Rolls-Royce May Rue Long-Term Hedging Decision as Pound PlungesNicholas Dunbar
Rolls-Royce Holdings Plc, Europe’s largest maker of commercial aircraft engines, may regret a decision to hedge $22.5 billion of dollar income against the pound for as much as six years, Deutsche Bank AG said.
By locking in dollar revenues at an average of $1.60 per pound for that long, Rolls-Royce won’t enjoy short-term benefits from the 8.8 percent plunge in sterling to a 2 1/2-year low of $1.4832 on March 12 from $1.6255 on Dec. 31, a move that would typically boost U.K. exporters.
“In the short term, companies with less long-term hedging coverage will outperform Rolls Royce,” said Ben Fidler, an aerospace and defense analyst at Deutsche Bank in London. “The earnings of Rolls-Royce will gain 15 percent in the long-term only if sterling stays at its new, weaker level.”
Rolls-Royce, which derived 32 percent of its 2012 revenues from U.S. customers, provided details of the currency trades in its annual report this month. About half of these hedges will expire between 2014 and 2018, the report said.
“Rolls-Royce operates in a number of very long cycle businesses and we therefore have a long-term hedging program to provide a degree of certainty to our cash flows going forward,” Rolls-Royce spokeswoman Jane Terry said in an e-mailed statement.
“Our hedging policy is structured so that Rolls-Royce can take advantage of short-term movements in market rates, albeit that the existence of the hedging program means that we have swapped some flexibility for the certainty that it provides,” she said.
Rolls-Royce reported 750 million pounds ($1.14 billion) in unrealized profit on derivatives in 2012, when the dollar weakened to $1.6255 from $1.5469 at the beginning of the year.
The company may have lost as much as 1.2 billion pounds on those derivatives this year, according to a Bloomberg analysis of the forward currency derivative contracts disclosed in its annual report.
The pound has weakened 5.4 percent this year, the second-worst performer after the yen among 10 developed-market currencies tracked by Bloomberg Correlation-Weighted Indexes, amid speculation the Bank of England will expand its asset-purchase program to spur the economy, a policy that usually debases a currency. The euro rose 1.4 percent and the dollar gained 3.3 percent.
The pound rose today after Bank of England Governor Mervyn King said yesterday policy makers aren’t trying to talk down the currency, while acknowledging that its drop since before the financial crisis has helped exports.
“The markets determine the level of exchange rate, not us,” King said in an interview with ITV News, according to a transcript of his remarks. “We’re certainly not looking to push sterling down.”
The profit-and-loss swings on currency derivatives are a consequence of Rolls-Royce’s decision not to use hedge accounting, Terry said.
“This does result in volatility to our headline P&L numbers, which we remove for underlying purposes,” she said.
Hedge accounting is where the impact of gains and losses due to currency swings on forecast revenues is combined with offsetting gains and losses on the derivatives purchased to hedge them, so that the effect of currency swings on headline earnings is reduced.
Rolls-Royce shares climbed to as much as 1102 pence today in London, the highest on record, according to data compiled by Bloomberg starting in 1988.
Meggitt Plc, a U.K. aerospace components group that’s the largest provider of wheels and brakes for military aircraft, is an example of a company less affected by long-term hedges and as a result is better positioned for a weak pound, Deutsche Bank’s Fidler said.
Meggitt’s Chief Executive Officer Stephen Young said the company will benefit from currency effects this year.
The exchange rate will probably be “a tailwind, not a headwind,” Young told analysts on March 5.
A spokesman for Meggitt didn’t return e-mails seeking comment.
GKN Plc, a supplier of parts to Boeing Co. and Airbus SAS jetliners, also highlighted the benefits of a weaker pound because it will boost earnings when foreign-currency payments are translated into sterling.
“Right now currency is a tailwind,” GKN’s Chief Executive Officer Nigel Stein said on a Feb. 26 earnings call. “If we get a tailwind, we’ll say thank you very much for that.”