This is part of an ongoing series of articles aimed at retail investors thinking of investing in shares. It explores the potential warning signs that investors should look out for before investing in shares of a company. This article focuses specifically on profit warnings: what they are and what one could mean for investors.
To illustrate the impact of profit warnings more clearly, I will use Ted Baker Plc, the fashion retailer (or “global lifestyle brand”) as a case study.
What are profit warnings?
In simple terms, a profit warning will be issued when a company expects its forecast earnings for the financial year to be lower than the figure previously advised to the stock market.
Profit warnings are usually included as part of regular trading updates released by the company to the market; although occasionally, an unexpected event will be announced by way of a separate RNS (Regulatory News announcement). In practical terms, there could be a number of reasons behind a profit warning:
- For example, the original annual profit forecast may have been built on very bullish management assumptions around revenue targets and cost cutting initiatives, neither of which have materialised.
- Revenue might have been hit by the company not securing a contract that they believed they would win (and which went to a competitor instead); or the price hike that they expected to roll out was scaled back over concerns about negative customer feedback.
- Equally, cost cutting measures may come unstuck because the Government imposed a bigger than expected increase in property rates or the pound tanked unexpectedly against the euro, which meant that the cost of importing raw materials from the EU increased as a consequence.
There are many reasons to explain why a profit warning might be issued; but it usually leads to a sharp decline in the share price. The Ted Baker case study will demonstrate the impact that a series of profit warnings can have on the share price and it also highlight what lessons, if any, can be learned.
Case study: Ted Baker Plc (TED)
On the 9th January 2019, TED announced that it expected its annual profits for the year ended 26th January 2019 to be in line with expectations of £73.8 million. Its share price that day closed at £21.20.
Just over one year later, on the 22nd January 2020, TED announced the results of an independent review into the value of its inventory. The review found that the value of inventory on the company’s balance sheet as at 26th January 2019 had been overstated by £58 million. Its share price that day closed at £2.98.
In a little over one year, Ted Baker’s share price had fallen over 85%.
While TED had experienced some difficult trading conditions during that period, which resulted in profit warnings being issued; and had also seen its CEO resign, there was no real indication that there was a serious problem with the value of inventory until 2nd December 2019. By that time, the share price had already declined significantly.
Analysis of Ted Baker’s share price decline
The fortunes of Ted Baker Plc have been heavily reported by the media throughout 2018 and 2019; in part, because of the alleged misconduct of the CEO but mainly because of the significant overstatement of its inventory value.
What I find interesting is that when you review the RNS’ released throughout 2019 (see the timeline below), almost 75% of the share price decline was apparent before problems with the inventory value emerged.
It seems to me that Ted Baker was already struggling with a competitive environment. Its distribution costs had increased substantially and it had also encountered some integration difficulties with overseas business acquisitions.
While there is no doubt that a £58 million write-down on the value of inventory would impact any business, the real damage to TED’s share price was done long before that; and specifically following the 2020 profit warning on the 11th June and the exceptional costs announced on 3rd October.
Could TED’s share price decline have been foreseen?
If you were an investor in TED or thinking about investing in the company, could you have foreseen the catastrophic decline in share price?
It is recognised that high street retailers generally are struggling so that in itself would be a cause for concern for any investor. That said, TED’s 2018 Christmas trading results released on 9th January 2019 were impressive and gave no indication of the profit warnings to come.
The first hint that there might be problems came in the RNS, dated 27th February 2019, when they company advised of a £5 million write-down of its inventory.
However, it was not until the trading update released on the 11th June 2019, when a profit warning was issued in respect of its year ending 25th January 2020 results. The share price that day fell from £13.24 to £9.39. The 11th June may have been the day for retail investors to seriously re-consider their investment position.
The next trading update on 3rd October 2019 announced a whole raft of exceptional charges and the share price tanked, from £9.26 to £5.55. Again, no mention of inventory value concerns.
