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Positive Economic Commentary

US Corporate Profits and the Peachy Greenback
October 24, 2003

Once again it's earnings season. And for the first time in recent memory pundits, analysts and the financial press can't seem to say anything but good things – you know the Dow-10,000 talk and whatnot. Ever the contrarian, I figure if Larry Kudlow is salivating like one of Pavlov’s dogs, then maybe there is less to these reports than everyone would have you think. There have been a few articles about the positive effect that the falling dollar has had on US corporate profits. So I thought I’d give it a go as well.

Let me first point out what I see as an irony with regard to exchange rates. We have an almost pathological focus on a country's nominal exchange rate – just track any recent US Treasury Secretary’s comments and the direction of the dollar to see if this true. We having been hearing for months how the Chinese refuse to revalue the yuan, which is pegged to the dollar. This, claim critics, allows Chinese exporters to price more competitively (read unfairly) than say those in the US, driving otherwise viable competitors out of business by flooding the market with cheap goods. This is what has American and other global manufacturers in an uproar. (Of course this ignores any improvements in cost structure or productivity in either country, but that's another commentary.) Based on people's obsession with how many little colored pieces of paper one can get for another little colored piece of paper, I find it somewhat strange that few have seriously pondered how much foreign currency translations are “adding” to corporate earnings. It seems to me that pundits' views on foreign exchange are like George Costanza’s belief in a higher power – it’s limited to only the bad stuff.

Below I've created a hypothetical 10-Q report for Great White North Inc., a Canadian subsidiary of the All-American Corporation. Mind you, like Jeffrey Skilling, former President and CEO of Enron, I'm not an accountant. Also, be advised despite Sarbanes-Oxley, CEO Dave McKenzie and CFO Doug McKenzie have NOT signed off on them. Under the “Actual’ column, I used the reported loonie/peachy-greenback exchange rate as of September 30, 2003. I have also assumed a corporate tax rate of 35%, and that once paid in Canada there is no further liability in the US. Again I’ve tried to keep this as simple as possible. What I have attempted to show is how the respective financial statements would change based solely on movements in the exchange rate. So here it goes.

First, the balance sheet. According to FASB assets and liabilities should be translated using the current method, which uses the exchange rate for the date shown on the balance sheet (9/30/03). The current method is required so that ratios such as the quick or current ratio will be the same when examined in either currency. One will notice that as the dollar falls against the loonie, asset values in dollar terms increase. This occurs despite the fact that no new assets were acquired. Appraisers have not determined that these are more valuable than before. So, although this appears as a plus, nothing real has happened unless these now-more-valuable assets can be sold in dollars or can be transported freely/cheaply to the US to find a buyer. The gain is solely an exchange rate phenomenon. Similarly, as the dollar declines, the value of liabilities rises even though the firm acquired no new debt or accounts payable. With a weaker dollar retained earnings also increase, but this too is merely an exchange rate phenomenon. The parent corporation's consolidated balance sheet will frequently have a line item- other comprehensive income - to reflect the change in currency values. This “black box” does not only include currency translations (which could come from a variety of business activities) but fair value adjustments made to securities classified as “available for sale”, unrealized losses resulting from recognition of the minimum liability provision under SFAS #87 – which covers defined benefit pension plans. In general though, this item becomes the “error term” on the balance sheet to get both sides to balance. So unless explicitly disclosed, its usefulness will vary.

Next we have the all important Income Statement. With little surprise, this is the statement that they squawk about on CNBC more than any other. After all it shows how much “money” the firm made, right? Notice that as the dollar falls, net income and earnings per share rise, all else equal. So, just having the local currency strengthen against the home currency gives an impression that earnings have risen. Of course once consolidated onto the parent corporation's income statement the effect on earnings per share will depend on how large of a component the subsidiary makes up of total income. One may argue that earnings have truly risen because this gain resembles a foreign exchange arbitrage. Sure, except that in this and most cases the business is not doing that. It is merely performing its normal day-to-day functions. However, thanks to a weaker dollar – which the firm cannot control – the company gets a boost in income. However, this “gain” is a freebie, and not really material. Similarly, a rise in the dollar would produce a loss – but this too would be the result of day-to-day operations, not some ingenious arbitrager working at the firm.

