00:00:00:19 - 00:00:25:23
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“Houston, we have a problem”. That immortal line, slightly misquoted here, was pronounced some 55 years ago by members of the Apollo 13 crew. Looking at the earnings reports from many US companies, we can say: “Houston, we have a foreign exchange problem”. Welcome to CurrencyCast! My name is Agustin Mackinlay. I am the Senior Financial Writer at Kantox, and your host.
00:00:26:00 - 00:00:58:04
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In this episode, we discuss the foreign exchange headwinds faced by many American companies as they struggle with a strong USD. We provide an answer to the question as to why this may be happening right now. And we go beyond risk mitigation. We ask ourselves, is it possible to profitably use more currencies in business operations to enhance profit margins?
00:00:58:06 - 00:01:33:24
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Amazon raised investors' eyebrows by announcing a 700 million foreign exchange headwind in terms of revenues in the fourth quarter of 2024. And by providing guidance for 2025 with an unusually large and unfavourable foreign exchange impact to the tune of 2.1 billion USD. Amazon is not the only one in the group of the so-called Magnificent Seven companies as Meta Facebook, and Alphabet Google, are also announcing foreign exchange headwinds for the first quarter of this year.
00:01:34:01 - 00:01:40:06
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So what is going on?
00:01:40:08 - 00:02:15:06
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I think it's fair to say that many currency managers have been taken by surprise by the strength of the US currency as the USD is acting not only as a growth asset on account of the artificial intelligence revolution, but also as a safe haven, given trade policy uncertainty and geopolitical tensions. Beyond the so-called Magnificent Seven companies, many other US firms are announcing foreign exchange headwinds, which is an elegant way of saying that total sales are going to be lower than anticipated.
00:02:15:08 - 00:02:40:05
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As foreign sales are translated back at a higher dollar exchange rate. So let's try and make sense of what is going on. I think many companies find themselves at the crossroads of two powerful trends. Number one, the need to expand international operations as a way to boost sales and reduce costs. And number two, the natural profit margin erosion
00:02:40:05 - 00:03:19:09
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that comes as the life cycle of companies runs its course. As companies become more sensitive to currency markets because they expand their international operations and//or their profit margins come under pressure, they must beef up their foreign exchange risk managementforeign exchange risk management capabilities. But many appear to be unprepared. I call this “Victoria's FX secret”. It's, of course, a reference to Victoria's Secret, the very successful retailer who tells investors that,, on the one hand,, it plans to boost international operations to increase sales.
00:03:19:11 - 00:03:57:05
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But,, on the other hand, also tells investors that it is not going to systematically manage its currency risk. It's only going to take from time to time foreign exchange hedges. Well, take the case of Uber, the platform company. It warns investors that it's going to suffer FX headwinds in the first quarter of this year, but also it tells investors that it has little experience in running foreign exchangeforeign exchange hedging programs.
00:03:57:07 - 00:04:44:02
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Let us discuss some of those foreign exchange risk management shortcomings that we see at many companies as they struggle with a strong USD. The first thing that comes to mind is the prevalence of manual processes across the entire FX workflow. From the moment the exposure to currency risk is captured, to the execution of the corresponding FX derivative transactions, and all the way to reporting and accounting,, spreadsheets circulate up and down the entire enterprise. Creating obvious risks such as email risk or the vulnerability in terms of the availability and confidentiality of data. And spreadsheet risk,,
00:04:44:08 - 00:05:12:11
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tthe risk of manual data input errors, off copy and paste errors, off formula error, and perhaps especially formatting errors. And key person risk, as many cases, just one person or a handful of persons know exactly what is inside those gigantic spreadsheets.
00:05:12:13 - 00:05:39:15
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Yet another widespread FX vulnerability is the management of interest rate differentials between currencies. Take the case of the exchange rate between the USD and the BRL. Arguably, this is not only a case of dollar strength is also a case of BRL weakness as the country struggles with its budget deficit. Now, the story evolves along those lines.
