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TUI Losses on Turkish Lira Defy Concept of KPIs

by Bob Lyddon

The package holiday business is normally a one-way street as regards foreign exchange exposure: revenues are in USD, EUR and other home currencies of the tourists, and expenses are partially in those same currencies, mainly in the home currencies of the destinations, with an overhang of USD due to the predominance of that currency in all things to do with aviation.

A Key Performance Indicator Framework ("KPI") for such a company would normally begin with a budget cycle in the late summer of the previous year, plotting in expected sales volumes and prices, and expenses, by source and destination countries, month-by-month through the following year. Then, using the then-current forward exchange rate for each currency pair and each month, the company would identify the profit margin, the capacity to afford to pay the premia on foreign exchange hedging via options, and a putative "break-even" set of exchange rates which, if realised, would assure the company its targeted Return on Equity.

The budget model would enable sensitivity analysis, and culminate in a view of what portion of budgeted sales should be locked in with forward contracts against the foreign currency expenses connected with those sales, what portion should be hedged with options, and what should be left uncovered.

With a situation like Turkey where the lira has depreciated by 30% against major currencies this year, a tour company would normally expect a windfall gain. There would of course be no windfall gain on what was locked in through forward contracts, but options to buy lira would be allowed to expire unexercised and the lira would be bought at a market price well below the option strike price.

Lira expenses that were not hedged at all would be covered at the market price, 30% lower than the estimates in the budget, and no doubt a last-minute sales campaign could be launched to increase volumes, with a very attractive price to the tourist but leaving some extra margin for the holiday company.

Not so TUI, the world's largest travel company, which announced a hit to its 2018 3rd quarter profits thanks in part to the devaluing Turkish currency.

TUI announced to the stock market that volatility affecting Turkey would have a bigger than expected impact on full-year earnings. An analyst from Shore Capital explained that, "the full year [foreign exchange] drag is expected to be around €35m, primarily from the revaluation of euro loan balances within Turkish entities... That is about €25m worse than previously expected, and will on profits."

The first point to make is that TUI's profile differs from our archetypal package holiday business: it owns "Turkish entities" which have a share capital denominated in Turkish lira. The parent company has a translation exposure between its own currency and Turkish lira on this shareholding.

The way to balance this from the parent's point of view could be to take on liabilities in Turkish lira, such as borrowings in Turkish lira itself. That is actually quite difficult for the parent company to do, as the money market in the currency outside Turkey is very thin.

The second hedging mechanism would be to have expenses in Turkish lira and to leave them unhedged: both the expenses and the asset would rise or fall in value in EUR or GBP terms in line with the gyrations of the Turkish lira. This is exactly the position TUI is in, and so TUI should have been adding another line into its KPI Framework and budget process to restrict the hedging of the Turkish lira expenses by the amount of its shareholding in its Turkish entities.

It seems that this was not done, and furthermore the Turkish entities appear to have magnified the parent's exposure by themselves borrowing in Euro, when their own assets are all denominated in Turkish lira.

This has the effect of leveraging up the parent's risk, because the Turkish lira-based capital which the parent owns is first diminished in the books of the Turkish entities themselves when the EUR-based loans increase in value, and then secondly the value of the residual capital diminishes when expressed back into the currency of the TUI parent.

The actions of the Turkish entities are understandable in one sense. With Turkish lira interest rates around 10% and EUR rates more like 2%, it is a temptation to borrow in a Low Interest Rate Currency and cash in an 8% annual saving on Interest Paid.

Private Turkish borrowers operate in quite a controlled environment. There is no money market in Turkish lira outside Turkey: credit in Turkish lira is only available from domestic banks and markets. Private Turkish borrowers are restrained from borrowing foreign currency from outside Turkey by several lines of taxes which do not apply to the state, state enterprises and domestic banks.

The result is that private borrowers do not take on foreign loans, but they do take on loans from domestic banks in both lira and foreign currency. Domestic banks on-lend the foreign currency they borrow from abroad, to borrowers who have few or no foreign assets or revenues to provide a foreign exchange hedge, and who are simply hoping to save on Interest Paid.

This is where the disaster of the 30% drop in the lira's value will play out: private borrowers whose loans are now worth 30% more in terms of the assets and revenues they have, and who will in due course default on their loans to the domestic banks.

Those banks could soon be holding Non-Performing Loan portfolios to rival those of the worst Eurozone countries: 40-45% of all loans are on Non-Performing status.

TUI, by contrast, needs to be looking at itself and at both its Treasury KPIs and budget functions were its EUR loans in its Turkish entities offset against its short position in lira expenses? and at its Subsidiaries management function why was it agreed that loans in EUR be taken, to finance what assets, and what was done locally or with the group to hedge the foreign exchange risk?

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