Which stocks will be hit hardest by spending cuts?

By Associate Editor David Stevenson Jul 23, 2010

David Stevenson

Share with
friends:

Comments (12) Print this article

It was all 'go-go-go' again in stock markets yesterday.

The FTSE 100 closed almost 100 points higher, while across the Atlantic the Dow Jones put on another 2%. In fact both markets are now within less than 10% of the highs they hit in April this year.

And much of this gung-ho mood resulted from a number of upbeat, 'better than expected', earnings reports from the States.

So has everything suddenly turned out all right again?

Not according to the message from one British blue chip this week. In fact, there could yet be some nasty profit surprises in store...

How expectations affect markets

I've never really understood how so many US companies manage to turn in 'better than expected' profits. According to Bloomberg data, about 85% of firms that have reported their results since 12 July have managed to 'beat' analysts' forecasts.

Recommended reading

Wouldn't you have thought that research teams would have cottoned on by now? And have upped their profit estimates? Or maybe managements are getting very canny about how they give out their earnings 'guidance'.

In any case, yesterday the US showed what can happen when results exceed expectations and statements sound nicely upbeat. Short-term, stock prices can surge.

The trouble is, it also works the other way round. As I blogged yesterday, (Britain's austerity drive claims its first blue-chip victim), earlier this week, the telecoms kit supplier Cable & Wireless Worldwide (LSE: CW/) came up with some news that investors certainly didn't want to hear. And the effect on its share price was very nasty indeed.

So what's gone wrong?

Earlier this year C&W Worldwide demerged from the global phone services firm Cable & Wireless Communications (LSE: CWC). That business, by the way, is totally unaffected by the news. In fact it was one of the top tips in our recent telecoms cover story (Why telecoms stocks are a good call). So it was good to hear from CWC's boss that its own trading year has "started well".

Back to C&W Worldwide (I'll call it CWW for convenience's sake). According to its website, the firm is "aiming to become the first choice communications integrator, specialising in the mission critical needs of large users of telecoms". Which roughly means it sells the stuff that the likes of businesses and governments need to talk to each other.

And the latter area is where the company's problems have cropped up. UK state spending that's "non-contracted" - i.e. that can be cut easily - is being slashed "very significantly", as CWW puts it.

Special FREE report from MoneyWeek magazine: When will house prices bottom out - and how will you know?

  • Why UK property prices are going to fall 50%
  • When it will be time to get back in and buy up half price property

"Take that as 'ground to a halt', at least until civil servants and public bodies can get a firm grasp on the size of the cuts in their telecom and IT Budgets", says Nils Pratley in the Guardian. In turn this has just forced CWW to issue a profit warning.

That's bad enough. But here's the really scary bit. Non-contracted work only accounts for 20%, or £50m, of CWW's annual UK public sector revenues. Compared with the firm's total turnover of almost £2.3bn, that's tiny. Yet the shares slumped 20% in just two days.

Either the market is over-reacting, or there's a lot more bad news in store. And the clue here is that CWW was making £20m-worth of profits out of that £50m. In other words, that's a very - almost ridiculously - fat margin. Which is being made out of the taxes that we Brits are now being told we'll be paying in ever increasing amounts.

Indeed, this is where the real problem lies. "Frankly, on the basis of these profit margins", says Pratley, "government procurement officers should start warming up".

At best that'll mean existing contracts being reworked to squeeze suppliers. Cabinet office minister Francis Maude has already told the 20 biggest suppliers of services to the UK government to cut their prices. At worst, the state cashpoint will stay shut. And as the public spending slashing hasn't really started yet, my money's on the latter.

All in all, not great for CWW. And there are plenty of other businesses that have done very well out of the UK taxpayer. Connaught, the social housing provider, has already fallen prey to the cuts. But what of other potential casualties?

What other stocks will the spending cuts hit?

"BT (LSE: BT/) is an obvious candidate", says Neil Hume on FT Alphaville. "Via its global services division, 11% of group revenues come from the public sector - roughly the same as for CWW". And IT services company Logica (LSE: LOG) derives 13% of sales and 15% of profits from the UK government.

Outsourcers Serco (LSE: SRP), Capita (LSE: CPI) and Babcock (LSE: BAB), which have taken on much of the work government departments used to do, could also take hits to profits, even though Capita remains confident it will do well from government cutbacks.

Sure, some of these stocks have already fallen. Logica, for example, has dropped by 30% since April. But Capita and Serco - both on pricey looking multiples of around 17 - have eased just over 10% since then. Babcock is down 7% from its recent high, with BT off just 3%. And the message from CWW, says Hume, "shows investors are still too sanguine about the size and scope of the coalition's cost cutting measures. They have every reason to be afraid".

So will the research community spotlight the bad news before it hits - any better than it foresaw those 'good' earnings reports in the States? I wouldn't want to bet too heavily on that. My view? With stock markets on a bit of a high right now, take advantage. If in doubt about a stock, get out - before the profit warning.

Our recommended article for today

Cash in on Asia's obsession with golf

Golf is booming in Asia, where it is an exclusive, expensive pastime. Now this London-listed small-cap company aims to cash in on the sport's soaring popularity, says Tom Bulford.

Comments (12)

Published in Stock markets | More articles by David Stevenson

Share with
friends:

Related articles

Comments

Leave a comment

  • 1. Bob Roberts

    (23 July 2010, 10:53AM)  Complain about this comment

    Marks & Spencer had a one day sale yesterday which is usually my reason to avoid the store. Hundreds of Women, sometimes thousands, pushing and shoving and grabbing the clothes from the rails is a nightmare for most men.

    But come lunchtime I needed some food, wandered in with fearing the worst and the shop was almost deserted. Sale signs up everywhere but where were customers?

