Riding the foreign exchange roller coaster

Transcription

1 OCTOBER 2012 Riding the foreign exchange roller coaster Corporate finance implications of a riskier currency environment

2 Published by Corporate Finance Advisory For questions or further information, please contact: Corporate Finance Advisory Marc Zenner (212) Tomer Berkovitz (212)

3 RIDING THE FOREIGN EXCHANGE ROLLER COASTER 1 1. Dealing with the currency environment you have (rather than the one you d like to have) Slower growth in developed economies relative to emerging markets, advances in transportation and telecommunication infrastructure and lower international trade barriers have led many U.S. companies to expand their offshore operations in recent years. Whether through M&A or organic growth, large multinationals derive a growing part of their revenue from non-domestic markets. For example, for the 25 largest companies in the S&P 100 index, the portion of non-u.s. revenues increased from almost 45% in 2006 to over 55% in However, with the benefits of faster growing non-domestic markets come the risks of foreign currency fluctuations. Figure 1 Non-domestic revenues are becoming increasingly important for large global firms Median % of revenue outside of North America % 47.2% CAGR : 4.5% 49.3% 50.1% 53.9% 55.6% Source: Bloomberg, FactSet 1 Top 25 S&P 100 companies by market cap 2011 Senior managers and capital market participants are used to dealing with risky operations and changing markets and prices. With ever-expanding non-domestic sales, however, the impact of currency fluctuations in predicting earnings and cash flows becomes paramount. Figure 2 Increasingly volatile FX environment calls for action FX environment More volatile Harder to predict Limited benefits of diversification Corporate environment Greater revenues offshore Increased investor attention to FX Increased FX-related earnings volatility Companies need to reexamine their FX strategy Source: J.P. Morgan This riskier currency environment profoundly impacts all aspects of corporate finance decision-making, from risk management to dividend policy, capital structure and M&A. To guide senior executives, we provide a roadmap that highlights key challenges and helps users avoid the most common pitfalls of this riskier currency environment.

4 2 Corporate Finance Advisory EXECUTIVE TAKEAWAY Large global firms realize a growing part of their sales from non-domestic markets, while currency volatilities have increased relative to pre-crisis levels, and the benefits of diversification have diminished. As a result, currency swings will have a greater impact on firm value going forward, unless decisionmakers adopt a proactive approach to dealing with this new reality. 2. How do you define your currency risk exposure? Following the recent (and some would say, ongoing) financial crisis and the flock of associated black swans, senior decision-makers are even more focused on measuring and managing risk. The traditional view is that investors expect higher returns when exposed to higher systematic risk (beta). We believe that there is another categorization of risk that is useful in the context of currency exposure: Core versus non-core equity risk. Core equity risk is a key risk borne by a firm due to the nature of its business; investors would likely choose to have exposure to this particular risk to enhance their returns. Asymmetric risk, however, creates exposure to a risk that investors are not necessarily seeking out when purchasing a stock. They can be material but are not key drivers of the firm s investment thesis (see examples of core and asymmetric risks in Figure 3). Figure 3 Core versus asymmetric risk exposures Core Asymmetric Definition Risk fundamental to main business activity Risk that is not fundamental to main business activity Investors perspective Investors purchase shares to achieve exposure to the core risk Investors do not purchase the stock to obtain exposure to this risk Investors may penalize the firm more for adverse outcomes than they reward it for favorable outcomes Examples Company Risk exposure Company Risk exposure Gas exploration Gas prices Waste management Trucking fuel and production Source: J.P. Morgan Real estate investment trust Real estate market Food and beverage Aluminum prices Oil refiner Crack spreads Iron ore Copper prices Gold mine Gold prices Global corporations Currency risk? We believe that for most firms, currency risk falls in the category of asymmetric risk. As a result, the growing impact of currency fluctuations is likely to be asymmetric. That is, the perceived shareholder benefit of a favorable currency outcome will be overshadowed by the penalty due to an unfavorable currency outcome. If currency volatility increases, exposure to asymmetric risk will be higher and corporate finance implications would likely be more severe.

