Is the Dollar Depressing Drug Companies?

In the past two weeks, the Federal Reserve cut the primary discount rate from 3.5% to 2.5%, on top of a large rate cut in January. In anticipation of and because of these rate cuts and a worsening economy, the U.S. dollar has fallen precipitously against several currencies like the euro and the yen over the past several months.

All companies with international operations feel the effects of these currency movements. Big pharmaceutical companies will soon release results from their first quarters. Most drugmakers have already given their 2008 earnings guidance based on certain assumptions about where currency exchange rates will be, so let's take a look at which drugmakers are poised to beat or underperform expectations with their first-quarter numbers, based on the weakening dollar.

Mixed results from Europe
The changing dollar relative to the euro and, to a lesser extent, the pound over the past year will have mixed effects for European drug companies, depending on which currency they report their earnings in and the geographic regions where their revenue and expenses come from.

French drugmaker Sanofi-Aventis (NYSE: SNY  ) might be the company that's most hurt by the dollar's precipitous drop. For every cent that the dollar drops against the euro, Sanofi's euro reported earnings per share (EPS) are expected to decline by half a percentage point, according to the company's latest press release on its 2008 earnings forecast.

In February, Sanofi said its earnings would grow "around 7%" in 2008 at a euro/dollar exchange rate of 1.37. Unfortunately, the exchange rate is now nothing close to that, and one euro is fetching 1.57 dollars. Based on these new exchange rates, Sanofi could easily end up announcing reported adjusted euro earnings-per-share growth in the negative percentage points for this year (although its constant currency results may look better).

Mainland European drugmakers like Sanofi aren't the only ones affected by the changing dollar. Last year, the earnings-per-share growth of U.K.-based GlaxoSmithKline (NYSE: GSK  ) was reduced by six percentage points, mostly thanks to the falling dollar versus the pound. This reduced Glaxo's reported EPS growth in 2007 to 4% from 10%.

Luckily for Glaxo, the dollar hasn't declined as much against the pound as it has against the euro in the past several months, but the pound has declined against other currencies like the euro and the yen. Glaxo built a bit of a falling pound cushion into its 2008 guidance of "mid-single digit percentage decline" in its EPS, so I don't expect any major "reported earnings" surprises from Glaxo for the first quarter.

One other mainland European drugmaker to watch out for is Switzerland's Novartis (NYSE: NVS  ) . It reports its financial figures in dollars, and its top line benefited nicely from the falling dollar last year. For 2007, Novartis' continuing operations were boosted with a sales growth rate of 11%, versus the 6% sales growth that it reported in local currencies. Novartis is a bit different than Sanofi or Glaxo, though, because it hedges against exchange-rate movements more extensively, so even if Novartis' pharmaceutical operations are affected by changing relative currency values, its hedging operations will help to counteract these currency effects.

At home
The U.S.-based drugmakers are a little easier to analyze. Like most exporters, their sales will generally be getting a nice lift from the falling dollar. Last year, for instance, Pfizer (NYSE: PFE  ) reported that it got a 3% ($1.5 billion) benefit to its sales as a result of the falling dollar.

It's worth remembering that just because a drugmaker's top line may be benefiting from a weakening dollar, it doesn't mean that will translate into bottom-line gains. Merck (NYSE: MRK  ) , for instance, is also a currency hedger. It didn't spell out how sensitive its financials are to a particular drop in the dollar for 2008, but any decline in the dollar versus the other currencies it operates in won't be helping Merck as much (or perhaps at all) because of these hedging moves.

Closing thoughts
Some may argue that investors should look at a drugmaker's "comparable" financial numbers at constant exchange rates when trying to gauge year-to-year financial performance. It's valid to use comparable versus "reported" financial figures, but it is the "reported" actual financial results that affect a drugmaker's ability to pay dividends, make acquisitions, and run its business, so I prefer to look at "reported" results when judging a drugmaker's investment potential and financial performance.

There's one important wrinkle to point out with the falling dollar exchange-rate equation. Drugmakers like Sanofi-Aventis whose shares trade on the U.S. stock markets as American depositary receipts or American depositary shares receive an automatic benefit in a falling dollar environment because their U.S.-exchange-listed shares rise versus their European-listed shares when the dollar falls.

While accounting for currency effects in a drugmaker's operations may sound daunting, some companies make it a little easier for investors to look up how currency changes affect their operations. If you go to their 10-K annual report filed with the Securities and Exchange Commission (or foreign listing equivalent) and search for "currency," they usually spell out in general terms how currency movements will affect them.

The big-money takeaway from all this currency rambling is that investors should be aware that (like most companies), drugmakers will often selectively report whatever financial figures cast themselves in the best light. Changing exchange rates do have real effects for both the top and bottom lines, and investors should take these effects into account.


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