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September 1, 2008

NORTHERN EXPOSURE

Canada's beleaguered manufacturing sector finally receives some relief from its provincial governments. But there's still a long way to go to play catch-up.

A small automotive supplier outside Windsor, Ontario, recently reinvented itself in an unexpected way. Capitalizing on the Alberta tar sands boom 2,300 miles to the northwest, it uses a tar sands resin byproduct to produce utility poles.

Illustration by Heidi Younge

The diversification by Tilbury-based Global Vehicle Systems Inc. was made possible through a $2.1 million loan from Ontario’s $500 million Advanced Manufacturing Investment Strategy (AMIS) program, started in 2006. The start-up has generated 100 jobs and enabled Global Vehicle to triple its sales to nearly $50 million.

“The economy is so heated in Alberta that it’s hard to keep staff there,” says David Butler, president of the subsidiary created to manufacture the pole modules. “We had the skill sets right here.”

Provincial loan programs such as this one are an attempt to help Canada’s troubled manufacturers—clustered mostly in Quebec and Ontario—that are suffering in part because of the unexpectedly strong Canadian dollar, which makes their goods more expensive in the United States. With a new administration certain for Washington, Canada’s initiatives to support its manufacturers provide interesting examples of useful policy changes for manufacturing competitiveness that the new president and Congress might beneficially consider. The Canadian approach includes initiatives that range from basic tax breaks to loan programs designed to spur investment, all focused on improving product quality, shifting business strategies or overcoming foreign competition.

In Canada, provincial initiatives to support manufacturing have outpaced the halting approach of the federal government, says Jayson Myers, president of the Ottawa-based Canadian Manufacturers & Exporters (CME), the nation’s largest trade organization, with a membership that accounts for 75% of the nation’s production and 90% of its exports.

PROVINCES TO THE FORE

Quebec, perhaps, is furthest along, with an integrated strategy adopted last year. That action plan includes $440 million in funding for such initiatives as direct investment in industrial projects. The provincial program supports a network of individuals who provide seed capital for a business and offers businesses access to productivity advice from consultants and specialists. The Quebec plan also includes $178 million in tax incentives, including a new tax credit for workforce training. That’s in addition to a one-year suspension of income tax and capital tax installments, which is expected to improve manufacturers’ cash flow by $500 million this year.

While the Canadian federal government allows tax credits for research and development of 35% up to $2 million and 20% beyond this threshold, Quebec, the only province to do so, also offers refunds, rather than just tax credits, on investments in R&D. The province allows a 35% refundable tax credit on 80% of eligible R&D expenditures incurred by a recognized research center, such as a university or hospital, on behalf of a provincial business. The government also allows a 17.5% refundable tax credit on salaries allocated to R&D. For small businesses, this credit is increased to 37.5% on the first $2 million of salaries.

The feature is considered attractive to startups because they don’t have to be profitable to be eligible for the credit. Myers notes that many aerospace companies in the province have thrived as a result of this and other provincial initiatives. For example, two aerospace companies recently received help from the economic development agency Investissement Quebec, separately and apart from the provincial program for manufacturers. LISI Aerospace Canada, a producer of screws, nuts and bolts for the Boeing 787 and other airplanes, received a $1.9 million loan toward a $10 million expansion program. RTI Claro Inc., a producer of titanium-alloy parts and another Boeing 787 supplier, received a $1 million contribution toward a $13.5 million expansion.

Ontario also has a quiver full of initiatives. Its answer to support manufacturing is a $1.15 billion fund, launched earlier this year, to invest in companies with products that reduce pollution, save energy, make transportation more efficient or help the environment in other ways. The fund, called Next Generation is Jobs, was modeled after an earlier program to spark automotive industry expansion. That program, Ontario Automotive Investment Strategy (OAIS), used $500 million in public funds to invest in automotive projects that demonstrated innovation, environmentally friendly technology or upgrading worker skills. OAIS resulted in more than a dozen projects by the former Big Three and other car and truck makers worth more than $7 billion.

The province also has several tax relief schemes in place. Its 2008 budget included $750 million in tax reductions for business, primarily benefiting the manufacturing and resource sectors. Besides eliminating the capital tax, the province also reduced tax rates retroactively and offers a new income tax exemption for corporations that commercialize intellectual property developed by Canadian universities, colleges and research institutes.

It was Ontario’s AMIS program that provided the loan that Global Vehicle used to diversify from its core business supplying custom automation equipment, painting and injection molding services to the auto, truck and recreational vehicle industries.

The AMIS initiative earmarked $500 million for loans, interest free for up to five years, to help manufacturers increase productivity and competitiveness. Other companies that benefited: Insulation manufacturer Roxul Inc. of Milton used $10 million for a new production line, and Sault Ste. Marie-based Flakeboard Co. used $1.6 million to develop applications for wood-alternative materials.

Global Vehicle realized it needed to reduce dependence on the Big Three automakers, Butler says. Managers warmed to an opportunity from Alberta-based RS Technologies, which developed a tar sands byproduct resin that was well suited as a composite material for utility poles.

The product wasn’t financially feasible to produce in Alberta, since labor is scarce and hourly rates are high. So Global Vehicle in early 2007 entered a contract with RS to manufacture the poles.

While most utility poles are 90 to 150 feet long, the largest of these modules is 38 feet long, which is easier to ship, Global Vehicle’s Butler says. They can be stacked inside each other “like those Russian dolls,” he adds.

The company sells its entire production to HD Supply, a division of Home Depot, under a $60 million, two-year contract. In addition to the AMIS loan, the company entered a $1.4 million lease buyback agreement with the community of Chatham-Kent for its production facility.

