• commodity risk
  • Hedging

Corporates face pricing vs hedging dilemma

by Nicholas Dunbar

Published: 6 December 2018

The strengthening of the US dollar against other currencies, and the recent spike in oil and other commodity prices, is proving a challenge for companies that buy inputs in dollars and sell products in emerging markets. The FX and commodity volatility has played havoc with the core treasury function of cash flow forecasting, leaving CFOs scrambling to explain to investors as earnings come under pressure.

“In less than the three months since our last earnings release, the foreign exchange headwind on earnings increased by $400 million after tax, $900 million in total for the fiscal year”, said Jon Moeller, CFO of Procter & Gamble on a 19 October analyst call. “Commodity costs are expected to be $400 million headwind. Crude oil, a key feedstock for many raw materials is up more than 50% than this time last year”.

Knowing that they will be punished for missing analyst estimates, CFOs face a dilemma. They can pass increased commodity costs or adverse FX rates directly to customers by raising the prices of their goods – but risk losing market share to better-placed competitors. Or they can attempt to keep prices stable by locking input costs with hedging contracts. But this strategy isn’t always successful.

Abbott Laboratories, a US healthcare giant that sells diagnostic equipment and nutrition products across many emerging markets, sums up the pro-hedging argument. “If you could predict currency for the whole year or beyond, it would be one thing, but we can’t” said Miles White, CEO of Abbott on a 17 October investor call. “And so, we take a lot of different actions to mitigate the volatility of it or the impact of it”.

Abbot’s net sales were $27.4 billion in 2017, with 40% in emerging markets. The company reporting having notional FX hedges at the end of 2017 totalling $23.4 billion, amounting to 130% of its non-US sales. These hedges were reduced to $19.2 billion at the end of September 2018.

“We’ve got a very sophisticated, and frankly, complex rolling hedging program on the currencies that we can hedge”, noted White. “So, we take out a lot of the unpredictability with that. We’re trying to be able to make our earnings and our sales more predictable, more stable, more reliable, in terms of what our investors want to see, and frankly, impact on us, so we can plan and manage”.

Abbott reported that its $1.7 billion of net earnings for this nine-month period were reduced by $1.2 billion of currency translation adjustments with only $120 million of gains on cash flow hedges. That suggests its hedging programme was not as effective as the company hoped. Abbott declined to comment further.

P&G, meanwhile, earned 56% of its $16.9 billion annual sales outside the US, and had notional FX cash flow hedges of $8 billion at the end of September, or 84% of non-US sales. The consumer goods giant doesn’t hedge its commodity exposure at all, and is being forced to increase pricing to offset a $1.3 billion hit to revenues. “As commodity prices and foreign exchange rates move, we will take pricing when the degree of cost impact warrants it and competitive realities allow it”, Moeller told analysts.

Towards the other end of the scale, paper products maker Kimberley-Clark hedged just 26% of its $9.1 billion non-US 2017 sales according to filings. In the last nine months, a third of its net income has been whittled away by currency translation adjustments. “We are responding by aggressively managing our business up and down the P&L”, commented CFO Maria Henry on a 22 October earnings call. “Our commodity inflation outlook is a bit higher on average, and so, as a result our teams are further reducing cost and raising selling prices.”

US consumer products giant Colgate-Palmolive goes even further. The company hedged a mere 7% of its $11.5 billion non-US annual revenues this year. The ability to re-price in local markets kept Colgate’s FX translation impact to just 13% of the last nine months net income. That strategy worked less well when it came to commodities however, not just in the cost of raw materials but the increased logistics cost of shipping soap and toothpaste to the myriad markets in which Colgate operates.

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“We tend to be light on hedging”, said Colgate CEO Ian Cook said on a 26 October call, as analysts probed the reason for the 3% decline in net sales. “We rely on our ability to price when we need to as the only logical and available offset to cost pressures”.

One company that has been more effective in managing this year’s volatility is Dutch technology company Philips. The company hedged €2.4 billion or 64% of its foreign revenues in 2017, and by the end of the third quarter in 2018 reported a currency translation impact of just 0.6% of revenues – despite not having hedged the most volatile emerging market currencies at the start of the year.

“If you compare the FX impacts we’ve had with competitors it has been significantly lower”, Philips CFO Abhijit Bhattacharya said on a 22 October call. “We do not hedge most of the emerging market currencies simply because the cost of carry is too high and therefore it doesn’t make sense.”

However, Philips’ treasury team was nimble enough to have spotted an opportunity in the FX market. “For a couple of emerging markets currencies, given the increased volatility the cost of carry has not moved as much as the increase in volatility”, Bhattacharya explained. “So on those currencies we can also take certain shorter term hedging measures”.