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Managing the Dollar's Decline

The melting greenback isn't necessarily bad news, but finding the best way to adjust could be a CFO's toughest challenge this year.
Kate O'Sullivan, CFO Europe Magazine
February 4, 2008

Ever since Carlo Ferro was promoted to CFO at STMicroelectronics, a $10 billion (€6.8 billion) Geneva-based chipmaker, two years ago, he's spent a lot of time pondering the plight of the dollar. The US-listed firm reports in dollars, and nearly all of its invoices are in dollars or Asian currencies linked to the dollar, while most of its operating expenses are in euros. As the dollar lost value against the euro — roughly 20% over the past two years — ST has taken a beating.

But Ferro hasn't sat idly by watching the dollar's tumble. Since becoming CFO, he has been "continuously evolving" how the company handles its currency exposure. This has meant readjusting the heavy euro weighting of costs of goods sold at ST, which has fallen from around 60% to 40%, while the dollar's share of costs increased from 40% to 50%. This was a critical move as the dollar slid to $1.47 against the euro last summer, the highest level since Europe's common currency began trading in January 1999. Ferro also introduced a programme to hedge around 50% of its dollar exposure which requires ST subsidiaries to book capital expenses in dollars rather than euros. (See "Accounting for the Dollar" at the end of the article.)

Managing a rapidly changing forex environment is critical at ST, asserts the CFO. The company aims to "absorb" medium-term changes to exchange rates through "organic growth, enhancing the quality of our product portfolio and progressing cost measures, while reducing the expense structure not only in Europe but also globally." That explains ST's decision to close facilities in Europe, North Africa and the US over the past year, moving work to sites in low-cost Asia, where most of the demand for its products comes from.

ST is certainly not alone. With the greenback at its weakest in decades, companies around the world are feeling the impact of its decline and scrambling to adjust. Consider Infosys Technologies in India. For every percentage point that the dollar slips against the rupee, the Bangalore-based outsourcing firm sees its profit margins shrink 50 basis points. And the dollar has fallen a long way over the past few years. Two years ago, one dollar bought 44 rupees. Today it buys 39.

The size of the earnings hit Infosys suffered is not all that surprising, considering how dependent the business is on dollar-denominated revenues. "About 98% of our revenue comes from overseas and about 63% comes from North America," says CFO V. Balakrishnan. Unlike his peers in industries such as manufacturing, however, Balakrishnan doesn't have significant US dollar costs to balance against the blow to revenues — as a service business, Infosys imports relatively little. "Indian companies like ours are very exposed," he says.

But other companies are happy to make adjustments. For example, for every cent the euro increases against the dollar, Connecticut-based United Technologies Corporation (UTC) records an additional $10m in earnings. The diversified manufacturer earns more than 60% of its revenues outside the US, and it received an earnings boost of about $100m last year as the dollar slid against the euro, according to vice president of accounting and finance, Greg Hayes.

Indeed, the change rippling through the global economic system affects different companies in very different ways. Indian outsourcers are suffering. US manufacturers selling into Europe are celebrating. In Europe, many are considering moving manufacturing operations not only to Asia, but also to an increasingly lower-cost America.

Every CFO, however, must eventually place a strategic bet on the dollar's future course, no matter what the relative economic advantage. If the dollar stays weak, what will be the net effect on diverse, global businesses? And what is the best response?

Now Or Forever?
This isn't the first time businesses have lived through a long stretch of a weak dollar — during the 1970s, for example, the dollar was in the doldrums, a situation which led, like today, to rocketing oil prices and economic malaise. But there are a couple of important differences between then and now.

For one thing, businesses are far more global and interconnected today, increasing the number of ways that currency values can influence financial performance. An American technology company, for example, is likely to have manufacturing operations in different parts of the world, some of which share the price benefits of a weak dollar, and others that are now more expensive. Each of those regional operations may import components from a range of countries with varying relative currency values. And the company's ability to pass on cost increases due to a falling dollar may not be the same everywhere.

The prospect of a prolonged decline in the dollar isn't as far-fetched as it might once have seemed. According to our most recent quarterly Global Business Outlook Survey, a stunning 50% of Europe's CFOs and 60% of Asia's believe the decline in the dollar represents a permanent or long-term devaluation. Only a third of their US counterparts agree.

"I think it's a fundamental adjustment," says Charles Kane, CFO of investment firm Global BPO Services and a lecturer on international finance at the MIT Sloan School of Management in Massachusetts. "There are a lot of factors driving the dollar down." And it could fall still further if, say, the oil-exporting countries decide to peg oil prices to another currency or to a basket of currencies.


