Monday, 1 September 2014

Good profit, bad profit

Many people are ambivalent about corporate profits: they don't know whether to cheer a successful business or boo an exploitative rort. Look at the recent reactions, for example, to the 45% increase in Air New Zealand's after-tax profit:  is this good management of a New Zealand business icon (especially when compared with the humongous losses at Qantas), or, as commentators from the Prime Minister downwards have wondered, a right royal rip-off of travellers on the regional routes?

I've got no problem per se with businesses making money hand over fist. Quite the contrary: that's kind of the point of it all, and in any event healthy profits are the engine that drives investment, hiring and innovation. Where I join the critics is when the profits aren't made on the battlefield of competitive markets: if, instead, they're being coined behind a monopolistic or oligopolistic or protectionist or regulatory moat, then there's good economic reason to push back against the profiteering.

As it happens, on Friday Statistics New Zealand released some data that throws light on the profitability of New Zealand businesses. It's the latest Annual Enterprise Survey, for 2013. It's fascinating - no, really, it is - and it leaves you wondering why some sectors make so little money and why others make so much.

Here's a table I've constructed from the Survey results, on industries' pre-tax return on equity in financial years 2012 and 2013.

Some of this is reasonably well-known: agriculture, for example, while it may be the backbone of the economy, generates a remarkably low 5%-and-a-bit pre-tax return on the equity invested in it.

But some of the other results are rather more surprising.

Why is the ROE in wholesaling so high? It looks to be one of the more humdrum, everyday sectors with (you'd think) not a lot of reason to be earning the sort of ROE a higher-risk, higher-innovation line of business might earn. But there it is, up among the higher earning sectors.

And then you look at retail trade, again earning one of the higher ROEs. And it's at this point, if wholesaling hadn't already got you beginning to think along those lines, that you start thinking deep, dark thoughts about whether there are strong enough competitive pressures at work to constrain the profitability of some lines of activity.

If you go down into the details of the Survey, within retailing (on 2013 data) you find that the accommodation and food services bit of it had an ROE of 15.3% (unusually high that year, it was lower in 2011 and 2012). Car yards and petrol stations did all right, too, with an ROE of 20.2% (again, to be fair, it had been quite a bit lower in the previous two years). There's an assorted 'other' category, where the ROE was 23.1%. But then you come to the 'supermarket, grocery stores and specialised food retailing' segment, and guess what: you find an ROE of 33%. And it had been a lot higher again in 2011 (46.7%) and 2012 (45.1%).

These are outsize rates of return, that - given the bread and butter nature of the sector - are not consistent with fully effective competition in the retail trade.

I'd say the same about construction, except that there are obviously unusual post-earthquake market conditions distorting the numbers which likely explain some or all of the observed ROEs in 2013 - particularly residential building's 48.5% (up from 29.9% the previous year and 27.8% in 2011), But there also looks to be an element of entrenched super-normal profitability in areas such as construction services (ROE averaging 31.2% over the past three years) and heavy and civil engineering construction (21.7% over the past three years). Non-residential building construction on the other hand had quite a modest average ROE (14.2%).

Perhaps there is another, better explanation. But for now, what these figures say to me is this: we have a bunch of domestic, non-tradable sectors that look as if they badly need more effective competition to drive down profits to more sensible levels.

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