Don't get slammed by the rising dollar
Investor Daily: Currency headwinds are about to hit U.S. multinationals - here's how to avoid being blown over.
NEW YORK (Fortune) -- For U.S. multinationals trying to sell in a slowing global economy, currency has been a hidden source of strength.
When the dollar was relatively weak, companies that do a lot of business abroad - Cola Cola, 3M and Philip Morris International, to name a few - saw profits increase when converted from foreign currencies into U.S. dollars.
Now, with the dollar up 13% against a broad index of major currencies in the last three months, the greenback is no longer giving multinationals a leg up on their less cosmopolitan rivals.
"Over the last few years, the currency tailwinds from international markets have masked U.S. weakness," said Gerrick Johnson, an analyst at BMO Capital Markets. "Now, they're going to take hits in their revenues."
The benefits of foreign exchange, which many companies would rather downplay, have been tremendous in recent months. Tobacco maker Philip Morris made more than half of its 17.5% sales growth last quarter from changing money. Merck posted a 2.1% decline in sales; without foreign exchange, revenues at the pharmaceuticals maker would have decreases nearly three times as much.
And when Coca Cola announced a 9% rise in revenues last quarter, the beverage maker beat analyst expectations. As with the company's fizzy drinks, however, most of that flavor came from an artificial source: Six of the nine percentage points were from currency.
But now that the tide is turning in favor of the dollar, analysts are growing bearish on American companies with heavy foreign exposure. Deutsche Bank analyst Marc Greenberg maintained a hold on Coke on the day that the company reported its impressive earnings, citing its currency exposure as a negative. Sterne Agee's Sam Poser recently downgraded apparel seller Nike (NKE, Fortune 500), noting, "Nike was amongst the companies that benefited most from the dollar's descent."
Multinationals themselves have also begun to sound the warning bell: PepsiCo (PEP, Fortune 500) and 3M both predicted that currency shifts would have a negative effect in the fourth quarter. Some companies have declined to forecast the next quarter's sales because of uncertainty over currency values.
"Most companies don't even know the impact of what's to come," said Wolfgang Koester, the CEO of FIREApps, a Scottsdale business that helps businesses control their currency risks. "The ones that have seen gains are going to start seeing losses - it's going to be a bloodbath."
So what's an investor to do? Before you jump ship on multinationals, take a closer look at the extent of their exposure - and how they're managing it.
One way to steer clear of volatile currency fluctuations is to pick U.S. companies that stay close to home. Consumer foods producer General Mills (GIS, Fortune 500), for example, has seen higher stock returns than most Fortune 500 companies this year.
Terry Bivens, an analyst with JPMorgan, notes that General Mills added just 1.7% revenue growth from currency exchange, while rivals Heinz and Kraft both made 5.6% off the weak dollar. (Companies typically report these figures on their balance sheets, under their overall net sales.)
"Mills, given its relatively low international exposure, has benefited relatively little from currency," wrote Bivens in a recent research report. "We therefore believe the emerging currency headwind for the company will likely prove minimal."
Johnson, the BMO Capital Markets analyst, recommends toy-maker Jakks Pacific (JAKK), which sells nearly 80% of its goods in the United States, over companies such as Mattel, which generates about half of its revenues internationally. "The best opportunities are companies with the smallest exposure to international markets," he said. "Jakks isn't going to get hit because of its currency exposure."
That said, some multinationals might not get socked by the dollar's strength. "Some of the big multinationals are hedged against currency fluctuations," said Axel Merk, the manager of Merk Mutual Funds. "If an international company has good hedging techniques, then I'd rather be there than at a company that deals solely with the American customer.
But currency hedging is a tricky business: Companies use derivative financial instruments such as option contracts and currency forwards to try to counterbalance the risk they incur from selling abroad.
Most hedging strategies are difficult to understand, but FIREApps' Koester offers a few tips for finding out which companies are good bets. "The main thing to look for is transparency - a company that says how much exposure it has, what derivatives it's buying to hedge, and what the net risk is," he said.
Koester also advises investors to seek out companies that have hedged for more than a quarter. "A business that's been historically showing a strategy to deal with this - that's one you can feel good about it." Apple (AAPL, Fortune 500) has had a program in place for years, and H.J. Heinz says it's hedged through the end of the year. Google, a FIREApps client, recently announced that it was hedged for the next 18 months.
Hedging programs can offset losses, but they can also backfire: Brazilian industrials Sadia and Vale recently lost hundreds of millions after overestimating the value of the Brazilian real. Poser, the Sterne Agee analyst, is skeptical of how effectively U.S. based multinationals have covered their risks - he predicts that Nike's hedge will turn against them in January.
A safer way to mitigate foreign exchange risk is through natural hedging, or producing and selling in the same location so that costs and sales are both expressed in matching currencies. Companies such as Johnson & Johnson and General Motors (GM, Fortune 500), which utilize local production, could offset some of their losses with lower costs, says Merk, the Merk Funds manager.
"You don't want your expenses in one country and your currency in another country," he said. "Natural hedging is the best way to reduce risks without the cost of derivatives."
But while hedges, both complex and simple, can stave off the currency headwinds, they can't compensate for a slowing global economy, says Poser. "When companies are pulling more than half of their income from international sales and those markets start blinking, you've got a problem," he said. "The dollar is getting stronger and the economy is getting weaker - it's a perfect storm."
Has the beating the market's taken got you wondering about how to invest now? Let us know what you'd like us to address in our next Investor Daily. E-mail Fortune. 
-
The retail giant tops the Fortune 500 for the second year in a row. Who else made the list? More -
This group of companies is all about social networking to connect with their customers. More -
The fight over the cholesterol medication is keeping a generic version from hitting the market. More -
Bin Laden may be dead, but the terrorist group he led doesn't need his money. More -
U.S. real estate might be a mess, but in other parts of the world, home prices are jumping. More -
Libya's output is a fraction of global production, but it's crucial to the nation's economy. More -
Once rates start to rise, things could get ugly fast for our neighbors to the north. More
