Wednesday, 3 September 2014

Outrageous fortunes

Yesterday I posted some data showing the profitability of different sectors of New Zealand business, based on Stats' brand new release of the Annual Enterprise Survey for 2013. And based on a quick squizz at the data I concluded 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".
I've done a bit more fossicking in the data, and I've ended up thinking even darker thoughts about the state of competition in parts of retailing - and the supermarkets in particular.

Here is what has been happening to the pre-tax rate of return on equity (ROE) in the main sectors of retailing. I've taken the data back to 2009 (which is where Stats started publishing more detailed sub-sector breakdowns), which helps to sort out whether any high recent ROEs are just a cyclical artefact of the recently strong economy rather than evidence of structurally limited competition.


There is no credible explanation for the high ROE of the "supermarket, groceries and specialised food" sector other than limited competition.

This is not a sector where you'd expect high ROEs because of the exercise of scarce, highly specialised skills. And it's not a "high beta" sector exposed to a high degree of cyclical risk - unlike the car yards (who made no money in the tough market of 2008-9) or the sellers of consumer durables (who lost money in 2008-09). If anything, the supermarkets' profitability increased in the tough times.

Let's be clear - the supermarkets are fully entitled to these ROEs. There's nothing wrong with charging what the market will bear. And if you were a duopoly behind reasonably formidable barriers to entry, you'd expect to coin it, too.

But the sooner a hard nosed, low priced Costco or Aldi comes along and upsets their apple cart, the better off we'll all be.

4 comments:

  1. Your story about supermarkets looks persuasive, but perhaps too persuasive? Are you sure there is nothing else that can explain the numbers? For example, I'm wondering how the contrast between an industry structure in which the whole Countdown business (retail outlets, distribution. marketing etc) is owned by a single Australian company, while New World et al are run as a cooperative. Are the profits for the distribution part of the Foodstuffs business showing in a different place than those for the Countdown business? (i'm not sure how any bias might show up, so this is purely a question). And if corner dairies are in that category, is a lot of the return on equity really just a return to the proprietors' labour?

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    1. Thanks Mike. I don't know the answer to the industry structure question: it's possible retailing ROE for a vertically integrated retailer could be spread across various sub-sectors in perhaps an arbitrary way. On corner dairies, it could be that ROE is high for them for the reason you suggest, though offsetting that are (a) corner dairies have tax incentives to take a salary which would reduce the amount attributed to capital, and (b) there is also, you would think, a longish tail of small boutiques etc in the clothing/footwear sector but its ROE (20.8% '13) hasn't similarly blown out to food retailing levels. Also, just back of an envelope, if we said 40% of food retailing is supermarkets, and 60% corner dairies, and gave the corner dairies a 40% ROE, the ROE on the supermarkets would still be 20% or so, which still looks high relative to the ROE for all industries (9.1%). Incidentally, I think I can also rule out higher leverage as a major factor juicing ROE, as equity as % of balance sheet is only modestly less (31.7%) in the food trade than in industry as a whole (36.7%). So while I'm temperamentally inclined not to find competition 'issues' where there aren't any, I'm kind of left with the Sherlock Holmes position - when you've ruled everything else out...
      There might be an argument around minimum efficient scale in the supermarket business, but I don't know how you'd prove that one way or another without a very large research exercise.

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    2. Thanks Donal. Isn't the tax incentive for small business owners the other way round - since the company tax rates is lower than the max marginal tax rate there are deferral benefits in declaring earnings as profit and leaving them in the business as long as possible? But fair point on small firms in other sectors, including accommodation (B&Bs and motels).

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  2. especially as at least here, even the adults are on the minimum wage and haven't had a pay rise for over 5 years.

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