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The Euro is Falling, the Euro is Falling!
The title of this article is a clear reference to the story of Chicken Little. A tale, reworked by Disney (DIS) a few years ago, in which a young chicken warns that the sky is falling because something fell on his head. When it turns out to be “nothing,” the townspeople heap scorn upon the child. There are many in the realm of finance who could be hit with the moniker of “Chicken Little.” That said, the current drop in the value of the euro versus the dollar is a big deal and will have a major impact on companies you may own, want to own, or follow.
How could the troubles of Europe spill over to a company like, say, McDonald’s (MCD) or CocaCola (KO)? It’s the aliens… No, wait, that’s the Disney movie—It’s the foreign operations that comprise a significant portion of the companies’ revenues. The problem, in this case, is the falling euro, the common currency used in most of Europe, with a major exception being the United Kingdom, which still used the pound. Of course, the pound has been weak in recent months, too, as there are growing concerns about the U.K.’s financial situation.
With the economic problems now facing Greece, and concerns about several other countries in Europe mounting, the euro’s value versus the dollar has fallen precipitously. So, it now requires more euros to buy a dollar—a lot more! So, when a company with significant exposure to euro-zone countries reports results from those nations, they get translated back to dollars. If it takes more euros to buy a dollar, then the results from those areas will be lower. That’s true even if the actual results in the euro zone were good, in euros, of course. In fact, a currency move like the one that has just occurred can turn local profits into losses when the results are translated into dollars.
What this means for U.S. companies with euro-zone and British operations is that results over the next few quarters are likely to take a currency hit. This would, obviously, depress results. To mitigate currency risk, some companies use complex hedging strategies. The recent move has been large and abrupt, and hedging cannot eliminate the eventual impact of currency changes of this magnitude. So, companies with large foreign components are likely to see some impact and investors should be aware of this going forward. In fact, even the revenues of just-released Iron Man 2, intellectual property that Disney owns subsequent to its purchase of Marvel, will probably be depressed by the drop in the value of the euro and the pound—perhaps Disney should consider releasing a follow up to Chicken Little using falling foreign currencies as the main theme.
Aside from the issue of translating results back to dollars, there’s another problem with such a swing in the pricing of currencies; it makes U.S. products more expensive overseas. This is, basically, the reverse issue. If a company such as Caterpillar (CAT) is trying to sell a tractor to a farmer in Italy, that tractor’s price is going to be based on euros even if the tractor was built in the United States. If it takes more euros to buy a dollar, then it takes more euros to buy anything that was made in a country that uses dollars as currency. So corporations that export to the euro zone may find it harder to compete with local companies. In the Caterpillar example, a locally built tractor that used to cost more might now look cheaper because of the decline in the value of the euro.
The flip side of this, of course, is that it costs fewer dollars to buy something that is made in the euro zone or in Britain. So companies that import product from Europe will find it less costly to do business. It will also be cheaper to travel to those locals on vacation, but that’s not something that will have a material impact on the bottom lines of most major corporations.
The preponderance of news surrounding Greece, the euro zone, and Great Britain has brought the issue of currency fluctuations forward. However, it is important to note that Europe and Great Britain aren’t the only countries where this is an issue. The change in the value of any currency can have this type of impact. For example, Flowserve (FLS) recently had to include a writeoff of $0.32 a share because of a change in the value of the Venezuelan currency, the Bolivar, versus the dollar. Earnings would have been over 20% higher had the exchange rate between the Bolivar and the dollar remained constant.
The important thing to take away here is that the economic troubles affecting Greece are having a far-reaching impact that is now slowly becoming apparent, and the psychological fallout is now affecting the world’s financial markets. Indeed, not only is the rest of the euro zone feeling some pain, but it might also show up on the income statements of companies that do business in the region. With so many large multi-national companies located in the United States, this issue is sure to wash up on our shores in one way or another. Hence, the stepped-up volatility on Wall Street and across Europe and Asia. On the bright side, now would be a good time to visit Europe—just avoid Greece, where economic issues seem have led to unsettling events.