Company Profit Warnings - The Power of three

The power of threes?  Is there a psychological association with this number?  In this post I am going to talk about it in relation to profit warnings for companies.  I’m sure I’ve heard the phrase that warnings always come in threes. I was recently analysing a company for a potential investment, at a share price that in all honesty looked very enticing given the next two financial years forecasts.  The one thing that has held me back however, was that the share price had suffered a 30% drop two months ago due to a profit warning, which related to a slowdown in European orders, coupled with a restructuring exercise that is taking longer to complete than expected, which when implemented will only deliver half of the savings originally envisaged.

This started me wondering as to why profit warnings in threes could be true, so I came up with the following musings to try and explain the situation.  You should be aware that everything written below is from my own mind, and, is not based on any research work undertaken by me or anybody else.

Profit warning one – I am assuming this situation arises out of the blue for the Directors.  I presume they are so overly confident and optimistic about their ability to run a company that they cannot envisage the scenario of profits ever falling.  It would be interesting at this point if the Directors revealed exactly what their contingency plan is (i.e. that is already in existence before it happened, as part of their normal duties) to deal with the situation.  The usual format of communicating this to the market is by a statement saying that profits are expected to be at the lower end of forecasts.  I’ve got to say this sort of statement is absolute garbage.  For many smaller investors they are probably not even aware of the company forecasts.  At the very least the company should restate the profit and loss account, and, balance sheet, so it is transparent to all investors as to what to expect.  I believe this would certainly focus the Directors minds, rather than issuing a form of words.  It would also be beneficial if the Directors also reduced their salaries and share options to an absolute minimum level, both to increase profitability through reduced costs, and, provide an incentive to management to achieve the specified target.

Profit warning two – At this point the Directors have presumably tried to undertake some form of corrective action, but realise that companies are like oil tankers and cannot be turned around in a short period of time, along with the fact that the environment has turned out to be far worse than they expected, and, at this stage the company is looking to report profits far lower than forecast, if at all.  Again a statement will be issued stating this, with further wording suggesting the business environment has changed to such an extent that could not have been foreseen by any sane commentators.

Profit warning three – As the reality of the situation bites, all hope is lost as previous efforts to restore profitability have failed.  The statement to the market will consist of an outline that the company is undertaking a full strategic review of its business model, usually with the help of a team of third party consultants.  This always puzzles me.  Surely the Directors should have instigated this review at profit warning one, and, in my humble opinion should be undertaken by internal company staff.  It just shows you that it is not only investors who cling on to the hope a company will recover, but the Directors do as well.  Throughout the warning phases it feels like the company have never really accepted the issues, or, the market changes that first caused the problems in the first place.  The whole warning process should also highlight the role of the non executive Directors as their role throughout is to hold the management of the company to account.

As always I welcome any comment you may have.