Jim Jubak

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Posted 6/8/2005

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• Thank Europe for a stronger dollar, 6/7/2005
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 Jubak's Journal
5 ways to play currency swings

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The weaker euro is enabling some European multinationals to export more, which could surprise investors and Wall Street.

By Jim Jubak

Call it Newton's first law of financial market physics: For each action, there's an equal and opposite reaction.

So the euro goes down on political turmoil in the European Union, and the U.S. dollar goes up.

And if a stronger dollar pushes up the U.S. bond market, which lowers U.S. interest rates, it also slows U.S. exports by making them more expensive, which increases the country's trade deficit and pushes interest rates back up.

And if a weaker euro threatens to slow European economic growth, it also increases the region's exports as products priced in euros get cheaper to consumers elsewhere.

For investors looking out over the next six months, here's the action/reaction to pay attention to: A strong dollar will take a bite out of U.S.-based multinational companies' earnings and a weak euro will increase European multinationals' earnings. This currency effect hasn't caught up with Wall Street's earnings forecasts for U.S. multinationals, and it hasn't yet been factored into estimates for European exporters.
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In 2004 and into 2005 the weak dollar gave a boost to U.S.-based multinationals' sales and earnings. When sales, recorded in euros or yen, for example, were translated back into dollars for financial reporting, the dollar's falling value put more dollars on a companies' books.

The give and take
How much?

Well in the fourth quarter Procter & Gamble (PG, news, msgs) figured that the weak dollar added three percentage points to the company's sales growth, bringing total growth to 9% instead of 6%. In the first quarter, the favorable exchange rate accounted for a similar three percentage points of the company's 10% in sales growth.

What the weak dollar gave, or course, the strong dollar will take away. And that's likely to be a big deal in the short run for the shares of some U.S. multinationals. With some, a boost from the weak dollar masked significant growth problems. At IBM (IBM, news, msgs), for example, first-quarter revenue growth of 3%, nothing to write home about, would've been just 1% without the exchange-rate boost.

Revenue growth from Europe, the Middle East and Africa looked great at 7% until you took out currency exchange effects, pushing it down to just 2%. Global hardware sales, the company's problem recently, looked even worse once you deducted the currency boost. Instead of being flat, they actually fell 2%.

With others, the withdrawal of the weak-dollar boost will put 2005 guidance at risk. At the end of 2004 P&G told investors that it would report high single digit sales growth for 2005. To reach that goal, management estimated that foreign exchange translation from strong currencies to the weak dollar would add two percentage points to sales growth for the year.

The European benefit
So far, at least, it looks like the dollar will cut into growth. The euro is down 9.4% against the dollar since Dec. 31, and more than half of that decline, 5.4% of it, has come since the first quarter's end. That's a huge swing for the quarter that's due to close on June 30 for many U.S. companies.

This swing goes the other way for European multinationals that'll book sales in stronger dollars and translate them to weaker, and more, euros at the quarter's end. Many Wall Street research reports are based on a euro selling for $1.30 and not for the $1.227 June 7 price. For example, Argus Research, a major supplier of so-called independent third-party research to online brokerage firms, pegged its earnings estimate for Germany's Siemens (SI, news, msgs) at $4.94 per ADR for 2005 based on a euro equaling $1.30 U.S. dollars. The Argus estimate for Nokia's (NOK, news, msgs) 2005 earnings of $1.10 per ADR is based on the euro at $1.29.

And it's not just analysts who're lagging behind the currency markets. Siemens based its guidance on a euro that would finish 2005 at $1.35.

In the long-run, more than six months out that is, nobody knows what the euro/dollar exchange rate will be. I don't expect the euro to rally to $1.35 by year-end, but then, I didn't expect the dollar's recent rally that cut the euro to $1.22 either.

Placing bets
It's a reasonably sure bet, however, that the euro won't rally back to $1.29 or $1.30 by the quarter's end that's now just three weeks away and that earnings at European multinationals are likely to be higher for the quarter than estimates (and that earnings at U.S. multinationals will be lower). It's reasonable to believe that the third quarter won't see too much of a strengthening in the euro either: The political fallout from the "no" votes on the proposed new EU constitution still has months to play out. (See my June 7 column, "Thank Europe for a stronger dollar.")

To get the most out of this six-month play you've got to either find a sector that leverages the effects of any change in the dollar/euro exchange rate or pick companies where a modest earnings surprise is likely to cause a big stir on Wall Street.

The short-term opportunity is especially attractive in the food sector. The shift in dollar/euro exchange rates means that European food companies will not only show higher-than-expected earnings but also will have extra profits to put into marketing programs that can increase market share.

In my regular appearance on CNBC's "Morning Call" Wednesday I picked three European food stocks that look like they could produce positive earnings surprises in the next quarter or two thanks to the stronger dollar and the weaker euro.

Finding a bargain
  • Nestle (NSRGY, news, msgs) doesn't really need help from a weaker euro (which is a good thing because it does business in Swiss francs), but the euro's weakness by contagions has made this European stock a bargain.

