Problems in Australian profit patterns

Interesting piece by Peter Durkin in the Australian Financial Review,
Accounting skulduggery hides $26b in losses, 

The article mixes together a few things, but I was struck by this graph from KPMG showing the profit patterns over the last eight years for Australia's top 50 listed companies. The numbers on the right hand side of the graph relate to revenue, on the left profits.

The graph suggests (I am just working from the visuals) that reported revenues have gone up by around 50 per cent. During that same eight year period, statutory profit before tax (the profit of the business after write-downs and charges) after rising sharply have trended down and are now lower in money terms than eight years' ago. Underlying profits have been trending down, but at a much slower rate and are still higher than they were eight years ago, leading to a growing gap between underlying earnings and statutory earnings.

Some measure of asset write-down is perfectly normal. Businesses make investment decisions. Some go wrong, some go right for a period and then go wrong. The most recent impairments reflect, at least in part, the end of the mining boom and consequent write-downs. However, the growing gap between underlying earnings and statutory earnings is a worry as is the poor performance of statutory earnings.

Both sets of measurement are subject to manipulation. New CEOs, for example, often seem to write of as much as they can in their first year to boost later performance in statutory earnings. Both businesses and investors focus on underlying earnings because they are meant to provide the best measure of the core strength of the business. We have had to make this financial write-off, but the underlying business is doing well. This creates an incentive to manipulate underlying earnings.

Accepting that both measures are subject to a degree of manipulation, the decline in both profitability measures relative to revenue is reasonably striking. Statutory earnings this financial year are likely to pick up because impairments will be less, narrowing the gap between the two measures, but I don't think that that will affect the overall trend unless underlying earnings increase.      

Sunday Snippets - lessons from the Murray Goulburn affair

Its a beautiful day here in Sydney. First load of washing hung out, second in machine. It's birthday season. Eldest's birthday was on the second, youngest today. Where have all the years gone?  I don't feel much like serious thought, so a random chat while I wait for the washing.

I briefly mentioned  the Northern Territory elections in Saturday Morning Musings - a changing Australia. The thumping that former Chief Minister Giles referred too has indeed been a thumping, with the Country Liberal Party reduced to two seats not including Mr Giles' own seat which he lost by just a few votes. There is some angst among the five independents that the CLP has been awarded official opposition status with the perks that go with that, but I guess that's the price you pay for being an independent.

I thought that I had commented on the Murray Goulburn affair. Apparently not, although  I have certainly written on cooperatives. It seems that the discussion was in comments, that I meant to write.

On its web site, the big dairy co-op bills itself (among other things) as The "Aussi farmer co-op." Therein lies the rub. Under the previous CEO, Gary Helou,  Murray Goulburn admitted external investors to raise additional funds utlising a reasonably complex financial arrangement in which the new non-voting shareholders were effectively guaranteed a return.The company pursued an expansionist policy to grow the business. In doing so, it got the milk-price wrong, creating a conflict between the needs of the business, the external shareholders and the co-op members.

I'm not sure that I fully understand the maths of what followed. However, as I interpret it, Murray Goulburn sets a milk price based on the price they expect to receive. This is then adjusted based on actual prices received. Murray Goulburn was slow to see that the market had changed. Then, when they did adjust prices, they declared that farmers had been overpaid and that this amount would need to be recovered from dairy farmers via future prices. So farmers were to receive a lower price because market prices had fallen, a lower price still to recover the "over-payment". This allowed the co-op to shift the amount of the "over-payment" from the profit and loss statement as an expense to the balance sheet as a capital item, one to be repaid by the farmers. In turn, this allowed Murray Goulburn to declare a profit and pay a dividend to the new external shareholders.

Farmers were outraged. Those who could, and they seem to be the bigger farmers, began to shift to other processors. Murray Goulburn's milk supply fell as a consequence, affecting production but also leaving the $183 million "over-payment" to be recovered from a diminishing group of farmers.

The problem now for Murray Goulburn is that the "over-payment" can only be "recovered" via future lower milk prices to producers. There is no legal obligation on farmers to repay the "over-payment", something you would expect from a capitalised item. By capitalising the item, they kicked the problem down the road a little, but also increased the incentive for farmers to move. If have interpreted the maths correctly, sooner or later Murray Goulburn is going to have to write a substantial portion of the "over-payment" off, thus reversing the previous "gain." In all, it's a bit of a mess.

Former CEO Gary Helou was clearly a charismatic leader with grand visions for Murray Goulburn. No doubt if he had got it right, much would have been forgiven. However, he lost sight of the principle that a co-op's first responsibility is towards its members and this inevitably dictates a degree of conservatism in approach. Growing the business has value if and only if it benefits the members. The business is a vehicle, not an end in itself.  

