A Stronger Dollar Sparks Second Quarter Earnings Worries for Corporate America
As the dollar rises against the euro, companies in the S&P 500 are cutting their forecasts for second-quarter earnings.
The U.S. dollar appears to be unsinkable. Despite the country’s undeniable economic problems, the greenback has gained about 15% against the euro over the course of the last year, perhaps because global investors, in light of the problems afflicting the eurozone, view owning dollar-denominated assets as preferable to exposing themselves to the uncertainty and risk that hovers overhead in Europe. (See the chart below for details of the shifts in the exchange rate in recent years.) The dollar’s strength – good news for anyone planning a holiday overseas – is creating a fresh headwind for U.S. companies, however, which, until recently, have been able to offset some of the weakness in the domestic market by exposure to stronger economies (such as some emerging markets) and by benefiting from the relative strength of other currencies vis a vis the dollar. The latter – which boosted the dollar value of overseas earnings – is today no longer a tailwind. Indeed, multinational corporations are facing a different environment altogether, and are warning their shareholders to expect less in the way of earnings growth from them in the coming quarters as a result of the slowdown in emerging markets, the European crisis – and the rise in the dollar. The dollar’s gains are the last straw; beyond the impact on profits, this could hurt sales revenues by making US exports more costly in local currency terms in major markets. That could magnify the existing problem – the fact that cash generated abroad in other currencies is worth less than it once was when translated into US dollars – by dampening demand for US exports altogether.
Tobacco powerhouse Philip Morris International Inc. (PM.N) powerhouse is just one of a growing number of companies in the Standard & Poor’s 500 index to cut its earnings guidance to reflect the impact of the stronger U.S. dollar; it also warned that it is seeing sales of tobacco and cigarette products to drop in the European Union. In the final days of the second quarter, other big multinational companies like Procter and Gamble Co. (PG.N), and PepsiCo Inc. (PEP.N) also are giving negative guidance for their second-quarter results. “Growth in developed markets has dropped off significantly,” said Bob McDonald, the company’s chairman and CEO, at last week’s Deutsche Bank Global Consumer Conference. “These markets still account for 60% of sales and an even greater percentage of our profit.” (It doesn’t help, the company noted, that its commodity costs also have risen sharply.) Pharmaceutical heavyweight Merck & Co (MRK.N) sees the same trends buffeting its own earnings. “At today’s exchange rates, for example, sales in the second quarter would be adversely affected by about 3%,“ cautioned Peter Kellogg, chief financial officer of Merck, during the company’s first-quarter conference call with investors and analysts back in April.
The strong dollar simply exacerbates the impact of economic weakness worldwide, particularly in Europe; the combination isn’t a good sign for the upcoming earnings season. The chart below provides a selection of companies in the S&P 500 (those that break out their sales by geography) that have the greatest exposure to Europe, as calculated as a percentage of their total revenue, with that revenue translated into British pounds. From among these companies, Coca Cola Enterprises Inc. (CCE.N) generates the highest percentage of its sales (66%) from Europe, meaning that its second-quarter earnings are very likely to take a hit. Not surprisingly, all 11 analysts covering the stock who have changed their estimates have lowered their earnings per share estimates for the quarter. The dollar effect? Well, Bill Douglas, the company’s chief financial officer, told the Deutsche Bank Global Consumer Conference that he expects currency translation “to have a negative high single-digit impact on (earnings)” for 2012 as a whole.
Of these “at risk” companies, Electronic Arts Inc. (EA.OQ) and Philip Morris International Inc. (PM.N) are most likely to post earnings that fall short of analysts’ estimates as a result of the dollar’s strength. Since the beginning of May, analysts have become significantly more bearish about Electronic Arts’ bottom line, cutting their forecasts until they arrived at the current mean consensus forecast of a loss of 42 cents a share. One five-star rated analyst issued a Bold Estimate predicting that the company’s loss may be larger still, at 45 cents a share. Such a Bold Estimate, published by a top-tier analyst and differing significantly from the mean, often signals a major opportunity or highlights a downside risk for investors, since such analysts being willing to break with the pack and make a risky call is a sign of a high level of conviction by an analysts with a strong track record.
Those downward revisions may not be at an end for EA, as the StarMine Analyst Revision Model (ARM) indicates that analysts likely will continue to revise their earnings forecasts downward as the quarter progresses. Electronic Arts has a StarMine ARM score of only 7, placing it in the bottom decile of all US companies with respect to this measure of change in the way analysts perceive the company’s prospects. The lower a company’s ARM, the more top-ranked analysts have been revising their earnings forecasts downward and the greater the likelihood that they will continue to do so.