    Interestingly, they have begun selling non-MS brands in their food stores now but, boy, the prices are M&S prices for goods that you can mostly find much cheaper elsewhere.

    So they are replacing their 'exclusive' food with food that you can pick up in any supermarket but charging a M&S premium on the price? I mention this as it is this kind of observation that keeps me away from M&S shares going forward.

  • 2. Bob Roberts

    (23 July 2010, 10:59AM)  Complain about this comment

    David, you have never really understood how so many US companies manage to turn in 'better than expected' profits?

    Have you not heard of the lorries driving around silicon valley every reporting quarter filled choc-a-bloc with computers, routers and other bits of IT kit? Some US accounting rule that apparently allows them to include such things as sales as long as they have been shipped out - anywhere.

    There was a case of a tech worker a few years back who, in the frenzy to load the vans full of expensive kit, got badly injured and who sued one of the big tech companies for a lot of money. It got settled out of court I gather.

  • 3. Jim

    (23 July 2010, 04:13PM)  Complain about this comment

    Interesting comment from 2.bob roberts.

    Here is another example. I upgraded my internet connection to wireless with a free laptop for £14.95 post & packing.

    Paid the £14.95 , all went well then I got charged another £14.95 a week later.

    Checked with the company and the guy said they had an accounting error where about 10,000 people, who upgraded as well, were accidentally charged p&p again, a refund is on its way.

    Refund arrived a few weeks later, then the company reported its accounts for the year and stated that growth is rising.

    Yes, I expect it would! After that I decided not to get any shares in that company.

  • 4. Tiny Tim

    (23 July 2010, 09:03PM)  Complain about this comment

    @ Bob Roberts no. 2

    Companies used to be able to claim a sale when they shipped but these days the goods have to arrive and be signed for to be counted as a sale. We have Sarbanes-Oxley to thank for this.

  • 5. Chris B-) - (Slough UK)

    (24 July 2010, 04:43PM)  Complain about this comment

    We’re clearly heading into double-dip bear territory. Doesn't really matter which ones will get hit hardest, unless shorting them of course? Just look at the last Mar09 low. Banks, Miners & Builders got hit most. All got blown away. I predict the markets hit new low, by Feb10 or less. Next crash will be faster & most certainly more severe than last. I think everyone realises that the bank stress tests are all set up to reassure the ‘little’ people that everything is under control. If everything is so under control, why would we even have them?
    It is a traders market, but as last time, it is very risky buying against the prevailing trend, and that my friends is clearly down. Market timing against a whip-saw action is fraught with danger. A sinking tide, lowers all boats!
    Beware the fall, better off in cash, until we hit bottom, then buy and hold for 6 months or so like Mr. Buffett does. That’s where the smart money is!

  • 6. franko

    (24 July 2010, 08:05PM)  Complain about this comment

    Wow i wish i knew as much as you guys! I been in cash for 12 months now and feel as if ive lost out, if only i did know as much as you all i bet i would have made as much money.
    Respect to Bob Roberts though thats the kind of resurch money cant buy.

  • 7. Bob Roberts

    (25 July 2010, 12:25AM)  Complain about this comment

    I have been in cash also expecting this second crash to come franko. I too have lost out - virtualy zero IRs. I am tempted to buy a property as at least I have something solid.

    The sale was still on today and M&S was heaving. Long queues for the ladies and it was bedlam in there. I think they expanded the sale to more lines.

    The way I saw people spending money today in Cardiff there was no sign of a recession.

  • 8. Tiny Tim

    (25 July 2010, 09:54PM)  Complain about this comment

    In my town today there were many shops where the staff outnumbered the customers and the customers were only window shopping too. If you are buying make sure it is on credit card so you are covered if the store goes bust.

  • 9. ROBERT

    (26 July 2010, 12:34AM)  Complain about this comment

    bob roberts-sage or not?
    one week he's advising C&WW looks a great prospect,then the next he's wisely explaining why it's not a good idea to be in it;shouldn't he have thought this through before going to print with his tip?.

  • 10. ROBERT

    (26 July 2010, 12:36AM)  Complain about this comment

    terribly sorry,I of course meant David Stevenson,not bob roberts,who I'm sure is a wise owl of the first order

  • 11. Bob Roberts

    (26 July 2010, 11:21AM)  Complain about this comment

    Nah, doubts? I am full of them.

    To succeed in finance I think you have to not care about losing - which either means you are wealthy enough to lose on your specualtion or desperate enough not to care.

    I look at the World economy and few organisations are hiring, in the UK we have massive cuts yet to come in the Autumn - because they have nt begun yet most people think that Cable and Osbourne are all talk and no action.

    I think the Winter and next year will be dire times for the UK in terms of jobs, in terms of spending in the shops and in terms of house prices.

    At the moment losing money in cash in the bank against inflation is about the best most of us can do IMPO. Not happy about it but there you go.

  • 12. Tiny Tim

    (26 July 2010, 08:23PM)  Complain about this comment

    I think we have identified Connaught , shares down 90%, as one company who won't last the distance in the current round of spending cuts.

Leave a comment

This will be the name displayed with your comment.

This helps us verify comments are genuine. It will not be displayed anywhere on the site and is stored confidentially.

Please keep your comment within 1,000 characters and relevant to the main topic. We encourage healthy debate, but we don't allow insults or bad language. Anything off topic or unpleasant, we'll remove. Enjoy the conversation! Thank you.

captcha To prevent spam-related comments please enter the characters shown in the 'Captcha' box to the left.

By leaving a comment you accept our terms and conditions.


FREE - MoneyWeek's daily investment emailJohn Stepek

Our free daily email, Money Morning, is an informative and enjoyable analysis of what's going on in the markets. Written by our Editor, John Stepek, and guest contributors.
Sign up FREE to Money Morning here.

>