Rising dollar, falling profits

By Roger Armstrong

Thursday 1st August 2002

The sharp rise in the Kiwi dollar is causing headaches for exporters. Roger Armstrong looks at the impact on the share market

If you didn't make money on the share market last year, you probably never will. Economic conditions - falling currency and interest rates - were the ideal backdrop for a booming share market. The low currency lifted exporters' profits and enabled the economy to bubble along nicely. Lower interest rates also assisted the economy and, more importantly for share investors, helped expand price earnings and therefore share prices.

All investors had to do in 2001 was avoid Telecom, Air New Zealand and the tech stocks, buy a good underlying business - Fisher & Paykel, Fletcher Building, Sky City, for example - and hold on tight. Okay, the September 11 attacks on the US caused some temporary rumblings on the market, but many investors feasted on high returns in this mid-cap sector.

Unfortunately, in 2002 we have the mirror image of last year's optimum conditions. Many a good company's share price has taken a beating at the hands of economic change.

This is no big surprise. Every housetrained economist and his assistant have been forecasting a recovery in our formerly collapsed currency and a rise in interest rates for some time. They eventually had to be proved right.

The problem has been the speed of the Kiwi's movement. It has risen 18% against the US dollar since the beginning of the year, leaping 10% in a recent five-week period. Ouch. The effect of such a sharp currency rise on exporters' income is profound. Low-margin operators are particularly susceptible to even small currency movements.

But even a fat-margin business like farming is not immune. Economists are predicting an approximate 30% reduction in farm incomes next year. Worst hit by the speed of the dollar's rise are lower margin manufacturing businesses.

Consider a hypothetical New Zealand widget-maker that exports to the US. It has, say, $8 million of costs in New Zealand and $US4 million in revenue. At a 40 cents exchange rate the company books revenue of $10 million and a $2 million profit. At a 50 cents exchange rate, sales go to $8 million and the 20% margin enjoyed previously is wiped out.

In reality, most exporters have some costs designated in US dollars, such as raw material, freight and distribution. Even if 25% of costs were incurred in US currency, our hypothetical company would still see its profit margin slashed from 20% to 5%.

Figures like these have halved the share price of Fisher & Paykel Healthcare this year and seen Sanford drop 30%. Already the forecast for Fisher & Paykel Healthcare is for a margin fall from 41% to 35%, despite the company avoiding most of the nasty effects of a rising currency to date with hedges at around the 43 to 44 cent level.

Not many large exporters to the US are listed on our share market, but some of the operations of Carter Holt Harvey and Fletcher Forests would be currently hurting if it weren't for the foreign exchange cover the companies locked in place when rates were lower. Such cover doesn't last forever. If the New Zealand dollar stays up, eventually the pain will be felt.

So far our market seems to have ignored the impact of the rising New Zealand dollar on early stage companies such as Mooring Systems and Genesis that have little current revenue but whose future anticipated revenues are in US dollars.

While the Kiwi has gained the most against the US dollar, it has also risen against other major currencies. The 6-cent move from 81 cents to 87 cents against the Australian dollar may not sound like much, but it will hurt many New Zealand manufacturers exporting to Australia at reasonably skinny margins. Take a local company with all its costs in New Zealand dollars previously enjoying a 10% margin on sales into Australia when the Kiwi was worth 80 cents against the Australian dollar. That same company will see only 2% of sales flow to the profit line when the Kiwi lifts to 87 cents. Companies such as Bendon (now part of Pacific Retail Group) and Cavalier are large exporters to Australia. Luckily both have a lot of costs in US dollars that provide relief from their lower export receipts.

Another effect on the share market of a rising currency is a reduction in the earnings of overseas subsidiaries when those profits are consolidated back to the parent company's accounts. A 10% strengthening in the New Zealand dollar against the Australian dollar sees any profits earned out of businesses across the Tasman devalued by 10% versus what they would have been at the old exchange rate. Nuplex and Michael Hill, which earn approximately 60% of their operating profits in Australia, are two of the most affected. Richina, with the majority of its value in China, is another. These companies partially hedge this currency risk by holding debt offshore.

Then there is the "second round" effect of a rising currency. When exporters get hurt, so do the companies that sell to them. Stock and station agents like Wrightsons, Pyne Gould Guinness, and Williams and Kettle have all been smashed in the market by investors who assume these companies' clients will clasp their chequebooks tighter in future. Smith City Market is another you would expect to be hurt.

Tourism operators face a similar second round effect, with a high currency likely to turn off some overseas visitors. Offsetting this is the fact that, as any of you who have recently travelled overseas will know, New Zealand remains one of the cheapest destinations in the world without actually having beggars in the street.

The New Zealand dollar hit a nadir of 38 cents and hovered in a range of 38 cents to 41 cents for a long time. That range now appears to have been an aberration. If exporters didn't make buckets of cash at that level they should just give up. The trouble is, at the start of the year the share market was pricing companies such as Healthcare and Sanford as if the dollar was going to sit at around 40 cents forever.

The currency move to date simply takes most exporters back to more normal profit levels. For example, farmers in the season just ended had never had it so good. They may incur 30% falls in income next year but this will take them back to the levels they made in 2000, which were still buoyant when you look back at previous years.

As a whole, most exporters or those servicing the sector are reasonably comfortable with a 49 cents dollar. The danger is in what lies ahead. The dollar is expected to go over 50 cents, with most economists picking it will rise to 55 cents. It may not be the actual level that does the damage. Fears that it will go even higher and hit 60 cents could frighten people into clamming up on expenditure and investment. Then we should all worry.

Disclosure of interest: Roger Armstrong owns shares in Pyne Gould Guinness

Roger Armstrong
finn.ltd@ihug.co.nz

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