CHANGING COURSE

The Global Vehicle initiative is an example of a province reducing dependence on troubled sectors and adding higher-margin goods. The margin on the poles runs from 9% to 10%, and is expected to improve as resin waste comes under better control, Butler say. Given the recent weak state of Canada’s manufacturing sector, such a direction change was critical.

“The industry has gone from flat-out to flat on its butt,” says Rob Hattin, president of Edson Packaging Machinery in Hamilton, Ontario. Edson is a medium-sized manufacturing company that designs and builds packaging machinery for consumer goods producers. It invested in product innovation and LEAN manufacturing to offset the strength of the Canadian dollar. That enabled it to double sales in the space of a year. The company, however, worries that its packaging industry customers, who are strapped by high costs, are on the verge of scaling back or canceling large capital projects. A downturn could threaten plans to expand the Hamilton plant.

At the other end of the spectrum are the auto behemoths—convulsing from their own self-inflicted wounds. Canada has a number of major automotive assembly and component plants serving U.S. and Japanese automakers. But business has been wobbly as auto sales have plunged. The automotive industry, for example, used to enjoy a margin of approximately 10%. That has dropped to as low as 2% in recent years. The latest indignity is General Motors’ recent announcement to close a major truck plant at Oshawa, outside Toronto, which will eliminate 2,000 jobs (see “Auto Angst.”).

This and other Canadian manufacturing woes contributed to a contraction in first-half GDP growth, reports the Bank of Montreal. The bank projects that Canadian GDP will grow at a paltry 1% this year, slightly lagging projected U.S. GDP growth of 1.5%. Manufacturing’s share of Canadian GDP fell to 15.2% in 2007 from 18.4% in 2000, with an average decline of 0.4% per year, the Conference Board of Canada says.

Since 2002, Ontario has lost 180,000 positions, or one in six factory jobs, while Quebec has lost 140,000, or one in five, a report by TD Bank Financial Group of Toronto says. Manufacturing employs about 2 million workers, or 12% of the 17 million Canadian workforce.

It’s true that until now, the decline in manufacturing largely has been offset by the nation’s boom in commodities—nickel, copper and precious metals, as well as energy. With oil at $115 a barrel, the Athabasca oil sands project in northern Alberta is wildly profitable, and companies there, such as Royal Dutch Shell, have big plans to expand output. Workers willing to brave the sub-zero temperatures of Fort McMurray earn sixfigure incomes.

Yet the resource boom has masked the problems of the manufacturing sector, leaving the economy vulnerable in this year’s cyclical downturn. The CME says that while current federal and provincial initiatives are a good start, a more sweeping and coherent policy is needed.

“The government looks at the averages,” says Mel Svendsen, CEO of Standen’s Ltd., a Calgary producer of heat-treated metal products for truck axles and suspensions. “But if the patient’s feet are freezing and his head is burning, that doesn’t make him healthy.”

Canada was slow to address manufacturing problems. The sector grew during the past 15 years, peaking in 2007 when the Canadian dollar reached parity with the U.S. dollar. The country’s fragmented government structure, in which different federal and provincial ministries oversee industry, human resources, the environment, energy, revenue and finance, didn’t help. Canada’s economy is so integrated with that of the United States—which accounts for 80% of its northern neighbor’s exports—that it’s impossible for any single government to address Canada’s problems in a vacuum. “You wish there could be more coordination,” Myers says. “There are a lot of best practices to be learned.” He points to the United States’ Manufacturing Extension Partnership, funded by the National Institute of Standards and Technology, which runs programs in productivity and sustainable development funded at the federal, state and local levels.

The weak Canadian dollar in the past mitigated the need to invest, and productivity lagged as a result. Tax policy didn’t help because, in the past, it tended to reward employment. “Our tax policy was geared to job creation,” Svendsen says. “We were punished for investing in equipment.”

Canada’s productivity growth accelerated in 2005 and 2006, but gains in output per hour slowed last year and have averaged a lackluster trend rate of 1% per year so far this decade, a recent report from TD Bank Financial Group says. In contrast, real GDP per hour worked in the U.S. manufacturing sector has advanced by more than 3% to 4% per year since the start of the decade.

“The single biggest weakness in Canadian manufacturing relative to the U.S. might be underinvestment in machinery and equipment,” the report says. “The Canadian dollar’s strength should have improved the climate for capital investment, since it has lowered the cost of U.S.-made machinery and equipment. However, manufacturers have been slow to take advantage of the lower machinery and equipment price tag, even taking into account the recent downward pressure on profit margins.”

An accelerated capital cost allowance for manufacturers or processors that invest in machinery and equipment was extended in the 2008 federal budget, but at a somewhat reduced rate, so CME continues to push for a better formula.

CME says it has been most successful helping manufacturers gain tax relief, as in the elimination of capital taxes and the reduction of the corporate income tax rate to 15% from 21% by 2012. Both Quebec and Ontario have already scheduled elimination of their capital taxes, following the federal government’s 2006 example.

CME advocates much more. It wants increased regulatory efficiency and investment in infrastructure. It urges more aggressive enforcement of trade laws and improved efficiency at U.S. border crossings, especially at the heavily congested Windsor/Detroit border, where traffic bottlenecks waste time and money. It would like more federal dollars for industrial training, technical education and skills development and wants to prod resource industries, vulnerable to swings in volatile commodity markets, to produce more value-added goods. A recent response: Ottawa in January established a $1 billion trust to aid communities hit by layoffs and high unemployment, such as New Brunswick towns hurt by the downturn in lumber and forestry. The trust finances job training and infrastructure projects that stimulate economic diversification.

But there’s a long way to go. “We’ve been hewers of wood and drawers of water,” Svendsen says. “We still lack enough value-added manufacturing.”