5 RIDING THE FOREIGN EXCHANGE ROLLER COASTER 3 EXECUTIVE TAKEAWAY All firms take on risk. Investors select equity investments based on the balance between expected returns and risk. Some firms provide risk exposures that are uniquely attractive to some investors. For most firms, currency risk does not, however, fall into this category. As a result, firms will be more negatively impacted by adverse currency movements rather than positively impacted by favorable ones. 3. A riskier currency environment 3.1. Sustained higher volatility level During crises, volatilities of financial assets tend to spike. At the peak of the recent financial crisis, equity volatility (as measured by the VIX index) jumped from a pre-crisis average of about 15% to as high as 80% on October 27, Following this trend, currency volatilities also spiked during the crisis, from a pre-crisis average of about 9% to about 13%. Despite the significant economic, regulatory, financial systemic and geopolitical risks, equity volatility has dropped back to pre-crisis levels of about 15 to 20%. In contrast, currency volatility has not yet returned to prior levels in all markets (particularly the Euro/USD rate). As one can see in Figure 4 below, currency volatilities have settled at a level that is about 50% higher than that prior to the crisis. The uncertainty around the future of the Euro, concerns about global economic slowdown, the U.S. elections and the fiscal cliff constitute a large part of this volatility. What does this mean for corporate decision-makers? For firms operating in non-domestic markets, this higher volatility implies more severe shocks to non-domestic revenues and earnings. Figure 4 Currency volatilities are still elevated in some markets Expected volatility of foreign exchange rates % 22.0% 20.0% Euro/USD volatility JPY/USD volatility GBP/USD volatility 18.0% 16.0% 14.0% 12.0% 10.0% Post-crisis median: 12.9% 8.0% 6.0% Pre-crisis median: 8.8% 4.0% 2.0% 0.0% 01/28/ /15/ /01/ /20/ /05/ /22/ /10/2011 Source: Bloomberg 1 One-year option-implied volatility

6 4 Corporate Finance Advisory 3.2. Reduced ability to predict currency volatility A more volatile foreign exchange environment makes it more challenging to forecast rate changes. In May 2007, when currency volatility was relatively low, most economists had roughly similar forecasts regarding future rates of the Euro. This estimated consensus was wrong. By the end of the third quarter, the Euro already spiked beyond the highest analyst forecast of just four months earlier and a similar trend was recognized during the following two quarters. When currency volatility reached its peak (at the end of 2008), the divergence in economists views almost tripled. Still, the actual spot rate was close to the highest estimate and significantly away from the median. What does this mean for corporate decision-makers? Firms often rely on economists forecasts and the forward curve to budget foreign earnings and cash flows that will be translated into USD. Whether evaluating a new project or M&A opportunity, the ability to forecast USD returns on investments is critical. When realized spot rates are drastically different from the rates used for calculating the expected ROIC, unhedged investments may turn dilutive (from both economic and accounting perspectives), even if the foreign currency cash flows of the project or the subsidiary perform as expected. Figure 5 Economists disagreement about future currency rates is growing Economists forecasts for the Euro spot price Trough 1 expected currency volatility Peak 2 expected currency volatility $1.70 Economists forecasts $1.70 Economists forecasts $1.60 $1.50 $1.40 $1.35 Euro spot price $1.40 $1.40 $1.40 $1.42 $1.60 $1.50 $1.40 Euro spot price $1.48 $1.48 $1.41 $1.52 $1.55 $1.30 $1.20 $1.26 $1.22 Standard deviation 4% $1.30 $1.20 Standard deviation 11% $1.10 $1.00 $1.16 $1.12 Q Q Q Q $1.10 $1.00 $1.10 $1.00 $1.07 $1.05 Q Q Q Q Source: Bloomberg, FactSet Note: Standard deviation refers to the average of the four periods standard deviation of economist forecasts 1 Trough implied Euro volatility and analyst estimates as of May 8, Peak implied Euro volatility and analyst estimates as of December 30, Greater difficulty in diversifying foreign currency risk Global companies operating in various international markets often rely on the diversification among different currencies to mitigate the net impact of currency fluctuations on their cash flows. In particular, the correlation between emerging market currencies, such as the Brazilian Real (BRL) and Indian Rupee (INR), and developed market currencies, was close to zero in the pre-crisis environment. Figure 6 shows, however, that in the new currency environment, the correlation between foreign exchange rates of emerging and developed markets has spiked. For example, the Euro/BRL correlation has jumped from zero to 60%.

