Profit Warnings
Magnhild Mongolo
"Following slower-than-expected trading over the summer months, including August and current client activity levels, full year expectations have been revised further," the company said (author's emphasis).
Often sales and revenue fall in lockstep together, by the very nature of how companies make (or lose) money. Another recent example is housebuilder Redrow, which also "guided" for lower sales and profits for the full financial year.
EY Parthenon, which has been monitoring profit warnings since 1999, defines them thus: "a profit warning is an official statement to the stock exchange from a publicly-listed company that says that it will report full-year profits materially below management or market expectations."
Not all profit warnings are equal. Just as bad news tends to be cumulative, so it appears do profit warnings: some companies are serial "warners" and are treated differently by the stock market. Fast fashion chain ASOS (ASC) is a familiar such company: the first of two last year, on June 16, pushed shares down 20%. There was another one in September that year and that followed warnings in 2021, and 2019. Morningstar analysts now think ASOS shares are significantly undervalued. They are currently priced at 3.92 but Morningstar's fair value estimate is 19.10.
Do profit warnings attract more profit warnings? It certainly seems to be the case. But an unexpected profit warning from a previously-star stock can also unsettle investors as much as a serial warner. Even Apple, which was the first firm to reach a valuation of $3 trillion (2.4 trillion), warned on profits in 2019, a mere 17 years after a previous warning. It can happen to the best of companies too.
Accounting is also inherently backward-looking, and a lot can change in between preparing and presenting results. Like all financial forecasts, earnings predictions are based on extrapolations and assumptions that can change dramatically. In recent years companies have blamed a "deteriorating macro environment", amid a global pandemic, industry slowdowns, and spikes in inflation.
There's plenty outside a company's control too. But there's also an element of "over promising" built into the reporting by listed companies: they want to present the best-case scenario to investors, which includes fund managers who decide whether to shares on your behalf! On the flipside, profit upgrades can be rewarded too: this year Rolls-Royce shares are up more than 128%. July saw a big leap higher when it upgraded its full-year forecasts.
As we've seen of late, half-year results can be a key moment for warnings. By then a company can roughly tell how the rest of the year is going to pan out, and what has changed since the predictions were last made.
Trainee fund managers and analysts are taught the "efficient market hypothesis", which posits that all possible (publicly available) information is priced in to shares. You could argue profit warnings vindicate this idea, that the market is adjusting its expectations of the company via the mechanism of the shares. But for the company to be worth, say, a quarter less than it was worth yesterday because it will make less money seems a stretch.
Should companies stop making forecasts? That could be one solution to the profit warning carousel, and one that happened in the pandemic. Firms cited the uncertainty over the outlook, which made them unable to make forecasts for the full year.
For the contrarians among us, share price overreactions after profit warnings help short sellers. You'll see that this week when we publish our quarterly look at the most-shorted shares on the FTSE 100. Shorting companies that issue punishing profit warnings is meat and drink to the short seller.
And what of the bigger picture? According to EY, in the second quarter of 2023, profit warnings increased again on a year-on-year basis, the longest run of rises since the financial crisis. There are structural factors at work, from low economic growth to rising debt costs.
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Adopting a close-reading approach to text analysis, the authors analyse three profit warnings of the now-collapsed Carillion, contrasting the rhetoric with contemporaneous investor conference calls to discuss the profit warnings and board minutes recording boardroom discussions of the case company's precarious financial circumstances. The analysis applies an Aristotelian framework, focussing on logos (appealing to logic and reason), ethos (appealing to authority) and pathos (appealing to emotion) to examine how Carillion's board and management used language to persuade shareholders concerning the company's adverse circumstances.
As non-routine communications, the language in profit warnings displays and mimics characteristics of routine communications by appealing primarily to logos (logic and reason). The rhetorical profiles of investor conference calls and board meeting minutes differ from profit warnings, suggesting a different version of the story behind the scenes. The authors frame the three profit warnings as representing three stages of communication as follows: denial, defiance and desperation and, for our case company, ultimately, culminating in defeat.
