Petrol profits

The Commerce Commission's paper on measuring profitability in the petrol business didn't formally call for submissions but if people had any views they could send them in by close of play today. Here are a few of mine.

The first thing is that, somewhat surprisingly, firms - perhaps many of them - can be earning persistent 'excess' profits even in workably competitive markets. The graph below, which is the absolutely standard 'demand curve crosses the supply curve' picture, shows how it happens.

We know that producer A would be earning its weighted average cost of capital at price PA because it is willing to offer to supply at that price, and it wouldn't if it wasn't. At the higher market price of Pe it is making above-normal-WACC returns.

Or as a very good text book* says, when you have upward sloping supply curves, as in my view you often will, "the market price in equilibrium will normally be determined by the level of cost of the higher-cost producers - the 'marginal producers' - who will make only a 'normal' profit (the market price only just covers their costs) ... At the market price, the lower-cost suppliers will make a healthy margin above cost".

So the ComCom paper is bang on when it says that "Even where competition is effective, the profitability of some suppliers may be above normal or competitive levels" (para 37) and that "Analysis of profitability by itself may not distinguish whether higher than competitive levels of profits are due to cost advantages [as with producer A in the graph], the exercise of market power, or a mix of both".

It follows that the focus of the profitability analysis should be firmly on the returns being earned by the marginal producer at Pe and not on intra-marginal producers like A. This was the approach correctly adopted in last year's first report from our Electricity Price Review (write-up here, with links to the review). It looked at whether prices were in line with the costs of the next (the 'marginal') generator commissioned.

The logic was

Contract prices that were above costs on a sustained basis would suggest weak competition among generators, and that the entry, or threatened entry, of new generators was not restraining prices. On the other hand, prices that were well below costs on a sustained basis would suggest looming problems with reliability of supply because new investment would not be able to keep pace with demand. The comparison suggests competition has been effective in restraining prices. Figure 14 shows how wholesale prices have moved broadly in line with the cost of adding more capacity. Importantly, there is no evidence contract prices have been above costs on a sustained basis in recent years (p32)

The other main point I'd like to make is that the ComCom paper currently places some reliance on where analysis of 'gross margins' might take you in any assessment of profitability. I'd say that the answer is, almost nowhere. They may have accounting or commercial relevance, but for all the reasons mentioned in para 68 of the paper they are indeed "an incomplete measure of performance". From an economic perspective gross margins tell you very little, although they might (in a very homogeneous industry) give some limited insight into productive efficiency. In particular there is no way of telling whether any particular level of gross margins is "too high"

I appreciate that in a world of limited and non-standardised industry data, ComCom is going to have to scrabble for whatever indicators, however indirect, are available to hand. But I'd downplay the gross margins route, and put more reliance on estimates of return on capital employed or return on equity (ROE), which in a market economy are the numbers that matter from an allocative efficiency point of view.

Two final small points.

In para 93 ComCom says that it will consider as an indicator of profitability "The returns being achieved on recent and proposed investment both by new entrants, and by existing participants expanding their operations, in the retail fuel markets ... we would expect returns on more recent investment to approximate the cost of capital if competition is workable and effective", which is very much along the lines of the point I made above about the profit conditions of the marginal producer. The only gloss I'd add is that, as ComCom looks at recent or proposed investments, it should be wary of the 'hurdle' rates companies tend to use to assess the profitability of investments (the projects have to have an internal rate of return that beats some minimum 'hurdle' level).

While generally it's very useful to examine internal company thinking at the time, the evidence is that hurdle rates are not good sightings of what the investing company thinks is its true WACC or ROE. The hurdle rate is typically well north of that, as companies tend to use hurdle rates to filter out overoptimistic managerial gaming of the investment budget.

And if the focus is going to be on ROE (as it ought), Stats already has some estimates of petrol company ROE in its Business Performance Benchmarker tool. Here for example are ROEs by size of petrol station. No idea of the basis of the calculations, but on the adage that if all else fails, read the instructions ...

* Gunnar Niels, Helen Jenkins, James Kavanagh, Economics for Competition Lawyers, 2nd edition, Oxford University Press 2016, p10

Where are the profits?

