Factor Forex Into Investment Decisions
Lack of revenue growth, even as the stock markets have rebounded, has been catching the attention of the financial media lately. What could be behind this phenomenon?
One oft-overlooked yet potentially significant factor in revenue declines is foreign exchange, particularly in the current market environment.
Most of the largest companies in the U.S. and many of the smaller ones also conduct business outside of the country. We refer to these companies as multinational corporations. When operating outside of the U.S., companies generate revenue in foreign (sometimes referred to as local) currencies, incur expenses in those foreign currencies and may issue debt in them. As far as earnings are concerned, foreign currency revenues and expenses are translated into U.S. dollars.
Here is how it works. Let's use
McDonald's
(MCD) - Get Report
as an example. Assume that McDonald's generated $5 million in revenue in the U.S. and 500 million Japaense yen in Japan during a quarter when the JPY/USD foreign exchange, or forex, was 100 (100 yen buy $1). The 500 million yen equate to $5 million of revenue for that quarter, so in U.S. dollars, the company generated $10 million in total revenue.
Now skip ahead to the same quarter in the following year. Assume that McDonald's sales were unchanged in each geographic region: $5 million in the U.S. and 500 million yen in Japan. Also assume that McDonald's did not open any new stores. But the yen-dollar foreign exchange (forex) rose to 108. The dollar has appreciated relative to the yen vs. the prior year, and now every dollar buys 108 yen, equating this time to about $4.63 million. Total U.S. GAAP-based revenue for McDonald's would be $9.63 million.
Thus, it appears that revenues declined by $370,000, or 3.7%. But that's not the entire story. In constant currency terms, revenue was unchanged. From a managerial operating perspective, the company performed on par with its prior year's results, but the effect of forex made it seem as though McDonald's had performed poorly. We cannot expect a diner in Tokyo to pay more for her Big Mac just because the yen devalued relative to the dollar. Thus, sales or revenue have to be analyzed on a constant currency basis.
Forex rates also impact expenses, and in our example, a similar effect on expenses likely impacted McDonald's operating costs in Japan. Thus, to perform an "apples to apples" analysis of McDonald's results, it's necessary to look at net operating income and gross margins by region or currency.
Now let's go from the theoretical to the real world. I ran some calculations on the dollar vs. the euro. Here are the average euro-dollar foreign exchange rates for the last six quarters:
first-quarter 2008: 0.668
second-quarter 2008: 0.64
third-quarter 2008: 0.666
fourth-quarter 2008: 0.759
first-quarter 2009: 0.766
second-quarter 2009: 0.734
This implies year-over-year strength for the dollar of 14.67% in first-quarter 2009 and 14.69% in second-quarter 2009.
Now let's do some simple mathematics. With most multinationals having 40% to 50% of their revenue based overseas and the strength of the dollar at about 15%, the estimated top-line impact just from foreign exchange falls in a range of about 5% to 8%. My estimated range, by the way, coincided with most top-line revenue declines. I have also observed that most companies have seen modest constant (local) currency revenue declines overseas, which implies that most of the top-line decline from international sources was almost exclusively from foreign exchange rates.
The recent rush to safety -- namely, to the dollar -- has hurt top-line revenues. Here's the good news: The dollar is starting to weaken once again. Its growth rate should slow down to about 6% to 7% in third-quarter 2009 and is likely to experience year-over-year declines in fourth-quarter 2009.
My guess is that the analysts, who often extrapolate from sequential and annualized revenue figures to arrive at their estimates, don't see this coming. So look for those multinational plays that could get you more bang for your buck in the remainder of 2009.
At the time of publication, Rothbort was long McDonald's, although positions can change at any time.
Scott Rothbort has over 20 years of experience in the financial services industry. In 2002, Rothbort founded LakeView Asset Management, LLC, a registered investment advisor based in Millburn, N.J., which offers customized individually managed separate accounts, including proprietary long/short strategies to its high net worth clientele. He also is the founder and manager of the social networking educational Web site
.
Immediately prior to that, Rothbort worked at Merrill Lynch for 10 years, where he was instrumental in building the global equity derivative business and managed the global equity swap business from its inception. Rothbort previously held international assignments in Tokyo, Hong Kong and London while working for Morgan Stanley and County NatWest Securities.
Rothbort holds an MBA in finance and international business from the Stern School of Business of New York University and a BS in economics and accounting from the Wharton School of Business of the University of Pennsylvania. He is a Term Professor of Finance and the Chief Market Strategist for the Stillman School of Business of Seton Hall University.
For more information about Scott Rothbort and LakeView Asset Management, LLC, visit the company's Web site at
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