Well by now, most firms have reported their 2Q 2007 results. So what can we make of them? Holding aside idiosyncratic, company-specific upside and downside surprises – for instance, results such as "our product is so amazing that everyone decided they had to have it" (e.g., Apple, Cisco) or "we’re in the midst of a restructuring and our strategy just stinks right now" (e.g., Nortel) – I saw two general patterns from the large, S&P-type firms.

1. We missed expectations because the consumer is struggling at home.

2. We beat expectations because of better performance overseas.

I found these explanations interesting.

The first explanation we can all understand. It’s no secret that oil prices are high, the US housing market is not performing well, and consumers are getting squeezed. As a result, corporate profitability has taken a bit of a hit. Interestingly however, although we’ve heard so much about the potential for a slowdown in personal consumption, this is the first that I had heard companies acknowledge it in any kind of systematic way. It seems like it’s finally starting to have more than a mere modest impact on earnings, and it’s no longer limited to home builders, auto manufacturers, and appliance makers/retailers.

The second explanation I find more interesting. Why? Because I’m trying to reconcile whether the improvement in performance by large multinationals was due solely to shifts in exchange rates and repatriation of profits in US dollar terms, or if it’s due to improved fundamentals (i.e., global growth is strong and demand growth will continue into the future). The former implies that it is likely a short-term, one-time pop to earnings. The latter would be more reassuring as it would suggest that we can expect firms to benefit from their multinational status moving forward. I’m not sure where I fall yet on this one.

Looking at the dollar index (DXY) versus a basket of foreign currencies, we have seen the dollar drop more or less from around 85 over the last 3 or 4 months to around 80. This implies a 6.25% devaluation of the dollar in that time. So foreign income/sales repatriated into US dollars should look about 6.25% better. For a US firm that does 100% of its sales in foreign countries (let’s assume in exact proportion of foreign currency represented by the DXY), it’s earnings, once repatriated, will be 6.25% better than it would have been had the currency remained unchanged. For a firm that does 50% of its sales outside the US, that would imply a 3.125% (0.50*0.0625) increase.

So for me, the telling question is whether firms earned more or less than their percentage of foreign-to-total sales times the dollar devaluation.

If firms that reported solid earnings of type #2 only out-earned expectations by what we could have predicted given
the dollar devaluation and repatriation of profits, then maybe we should look at Q2 earnings skeptically. If so, then we should also probably wonder about whether the nature of the effect is temporary (either as a result of a future stabilization in the dollar or even a strengthening of the dollar). If temporary, we should not expect Q3 corporate earnings to look as healthy as Q2, …especially since I’ve seen more explanations of type #1 for Q2 earnings than in the past several years.

I should say that while this analysis is easy to consider in theory, it is complicated by several factors. First, it’s silly to assume that firms do business overseas in exactly the same proportion that the dollar index basket represents. For example, if 100% of a firm’s foreign sales were to Japan, using the DXY index would overshoot the improvement. Second, while it’s relatively easy to get the breakdown of foreign versus domestic sales for any company, it’s much more difficult to get breakdowns in sales and earnings by country. If you knew exactly how much each company sold (and/or earned) in each country, the calculation would be pretty straightforward because you could weight each country result by the appropriate exchange rate. Third, doing such a calculation also assumes that firms do not hedge. If firms were perfectly hedged, we should not expect to see any earnings explanations of the #2 type unless the improvement in performance is driven solely by fundamentals and not simply repatriation.

So then what am I trying to say here? I guess I’m saying that we should think carefully (and critically) about why some firms performed well in 2Q, especially those that used improved foreign sales as an explanation for such performance. Also, although imperfect, we can use the change in the DXY index (6.25%) times the percentage of foreign sales as a proxy for  how much better we could have expected firms to perform over analyst expectations had it simply been a repatriation.

If consumers continue to struggle in the US and it turns out that the improvement in Q2 performance was a result of a temporary improvement in the repatriation of foreign profits, we can and should expect a difficult Q3, …and a long road to economic recovery.

This entry was posted on Tuesday, August 14th, 2007 at 2:56 pm and is filed under Corporate Strategy, International Strategy. You can follow any responses to this entry through the RSS 2.0 feed. You can skip to the end and leave a response. Pinging is currently not allowed.