The paper views profit warnings as a communication artefact and examines the rhetoric in these corporate documents to elucidate their key features. The paper provides novel insights into the role of profit warnings as a corporate communication vehicle/genre delivering bad news.
Rather than question the impact of bad news on investors, our research aim is as follows: What language does Carillion management use to deliver the bad news in profit warning documents? We elaborate our research aim into two research questions. In the context of delivering bad news (profit warnings) before its collapse, we contrast Carillion's rhetoric in the profit warnings with the rhetoric in its contemporaneous conference calls with analysts and board minutes.RQ1. How does Carillion management communicate across the stages of the three profit warnings? What is the nature of the use of rhetoric (logos, ethos and pathos) adopted in Carillion's three profit warnings?
Do Carillion's profit warnings tell the whole story? How does the use of rhetoric (logos, ethos and pathos) adopted in Carillion's three profit warnings compare with Carillion's contemporaneous conference calls with analysts and board minutes?
Language use varies depending on whether the news is positive or negative. Corporate narrative documents generally contain good news and may also include bad news. In contrast, profit warning press releases are solely motivated by the need for companies to deliver bad news. Previous literature suggests that routine bad news in annual reports is subject to the Pollyanna effect (excessive optimism) and managers use complex language to obfuscate bad news (Rutherford, 2005, 2013). In such routine communications, the opportunity for the Pollyanna effect exists because the presence of good news would not necessarily seem disproportionate or out of place. However, investors expect bad news in profit warnings, so excessive optimism would seem out of place. This bad-news context limits the opportunity for the Pollyanna effect. Therefore, understanding language use when delivering bad news in profit warnings is an important area of study. In experimental research, Chen and Loftus (2019) study the effect of language on perceptions of managers' credibility, finding higher credibility perceptions for self-inclusive singular pronouns vs collective plural pronouns when performance news in earnings conference calls is negative. Guo et al. (2020) examine plain, straightforward language vs complex and vague language in negative earnings surprises for its effect in signalling weakness on the competitive activity of rival firms.
In summary, the puzzles motivating our study are as follows: First, that language use in corporate narrative documents is important, yet we know little about it (Merkl-Davies and Brennan, 2017). Second, we know little about language use in non-routine corporate narrative documents. Third, most studies examine communication one-dimensionally within a particular context. We examine profit warnings by contrasting them with contemporaneous conference calls and board minutes. Finally, previous research examines delivering bad news in narrative documents where investors expect good news. Profit warnings are bad news, and studying good news in such documents seems out of place. So we need a better understanding of the language within profit warnings.
We base our analysis on three profit warnings issued by UK facilities management and construction multinational, Carillion plc, in the seven months before it collapsed in January 2018. We summarise the key events in our case in Figure 1.
We analyse Carillion's three profit warnings, transcripts of two investor conference calls following Profit Warning 1 and Profit Warning 2 and board minutes that became public following the UK House of Commons (2018a) parliamentary enquiry into Carillion. We download the profit warnings from the London Stock Exchange's Regulatory News Service, which are in the form of press releases. We examine the data commencing at the headline in the profit warnings and ending before the housekeeping details at the end of each press release. We obtain conference call transcripts from Bloomberg. We only analyse the transcript text where Carillion management is speaking, excluding any text relating to the operator or analysts and others attending the call (i.e. excluding the analyst questions but including Carillion management responses). We download the board minutes from the UK House of Commons (2018b) parliamentary enquiry website. We exclude the date of the meeting and list of attendees at the start of the board minutes. Board Minutes 5 includes some information on the Grenfell Tower fire disaster on 14 June 2017 (326 words), which we do not include in our data. Board Minutes 5 is the only document that includes text not directly related to the profit warnings. We exclude the names of speakers in conference call transcripts and board minutes. Table 1 summarises the data.
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