Woolworths pulls the plug on Masters

The decision by Australian supermarket chain Woolworths to throw in the towel on its attempt to build a hardware chain to rival Bunnings did not come as a surprise. It all proved just too hard.

Nine years ago, Woolworths under CEO Roger Corbett had the then second ranking Coles' group on the ropes. Coles had been bigger and more successful, but had suffered from lack of strategic investment and from corporate games. In 2007, the then industrial conglomerate Wesfarmers made an opportunistic bid for Coles. At the time it was seen as a gamble, but it proved to be be a successful move.

The seeds for later problems are often sown during periods of apparent success. Under Mr Corbett, Wooloworths had modeled itself to some degree on the US Walmart chain then seen as the global retail success story. However, and I am now speaking from a customer perspective, the company had under-invested in its existing stores, many of which seemed old and tired.

At the time of the Coles purchase, Wesfarmers already owned the Bunnings hardware chain.Since its acquisition in 1994, Wesfarmers had grown the Bunnings chain through further acquisitions and investment in big wharehouse stores.  In doing so, it overtook the previous market leader, Mitre 10, establishing a dominant market position.

The decision by Woolworths to establish Masters in conjunction with the American hardware chain Lowes had known risks. By the time of the launch of the first Masters store in 2011, Bunnings was very well established indeed. The new venture faced two practical problems. The first was simply finding suitable space for the stores. The second linked problem was building volume to get stock costs down and margins up. In the end, Woolworths was failing on both counts, leading to continuing losses. .

The move to close or dispose of Masters has been welcomed by investors and commentators. I'm not so sure. I would have thought that a for a new venture of this type you have to be prepared to adopt a really long term time horizon. Clearly Woolworths could not afford to do so. The real losers in all this are not just Masters staff, but also the suppliers who opted to supply Masters as an alternative to Bunnings.

Postscript

Another view on the strategic errors involved in the Masters matter - and another..  

Confusions over corporate social responsibility and the creation of shared value

The term corporate social responsibility emerged during the 1960s. In 2006, Michael Porter and Mark Kramer popularised the term creating shared value. Whereas corporate social responsibility focused on doing the right thing because it was the right thing, something leading to a compliance focus, creating shared value suggested that corporations could actually make money by benefiting the communities within which they lived and operated. I quote from the wikipedia article on creating shared values:

The central premise behind creating shared value is that the competitiveness of a company and the health of the communities around it are mutually dependent. Recognizing and capitalizing on these connections between societal and economic progress has the power to unleash the next wave of global growth and to redefine capitalism.

That's a big claim. I mention is now because Mark Kramer has been in Australia as guest speaker at a conference arguing that:

The Australian government should outsource social services to the private sector by providing tax breaks to corporations behind business ideas that help the vulnerable, leading US business scholar Mark Kramer has said.

The co-founder and managing director of US-based social impact advisory firm FSG said the government played a key role in galvanising companies to come up with services that would be both lucrative for the provider, and beneficial to the disadvantaged and neglected sectors of society – a concept he labelled "shared value".

On the surface, the idea that Governments should provide tax breaks to galvanise the private sector to come up with innovative solutions has little to do with the original concept of creating shared values. That focused on business doing things because, in the end, business would benefit, a very different concept from providing tax subsidies to unleash business creativity to solve social problems.

I mention this now in part because I am interested in the evolution of ideas about the role of business in society and the way this translates to rules and structures, more because it links to a very current trend, the search for "innovative solutions" in meeting social needs at a time when government action is increasingly constrained by the combination of cash constraints changing views about the role of government.

I call it the search for a magic bullet, and it doesn't work. This doesn't mean that I am necessarily opposed to the concepts of either corporate social responsibility or the creation of shared vales. It's just that I find current discussions very confused. Certainly they confuse me!.

Ubernomics

I hadn't really been following the rise of Uber and its competitors, nor the response of authorities until I saw this fascinating ABC story on the attempts by the Queensland authorities to crack down on the service. I was also interested in the pro and anti comments on the ABC story.

Uber is one of those fascinating examples of the disruptive effects of internet technology on existing businesses. The company obviously has deep pockets to be able to fight on so many fronts at the one time, including paying the fines of drivers in Queensland. I was also interested in this piece on Wired about the Rideshare Guy.

The economics of Uber seem to depend on the capacity to offer a lower cost guaranteed service in markets with restricted entry where regulation imposes costs on existing operators. Uber is also using a pricing algorithm, not always successfully as we saw in Sydney during the Martin Place hostage crisis, that allows it to surge prices at high demand periods.

To offer a guaranteed service,  Uber has to have sufficient cars and drivers available. As a niche service, Uber could depend on amateurs. As the service grows, it has to effectively create its own cottage industry, its own taxi service. The Wired article highlights some of the issues here.

