Lost In Translation

10/7/2013


As U.S. companies race to extend their reach in overseas markets, foreign-currency fluctuations become more important to operating results. Investors should understand how currency rates can affect a company's performance.

Each quarter U.S. companies must convert revenues, expenses, assets, and liabilities denominated in other currencies into U.S. dollars. But earnings releases often try to deflect investors' attention away from currency by reporting results that exclude the effect of exchange rates.

Which number should investors believe? Like just about all of the important questions in the investment world, it depends.

Currency exchange presents two principal risks. Translation risk affects companies with foreign subsidiaries, such as Aflac ($63; AFL), Colgate-Palmolive ($60; CL), and Procter & Gamble ($76; PG). In the case of stand-alone foreign businesses owned by U.S. firms, investors often treat currency effects as noise. Aflac, Colgate, Procter & Gamble, and many other U.S. companies have self-sustaining operations overseas, with both costs and revenue in local currencies, significantly reducing the economic impact of currency fluctuations.

But when companies expand their sales bases through exports, revenues don't correspond to costs. These companies face transaction risk, which occurs when a company's sales or purchases are denominated in another currency than the rest of the business.

For instance, suppose a U.S. company completed a sale for 100 million rupees to an Indian client in February, when the exchange rate was 53 rupees per dollar. Immediately, the seller recognizes the sale and records an account payable of $1.89 million in U.S. dollars (100 million rupees divided by 53 rupees per dollar).

Payment arrives six months later, when $1 will buy 63 rupees, equating to just $1.59 million (100 million rupees divided by 63 rupees per dollar) As a result of the stronger dollar, the U.S. company must recognize a loss of about $300,000 on its income statement.

Below, we consider how foreign currencies affect operating results and the strategies companies deploy to cope with the volatility.

To hedge or not to hedge

Wal-Mart Stores ($73; WMT) derives close to 30% of sales from outside the U.S., but it does not hedge against currency changes. In past years, with the U.S. dollar trending generally weaker, the no-hedge strategy has helped the retailer. Currency-rate fluctuations boosted sales in the fiscal year ended January 2012 by about $4 billion. But the dollar, which has strengthened since the Federal Reserve announced in May that it planned to curtail its bond-buying program, carved $1.69 billion out of Wal-Mart's sales in the six months ended July. Management cited currency headwinds as a contributing factor in its decision to cut its full-year outlook in August. Wal-Mart is a B (average).


Unlike Wal-Mart, Celgene ($156; CELG) tries to manage the risks of foreign currencies by using derivatives. With an international headquarters in Switzerland, Celgene operates in more than 50 countries and generates sales in more than 70. About 42% of 2012 sales came from outside of the U.S. Celgene relies on forward currency contracts (contracts that lock in the purchase or sale of a currency at a set price for a future date) to hedge risk on international sales expected to occur within the next three years. The company also uses forward contracts to hedge against fluctuations that can cause sharp swings in the value of assets and liabilities denominated in foreign currencies. Celgene entered 2013 with forward contracts for currencies in Australia, Canada, the United Kingdom, Japan, and the European Union. Celgene is a Buy and a Long-Term Buy.


Since Cognizant Technology Solutions ($83; CTSH) generates about 80% of its sales from North American customers, its revenue faces little translation risk. However, much of its operations are based in India, leaving Cognizant's balance sheet and operating costs exposed to currency fluctuations. Most of Cognizant's workers live in India, and the rupee's weakness relative to the U.S. dollar has kept down labor costs. About 31% of operating expenses are denominated in the rupee.

Cognizant has rupee hedges in place through 2016. Although the company reported losses on the hedges in 2012, they have reduced volatility in Cognizant's operating results and could become profitable should the rupee recover. The company booked a gain on its rupee hedges in 2011. Cognizant's heavy use of hedges mitigates — but does not eliminate — currency risks. Without the hedges, Cognizant says each 1% change between the Indian rupee and the U.S. dollar would move its operating profit margin by about 23 basis points (0.23%). With the hedges, a 1% change affects the company's margins by just 10 basis points.

