How changes in the AUD affect global-facing businesses
The gyrations of the Aussie dollar are a constant focus of media attention. And well they might be. Because, apart from reflecting our national economic health, the strength of the Aussie dollar relative to other currencies has a big impact on exporters, and on businesses that generate earnings overseas.
Having fallen significantly from its lofty levels above parity with the USD maintained between 2011 and 2013, the AUD has recovered somewhat over the last 18 months. This has come on the back of a combination of a weakening USD as well as improving commodity prices.
The Trump tax plan has reignited the reflation trade, and in combination with quantitative easing (QE) Tapering bolstering the USD, the AUD has fallen from its recent highs.
Movements in the AUD impact company earnings in a number of ways. The main two types of impact are though translation and transaction exposure.
Translation exposure refers to companies with earnings generated from overseas operations. These companies will have both revenue and costs denominated in foreign currencies. The impact of a fall in the AUD will generally increase the AUD profit generated by the business by a similar percentage as the increase in revenue and costs. Some examples of companies with high levels of translation exposure are Brambles, Amcor, Boral and Computershare.
Transactions exposure generally impacts companies that export products from one country to another. As a result, a proportion of the company’s costs will be denominated in a different currency to its revenues. This can lead to significant movements in product margins as a result of changes in exchange rates. Resources companies and other exporters like wine producers have high levels of transactional exposure to the AUD. Another source of transactions exposure is through input costs that are denominated in foreign currency.
Given changes in the AUD impact margins for companies with transactions exposure, the earnings of these companies tend to be far more significantly impacted by exchange rate movements.
The market will generally anticipate the impact of recent movements in the AUD on company earnings. However, projections tend to use simplistic sensitivity ratios. The actual impact is generally more difficult to estimate due to secondary impacts, particularly when underlying product pricing is less visible.
The wine industry provides a typical example of where basic earnings sensitivities can overstate the benefit a company’s earnings will generate from the fall in the AUD.
Wine exports are generally priced in the currency of the destination market. Movements in local currency pricing will be driven by the market power of customers and the activity of competitors. The fall in the AUD should lead to a significant increase in gross margins for Australian wine producers due to the impact it has on unit revenue in key export markets (US, UK) while leaving unit costs unaffected. For example, Treasury Wine Estates (ASX: TWE) indicated in its 2017 result presentation that a 10 per cent change in the AUD against the USD and GBP would impact group earnings before interest and taxes (EBIT) by over 10 per cent
However, two factors must be remembered. The first is that this sensitivity is net of the impact of hedging. As of a month ago, TWE had hedged 65 per cent of its exposure to the GBP and 55 per cent of its exposure to the USD if the AUD moved above US$0.79 and £0.59. This is a temporarily benefit that merely delays the impact of AUD movements.
Secondly, wine companies such as TWE are selling into highly concentrated retail markets. Additionally, a number of other wine producing countries are also benefiting from depreciating currencies, namely producers from Chile, South Africa and Argentina. The average AUDUSD increased 3 per cent in the 12 months to June 2017. This compares to a 4 per cent rise in the Chilean Peso, a 22 per cent fall in the Argentine Peso and a 6 per cent rise in the South African Rand.
The Australian industry has merely maintained its FX determined cost competitiveness on unit costs relative to a large proportion of its competitor base in FY2017.
Retailers are also able to calculate the benefit of the falling AUD to the producer, providing them with a strong argument in negotiating reductions in local product prices. The increased competitiveness of producers from Chile, Argentina and South Africa, along with other producers in Australia provides the retailers with leverage in negotiations. As a result, at least some of the transactional benefits from the falling AUD are likely to be competed away.
For companies with translation exposure, the key to determining the net impact on margins is determining whether the business has competitors that have cost bases denominated in other countries.
The current AUDUSD spot rate is around 4 per cent higher than the average for FY2017, indicating that, at current exchange rates, the AUD will be a drag on growth in FY2018.
The flipside, and potentially underappreciated benefit, is for companies focused on the domestic Australian market with local cost bases that primarily compete with imports. While a falling AUD might not have an immediate impact on competitor pricing and activity, over time the willingness of import competition to absorb the impact of the weaker AUD is likely to dissipate. The opposite applies during periods of sustained appreciation of the AUD.