Three small caps enjoying the $A fall

It was sobering to see the Australian dollar tumble to fresh 33-month lows against the greenback on Tuesday evening.

This makes the Australian dollar the worst-performing major currency over the last six months, and its fall from grace is unnerving many in the market who regard the strong Aussie as a symbol of everything that has gone right with our economy.

But the weakening exchange rate leaves a good number of small cap stocks on the cusp of an earnings upgrade cycle, as highlighted by Ian Verrender last month, as analysts have been caught off guard by the sudden and vicious drop in the Aussie. It plunged to a low of US93.3 cents yesterday, but has since recovered to around US94.5 cents.

This might surprise you, but the currency impact is being just as acutely felt, if not more so, among a select group of juniors than large cap stocks.

While it is true that smaller companies tend to have far more limited offshore sales exposure than their bigger rivals, a good number of emerging companies in the Uncapped 100 generate almost all of their income in foreign currencies.

In fact, around a quarter of the Uncapped 100 stocks (you can find the full list of the Uncapped 100 at the bottom of the article) make at least half of their sales in another currency, and these aren’t just made up of resource companies that sell mineral and energy commodities to the global market in US dollars.

Industrial stocks in the Uncapped 100 with the greatest foreign currency exposure

For instance, industrial companies like property investment company Astro Japan Property Group (AJA) and Asian real estate website operator iProperty Group (IPP) have next to no Australian market exposure.

However, it is not easy to quantify the earnings impact from the exchange rate because a number of these companies use derivatives to hedge their currency risks.

Take Acrux for example. Most of the biotech’s revenue comes from royalties that are paid in US dollars, but in its 2012-13 accounts the company said that a 10% change in the exchange rate would have an “immaterial impact” on its net profit as it uses spot and short-term forward sales of US dollars.

Further, trying forecast where the Australian dollar might go over the short term is hard enough, let alone guessing where it will average for the year, with the latter being more important in determining earnings.

With the financial year ending in just a few weeks, the Australian dollar is likely average $US1.03 for 2012-13, and a number of investment banks have been busy cutting their exchange rate estimates for the new year to between US85 cents and US90 cents. This could represent up to a 17.5% tailwind to the US earnings for some companies.

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I’ll ignore the performance of the local dollar against other currencies for now, as the US dollar is the current focus. On the back of this, there are three companies that stand to benefit materially from the strengthening greenback.

Nanosonics (NAN)

When it comes to currency leverage, it’s hard to look past Nanosonics.

The stock is attractively priced, even if our dollar was at parity, and any fall-off in the Australian dollar will only make the stock more compelling.

The company has developed a device to more efficiently disinfect ultrasound probes and generates 69% of total revenue from North America.

However, unlike most of its peers, it manufactures the units and consumables (such as disinfection liquids) locally. This means a lower Australian dollar will not only increase its top line, but will pad its profit margin as well.

This can be seen if its 2011-12 accounts are used as a guide. Nanosonics’ chief financial officer, McGregor Grant, estimates that a 10% decline in the Australian dollar against the US currency would have added $1 million, or 17%, to its earnings before interest and tax.

What’s more, Nanosonics is not locked into any long-term hedging contracts and is well placed to benefit from the lower Australian dollar over the next 12 months.

The next catalyst for the stock could come in the next few weeks as GE, which has the exclusive right to distribute Nanosonics’ device in the United States, is expected to sign a new agreement with Nanosonics that could see the global conglomerate commit to a large order for the devices.

The stock is hovering close to its more than two-year high of 58 cents, but that is still comfortably under the average broker price target of 69 cents a share. The longer the Australian dollar remains on the back foot, the greater the probability that this price target will be revised upwards.

Unity Mining (UML)

Miners will be eagerly watching the declining Australian dollar, but those with onshore operations will be wearing the biggest grins.

This is because selling commodities in US dollars, but having most of your costs in Australian dollars, will enable the miner to report higher translated revenue from the stronger US currency and fatter margins as Australian dollar expenses fall relative to sales.

YTC Resources, Doray Minerals and Unity Mining are the only mining companies on the Uncapped 100 with all their assets in Australia, but only Unity is in production and can benefit from the current slump in the exchange rate.

The chief executive of the Tasmanian-based goldminer, Andrew McIlwain, told Eureka Report that a 10% fall in the $A/$US exchange rate will lift its earnings before interest, tax, depreciation and amortisation (EBITDA) margin by around 25%.

The floundering Aussie could mark a turning point for the stock, which has bounced 28.3% to 7.7 cents since hitting a record low of 6c cents in May due to the falling gold price and general market distaste for risky smaller producers.

There is value in Unity for those with a stomach for risk. The Henty gold mine, which is Unity’s flagship project, is cash flow positive and financially viable given its low cash cost of $900 plus per ounce including royalties.

Henty produced 4,831 ounces of gold in April and is on target to achieve full-year production of around 50,000 ounces for 2012-13.

All brokers polled on Bloomberg rate the stock a “buy”, with an average price target of 15 cents.

Sirtex Medical (SRX)

The market darling is starting to look fully valued after its share price doubled over the past 12 months, but the exchange rate is starting to inject some value back into the stock.

The liver cancer treatment developer is the ninth-best performer in the Uncapped 100 as investors have gotten excited that its technology is gaining serious traction around the world.

The downside to the success is that Sirtex is trading on an estimated one-year forward price/earnings ratio of over 25 times.

But with close to 98% of total revenue denominated in US dollars, brokers will probably be upgrading their profit forecasts on the stock if the Australian dollar remains under pressure.

Consensus estimates is currently anticipating a 43.5% surge in adjusted net profit to $27.4 million for 2013-14, but analysts are probably assuming that the Aussie hovers around parity to the greenback.

At US85 cents though, analysts will upgrade Sirtex’s net profit to just under $30 million as half of Sirtex’s earnings are naturally hedged because of its US manufacturing operations.

This means an 18% drop in the Australian dollar will see its bottom line increase by 9%.

This in itself won’t put the stock deep in value territory, but it will put the stock on a relatively attractive forward P/E of about 23 times, or about a 39% discount to global peers and 4% discount to Sirtex’s five-year average.

But one shouldn’t be thinking of Sirtex like a value stock. If you did, you would never buy it and would have missed out on its stellar run.

A company with Sirtex’s track record and growth projector will always command a market premium, and the trick is to get in with as small a premium as possible.

Brendon Lau may have interests in some of the stocks mentioned in the article.

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