Profitability Monitor

Originally published 4th April 2005

Our regular assessment of the current state of the profitability of British business and the economic factors influencing its prospects for the future, prepared by Roger Bootle, Economic Adviser to Deloitte.

• The drop in profitability in the fourth quarter of last year signals the start of an increasingly tough period for the UK corporate sector. Profits growth is set to slow markedly in the face of a consumer slowdown and weaker global demand.
• Some of the fall was down to a sharp drop in the profitability of oil companies; excluding volatile North Sea profits, profitability was flat at 12.6%. But this was only because of a strong pick-up in the agriculture, construction and power supply sectors.
• Manufacturing profitability dropped particularly sharply from 7.1% in Q3 to 6.1% - the lowest in almost two years – suggesting that record high oil prices and a high exchange rate are starting to take their toll.
Profits themselves failed to rise at all in 2004. 2003’s recovery – when profits rose for the first time in six years – has therefore proved to be disappointingly short-lived.
• Looking ahead, the profits share – profits as a proportion of GDP – is already close to its long run average, suggesting little scope for further robust profits growth. (See Chart 1.) What’s more, the equilibrium profits share might have fallen in recent years, given that margins have been squeezed by the intensifying competitive forces of globalisation and the internet has made consumers increasingly price conscious.
• Weakening economic growth will put profits under further pressure. The Deloitte forecast is for GDP growth to drop from 3.1% last year to 2.0% this year and 2.2% in 2006. Moreover, as GDP growth slows, profits growth is likely to slow even faster, given that productivity growth tends to slow in economic downturns. In the past, a 1% fall in GDP growth has led to a 4% fall in profits growth.
• The drop in services sector profitability from 15.5% in Q3 to 15.1% suggests that the slowdown in consumer spending is already hitting companies’ profit and loss accounts. So although profits in the services sector rose by 7.9% in 2004 overall, the best performance since 1998, this will be as good as it gets. As consumers tighten their belts, they are likely to become more cost conscious than ever, leaving companies little scope to raise prices to protect profit margins either.
• Meanwhile, the renewed rise in oil prices to new record highs in March will raise costs for manufacturing companies. And although global activity has strengthened recently, we expect it to weaken in the face of global imbalances, threatening to blow the recovery in UK exports off course.
• The Deloitte forecast for growth of (nominal gross trading) profits is 2.4% for 2005 and 2.6% for 2006, after 6.9% in 2004. The deteriorating outlook for profits highlights the risk that the corporate sector may not be up to the task of driving economic growth as consumer spending takes a back seat.

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