Monday forum - US default & the implications for 2014

We will see this week whether or not the game of political Russian roulette being played out in the the US will lead to US debt default. It is difficult for someone at a distance to properly understand just what it is happening. If this New York Time story is any guide, it may be equally difficult in Washington. This Economist story on reactions in Peoria is, I suspect, probably not a bad guide to US local reactions outside Washington.

Meantime, major glitches have emerged in the roll-out of the the new insurance exchanges that form a key element of Obamacare. That's not surprising. The technical challenges were obviously considerable. Think NBN for an Australian example.

We now seem to have two choices. Later this week, the US will start defaulting as it seeks to meet daily bills only from the cash collected that day. There has been discussion about the extent to which the US Administration has power to prioritise, to focus on meeting its financial obligations while stopping other Government spend. I imagine that, regardless of the formal position, the US will try to avoid or minimise default on financial obligations.

The second choice is some form of compromise that will at least defer debt default. However, that is unlikely to provide a solution, if indeed a solution is possible.

I am trying to finish a major piece for Australian Business Solutions Magazine on the outlook for 2014. I suspect that you will see my problem. I am reasonably knowledgeable, but I struggle to break free from the shackles set by immediate issues.

I suppose that my immediate personal view is that a short term US default might not be such a bad long term thing, but then the global financial system is now sufficiently vulnerable that no-one can be sure. So to help my thinking, what do you think that the real outlook is for 2014? What would be the implications of a US default? 

Don't feel that you need to limit responses just to these questions. I am looking for inspiration!   

Postscript

The ripples from a prospective default spread. According to reports in the financial press, a number of the larger US money market funds have sold off their holdings of US Treasuries maturing in late October or early November, boosting their cash holdings and pushing short term interest rates higher. Short term funding issues are starting to emerge for US banks as well.

Writing in the Australian Financial Review, Karen Maley says that the impasse is now placing pressure on the $US5 trillion per day repurchase or repo market. In this market, banks or other borrowers use Treasury Bills as security for short term borrowing purposes. Say you need overnight cash, rather than trying to sell securities, you pledge them for cash from the money market funds. If you cannot pledge those Bills, you have a problem.

I imagine the the Federal Reserve could actually do something about that by pledging to buy Bills at face value or even at a premium to cover any missed interest payments. That would also provide protection for non-US holders.

Still, it is uncharted waters. 

Are Australian banks and supermarkets killing the goose that laid the golden egg?

The phrase Killing The Goose That Laid the Golden Egg comes from Aesop's. Interestingly, and this bears upon the discussion on the nature of civilisation, there is debate as to whether Aesop drew from India or India from Aesop.  However, that's a discussion for another day.

The point of the story and saying is that greed can lead to its own destruction. Two stories in the Sydney Morning Herald bear directly on this question.

Ian Verrender's Banks playing risky game with rates looks at the approach adopted by Australia's big banks to the setting of interest rates.

For the benefit of readers who don't know the Australian scene, four big banks dominate. There are smaller local banks and other financial institutions, but they play a subsidiary role. Overseas banks are present, but their role is even more limited and has become more so since the global financial crisis. This is a matter of economics, not legislation. Even in the days of the internet, It is very difficult to access the domestic savings base without an extensive network of branches, ATMs (Automatic Teller Machines) and EFTPOS facilities,

The smaller local banks, the regionals, and other institutions do provide a measure of competition at the margin.

Over the last thirty years, there has been a pattern in which the big banks effectively vacate certain niches because they can't make enough money out of them. Sometimes those decisions make sense, at other times not. The closure of bank branches in the name of efficiency is an example of the second. In recent years, all the majors have had to spend quite heavily rebuilding branch networks in order to maintain access to their customer base.

The niches neglected by the big banks create opportunities for other players. They move in and grow. That's competition. Government policy prevents the big banks buying each other, That's competition policy. Instead, the big banks buy the more successfully minnows, thus regaining the markets they abandoned, Again, that's competition.

In market terms, the Australian banking scene is best described as an oligopoly, a market in which a small number of players have the ability to be price setters rather than price takers. They watch each other and respond to each other, but try to do so in ways that will not damage their profits.

This is where Ian Verrender's article comes in. He argues that the approach adopted by the big banks to the setting of interest rates actually threatens the Australian economy. Instead of trying to sell money, that's what banks normally do, they are focused instead on increasing the margin between their costs of borrowing and the return obtained on loans. Watching each other carefully as they do, they wait for one bank to move and then the others follow. It's a ratchet effect.

To Mr Verrender's mind, this approach has two adverse results. It limits the availability of credit to new borrowers, while increasing costs for new borrowers. Profits rise as margins rise, However, if all the banks follow this approach, total lending will be adversely affected. Economic activity will decline, and so will bank profits. The goose will have been killed.