So, could the collapse in share price have been predicted, probably not. But investors who bailed out once the first 2020 profit warning was issued, on the 11th June, could have saved themselves a lot of money. Those who had sold out on the 2019 profit warning, issued on the 27th February, would have been delighted at their good fortune.
What can investors learn from Ted Baker?
If you were a shareholder or potential investor, there were enough red flags (and profit warnings) scattered throughout the regulatory news releases in 2019 to suggest there were issues of concern, even before the inventory problems came to light.
There are two aphorisms that I am always reminded of when it comes to investing: never catch a falling knife; and, the trend is your friend. Investors who adhered to both these sayings would not have invested, given the steady month-on-month decline in the share price.
The lesson for investors is be very wary of profit warnings.
Ted Baker RNS Timeline:
6th December 2018
News release covering the 16-week trading period to 1st December 2019: group revenues were down 0.2% but company described its performance as resilient. Some concerns raised about unseasonable weather and also alluded to the difficulties faced by House of Fraser. No reference to inventory levels.
One day later, TED announced that the CEO was taking a leave of absence over allegations of misconduct (he eventually resigned on 4th March 2019).
Share price closed at £15.11 (previous day close £14.67).
9th January 2019
News release covering the 5-week period to 5th January 2019 (the Christmas trading period update) confirming like-for-like retail sales were up 12.2% and e-commerce sales were up 18.7% (versus same period previous year).
Board also confirmed that it anticipated results for the year ended 26th January 2019 to be in line with expectations. No concerns raised at this stage about inventory levels.
Share price closed at £21.20 (previous day close £16.16).
27th February 2019
News release advising that Profits Before Tax (PBT) for the year ended 26th January 2019 would be approximately £63 million.
PBT was adversely affected by foreign exchange movements (£2.5 million), additional product costs (£2.5 million) and an unexpected inventory value write-down (of £5 million). First hint that there might have been a problem with inventory.
Share price closed at £18.20 (previous day close £20.00).
21st March 2019
Annual results announced indicating revenues up by 4.4%, profits before tax and exceptional items of £63 million and PBT of £50 million. The board recommended a final dividend of 40.7p (full year 58.6p per share).
Share price closed at £16.01 (previous day close of £17.10).
11th June 2019
News release covering the 19-week trading period from 27th January 2019 to 8th June 2019. Company expressed material concern over difficult trading conditions and ongoing external challenges.
Although group revenues were up 3.8% compared to the same period, the previous year; “elevated levels of promotional activity” and unseasonable weather were expected to lead to reduced gross margins.
Advised that anticipated profits for the year ended 26th January 2020 would be in a range between £50 million and £60 million. First indication that TED had concerns over meeting its 2020 profit targets. However, no mention of inventory problems.
Share price closed at £9.39 (previous day close £13.24).
3rd October 2019
Interim results for the 28-week period to the 10th August 2019 were released. While group revenues were down just 0.7%, the real problems were revealed in the £17.4 million cost of exceptional items disclosed in the half-year update.
The exceptional costs related to accounting adjustments on prior year acquisition of a footwear business (£3.5 million); restructuring of a legacy business in Asia (£11.8 million); and the cost of investigation into alleged misconduct by CEO (£2 million). Again, no mention of inventory problems at this stage.
Share price closed at £5.55 (previous day close £9.26).
2nd December 2019
First formal indication from TED that the value of inventory held on its balance sheet had been overstated by between £20 million and £25 million.
Share price closed at £3.66 (previous day close £3.98).
10th December 2019
Full year outlook trading update. TED advised that expected profits before tax for the year ended 25th January 2020 have been reduced to a minimum of £5 million. Suspension of dividend also announced.
Share price closed at £3.46 (previous day close £4.00).
22nd January 2020
TED announced the outcome of a review into the value of inventory on the company’s balance sheet and found that the value had been overstated by £58 million as at 26th January 2019.
Share price closed at £2.98 (previous day close £3.19).
Further articles in the series: Investing in shares
While I have covered the impact of profit warnings here, there are other warning signs, such as over leverage, that investors should be alert to before investing in shares. You can read about this by clicking here.
