A bad year for profit warnings

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Why Did Marconi Turn Red?

Like buses they have an unnerving habit of coming in threes. They can strike fear into the heart of even the steeliest investor and can send stock markets round the world reeling.

Profits warnings by their nature spell bad news, but it has been a particularly bad year both in terms of the number of announcements and their impact on shares.

Marconi's shares took a battering last week after the telecoms equipment maker issued one of the most hard-hitting profit warnings in recent years. It slashed over 50 per cent off the value of its shares in the first 20 minutes of trading on Thursday.

The handling of the announcement particularly incensed the City. Analysts were fuming after being left in the dark while shares were suspended for an entire day.

It is an extreme example, but Marconi is only the latest in a long line. After earlier assurances from its chief executive, last week also saw one-time market darling Regus issue a warning, wiping out half of its value. Motorola, Ericsson and Nokia have all bitten the bullet in the last year. In June, Merrill Lynch issued only its second profit warning. Cap Gemini Ernst & Young shares tumbled 20 per cent in one day last month after it announced a profits warning, and earlier this month IT recruitment specialist Glotel announced its third profits warning in less than six months.

Given the current downturn in the US economy analysts are bracing themselves for a long summer of embarrassed chief executives in confessional conference calls with investors. The warnings often cost the bosses their job – it is assumed in the City that the new pay deal for Alan Yurko, the combative boss of Invensys, is to soften the pain of his likely exit.

But is there really any way of sweetening the pill? The overall question is one of "managing expectations". Typically, companies only have to issue profit warnings if forecasts drop by 10 per cent or more in a short period of time. Profit warnings are popular after large acquisitions, and more cynical observers suggest they can help a company smooth the path for years to come.

If a company can foresee problems ahead a couple of choice words to an analyst and you may be able to get away with revision estimates rather than an out-and- out warning. In the past this sometimes led to accusations of "cosy" relationships between companies and City institutions, to the detriment of retail investors. More recently, there have been moves to wider disclosure. In the US there is now what the City refers to as the Securities and Exchange Commission's "Reg FD" rule that states that there must be full and fair disclosure to everyone rather than to a small group of people. But some analysts say that announcing bad figures to everyone in one go contributes to the likelihood of sharp, one-day drops.

When it comes to biting the bullet it helps for companies to find a form of words or particular factor on which to blame their woes.

Phrases such as "tough market conditions" and "unforeseen circumstances" are old favourites. Food and leisure companies have had a veritable feast of options including the impact of foot and mouth and BSE. There are even rarer factors. One analyst cited a food firm that blamed its poor figures on "light levels affecting tomato growth".

The established pattern is for warnings to come in threes. The first warning is usually enough to send share prices tumbling. A second and you can expect to see job cuts and site closures to appease the City. A third straight warning and it's typically time to part with senior personnel. The potential upside here is the opportunity to blame the previous management – "sell on the first buy on the third" is the oft-quoted mantra. "You need to do three before you get out of jail. That's the classic model. Companies need to do their 40 days and 40 nights in the desert," said one analyst who declined to be named.

Unsurprisingly, the "three warnings rule" is one that companies have cottoned on to. Anecdotal evidence suggests some have sought to bring in warnings earlier, getting three out of the way in the hope of an upside. One word of warning: "In the current market no one buys in hope on number three," said one unnamed analyst.