Why Currencies Play an Important Role in Corporate Earnings

By: Bryan_Rich

It’s earnings season. And more and more companies are talking about currencies.

The headlines read like this …

“Weak Euro a Drain on S&P 500 Revenues”

 ”Currency Fluctuations Wipe $500 Million off IBM Top Line”

 ”EBay Lowers Forecast as Currency Weighs on Revenue”

“PepsiCo Earnings Down 3 Percent on Currency Moves”

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.

S&P 500 companies get a big percentage of their sales from foreign markets.

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.

During the most recent calendar quarter, that’s certainly been the case. In fact the dollar index, which measures the dollar against a basket of currencies, gained more than 6 percent during the period.

And in Europe, the problems surrounding sovereign debt and the uncertain future of the euro have made the euro quite weak — posing a significant headwind to companies that do business in or with Europe. Every euro of revenue generated at the beginning of the quarter bought nearly 9 percent fewer U.S. dollars at the end of the quarter.

Many large multi-national companies have active currency hedging strategies that, in theory, can manage or even eliminate the risk of currency fluctuations. But the approach and objectives of corporate management varies to a large degree. And they don’t all solve the problem; they sometimes compound it.

Consequently, 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.

Some companies choose to ignore currency fluctuations in their earnings presentations.

As a currency 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. 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.

Company Executives Playing the Role of Currency Speculator

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 the reality is 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 on their business, just the negative influence. This begets speculation, which exposes companies to losses.

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

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

Bottom line: Don’t ignore currencies. In a world where debt and deficits are being scrutinized, currency devaluations will likely follow. That means you should expect global currency markets to continue to be volatile and undergo major adjustments, which will indeed pose a formidable challenge for your stock portfolio.

Regards,

Bryan

P.S. I’ve been showing my World Currency Alert subscribers how to use exchange traded funds to protect their wealth and profit … as currencies rise and fall. If you’re not a subscriber, you can check it out by clicking here.

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