The Canadian economy may be underperforming, but the same can’t be said of the country’s corporations.

According to a study conducted by economists with CIBC World Markets, the average profit margin of Canadian non-financial corporations hit a record high of 8% during the fourth quarter.

And Statistics Canada reported that while fourth-quarter operating profits across all industries declined by 2.8% quarter over quarter, net profits rose by 2.2% over that same period.

On a year-over-year basis, net profits climbed 12.3%, while net profits for non-financials were up by 14.6%.  

Meanwhile, Canada’s economy grew by 2.4% annualized during the fourth quarter and 2.5% for full-year 2014.

Bank of Canada Governor Stephen Poloz previously identified gross domestic product (GDP) growth of 2.5% as the minimum growth threshold necessary to remove slack from the economy.

Although Canada managed to hit that number last year, that’s hardly the sort of robust growth that could explain record margins.

So CIBC’s economists dug a little deeper.

Their first theory was that perhaps higher-margin industries such as manufacturing, transportation, agriculture and forestry had taken on a greater share of the economy.

But as we’ve written previously, the country’s beleaguered manufacturing industry is only just beginning to emerge from the carnage it suffered during the Global Financial Crisis. And the other aforementioned sectors have also seen their shares of the economy fall in recent decades.

At the same time, low-margin sectors such as retail and construction have assumed greater importance to the overall economy. Both evidence the extent to which Canada’s debt-burdened consumers have been driving the economy, with the wealth effect from the country’s housing boom spurring spending in other areas.

Excluding the energy sector, high-margin sectors’ share of GDP has fallen by about 7 percentage points since 1997, to around 62%.

As such, record profit margins are actually more widespread than they might have been previously. Indeed, with the exception of the resource space, every sector in Canada is enjoying above-average profit margins relative to their long-term average.

So that still doesn’t clear up the mystery. But timing turns out to be key.

CIBC observes that since 2012, profit margins have expanded by nearly a full percentage point. That sudden strength helps narrow the focus to two factors in particular: falling labor costs and a lower exchange rate.

Growth in labor costs has decelerated sharply over the past two years, from 3.5% year over year in 2012 to 1% in 2014.

More important, the Canadian dollar dropped by about 13% from the beginning of 2012 through the end of 2014. And at current levels, near USD0.80, the loonie is down about 25% from its trailing five-year high of USD1.06.

As investors who benefitted from a considerable tailwind as the loonie climbed above parity with the U.S. dollar, it’s been dispiriting to watch the currency crumble.

At the same time, Canadian policymakers believe a lower loonie is crucial for kick-starting the country’s economy again. For instance, Mr. Poloz has repeatedly said that he believes a falling exchange rate will beget a virtuous economic cycle of rising exports, increased business investment, and more hiring.

Well, it looks like the decline in the exchange rate is starting to work some magic. CIBC estimates that the depreciation in the Canadian dollar may be responsible for the entirety of the margin expansion that’s occurred over the past two years.

Naturally, export-oriented sectors such as agriculture and manufacturing have enjoyed the biggest boosts to margins, as have the rail and truck subsectors of the transportation industry.

Of course, as practitioners of the so-called dismal science, CIBC’s economists also worry about whether profit margins will eventually suffer a reversion to the mean. The theory is that rising margins invite competition that eventually leads to their erosion.

In this case, however, the decline in the exchange rate is a factor that’s felt across the board. And on that basis, CIBC believes that for now record profit margins are fully supported by fundamentals.

Portfolio Update

In the Canadian Currents column in the March issue of Canadian Edge, we wrote about Algonquin Power & Utilities’ (TSX: AQN, OTC: AQUNF) sudden selloff following management’s announcement that it would be postponing the company’s earnings release.

At the time, our surmise, based on publicly available information, was that Algonquin chose to delay its earnings release due to wrangling with the Canada Revenue Agency over the tax consequences of the company’s conversion from an income trust to a corporation back in 2009.

But when Algonquin finally released its fourth-quarter and full-year financials on March 16, it also revealed that anonymous allegations against company personnel were the actual cause of the delay.

According to management, shortly before the originally scheduled earnings release on March 5, they became aware of these allegations and then proceeded to share them with the company’s auditors to determine whether the allegations that related to financials would affect the company’s results.

Management says that assessment was led by a committee of independent directors with the assistance of independent legal and accounting advisors. Once they determined that the allegations did not impact the company’s financials, they proceeded to announce fourth-quarter numbers, which ended up being about 10 days ahead of the date to which they had been rescheduled.

However, the committee is continuing to investigate the allegations that are not related to company financials, and that process remains confidential, since it’s company policy to protect the confidentiality of both parties.

During the Q&A portion of Algonquin’s earnings call, analysts pressed management for additional details about the allegations and the resulting investigation.

One analyst asked whether any changes had been made to the financial statements or the notes accompanying them as a result of the investigation. CFO David Bronicheski said that no changes were made to the financials.

The same analyst asked about the timeline of the remaining investigation. Bronicheski said they hoped to resolve everything on an “expedited basis.”

Then he asked about the scope of the investigation, whether it involved a single employee or multiple employees. The CFO responded that the remaining allegations, which are non-financial in nature, pertain to “the workplace environment.”

Another analyst asked whether management expected to revisit any aspect of the investigation into the allegations related to financial reporting. Bronicheski confirmed that this particular investigation is complete, and that he doesn’t expect any effect on future financials.

As far as financials go, Algonquin reported strong fourth-quarter results that beat analysts’ consensus forecast by 42.9% for adjusted earnings per share and by 11.1% for revenue.

Also of note, analyst sentiment has not changed since mid-December. The stock currently has strongly bullish sentiment, with eight “buys,” one “hold,” and two “sells.” The consensus 12-month target price is CAD10.83.

The stock is up about 10.4% (at time of writing) from its recent low following the earnings postponement. But it’s still about 8.7% below where it closed prior to the announcement of the delay.

Without knowing any further details about what transpired, it’s hard to be fully relieved that the allegations had no apparent effect on the financials. After all, we’re essentially being asked to take management at their word, though at the very least their word is backed by auditors.

While it’s entirely possible Algonquin has handled everything properly, it will take more time for the company to fully win back our trust.

The first step would be the satisfactory conclusion of the investigation into the non-financial allegations. And it would be nice if that resolution occurs in a manner that allows the company to shed some additional light on what transpired with regard to both the financial and non-financial allegations, though such a disclosure seems unlikely.

The next step would be another quarter (or two) of strong financial performance, hopefully without any ongoing investigation casting a shadow over the numbers. Algonquin remains a hold.