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Delayed reaction

By Roger Armstrong

Monday 1st September 2003

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A low New Zealand dollar is like a steroid shot for exporters. The poor of health can be made to feel passably good for a while and the truly healthy made to feel invincible.

On a macro level our fragile little economy also gets a fillip from a low currency before once again showing its true anaemic self when the Kiwi picks itself off the floor. With the dollar now occasionally hitting US60c, watch out for serious withdrawal symptoms from those caught on the elixir of a low currency.

For some corporates the withdrawal symptoms are being delayed as they use up a stash of low currency acquired through clever hedging when the Kiwi was grounded. But boy, when the hedging runs out these exporters risk the financial equivalent of the bends as they go from a US40c currency to US60c, in some cases overnight.

On the sharemarket the two companies with the big forward cover books are Carter Holt Harvey (CHH) and Fisher & Paykel Healthcare (FPH). Currently, the market appears to have been lulled into a false sense of security with these exporters because their earnings are holding up, even though the theoretical damage to their valuations - caused by the currency rise - is huge.

CHH has hedged its entire US dollar sales in 2004 at US44c. Given where the dollar is currently, it's estimated that these hedges will make the company around $180-$190 million this year. If CHH was selling at the spot rate the company would be very close to break-even point judging by brokers' forecasts, which vary between $190 million and $230 million.

Amazingly, CHH shares are up from around $1.60 in September last year when the currency was at US46c. The market appears to have ignored the enormous value implications of a higher currency just because this year's earnings are insulated.

It's not just the low margin exporters stand to lose from the soaring Kiwi. Take FPH, which this year is forecast to make sales of just under $US120 million ($207 million). Translated at its hedged rate of US49c for profit and loss purposes this gives sales of $242 million; translated at US60c the sales would look less impressive at $197 million.

More importantly, if not for the hedges, FPH's margins would be squeezed by the rising currency as almost all sales are in foreign currencies and a good deal of its costs in New Zealand dollars.

The analysts appear to be assuming the company will make fat operating margins this year of around 34% (down from a 38% peak when the currency was at lower levels in 2002). Some simplified modelling suggests margins would contract to around 28% if the company was transacting at US60c. This modelling is consistent with the 29% margin achieved in 1998 when the dollar was last around current levels.

High-margin technology exporters like FPH do not get thumped by a high dollar as much as low value-added commodity players, but they still get a reasonable tickle up. Because FPH has considerable cover locked in until 2007 the market is pretty relaxed about the effect of the rising currency, the share price having risen from under $10 in September last year to $11.96 at the time of writing, notwithstanding the strength of the Kiwi dollar.

If the company was having to trade at around a US60c spot rate its operating profit would be roughly a third less than that currently being reported. Investors should arguably be very concerned at what happens to profits when the low currency injection wears off. Or another way to look at the same issue is to ask what the company would look like if it cashed in its currency hedges tomorrow, banked the cash and starting selling its produce at the spot rate of around US60c.

This is how a sophisticated corporate buyer would evaluate a company in FPH's position. If you assume the currency stays relatively constant at current levels, in theory the value of the company is similar whether it cashes in its hedges today or whether it lets them run their course.

Looking at FPH this way suggests it is trading on the equivalent of an ungeared PE (price/earnings ratio - the company's market price over earnings per share) of about 28. It is debatable whether most investors realise that they are effectively paying such a high underlying multiple for this admittedly brilliant business.

It could be that if the currency sinks before the company's hedges have been extinguished there will never be a problem, but if it stays at US60c for the long term investors may get the same rude shock as the company itself.

Favourable currency hedges are a nice tonic but they are not a permanent cure to a long-term movement in the currency.

Roger Armstrong is an independent analyst. Disclosure of interest: nil.

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