7 RIDING THE FOREIGN EXCHANGE ROLLER COASTER 5 The increased correlation is a result of several factors. First, integration of global economies and capital markets, combined with innovations in the financial industry, has led to increased correlation between markets. Similarly, the correlation between emerging and developed markets equities has increased significantly in recent years. Last, the use of U.S. Treasuries as a safe haven and more macro-driven investments are driving correlations closer to one. What does this mean for corporate decision-makers? The value of diversification across different currencies is diminishing, leading more global firms to be more aggressive about hedging alternatives. Figure 6 Benefits of currency diversification are reduced in today s environment Emerging markets One-year rolling correlation of Euro/Indian Rupee Developed markets One-year rolling correlation of Euro/Australian Dollar 0.9 Euro/AUD correlation 0.8 Euro/INR correlation /29/04 1/29/06 1/29/08 1/29/10 1/29/12 1/29/04 1/29/06 1/29/08 1/29/10 1/29/12 One-year rolling correlation of Euro/Brazil Real One-year rolling correlation of Euro/Canadian Dollar 0.9 Euro/CAD correlation 0.8 Euro/BRL correlation /29/04 1/29/06 1/29/08 1/29/10 1/29/12 1/29/04 1/29/06 1/29/08 1/29/10 1/29/12 Source: Bloomberg EXECUTIVE TAKEAWAY The new currency environment presents significant challenges to corporate executives. Foreign exchange rates are more volatile and harder to predict. Moreover, diversification offers limited value as correlations have increased.

8 6 Corporate Finance Advisory 4. Analysts and equity investors pay attention The new foreign exchange environment and its impact on corporate earnings have not gone unnoticed by equity analysts and investors. For some global consumer retail, pharmaceutical and technology companies, the foreign exchange impact on second quarter sales this year was up to 15% of revenues or US$3.0 billion (see Figure 7A). Following this significant impact on revenues, equity analysts are now more focused on FX. For example, in second quarter earnings calls, 34% of multinational companies were questioned by analysts about FX, versus only 23% in the first quarter of 2012 (see Figure 7B). During the third quarter, investors have returned to risk on trades causing the USD to weaken again, which should have had a positive impact on the revenue of U.S. companies that operate globally. The volatility in FX rates remains a major issue, however, and adds to the uncertainty regarding future earnings and cash flows. If currency risk is perceived as asymmetric by investors (as discussed in Section 2), then adverse moves in FX rates will lead to increased investor attention and negative market reaction, while favorable FX trends will not be rewarded because they are not viewed as sustainable drivers of longterm growth. Figure 7A Investors are becoming increasingly focused on currency losses Notable impact of FX fluctuations on Q revenues US$mm $3,000 $2,500 $2,000 $1,500 $1,000 $500 $0 Telecommunication Internet software Medical technology Absolute FX impact on revenues FX impact as a % of revenues $84 $102 $119 $200 $301 Integrated O&G Industrial conglomerate Chemical $430 $441 $492 $523 Pharmaceutical Pharmaceutical Food & beverage Aerospace & defense Type of company Source: Press releases, Company filings, earnings calls transcripts $690 $692 $900 $1,000 $2,200 $3,000 Pharmaceutical Industrial conglomerate IT consulting Super centers Household products 15% 10% 5% 0% % of revenues

9 RIDING THE FOREIGN EXCHANGE ROLLER COASTER 7 Figure 7B Investors are becoming increasingly focused on currency losses (cont d) Multinational firms questioned by analysts about FX 1 40% 35% 30% 25% 20% 15% 10% 5% 0% 23% 34% Q Q Source: Press releases 1 According to a review by foreign exchange risk management company FiREapps EXECUTIVE TAKEAWAY Heightened uncertainty in the foreign exchange market is attracting the attention of equity analysts and investors, who are concerned about its impact on corporate earnings. Corporate executives, who are already receiving more FX questions from analysts during earnings calls, are currently reexamining their FX strategy in light of this new environment. 5. A roadmap to avoid the most common pitfalls Foreign exchange rates affect various aspects of a firm s corporate finance strategy. As U.S. firms generate a larger portion of their revenue offshore and the foreign exchange environment remains more volatile and harder to predict, companies should reexamine their strategy. Figure 8 offers a corporate action plan for decision-makers to potentially mitigate risk exposure to the increasing currency volatility. Companies should measure the impact of FX fluctuations not only on their earnings and cash flows, but also on their leverage metrics, payout ratios and liquidity position. Hedging should be considered, especially if the company believes that FX exposure is asymmetric and non-core to the business. In addition to forward contracts and cross-currency swaps, companies can use option strategies to keep some exposure but protect against tail risk. The application of hedge accounting will also be important in certain situations and companies need to be aware of the rules in order to avoid increasing earnings volatility while hedging economic risk.