"My concern is not that the dollar's decline is cyclical, but that it's a long cycle," adds Scott Goble, finance chief at Alliance Flooring, a Tennessee-based private company with more than $1 billion in annual sales. Although Alliance only does business domestically, the company has been affected by rising raw-materials costs. "We need to keep interest rates low to keep the housing situation from getting out of hand, but we need to maintain high enough rates to keep foreign investment coming in," Goble says. "I don't see a way to do that without a devalued currency."

Seizing The Day
The earnings benefit for US companies with overseas sales is undeniable. For Compact Power, a small manufacturer of landscaping and construction equipment based in South Carolina, the falling dollar has meant a rapid rise in the company's overseas sales. The $100m company began selling internationally only two years ago, has doubled its worldwide sales in the past year and plans to double them again in 2008. "We've absolutely accelerated our international growth because of the exchange rate," says CFO Norman Boling. "The falling dollar has made us competitive in markets where we're up against established existing competition."

Compact Power recently developed two diesel units that will be distributed in the UK this year, and has entered into a distribution agreement with an Italian manufacturer to sell that company's product — tractors — in America. To address currency fluctuations, the two companies agreed on a rate in their contract, a strategy Compact Power plans to continue with other partners. While the manufacturer does not do financial hedging, "by locking down the exchange rate at which we purchase, we can take out some of the risk," says Boling. Trade partners have been willing to agree on rates in their contracts because the practice removes uncertainty for them as well. "We might feel a pinch here if the dollar goes back the other way," says chief operating officer Michael Edwards. "We're developing sources out of Europe and other regions so that we can play the other side when that happens."

In Asia, meanwhile, many companies rely on dollar-denominated exports. But not every company in the East is bemoaning the weak dollar. Martin Cubbon, CFO of Swire Pacific, the HK$19 billion (€1.6 billion) Hong Kong-based owner of Cathay Pacific Airlines, is unperturbed by the dollar's slide. "Although we do have a lot of Hong Kong dollar revenue [the Hong Kong dollar is pegged to the US dollar], we also have a lot of renminbi, euro and yen," he says. "And we have a lot of dollar costs, namely fuel and capital costs. It's a good position to be in."

Making Adjustments
Over in Europe, what's striking is the growing number of companies that are considering moving operations to America to reduce costs. Perhaps the highest-profile backer of this strategy is Louis Gallois, CEO of EADS. According to Gallois, the European aeronautic and defence company — which sells its jets in dollars, while many of its costs are in euros — loses €1 billion for every 10-cent rise in the euro. Now, as part of a new strategic plan that has drawn the ire of various European politicians, EADS wants to offset the effects of the depreciating dollar by moving more manufacturing operations from Europe to cheaper locations. The plan is that by 2020, 40% of EADS's purchasing and 20% of its workforce will be outside Europe.

For other European companies, ramping up investments in the US is as much a by-product of globalisation as a response to currency values. Consider Novo Nordisk, a DKr38.7 billion (€5.2 billion) Danish pharmaceutical company which produces nearly all of its drugs in Denmark but derives more than 30% of its sales from North America. The company also conducts most of its research and development just outside Copenhagen.

In addition to increasing its financial hedging, Novo Nordisk has expanded its production facilities around the world, opening a new facility in Brazil and developing plans to expand production in China this year to join its 50-person research team there. The company also opened an R&D office in New Brunswick, New Jersey in 2006. "We are looking for a better balance between our production cost base and our income base," says CFO Jesper Brandgaard.

Yet Brandgaard also puts the dollar's decline into perspective. He stresses that while the fall may be accelerating operational changes, foreign-exchange concerns are not the only reason to make a move. "The business logic is the primary driver for any new initiative, but we have been acutely aware of the impact of currency changes, and we've been trying to bring that into our decision-making process," says Brandgaard.

It's a similar story at Alstom, a €14 billion French maker of high-speed trains and power turbines. The firm unveiled plans in December to build a $200m facility in Tennessee, in part to mitigate the impact of the weak dollar on margins, according to CFO Henri Poupart-Lafarge. As he sees it, the move is simply smart risk management. "We are in a heavy industry and exchange rates that change at the pace they're changing add to the difficulty," he explains. "We have a platform in China to serve the Chinese market and in India to serve the Indian market. It's important for us to have some industrial activities in the States to harmonise our global platform with our sales and revenue."


In contrast, companies headquartered in the United States are putting the brakes on investments overseas. "New investments could become less justifiable because of higher local costs," says Pablo Edelstein, CFO of Dow Latin America, part of the US chemical company. Because many of Dow's raw materials — such as ethylene, which is derived from oil — are linked to the dollar, margins will shrink internationally unless the company raises prices. "We do transfer those increases to our selling prices, but sometimes there is a lag, particularly when oil prices shoot up rapidly," Edelstein says. If the dollar's weakness lingers, the company will have to reconsider the economics of new investments, he says.

