Late Sunday night, the United States and Canada reached a deal to update the North American Free Trade Agreement (NAFTA). The new deal also includes Mexico and will be called the U.S.-Mexico-Canada Agreement, or USMCA.
"Clearly, this is a major relief for Canada, lifting a heavy cloud of uncertainty from the outlook. The one change we are making to our forecast as a result of the deal is one more Bank of Canada rate hike in 2019 (in January)," said BMO's chief economist Douglas Porter in a report on the new trade agreement, noting that this deal, along with last week's solid run of data, all but cements a rate hike at the next policy announcement on Oct. 24, barring something truly shocking over the next three weeks.
The USMCA will last for 16 years. At the six-year mark, a mandatory joint review will be made, at which point the countries could continue the deal or renegotiate.
From a Canadian perspective, the changes in the dairy agreement, automotive manufacturing and imported online goods are some of the major changes in the new deal. Here is a quick overview of each, and a brief look at a star-rated stock from each of these sectors.
The USMCA gives American farmers access to about 3.5% of Canada's protected dairy market. This is higher than the access that Asia-Pacific nations get, which is at about 3.25% under the Trans-Pacific Partnership agreement, signed in January this year. Additionally, the USMCA states that, "Canada shall ensure that milk class 6 and milk class 7, including their associated milk class prices, are eliminated six months after entry into force of this Agreement".
In 2016, the Canadian dairy industry created "class 7" milk, to price certain ingredients like skim milk and whole milk powder below cost, which other milk producing countries, including the United States, protested.
A major listed Canadian dairy player is Saputo Inc. ( SAP ). Saputo is a dairy processor and cheese producer that operates in Canada, the United States, Argentina and Australia and sells products in more than 40 countries. It is the largest cheese manufacturer in Canada (35% of revenue) and one of the top three cheese producers in the United States (53% of revenue).
The stock has a narrow moat and a 2-star Morningstar Rating. "As one of the largest global dairy processors, Saputo benefits from an attractive cost position formed by substantial economies of scale, in our view. This cost advantage underpins our belief that the firm has a narrow economic moat, allowing it to generate solid economic profits over the past decade, with adjusted returns on invested capital averaging 14% -- well above our 8.5% cost of capital estimate -- over this time frame," says Morningstar equity analyst Sonia Vora.
The USMCA provides for a tariff exemption on up to 2.6 million passenger vehicles exported from Canada to the U.S. on an annual basis, as well as auto parts amounting to US$32.4 billion in declared customs value in any calendar year.
"These are not binding constraints as Canada currently produces just under 2 million light vehicles for its domestic and export markets, and currently exports just over $20 billion (or roughly US$16 billion) in parts. Effectively, this portion of the agreement is more of a safeguard that Canada will not become a high-volume producer in the future; given that Canada's vehicle production has been falling for more than 15 years, this was a low-probability likelihood. We would judge the overall effect of the agreement on autos with the U.S. and Mexico as a net positive for Canada," said Porter.
An auto-part company that Morningstar analysts believe is currently trading below fair value is Magna International ( MG ). Magna is trading at about an 8% discount to fair value estimates.
Magna is one of the largest, most diversified auto-parts suppliers in the world. Many suppliers focus on a particular area of the vehicle. In sharp contrast, Magna's capabilities are so broad that the company could nearly design, develop, supply and assemble vehicles all on its own, notes Senior Equity Analyst Richard Hilgert.
The company has no economic moat.
"We think the company has become so large and decentralized that any moatiness developed in individual business groups from innovation or cost advantages from scale gets diluted in the consolidated results. Even so, the company's healthy liquidity and balance sheet are able to support operations through severe industry downturns," he said.
Online imported goods
The USMCA raised the minimum threshold value of Canadian imported goods bought online that qualify for duty-free access from $20 to $150. Imported goods valued at less than $40 also will be exempt from sales taxes.
"Canadian consumers will enjoy lower prices and faster delivery times due to less customs processing. Small and medium sized Canadian businesses that buy U.S. supplies online will save on administration costs and face fewer delivery delays, reducing uncertainty in their supply chain. However, Canadian retailers will lose out due to the relative loss of competitiveness," the BMO report said.
Three-star rated Loblaw Companies ( L ) is the largest grocery chain in Canada and owns four of the top 10 brands, including Canada's number-one (President's Choice) and number-two (no name) private-label brands. Loblaw is diversified, operating through four different formats and 25 banners, allowing it to target a wide range of consumers and geographies, and to glean insights from each respective segment.
"Despite these strengths, Loblaw hasn't been able to garner strong profitability, most directly shown in its return on capital that barely clears its cost of capital. We attribute these hardships to the competitive environment in which it operates, the low-switching cost grocery industry, and a value proposition not able to protect economic profits," says senior Morningstar equity analyst Dan Wasiolek.