The most obvious approach is to take advantage of any “natural hedges” within the business; for example, where a subsidiary generates revenues in a foreign currency that it can also use to pay for costs incurred in the same currency. Natural offsets of this sort provide a measure of protection. Crucially, though, in a large and complex international corporation with scores of subsidiaries and a global supply chain, harnessing them can be highly complex and depends on having timely information about where and when the company is generating and spending cash.
“Prior to the past two years, companies generally had that information on a monthly or quarterly basis,” says Royall, “but in 2015, exchange rates moved so dramatically within a month that this wasn’t good enough for some companies. They wished they had daily – or at least more frequent – information.”
A rolling hedging programme
Natural hedges are an important part of the approach taken by Abbott, the US-based health care company with extensive emerging markets operations. Since its demerger from the pharmaceutical company AbbVie at the end of 2012, Abbott has had much greater exposure to emerging market currencies, according to its CFO, Brian Yoor. This is a necessary condition of its long-term strategy to benefit from growing demand for health care across the developing world.
Where possible, says Yoor, Abbott’s strategy of serving markets better by increasing its local presence – expanding sales and marketing teams, manufacturing, and even opening R&D and administrative centers – not only matches costs more closely to the spending power of local customers, but also has the beneficial side effect of creating bigger natural hedges within the business. “It serves the need to find as good a natural offset as you can,” says Yoor, “but at the same time, it’s tied to your long-term strategy, and for us, strategy comes before all.”
The demerger created a business with 70% of its revenues outside the US and 50% in emerging markets. Although natural currency offsets were important, Abbott’s management realized they would also need to manage the company differently, Yoor explains. Having previously taken a “more opportunistic” approach to hedging, Abbott now put in place a rolling hedge program that looked 18 months ahead. “We went through to see where hedges were available in certain countries and whether they were affordable. Can we get the hedge accounting treatment that we want? Is it a liquid market?”
The hedging program cannot provide the same perfect match as a natural hedge, but it served Abbott well during the turbulence of 2014-15, says Yoor: “We were able to use a blend of certain instruments that generated income for us in a very volatile environment and enabled us to continue to invest in the business.” He adds that Abbott investors understand that the benefits of a rolling hedge program will change over time; for example, as hedges taken on 18 months earlier start to expire and are replaced by new positions that may be more expensive. “You’re still realizing a benefit, but it’s not as much year-on-year,” says Yoor.
Economic hedges
Like Abbott, Vodafone Group underwent a transformation that changed its currency profile, with the sale of its stake in Verizon Wireless in the US. The mobile telecom company that emerged reported its results in sterling but had half its revenues in euros, 15% in sterling, 10% in rupees and another 10% in rand.
CFO Nick Read says that, in the last full year, currency movements reduced reported revenues by about £2b and earnings before interest, taxes, depreciation and amortization by about £700m. However, with its longstanding exposure to emerging market currencies, which are prone to volatility, the company has developed an approach to managing its currency risk that has several strands.
Part of this involves “economic hedges,” says Read, in which Vodafone matches the currency mix of its debt to the discounted cash flows of its various foreign subsidiaries. “What that means is that a negative impact on the P&L provides us with a reduced or positive impact on our net debt, which reduced by £2b [last year]. So there’s an economic hedge.”
The company manages its global procurement centrally, reducing the exchange rate risk of purchases priced in emerging market currencies by converting the contracts into local currency payables. In this way, it avoids negotiating in euros and risking a translation hit through the rest of the year.
Read says that Vodafone’s policy is to report on its “organic performance” and then to isolate the impact of currency fluctuations to make them clear. Investors have a good grasp of the effects of currency volatility on Vodafone, he argues, pointing to the close relationship between movements in the company’s sterling-denominated share price and changes in the sterling to euro exchange rate. However, given that half the company’s revenues are now generated in euros, in April 2016 it switched its functional currency to euros instead of sterling and announced that, in future, it would also declare dividends in euros rather than sterling. This should result in less volatility in Vodafone’s reporting and also means that it will no longer be generating cash flows largely in euros but paying dividends in sterling. The change effectively passes inherent exchange rate risk from the company to its shareholders.
“I polled institutional investors on their support for moving to euros and they were overwhelmingly in favor, given that they can manage the currency risk from their end,” says Read.
What’s your approach?
Royall says that the foreign exchange (FX) volatility leading up to the UK’s EU referendum and the repercussions afterward illustrate that the issue of managing FX risk is still a live one. “There’s an uneasy calm at the moment,” he says. “A year ago, everyone’s consciousness was raised about how bad the movements can be and a lot of companies started to ask themselves, ‘What’s our philosophy about foreign currency?’”
That is the question they must all ultimately answer, he believes. “The issue is volatility, not what the long-term trend is. Hedging doesn’t reverse the long-term trend; it helps to smooth the jolts along the way. You have to decide if hedging is something you believe in or not.”
Some companies will feel they need as much protection as possible; others will take the view that currency swings are part of being a long-term international enterprise and that currency volatility tends to even itself out in the long run. But whatever their view, CFOs of multinational companies will need to continue focusing on the twin challenges of managing currency risk and ensuring that they are communicating their approach to this complex, multifaceted problem as clearly as possible.
Companies have a variety of tools available to help them manage currency risk, but they can never escape the effects of volatile exchange rates entirely. The key is to keep reassessing whether they have the best mix of measures to address their particular exposure, and to redouble their efforts to help investors understand the hedging philosophy they are acting upon and the reasons underpinning that philosophy.
