By Daniel Hunter

One of the wettest summers on record contributed to the highest number of profit warnings issued in a third quarter since 2008, but it was the underlying weakness of the UK and global economy that landed the heavier blows on the nation’s listed businesses.

According to Ernst & Young’s latest Profit Warnings report, UK quoted companies issued 68 profit warnings in Q3 2012, a third more than the same quarter in 2011, the highest third quarter total for four years and eight more than the previous quarter.

Twelve companies cited adverse weather in their profit warning, the highest number of companies blaming the weather since the winter freeze of 2010-11. However, bad weather was an exacerbating factor in most profit warnings. Many of these companies had warned before and the majority cited other reasons such as weak UK demand, a slowdown in global markets and the growing risks to the economic outlook.

The sectors with the highest numbers of profit warnings this quarter reflect these weaknesses and concerns. FTSE Support Services led the way in Q3 2012 (15 warnings) followed by FTSE Industrial Engineering (6) and Electronic and Electrical Components (5).

“While some profit warnings from consumer facing sectors blamed the poor weather, the underlying weakness of the UK economy and global growth concerns landed the heavier blows to profits and expectations," Keith McGregor, head of restructuring for Europe, Middle East and Africa, said.

“In the UK, an exceptional series of one-off events has inevitably created dips in demand and productivity which has made it hard to get an accurate fix on the state of the economy. Across Europe, the outlook still appears weak and economic growth will remain slow.”

FTSE Support Services issued the highest number of profit warnings in Q3 in over three years and up from five in the previous quarter. Support Services is the largest FTSE sector and is highly diverse, covering facilities management, waste management, recruitment and consultancy; making it a useful indicator of future corporate spending plans.

In particular, warnings from recruitment companies can indicate changing expectations. The Recruitment and Training sub-sector of FTSE Support Services sector issued four warnings in Q3 2012, the highest for over three years — a sign that more companies might be preparing for leaner times ahead.

“This breadth and exposure to government and corporate spending patterns can make Support Services a useful bellwether of confidence and demand in the wider economy," Alan Hudson, head of Ernst & Young’s UK & Ireland restructuring practice, said.

“Companies in this sector in particular are in the austerity firing line and this quarter’s spike in profit warnings could reflect the trend towards companies cutting their cloth to match new realities. The three-year high in recruitment company warnings, for example, is consistent with businesses focusing on operational improvements to drive growth rather than transaction M&A activity, in light of the low growth and low capital environment we face.”

The rise in profit warnings from those sectors involved in manufacturing comes as the customers and end-markets they serve remain sluggish at home and slow abroad, especially in consumer and some defence sectors. The FTSE Electronic & Electrical and FTSE Industrial Engineering sectors issued their highest number of warnings since Q1 2009, five and six respectively. A slowdown in previously fast growing Asian markets and the strain on consumer and defence end-markets, in particular, strained profits and expectations.

“Unusually, this rise in manufacturing profit warnings didn’t come as a consequence of rising prices. Just five companies across all FTSE sectors blamed rising costs for their profit warning this quarter, the lowest for almost two years," Hudson adds.

“And while significant and widespread commodity price increases remain unlikely in the current economic climate, recent surveys do show input prices are rising again in manufacturing and construction. Given the weaker outlook, even a moderate rise in costs could prove toxic for many weakened companies.”

UK listed retailers have had a tough time over the last year, but surprisingly bucked the overall rising trend of profit warnings this quarter. For the first time in almost two years, there were no warnings from FTSE Food & Drug Retailers, while FTSE General Retailers issued just three profit warnings in Q3 2012, two fewer than the previous quarter and the lowest total since Q3 2010.

It has been exceptionally difficult to gauge the strength of consumer demand in 2012. This year’s celebrations and the summer’s exceptionally wet weather have altered consumer behaviour and caused retail volumes to fluctuate considerably from month to month.

The uptick in spending in September will give retailers a little more confidence, but the next three months are not without risk, as Hudson explains, “Energy prices are rising and, while retailers are doing their best to absorb the recent rise in food prices, some increases are inevitable given the exceptionally poor global harvests.

“There is also strong pressure on retailers to drive sales, when volumes are low, especially in the run into Christmas when it is so vital to maintain momentum. The temptation to discount will be strong and companies will need to be careful to avoid trapping themselves in a discounting spiral that damages their brand and leaves consumer confused about the value of their product.”

Looking towards to the end of this year and into the new year, McGregor concludes, “What is becoming clear is that both the UK and Europe’s climb out of the down-cycle will be both lengthy and volatile.

Companies are having to adjust to the new reality and focus on strategy to protect and improve earnings in an extended period of low growth and, for all but large companies, low access to capital.

“This is leading to a focus on operational improvements rather than transaction activity, although there will be opportunities to acquire technology, territory and channels to market from weaker corporates. We are also seeing a trend towards corporates acting to protect weaker but critical companies in their international supply chain.

“It will be fascinating to see the focus of companies in the current environment and how they will drive their operations to meet profit expectations over the next part of the cycle.”

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