Prices vs. Profits

By DAVID MOON, Moon Capital Management
July 8, 2007

There is something that draws me to extremes. I love convenience stores and Wal-Marts.

One is just a little bitty version of the other. They each sell magazines, fresh quasi-pizza, baseball caps, CD players, toilet paper and gasoline.

Lots of gasoline.

Families across our great nation are enjoying the summer, continuing traditions that span generations. Things like beach vacations or Disney World. Camping trips and mosquito bites. Visits with grandparents.

And higher gasoline prices.

The relationship isn't perfectly predictable, but retail gas prices normally increase about 10 to 20 cents a gallon from January to June.

That's why I was so surprised when the independent gas station-convenience store down the road from my house closed a few weeks ago.

How could a business fail when its most visible product is increasing in price?

More easily than you might think.

Most people don't realize it, but the retail profit in a gallon of gasoline ranges from negative 2 percent to positive 7 percent of the pump price. The average for a well-run company is about 3 percent. For every gallon of gas you purchase at the corner Pilot station, the company probably makes less than a dime.

The average price of a gallon of regular gas in Knoxville is about $2.82. The largest part of that amount pays for the cost of the crude oil. At $70 a barrel, $1.60per gallon of the pump price simply pays for the stuff in the ground. It costs another 80 cents a gallon to refine it. Then there are state taxes, federal taxes and distribution costs. The bank that processes the credit card transaction makes 2 percent.

You pay $2.82. The gas station is left with 8 cents.

The bank gets 6 cents, almost what the gas station makes.

And as the pump price of gasoline increases, the retailer actually makes less money.

When the price of crude oil increases, that price is immediately reflected in the cost to the refineries. But it typically takes seven to 12 weeks for the wholesale price increase to be fully reflected at the retail level.

During that adjustment period, the retailer experiences smaller margins.

With that piece of information, it becomes a bit easier to see how that gas station down the road from me failed. Oil prices increased, as did the pump prices, but the small businessman who owned the station was actually making less money. And if any of his customers reduced their driving because of higher prices, his problem was compounded.

When you're selling a product with a 1-percent profit margin and that margin is declining, it doesn't take much of a decline in sales to shrivel your bottom line.

I'm guessing that this little gas station wasn't selling enough cappuccino and gross cheeseburger-flavored things shaped like hot dogs to compensate for the decline in fuel profits.

As consumers, it's pretty easy to mistakenly assign all the blame of retail price changes to the folks who actually hand us the goods we buy.

But if the product is readily available in many locations, if the retailers are selling the same product and if consumers have knowledge of their shopping alternatives, it's a good bet that changes in the retail price reflect changes well up the manufacturing-distribution channel, not at the retail level.

David Moon is president of Moon Capital Management, a Knoxville-based investment management firm. This article originally appeared in the News Sentinel (Knoxville, TN).

Add me to your commentary distribution list.

MCM website