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The Globe and Mail

Bulls face tough slog as corporate profit margins hit wall

It's so nice for Canada's big banks that they are raking in the money. Too bad the rest of corporate Canada isn't so lucky.

In a week in which the country's five largest banks reported quarterly profits totalling an astounding $7.8-billion, Statistics Canada released data showing that Canada's non-financial corporations suffered a 5-per-cent decline in operating earnings in the second quarter compared with the first quarter. It was the second straight quarter-to-quarter drop.

Non-financial corporate profits were also down on a year-over-year basis – the first time that has happened since the recession ended in 2009. The problem isn't so much that sales are substantially slowing; indeed, revenues were up 4 per cent from a year earlier. But profit margins have hit a wall.

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It's written in the margins

Operating profit margins dipped to 8.5 per cent in the second quarter, from 8.9 per cent in the first quarter. While economists noted that this is still relatively high historically, the margin trend looks particularly worrisome in two of Canada's key sectors: Energy and manufacturing.

David Madani, Canadian economist at Capital Economics, noted in a report that margins in the oil and gas sector "have fallen to the lowest level since 1998, when oil prices were as low as $12 (U.S.) a barrel, compared to $95 a barrel today." The slumping margins are evidence of the "enormous costs" of developing and producing the Alberta oil sands, he said.

Meanwhile, margins in the manufacturing sector have dropped to about 6 per cent, the lowest in two years and less than half of the 14-per-cent margins enjoyed just a year earlier. This drop-off is evidence, in part, of the impact of the high dollar on this export-heavy sector, said National Bank Financial economists Stéfane Marion and Marc Pinsonneault in a research note this week.

Already priced into stocks?

The eroding profit margins give companies even more reason to sit on their cash piles – which already amount to $526-billion, and counting, on non-financial balance sheets. Mr. Marion and Mr. Pinsonneault warned that with margins shrinking, companies will be reluctant to invest in capital-spending programs and hiring.

Not surprisingly, then, margin downturns are a distinct negative for stock valuations. The price-to-earnings valuations for the S&P/TSX composite index have historically tracked profit margins fairly closely.

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But over the past year, P/Es and profit margins have diverged, leaving margins looking high relative to stock values. It looks like the Canadian stock market has anticipated this margin slump – and already priced in a further margin erosion. We can probably expect valuations to remain depressed as long as margins continue to slip.

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