Beware the Strong U.S. Dollar

Rupert is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

The DXY -- the index that measures the U.S. dollar against a basket of currencies -- has been rising since the beginning of 2011 and is on track to make multi-year highs again sometime this year:

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Over a three period average with a moving average placed over the top, the trend becomes clearer.


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How does the strong dollar affect earnings? 

Throughout 2012, the U.S. dollar was strong as the euro crisis drove investors into safe haven assets such as U.S. government securities. In addition, investors were looking for safety in currency as the euro was effectively devalued and it looked like the financial system in Europe was going to collapse. 

According to the DXY index, the dollar was almost 10% stronger in 2012 than in 2011, and this strength significantly damaged earnings.

Unfortunately for U.S.-based multinationals, during the first quarter of this year, the dollar index averaged $81.15. During the second quarter, the DXY average $83.05, or 2.3% higher. What is the likely affect on earnings for some of the most exposed companies?

Here I have used estimated figures to establish an unfavorable currency effect. To calculate the effect that the stronger dollar will have on EPS, I have taken the unfavorable currency effect in Q1 2013 and then multiplied it by the DXY change from the previous quarter, as is shown below the first table.

Philip Morris International (NYSE: PM)

<table> <thead></thead> <thead> <tr><th> </th><th> <p><strong>Q1 2013</strong></p> </th><th> <p><strong>Q2 2013</strong></p> </th></tr> </thead> <tbody> <tr> <td> <p>DXY average value</p> </td> <td> <p>$81.15</p> </td> <td> <p>$83.05</p> </td> </tr> <tr> <td> <p>DXY change from previous quarter</p> </td> <td> <p>1.4%</p> </td> <td> <p>2.3%</p> </td> </tr> <tr> <td> <p>EPS</p> </td> <td> <p>$1.35</p> </td> <td> <p>N/A</p> </td> </tr> <tr> <td> <p>Unfavorable currency effect</p> </td> <td> <p>-$0.07</p> </td> <td> <p>-$0.12 E</p> </td> </tr> <tr> <td> <p>Adjusted EPS</p> </td> <td> <p>$1.28</p> </td> <td> <p>N/A</p> </td> </tr> </tbody> </table>

The DXY change from previous quarter equals 2.3%, which is 64% larger than the 1.4% rise in the previous quarter. The 1.4% rise in the previous quarter, affected EPS by ($0.07) so the rising DXY will hit earnings 64% more this quarter than it did last quarter. So, ($0.07) multiplied by 64% is ($0.12).

Philip Morris has no revenue from inside the U.S. and in the past the company has suffered and benefited more from movements in the value of the greenback than any other company.

Indeed, during the first quarter of this year, which saw the DXY rise on average 1.4%, the company suffered an unfavorable currency impact on its earnings to the tune of $0.07. During the last quarter, Q2 the DXY rose on average 2.3% almost 64% more than the gain seen during the first quarter, implying that Philip Morris will take a $0.12 per share hit on its earnings due to unfavorable currency movements.

McDonald's (NYSE: MCD)

<table> <thead> <tr><th> <p><strong> </strong></p> </th><th> <p><strong>Q1 2013</strong></p> </th><th> <p><strong>Q2 2013</strong></p> </th></tr> </thead> <tbody> <tr> <td> <p>DXY average value</p> </td> <td> <p>$81.15</p> </td> <td> <p>$83.05</p> </td> </tr> <tr> <td> <p>DXY change from previous quarter</p> </td> <td> <p>1.4%</p> </td> <td> <p>2.3%</p> </td> </tr> <tr> <td> <p>EPS</p> </td> <td> <p>$1.28</p> </td> <td> <p>N/A</p> </td> </tr> <tr> <td> <p>Unfavorable currency effect</p> </td> <td> <p>-$0.01</p> </td> <td> <p>-$0.02 E</p> </td> </tr> <tr> <td> <p>Adjusted EPS</p> </td> <td> <p>$1.27</p> </td> <td> <p>N/A</p> </td> </tr> </tbody> </table>

Elsewhere, McDonald's also suffers from the strong U.S. dollar but not to the same extent that Philip Morris does. That said, according to my estimate above, the company will be hit by a $0.02 per share unfavorable currency effect.

Indeed, analysts have consistently downgraded the company's full-year earnings projects for 2013 in line with the strengthening dollar. At the beginning of the year, McDonald's was predicted to earn $5.78, but this has now been lowered to $5.70.

The company's sales estimates have also been lowered as the strong dollar chips away at revenue growth. Forecast to turnover around $29,000 million at the beginning of the year, the company is now inline to turnover $28,500 -- 2% lower, reflecting the unfavorable currency effect.


Lastly, 3M has been suffering from a strong dollar and has already reduced full year estimates in order to reflect the damage that is being done. In the first quarter of this year, the company reported that the strong dollar impacted and reduced earnings by 1.8% year-over-year.

In addition, within its Q1 results, 3M stated that it expected foreign currency translation to reduce full year sales by approximately 1.5%. The company originally forecast no impact. However, with the dollar continuing to gain in strength this forecast could be reduced again. The company has reduced the full-year outlook from $6.70 to $6.95 per share to $6.60 to $6.85 per share.

These three companies are all being strangled by the strong U.S. dollar. In all three cases, the strong dollar is ruling out most of their earnings growth. That said, it is not just the dollar that is causing these effects -- the weak euro is causing chaos as well. 

All in all, weak currencies around the world are damaging company revenues not just for these companies but for companies throughout the S&P 500. With the dollar continuing to strengthen, it could be time to reconsider investment strategies and look for companies with no international exposure and the resulting currency risks -- especially in the case of Philip Morris.

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Fool contributor Rupert Hargreaves has no position in any stocks mentioned. The Motley Fool recommends 3M and McDonald's. The Motley Fool owns shares of McDonald's and Philip Morris International. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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