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How to Protect Your Corporate Earnings: Lessons from Q1

  • By Nilly Essaides
  • Published: 6/18/2015

The impact of currency volatility on corporate earnings and revenue was at its highest level in years in the first quarter of 2015, rising to $31.7 billion for North American and European companies from $20.2 billion in the fourth quarter, according to a new study by FiREApps.

FiREApps examined 1,200 company earnings calls and found that nearly 60 percent reported that currency shifts hit their results. And while the euro has shown signs of life lately, the dollar has risen again, reaffirming the continued volatility in the currency markets.

Companies often must explain how FX affected earnings because they like to separate any downturn in operations from market effects, which are largely outside their control. According to FiREApps, in North America in Q1 2015, 279 companies and 35 European companies reported currency headwinds, up from 215 and 29 respectively in the prior quarter.

Under FAS 133, companies cannot get hedge accounting for managing net income, so many companies avoid the practice to avoid volatility resulting from the fair value changes of the derivatives. But that does not mean there is no way to mitigate that risk.

The first step is for companies to study how FX impacts their earnings, what their translation exposure is, and how the translation of earnings affects their results. “They look at cash flow and translation risk as two separate things,” observed one hedging expert at a bank. “The key is to get companies to understand the earnings risk versus just the cash flow risk. Companies don’t necessarily have the data for euro revenue for euro entity since it’s not hedged. While that may be true from a cash flow perspective, it represents a true earnings exposure. They are not quantifying the exposure and reporting it the right way. The first message is to measure and understand it.”

Five ways to manage the risk 

Hedge intercompany transactions. By far the simplest way to look at managing earnings risk is by looking at any non-euro currency denominated intercompany exposures like royalties or expenses and other intercompany billing or even USD-denominated materials cost. “By hedging these exposures you can reduce the earnings risk and get hedge accounting since it’s attached to an actual transaction,” said one FX expert. “The issue is how much of an earnings risk reduction the company can achieve relative to net income or margins, i.e., how many transactions you can find to attach the hedges to in order to protect the exposure and lower earnings at risk.”

Hedge nonfunctional currency expenses. If the entity in Europe is euro functional, the company may have to designate its net income hedges against dollar expenses. The result of the hedge will show up on the expense rather than the revenue line, but for investors interested in the financial end result the geography may not matter. Another approach is looking for dollar-FX exposure elsewhere in the world and hedging that risk to mimic the euro position and benefitting from the changes in the value of the derivatives in protecting net income.

Set up the right sourcing relationships. “Consider earnings translation when you set up your sourcing relationships,” advised a seasoned treasurer. “In too many cases, the decision revolves around very few pennies. Add to that the magnitude of a possible earnings hit and the match changes significantly.”

Set up a centralized rebilling entity. Some companies have a dollar-functional centralized rebilling entity, or a holding company for the non-USD subs. In that case, the hedge may be a hedge of intracompany flows vs. third party flows, presenting some issues with timing, but the end result—an approximation of the net income position—can be achieved. “You can get the direction and roughly the size right,” said Scott Bilter, partner at Atlas Risk Advisory. A lot of companies have looked to isolate that exposure so there is a risk they can hedge from a FAS 133 perspective. That may also apply to hedging expenses such as dollar inventory in cost-plus arrangements, he said.

Hedging AFS Securities. A somewhat trickier approach is hedging the expected sale of available for sale (AFS) securities. Some companies are using indirect approaches such as the sale of FX denominated AFS securities and hedging of non-functional currency intercompany transactions as a proxy for net income hedges. In this case, the European subsidiary buys U.S.-denominated assets (Treasuries) and instead of holding them to maturity, it documents that it expects to sell them prior and hedges that anticipated exposure. That’s legitimate under FAS 133. The position obviously matches expected net income. There are various caveats to this strategy.

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