British American Tobacco: how currency fluctuations can crush your profits

Your total revenue rises 4.2% while concurrently, your profits slip 2%. What’s wrong with this picture? This is what happens when international businesses chose to ignore the risk associated with foreign currencies, instead of protecting their margins with appropriate hedging instruments.In late June, the pound fell about 14% against the dollar, triggering sharp currency movements across the board. For British American Tobacco (BAT), they found themselves on the wrong side of this drop. Indeed, according to their own estimates, excluding the depreciation of the pound, the total revenue would have risen 8% -about 10% more than the actual reported figure for H1 2016.

Hedging currency volatility

Surprisingly, companies commit this serious mistake all too often, usually by neglecting to account for forex movements in quarterly reporting.When they were preparing the yearly budget, the financial managers at BAT calculated their revenues according to a fixed dollar/pound exchange rate. Erroneously, they assumed that this exchange rate was going to stay relatively stable, choosing to accept the risk that if the USDGBP appreciated, they would lose out on additional, speculative revenue.[caption id="attachment_26683" align="aligncenter" width="750"]

GBP/USD Chart: January - July 2016[/caption]Despite the perceived complexities, you can predict how currencies are going to behave and protect yourself against their volatility. In BAT’s case, their mistake was a careless reluctance to lock their exchange rate.By using a simple forward contract, they would have locked their target rate for the whole year. Indeed, this product can shield budgets from the whims of the market, protecting margins and simplifying forecasting. In BAT’s case, they instead chose to speculate and they lost.In the weeks building up to the UK referendum, we witnessed a sharp increase in the demand for pound sterling forward contracts. Indeed, a good number of our clients, concerned about the possibilities of an unexpected victory of the Brexit, hedged their exposure.Those clients are now enjoying an important competitive advantage: their higher margins allow them to cut prices and increase their sales in the UK market.