US tech giants slashed FX hedges before EM currencies plunged
Treasurers at companies with high EM FX exposure caught out by poor decision on hedge timing.
Exposed to weakening emerging market currencies and an appreciating US dollar, US tech companies including Microsoft, Amazon and Alphabet are facing a $12.1 billion hit if FX continues to move against them.
The likely headwind to earnings is exacerbated by a decision by some treasurers at the tech giants to reducing their foreign exchange hedges during the first six months of 2021. After enjoying benefits from currency tailwinds early this year, these companies may have assumed that EM currencies would continue to strengthen.
The EM pullback
However, with the announcement by the US Federal Reserve in September that it would start tapering asset purchases, emerging market currencies declined, putting pressure on FX hedging portfolios of these companies.
With operations around the world, a weakening domestic currency benefits the tech giants when they convert cash inflows in foreign currencies to the US dollar resulting in currency translation tailwinds and higher realisations. This was the scenario in the first half of the year when the EM currencies were strengthening against the US dollar.
Consider computer giant Apple, which uses foreign currency forward and option contracts to hedge FX risk associated with existing assets and liabilities, firmly committed transactions, forecasted future cash flows and net investments in foreign subsidiaries.
With a weakened dollar during the first half of the year, gross margins on products and services improved significantly and with an expectation of this trend to continue forward, treasurers reduced the designated and non-designated FX hedge notional by $44 billion during the last six months, taking the FX hedging portfolio to $149 billion at the end of Q2 from $194 billion at the start of the year.
But now as currency strengthens, Apple expects this tailwind to moderate going forward.
“That benefit [weaker US dollar] is going to be about three [basis] points less in the September quarter than what we've experienced during the June quarter because the dollar strengthened against most currencies in recent weeks” said Luca Maestri, CFO at Apple during a July 27th earnings call.
FX hedging is important as there is a risk that the company will have to adjust local currency pricing due to competitive pressures when there has been significant volatility in FX rates. A reduction in notional exposure opens the company to these risks along with currency translation losses going forward.
Following Apple, treasurers at Microsoft also reduced hedging notional by $872 million, taking the portfolio to $6.7 billion at the end of Q2.
Even though the company booked $1.4 billion in translation gains from a weaker dollar in the second quarter, it warned that a 10% decrease in foreign currencies could reduce its earnings by $6.756 billion.
Intel and Salesforce were amongst other companies which also reduced notional hedging by $483 million and $600 million respectively during the same time period.
Accelerating hedging against volatility
Meanwhile, Alphabet, the holding company of the tech giant, Google was also a beneficiary of currency tailwinds during the first half as revenues increased by 4%, or $1.8 billion solely due to a weaker dollar.
Contrary to Apple approach, treasurers at Alphabet added an additional $7.1 billion of FX hedges during the first six months taking notional exposure to $29 billion to counter a negative impact from a stronger dollar in the coming months.
The notional exposure includes currency forward and options contracts classified as cash flow, fair value and net investment hedges. The company also holds FX contracts not designated as hedging instruments to manage risks relating to interest rates, commodity prices, credit exposures and to enhance investment returns.
After factoring in these hedges, Alphabet said in a filing that a 10% depreciation of foreign currencies can reduce the value of its revenue and investments by $2.4 billion.
For the California based tech giant, Nvidia which designs GPUs and chips, FX hedging is of utmost importance as 85% of its revenue comes in non-functional currencies including the Taiwan dollar, Chinese Yuan, Euro and other EM currencies in the APAC region leaving the top-line susceptible to degradation if EM currencies depreciate against the US dollar.
As per company’s Q2 filings, “an increase in the value of the US dollar relative to other currencies would make our products more expensive, which could negatively impact our ability to compete.”
Following Alphabet’s strategy, treasures marginally increased the FX hedging portfolio by 4% or $44 million during the first six months, taking the notional exposure to $1.35 billion at the end of Q2.
The hedges included foreign currency forward contracts to mitigate the impact of FX volatility on operating expenses and monetary assets and liabilities in foreign currencies.
Amazon, Tesla and Facebook stood apart from the remaining pack as they shunned using FX hedging to reduce volatility.
With 28% of its revenue from international markets, Amazon’s no hedging stance can have a big impact on its top line. The company estimates that a 10% fall in foreign currencies can lead to a $2.885 billion reduction in the value of its investments and inter-company cash balances.