    After a big overhaul of its product lineup in 2003, the company looks set to churn out organic (that is without counting currency effects or acquisitions) sales growth of 5% in 2005, led by 5.2% growth from its water and coffee segment, 5.5% from is milk and ice cream group and 5.9% from pet care. Earnings will grow at an even better rate since the company has steadily increased profit margins in the last year, and I expect that to continue this year. Earnings could climb by as much as 30% in 2005, Standard & Poor's estimates.

    And the stock is quite cheap, especially in comparison to its U.S. peers. Prudential calculates that over the next five years, Nestle will growth earnings by 10% a year. That's better than the 7% annual growth it estimates for Kraft (KFT, news, msgs), the 8% it estimates for General Mills (GIS, news, msgs) or the 9% it estimates for Kellogg (K, news, msgs) . But Nestle trades at just 15.3 times estimated 2005 earnings per share, again by Prudential's calculations, versus 16.8 for Kraft and General Mills and 18.3 for Kellogg. Our StockScouter doesn't rate Nestle's stock.

    Finding growth overseas
  • Groupe Danone (DA, news, msgs) is projected to grow even faster than Nestle, 11% annually over the next five years, and it's almost as cheap with a price-to-earnings ratio of just 17.3 times projected 2005 earnings.

    U.S. consumers know the company because of its yogurt brand, and the company's fresh dairy division makes up 47% of sales. But the real growth engine, and a reason that this company may be a buyout target not too far down the road, is its water business (27% of sales). In 2001, it became the global leader in bottled water sales, and the company is far and away the dominant bottled water company in its home market of France with a 60% market share.

    But growth in 2004 and the future comes from Latin America and Asia. In 2004, the company's bottled water sales soared 30% in Mexico, for example, and climbed 14% in Asia, where the company's main markets are China and Indonesia. In the first quarter, a strong euro knocked about 1.2 percentage points off the company's 5.1% growth rate, according to management. A weak euro should turn subtraction into addition for the next quarter or two. Our StockScouter doesn't rate this stock.

    A turnaround story
  • Unilever (UL, news, msgs) is a turnaround story that's finally delivering some results. In the first quarter, organic sales increased by 2%, led by a 7% increase in emerging-market sales. Those markets, which make up 35% of the company's sales, more than made up for a 2% decline in European organic sales. The company continued to lose market share to tough competitors such as P&G, but the days of huge share losses seem over.

    Unilever's categories grew by 3% while the company grew sales by 2%. Earnings soared in the quarter, showing 25% growth from the same quarter in 2004, but about 80% of that gain was a result of a lower tax rate and a big drop in restructuring costs. This company is still, clearly a work in progress but the shares are priced to reflect the still tentative state of the turnaround.

    Prudential estimates sales growth of 7% a year for the next five years at Unilever and calculates a P/E ratio of just 12.9 on projected 2005 earnings. A weaker euro should help Unilever in its battle against P&G in North America by giving the company a cost advantage. Any missteps at P&G as it tries to integrate Gillette (G, news, msgs) will also help Unilever. Our StockScouter rated the stock an 8 out of a possible 10 on June 8.

    Although the food sector offers the most leverage to exchange-rate changes, two specific technology companies also provide good weak euro plays over the next six months. So here, as always, are two exclusive picks for CNBC.com on MSN Money readers.

    Exclusive picks
  • Siemens offers good leverage to the weak euro precisely because business in the company's home market of Germany, where Siemens does 23% of its sales, is so bad that an increase in exports will make a big impression on the company's books. And Europe, which accounts for 58% of sales, isn't much better with growth forecast at less than 2% this year. The United States, at 18% of sales, is the company's biggest export market, which is why a strong euro hurt so much in 2004.

    Last year the company saw 3% sales growth before currency conversion turn into a meager 1% gain thanks to the weak dollar. In the first quarter, again thanks to exchange effect, sales fell 1% from a year earlier. No wonder the company's management has become so pessimistic that it issued its projections for 2005 growth based on a yearend value of $1.35 for the euro. The company, and investors, will get a pleasant currency surprise this quarter and next.     Our StockScouter rated the stock a 6 on June 8.

  • Nokia gets its currency leverage from a different source. The company is in the midst of a new product cycle that has succeeded in recapturing market share it lost to Motorola (MOT, news, msgs) and Samsung. A boost to sales and profits from a weak euro will make market share growth look even stronger in the short run. The last data from Gartner Dataquest shows Nokia's share of the handset market increasing to 33% in the fourth quarter from 31% in the third quarter. (Since Motorola increased share, too, Nokia's gains seem to have come at the expense of Samsung and Siemens.)

    A weak euro will also help Nokia keep its edge in China (where the yuan is pegged to the U.S. dollar). Nokia's sales climbed 69% in China in the first quarter from a year earlier. Our StockScouter rated the stock a 7 on June 8.

    One final caveat. The short-term swings of a currency only make a company's sales and earnings look better -- they don't have any lasting effect on its long-term growth. But history shows that investors have a marked tendency to see short-term swings as evidence of long-term trends. It's that tendency that these trades look to exploit.


    Editor's Note: A new Jubaks Journal is posted every Tuesday and Friday.

    E-mail Jim Jubak at jjmail@microsoft.com.

    At the time of publication, Jim Jubak didn't own or control shares in any of the equities mentioned in this column. He doesn't own short positions in any stock mentioned in this column.

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