Curse of the profit warning

For a quoted company, a profit warning out of the blue can do its share price profound damage, especially since a first profit warning is often followed by a second downgrade.

In the latter part of August, the shares of two well-known quoted UK companies plunged on the back of major profit warnings. Shares in sub-prime lender Provident Financial took a real bath. falling no less than 66 per cent on August 22nd, the day that it reported its expectation of heavy losses, the passing of the dividend and the immediate exit of its embattled chief executive.

A few days later, Dixons Carphone’s share price plunged by around a third after it announced a material shortfall in its profit expectations as the UK’s leading electronic retailer faced challenges on several fronts.

With very few exceptions, UK utilities, aside from BT Group and its troublesome Global Services subsidiary, have seldom faced the highly negative impact of a shock profit warning – unless much tighter price regulation has been foreshadowed.

As such, any downward share price movement within the utilities sector tends to be gradual rather than being precipitous as in the case of Provident Financial. To that extent, when sector sentiment turns negative, utility prices drift down. This characteristic has been noticeable in recent times with Centrica, which faces a raft of challenges.

Since the utility privatisations in the decade spanning the mid-1980s and mid-1990s, much of the downward share price movement has been driven by regulatory intervention. The infamous U-turn of its highly generous distribution review by Offer (the then-electricity regulator) on March 7, 1995, saw the shares of the 12 regional electric companies fall by c20 per cent within seconds of the market opening – with billions of  pounds of shareholder value lost.

Subsequently, the culmination of British Gas’s seemingly eternal battle with Ofgas (the gas regulator) over the regulation of Transco saw a massive hit to its “p-nought” (the base price used in the regulatory formula setting its prices). British Gas’s shares plunged immediately after the publication of Ofgas’s highly controversial proposals. 

Within the water sector, apart from the unexpected 1992 general election result, share price movements have been less volatile. Of course, this could change later this year when Ofwat fleshes out its financial proposals for the 2019/20 periodic review. A much tighter real weighted average cost of capital (Wacc) assumption would drive down share price ratings.

Of the currently quoted privatised utilities, BT Group is widely regarded as being the most vulnerable to profit warnings unrelated to price regulation – as the serious mishaps at its Italian operations recently demonstrated.

In the water sector, Pennon is more exposed by dint of its energy-to-waste operations, where treated volumes and selling prices can change quite sharply.

Drax Group is also more exposed than most energy market businesses because its volumes, selling prices and margins fluctuate quite markedly. In recent years, Drax’s share price has also been driven by legal rulings on its various plant re-fuelling applications.

Outside the major players, the energy supply minnow Flow Group has also seen its share price collapse – from 25p in April 2016 to less than 1p currently – as its boiler-led supply strategy has been found seriously wanting. 

Nonetheless, the most volatile privatised utility was the former British Energy, whose main nuclear assets now rest with EDF.

Prior to its spectacular share price collapse in 2002, British Energy’s share price moved rather like that of a dotcom stock – it was driven by short-term wholesale price movements. The company’s volatility
was totally different from any traditional utility stock.

For fund managers, severe profit warnings, especially if they are totally unexpected, can cause significant damage to a fund’s annual performance: a wipe-out investment is the worst-case scenario.

Consequently, fund managers remain very wary of profit warnings, often expecting a second one to follow within a matter of months. After all, in assessing regulatory reviews, such as the forthcoming 2019/20 water periodic review, they can make worst-case assumptions – and adjust their investment perspective accordingly, especially if the future dividend flow looks likely to be materially reduced.

Of course, for short-sellers, profit warnings are generally good news. Several hedge funds undoubtedly made good money through shorting shares in Provident Financial as details of its many problems were confirmed to the market. 

For years, utility stocks were generally regarded as defensive investments, although the woeful performance of most electricity stocks after the 2008 credit crisis disproved that long-held theory.

Nonetheless, utility stocks will still have lower beta ratings – which reflect overall risk – than many racier, if well-regarded, stocks on the market. This partly reflects the former’s lack of exposure to trade-related profit warnings.

It seems certain that other very material – and high-profile – profit warnings will follow those of Provident Financial and Dixons Carphone. But with the exceptions of BT Group and possibly Centrica, they are unlikely to be in the utilities sector.

Nigel Hawkins, director, Nigel Hawkins Associates