Having to do business in US dollars is bad news for European aerospace companies. But allhave strategies to beat the effects of the adverse exchange rate
Airbus is flying high: the Toulouse-based manufacturer out delivered Boeing for the second year running in 2004 and expects this trend to continue in 2005. But a dark cloud is looming on the horizon, and it comes in the shape of a US dollar that has lost more than a third of its value against the European euro in the last three years (see chart).
In an industry in which transactions are largely dollar-denominated, the falling dollar cannot fail to make an impact on those that find themselves on the wrong side of the currency divide. While Airbus has attempted to encourage customers to pay for aircraft in euros, "this is an industry that is used to dollar pricing", says chief financial officer Andreas Sperl.
To survive the dollar's recent decline, companies with euro-denominated expenses and dollar-denominated sales have put currency hedging arrangements in place (see box, P31). But as the dollar shows no signs of rallying, analysts agree that rates for future hedging arrangements will be less favourable.
EADS says it has "one of the most comprehensive hedging strategies of all European companies", one that plays a major part in combating the effects of its significant currency exposure. Roughly two-thirds of the company's turnover is dollar-denominated, of which half is naturally hedged and half needs to be protected against exchange rate fluctuations. EADS currently has more than $40 billion in future revenues hedged at an average rate of 1/$1.02.
But the average euro/dollar exchange rate for EADS's hedging cover falls from €1/$1.00 for 2005, for which the company has $10.4 billion of cover in place, to €1/$1.13 for 2011, for which the company had just $400 million of cover in place as of the end of September 2004, the latest figures available (see chart P31).
Increased risk
For aircraft deliveries in the short term, Airbus's hedging cover retains favourable rates, but if the dollar remains weak the average exchange rate it locks in will fall, making future programmes and longer-term aircraft deliveries potentially riskier for the company.
EADS says that faster-than-expected growth in deliveries at Airbus, as airlines bring forward their aircraft from 2006 to 2005, necessitates additional hedging for this year, as the required cover is arranged when the company books an order. The encouraging forecasts for future deliveries, however, will help protect Airbus and its parent company from the weak dollar, as the impact it feels from euro-based overheads will be partially offset by a higher number of aircraft sales.
In the longer term, Airbus sees the huge revenues predicted for the A380 as its major weapon to tackle the exchange rate, with the market for ultra-large aircraft put at over $400 billion through the next 20 years. "Once the A380 is in full production, the sheer size of the business it generates will have a powerful hedging effect all by itself," says chief executive Noel Forgeard.
But hedging alone is not enough: cost-cutting is crucial to EADS's risk-reducing strategy: "Hedging buys us time to implement programmes to cut costs," the company says. Airbus has a long-running cost-reduction programme, dubbed Route 06, which is intended to reduce its cost base by €1.5 billion ($1.9 billion) by next year, compared with 2003. Route 06 "is a key element that will help us to cope with the dollar weakness, should it continue to stay low", says Forgeard. All the Route 06 measures have been identified and implemented, and the programme is "on target", he says.
Rolls-Royce, which also has the strong UK pound to contend with, agrees that cost-cutting is vital. The engine manufacturer also has a long-term hedging policy, with around $9 billion of cover in place. "This means we sell forward dollars in a controlled way, taking advantage of periods when the rate is favourable and we don't necessarily have to rush in and take extra cover if an order comes in and the dollar weakens," the company says.
"In theory, we could go three and a half years without taking further cover. In reality, that could leave us exposed in four years' time if the dollar remained weak. However, it creates a breathing space, during which we can take mitigating action," R-R says. The company has cut costs aggressively in recent years, reducing its workforce by 20% in 2002-3. The company has also invested in new manufacturing facilities and introduced modern working practices to improve efficiency. Supply chain simplification, lead time reduction and implementation of the SAP enterprise resource planning system have also contributed to reducing costs, R-R says.
The UK-based company says its hedging policy has been so effective that its average dollar/sterling rate has fluctuated by just 10¢ over the past 15 years, compared with a market rate fluctuation of 70¢. "Our strategy has worked very well for 15 years – it's a little early to conclude that this will not be the case in the future. We expect our hedging policy will continue to work well," R-R says.
But sourcing more parts in the USA provides another layer of protection against the sliding dollar, R-R says. US-based suppliers and risk- and revenue-sharing partners provide some natural hedging. The company's net dollar revenues make up 23% of its turnover, or around $2 billion a year.
Natural hedging
R-R already owns activities in the USA – including the former Allison Engine in Indianapolis – which are part of its natural hedging. The manufacturer says it would only consider buying other US companies where they fulfil strategic goals – not just as a form of currency hedging: "Where we do have US operations, we could consider increasing manufacturing or the proportion of risk/revenue-sharing partners."
