Inflation has caught many companies off guard but it’s not too late to devise a hedging strategy or revisit the one you have to manage price volatility, Chatham Financial Managing Partner Amol Dhargalkar told CFO Dive.
“The V-shaped recovery that people were talking about [during the pandemic] didn’t quite take place in 2020 nearly to the degree that we saw at the beginning of 2021 as vaccinations took root,” said Dhargalkar, whose firm helps companies devise hedging programs and calculate the price of derivative instruments. “So, companies didn’t hedge a year ago, based on our experience, whereas today that’s a much higher priority and we’re having just so many conversations right now.”
The kind of risk you need to hedge against depends on the industry you’re in. Manufacturers are seeing increases in oil, metal and commodity prices, so they need to devise a plan for insuring against future increases in these areas if they don’t already have one.
This type of hedging tends to involve futures or options contract purchases, transactions complicated by the need to determine the market price and the markup that’s being hedged against.
“It’s trying to understand the bank’s cost of offering this product and a reasonable markup for my firm, my situation, my credit,” he said. “That’s particularly difficult because, unlike exchange traded derivatives, these tend to be customized products, traded on credit. Because you don’t post cash collateral, your counter-party is taking risk from the company that could default, go bankrupt.”
There are few options for companies wanting to get a handle on contract pricing other than working with consultants who have access to market data, unless they want to hire a banker to work for them or try to work collaboratively with other companies.
“If you hire a former banker onto your team that used to sell these products, he or she might have knowledge that could help benchmarking pricing,” he said. “If you could get together with your competitors and compare pricing that would be ideal but that, of course, is frowned upon and highly unlikely to occur.”
Cloud software risks
Cloud-based software companies, even though they don’t face the commodity or other input risks of a manufacturing company, need their own strategy to hedge against exchange rate or interest-rate risks.
The need to hedge is the case if they sell in multiple countries because of volatility in currency rates, but even if they only sell in the country they’re based in, say the United States, they might still need to hedge if they have development operations in another country.
“You could have a portion of your development costs denominated in a different currency,” he said. “It could be that you’re a cloud-based multinational where revenues are being denominated in a number of different currencies, based on your customer base.”
The good thing about exchange-rate risk is it tends to be more transparent than commodity price risk, but even here, knowing how to price derivative contracts and their markup can be difficult.
There tends to be two types of currency hedging risks, he said. There’s a short-term risk that involves receivables and payables, since those tend to operate on 30- or 60-day timeframes, and a long-term risk, sometimes called cash flow risk, that involves projected revenues and expenses, or the net of those two, over one or several quarters.
“If you look at most public technology companies that provide some form of cloud services, it would not be hard to find in their financials they’re doing some form of currency hedging,” he said.
Almost as important as the strategy is how you communicate it to investors, Dhargalkar said. The last thing you want to do is spend time on earnings or investor calls explaining why your balance sheet looks the way it does because of your hedges.
“If your program is small and your company is big, you can do things without having to explain them too much to investors, because it takes a very tiny portion of your financial results and line items,” he said. But if the programs are material, “you don’t want investors to look at your derivatives and start worrying, is this company doing the right thing?”
Finance teams generally have two ways to account for their programs in their financials, what Dhargalkar called an easy way and a hard way for the accounting team.
The easy way is to show the volatility as it’s happening, whether that involves exchange rates or commodity prices, and not show the impact of the hedge until it happens, even if that’s a year or so down the road.
“In the general accounting treatment, you mark these derivatives, these transactions, to market, but you don’t mark your exposures to market,” he said. “You don’t pull that forward in your financials today but your hedge does get pulled forward.”
This can make financials look negative if investors don’t understand what’s going on, and for that reason it can require a lot of explaining on calls.
“You explain to investors, ‘Trust us. We know what we’re doing. We’re hedging against this price that we’re worried about increasing a year from now,’” he said.
The other approach removes the negative-looking volatility from the financials by enabling the finance team to show, or “leak,” that volatility only when the hedging impact actually occurs, say a year down the road.
“That volatility stays on your balance sheet, not on your income statement, and then [a year later], when those sales occur, you take that volatility and you apply it to that month,” he said. “From an investor standpoint, the presentation is much easier to understand. It aligns accounting and economics.”
This second path is more challenging, though, because the accounting rules that apply to it are specialized and complex.
“There’s a 900-page book,” he said, “and all of this nuance associated with how you do it has been updated a few times.”
This second path, he said, “is the easy path for the CEO and the hard path for treasury and finance and accounting and procurement.”
This difficulty is a tactical, not a strategic, consideration. More important from a strategic perspective is simply deciding what type of hedging you need to do, and when to do it. Those are the questions the C-suite needs to be answering now as they try to understand what prices are rising in this new inflationary environment: Commodities? Oil? Metals? Interest rates? Exchange rates?
In looking at these strategic considerations, leaders should bring in internal company specialists from a wide range of function areas, not just treasury, because hedging programs can impact function areas that are hard to see unless you have everyone in the room.
“It can be challenging if you start a program and then later on the tax department comes and says, ‘Did you realize you just violated, like, three things that we were never supposed to violate?’” he said. “‘Now we’re going to have to start paying taxes in this country, because now there are some unrealized gains that we have to pay at the statutory tax rate.’”
Dhargalkar Suggests that, in addition to treasury and procurement, you should have tax and other function areas in planning meetings, including audit. Audit should be there to take a quick look at the program to ensure it’s compliant with accounting rules.
Otherwise, he said, “you could end up in a situation where, at the year-end audit, your auditor comes back and says. ‘You didn’t do that correctly; we’re going to ask you to redo it.’ Or, a few years later, some new auditor comes in and says, ‘You haven’t been doing this right for the last two or three years; we’re going to have you restate because it’s such a material component.’”
The alternative to doing the hard work required in a hedging program is to simply pass on price increase to customers, but that could backfire on you. If your competitors have hedged costs, they’ll be able to keep prices down, taking away market share from you, or they could match your higher prices and, thanks to their hedging, improve their margins.
“You’re actually giving your competitor margin that they could use in a variety of ways, including reinvesting in the business,” he said. “So, pricing power is great if you're a company that has it, but you have to think a little deeply about whether it makes sense to exercise that pricing power or not, and that's a C-suite type conversation.”