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Tech firms face growing risk from stronger dollar
Weak exchange rates have boosted reported revenues for first half of 2008
SANFRANCISCO -- The recent strengthening of the U.S. dollarcould signal a danger in the third quarter for many technologycompanies that have been enjoying a strong boost from currency exchangerates so far this year.
A strongerdollar could pose a challenge for big tech names such as Apple, IBM,Hewlett-Packard, Dell, Google, eBay, Amazon.com, Oracle and Microsoft-- all of whom have seen notable benefits in their most recentreporting periods from currency rates. In some cases, a majority of therevenue growth reported by these companies came from favorable benefitsfrom foreign exchange rates -- leading to the risk that reports forupcoming periods could show a seemingly dramatic slowdown in top-linegrowth in what is already a difficult economic environment.
"From an investor'sperspective, the biggest risk is when you have a big currency move in asingle quarter," said Richard Keiser, senior technology analyst withSanford Bernstein. "The risk is that a big change can create misses onthe top line."
After several months ofweakness against other currencies, the greenback has made significantgains during the month of August. As of Aug. 26, the U.S. dollar hadgained more than 6% against the euro since the beginning of the month.Against the British pound, the dollar currently sits at its highestlevel in more than two years.
That's asignificant rebound. In July, the dollar reached its record low againstthe euro since the singly currency began trading in January 1999.
While potentially goodnews for currency traders, a stronger dollar poses a risk for companieswith a significant revenue base coming from offshore. A weaker currencyis good for companies with overseas sales because it makes their goodscheaper and therefore more competitive in overseas markets. It alsoincreases the value of their profits when repatriated into their homecurrency.
When a sharp upswinghappens in a short period of time, the risk is that analysts andinvestors may not update their expectations in time for the reports.This can create a risk that reported revenue could miss Wall Street'stargets and put additional pressure on stock prices.
A strong boost
The weak dollar in the first half of the year has given a large boostto tech companies. According to research from Bernstein, U.S.-basedtech firms saw currency exchange rates lift their reported revenues byan average of 4.2% in the first quarter of this year and 4.5% in thesecond quarter.
This is the largestlift from exchange rates for tech companies in at least three years,according to research from the brokerage.
"Tech companies havebeen benefiting from foreign exchange erosion in 22 of the past 25quarters," Keiser said. "For all intents and purposes, currency hasbeen a net gain for tech companies for the past six years."
That was especiallynoticeable in the second quarter and for some, the impact wassignificant. International Business Machines (IBM) reported that revenue grew 13% for the second quarter, beating WallStreet's expectations. But without the benefit currency rates, thecompany said its revenue growth would have been only 6% for the period.
Ditto for Hewlett-Packard (HPQ ) ,which saw revenue grow 10% for its third fiscal quarter ended July 31.Excluding currency benefits, that top-line growth would have been only5%.
The impact is less significant for companies with higher growth rates. Web search giant Google (GOOG) would have seen revenue grow by 32% in its most recent quarter whenaccounting for exchange rates instead of the 39% reported by thecompany. Amazon's (AMZN) 41% revenue growth rate would have been 35% without the currency benefit. At eBay (EBAY) , revenue growth for the second quarter would have been 13% instead of 19% if the currency benefit was excluded.
Other companies are less clear about the impact. Software giants Microsoft (MSFT ) and Oracle (ORCL) did not disclose a foreign exchange impact in their most recentearnings releases, but told investors on a conference call thatrevenues were boosted by 4-6 percentage points. Dell (DELL ) and Apple (AAPL ) do not disclose any foreign currency impact in their recent reports,though both companies generate a significant portion of their salesoverseas.
Foreign exchange impact on U.S. technology companies
| Quarter | Year-over-year impact |
| Q1, 2006 | -3.0% |
| Q2, 2006 | -0.6% |
| Q3, 2006 | 0.9% |
| Q4, 2006 | 2.4% |
| Q1, 2007 | 2.2% |
| Q2, 2007 | 1.3% |
| Q3, 2007 | 1.9% |
| Q4, 2007 | 3.2% |
| Q1, 2008 | 4.2% |
| Q2, 2008 | 4.5% |
| Q3, 2008 | 2.4%* |
| Q4, 2008 | 0.8%* |
| * Forward estimates, based on current spot rates. | Source: Sanford Bernstein |
"Investors may get a little sloppy about not realizing how muchcurrency is a driver of growth," said Walter Pritchard, technologyanalyst with Cowen & Co. "And there are some companies guilty ofnot telling the whole truth."
Potential weakness ahead
Provided the dollar maintains its recent strength, many big techcompanies will likely see a significant slowdown in revenue growthrates for the rest of the year.
According to researchfrom Bernstein, foreign exchange rates will have an average impact ofonly 2.4% in the third quarter -- based on exchange rates dated Aug.25. That is nearly half of the benefit seen by the sector in the secondquarter.
For the fourth quarter,foreign exchange rates will only boost top-line results for tech firmsby an average of 0.8% based on current rates, the Bernstein reportpredicted.
Companies such as IBMand H-P are thought to have the greatest exposure to the changingrates. Generally, companies that generate a large portion of theirsales overseas will face the greatest risk. Both IBM and H-P generatednearly 60% of their total revenue in the past quarter from salesoutside North and South America.
Dell generated only 47%of its total revenue from foreign markets in the July quarter, makingthat company slightly less exposed to currency fluctuations.
"Even though mostcompanies hedge [foreign exchange] in some form, we expect recentdollar strength [if sustained] to pressure revenues and earnings growthacross the IT hardware sector," Deutsche Bank analyst Chris Whitmorewrote in a recent note to clients. "For instance, we expect H-P todeliver a solid quarter, but believe consensus revenue estimates appearaggressive."
Companies likeAmazon.com could also be affected. In a mid-August report, Tim Boyd ofAmerican Technology Research estimated that gains by the dollar by thattime had chopped about $173 million, or 2.4%, from his projectedfourth-quarter revenue target for the online retailer.
One factor that canoffset currency impact on sales for a company is a large foreignworkforce, which can grow more expensive on a weak dollar. The higherexpense offsets the revenue boost for the bottom line.
But in the case of acompany like Amazon, which has most of its workforce and other expensesbased in the U.S., Boyd says a decline in off-shore revenue can take"high-margin" dollars out of the picture, leading to lowerprofitability.
In the softwarecategory, Pritchard of Cowen & Co. estimates that 22 of the 29companies his firm covers have seen a currency benefit over the pasttwo years and may be vulnerable to a decline. He predicted in an Aug.15 report that currency will begin to "diminish as a driver inSeptember and by March could be a headwind at current levels."
He adds, however, thathaving a diverse revenue base "is a good thing overall," despite somefluctuations from currency.
The changing currencyrates are causing some companies to worry about their upcoming reports.Wolfgang Koester is the CEO of FireApps, which makes software systemsdesigned to help companies better control their foreign exchangeexposure. He said he's been meeting with directors of many large techcompanies of late who are worried about the impact of the strongerdollar on their companies' results.
"People knew this wascoming. The same thing happened across the pond in Europe over the pastthree years," Koester said in an interview. "They don't want asurprise, but I believe we will get quite a few surprises."
Dan Gallagher is MarketWatch's technology editor, based in San Francisco.
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