Earnings hit as UK profit warnings reach a three-year high

This article is part of
Equity Income - September 2014

Many UK shares that have traditionally paid attractive dividends are facing challenges that may mean it will be difficult for them to sustain or grow these distributions, leaving investors’ incomes at risk.

In spite of the economic recovery and generally positive investor sentiment that has helped the stock market continue its steady upward march to a recent 14-year high, a large number of companies’ earnings are under pressure.

A recent report from consultancy group EY showed profit warnings from UK companies hit a three-year high in the first half of this year. Increased competition and squeezed margins were among the reasons given by a diverse range of businesses for issuing profit warnings. These included retailer Asos, luxury brand Mulberry Group and outsourcing company Serco.

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Tesco is currently the most high-profile example of a former reliable dividend payer now suffering a reversal of fortunes. Its struggles are well known and the announcement of a far sharper-than-anticipated 75 per cent cut to its interim dividend may pose a real problem for investors who rely on such payments.

It is not alone; other supermarkets are facing the same deflationary pressures that are denting profitability amid fierce competition from low-cost rivals.

Diageo is another income fund staple, where the dividend profile is unattractive. Earnings have been lower than expected due to a number of factors, including pricing pressure and weak demand.

The consensus assessment is that the drinks manufacturer will increase earnings by a cumulative 5 per cent over the next two years, yet the dividend is forecast to increase faster than that in both years, even though it had already grown ahead of profits in 2013. That rate of dividend growth is ultimately unsustainable unless earnings pick up.

September’s US court ruling of gross negligence against BP – the third-highest dividend payer in the FTSE All-Share index – for the oil spill in the Gulf of Mexico in 2010 provides a further example of an income stalwart stock subject to considerable uncertainty about its future dividend payments.

By contrast, secular growth companies with strong operational momentum have the potential to grow earnings faster than consensus expectations and use increased free cashflow to maintain and increase dividends.

Firms such as Howden Joinery Group and international industrial equipment rental company Ashtead Group are benefiting from strengthening UK and US economies. In Ashtead’s case, this was evident in early September when it announced a 33 per cent increase in first-quarter profits, largely on the back of US and UK demand.

Ashtead’s dividend yield – currently about 1.4 per cent – may not be high in absolute terms, but this represents 27 per cent growth on its previous dividend, far outstripping inflation.

Elsewhere, the resources sector is providing some opportunities. In particular, Rio Tinto, where strong capital discipline is increasing free cashflow to an extent that is not yet fully appreciated by the market. Recent figures confirm the company’s ability to increase its distribution of cash to shareholders, even with the current weakness in the iron ore price.