Will a rising dollar crimp corporate profits and slam stocks?

It's often been said that a weak dollar is good for corporate profits. That means that a rising dollar -- spurred by U.S. job creation and rising interest rates -- could hurt corporate profits and slam stock prices.

How so? A weak dollar is good for corporate profits if a company makes its products in the U.S. and sells them in other countries where the dollar has been steadily weakening. That's because the weak dollar translates into a relatively cheap price for customers outside the U.S.

So if the dollar strengthens relative to the currencies in that country, it should put the company at a disadvantage -- putting a crimp in profits. And lower profits could mean that investors are disappointed with earnings results and sell the stock of companies that report those lower earnings.

Hedging Effects

But the reality is more complex because of the actions that companies take to hedge those currency risks. On Monday I spoke with an IBM Investor Relations staffer, Kory Liss, who explained that International Business Machines (IBM) -- which gets 66% of its sales outside the U.S. -- has different ways of managing the effect of currencies on its different businesses. Overall, a weak dollar is good for its business and a strong dollar hurts it. But IBM reports its results in a way that reveals those currency effects, and takes steps to mitigate currency fluctuations.

From the standpoint of currency fluctuations, IBM can be thought of as two separate companies. One, its hardware business -- which accounts for 20% of its revenue -- makes its products in the U.S. and sells them overseas and thus a weak dollar boosts its profits while a strong dollar reduces them.

IBM uses currency hedging to limit the risk of two-thirds of these fluctuations. (IBM's software unit, which represents 30% of its business, is more complicated since it sells code in some countries that differ from the ones where its workers write code.)

The second IBM business operates as what Liss calls a natural hedge -- meaning that the benefit of a weak dollar to the local prices is somewhat offset by the cost of paying its workers more. Liss refers here to IBM's consulting unit, accounting for 50% of IBM's revenues, which sells its services and pays the people who deliver the services in the local currency. For example, in India, IBM's Global Services sells services and pays people in rupees.

IBM also helps investors measure the impact of currency fluctuations on earnings. According to Liss, IBM reports its results on a constant and actual currency basis. The constant basis assumes a fixed exchange rate -- say between the dollar and the yen between the current and prior reporting periods. The actual basis of reporting calculates results based on the differing exchange rates between the two periods. Comparing the two reporting bases helps investors calculate the impact of currency risk on IBM's profits.

McDonald's (MCD), which operates 32,000 restaurants in 100 countries, has a different approach to hedging currency risk. According to its most recent quarterly report, McDonald's sells debt denominated in foreign currency and derivatives to hedge the impact of currency fluctuations.

When the dollar rises in value, its decline in royalties from franchisees is offset by gains in the value of its derivatives -- so-called forward foreign currency exchange agreements and/or foreign currency options. Conversely, a weak U.S. dollar boosts the value of McDonald's royalties which is offset by losses in the worth of those derivatives.

Simply put, a rising dollar would hurt IBM's profits somewhat; depending on the extent of the offset, it would have a little impact on McDonald's profits. But in each case Wall Street analysts could probably put a number on the effect. Thus they ought to factor currency fluctuations into their earnings forecasts.

As a result, analysts should not be disappointed with lower reported results due to a stronger dollar, since they'd adjust their expectations accordingly.

In that case, the rising dollar alone would not ding the stock prices of these global companies much, if at all.

Peter Cohan is a management consultant, Babson professor and author of nine books, includingCapital Rising (due in June 2010). Follow him on Twitter. He has no financial interest in the securities mentioned.

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