Change is the only constant
29 September 2010
Sean Russo
FOR some time now much of the mining community has outsourced the concept of managing metal price and currency price risk to its shareholders. “That’s why they buy us”. “Not up to us to try and second guess the market”. Simple statements that supposedly pass the responsibility for significant risks that could (and regularly do) lead to business failure belie the truth of complexity and responsibility of properly running a multifaceted business such as a mining company with multiple exposures to metal(s), various currencies, diesel, electricity, freight rates etc.
The concept that shareholders see gold price exposure as the key determinant for the purchase of shares leads to a position that a company must remain fully exposed to Gold Price, whatever the potential consequences. But look around, in the case of a gold price constantly rising, so far, so good. But look a little bit further afield at the type of volatility that we’ve seen in the price of nickel shares and other metal producers when those markets have failed to hold their uptrend and not returned to their highs. See the damage that was wrought on copper producers’ best laid plans (and share prices) during the GFC price slump and it’s quite clear that when you outsource metal price risk (and other risks) to shareholders, you in-source the risk of having your share price collapse and with it the loss of nearly all your operating flexibility. It is, however, very clearly a feature of investing in or working in the resources sector that will continue for some time while there is a belief in current themes and trends and all participants are consenting adults no-one is forced to play.
A parallel trend I find quite disturbing is that we are now observing similar behaviours and attitudes in industrial or corporate enterprises. Management is taking the view, and to some extent promoting the view, that because their core business is exporting a product like overpriced board shorts, or selling a technology or software – basically selling anything overseas – that it should concentrate on that and not on the business of speculating in foreign exchange!
Sorry, if you have costs, major capital investments and debt in one currency and revenues in another you are in the business of foreign exchange, whether you admit it or not. What’s more ridiculous is that the speculating they are actually referring to is properly called hedging. The speculation was entered into some time before when they built a long term business plan on an assumed exchange rate. On a year-to-year basis as a company tries to deliver on its long term plan it should quite reasonably look to manage its exposure to exchange rates to ensure revenues exceed expenses by a healthy and predictable margin.
Of course hedging removes the opportunity to have a favourable outcome when exchange rates move your way, despite the fact everyone under 21 in the US is going Emo and not buying board shorts like they used to and USD revenues are down. But that’s not speculating, according to many of our leading companies. To hedge is to speculate and to remain open to the markets is proper and prudent. In fact, I do believe they are starting to parallel the mining industry and suggest that shareholders know about these risks and they would only confuse things if they started to try and manage them.
Of course the problem is you the mining industry are getting away with being exposed to a rising AUD because your products are currently keenly sought after. You have an embarrassment of riches, rising USD prices and rising demand leading to USD revenues outstripping the negative impact of the AUD/USD rise. You are the source of their exchange rate nightmares but they are emulating your equity market strategy!
Back to simple statements to deal with complex problems. The recent reporting period saw an increase in many of our leading industrial companies (if that’s how we categorise non-miners these days) that are exposed to exchange rates reporting their earnings numbers in a number of different ways. The wonderful new contribution to truth in reporting all things financial is ‘Constant Currency’.
What’s ‘Constant Currency’ I hear you ask and where do I get it? No it’s not the latest exotic derivative invented by the banks to fleece you, it’s much simpler. It goes like this ...
“Dear shareholders, we had a shocker but if you actually recast the numbers to ignore the exchange rates Mrs Market dealt us over the reporting period and re-run them holding constant the exchange rate we experienced this time last year, the accounts show we would have made money!”
Elegant, simple, but total manure. I understand why it happens but I don’t understand why the boards of those companies accept it. And please don’t tell me it’s because shareholders are happy self-managing the currency risk inherent in a building or board-short company or a software seller they happen to hold. It is almost as bad as the teenage kid who says, “of course I could have done a lot better in the exam if I had studied”.
Of course in any given period (unless it was really choppy and somewhere during the year management panicked and hedged) you are only likely to see this reporting methodology used by either exporters or importers in any one period. What management team in their right mind who got a currency pick up is going to show you that but for the rally/fall in the Aussie they were pretty ordinary?
When you look into those accounts and you see what those management teams pay themselves someone clearly thinks they are pretty clever. Surely they should be able to realise that a couple of years of Constant Currency might just bankrupt them in the real world! Of course the cynic could say that one of the reasons they don’t manage the impact of currency on the businesses is because every now and then the currency goes the other way and when that happens they have superior performance, get even larger bonuses than the bonuses they managed to pay themselves in the years when they don’t perform but for Constant Currency, and then they quickly move on.
In this day and age clearly producing your accounts and being accountable are two very different things.
It is a little bit hard to be sympathetic to a corporation exposed to a rising AUD when the AUD has gone up in seven of the past nine years (at an average of 10% pa) and has been doing so against a background of a fairly wide and publicly held opinion of the slow but certain demise of the USD; with the obvious and rather dramatic exception of 2008 and the impacts of the GFC. This trend has been very consistent and surely should be something that these companies should have been factoring in to their businesses. What’s more the forward points pay you to hedge.
Mining companies at least have had the offsetting benefit of generally rising commodity prices and the fact that their commodities are priced in USD does give them some level of a natural hedge and you would imagine equally that falls in the USD commodity prices would be accompanied by a fall in the AUD. Still, with such a consistent trend it’s not unreasonable to suggest that mining companies, at the very least, should have sought to manage their currency risk sensibly by the use of call options. Those that have, have benefited, but they are few and far between.
If you are reading HighGrade you probably don’t invest in industrial companies because you think a conservative company is one unlikely to be better than a five-bagger. But don’t ignore this article all the same, just remember this column when you see major mining companies reporting their results on a Constant Commodity basis. I suggest that might be time to head quietly for the door, before all those CEOs do, because unlike CEOs shareholders seldom get a golden parachute.