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People must often think that profits warnings are like buses: none for ages then one after another! There is a tendency not to recommend buying a company after it has warned, fearing more bad news. Is this true? If so, why? And is there any advantage to be had?

I’ve watched company profit warnings for many years. Doing this makes it easier to understand if the warning is a buying opportunity or maybe the first of many. I have found is that the saying that profit warnings come in threes is true. One profit warning and the company’s response to this can lead almost immediately into another. Why is this?

First warning

The first profit warning usually comes after reporting slower sales, normally indicated as a ‘market condition’. Sales slow down, costs rise suddenly or some external impact affects things and the company goes to the market to lower expectations. In response to the first warning, the company normally revisits some core aspects of its business such as terms and conditions with suppliers, operating margins or operating efficiency. These I would classify as outward costs, that is, assume the problem can be resolved externally by pushing out costs without need for internal reform.

Second warning

Warning two is where internal issues have been addressed. Often, after initial measures have failed, management reconvenes and makes some hard decisions. Usually the first is to cut costs and address underperformance. Weak links are cut and underperforming management is sent to the blocks.

At this point you reach the stage where the ‘proper’ warning comes out. We are beyond the ‘things are not great’ stage into the ‘lets take immediate action to rectify this reversal in our business’ stage. This usually involves a restructure of some sort, often write-offs and more often than not a ‘proper’ lowering of expectations with investors.

Third warning

If the business is in serious trouble the final stage approaches. This is when even the restructure fails. Often a very senior person has to depart, new management takes over and gets the chance to bring out the brush and sweep away the old regime. Quite likely is the writing off of inventory or fixed assets, which allows earnings to step up a gear in later reporting periods.

Signs

Spotting this sequence in a company that has warned already is straightforward. How about picking up on a company that is likely to warn? Your focus should be to spot weakness in the financial statements. Often ‘creative’ accounting can precede a warning. You can use these methods to look for possible candidates. Creative accounting tends to occur because of pressure to meet targets.

The typical case begins with a strong record of success. The company has posted good sales and earnings growth over recent years. Its stock price trades at a high PE multiple as the market expects things to continue.

Unfortunately, behind the scenes, it is becoming more difficult for the company to maintain the growth that the market has grown to expect.

Stage one – Sales are behind target, so management runs incentives for its sales force to accelerate sales and uses overtime to ship out its products. It works and the company meets expectations.

Stage two – Thanks to the previous performance, expectations are raised for the next period. However, sales still have not picked up to the level required. The company provides additional incentives to its sales force, uses overtime to boost shipments but now has additional expenses to contend with. Because of these actions it decides to alter its treatment of expenses.

Stage three – The following reporting period comes around and sales still haven’t recovered, but the analysts keeps raising the bar. This time the operating tactics are not enough, so management pressures the chief financial officer to make the numbers. The chief financial officer is aggressive in the interpretation of sales and expense accruals, and the company meets expectations again.

Stage four – Expectations keep rising, as does the firm’s stock price. As the next reporting period comes, sales still are not at expectations. The chief financial officer overstates sales and under-accrues expenses to meet expectations. The company has gone from aggressive operating practices to outright fraud.

If there isn’t a turnaround in the business soon a profit warning will be inevitable. At this point, often ahead of the warning, resignations may start to appear and share sales occur as people look to exit this unhappy scenario.

This sort of corporate malevolence always gets bad press and destroys shareholder value; but it often has innocuous beginnings. That said, very few companies suddenly start to struggle it’s a slow process that builds over time. By understanding how warnings occur and by keeping your eyes open and ears to the ground you should be in a better position to avoid any potential traffic jam of warnings.