Slide in the dollar puts pressure on companies with high US earnings

There's something in the water for AWG; Vernalis struggles back to health
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The Independent Online

The US dollar may have livened up a bit this week, but for the past three years it has dropped against the pound. This slide is expected to continue and the effect on UK companies is to depress the earnings of those that have large operations in the US.

Morgan Stanley estimates UK companies get 25 per cent of sales from the United States. But translating US earnings into sterling when the dollar is weak makes for fewer pounds.

This is particularly acute for the fund manager Amvescap, which gets about 90 per cent of its profits from the US.

This is close to a one-for-one hit on sterling profits from the falling dollar, and the US stock markets have not risen enough to offset the loss due to currency movements.

But for companies that have physical operations in the US, their costs will also be in dollars, which lessens the impact on earnings.

UK companies can also benefit by having their debts denominated in dollars, as interest payments are cheaper. Pearson, for example, has 95 per cent of its debt in dollars.

Many companies with a large part of their earnings in the US hedge their currency exposure, by, for example, bulk-buying dollars at a certain exchange rate.

The biggest impact on earnings is on companies that export goods to the US, such as engineering companies, as they become less competitive.

Looking at the bigger picture, dollar-earning UK companies should not take a huge hit thanks to currency hedging, cost management and the boost from European earnings, where the change into sterling is beneficial. Unless a stock is extremely vulnerable, such as Amvescap, dollar earners should not be avoided on a currency basis alone.

However, investors in stocks that report and pay dividends in dollars can not escape a pinch. Morgan Stanley estimates that UK investors have lost £3.3bn in the past three years from exchanging dollar dividends into sterling. HSBC, Standard Chartered, BP, AstraZeneca, Lonmin, Rio Tinto, BHP Billiton and Carnival are among those in this group.

Earnings and dividends may be up in dollar terms, but for UK shareholders they will remain flat. With the dollar expected to fall further, the situation can only get worse.

There's something in the water for AWG

AWG, the infrastructure management and water services group (bricks and water, if you like), yesterday had little new to say in a trading statement. The company remains full of potential, both upside and downside.

It has opted for a "high leverage, low equity" approach to funding. This means it has lots of debt and not many shares, guaranteeing a position in the "high risk, high reward" bracket.

The company's water business has performed strongly and it now ranks fourth in England and Wales in Ofwat league tables. The infrastructure management business (IMB), which provides construction and project management services, has shown some signs of improvement. It accounts for nearly 60 per cent of turnover, but there are margin pressures within its utility services section.

There is some growth potential in IMB from its "hub and spokes" strategy, which has seen contracts with Norwich City Council expand into business opportunities with local police and fire stations. Continued activity in private finance initiatives (PFI), where private companies invest in public sector projects, should give revenue potential.

It is trading at around 13 times earnings, which is not that high. But with such a small equity base, volatility is a risk. The dividend yield, 9.7 per cent, may also be under pressure if capital expenditure in its water division is not met by price rises. AWG was a target of bid interest earlier in the year and the prospects of further bids cannot be ruled out.

Even with the risk, there is enough evidence of reward to say that there must still be something in the water. Hold.

Vernalis struggles back to health

Hi, this is Simon Sturge, chief executive of RiboTargets... sorry, of British Biotech... er, I mean of Vernalis. No wonder the poor man doesn't know how to answer the phone. He has been swept up in the consolidation at the bottom end of the UK's cash-strapped biotech sector, first when his company, RiboTargets, was acquired by British Biotech, and then with his own acquisition of Vernalis - a company with one product for migraines and not much else.

The deal, completed yesterday, has allowed British Biotech to ditch its historic but tarnished name and it is now to be called Vernalis. It is still a work in progress, though, and further acquisitions will be needed for there to be a coherent path to profitability. As it stands, the company has about £50m in the bank to fund work on four drugs in human trials and only a modest income from the migraine drug, Frovatriptan.

If all goes according to plan, there will proof of principle for its leading drug - which might be a treatment for strokes or problems with arteries in the limbs - by the end of this year and the product can then be licensed to a big pharmaceuticals company. There might also be a couple of £15m windfalls in 2005 if sales of Frova improve, although the migraine market is proving viciously competitive.

As ever with a speculative biotech venture such as this, much can still go wrong, and the slimmed down Vernalis pipeline unveiled yesterday is not wide enough or advanced enough to compete for investment funds with sector stars such as Alizyme. Up 3p to 83p, Vernalis shares are still a wild gamble.