Exchange Rate Risk: Mobile Streams

Whilst most exchange rate impacts are either minor or moderate, they can be catastrophic in rare cases. For reference, this tutorial looks at the generic impacts that a rapid exchange rate change can have. This tutorial will set out the impacts that a severe exchange rate devaluation had on the share price of AIM listed Mobile Streams (LSE:MOS) and how this is not a risk that cannot simply be dismissed.  In fact, since the exchange rate risk has worsened, roughly £26m has been wiped off the market cap with the share price down over 90%. This case study will look at the risk that Mobile Streams faced at the time and why it could have been mitigated.

Stage 1: Setting the Scene

Mobile Streams was founded just before the turn of the century in 1999 by Simon Buckingham (still CEO). It listed in February 2006. The company focuses upon the provision of Mobile Internet Services, primarily to Argentina which accounted for around 85% of total revenues at the time. "Mobile Streams licenses and distributes a wide range of mobile content- including games, apps, eBooks, music, pictures and videos- that are retailed around the world".

As the above chart shows, between January 2012 and around October 2013, Mobile Streams saw incredibly strong share price growth from around 9.5p to around 82p. This was on the back of strong growth within Argentina, as demonstrated by the figures below.

Yet at 82p the shares traded on a trailing PE ratio of 11.5 and an even lower figure ex-cash. Given the rapid revenue and profit growth rates and the sector of operation, that was highly appealing. In fact the PEG ratio in light of the rapid profit growth stood at far less than 0.1, which is exceptionally low. However, there was a storm brewing in the background and what may have appeared to be an incredibly rare value opportunity actually turned into a serious value trap.

Stage 2: The Argentine Peso

The problem for Mobile Streams was two-fold and largely revolved around the fact that Mobile Streams sold its apps in Argentine Pesos yet incurred a significant proportion of its costs in US Dollars. The problem was that the Argentine Peso was an unstable currency and has been falling in value for many months in a row over this rapid growth period.

The second problem was that, partly as a result of the devaluation, the Argentine government had imposed currency restrictions meaning that Mobile Streams found it difficult to get cash out of the country; in technical terminology, that is a cash repatriation problem. This second factor was alluded to in 2013.

The problem was that Mobile Streams was not comprehensively enough hedged against exchange rate movements. Exchange rate hedging seeks to offset any losses that may arise from a rapid unfavourable exchange rate movement using complex financial instruments. Whilst many large companies do hedge as protection, Mobile Streams was still a small business and they made the error of not putting hedges in place soon enough.

Therefore, whilst the revenue and profit growth through 2012 and 2013 were staggeringly good, the Peso was struggling badly. In fact, between January 2012 and October 2013, the US Dollar to Argentine Peso exchange rate weakened from 4.3 to 5.8, or 35%.

Stage 3: A Worsening Devaluation

A rapidly depreciating exchange rate can present many problems to a government. Chiefly, it leads to the country's exports being cheaper, which helps raise inflation. Whilst we are used to inflation between 0% and 3%, Argentina was in an inflationary spiral with independent estimates for inflation in 2013 stretching to 30%.

The problem for the government was that there were effectively two exchange rates. The official exchange rate was that shown above. However, there was also a black market exchange rate; this was literally the exchange rate being offered on the streets of Argentina. It was impossible to control and importantly it was at a far weaker level than the official exchange rate. So whilst the official exchange rate may have been 5.8 Pesos to the Dollar, the black market exchange rate may have been between 10 and 11 Pesos to the Dollar.

So why was that? The extreme inflation and lack of confidence in the Peso meant that ordinary people in Argentina were rushing to cash in their Pesos and switch into Dollars and other more stable currencies. This was part of the reason why certain currency controls were imposed. For the official currency, this led to a devaluation spiral with nothing to prevent a continued devaluation, but the government.

An exchange rate is based off supply and demand like most things. Demand for pesos was low, hence the Argentine government was trying to prop up the currency and prevent a further devaluation by buying Pesos in the FOREX market. But this was costly and a drain on foreign exchange reserves. In fact, in 2013, the Argentine government exhausted 30% of its foreign exchange reserves and by the end of 2013 they had fallen to £18 billion. The Argentine government was losing its ability to slow a further devaluation. A crossroads was approaching and all the while, the Peso continued to weaken, with the USD:ARS rate reaching nearly 7.0 by late January.

Stage 4: 24 Important Hours

It only took 24 hours for Mobile Streams to have its entire outlook moved from its hands, and all thanks to a failure to implement hedging policies.

As the above graph shows, on January 23rd 2014, the central bank of Argentina announced that it would pull back on its support for the Peso because it was simply too costly and ineffective. With foreign exchange reserves dwindling, the central bank really did not have much choice. Within minutes, the Peso depreciated rapidly towards the 8 Pesos to the Dollar mark; a fall of more than 15% against the dollar.

The impact on Mobile Streams in the months ahead would turn out to be pivotal with the devaluation sending the growth story into reverse and damaging profitability and cash holdings in Argentina, badly. However, the full impact was not immediately felt in the share price. Unless you had a keen eye and observed the exchange rate devaluation because you were tracking it on a day-by-day basis, then it would have been easy to miss the devaluation and the impact on the share price.

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In fact, although there was an initial ~10p fall on the day after the devaluation, that was a fraction of the fall that was to occur. It wasn't until January 29th that Mobile Streams released a news announcement regarding the movement of the Peso. The devaluation essentially prompted a profit warning from the company, and the text for that is shown in the image to the right.

So although the company commented about hedging arrangements, it admitted that it had only recently begun to put the hedging structures in place, hence the benefit of them would be limited. Unfortunately it was a case of far too little, too late.

The share price movement of Mobile Streams in response to the currency devaluation is below. Notice that the fall on the day of the news announcement was significantly greater than that the day after the actual currency fall. That reflected that most shareholders were either unaware of the currency devaluation or were unclear what impact it would have. On the day of the news, the share price fell by 38%.

Stage 5: The Story Since

The pathway of the share price since has been a continual downward drift in line with the Peso situation not abating. However, the inflation situation in Argentina has started to calm as a result of a deepening recession trimming domestic demand for goods and services; hardly a reason to be crack out the celebration banners.

Yet despite that, the Argentinian Merval stock index is up over 25% year-to-date reflecting the market's optimism in a fresh set of Argentine presidential elections in the second half of the year, and unexpected appetite for the country's sovereign debt. Still, the Peso has continued to devalue from 8 Pesos to the dollar to 9 Pesos to the dollar. (Figures valid as of 29/05/15)

For Mobile Streams, the situation has continued to deteriorate. The currency devaluation led to significantly worse profitability in 2014 with revenue dropping from £54m to £49m and trading EBITDA collapsing by 85% to £740,000. Earnings per share were comfortably negative and forecasts for the next few years will remain notoriously difficult to predict, not least because the currency is continuing to devalue, and the demand for Mobile Stream's services is falling in absolute terms too.

In a recent trading update, Mobile Streams announced that total revenues for the 9 months ended 31st March 2015 were down 12% in Peso terms (i.e. ignoring the exchange rate). That is partly down to the weak consumer demand, but also because of "a level of saturation amongst users of [their] services." The company is seeking out new sales avenues in other countries, but that will be a long road to travel down.

The one lesson that management of Mobile Streams won't be forgetting is the importance of currency hedging when dealing with unstable currencies. As an investor you should appreciate the very real risk that exchange rates can present; by doing that you can avoid any exchange rate value traps in the future.