Last week Apple made headlines by announcing a massive $15 billion dollar bond offering. What was remarkable was that Apple already had plenty of cash and did not appear to need to issue any debt. In fact, Apple had more than $200 billion in cash, far more than any company in history. The cash, however, is mostly stashed overseas, where, like most U.S.-based multinational companies these days, Apple is squirreling away its profits from foreign transactions in order to avoid paying U.S. taxes when the money is repatriated.
There are lots of questions that you could ask about this move by Apple. Is it ethical? Is it patriotic? Does it benefit shareholders? Many people have explored these various angles. One things that is less often discussed, probably because of the complexity involved, is what impact exactly does it have on company earnings and financial statements?
Earnings season, which is when companies report their results for the previous quarter, is just now winding down for last years fourth quarter. The impact of the strengthening U.S. dollar in relation to most other major currencies has been perhaps the biggest theme for the past several quarters (in close competition with the massive decline in the price of oil and other commodities.)
One company hit hard by the strong dollar was Wal-Mart, which reported revenue down 1.2% in the fourth quarter, though it would have been up 2.2% had it not been for currency changes. It was a difference of $4.8 billion–not a trivial amount in one quarter, even for a company the size of Wal-Mart. Johnson & Johnson said the currency impact on revenue for the full year was 7%, which amounted to over $5 billion. Apple in its recent earnings presentation included a slide saying: “$100 of Apple’s non-U.S. dollar revenue in Q4’14 translates into only $85 U.S. dollars today.”
What is not often mentioned in these earnings reports though is that while these currency swings appear to be having a huge impact on earnings, to the extent that the earnings are stashed overseas, some of these losses will never be realized. If Apple reinvests its cash in the countries where the money was earned, say, building a new European headquarters in Ireland or beginning to build stores in India, as it recently announced it would, both the U.S. taxes and the currency impact will never be paid on that money. There is not necessarily anything wrong with this, and it may be a savvy move by Apple, but the disconcerting thing is that these losses have already been recognized on the companies incomes statements and balance sheets. With the dollar strengthening, each quarter companies write down the value of foreign cash, inventory and other assets in dollar terms and recognize losses on the income statement that lower earnings, even though these cash losses might never occur.
The way the accounting works, Apple, for example, must keep a separate set of financial statements for each of its foreign subsidiaries. However, when Apple reports earnings each quarter, the company must consolidate all of its various domestic and foreign businesses into one set of U.S. dollar-denominated statements. If the U.S. dollar is gets stronger relative to the local currency of the foreign subsidiaries over the reporting period, Apple reports a loss when it translates the foreign cash and other assets to dollars. This can make it look as though a repatriation of cash has occurred when in fact it hasn’t.
So what does this mean? For many foreign-cash-hording companies like Apple, at least, it seems the impact of foreign currency is not as big as it appears in earnings reports. Much of these losses are purely “paper” or “accounting” losses. It may also be an example of something akin to the accounting move known as taking a “big bath” when companies purposely take as many losses in an already bad quarter as they can in order to facilitate a bigger rebound when things eventually return to normal. It’s a bit like the 76ers who are known for not trying all that hard after a bad start to the season in the hopes that a last place spot will lead to a number one draft pick next year.
This is welcome news during this decidedly mediocre earnings season with the overall combined earnings of the S&P 500 companies set to decline over 4%, the third quarterly decline in a row according to the latest tally from FactSet Research. However, while this exaggerated effect of currency losses on earnings may be true generally, not all companies are alike in regard to foreign currency exposure.
Just as some reported currency losses are not real cash losses, some real currency effects are not directly reported in financial statements. This is the case when the currency swings, in addition to resulting in gains or losses on assets or transactions, also leads customers to forgo buying a product or service in favor of a substitute that is denominated in a weaker currency. This was the case last quarter with Boeing whose stock dropped 10% after the company reported that many foreign customers chose the European competitor Airbus over Boeing because the strengthening dollar made the Boeing planes more expensive. This didn’t actually show up in most of the main earnings numbers, though, because Boeing is still executing orders from several years ago. Where the currency impact hit was in the number of future orders in the pipeline and in management’s guidance for the future. Though it didn’t show up in earnings right away, this still sent the stock sharply lower.
Another wrinkle in the currency impact that is not often discussed is that companies that both buy and sell in the same foreign currency have a natural hedge of that currency. For example, if the Chinese yuan is weakening against the dollar, and Apple buys computer chips and pays manufacturers in yuan but also sells a lot of iPhones to Chinese consumers, the currency impact of these transactions will offset to a certain degree.
The complicated treatment of foreign currency translation is one of many accounting foibles that can obscure what’s really going on with the core business of a company, but there are ways to work around it. Most companies will provide some indication of organic or core earnings which is earnings excluding the currency impact as well as mergers and other “one-time” events. Specific industry metrics like the change in same store sales for retailers or cases sold for a beverage company like Coca-Cola can be helpful when revenue or earnings are somewhat distorted. Looking at the Cash Flow Statement in this case may also be helpful since phantom currency losses will not appear there since there has been no outflow of cash. Digging into the footnotes of the financial statements and reading various supplemental tables also sheds light on the accounting of the currency situation.
The bottom line (pun intended) is that when you look at earnings you need to look under the hood, especially in these turbulent times when currency swings can muddy financial statements and distort earnings and margins. When it comes to earnings you can’t trust the newspaper headlines or take the numbers at face value, but instead you have to look at the whole picture.