Do currency fluctuations impact earnings? The recent rise in the value of the euro against the U.S. dollar could affect European producers, but it is a complex picture.

In the middle of this year, the European currency--the euro--made some spectacular value gains against the U.S. dollar. From a 2002 high of just over EUR 1.16 to the dollar at the beginning of February, the greenback steadily lost ground until the euro broke through the parity barrier in mid-July. After a brief spike at just under EUR 0.99 to the dollar at the end of the third week in July, the exchange rate settled down at around US$1.02 for most of August. Even that level represents a 9% drop in value for the dollar since the beginning of the year. Figure 1 shows the dollar's exchange rate against the euro.

[FIGURE 1 OMITTED]

For European holidaymakers traveling outside the so-called "Eurozone," the decline represented an extra spending boost, especially for those visiting the United States. But according to calculations from at least one analyst, the drop could also signal a boon for U.S. papermakers.

According to analysts at Morgan Stanley, there is a relationship between share performance and exchange rate movements, mainly in terms of the relative performance of U.S. producers versus their European counterparts. A recent paper from the team showed that, in previous periods of fluctuations between the dollar and European currencies, an increase in the strength of the dollar has typically benefited the share index of European producers and vice versa, as shown in Table I.

The analysts also pointed out that, while currency swings are significant, they are still a secondary factor in determining the performance of European companies within the Eurozone. As the team noted, "Instead, we believe that the industry's powerful cyclical swings are the prime driver of share performance."

COMPLEX PICTURE

That caution is echoed by Jaakko Poyry financial expert Timo Teras. "The value of the dollar affects so many things it is difficult to say exactly what the overall effect would be for European producers," he commented. "Obviously, a weaker dollar has a big impact on sales off paper to countries outside Europe and into the U.S. itself; but a weaker dollar means that hardwood pulp costs less in euro terms."

Teras added that the internationalization of the pulp and paper industry means that many larger companies simply gain on one hand while losing on the other. "Big companies like UPM-Kymmene and Stora Enso now have major assets in the U.S., for example, so while they might do less well selling paper from Europe, they may be able to offset that with extra sales in the U.S. If your revenue streams are in euros, you suffer in some ways, but plenty of other consequences counter this."

Among a broad range of other factors that he felt should be taken into consideration, Teras singled out energy costs as a key component in the dollar/euro exchange rate equation. With dollar-based oil markets underpinning much of the energy sector's pricing policies, the depreciation of the dollar provides a boost for energy-intensive net users at a time of rising energy costs. Equally, net energy providers could be losing out.

Some commentators have indicated that the dollar's decline may already have played its part in aiding the recent months' rise in pulp prices across Europe, especially for hardwood grades. Teras agrees. He explained, "One thing we can say for sure about the strength or weakness of the dollar is that it has a major bearing on how fast or slow the price of pulp goes up or down."

A spokesman for Swedish pulp group Sodra also indicated that recent dollar weakness had made the group's life somewhat easier "The dollar does affect pulp prices, but it should not be overstated. The price of pulp has been quite low, so increases in the value of the euro against the dollar have made it a little easier for us to reach the prices we want in recent months, in the long term, though, fluctuations cause us very few problems."

INTERESTING ANALYSIS

While analyzing the specific impact of the relative strength or weakness of the euro and dollar on each company's specific costs or sales is a massively complex task, Morgan Stanley's analysis does provide some intriguing insights. The group targeted net currency flows and hedging policy (where known) as key elements in their analysis of Europe's main producers.

According to the analysts, groups that report in cures and do not have broad exposure outside the Eurozone could suffer declines of 10% or more on normalized earnings per share, compared with a stable currency regime at previous euro/dollar levels. While the group notes that Stora Enso and UPM-Kymmene are less exposed than most, Morgan Stanley indicates that M-Real, Norske Skog and SCA could all be hurt by the cure's strength.

Underlining the complexity of the calculations, Store Enso noted that net foreign exchange gains actually showed a gain of EUR 10.9 million in its second quarter results. As the company explained, Stora Enso currently hedges 50% of its dollar and sterling cash flows. Although the currency effect of the closing rates on the second quarter was material, the company's dollar denominated debt helped balance the impact of currency fluctuations overall.

On the flip side of the coin, Morgan Stanley's report indicated that companies such as David S Smith and Sappi are expected to benefit from the dollar weakness, because they do not report in euros. That view seems to concur with Sappi's own position.

In its recent interim statement, the company said, "The relative strength of the euro compared to the U.S. dollar is expected to enhance the dollar earnings of Sappi's European business because its sales are predominantly in euros, while part of its costs (particularly purchased pulp) is in U.S. dollars. It is estimated that, other things remaining unchanged, a 10% strengthening in the euro would result in approximately US$ 0.13 improvement in earnings per share. For Sappi's Southern African businesses, a strengthening of the rand against the dollar of approximately 10% would result in approximately US$ 0.11 reduction in earnings per share. On balance, however, the weakening of the U.S. dollar is favorable to Sappi."

MISSION IMPOSSIBLE

As Teras pointed out, "It is almost impossible to say with accuracy what the effect of the dollar weakness will be on these companies without digging into very great detail on every aspect of the business. You'd have to look not only at a company's hedging policy, but also exactly what it did in practice, as well as figuring out exactly what debt was dollar denominated and what was in other currencies. Unless you had Juha Niemela [UPM-Kymmene CEO] or Jukka Harmala [Stora Enso CEO] work it out for you, it would be a massive task."

Overall, currency fluctuations do provide a crucial dynamic in the pulp and paper trading environment, particularly with respect to trade flows. Still, while it is well worth keeping an eye on the numbers, investors should not expect to see clear links between exchange rate movements and share price performance.

In addition to the inherent complexity of evaluating the inputs and outputs, pulp and paper companies are becoming far more sophisticated in their approach to risk management-and that includes currency movements. As a result, the rise of the cure against the dollar may well affect profitability among some players, but broader industry trends are likely to swamp the impact of currency fluctuations in many cases.

Table I: Performance of
European Paper & Forest
Company Share Price
Index relative to U.S.
Paper & Forest Index

                         Share performance of
                          European producers    Change in value of euro
Period                     vs U.S. producers      currency vs the US$

May 1989-Aug 1992               -54%                      30%
Aug 1992-Nov 1993                39%                     -40%
Nov 1993-Jun 1995                -2%                      25%
Jun 1995-Jun 2001                59%                     -36%
Jun 2001-Jun 2002                 7%                      16%
Euro Currency Strength          -16%                      24%
Euro Currency Weakness           49%                     -38%

IN THIS ARTICLE, YOU WILL LEARN:

* The relationship between share performance and exchange rate movements

* The implications of exchange rate fluctuations for the paper industry

* The effects of the dollar's decline on pulp and paper prices

ADDITIONAL RESOURCES:

* To participate in the TAPPI discussion board on the industry's financial performance, or to view discussion boards for other topics, go to http://www.tappi.org/index.asp?limit_to=-1&ch=6&rc=-1&Show_only=57

About the author: Jim Kenny is contributing editor/Europe, for Solutions! magazine, and is based in Brussels, Belgium. He is the former vice president of editorial for Paperloop and today heads his own company, DSI. Contact him by phone at [phone], or by email at [e-mail]