All in all, the weak rupee has fattened Cognizant's operating profit margins in recent quarters, though not as much as rivals that use fewer hedges. The favorable currency environment has helped offset wage inflation as well. Cognizant, which says it plans to accelerate some of its investments in India while the rupee is depressed, is a Focus List Buy and a Long-Term Buy.


When governments meddle

DirecTV ($60; DTV), like Celgene, has both sales and costs denominated in foreign currencies, offsetting some of the volatility. But the company took a hit when Venezuela's government announced in February that it would depreciate its currency, the bolivar, by 32% relative to the U.S. dollar. As a result, DirecTV took a $166 million pretax charge in the March quarter on its monetary assets held in Venezuela. DirecTV holds a leading 40% share of Venezuela's pay-TV market, and the country accounts for an estimated 3.5% of the company's revenue. Other U.S. companies, including Colgate-Palmolive ($60; CL), Halliburton ($49; HAL), Johnson & Johnson ($87; JNJ), Merck ($49; MRK), and Procter & Gamble ($76; PG), took similar write-downs. Venezuela has devalued its currency five times in the past decade.

Ideally, DirecTV's monetary assets (such as cash and accounts receivables) would equal monetary liabilities (such as accounts payable), with excess funds moved to other countries for use if needed. But Venezuela sets an official exchange rate, requiring companies operating there to obtain the government's approval to exchange bolivars into U.S. dollars. That limits the ease with which DirecTV can shuffle cash in and out of the country, resulting in a larger cash balance than management would otherwise maintain in Venezuela. As such, DirecTV has warned that the cash may ultimately be repatriated below its current value.

Even after the write-down, effects of Venezuela's decision still linger. DirecTV blamed the bolivar's devaluation for contributing to weaker revenue growth for its Latin American unit in the first half of 2013. Moreover, the company has also experienced unfavorable exchange rates in Argentina and Brazil this year.

DirecTV reflects changes in exchange rates on its income statement, making operating results more volatile. The Latin American business (including Brazil, Argentina, Chile, Columbia, Ecuador, Puerto Rico, and Venezuela) accounted for 21% of DirecTV's revenue last year and generated most of the company's growth in recent years. DirecTV, a Focus List Buy and a Long-Term Buy, is profiled in Analysts' Choice.


Bringing the cash back home

Aflac ($63; AFL) generates about 80% of its sales in Japan, a self-funded business where profits are matched against costs. But Aflac does hedge Japanese profits earmarked for U.S. repatriation. The company regularly moves cash from Japan to the U.S. to help fund the quarterly dividend and share repurchases. Aflac has repatriated at least 76.8 billion yen ($795 million) this year and will likely repatriate 96 billion to 98 billion yen in 2014. Share repurchases could reach $600 million this year and $600 million to $900 million in 2014.

The company said that in recent years it has become more sensitive to currency fluctuations. Although shifts in the yen relative to the dollar can significantly impact reported results, Aflac does not hedge its operating results against currency fluctuations. That leaves analysts to handicap the chances of Aflac meeting its guidance following significant shifts in exchange rates.

A strong yen boosted per-share profits in the five years leading up to 2013. But the yen has weakened this year, so much so that at least two analysts downgraded Aflac's stock in the first months of 2013 primarily due to currency concerns. Still, Aflac has proved adept at managing expectations.

For the September quarter, the Japanese yen averaged 99 to the U.S. dollar, slightly below the midpoint of management's projected range of 95 to 105. With the dollar slightly less strong than management had projected, Aflac could see some upside when it reports earnings Oct. 29. Aflac is a Buy and a Long-Term Buy.

Tapping into cheaper debt

As U.S. interest rates creep higher, companies are ramping up their debt issuance in the euro and pound sterling to take advantage of lower borrowing costs in Europe. Some of the companies then use cross-currency swaps to eliminate foreign-exchange fluctuations.

In most currency swaps, one party agrees to receive a series of payments in a particular currency while making payments to the counterparty in a different currency. DirecTV has issued £1.25 billion in bonds since early September 2012. It then entered into swap agreements to convert all of that debt into U.S. dollars at a fixed rate.


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