In a state of flux
With globalization, opportunities and strategies exist for U.S. companies to take advantage of changes in the value of money
By Staff -- Manufacturing Business Technology, 11/1/2005 12:00:00 AM
Recent fluctuations in the value of the U.S. dollar in global currency markets represent a classic good news/bad news scenario for manufacturers. On the one hand, when the dollar falls, products made in the U.S. become more price-competitive, particularly in emerging markets like China. On the other, U.S. manufacturers may find raw materials and components from overseas suppliers more expensive.
Currency turbulence also may put long-term contracts and existing agreements at risk, since the terms of deals may become less attractive over time. This is so because a contract often is based on the future price of an asset, entailing significant uncertainty about its value.
To reduce these uncertainties, there are methods to combine futures, options, and assets in portfolios that make the contract relatively risk-free. These methods are called hedging.
The stakes are high. Industry and financial analysts agree: any manufacturers doing business overseas—or any company that deals in multiple currencies—has some risk exposure. And there is consensus that it takes only one bad experience—i.e., one deal that takes a hit on margins because of changes in exchange rates—before even small companies realize they need to protect themselves through hedging.
No matter how large the business or convoluted the cash-flow situation, there are several practical steps that can be taken to reduce risk. There also are opportunities and strategies that take advantage of currency shifts.
How to proceed
Contracts are a good place to start. Manufacturers can work directly with customers or suppliers to set sale or purchase prices and payment terms at today's rate, or no worse than today's rate. Or, contract terms can be manipulated to accelerate or defer payments based on rate moves. These private agreements are good for deals involving capital goods, and preferred customers or familiar parties.
"The idea is to lock in rates at today's levels, and if they improve, the buying organization typically receives more favorable rates at some percentage of the gain," says Jeff Pikulik, manufacturing and supply chain analyst with Boston-based AberdeenGroup.
Manufacturers that would rather work through their banks can safeguard individual deals by entering into simple hedging contracts on forward transactions. Widely available through commercial financial institutions, "forwards" can be used to protect specific amounts for an established period of time—from as little as a few business days to six months or more.
According to Joe Areddy, VP of foreign exchange, Fifth Third Bank, "Forwards are very basic, but very useful, even for million-dollar-plus transactions. Basically, they take the guesswork out of the exchange-rate equation."
There are several types of forwards, including single-dated forward contracts, which are tied to specific dates in the future; and window-forward contracts that offer fixed rates across a certain time period.
More complex than forwards, options give companies the right to purchase quantities of a foreign currency by a certain date, but don't oblige them to. Options are speculative and better suited to companies that think currency swings might work in their favor and are willing to accept more risk. Fees for options are based on several variables, including strike prices and expiry dates. In general, the longer the time frame, the more expensive the option.
"Options can work like insurance policies," says Areddy. "You pay a premium to protect yourself, but you may never use the policy."
Navigating the choices
"When it comes to currency strategies, cash-healthy companies have one set of options, and cash-constrained companies have another," Pikulik explains. For instance, cash-sound companies may be able to extend credit through their banks to customers and suppliers that might not otherwise have access to it. "This can be very helpful in deals with businesses in countries where the banking laws are opportunistic," he adds. "You get umbrella protection from financing sources for purchases of components or semifinished goods."
Pikulik is careful to point out these strategies offer risk protection for fluctuations in currency, not necessarily risk protection from a business-model perspective.
Cash-constrained companies are more likely to use spot contracts, secure price points, or sliding-scale commitments that link purchases of specific currency amounts to a range of product amount. They also can borrow money now to buy in the future.
Which tools and strategies work best will depend on a company's size, cash flow, flexibility, customer base and risk tolerance, as well as the size of the deal. Many companies combine hedging vehicles.
Some examples
Ontario-based Canadian General-Tower(CGT), which makes the seating fabrics, door and instrument panels, and other interior trim products for approximately 85 percent of cars and light trucks in North America, mixes forwards with "a natural hedge." The company was faced with currency shifts and significant swings in the cost of raw materials. Handling more than 90 percent of revenue and raw material purchases in U.S. dollars gave CGT a natural hedge, but the company wanted to do more, according to Mike Spence, CFO.
"We use both flat forwards and reverse knock-in forwards on a 12-month rolling cycle," says Spence. Knock-in forwards hedge CGT's risk immediately, while giving it the opportunity to gain from favorable shifts in exchange rates. "We give a little on the downside to have some play on the upside," he adds.
Purafil, a $50-million manufacturer of gas-phase air-filtration systems based in Doraville, Ga., takes a different approach.
"We pay very close attention to currency fluctuation, but the bottom line is, we trade in dollars," says President David Nicholas. "Because we do business in 60 countries, we would need a full-time currency trader to keep up. With a company of our size, that's just not realistic."
To protect itself, Purafil sells through brokers or independent manufacturers' representatives, which Purafil trusts to diffuse risk at the local level. Purafil also uses currency fluctuations to adjust prices or extend terms, especially on large capital projects that may start up to a year after bidding.
Purafil's broad approach has been effective so far, according to Nicholas, though the company's European subsidiary has been exerting some pressure to deal in the euro. "We see currency risk as a cost of business that has to be placed somewhere in the supply chain," says Nicholas. "Typically we place it with the local banks in the areas we do business."
Managing commodity risk
Most of the aforementioned strategies are appropriate for capital-goods transactions. Manufacturers also can implement a number of risk-management strategies when buying commodities from overseas, the price of which can be affected by currency shifts, among other factors. For instance, some companies use escrow accounts to reduce the impact of surcharges for fuel, steel, or other commodities.
"Buying in volume through brokers can insulate companies from the big risks, like those that occurred in the late '90s Asian currency crises," says Pikulik. "Brokers offer another layer of protection, which can be valuable if you're doing business in new, unfamiliar markets."
Brokers have an added benefit: because they can consolidate orders, they can sometimes help smaller companies access volume discounts for materials.
Technology is part of the solution. And it may be the case that a manufacturer's current IT portfolio already holds tools that can be used to understand risk and how much hedging may be needed.
Many ERP packages, especially those that originated in Europe, offer support for multiple currency accounting. Advanced business intelligence and analytics tools also are becoming more popular as they help manufacturers with everything from compliance with procurement regulations to sales & operations planning.
"With raw materials skyrocketing and ongoing currency turbulence, visibility into overall spend, cash flow, and accounts receivables is key for both controllers and CFOs," says Nima Bakhtiary, an automotive industry specialist with IT integration services provider Unisys. "It can lead to better purchasing decisions—like whether or not to lock in prices on commodities—and diversification of cash holdings to reduce risk more broadly."
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