10 8 Corporate Finance Advisory Figure 8 A roadmap to avoid the most common pitfalls Action plan 1. Valuation and earnings Assess the potential impact of FX volatility on your company s earnings guidance Focus not only on net currency exposure, but also impact on top line growth 2. Operations Consider USD denominated contracts in foreign countries as a natural offset to FX volatility Take into account that FX movements will still impact your firm s competitiveness versus local peers 3. Hedging strategy 4. Capital structure/ ratings 5. M&A and capital allocation 6. Liquidity management 7. Shareholder distributions Debate de-risking strategies, especially if your company has concentrated currency exposures, limited liquidity and modest flexibility with your credit rating Recent spike in correlations across currencies underscores the limits of diversification Centralizing risk can provide a better perspective on company-wide currency exposure Maintain EBITDA cushion within your rating category (and financial covenants) or think about hedging to protect against the impact of FX on leverage metrics Match the currency mix of your debt to the EBITDA, either through issuance in local markets or synthetically Weigh the valuation of foreign M&A targets in both the local currency and the USD Though theoretically the two methodologies should result in similar valuations, recent market dislocations and practical limitations often lead to different valuations Convert excess liquidity (such as trapped offshore cash) to match the currency of your liabilities Test the sustainability of your company s dividend payments under a downside scenario, taking the impact of FX into account Source: J.P. Morgan EXECUTIVE TAKEAWAY In today s global economic environment, the importance of managing the impact of foreign exchange rates on companies becomes increasingly important. In contrast, the ability to predict currency movements and the use of diversification to protect against adverse rate changes are declining. Many companies are currently analyzing the corporate finance implications of this new environment and reconsidering their FX strategy. We offer a corporate finance action plan that addresses the key factors affecting global companies.

11 Special thanks go to Jessica Lupovici, Matt Matthews, Allison Greenwald and Noam Gilead for their invaluable contributions in shaping this report. We appreciate Mark De Rocco, Evan Junek, Andrew Kresse, Elizabeth Myers, Fernando Rivas and John Wang for their comments and suggestions. We would also like to thank Jennifer Chan, Sarah Farmer and rest of the IB Marketing Group for their help with the editorial process. This material is not a product of the Research Departments of J.P. Morgan Securities Inc. ( JPMSI ) and is not a research report. Unless otherwise specifically stated, any views or opinions expressed herein are solely those of the authors listed, and may differ from the views and opinions expressed by JPMSI s Research Departments or other departments or divisions of JPMSI and its affiliates. Research reports and notes produced by the Firm s Research Departments are available from your Registered Representative or at the Firm s website, Information has been obtained from sources believed to be reliable, but JPMorgan Chase & Co. or its affiliates and/ or subsidiaries (collectively J.P. Morgan) do not warrant its completeness or accuracy. Information herein constitutes our judgment as of the date of this material and is subject to change without notice. This material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. In no event shall J.P. Morgan be liable for any use by any party of, for any decision made or action taken by any party in reliance upon or for any inaccuracies or errors in, or omissions from, the information contained herein, and such information may not be relied upon by you in evaluating the merits of participating in any transaction. J.P. Morgan is the marketing name for the investment banking activities of JPMorgan Chase Bank, N.A., JPMSI (member, NYSE), J.P. Morgan Securities Ltd. (authorized by the FSA and member, LSE) and their investment banking affiliates. JPMorgan Chase and its affiliates do not provide tax, legal or accounting advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.

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