Five asx small caps benefiting from the currency moves

Currency is complicated and it’s important to remember that unless you are renowned fund American fund manager George Soros, don’t invest on the basis of currency. Having said that, here are five companies that stand to benefit from a lower for longer Australian dollar (remember, think exporting) and then below I go into some depth about how currency effects companies.

1. Austal (ASB:ASX)

Austal is a global designer and builder of ships. Its main ship yards are in WA and in the US. It designs and manufactures defence and commercial ships. It specialises in twin hulled aluminium ships and ferries.

The ship builder has the bulk of its contracts in US dollars and has made the correct decision to raise US dollar debt and carry cash on the Australian side to offset currency risk. For example, the ship yard is valued in the region of US$200m, but this is funded with US debt, so currency moves don’t affect its gearing ratio.

Under the Radar’s view:

We were buyers around $2 late last year and earlier this year, but now that the shares have almost doubled to $3.84, we are taking some risk of the table. TAKE PROFITS.

2. Evolution Mining (EVN:ASX)

This company has diversified gold mining operations in Australia and is the country's second largest producer of the yellow metal.

It’s easy to forget, but US dollar denominated gold had a big shakeout after reaching a high in the latter half of 2011 of around US$1,900 an ounce to lows of close to US$1,000 an ounce in the following four years. The Australian dollar gold price has been kind to the surviving producers like Evolution Mining and Northern Star; as has their ability to mop up cheap but profitable mines. It’s clear that this domestic consolidation has come to an end for the time being.

Under the Radar’s view:

It’s a brave investor to step in front of the Evolution team, our favourite gold stock, led by the ex-Macquarie Banker Jake Klein, whose philosophy very much fits the zeitgeist of not paying up for mines and creating a big portfolio that delivers no matter where we are in the cycle. This style suits investors who are risk averse, and it has worked a treat, having returned 44% in the past 15 months for subscribers and more than four fold since we first recommended the stock back in late 2014. HOLD.

3. Afterpay Touch (APT:ASX)

Afterpay is a buy now pay later credit provider, operating in Australia with a growing presence in the US and has recently entered the UK market. Credit is extended on an individual purchase transaction basis at the point of sale (in store or online). Customers pay for their purchase in four instalments, due every two weeks. The customer is not charged interest but is liable for late fees. The merchant is paid straight away less commission (4%-6% commission plus a 30 cent at fee). The credit risk is borne by Afterpay.

The domestic market is important, but the key to this stock is the US and fortunately where it is kicking goals. Here the company is achieving $1.7bn in annualised gross merchant value (GMV) in 13 months of operations; the country now contributes 17% of group sales. However, we suspect the group is still making losses in this market as it spends big for growth.

Under the Radar’s view:

The company has first mover advantage and is building a competitive advantage. If management successfully execute the offshore strategy this stock will likely run further. But there is significant price risk. HOLD.

4. Nearmap (NEA:ASX)

Nearmap is an Australian export success story. It provides instantly accessible, frequently updated, high-resolution aerial imagery taken from light aircraft. Its intellectual property lies in its camera and software technology. The company has a user-based subscription model that provides an annuity style income stream. A wide-range of industries are serviced, including architecture and engineering, construction, government, insurance, property, rail, roofing and solar. It currently operates the Australian and US markets and is looking to expand other geographies.

Under the Radar view:

Despite bottom line losses increasing in its FY19 result this month, the company has good momentum at the top line. It is still an early stage and requires investment to expand and is not cheap trading on an estimated FY20 EV/revenue multiple around 12 times. Having realised some gains a number of times, the pullback in the share price is an opportune time to upgrade to HOLD.

5. Catapult (CAT:ASX)

The company is leveraged to the growing need for winning strategies in sport which don’t include ball tampering. The fast-growing sports analytics technology company has made a big mark on the world stage. We spot a buying opportunity following a fall in the share price & a capital raising. The FY19 result showed that investors are cottoning on to this Under the Radar story, boosting its share price by 20% on the day of release.

Under the Radar view:

The stock is still recovering from a big sell off since its $4 level in mid-2016. At $1.40 it’s still great value, trading on a sales/market cap multiple of 2.5 times for FY20. The company is attacking the lucrative elite sports market and although it does have problems, these are nothing that growth can’t fix, helped along by the tail wind of a weak Australian dollar. SPEC BUY.

What’s going on with the Australian Dollar

The Australian Dollar is always a wild ride, but never more so than now when predicting its moves is harder than anticipating what’s going to come out of the U.S. President’s twitter account.

The two are not unrelated because relatively speaking, the Australian economy is small and remains resources based, which means it is heavily dependent on global economic growth, which is showing signs of stalling against the backdrop of the US-China trade war, stoked in no small way by one Donald J Trump.

Not helping is an iron ore price in free fall, having fallen 30% this month on global growth fears, plus the recommencement of production of the giant Brazilian miner Vale following the collapse a dam and the loss of some 250 lives. Iron ore and coal are Australia’s biggest exports, representing almost 40% in value terms.

Exporters win, but it’s not that simple

Wild though it may be, the word exporter comes to mind when you look at the 38% devaluation of the Australian dollar when compared to the US dollar over the past eight years, since its record level of circa US$1.10/A$ in May 2011 to where it trades today at just below US$0.68/A$.

Any Australian company that earns money from offshore markets and translates that back into Australian dollars is a beneficiary.

But if it was so simple as just going out and buying an Australian exporter, more fund managers wouldn’t be going out of business. You don’t invest on the basis of currency unless you’re Soros, who I mentioned earlier in the article. In 1992, Soros made US$1 billion by betting that the British Pound would go down – but feats such as this are extraordinarily rare and risky.

Many analysts, including us, work on the assumption of eliminating the currency effect to establish what the “real” or “underlying” earnings of a company are, which is why companies often cite sales result comparisons with prior periods on a constant currency basis (using the same exchange rate for each period).

Let’s put it another way, if we’re recommending Austal (ASB) it’s because we like the company’s ability to build ships and that the demand for those ships is increasing. We’re not doing it because it might get a currency kicker after the rapid depreciation of the Australian dollar. This is a ship builder not a currency trader.

This doesn’t account for the small cap factor

Big companies are called multinationals for a reason. Companies like BHP and Rio Tinto have assets all around the world, which creates an effective hedge against currency movements.

The stocks that stand to be most affected are much smaller and are exporters in the true sense of the word, because they don’t have the same opportunity to diversify their production as well as their sales. These companies create products or services here, so have fixed costs in Australian dollars, but generate significant sales from offshore.

It’s also worth noting that the effect of sharp changes in exchange rates often takes longer to play out on companies that are genuine small caps. Because these companies are less scrutinised by the market often the effect of an exchange rate move only occurs when they report, leading to a surprise (either positive or negative). Share prices move big time when there are earnings revisions.

Weaker for longer?

Finally, a downward move occurred in the past month following the devaluation of the Chinese yuan to its lowest level since 2008 when the People’s Bank of China allowed the market to set its rate causing it to breach 7 against the US dollar. On top of this the RBA is in an interest rate reducing phase due to weakening domestic growth (although it can’t go much lower than the current official rate of 1%).

There is a consensus that the Australian Dollar is headed for more weakness. For companies, outlook statements in the current reporting season will be important, as will be the amount of hedging. If a company hedges its foreign exposure, then it’s possible that any change in gross profit margins in Australian Dollar terms will not happen for as long as a year (assuming exchange rates remain at current levels) when it has to roll over those hedges.

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