Finally, we have the statement of cash flows. Again, as the US dollar weakens against the Canadian dollar, cash flow from operations appears to increase. Great!! However, here we have a line item that accounts for the gain/loss on exchange rates. This enables us to see that this top line “gain” in net income is simply an exchange rate translation rather than greater sales or stronger economic performance. Because no more cash came into the corporation, the net increase in cash is equal across exchange rates. So despite increased cash flow from operations, the firm will not be in any better position to pay dividends. It doesn't have any more cash to invest in equipment or other productivity-enhancing investment. So clearly, if one takes a cursory glance at the income statement or solely focuses on EPS, one may conclude that the company is doing better, even great. Similarly, if the dollar strengthens one may conclude that the firm did worse. That is because the income statement makes no attempt to correct for currency translation, whereas both the balance sheet and statement of cash flows do. But who has time to look at those? Fear not, I'm sure Kudlow and Kramer do.

Okay enough of Accounting 101. What does all of this mean? I'm sure there are some companies that have improved and I'm equally confident that there are some companies that have deteriorated. Some may have achieved improved earnings from cost cutting measures, and some may have seen their margins eroded through higher costs. That's the nature of business, and those are legitimate earnings/losses. However, there are those companies and analysts that claim currency translation as a material component of earnings. Again, it's curious how companies explain away losses because of forex, but play down the gains. It does work both ways. I'm not trying to completely discount foreign exchange effects as immaterial. To be sure, companies make/lose money on currency futures, swaps, etc., but for most non-financial firms these are moves to hedge risks and minimize losses from normal day-to-day business, not to drive profits. As an investor I would like to see GM hedge their foreign currency risk, which may at the margin make or lose money. However, I would not like to see the CEO talk about how shifting exchange rates boosted the bottom line by X dollars. I'll invest in a hedge fund if I want to make money off of currency movements.

So the bottom line is that yes, reported corporate earnings have risen. This is not what I am questioning. It's the magnitude of both the gains and losses that I question. Currency translation is merely noise. More specifically, central-bank generated noise. An international fiat monetary system ensures that we will have this noise. Given the current and expected continued fall in the dollar, maybe we can expect more noise and therefore further positive earnings this quarter, depending on which currencies are being translated. Even those companies that do not have foreign subsidiaries may do better. They could have pricing power because competitive imports would become more expensive. So small- and mid-caps could be set for more solid performance as well. However, this is inflationary, and the companies that need to import goods would be left worse off because in either case they would have to pay more, with a less valuable dollar. Let us not forget about the average American who too will have less valuable dollars with which to buy more expensive goods. But before you weigh the pros and cons of this, ask yourself how sustainable all of this is. We frequently hear talk about the quality of earnings. By purely focusing on the income statement, which does not account for forex translation one could easily be misguided about a company's performance. In this scenario, the cash flow statement probably represents reality most clearly, because although net income has risen, ending cash flows have not.

So the next time an analyst or TV talking head says Company XYZ beat earnings by a penny and talks about currency translation, ask yourself whether you should be sending fan mail to the CEO or to Alan Greenspan. Then ask yourself whether next quarter you’ll be sending hate mail because currencies have moved in the opposite direction. And finally, ask yourself whether that penny +/- is truly meaningful. To me, claiming that foreign currency translation honestly boosts net income is like me claiming a raise that exactly matches inflation honestly boosts my take home pay. Sure my salary has increased and that's great news to tell my wife over dinner. But I wonder if she'll agree when she realizes that big raise won't buy her any additional dresses at Ann Taylor.

Lance Connelly
Associate Economist

The information herein is based on sources which The Northern Trust Company believes to be reliable, but we cannot warrant its accuracy or completeness. Such information is subject to change and is not intended to influence your investment decisions.

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