In addition to reconsidering or redirecting investments, some companies are coping with the dollar-induced earnings squeeze by re-engineering their entire business models. "Big companies like ours that have a flexible cost structure are able to absorb the impact of the dollar and still maintain margins," says Balakrishnan of Infosys. The company is keeping costs low, largely by outsourcing much of its own back-office work, fittingly enough for a BPO firm. It is also increasing employee utilitisation.

Critically, Infosys is positioning itself for a long-term rise in the value of the rupee by moving aggressively into higher-margin consulting work. "The proportion of our revenue coming from high value-added services will definitely go up," says Balakrishnan.

"Look at what happened in Japan," he says. "When the yen was 320 against the dollar and moved to 120, they started setting up operations outside the country and became more efficient and managed it. Large companies in India will try to do the same."

Infosys rival Tata Con-sulting Services is also seeking higher-end work, and the company is trying to steer clients towards projects that are based at its own facilities in India, rather than at client locations, to boost margins. All these changes may not be enough, says CFO S. Mahalingam. "If the rupee gets to 35 [to the dollar], that's a different matter. Then we will have to look at creating more delivery centres overseas." At the end of 2007, the rupee clocked in at 39.2 to the dollar.

Of course, there is an ever-present danger of an over-reaction to the dollar's decline. After all, the very processes that restore economic equilibrium — such as boosting American exports and attracting foreign investment — are already beginning to bolster the American economy. Edelstein of Dow anticipates that exports and cross-border M&A activity into the US will rise now that the dollar is weak. Dow itself just announced a US-based joint venture with Petrochemical Industries Company of Kuwait to produce and market plastics.

As these countervailing forces build, another factor in restoring the dollar to health could be the absence of an alternative currency to take up its mantle. Many doubt that the euro will become the world's leading currency, despite the occasional endorsement economists give it. "If you look at the prospects in Europe versus the US from an economic-growth standpoint, I would put my money on the US," says Hayes of UTC.

In Hong Kong, Cubbon of Swire Pacific is equally confident. "The dollar will strengthen next year," he says. "The US has a way of regenerating itself," he adds. "It's still the world engine. China may become that in the future, but it ain't there yet."

Perhaps, says ST's Ferro, but global companies need to go wherever the growth is. "Now the bulk of our growth is in Asia, which has the advantage of a good cost structure, less currency exposure and, more importantly, is closer to the final demand, he says. Ferro also doesn't expect the dollar to gain much strength any time soon, predicting a dollar/euro rate similar to or slightly lower than the current $1.47 over the medium term. But Ferro adds that one of the biggest lessons the past few years have taught him is that predicting which way currencies will move is a difficult task. Harder still — but arguably more important — is for companies like ST to find ways to manage and deliver profitability regardless of which way the dollar travels.

Kate O'Sullivan ia a senior writer at CFO.

Additional reporting by Don Durfee, Tom Leander and Janet Kersnar


Accounting For The Dollar

Beyond the cash flow implicationS of a falling dollar, there are also some accounting worries. This is particularly true for companies that book expenses in an appreciating currency, such as the euro, but report earnings to shareholders in dollars.

This is what Carlo Ferro, CFO of Geneva-based chip maker STMicroelectronics, has discovered. The $10 billion company reports earnings in dollars, while roughly 40% its expenses are euro-denominated.

According to Ferro, capital expenses the company made back when the dollar was stronger are now distorting ST's reported earnings. Under US GAAP, when depreciating a capital good over a number of years a company doesn't convert the currency using the exchange rate at the time of purchase. Instead, any depreciation reported today must use the current exchange rate. If the currency used to make the purchase is appreciating, then the asset looks more expensive than it really was.

Consider a hypothetical example, says Ferro. ST bought a tool for €100 back when the dollar/euro exchange rate was roughly 1:1. ST would have posted the purchase in its books and it would start to depreciate over five years, at €20 a year. Now that the exchange rate is 1.4:1, the €20 depreciation converts to $28. "Under current accounting rules, a global company purchasing tools in euros and reporting its consolidated financial statements in dollars must depreciate $140 through the life of the asset for something it has paid $100." That distortion affects the company's margins.


To avoid this problem in the future, Ferro is using something he calls "accounting hedging" — he's requiring ST's subsidiaries to do their functional reporting in US dollars, to better match expenses with the reported earnings. "This is something in my opinion that is very effective," says Ferro, "but it will take time to benefit fully from the new methodology." — Don Durfee




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