By Claire West

Ernst & Young, who have analysed data on corporate profit warnings since 1998 suggest that 2011 is likely to be a 'crunch year'.

Because the UK economy is still in recovery mode, far fewer companies are blaming macro-economic conditions for their profit warning. Just 22% of companies warning this quarter cited difficult trading conditions, compared with 46% in the same period of 2009. Instead, contract amendments or cancellations were the main reason for warning, with nearly a third of companies blaming contract issues, up from 17% in the same period in 2009. This figure includes six profit warnings from companies whose contracts were subject to cancellation or hiatus in the early stages of government spending cuts; a theme that looks set to figure prominently in the year ahead.

Keith McGregor, restructuring partner at Ernst & Young, said: “UK plc could be in for another rough ride. Profit warnings reached a near seven-year low in the second quarter, falling below 50 for the first time since 2003. However, this will be the last period in which an expansionary fiscal policy helps to keep profit warnings low, and a number of companies have already cautioned that they expect much tougher times ahead, when further fiscal tightening reins in public sector and consumer spending.”

Risk-reward Budget faces headwinds from Europe and uncertain credit markets

The emergency Budget in June signalled how severe this retrenchment will be. By common assent, widespread fiscal adjustment is necessary to ensure the UK’s credit reputation, avoid disorderly market conditions and help create the right environment for strong private sector growth. But, while potential rewards for such accelerated austerity are high, the risks are too.

Alan Hudson, restructuring partner at Ernst & Young commented: “It looks like 2011 will be a crunch year. It is then that the first significant wave of fiscal tightening, including the rise in VAT, will likely coincide with interest rate rises and the upslope of a refinancing peak. A firmly entrenched private sector recovery would soften these blows, but with growth still fragile and the economy still battling headwinds from the eurozone and stuttering credit markets, this support is by no means certain.”

Keith said: “A question mark still hangs over the ability of both investment and exports to build momentum in the year ahead. Access to credit is also a vital prerequisite for a strong private sector recovery, but the lingering fallout from the credit crunch, combined with fears over the viability of the eurozone and the solvency of some members, is limiting bank credit and periodically slamming the bond market door shut.

Keith continued: “This will be immediately concerning to those companies looking to refinance, because the bond markets had been ready to provide funding when no one else would.”

Profit warning outlook

High levels of public sector spending and fiscal stimulus have provided a buffer for many companies against the worst of the credit crunch and recession. Although, there is an element of weaning the patient off the life support by delaying the main wave of fiscal tightening until 2011; from that date, the level of public sector support drops dramatically.

Alan concluded: “Cutting back the public sector to allow space for the private sector to grow should, in the long term, help promote higher levels of growth that will benefit UK plc. But, given the size of the adjustment required, the transition will inevitably be painful.

“This leaves UK plc with a very difficult hand to play. Many companies are now enjoying a trading uplift, which explains the exceptionally low levels of warnings in some sectors. However, given the potential challenges to growth in the year ahead, companies will need to manage costs and expectations carefully to mitigate a potential stall or stutter in 2011, when government spending really starts to retrench. Uncertainty and demand volatility is usually associated with a rise in profit warnings and we continue to expect the number of warnings to increase in the year ahead.”

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