French manufacturer Snecma insists that the weak dollar will have a limited effect on its results for this year. The company achieved a confirmed €1/$1 hedge rate for 2004, but one analyst predicts it will secure an average rate of €1/$1.06 for 2005, assuming that any new hedging contracts taken out from now on will be at a rate of €1/$1.35, with each cent of deterioration representing a loss of as much as €25 million.
Italy's Finmeccanica says it has largely avoided any impact from the weak dollar to date because of its policy of covering itself immediately, through hedging, on the orders it receives in dollars. Most of the company's 2005 revenues will come from orders placed in previous years, and are therefore already covered. "We don't anticipate a significant impact from the weak dollar in the future either," the company says. "Our budget for the period 2005-7 is calculated on the basis of a euro at $1.30, so is already forecasting anunfavourable exchange rate."
Finmeccanica adds: "In the long term, the current dollar rate will have an impact on the competitiveness of European high-tech products compared with their US counterparts. But as far as Finmeccanica is concerned, as our quota of revenue in the USA grows, so too will our US purchasing, and this will offset the imbalance."
EADS says it is pushing for more US dollar-denominated purchasing, even from European suppliers. A French or German supplier can be asked to sign a contract in dollars, sharing the risk. In fact, nearly all recent supply contracts have been signed in dollars and Airbus's newer aircraft have a significantly higher proportion of US dollar-denominated content.
The company has progressively increased the dollar content of its aircraft, which it says is now more than 70% of unit cost for every in-production type. "It will be even higher for the A380," says Forgeard. "We buy in dollars all around the world – not only in the USA, where we procure more than $5 billion a year," he adds.
Globalisation
Further efforts are under way to increase sourcing from non-euro regions, for example China and Russia. EADS calls this its "soft globalisation strategy", and says it will allow the company to get close to its customer base and increase its natural hedging. But the company insists it does not intend to move capacity away from current locations. The European giant acknowledges that further outsourcing may make life difficult for manufacturers further down the supply chain and will accelerate consolidation of its supplier base.
French industry organisation GIFAS warns that, while the larger organisations have complex strategies in place to cut their risk from the weak dollar, it may be too late for the smaller companies that have not yet put hedging cover in place. Small and medium-sized enterprises may bear the brunt of the dollar's weakness, GIFAS says. And it expects further consolidation in the manufacturing sector in the next two years if the dollar does not strengthen. "The real problem may be how long the dollar remains weak," GIFAS says.
Things are more difficult at Airbus's Toulouse-based neighbour ATR, which has two-thirds of its costs in euros. Senior vice-president commercial John Moore says ATR's main effort to limit the impact of the weak dollar is focused on reducing costs, but it is also looking at ways of reducing its euro exposure. "We're well advanced in an internal efficiency drive to reduce costs, and are also evaluating ways to shift part of the cost-base out of euros or into dollars," he says. The latter could see an increase in the use of repair stations outside the "euro zone" as well as a possible increase in sourcing from non-European countries, such as China.
Across the Atlantic, the US Aerospace Industries Association agrees that, if the dollar remains weak, increased sourcing of parts by European companies in the USA is likely as the market adjusts. "We haven't seen any dramatic shifts yet, but if current ratios hold we would expect a shift in sales over the next few months or years. It's not an industry that reacts quickly, as it would if it had shorter product cycles."
For some companies, the cloud may have a silver lining, however. Although European manufacturers may start to suffer the effects of the weak dollar over the coming months and years, the exchange rate gives them a golden opportunity for acquisition bargains in the USA. A growing defence budget has meant the USA has been a target for some time, but the current exchange rate makes for some good buys. And even as the US budget deficit puts the brakes on defence spending, industry insiders believe it will remain an attractive market for European companies.
"We believe the biggest growth opportunities exist in the USA," says UK-based aerospace group Cobham, which late last year agreed a $260 million deal to acquire US communications and radar specialist Remec Defense & Space in the latest in a series of US acquisitions. The company has plans for further US purchases, but sounds a note of caution – revenues from US branches of a business must still be converted back into sterling or euros, meaning the losses may be felt after all.
US acquisitions
The AIA agrees that further transatlantic acquisitions are likely: "If our stocks look cheap we would anticipate that European companies that have a reason to expand here – either because of the larger defence budget, or because they wish to source more parts from the USA – would have an increased incentive to look at acquisitions in the USA. The price of some of our companies has dropped 20% – that should be of some interest in the boardroom." But the industry group points out it is hard to differentiate "between Europeans wanting to buy into the defence market and Europeans wanting to acquire businesses in the USA to cut euro costs".
Whatever the future fluctuations of the dollar against the euro, European aerospace companies predict that the measures they have in place to protect against the currency risk will be enough to weather the storm. "No-one really knows where the dollar's going, but we're prepared," says EADS.
HELEN MASSY-BERESFORD / LONDON AND MAX KINGSLEY-JONES / PARIS
Source: Flight International