Yesterday I wrote up the big themes from the Budget (and a few of the minutiae), but didn't have time to write up one of the more interesting forecasts in the documentation (and you may well have a devil of a time finding it yourself, as it's in the 'Budget Economic and Fiscal Update 2015 Additional Information' document, which is the befu15-11of11.pdf file in all the bumph - you can find it here).

It's the forecast for profits - strictly speaking, net operating surplus, but same diff - for agriculture and for the rest of the economy over the next four years (years ending in March). I've extracted the numbers (from Table 3) and put in the percentage changes, and here they are.

Three thoughts, assuming the forecasts are mostly on the mark.

One, agriculture looks to be doing it tough over the next couple of years, and you can see why farming cropped up as a topic at the Reserve Bank's financial stability report last week.

Two, it's not much of a profit boom for the rest of the economy, either, is it? You'd think that in a economy of moderate wage growth, low interest rates, and ongoing economic growth averaging 2.8% a year, there'd be more of a profit gusher than this.

And three, our share market has risen to quite fancy levels on measures such as p/e ratios. Those expensive valuations may be explicable in a world where asset prices of all kinds have been inflated by globally cheap money, but shares priced as growth stocks don't make much sense if this is the profit outcome that's actually going to unfold.

Where would you expect to see high returns on equity?

Last week I posted some data showing the pre-tax rate of return on equity (ROE) for different sectors of New Zealand business, based on the latest Annual Enterprise Survey (AES) from Stats, and taken back over the past five years. Going by hits on the post, there was a lot of interest - partly, I think, because profitability is an interesting and important concept, and partly because nobody else seemed to be mining the rich seam of data in the AES, or not in public at least, so the results were new to a lot of people.

One of the conclusions I came to was that some sectors seemed to be achieving rates of profitability that looked rather high for the kinds of activity they're in, with wholesaling, retailing and construction, in particular, earning what looked like high rates of return for what looked like relatively workaday industries (although recently high ROEs in housebuilding were more explicable, given the very large post-earthquakes demand for scarce housebuilding resources). It's possible that there are subcurrents in the data that are exaggerating the ROEs being earned: for example, some industries don't need much capital invested in them, so any profits at all get compared with a small investment, giving you a large ROE. Or returns to human capital are being misattributed to physical or financial capital. But overall it still looked to me as if some industries seemed to be earning quite generous profits, given what they do.

That, however, was based on a rather subjective view of the relative riskiness of each sector of business. And it seemed reasonable to do that, at least for some sectors: without doing any sophisticated analysis at all, I'd have rated the more infrastructural activities like electricity, water, gas, transport, and warehousing as relatively low risk, everyday activities that would be consistent with earning modest ROEs, and indeed that's exactly what the AES data show. But for all I know there's more risk in some sectors than amateur navel-gazers might guess from the outside, and higher ROEs might well be appropriate compensation for those real risks.

Which was why I was interested to come across this guest post, 'The Industries Plagued by the Most Uncertainty', on the Harvard Business Review blog site. The three authors came up with one of these 2 x 2 tables, with an index of technological uncertainty along the horizontal axis and an index of demand uncertainty on the vertical axis. Here are the results: they're on American data, but I don't think that makes much difference, though we obviously don't have some of the industries that the States does (such as aircraft manufacture, or big pharma).

This seems to me to provide quite a nice anchor for the ROEs you might expect to see in an industry: it may not cover absolutely everything that an equity investor might expect to be compensated for, but it certainly captures two of the major kinds of risks, In the bottom left, you'd expect lower ROEs, since there isn't a lot of demand or technology risk that investors need to be compensated for, and you'd expect higher ROEs in the top right corner, where both risks are high. And when you look in detail the results, they seem commonsensical. The utilities, for example, feature where you'd expect them (bottom left), as do the high tech sectors (top right).

The bottom line is that I'm still left with some of the same conundrums as before. Why, for example does wholesaling, which on this analysis is one of the least risky business activities (and which you might have guessed was, without ever seeing this analysis), earn an ROE in New Zealand in 20-22% territory? Twice the return that manufacturing earns?

And it's not just industry sectors earning more than you'd think they ought - there are also some strange examples of industries earning less than you'd think they should be. Agriculture on this analysis is reasonably risky - it squeaks into the top right quadrant - but in New Zealand it earns a pitiful, pre-tax, 5% return on equity in recent years.

