A multinational corporation is one whose operations are set up in one or more jurisdictions other than the domestic country of the company.
When a company reports its financial statements, usually on a quarterly basis, results are usually consolidated into one functional (operating) currency incorporating all subsidiaries and/or foreign operating divisions. Such consolidation usually results in translation effects, or in simpler terms exchange rate gains or losses.
When investors look at financial statements, items such as profit margins and revenues may appear to improve year on year. Many take this for granted, that the figures are sufficient to generate a positive outlook for the following quarters. This will not always be the case.
It is imperative for investors to distinguish between organically generated profits and profits resulting from translation effects. Taking Sappi Papier Holding as an example (a company specialising in graphic and specialty paper), the company is a US domiciled firm with large foreign operations in Europe and South Africa.
In Sappi’s recent earnings announcement, the company reported lower revenues on a LTM (last twelve month) basis, despite improved LTM profit margins and volumes sold out of their specialty paper divisions. The lower revenues were the result of negative conversion effects of Sappi’s EUR and ZAR denominated revenues into the company’s functional and reporting USD currency as a result of the appreciating dollar.
Lower revenues could have led the average investor to jump to conclusions of potential troubles ahead for the company. Whilst appreciating that the paper industry is currently experiencing stale to falling demand for graphic paper, lower reported revenues should not automatically be linked to the larger macro picture of the industry, as in Sappi’s case the foregone revenues in graphic paper were more than covered with improved volumes and market share out of their specialty paper division.
Inflation would play a role in determining which functioning currency to adopt for multinational corporations. Currencies tend to depreciate under inflationary pressures, as purchasing power is reduced and demand for a country’s currency becomes subdued.
Translations of weaker foreign currencies as a result would lead to weaker performance results when converted back to the stronger functioning currency.
Hence, a company’s management would clearly need to analyse the jurisdictions and currencies in which it plans to operate and accordingly choose a functioning currency that best meets its reporting responsibilities and operating objectives.
In today’s economic environment, the euro as a functioning currency, would result in high positive translation effects, given the ongoing monetary easing policies and downward pressures on the currency, assuming a comparison to foreign divisions operating in USD and/or JPY as examples.
The above are imperative considerations in performance reporting, which can be affected in many ways other than through translation effects, but that is a discussion for another day.
Disclaimer: This article was issued by Mathieu Ganado, Junior Investment Manager at Calamatta Cuschieri. For more information visit, www.cc.com.mt .The information, views and opinions provided in this article are being provided solely for educational and informational purposes and should not be construed as investment advice, advice concerning particular investments or investment decisions, or tax or legal advice. Calamatta Cuschieri Investments Ltd has not verified and consequently neither warrants the accuracy nor the veracity of any information, views or opinions appearing on this website.