the euro decline
Since early January, the euro has dropped against the dollar by about 15%, from 1€=$1.45 to 1€=$1.22. How will this affect the earnings, and consequently the price performance, of US multinationals that have substantial operations in Europe, like pharmaceuticals, or food, beverage and personal products companies?
My answer is:
–the effect is negative, but it will vary in importance by industry–meaning by how much of a firm’s European costs are denominated in dollars, what discounting it can get from its suppliers and whether it can substitute euro-denominated cost items;
–in my experience, investors tend to make a relatively large positive response to earnings gains that seem to come from being in a rising-currency country and to more or less shrug off losses that come from being in a declining-currency country. The only exception I can think of to this “rule” is Japanese electronics companies. The market in Tokyo seems to regard these firms as commodity producers with indifferent management, therefore a relatively pure play on currency movements.
the much BIGGER story
My conclusion from all of this is that the big investing story–which I think is already beginning to unfold in price movements–is the attractiveness to European investors (and thus for everyone else in the world) of multinationals based there that have dollar exposure.
There are two types of currency effects that appear in the financials of multinationals.
–One is the operational positive (negative) of having hard-currency revenues (costs) and weak-currency costs (revenues).
–The other is translation effects. In my experience, investors everywhere ignore these. (In simple terms, they come principally from converting foreign-currency balance sheets into the home currency at the end of an accounting period. A US company, for example, would show a translation gain in the present circumstances from the loss in dollar value of its euro-denominated debt, offset by translation losses in the value of its euro-denominated assets.)
what about hedging?
Most larger companies hedge a least a portion of their anticipated foreign currency exposure. In the case of exporters with long gaps between the time when they take/price an order and when they make delivery/collect their money– especially if the price is denominated in a foreign currency, —hedging can be crucial.
The purpose of hedging is to increase the probability of obtaining a satisfactory profit from operations. It’s not to secure the highest possible profit. So it’s reasonable to assume that hedging operations temper the size of any gains due to currency movements on the way up, as well as cushion any losses on the way down.
If a company faces a permanent depreciation of the currency in one of its export markets, I think that the fact it may have hedged against this for the next six months is irrelevant to the stock’s price. Investors will understand that, although the company has done a good thing, it has only postponed the depreciation-induced hit to earnings–not eliminated it. The stock will trade on anticipated post-depreciation results.
Porsche was an interesting case along these lines about seven or eight years ago. The company, which produced its luxury cars exclusively in Europe, hedged three years’ worth of anticipated sales in dollar markets to offset what it (correctly) viewed would be a prolonged period of euro strength. Let’s say the appreciation in value of its hedging contracts made up a third of the company’s earnings over this period. How do you value this portion of company profits. My view, and that of virtually all American investors, is that hedging profits should be awarded a much lower multiple than the manufacturing operations’ results. Europeans–and they were the dominant force in their home market–by and large thought the opposite. Crazy, but true.
Another issue in dealing with hedging income is that most companies seem to me only to talk about the topic when things have gone badly wrong. The cynic in me thinks that companies understand that hedging earnings aren’t highly valued, so they remain mum. Among American companies, MCD is unusual in having said that it has hedged its anticipated profits from Euroland for all of 2010 at a rate of $1.41.
So: 1. investors, especially in the US, don’t care much about hedging, and 2. even if they did, many firms don’t disclose enough data to make the task worthwhile.