So there are some real puzzles here. And even for those of us who reckon that markets in general are a pretty good way of getting the most out of our resources and best delivering what people want, you find yourself wondering if something isn't working out the way it should.  On face value, these patterns of profitability don't sit comfortably with the view that competition will deal to excessive profitability, or (consequently or independently) that capital is being allocated to its most productive use.

Where the profits come from

In the last couple of posts I've been looking at the profitability of different sectors of New Zealand business, using the data from Stats' latest Annual Enterprise Survey.

For some reason the fascinating data in the Survey don't seem to get a great deal of airtime, so partly to make the case for greater use of it, and partly because the trends in the data are fascinating, and as a little bit of a public service (the numbers need a degree of assembly), I've pulled together this composite picture of business profitability over the past five years.

I've broken down some of the line items into sub-sectors where it seemed interesting, though there are still lots of sub-sector alleyways I haven't gone up, for example within agriculture and manufacturing. And in some sectors I've split out an "ex government" breakdown (eg in education and health where government is a big player) to get a better feel how private business is faring in those sectors. Profitability, by the way, is pre-tax return on equity. The years are financial years ending in March.

You'll see the unsurprising effect of the overall business cycle on profitability: ROE across all industries was only 6.2% in recessionary 2008-09, and has worked its way higher to the latest 9.1% (and I wouldn't be surprised if it edged higher in 2013-14). There may be additional cyclical stuff going on in the manufacturing ROE too: I wonder if that fall in the 2013 year was down to the impact of the high Kiwi dollar?

And you can see the impact of the Canterbury earthquakes in the 'health and general insurance' line, which took a hammering in financial 2011 and 2012. You see it again, less directly, in the ROE on residential construction in 2013, which rose to extravagant levels. There's quite a bit of year to year volatility at a sub-sector level, so I wouldn't read volumes into the latest reported 48.4% ROE on housebuilding, but whatever the number is, it's clearly happy days in the building trades.

Generally the pattern of profitability is much as you might expect a priori, with (for example) the utility/infrastructure end having a relatively low ROE. I'd hoped to unpack that 'information media and telecoms' line a bit more to see the infrastructural component, but confidentiality issues mean that Stats was only able to release a breakdown for 2013, so I flagged it away.

As I've noted before, some of the returns look on the high side for the kind of business they are - wholesaling, retailing, and construction in particular (the ROE on the various parts of construction was quite high even before the earthquakes). At a blind guess, before seeing the data, I'd have picked their ROEs as somewhere around the mid teens, but they're well north of that. It's hard to go past the thought that these are all non-tradable sectors that don't face the degree of competitive pressures more trade-exposed sectors like manufacturing have to cope with.

And while I'm open to anyone who can show some other realistic explanation of the high returns in these domestic sectors, I doubt that there's enough domestic competition to adequately constrain ROEs, either. Look at the comparison with the banks, for example: there are some sceptics who wonder about high profits from a banking oligopoly, and it was the explicit premise behind the formation of Kiwibank, But the returns from wholesaling, retailing and construction are all substantially above the ROE in banking, even if you take a generously high view of the banks' ROE (15.8% in the latest year).

The professional services sectors show an interesting pattern, too. The reported ROEs for the likes of science, architecture, doctors and vets, IT professionals, and lawyers and accountants are all quite high. And I don't have a problem with that (always assuming that the high ROEs aren't the result of gatekeeper restriction on supply). You'd expect it: these are scarce, often highly specialist skills that you'd imagine can command high returns as high productivity inputs.

But clearly there's something odd in attributing all of the return to the monetary capital invested in the business. The reported return on shareholders' funds grossly exaggerates the return on the capital invested, as it conflates the return to the tangible assets with the real source of the high returns - the intangible capital between the professionals' ears. And in turn that makes me wonder about some of the conclusions that Thomas Piketty comes to in Capital in the Twenty-First Century, where that 'high' rate of return on capital that he quotes must also be inflated by including returns that should more properly be attributed to a different factor of production. And the inflation will be getting worse as high knowledge activities progressively account for more of a modern economy
.
In any event, that's only one of the ideas that might come to you when you start using this data. There's lots more there - I've chosen to focus on ROE, but you could look at sales or profit per employee, balance sheet structures, margins on sales - so if you've got an interest in the performance of New Zealand business, tuck in. It's an invaluable resource.

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.

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.