A surprisingly strong euro has hit the earnings of many European and US multinationals this year. But how significant is the problem and what can corporate treasurers do about it?
Earlier this month, the French pharmaceutical group Sanofi released a statement revealing that the estimated negative foreign currency impact on its Q2 financial results would amount to 6% on sales and between 8-10 percentage points on business earnings per share (EPS).
Sanofi says it has suffered particularly from the recent strength of the euro. They are far from being the only ones. If you have skimmed through the pages of the financial press on any given day this year then the chances are you will have read about some company or another citing negative currency impacts on their earnings.
The scale of the impact is quantified in a recent report by FX consultancy FiREapps. In the report, FiREapps analysed the earnings calls of 846 publicly traded North American companies and 354 European companies across a range of industries. What they found was that on both sides of the Atlantic, a sizeable number of companies have seen FX impacts on earnings. The figures show that the total reported negative currency impact in Q1 2014 was $7.4 billion; that European companies bore more of the brunt with an aggregated negative impact of $4.19 billion; and that for North American corporates EPS impact jumped from an average of $0.03 EPS in 2013 to $0.05 EPS in Q1 2014.
What can treasurers do?
Should these impacted companies be hedging their translation risks? That remains a matter of contention for treasurers. Translation risk only arises because of the need to draw up financial statements and, on that basis, some treasurers argue that it does not constitute a real risk. However, as the FiREapps report points out, it can have a much deeper impact over time. For a corporate of Sanofi’s size and credit rating, a minor impact over one isolated quarter might not be a huge concern. But a corporate experiencing substantial and ongoing translation losses accumulating in its equity account could see some deterioration in its financial ratios in the long run. That, in turn, could lead to credit rating downgrades that raise the company’s cost of capital, or debt covenant breaches that limit the company’s access to liquidity. The need to hedge these risks, then, is likely to be greater for firms with a higher probability of default.
For that reason, there are multinationals that set targets of less than $0.01 negative EPS impact just from balance sheet exposures, way below the average $0.05 EPS hit from all business exposures reported by North American companies in FiREapps report. Of course, treasurers do not have crystal balls. There is no way they can predict when the next geopolitical crisis is going to send an EM currency into a ‘death spiral’. But that does not mean that keeping currency impacts below $0.01 EPS is impossible.
One treasurer from a leading multinational explained to Treasury Today that his treasury team takes the view that translation risk, being mainly accounting driven, is not something to be overly worried about. Treasury, then, do not have an explicit EPS impact target. That being said, treasury recently started what they call an anticipatory cash flow hedging programme and, one side effect of this, is that it also hedges the earnings. “Hedging translation risk was not our motivation,” he says, “but it did get us part of the way there.”
Perhaps use of cash flow hedging could explain why European corporates were impacted more heavily. After all, European and North American corporates share reasonably similar currency exposures, so one would assume that there shouldn’t be that much difference in impact – unless, that is, there are significant differences in the hedging polices practised by businesses in the two regions. That is where Wolfgang Koester, CEO of consultants FiREapps believes the explanation resides. Transactional hedging is more widely practised by companies in Europe and that, he says, creates much more uncertainty towards the latter part of the hedge, which North American corporates have largely avoided by using cash flow hedging. “If you anticipated cash from a Russian company that did not come when your hedge was due, but rather a month later, after the ruble had moved significantly lower, you would have gotten hurt – just like a lot of companies did.”
It is not the only way in which approaches diverge. “I still see a significant difference in the way European corporates manage currency risks when compared to their US counterparts,” he says. “What you see in America is that more companies are now taking a portfolio approach to gaining visibility across all exposures, not just the five largest.”
If companies do decide to hedge their translation risk, which currencies are they most likely to be concerned about? The answer to that question of course depends on the particular exposures of the company in question. But we can identify some that have proved increasingly problematic for many companies this year. Unsurprisingly, a lot of European companies – like Sanofi – cited the strength of the euro as their biggest problem this past year. But the report highlights how challenges with emerging market (EM) currencies, including many of the same culprits that were at the centre of the turmoil in 2013, are also continuing to weigh heavily. Among the five currencies mentioned most in the earnings calls of US corporates examined by the report, three – the Brazilian real, the Venezuelan bolivar and the Argentine peso – were EM currencies. For European companies, the Russian ruble, which saw a dramatic depreciation during the crisis in Crimea, along with the Turkish lira and Brazilian real, were the EM currencies frequently cited as having an impact on earnings.
The turbulence in emerging markets has subsided somewhat in the past few months, but Koester says that there could well be more to come. “I would certainly not be thinking this is over if I were a corporate,” he says. “Volatility is still there and uncertainty is as high as it’s ever been. Everywhere you look now there are fires.”