Profit warnings and how to profit from them are firmly in the news. On the one hand, the list of UK companies issuing profit warnings seems to grow almost daily. On the other hand, the infamous Tesco profit warning of September 2014 - its fourth of that year and the fifth in a series that began two years earlier - is now the subject of formal judicial proceedings.
Three former senior Tesco executives find themselves in the dock at Southwark Crown Court in London accused of overstating group profits. In October 2014, Tesco followed up its warning by reporting a 92% fall in profits after writing off £263m.
At the time, this was put down to a simple outbreak of overenthusiasm. It transpired that Tesco managers had been over-optimistic in estimating how much the company would receive in rebates from suppliers.
Something more sinister
Only later did it become clear that something altogether more sinister had taken place. Awareness grew that Tesco, its management, its shareholders and its customers were facing a scandal involving aggressive accounting.
In the wake of the profit warning the share price fell to as low as 165.95 pence in December that year compared to a five-year high of 385.00 pence in May 2013. pence in April of that year. It has recovered since then, albeit weakly.
It has been as high as 218.25 in November 2016 demonstrating that there is still money to be made by investors even in the wake of apparent disaster. After investment bank Jefferies recently raised the target price to 185 pence, the price finished September at 187.15.
Profit warnings the result of inappropriate behaviour
It is not so much profit warnings themselves that are the problem. Yes, the impact can be devastating, even fatal. But profit warnings are often just the logical result of underlying inappropriate behaviour that should not have been allowed to develop.
They then represent the start of a process of purging that can quickly result in humiliating individual dismissals and much-need corporate restructuring and self re-assessment. A worst case scenario will end in takeover, administration or liquidation.
The Tesco case is far from unique as highlighted in a recent feature by Marcel van Rinsum of the Department of Accounting & Control at the Rotterdam School of Management.
It told how the pages of corporate history are littered with examples of aggressive accounting. It is immediately obvious in such cases that profit warnings are almost inevitable.
Aggressive accounting examples in recent decades include
- British & Commonwealth/Atlantic Computers
- Hewlett Packard/Autonomy
Profit warnings create opportunities for contrarian investors. As with much of matters relating to international finance and institutional investment, it all ultimately comes back to fundamentals.
Is the underlying business sound? What is good about it? Tesco has a large market share built up over decades. The UK's competition authority seems prepared to allow it to continue to grow. Is it genuinely commercially successful?
It is certainly struggling to cope with a lower inflation environment and the challenges posed by competitors. Discounters Aldi and Lidl are particular thorns in its corporate flesh.
More recent warnings have been issued by
- Spire Healthcare
Switching sectors completely, constructor and outsourced services provider Carillion is another member of the profit warning brigade. It issued a shock profit warning in July 2017.
Shares that had been worth 379.40 pence in February 2014 fell to 54 pence on the reporting of a first-half loss of £1.15bn. It then not unexpectedly reported a reduction in its full-year revenue outlook at the end of September, the share slipping further to 51.25.
Might Carillon be worth considering either on the upside or further downside? For what it's worth, the UK government has spoken out in its favour, emphasising the long-term nature of its own commercial relationship with the company.
Redirection efficacy in question
Courtesy of Carillion
Management are at least making the right noises about addressing the issues and restructuring the business. And while some question the efficacy redirection already being taken, Stephen Rawlinson, an analyst at Applied Value, sees a future for the company. Carillion did, after all, record sales of £4.395bn in the year to 31 December 2016.
It could go either way. If the restructuring works and the company stays in business, the shares could recover. If it doesn't and other problems begin to surface, it might be on the road to eventual ruin.
Different investors will take their different views on upside and downside. They will buy or sell accordingly, either via institutional and personal direct investment, institutional short selling or the striking of agreements on contracts for differences.
Back to fundamentals
It all comes back to fundamentals, which demonstrate that some profit warnings can be easier to forecast and anticipate than others. London-based insurer Beazley, for example, announced a profit warning on 29 September 2017.
It said that earnings would be US$150m lower as a result of claims following recent natural disasters. It has calculated that the average net cost of Hurricanes Harvey, Irma and Maria, and Mexico's earthquakes, will be $175m-$275m.
It would not have required a degree in rocket science for the intelligent investor to have come to the conclusion that major disasters will have an impact on insurance and reinsurance companies.
A good simple discipline when there is news of a natural disaster is to ask oneself who will benefit and who will lose. Insurers will clearly face large claims. They might not, however, be as large as first thought.
RMS, which lays claim to be the world's leading catastrophe risk modelling company, suggests that total insured losses from Harvey and Irma alone cost the industry in the region of $60bn-$90bn.
Maria could cost a further $15bn-$30bn and the Mexico earthquakes a mere $1.2bn maximum. The cost could have been much, much more, RMS suggests. Significant amounts of property damaged were not insured limiting costs to the industry. Even in a catastrophe, the insurance industry seems more than capable of coming out ahead.
An ill wind that blows nobody any good
It is an ill wind that blows nobody any good, as we noted in September. Businesses such as Ashtead, an international equipment rental company with national networks in the US and the UK and a small presence in Canada, will benefit.