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VW: faces strategic challenges in pushing sales and cutting costs, but currency risk is often overlooked |
At the end of February, Standard & Poor’s revised its outlook on Volkswagen’s single-A rating from stable to negative, owing to the car company’s lower than expected 2003 earnings. VW’s operating profits were down 48% to e2.5 billion in 2003, according to its headline numbers published last month. S&P said the sales performance of its new Golf, retaining its profitability in Europe and its ability to carry out planned annual cost cutting of e1 billion were the company’s key challenges in 2004.
Yet some analysts think that S&P should be focusing more on VW’s currency risks, which reduced operating profit by e1.2 billion in the first three quarters of 2003. When it formally publishes its full-year results in March, the currency hit to VW’s balance sheet, particularly the euro/dollar rate, is likely to account for half of its fall in operating profit. The problem is not going away in 2004.
Traditionally, Europe’s biggest carmaker hasn’t hedged a lot of its dollar currency exposure, despite the fact that it has a strong sales base in the US in dollars yet no manufacturing base there and most of the cars it sells in the US are produced in Europe.
Earlier last year when some of its European competitors such as BMW and Porsche were fully hedged, VW hedged only about 40% of its exposures. But then it racked up currency losses of $800 million in the first six months of 2003 and was forced to change tack. In September, the company announced that it was upping its financial hedging to two-thirds of its currency exposure to “secure itself against excessive currency fluctuations”.
“VW’s initial policy was to ride out currency fluctuations because, like many others, they did not anticipate the euro’s future strength,” says Eric Sharper, auto credit analyst at Dresdner Kleinwort Wasserstein. “However the weakness of the dollar was much longer and deeper than they expected, so they didn’t have much choice but to increase their hedging, although in hindsight they should have done this earlier.”
Profit warnings
The currency impact on VW’s fourth quarter in 2003 is likely to be mitigated by its new financial hedges, but some analysts predict that companies such as VW and BMW may have to put out currency-related profit warnings in 2004 as their currency hedges expire, the dollar continues to weaken and they have to hedge their exposure at a higher rate. Whereas BMW was fully hedged last year, now it is hedged only against two-thirds of its exposure and VW is now half hedged.
Goldman Sach’s auto equity analysts predict negative currency impact of e400 million in 2004 for BMW, which they say will largely cancel out profit increases from the introduction of new models. Goldman also estimates that the unhedged portion of VW’s net exposure, along with the fact that its hedged portion was done last year at around $1.10, could cost it e300 million in 2004. When Euromoney went to press, the euro/dollar spot rate was $1.26.
Even companies that hedged their euro/dollar rate at $1.20 at the end of 2003 found themselves in trouble when the dollar slumped closer to $1.30 earlier this year. “Some companies have set up their budget rate in the area of $1.20,” says Stephane Treny, head of European corporate FX sales at Deutsche Bank. “If you’ve got a contract to buy euros at $1.20, do you want to buy at $1.30 and take a loss? Some companies can’t use leveraged products and just prefer to wait until the dollar strengthens again.”
He says that, overall, companies are still very short in euro/dollar positions. However, it’s a risky game. A panel of economists at Euromoney’s bond investors’ congress in February predicted euro/dollar rates of between $1.30 to $1.40 by the end of 2004. A poll of the audience revealed that 44% thought that the euro would strengthen at least a further 10% against the dollar by the end of the year.
“Currencies tend to overshoot so the odds are that it will reach the $1.50 range and come back to $1.40 by the end of the year,” says Michael Workman, head of fixed income research at Trust Investment Bank. As a consequence, some companies are now putting on euro/dollar hedges at $1.30.
VW is stepping up manufacturing in Mexico, which it hopes will increase its natural hedging as the peso is closely linked to the dollar. It doesn’t have a natural dollar hedge in the same way that BMW does because BMW produces its Z4, X4 and X5 models in the US.
Even if this is successful, the benefit will not register this year, and analysts are sceptical about what sort of impact this can have: “It’s not really realistic to increase production in Mexico when VW has low capacity utilization levels in Europe and the last thing they want is more spare capacity in Germany,” says Max Warburton, automotive equity analyst at Goldman Sachs. “BMW isn’t much better placed. People assume it could just make more cars in the US to protect itself against a weak dollar but it can’t increase US production much for the same reason.”
It looks like the currency problems of European carmakers aren’t going to go away in a hurry.
