Persistent declines in the index darken profitability outlook: Conference Board of Canada

The Conference Board of Canada’s Leading Indicator of Industry Profitability Index fell for the fourth straight month, which suggests that the near-term outlook for Canadian corporate profitability is weak. The index is being dragged down by a swoon in manufacturing industries, a cooling domestic housing market, and weakness in some of the retail and services industries. As well, the Canadian economy downshifted in the second quarter, growing at a 1.7 per cent annual pace, compared with 2.2 per cent in the first quarter. The weak economic environment offers little hope for any improvement in corporate profits growth in the next three to six months.

The domestic housing market has weakened considerably over the past year, a direct result of the tighter mortgage rules and lending guidelines introduced in the summer of 2012. The weakness has had a negative effect on the furniture and appliances stores segment. The latest Statistics Canada data show that the value of residential building permits in June 2013 totalled $4 billion, down 12.9 per cent from the previous month. Building permits are an early indicator of construction activities, and the data are hinting at a slowdown in housing starts in the coming months. Moreover, led by the Royal Bank in August, banks have been hiking their mortgage rates, especially the five-year rate, which could further dampen home sales by reducing affordability. At the same time, consumer spending may take a hit because it will cost more to finance purchases of furniture and appliances. In this environment, it is not surprising that the profitability index for furniture and appliance stores is on a seven-month slide.

The slowdown in the Canadian housing market has also dampened the demand for building materials. According to Statistics Canada, sales at building materials and garden equipment and supplies stores were down 1.9 per cent in June, marking the third decline in the last four months. The impact is apparent in the results of Rona—Canada’s largest home-improvement retailer and distributor—which posted a loss in the second quarter of 2013. The profitability index for the building material dealers segment has now dropped in each of the past five months.

Food and beverage stores are another retail segment with a negative profit outlook due, in this case, primarily to an increasingly competitive marketplace. Walmart’s expansion into selling fresh food products, the entry of U.S. retailer Target into the Canadian market, Loblaw’s recent decision to buy Shoppers Drug Mart for $12.4 billion, Sobey’s $5.8-billion purchase of 213 Safeway stores in Western Canada, and Metro’s plans to reorganize its Ontario grocery retail networks are all factors that will intensify the grocery war. As a result, the industry’s profitability index has been trending down for the past three months, pointing to weaknesses in the profitability outlook in the near term.

Many segments of the information services sector are also facing negative profitability outlooks as a result of increased competition. For telecommunications companies, consumers are “cutting the cord” in increasing numbers, as they opt for online streaming and over-the-air signals as an alternative to cable or satellite television. Indeed, the five largest cable and satellite companies all experienced a drop in subscribers in the second quarter of this year.1 While this may mean increased data packages for some providers, such gains are usually insufficient to offset the loss of revenues from consumers cancelling their television service.

The “other information services” industry is also facing more competition in the form of digital content and online advertising. As a result, its profitability index has dropped in five out of the past eight months. The broadcasting segment, in particular, has been affected by Canadians opting to cut their cable packages in favour of online content. At the same time, an increasing share of advertising revenues is also shifting to online media. According to the Canadian Radio-television and Telecommunications Commission, national TV advertising spending fell 8 per cent in 2012 to $1.4 billion. Not surprisingly, TV networks posted losses. CTV lost $15 million in 2012, while the CityNews Channel and OMNI networks posted combined losses of $40 million. With online ad spending continuing to eat into the market share of television, radio, and print ad spending, the profitability outlook for the publishing and other information services industries remains challenging.

On the other side are a number of industries with more positive profitability outlooks. The mining industry’s profitability outlook has improved, thanks to the recent rally in commodity prices, especially for copper, steel, and gold. Upticks in China’s manufacturing indexes have lifted copper and steel prices on expectations of stronger Chinese demand for these metals. Moreover, gold is often viewed as a safe haven during times of uncertainty. Concerns over a U.S.-led military intervention in Syria’s civil war could, however, derail the fragile global economic recovery that drove gold prices to a three-month high in August.

Rising geopolitical tensions in Syria have also fuelled the rise in oil prices, as worries over conflicts in the Middle East always increase supply concerns. The West Texas Intermediate (WTI) crude oil price rose 12 per cent in July, reaching US$104 per barrel—its highest level since March 2012. Alleviation of a bottleneck situation at the oil transportation hub of Cushing, Oklahoma, (thanks to new transportation infrastructure coming online) has also contributed to the rise in the WTI price. As a result, the spread between the WTI and other global benchmark prices has narrowed.

Ultimately, surging oil prices are welcome news for both the oil extraction industry and for gas station owners, two segments that have seen their profitability indexes improve for the last two months. Also, the profitability index of the banking industry has been trending up for the past seven months. Bank of Montreal, National Bank of Canada, Canadian Imperial Bank of Commerce, and Royal Bank of Canada all reported their highest-ever quarterly profits last month. Cost reductions and strong earnings from personal and commercial banking were the two main contributors. So far, the slowdown in home buying and related borrowing has yet to hit the bottom lines of the major banks—but it remains a key risk.

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