Corporate profit margins in Canada hit a 27-year high in the fourth quarter. And, while some erosion from a softening economy is likely, margins are expected to remain strong, finds a report from CIBC World Markets.
The average profit margin of all non-financial corporations rose to 8.2% of sales in Q4 2014. Also, excluding the recently hard-hit energy sector, profit margins are currently at their highest in almost three decades at 7.6%.
Further, the gap between non-energy profit margins and real GDP growth is about as large as in any non-recessionary period in the past 25 years, the report says.
“Some of the structural forces that helped to elevate the trajectory of corporate profitability might start to fade in the coming years, but for the here and now, profit margins are fully supported by the fundamentals,” says Benjamin Tal, deputy chief economist, CIBC.
He notes that while corporate profit margins fluctuate with the economy, historically they’ve tended to average less than 5%. But he argues that structural changes over the last decade have moved that average to more than 6%. “There are no shortage of explanations for such an upward structural trajectory – globalization, innovation, lower cost of capital, high barriers to entry, and reduced bargaining power of labour – to name just a few.”
Tal adds profit margins are largely assumed to be one of the most mean-reverting series in finance, and the concept of margin means revision is embedded in investors’ equity valuation models. The rationale here is simple, he says. The theory is, above-average margins must attract competition and investment, which in turn, can reduce overall profitability.
A look back
The rise in profit margins over the past two decades came despite the headwind from a less favourable sectoral composition, he says. The share of high-margin industries, such as manufacturing, transportation, agriculture and forestry, has fallen notably, while low-margin sectors, such as retail trade and construction, have gained ground.
However, the upward trajectory in margins since 2001 has been widely based, supporting the assessment that the driving forces for a higher mean are structural, the report says. Average profit margins are above their long-term average in all sectors but one – mining and quarrying.
Even within the context of a structural upward trajectory, the rise in margins over the past two years has been relatively strong, with margins expanding by almost a full percentage point since 2012, the report says. This is due to two factors, softening labour costs and a sinking loonie. The pace of growth in labour costs dropped sharply from 3.5% in 2012 to 1% in 2014, while the Canadian dollar has depreciated nearly 25%.
“No less than one third of Canadian GDP last year was produced by sectors with falling labour unit costs,” Tal says. “But, more important is the lift companies are getting from the loonie’s demise.” He estimates the depreciation in the value of the dollar is responsible for “no less than a full percentage point increase in average profit margin since 2012.”
The impact of the loonie’s decline though is far from uniform, the report notes. Export sectors, such as agriculture and manufacturing, are the biggest beneficiaries, with sub-sectors in the latter like wood products, pulp and paper, motor vehicles, electrical equipment, clothing, textile and basic chemicals leading the way. The lift to profit margins in the transportation industry is mostly in rail and truck sub-sectors, while air transport is marginally negative.