The report notes that profit margins for corporate Canada as a whole have been rising since the early 1990s due to a number of favourable trends.
“Falling interest rates and record-low debt-to-equity ratios have shaved interest costs, while industrialization in emerging markets has led to sustained traction in commodity prices,” says Avery Shenfeld, chief economist at CIBC.
“That has helped to boost operating leverage despite the drag from a stronger loonie and intensified competition in some key sectors. The recovery in margins since the last recession has tracked changes in the profit share of GDP. That ratio is closer to past peaks in the U.S. than Canada, suggesting Canadian firms may have a bit more room to grow profits from here.”
Profit margins for TSX Composite companies are higher on average than for the average Canadian firm. The report, co-written by Mr. Shenfeld and CIBC senior economist, Peter Buchanan, states that this may be a reflection of the benefits on the capital cost side from listing and index inclusion, as well as sectoral differences and scale factors.
They note however, that the generally positive longer-term trends mask some notable differences at the sector level. Margins in the TSX materials and info tech sectors have risen strongly in recent years, recovering from the recession’s hit to resource prices and investment. Profit margins have also risen in the major consumer groups, although in the staples sector, which includes the major food and drug chains, they generally remain low compared to other areas of activity. Competitive developments have stalled improvement in the telecom sector although levels remain healthy.
“Viewed purely in terms of earnings per revenue dollar compared to performance stateside, the best TSX sectors to invest in are mining, REITS, wireless telecoms and the health care segments,” says Mr. Shenfeld. He notes that apart from health care, the numbers for all of these sectors have also been on the rise.
“In isolation, domestic forces would appear to be favourable for a further improvement in TSX and broader Canadian profit margins. Materials costs often hold centre stage, but for many sectors, workers are a more critical input, and unit labour costs appear likely to remain well-contained. Even with reported shortages in some skilled occupations like mining and oil extraction, job market slack continues to handcuff wages in most other sectors. Benefiting unit costs, labour productivity also looks poised to pick up, due to rising investment outlays. After hunkering down during the recession, a near record proportion of firms are planning to boost their investment in machinery and equipment according to the Bank of Canada’s Business Outlook Survey.”
Factors outside of Canada’s borders present more of a mixed picture insofar as future performance is concerned. Recent margin gains in the TSX materials and oil sectors have been largely tied to soaring global commodity prices rather than improvements in costs per unit of output and some of those prices may be getting close to a near-term peak. Emerging markets like China and India are being forced to apply policy brakes to slow growth and quell inflation, which could lead to weaker resource demand from those countries, at least in the short run. However, any softening in commodity prices would be a plus for downstream resource industries and for other sectors like airlines and trucking where fuel is an important input cost.
“The exchange rate is the other key price set by global market forces that will have widely differing implications for Canadian margins,” says Mr. Shenfeld. “The Canadian dollar’s climb may be squeezing manufacturing but is helping to insulate retailers’ margins from this, offsetting inflation in their U.S. dollar cost-of-goods-sold. Some domestic services providers, like telecoms, also benefit from similar cost savings on key imported inputs.”
He notes however, that exporters with production facilities based in Canada, including industrials, will feel the fallout for their Canadian dollar-denominated costs. The top- and bottom-line performance of Canadian-based multinationals will also look appreciably less impressive when the cash flows from their offshore subsidiaries are converted back into a pricier loonie.
“Although we expect the Canadian dollar to ease from its recent highs, a trading level of US$1.02 six months out would still leave the currency 12 per cent above where it stood against the greenback just over a year ago,” notes Mr. Shenfeld.
The report adds that rising retail fuel prices are further squeezing the purchasing power of Canadian consumers already grappling with high debt loads. Gasoline spending is relatively insensitive to price changes, with a 10 per cent rise paring demand by as little as half a per cent in the near term. That means higher prices are likely to lead to cutbacks in spending in other areas.
“Add it all up, and there is much to think about for equity investors, as they assess future earnings and margins trends,” finds Mr. Shenfeld. “Canadian retailers and domestic service providers look positioned to fare better than their U.S. counterparts due to Canadian dollar strength. The lofty loonie should help to cushion grocery chains from rising raw food prices.”
“Resource sector margins are significant winners in the near term, but equity investors might want to factor in prospects for somewhat cooler selling prices, as well as some cost pressures emanating from selective labour shortages in these hot sectors. That said, the broad trend for margins is still favourable, owing to soft wage costs and improving productivity, as well as cheaper Canadian dollar prices for imported equipment and other inputs. Top-line growth should also improve capacity use and unit cost performance by spreading out fixed costs.
“All told, expectations for healthy earnings ahead don’t seem out of line.”
The complete CIBC World Markets report is available at: http://research.cibcwm.com/economic_public/download/eiapr11.pdf.
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For further information: Avery Shenfeld, Chief Economist, CIBC World Markets Inc., at (416) 594-7356, [email protected]; or Kevin Dove, Communications and Public Affairs, at 416-980-8835, [email protected]