Commentary: Business Won't Hedge The Euro Away

The euro was not kind to large U.S. multinationals this year. As the currency plummeted from $1.04 last January to a low of about 82 cents in October, many companies watched helplessly as the dollar value of their European earnings headed south. McDonald's Corp., for instance, reported that the euro's fall could slash its full-year earnings by as much as 7 cents a share, or about 5%.

Such damage wasn't preordained. Coca-Cola Co., with 20% of its sales coming from Europe, didn't lose a penny. Reason: It hedged its foreign earnings by buying options that have a guaranteed currency-exchange rate. Many other companies, though, were not so smart--or lucky. Should investors take them to task for failing to hedge successfully?

The short answer is no. Hedging is an expensive, inexact science--far more complex than it might appear at first glance. A company that spends large sums on hedging--by using forward contracts, swaps, or options to get fixed rates--is essentially betting on a currency's move. The euro's 20% plunge this year is an unusually large move, and most companies didn't foresee a need to hedge against it. Moreover, exchange rates also go up. It clearly wouldn't make sense to criticize a company that benefited from a windfall 20% gain because a currency went up.

"NIGHTMARE." Each quarter, U.S. corporations must tally their foreign revenues and earnings and then translate them into dollars. So if a company earns 1 million euros, but the euro's value drops from $1 per euro to 90 cents, they would be worth only $900,000, not $1 million. An option to sell euros at $1 each would avert the loss. But hedging isn't cheap. According to Goldman, Sachs & Co., hedging $500 million worth of earnings costs about $26 million.

Peter C. Gerhard, managing director and global head of foreign exchange at Goldman Sachs, figures only 30% of U.S. companies buy options to hedge earnings. "There isn't a company on earth that has a 100% hedging program," says Allan Kessler, J.P. Morgan & Co.'s vice-president of foreign exchange.

Adding to the uncertainty, the Financial Accounting Standards Board this year began phasing in new, more stringent accounting standards for options, forwards, and swaps. Called FAS 133, the new rule requires companies to value hedging instruments at market value each quarter--what's called "marking to market"--instead of amortizing them over the option's or swap's life. "It's a nightmare," says Jason Wilson, treasury manager at Honeywell International Inc. "The statement is so complex that many companies are having trouble understanding it."

One way to avoid messy accounting and the expense of buying hedges is to use natural hedging. That entails matching revenues and costs in the same currency--by manufacturing and buying supplies locally. "Some companies suffer much more than others because they are forced to buy crucial raw materials with dollars rather than local currency," points out Amanda Tepper, consumer products analyst at Chase H&Q. For example, Kimberly-Clark Corp. manufactures diapers on the Continent--but has to pay for wood pulp in ever-rising dollars. So it gets hurt twice. "They lose as their margins are eroded by paying a high price for pulp, and they lose again when they translate quarterly results back into dollars," says Tepper. In the third quarter, the euro's fall cut Kimberly-Clark's net income by 2 cents a share.

TURNABOUT. Some companies, such as Dow Chemical Co., use both natural and financial hedges. Half of Dow's sales are made outside the U.S. but in public, company execs neither blame nor praise currencies for deflating or inflating earnings in any particular quarter. "If the euro turns the other way and starts to strengthen, and profits get better, should you say you shouldn't have earned as much as you did? If not, then it's a bit duplicitous if you say you would have earned more if it weren't for currencies," says Kathleen C. Fothergill, who heads Dow's investor relations.

No matter how well a company hedges, its earnings will sometimes get hit. But investors who buy shares of multinationals shouldn't complain. They would be smarter to learn to hedge their own bets.

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