Profit Warnings Need Not Be Menacing

Something has to change. It is probably not by some strange coincidence that the alarming expression “profit warning” sounds remarkably similar to the equally menacing term “prophet warning”. It conjures up images of a messenger of god being sent down to earth to caution us all to mend our ways before something terrible could befall us.

Whilst a “profit warning” is not nearly as frightening as a “prophet warning”, it can, nevertheless, be painful, if you happen to be a shareholder of a company that has just announced one. That is because profit warnings are generally accompanied by share price drops. Falls of between 10% and 30% are not unusual.

Why warn at all?

An all-too-common question that many investors ask is why do companies even have to warn at all. Thing is many companies try to help investors by giving analysts some idea of the profits that the business could make. Analysts then rely on the information to try to understand how the companies they cover are performing.

Only when they have some idea as to what could happen to profits can they use those figures to arrive at a valuation for the company. Meanwhile, companies are happy to share their investment plans with the market because it keeps investors informed about how their money is being deployed.

But these, we need to remember, are only forecasts. Sometimes, profits could come in better than expected, which could lead the company to revise its profits higher. At other times, if things don’t go quite as well as expected, they issue profit warnings.

For better, for worse

Following a revision of profits, analysts can go back and plug the new information into their spreadsheets to arrive at a revised valuation. A worse-than-expected profit forecast could suggest that a company may be worth less than previously thought, which means that share prices could fall.

A better-than-expected profit could have the opposite effect. But it is important to appreciate that a good company does not turn bad after a profit warning. By the same token a bad company does not automatically become good simply because of one favourable quarter.

Profit warnings come in various shapes and sizes. A couple of months ago, ASL Marine (SGX: A04) warned that profits could be lower following a drop in revenues linked to ship-repair and conversion work. Staying in the water, Kim Heng Offshore & Marine Holdings (SGX: 5G2) warned that profits could be lower because it had taken on more lower-margin projects.

In the summer of this year, Singapore Airlines (SGX: C6L) warned that intense competition, which led to ongoing promotional activities, could hit margins. Environmental engineer, HanKore Environment Tech Group (SGX: B22) was not enjoying its day in the sun either. It issued a profit warning due to the way it accounted and paid for an acquisition. More recently, GMG Global (SGX: 5IM) issued a profit warning on the back of lower natural rubber prices.

Timely reminder

Profit warnings can be a timely reminder about why we are paid a premium to own shares. There are risks involved in investing but the rewards could also be substantial. It is also important to bear in mind that there are no text-book responses to profit warnings. Each profit warning could be unique to a company, an industry or even a geographic region.

Consequently, it is important to understand the causes and the possible effects of the profit warning. Sometimes, it could even be something as innocuous as a company moving from a phase of rapid growth to a more sedate maturity phase. That should not be a reason to worry, unless you have an aversion to mature companies.

This article first appeared in The Independent on Sunday.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore Director David Kuo doesn’t own shares in any companies mentioned.