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How Currencies Impact Corporate Earnings

Companies / Corporate Earnings Jul 25, 2009 - 04:04 PM GMT

By: Money_and_Markets

Companies

Best Financial Markets Analysis ArticleBryan Rich writes: It’s earnings season. And more and more companies are talking about currencies.

The headlines read like this …


“Alliance Data 2Q Profit Down 37 Percent, Hurt By Currency Headwinds”

“McDonald’s Profit Narrows By 8 Percent On Currency Exchange Impact”

“Pepsi 2Q Down 2 Percent On Currency, North American Pressures”

“Omnicom Profit Plummets As Economy, Currency Do Damage”

It’s important to realize the role that currencies play in the performance of multi-national businesses. The impact can be huge. However, the attention given to managing such a powerful force is, in many cases, shockingly little.

S&P 500 companies derive nearly half of their sales from outside the U.S. And for any global company, currencies can impact business in a number of ways. For instance, there’s:

  • Translation exposure, when a company converts foreign-earned revenues to its home currency …
  • Transaction exposure, where prices paid or received for goods are influenced by currency …
  • And economic exposure, where the company’s competitive advantage, cost of goods sold, input costs, balance sheet values are affected.
Companies experience translation exposure when converting foreign earned revenues back to their home currency.
Companies experience translation exposure when converting foreign earned revenues back to their home currency.

For an American-based company, when the dollar is stronger during a reporting period, translating its foreign earned revenue can result in a drag on performance. That’s because each unit of foreign-currency denominated revenue will exchange for fewer dollars when it’s converted to report financial results.

But for the most recent calendar quarter, that hasn’t been the problem. In fact the dollar index, measured against the euro, Japanese yen, British pound, Canadian dollar, Swedish krona and Swiss franc, lost 6 percent during the period.

This should be a boon for companies with euro-denominated revenues — every euro of revenue generated at the beginning of the quarter bought 8 cents more at the end of the quarter.

Examples of the positive effect from currencies include companies like GlaxoSmithKline. Its sales grew 14 percent to almost $11 billion due to the currency conversion. Without that effect, sales would have dropped 2 percent.

Meanwhile, Pfizer, a competitor, lost money from the impact of currencies.

So why the discrepancy? Why are so many companies experiencing losses associated with currencies even as the dollar has weakened?

Because most large multi-national companies have active currency strategies but they don’t all win!

As a result, you might have seen more and more quotes like this in reporting statements … “In constant currencies, the Company posted higher revenues, operating income and earnings per share compared with the prior year.”

Here’s What That Means …

Constant currency reporting allows companies to show performance without the effect of currency fluctuations.

These results are calculated by translating current year results at the prior year’s average exchange rates.

About 25 percent of large companies that are exposed to currency risk don’t do anything to hedge it.
About 25 percent of large companies that are exposed to currency risk don’t do anything to hedge it.

As a trader, I have a hard time taking things at face value. So when I see a company stripping out currency effects, I know that’s the first area I should investigate.

In most cases, companies underestimate the power of currencies on their global business.

Furthermore, about 25 percent of large companies that are exposed to currency fluctuations don’t do anything to hedge it.

And smaller firms are much less likely to do so. They don’t have the resources (time/staff/expertise), they don’t think the risk is a big deal, or they just don’t think that hedging adds value.

So in many companies, the plan of action to address currency risk is … no action.

For all of the efforts to improve efficiencies, lower costs, boost sales … when it comes to currencies, many companies just go about their business and hope for the best. The notion: It will all even out in the long run.

When currencies work in their favor, they’re heroes. Geniuses. When currencies work against them, they blame currencies and talk in “constant currencies” terms. What’s certain is this: Whether or not currency exchange rates even out in the long run, they can crush a company’s investors in the short run.

So when a company heavily promotes revenues and earnings in “constant currencies” during an earnings report, you can bet that either the company chose to ignore currency risk or they’ve attempted to manage currency risk and made some bad bets.

Meanwhile, Some Companies Become Currency Speculators

If a company is happy reporting in “constant currencies,” it should just fully hedge its currency risk. In other words, it should just take the impact of currencies out of its business.

Then all of the constant currency speak would approximate reality!

But some companies have a tendency to fold to human nature and become speculators on currencies. They don’t want to lose the positive influence of currencies, just the negative influence. This begets speculation, which exposes companies to losses.

And that’s likely what’s going on.

In the last two quarters, McDonald’s gave up 9 percent of its earnings due to currency fluctuations.
In the last two quarters, McDonald’s gave up 9 percent of its earnings due to currency fluctuations.

Take McDonald’s for example. In the first quarter of 2009, McDonald’s (MCD) reported losses from currencies. And the dollar was 5 percent stronger during the period. This week, MCD reported losses from currencies for the second quarter while the dollar was weaker by 6 percent! The impact should have been positive. Yet, the company gave away 9 percent of its earnings each quarter because of the negative drag from foreign currencies.

Also, we know that investors can be dealt blows based on changes or misses in a company’s guidance by as little as a penny. It should also be known that a major component of that guidance is driven by guesstimates that company executives make on the future path of currencies.

Yes, the executive teams at drug makers, car companies, and IT firms are all forecasting currencies. These aren’t small decisions. They’re huge! And as we’ve seen, these decisions can result in hundreds of millions of dollars of losses. Even BILLIONS.

Forget about the fast and loose assumptions already taken with their core business projections. When these folks are guessing where currencies will be in three months, performance guidance becomes dramatically more error prone.

Bottom line: Don’t ignore currencies. In the worst global recession since the Great Depression, where global currency markets are likely to continue to make major adjustments, your future investment returns — even from stocks — will continue to be highly influenced by currencies.

Regards,

Bryan

This investment news is brought to you by Money and Markets . Money and Markets is a free daily investment newsletter from Martin D. Weiss and Weiss Research analysts offering the latest investing news and financial insights for the stock market, including tips and advice on investing in gold, energy and oil. Dr. Weiss is a leader in the fields of investing, interest rates, financial safety and economic forecasting. To view archives or subscribe, visit http://www.moneyandmarkets.com .

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