Similarly, seven of the 13 analysts that cover Phillips Morris have revised their earnings estimates downward, to a mean consensus forecast of $1.35 a share. After the company last week lowered its guidance due to negative foreign exchange trends, and weakness in Europe one five-star rated analyst cut his forecast to only $1.32 per share, Despite this, StarMine’s Price Momentum (Price Mo) model, which combines information from multiple sources with respect to price momentum, suggests that Phillip Morris’s stock price has more momentum than any of its peers; it scores 100, the top ranking possible, on that model.
Hedging their exposure to foreign currencies is a tried and tested way for multinational companies to reduce the likelihood that their earnings will be dealt a blow by a sudden unfavorable move in the dollar exchange rate. While most companies don’t disclose these hedging activities on their balance sheets, it is logical to assume that many are embarking on some kind of hedging strategy, as Priceline.Com Inc. (PCLN.OQ) has done. The online travel company is more reliant on international gross bookings than it is on its U.S. revenues, and, like many of its peers, reduced earnings guidance during its most recent conference call with investors and analysts in light of the challenging economic conditions in Europe. Dan Finnegan, the chief financial officer of Priceline.com, warned that expected volatility in the euro/dollar exchange rate “can materially impact our results expressed in U.S. dollars.” In order to protect its sales, the company explained that is has contracts in place to shield a substantial portion of its second quarter EBITDA and net earnings from any fluctuation in the euro or pound against the dollar during the second quarter, Finnegan explained.
Recently, Adobe Systems Inc. (ADBE.OQ) posted results that were slightly better than analysts had predicted (it announced earnings of 60 cents a share, compared to the Thomson Reuters consensus forecast of 59 cents a share) for its fiscal second quarter, which ended May 31. However, the company saw a $14.5 million decrease in revenue due to unfavorable currency rates over year-earlier levels. Mark Garrett, the chief financial officer at Adobe Systems told conference call attendees that the company had a $10.7 million gain from hedging activities in the second quarter, compared to a $200,000 gain form hedging during the second quarter of 2011. “Thus the net year-over-year currency decrease to revenue, considering hedging gains, was $4 million,” Garrett said.
AlphaNow data on earnings preannouncements paints a less-than-rosy picture of what lies ahead. Companies In the S&P 500 have issued 26 positive EPS preannouncements, but that has been dwarfed by the 93 preannouncements cautioning that these companies might not live up to analysts’ expectations for second-quarter earnings. To compute a ratio between these negative and positive preannouncements (an N/P ratio), you need only divide 93 by 26; the answer, 3.6, is the weakest showing in more than a decade, since the third quarter of 2001. The Information Technology, Consumer Discretionary, and Health Care sectors have seen the largest number of negative earnings preannouncements. In addition to the unfavorable exchange rates, companies are citing slower economic growth in emerging markets and Europe as one of many problems that corporate America must grapple with.
Analysts’ downward revisions, coupled with negative guidance from the companies themselves, makes corporate earnings look bearish in the second quarter. As a result, the estimated growth rate for earnings by companies in the S&P 500 has fallen from 9.2% to 6.1%, since the second quarter began in April. If the expected earnings growth rate comes in at 6.1%, it will be the third quarter in a row in which earnings growth has remained stuck in the single digits, after eight consecutive quarters of double-digit growth. Excluding Bank of America (BOA), the estimated growth rate for the S&P 500 drops to a 1.1%. (See Exhibit 3, below.)
It doesn’t help that those companies that are generating growth in sales are still having difficulty converting that into growth on the bottom line. According to Thomson Reuters I/B/E/S data, nine of the ten sectors in the S&P 500 will record higher revenues for the second quarter, but only five sectors will see earnings grow by more than 1%. Analysts expect that three of the ten sectors in the S&P 500 will see earnings decline: Utilities (-16.2%), Energy (-13.5%) and Materials (-11.1%). This trend highlights the clear discrepancy between earnings and revenue growth that we discussed previously, and most companies are still facing higher commodity costs, which are eating up profits. Troy Alstead, chief financial officer of Starbucks (SBUX.O) reminded his listeners at a recent conference that his company, like many of its peers, has suffered from “extreme commodity cost pressures.” Today, with the end of the second quarter only days away, the company, along with those same peers, now must also battle the “macro challenges that we face in Europe”.
For more on analysts’ changing views of corporate earnings, please watch this interview with analyst Jharonne Martis.