If the Australian banking sector displays oligopalistic tendencies, the Australian retail sector is a very clear oligopoly with two huge chains dominating most market sectors. To their many competing suppliers, those chains are an effective oligopsony, a few buyers and many sellers. The buyers control the market.

In competition terms, oligopoly is inherently unstable. Profit maximisation effectively depends on firms not competing on price, for if one firm shifts on price, the others must follow. Subject to price elasticities, the extent to which lower prices increase demand, profits fall for all.

The equation changes if the oligopolists are also oligopsonists. Their market power allows them to pass the costs of price competition on by squeezing their suppliers. Now the costs of competition are carried in whole or part by the supply chain.

This is just what is happening in Australia at the moment.

The two retail giants are in a price war centered on essential groceries. From an overall consumer perspective, the immediate gains are not as clear cut as might appear, for the chains have been increasing prices on other items. Still, products like bread and milk are at prices not seen for decades. This affects the consumer price index, for we actually have deflation in some areas. In turn, this makes it easier for the Reserve Bank to lower interest rates.      

So far so good. The problem lies in the squeeze placed on suppliers. This is explored in another Sydney Morning Herald article, Suppliers count the cost as Woolies and Coles shoot it out over prices.

As a consumer, I have noticed the progressive withdrawal of products I like from supermarket shelves. I do buy store brands, often I have no choice, but I don't have to like it. Beyond my personal response, the supermarkets are now effectively forcing industry restructuring in those sectors most dependent upon them as they seek to cut costs and build their own brands. They are holding their profits despite the competition, but the costs of that competition are being forced on suppliers.

In the longer term, that's not sustainable. Again, it seems another case of the golden egg.  

The Yindjibarndi controversy

Miss Eagle wrote in a comment on a post:

I haven't got to watch the Cleo stuff yet. Just writing to tell you about an advertisement appearing on your site. I don't know if you are aware but a Twiggy Forrest/FGM ad about the Yindjibarndi dispute at Roebourne is on your site. Please read the post on my blog about it - http://bit.ly/dK1Vou.

I checked through to the post in question. There I read in part:

I "Follow" Jim Belshaw on Twitter and I am a frequent visitor to his blog, Personal Reflections, and I happened to glance at his sidebar and discovered the Yindjibarndi advertisement.  Google ads do their best to match advertisement type to site text.  Jim occasionally writes about Aboriginal matters/history around New England in New South Wales where he lives as did his family before him.  So the word 'Aboriginal' is the only connection between Jim and his blog and the Google ad.

I actually live in Sydney now, but still call New England home. However, that's a minor quibble.

Miss E is a regular commenter and very interesting because she has different experience, a knowledge of the North, and so feeds me a different perspectives. On the other hand, I wasn't sure how to respond to her comment.

  It's interesting but actually not surprising that the Google algorithm should spot this blog. On this blog alone I have written over 100 posts on Aboriginal policy, history and life. Across my blogs I have now written almost  200 posts. Six of my last ten posts on this blog have dealt with or mentioned Aboriginal issues. Really, far to many for the balance I try to maintain. So the Google placement was not a surprise. 

I first became aware of Mr Forrest and the Yindjibarndi controversy when my past posts on Mr Forrest and Generation One (Andrew Forrest's 50,000 indigenous jobs, Generation One, Andrew Forrest and Aboriginal jobs) started getting new comments long after the post dates. As part of this, JabulaniSon in a comment referred to a vimeo video on the matter. By the time I looked at it, this had been taken down, apparently following protests by Fortescue. If you click through on the ad referred to it is clearly a response to the video. 

The Yindjibarndi people are one of the traditional owners of land on which Fortescue is developing its Solomon Hub.

On April 4 a misleading, heavily edited video of a important community meeting was circulated online. It is important that the facts are told.

The people speaking in this video are Yindjibarndi. They formed another corporation called Wirlu Murra Yindjibarndi as they believed the Yindjibarndi Aboriginal Corporation was not fairly representing their interests.

A meeting was held on March 16 2011 in Roebourne. All Yindjibarndi were invited, 170 attended. All had the right to vote, regardless of where they came from, regardless of how they travelled to the meeting.

The Fortescue offer to the Yindjibarndi is a $10.5 million package of cash, training, business development and housing.

20 people voted against the Wirlu Murra Yindjibarndi resolutions while over a hundred voted in favour of them. The 20 people control a media group and only wanted cash payments. The Community wanted jobs, training, housing and apprenticeships.

I am not in a position to comment on the accuracy of the Company's PR. Miss E's assessment can be found in these posts. The last post contains links to other material:

• 13 April
• 14 April 
• 19 April
• 20 April

For those who are interested in learning further I have given a few links below. I haven't attempted full coverage.

• ABC North West WA The Yindjibarndi FMG case provides an introduction along with links to previous ABC coverage on the matter
• ABC AM coverage here
• Age coverage here