Shades of 2012...

I'm always wary of making investments predicated on trends if macroeconomic variables, for the simple reason that it is very difficult to forecast whether or not any such trends will continue, or reverse.

But I do like to keep remotely abreast of key extraneous economic factors that might have significant impacts on financial performance - and, hence, the market's valuation - of stocks.

And in the case of SDI, a company that sells internationally, about 95% of what it produces in Australia, the relative strength of the A$ is a very significant determinant of SDI's earnings.

Ordinarily, running commentary on what exchange rates are doing at any given point in time is not worth very much, I don't think; however, some quite unusual things are happening in capital markets which I believe warrants some attention.  

Namely, interest rate differentials between US and Australian government debt turned negative in February this year (for the first time ever... well, except for a very brief period in 1998, during the Asian Financial Crisis) and have become increasingly so.

(See red line in the chart below, which represents the difference between the yield on Australian government 10-Year bonds and the yield on US 10-Year Treasuries).



As can be seen, historically, the spread has always been positive (i.e., Australian government debt yields have always exceeded US Treasury Yields).

At the time of writing, the yield Aussie 10-Year bonds is 265bp. compared to the US 10-Year yield of 290bp.
This differential represents an all-time low.

As the chart shows, whenever the spread narrows, it becomes relatively more attractive for global capital to hold US bonds, resulting in relative strength for the US dollar vs the Australian dollar (the A$:US$ being represented by the blue line, and read off the RH-Axis).

Interestingly ,the gap between the red and blue lines has widened in recent years, and it is currently close to its widest point.

Also, the last time the spread went to zero, the AS:US$ rate went to 0.55.
Of course, I am not for a single moment that the same should be the case today: there have been many major structural changes in the global macroeconomic landscape in the intervening period which means that what happened two decades ago might not happen to the same extent today.

All I am pointing out is that there happens to be a factor - rising interest rates in a resurgent US economy compared to static interest rates in Australia - which is proving to be a headwind at the moment for the A$.

And the A$ weakness over the past 6 months is not just a function of a strong US$; the A$ is currently weaker than other major currencies, too (refer Table below):



So, what does this mean for SDI?

Well, at the time of the company's interim result, the A$:US$ rate was 0.80, and the A$:GBP rate was 0.60.  

Those were the inputs I used at the time in updating my financial model for SDI.  For what it's worth, my forecasts for the salient financial elements looked something like this (for context, I've included a number of prior years):



Not that I am any great financial modeller, at the time it looked me like SDI's FY2018 performance (and let's use EBIT as the "cleanest" measure of operating performance) was going to be down some 29% on FH2017 (recall that, at the interim stage, EBIT was down 45%, although this needs to seen in the context of the first-half being seasonally weaker, typically representing between 25% and 40% of SDI's annual EBIT), and FY2019 was looking to be roughly flat on FY2018, with modest organic growth in constant currency terms being negated by projecting forward the prevailing A$ levels, which were higher at the time than they are today.

However, over the past 4 months, the A$ has fallen quite sharply, by 7.5% against the US$, 7% against the GBP. and 3% against the Euro.  If I mark-to-market my financial model using recent levels of the A$ (i.e., 0.75 vs the US$ and 0.56 vs the GBP), the result is double-digit EBIT growth in FY2019.  



In terms of changes to earnings expectations - the aspect on which the market likes most to focus - the degree of uplift from the change in exchange rates is not immaterial:



And the valuation metrics go from being just so-so before the exchange rate changes ("OLD"), to quite attractive after adjusting for current exchange rates ("NEW"):




Operating Leverage - The Gross Profit Margin Question

All of the above discussion deals only with the direct currency translation effects on Revenues.  
What it omits to consider is the second-order impacts in the form of operating leverage at the Gross Profit level.

While SDI's Gross Profit Margin has been influenced by changing product mix over time (increasing sales of composites, replacing structurally declining amalgam products), given its Australian manufacturing domicile, the level of the A$ is very significant, and inversely correlated, influence on the Gross Margins generated by the business (refer following graphic):



As the red points show, in the absence of knowing any better, my modelling assumes, for JH2018, and for FY2019, a Gross Profit Margin of 59.0%, in keeping with the trend over the past few financial periods (DH2017,  JH2017  and DH2016 levels of 59.3%, 59.9% and 60.2%, respectively).

Clearly, a 59% Gross Profit Margin, when the A$:US$ rate is 0.75 (or, 0.74, where it is today), is at the lower bounds of the historical relationship between these two variables.

If I plug in a Gross Margin of 60% (clearly a figure well within the realms of possibility based on the crude best-fit line in the chart), the impact on SDI's earnings and valuation is pronounced:




NB.  Given the imprecise nature of the above analysis, any conclusions that arise from it should be treated as indicative, rather than prescriptive. That is to say, while SDI's earnings and valuation are certainly a function of exchange rates, the relationship between earnings/valuation, and exchange rates might not be as precise as the figures presented above; i.e., while the relationship is unlikely to be precise, it is likely to be highly proximate.

As such, all I have tried to do is to demonstrate - even approximately - is that SDI's earnings and valuation are highly sensitive to the relative strength of the A$, and that currently, there is likely to be a significant earnings tailwind being enjoyed by SDI.

And, evidently, judging by the share price, the market has not quite picked up on it, for whatever reason.



To get back to the header of this thread - which might be a bit cryptic:  it was in 2012 that I first acquired SDI shares, after the rampant A$, having gone from from 0.65 to 1.10 in the preceding two years, caused SDI's earnings to fall by two-thirds between FY2009 and FY2011.

When the A$ eased in subsequent two years (from above 1.00 to 0.80), SDI's EBIT rose more than fourfold and its Net Profit increased by a factor of five.

Needless to say, the share price responded accordingly.   

If current macroeconomic trends continue, or even if they are maintained, then SDI is almost sure to have now moved past the cyclical low in its earnings cycle, and is likely to see earnings forecasts upgraded (that is, by the very few broking analysts that even make an attempt at covering the stock).

Absent the impact of some residual tax-driven selling over the next 8 trading days, or a totally unprecedented, left-field event such as a major operational issue or the loss of a major supply arrangement, I suspect there remains limited downside to the stock price from the current level.

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