UK plc braced for slowdown as debt rises and profit margins fall

6 Sep 2019

With Britain’s departure date from the European Union (EU) fast approaching and the global economy bracing itself for a slowdown, the outlook for companies in the UK has become increasingly challenging.

While revenues for firms in the UK increased in the second quarter, the trend was mainly driven by the weaker pound and was concentrated among the country’s largest 40 listed companies while smaller and mid-cap businesses faced serious challenges.

Average bottom-line profits for UK companies grew by 3.1% in the three months to the end of June, but fortunes were limited to the top 40% of companies ranked by market cap, which saw their profits rise by 13.3% while more than half of all businesses in the UK reported lower profits, according to the Share Centre.

Small and mid-caps faced bigger challenges because of their higher exposure to the UK market with the domestic economy “teetering on the brink of a technical recession” Share Centre chief executive Richard Stone said.

A key factor underlying the poorer corporate performance was a dramatic squeeze in margins since 2007. Despite generating £787bn in sales in the past year, British firms only generated £16bn in profit, which translates as 2p profit from every £1 of revenue.

“The market’s expectations for earnings growth this year are still achievable but for the year after optimism seems too high in our view, given the current slowdown in the world economy and uncertainty in the UK over Brexit. Moreover, any recovery in the pound would act as a significant drag on growth,” Stone said.

Despite the relatively cautious outlook, investors in UK firms benefited from record levels in dividend payments, again concentrated among larger firms. As global dividends increased by 1.1% to a record $513.8bn, underlying dividend growth in the UK rose by 14.5%. This amounts to a record £37.8bn in shareholder pay-outs in the second quarter alone, according to Link Asset Services.

This was largely due to sharp dividend increases among mining firms and banks as Rio Tinto, Micro Focus International and RBS all cashed out larger incentives to shareholders. Nevertheless, according to Link, a rise in corporate debt was not an immediate cause of concern due to the current low level of borrowing costs.

Despite the share of interest payments as a percentage of operating profits increasing slightly, they remain below average levels for the last decade, Link said. Yet Michael Kempe, chief operating officer of Link Market Services, warned that the outlook might be less rosy. “Investors are being dazzled by eyecatching specials and exchange-rate trimmings, but the UK’s dividend clothes are starting to look a bit threadbare underneath.”

Link warns that excluding volatile special dividends, underlying growth is set to be 2.9%, almost two thirds of which is down to likely exchange-rate gains. The group therefore downgrades its forecast for underlying dividends by £500m to £98.7bn.

Another factor which should raise investor caution are record levels of corporate debt. Following eight consecutive years of borrowing, corporate debt levels in the UK have reached a record £443.2bn. Large caps, healthcare and utilities companies in particular are driving the borrowing spree.

The risks of higher borrowing levels were somewhat offset by cash balances increasing rapidly by 8.9% to £198.1bn in 2019 alone, according to Link.

However, Damian Watkin, director at advisory firm DF King, warned that there has been a fundamental change in the nature of debt issued, which could point to potential liquidity challenges. “As companies have moved away from short-term debt, we have seen the type of debt they are taking on change, too. Bonds have risen in popularity, at the expense of shorter-term loans.

In particular, the issuance of high-yield bonds has exploded in the past decade. “Should rising interest rates close the high-yield market to lower quality borrowers, however, a significant rise in debt restructurings and defaults would be on the cards among highly indebted companies,” he added.

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