businesses. Suppliers will demand cash up front, putting pressure on cash flows, and if customers get a whiff of something up, your bargaining power is compromised.

But when a listed company expects profits to miss City forecasts by over 10%, directors are bound by stock exchange rules to issue a profits warning. Sometimes they don't (see Marconi case study), which is when shareholders have a real problem. Director selling after a maiden profit warning should set alarm bells ringing.

"If you get in a lousy business, get out of it"Warren Buffett

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 charming 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.

While you're on the website, take a look at any videos - most sites have them. You can attend the annual general meeting, too. Make sure you turn up with plenty of questions for top brass.

Assuming you're happy with who's running the business. Find out if the company has a history of disappointing the market. That might mean persistent delays to contracts. Support services firms are certainly doing better than they were a few years ago, yes, but there's always the possibility of a hiatus in decision-making around election time. That might cause a slowdown in orders ahead of the 2015 General Election. We'll see. There'll also be companies that have developed a wonder product but which never quite manage to commercialise it.

What's the competition like? If it's a fiercely competitive industry - the UK supermarket sector is a good example - trouble could be lurking (see above).

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. Exporters, like manufacturers and consumer good businesses, heavily exposed to currency fluctuations spring to mind here. A strong pound is wiping out organic growth and reported profits are suffering - online fashion retailer ASOS, cosmetic ingredients firm Croda and drug giant GlaxoSmithKline have been affected.

And that's why it's important to check out any change in the rhetoric. Croda had flagged as long ago as October that currencies were becoming an issue. The share price fell 13%, but another heads-up in February and again in April had no effect on the shares. It wasn’t until June, when the company warned that the currency effect would be "greater than originally expected" that they fell sharply. That was because sales and margins in some areas of the business had weakened, too - a double-whammy.

There were also other tell-tale signs in this example that investors should watch out for. It was interesting to see that Croda told the market that finance director Sean Christie was leaving just six days before its June profits warning. A sudden departure like that is rarely good news.

It's worse 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. Ben van Beurden did it at Shell in January. Expect Unilever director Dave Lewis to do the same at Tesco who he joins in October. He may not wait until full-year results next April to do it.

And that brings us on to the financial numbers. 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. Remember Chemring? It sells military consumables like flares and pyrotechnics, and recently sold its ammunitions business. But demand tails off when peace breaks out, and the US withdrawal from Iraq and then Afghanistan blew a massive hole in Chemring's profits. A string of profits warnings followed and two chief executives lost their jobs.

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 as 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.

Will it happen to me?

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. Often there is a third, or fourth (think Balfour Beatty, Carpetright or Chemring), and the repair job can take years. Some companies never recover.

There's an old saying in the City that the first cut is the cheapest. All too often it is.