00:05:39:17 - 00:06:13:00
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First, the Brazilian currency weakens in currency markets. Then, the central bank raises short-term interest rates. Now, at this point, something very important may happen. Currency managers can mistakenly take the higher interest rates in the Brazilian currency as a sign of impending stability in the currency. But then the BRL weakens further, and the central bank once again raises short-term interest rates.
00:06:13:06 - 00:06:54:11
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Now, the selic rate in Brazil is at 13.25%, and that happens at a time when interest rates come down in both the USD and the EUR. The Fed funds rate is now in a range of 4.25 to 4.5%. Now, that leads to a deep forward discount of the BRL to the USD. That discount is now about 9% taking one year forwards, and that further inhibits currency managers from protecting their exposure to the Brazilian currencies.
00:06:54:13 - 00:07:26:17
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Now, if you think that the problem stops here, well, it's not always the case. Nutrien, a Canadian fertiliser company with large operations in Brazil, had to suffer a 220 million CAD loss on account of unauthorised FX transactions as its Brazilian subsidiary. And that's because as losses mount, that risk increases proportionally. Now, the good news is that there are solutions
00:07:26:19 - 00:07:55:03
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when you manage high discount forward currencies. Start by pressing with a forward rate instead of the spot rate. Granted, you will be less competitive than if you had priced with a spot rate but you're not leaving a lot of money on the table. Or when it comes to hedging, create a corridor for the exchange rate by setting stop loss and take profit conditional orders so that you delay the execution of hedges.
00:07:55:05 - 00:08:30:22
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And that means that you are suffering less from the forward discount of the currency in question. Another solution would be to implement an in-house FX type of solution, in which only Headquarters is authorised to execute external transactions with banks. Now, needless to say, all of this requires a certain degree of automation. You will need real-time API connectivity to price with a forward rate to set your markups, per client segment and per currency pair.
00:08:30:24 - 00:08:55:12
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And you will need also that real-time API connectivity to create a corridor for the exchange rate. At Kantox, we have been warning about the problems of managing high discount currencies for years now. It happened in the past. It’s happening right now as we speak. It's going to happen in the future, but doesn't need to be that way.
00:08:55:14 - 00:09:30:12
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As Nadia Corbett, Enterprise Sales Manager at Kantox, explains, obtaining savings from delaying the execution of hedges in the event of unfavourable forward points is a win-win proposition. Because you are getting the benefits and you don't take anything away from your stakeholders, liquidity providers, your banks or your customers. And I would add that it's not only a win-win proposition, it's only a recurrent gain that you will obtain
00:09:30:18 - 00:09:43:02
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each time you do it. As opposed to a one-off type of gain that has no impact on company valuation.
00:09:43:04 - 00:10:10:09
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We started this podcast by mentioning the foreign exchange headwinds faced by Amazon and other members of the so-called Magnificent Seven companies. But also at many other North American companies. We went on to develop a theory of sorts linking the level of profit margins, the weight of FX in the business, and whether or not foreign exchange risk management should be seen as a strategic priority.
00:10:10:11 - 00:10:58:24
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But currency management is more than just about risk mitigation. It’s also about once you have currency risk under control, enabling your company to profitably use currencies in order to expand sales when you sell in the currencies of your customer. Reduce the credit risk in your Accounts Receivable by also selling in the currency of your customers. Enhance profit margins by sidestepping FX markups when you buy in the currency of your suppliers. Or passing on some of those benefits on to your customers, thereby becoming more competitive. And finally, it can put your company in a position to diminish the variability of company cash flows.
00:10:59:01 - 00:11:31:03
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Is it not precisely what Netflix is doing as it manages more than 40 currencies? And it's the share of international sales is more than 60% of total sales. On the earnings call with analyst CFO Spencer Neumann explicitly linked the company's successful FX layered hedging program to its pricing parameters because it allows the company to keep prices as steady as possible for as long as possible.
00:11:31:05 - 00:11:45:21
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It also allows the company to reduce the variability in the firm's cash flows. The market capitalisation of Netflix is north of 430 billion USD. Talk about a success story!
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