Euro's Eroding Value May Drag On Earnings Of U.S. Companies

The upcoming earnings season should shed light on the painful impact the euro's 15% drop this year vs. the dollar is having on U.S. companies, especially those that garner much of their sales in Europe.

A wide range of American firms — including those in high tech, retail and manufacturing — will likely report lower revenue due to the slumping euro. In some cases, the weak currency will hurt profit margins or key financial metrics, such as average selling prices.

U.S. companies aren't the only ones feeling the pinch. Shares of some Chinese solar panel makers, which generate a big chunk of sales in Europe, have been slammed due to disappointing earnings tied to the weaker euro.

Currency swings are nothing new to U.S. firms, which typically use financial hedging strategies to offset unfavorable exchange rates. The euro's drop vs. the dollar, which began in November and picked up in April, has been unusually sharp for a major currency. The euro is down 19% since Nov. 25 and 10% since April 14.

"What's unsettling is that the corporate hedgers, whatever strategy they're following to manage their currency exposure, were likely caught off-guard by a large move like that," said Brian Dolan, chief currency strategist at Forex.com, part of Gain Capital.

He added: "A lot of companies and institutions didn't see it coming as late as March."

Companies thought the euro would return to being worth more than $1.50, a level it last reached in December, Dolan says. Instead it's trading nearly 19% lower, dipping at times under $1.22. "A lot of them underestimated the risk of a sharp decline in the euro and were caught flat-footed," said.

How big a hit on revenue companies take when they report second-quarter earnings may depend on their European sales and how well their hedging strategies worked. Firms typically use futures contracts, options orders and trade in the derivatives market to offset fluctuating currencies.

A wave of research reports from stock analysts suggests the weaker euro's impact on second-quarter results may be widespread.

In a report published on June 1, Susquehanna's Marianne Wolk lowered her second-quarter earnings estimates for Google (NMS:GOOG), eBay (NMS:EBAY), Priceline (NMS:PCLN) and Expedia (NMS:EXPE). The analyst lowered her fourth-quarter 2010 and first-quarter 2011 revenue targets for Google based on a forecast that the dollar's strength will continue.

Cowen & Co. apparel maker analyst John Kernan said in a June 1 report that "rapid deterioration in the euro" is the top near-term risk for Guess (NYSE:GES - News), Phillips-Van Heusen (NYSE:PVH - News) and Polo Ralph Lauren (NYSE:RL - News).

"Euro exposure clouds visibility into estimates," he wrote.

Guess, which garners 35% of sales from Europe, on May 27 lowered its second-quarter earnings guidance. "The euro has now weakened significantly below our planning assumptions," said Carlos Alberini, Guess' chief operating officer who left later to join Restoration Hardware as co-CEO.

Big-cap companies on average generate 14% of sales in Europe, while small-cap stocks generally have less exposure, with 4% of sales, says S&P analyst Howard Silverblatt. The top 20 U.S. companies in European sales include General Electric (NYSE:GE - News), Ford (NYSE:F - News), Johnson & Johnson (NYSE:JNJ - News), Pfizer (NYSE:PFE - News), Kraft (NYSE:KFT - News), McDonald's (NYSE:MCD - News), Cisco Systems (NMS:CSCO), Coca-Cola (NYSE:KO - News), Best Buy (NYSE:BBY - News), Intel (NMS:INTC) and cruise ship operator Carnival (NYSE:CCL - News).

"Currency translation is going to be a drag on earnings. We expect to see a lot of text and numbers on that for the second quarter as companies explain the impact of the euro," Silverblatt said.

Citigroup analyst Walter Pritchard in a May 25 research note wrote that VMware (NYSE:VMW - News), Oracle (NMS:ORCL), Adobe (NMS:ADBE) and Symantec (NMS:SYMC) are among high-tech firms with sales exposure to the weak euro.

"Revenue impact is clear ... EPS impact less clear but still negative," Pritchard said in the note.

He said that because the effectiveness of hedging strategies fades, a weaker euro could have more impact on earnings in 2011.

Broadpoint AmTech analyst Mark McKechnie in a June 2 report said Qualcomm, a maker of electronic chips for mobile phones, may see lower average selling prices because of the weaker euro: "Given near-term hedging, we assume (a weaker euro) does not impact earnings until the December 2010 quarter."

Colin Sebastian, an analyst at Lazard Capital Markets, said in a June1 report that Internet firms Amazon and eBay as well as some video game companies have exposure to the weak euro.

Adam Fleck, equity analyst at Morningstar, says U.S. firms that manufacture goods in Europe will see less impact on profits because of lower operating costs. "The magnitude of the currency fluctuation is a factor, but companies do have natural hedges by moving production closer to customers," Fleck said. "Caterpillar (NYSE:CAT - News) and 3M (NYSE:MMM - News) have done that."

Jeffrey Immelt, GE's CEO, took that tack on a conference call on May 19. "We've got a European manufacturing base and a European revenue base that are more or less matched," he said. "So while (the weak euro) may have some impact on revenue, it shouldn't have a big impact on earnings."

Some CEOs claim that concern over the euro is overblown.

"A higher euro is good for us with our business in Europe, but a bad euro isn't probably as negative as some of the things that have been written," Hewlett-Packard (NYSE:HPQ - News) CEO Mark Hurd said on the company's earnings call on May 18.

HP said on the call that its models assume the euro's exchange rate vs. the dollar stabilizes in the mid-1.20s range. Other companies are in the same ballpark.

The euro's decline has leveled off since Tuesday. It closed at $1.22. However, many economists believe the shared currency could fall further in the long run.

And some of Europe's political leaders support an "orderly" decline because a weaker euro helps boost exports.

At Forex.com, Dolan forecasts the euro will trade at 1.15 vs. the dollar by year-end. On the plus side, he notes that's not far from the 10-year-old currency's average of 1.17 vs. the dollar.