Natural Performers

Companies are increasingly relying on natural hedges to juggle currency risks.

Until cost-cutting efforts began to take effect about a year ago, in fact, credit analysts were worried about Gillette’s balance sheet, and some remain concerned that a large debt-financed acquisition would undo the improvements in its financial condition. Granted, some credit analysts pay little heed to changes in shareholder equity. “It’s not a primary focus when we analyze companies,” says Fitch Ratings’s Karen Lynch Ghaffari.

Elsewhere, however, the measure is followed more closely. “If shareholder equity falls far enough, creditors will become concerned,” notes Charles W. Mulford, an accounting professor at Georgia Institute of Technology’s Dupree College of Management. And as recently as the quarter that ended March 31, 2001, Gillette’s return on equity was only 14.5 percent — some 10 points below the average ratio for competitors that got the same A+ credit rating as Gillette from Egan-Jones Ratings.

To be sure, Gillette does use currency forward contracts and debt instruments to hedge against the translation risk posed by assets primarily in countries where interest rates are lower than in the United States. “We hedge that exposure, because we will benefit from lower interest costs and our exchange on that hedge will offset our net investment in that country,” says Sullivan. But that formula doesn’t work in countries where rates are higher than U.S. rates. As a consequence, three such markets — the United Kingdom, Argentina, and Brazil — accounted for a significant portion of Gillette’s losses from this type of currency risk from 1997 until 2001. At present, says Sullivan, Gillette hedges against this risk from only three currencies: the Japanese yen, the Swiss franc, and the Taiwanese dollar.

Eastman Kodak Co. has had a similar experience. From 1999 to 2001, the company’s shareholder equity declined by 26 percent, from $3.9 billion to $2.9 billion. And about a third of that decline was due to currency-translation losses that weren’t offset by the company’s hedging efforts. In comparison, P&G’s losses from foreign currency translation from 1999 through 2001 averaged almost $500 million per year, only 4 percent of the company’s roughly $12 billion in shareholder equity during the period.

Falling Arrow

Such losses aren’t limited to large multinationals. Arrow Electronics, for instance, gets $2.5 billion of its $10 billion in revenues from Europe, with operations in 19 countries on that continent, and makes use of financial instruments when it can’t take advantage of natural hedges. Nevertheless, Arrow has experienced a loss of $98.8 million in 2001, which accounted for two-thirds of its decline in shareholder equity that year, to $1.8 billion from $1.9 billion in 2000. And its shareholder equity in 2000 would have risen by another $65.6 million had it not been for a currency translation loss that year.

Movado fared a bit better. Its currency translation losses of roughly $21 million between 1997 and 2002 did not prevent its shareholder equity from increasing 60 percent during the same period, from $104 million to $172 million. Yet the rise would have been even greater if not for those losses.

Of course, the swings in shareholder equity due to currency translation would have been greater still at these companies without their hedging efforts. However, Gillette, for one, has decided that the benefit of hedging all of this exposure isn’t worth the cost. But even Gillette doesn’t go completely exposed. “If you don’t hedge your net investment in a country, you’ll have a balance-sheet exposure, and that could grow to be significant,” warns Sullivan.


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