Adventure & Recreation Technologies, Inc.
Foreign Exchange Exposure, Foreign Currency Debt, and Currency Swaps
Sitting behind his desk, Ben Nunnally told Anna Martin:
At last week’s corporate board meeting, there was a discussion on the economic situation in Europe. One board member said that he had read that two major banks were predicting a substantially lower euro (versus the US dollar) by year’s end, from today’s spot FX rate of 1.333 $/€ (in February 2013) to 1.20 $/€ by the end of 2013. Another asked me how I thought a depreciation of the euro might affect the company’s future cash flows and stock value.
The meeting between Nunnally and Martin was taking place in early March 2013 in Nunnally’s office at Adventure & Recreation Technologies, Inc. (ART), in Boise, Idaho. Nunnally, who had been ART’s Chief Financial Officer and Treasurer since before the company went public in the 1980s, added:
I told them that because roughly 20% of the company’s revenues are in euros, both future cash flows and the stock value would likely drop; the amount of the drop would naturally depend on how far the euro depreciates. How is that for sounding informed while stating the obvious?
Nunnally also told Martin, “I promised to study the question and provide a more thorough answer at the next board meeting, and that’s where you come in.”
Martin had been an assistant treasurer with the company for five years. Nunnally asked Martin to take a thorough look at ART’s FX exposure to the euro and report back. Martin had taken a course in international corporate finance at Michigan State University, and had enjoyed the course. She told Nunnally that she would get back to him as soon as possible with an analysis.
Adventure & Recreation Technologies, Inc.
Adventure & Recreation Technologies was founded in 1973 by outdoorsman Rick Zuber to produce plastic watercraft, mainly canoes and kayaks. In the 1980s, ART bought Divemaster Company from its founders, Reinhold “Reiny” Lamb and the legendary Navy “frogman” Carmelo Giaccotto. Divemaster manufactures the most technologically advanced scuba diving equipment in the world, having developed the dive computer that had become the industry standard. Divemaster’s headquarters are in the United States, but the company’s renowned research center, where the dive computer was developed, is in Italy. A significant portion of Divemaster’s sales and production are also in Europe. In 2006, ART acquired a marine sonar business, Houston Marine Electronics (HME). ART’s strategy across its three business segments is to use sophisticated research and cutting-edge technology to create the world’s best-known brands of outdoor recreational products.
ART’s consolidated revenue for FY 2012 was around $300 million, with roughly $150 million from Divemaster, $100 million from HME, and $50 million from the watercraft business. ART’s overall operating cash flow in FY 2012 was about $40 million. In the previous five years, ART substantially reduced its long-term debt, to $10 million by the end of FY 2012. In February 2013, ART held $60 million in cash, for a net debt position of −$50 million. The securities held in the cash account were mainly denominated in US dollars.
ART’s shares trade on the Nasdaq. In February 2013, ART’s share price fluctuated around $22, and total equity market capitalization was about $250 million. Historically, the share price rose from about $10 in 2000 to about $25 in 2007, but then plunged to a low of $6 in March 2009 before gradually rising to around $22 by March 2013.
ART’s FX Operating Exposure to the Euro
ART’s marine electronics and watercraft businesses have no FX exposure to the euro, but Divemaster does. In FY 2012, $60 million of Divemaster’s $150 million in revenues were generated in the Eurozone, in euros. The other $90 million in revenues were mainly generated in the United States, in US dollars. The scuba equipment sold in the Eurozone is manufactured in Europe, whereas the equipment sold in the United States is manufactured in Malaysia.
Martin looked first at the $60 million in euro revenues from Divemaster’s sales in Europe. She understood the conversion impact of FX changes: if Divemaster were to generate the same revenues in euros in FY 2013 as in FY 2012, and if the euro were to depreciate by 10% versus the US dollar, the FY 2013 euro revenues would convert to an amount in US dollars that would be 10% lower than $60 million, or only $54 million.
Martin called the Divemaster CFO, Alain Krapl, to see if he had any additional insights. Krapl told her that he thought there was more to the story, because in addition to the conversion effect, there is an economic effect. He told her that in the past, when the euro appreciates, Divemaster’s equipment sales volume in Europe tends to rise, and so the revenues in euros rise. By the same token, when the euro depreciates, Divemaster’s equipment sales in Europe tends to drop, and so the revenues in euros drop. Krapl said that he thought the FX rate tended to reflect the fortunes of the European economy. He added:
I think that Divemaster’s euro revenues have tended to change by roughly 20% of a given FX rate change, in the same direction. So, if the euro were to appreciate (depreciate) by 10%, my best guess is that the Eurozone revenues (in euros) would rise (drop) by 2%.
Combining the conversion and economic effects, Martin estimated that in US dollars, Divemaster’s Eurozone revenues would drop by roughly 12%, or by $7.2 million, to $52.8 million, if the euro were to depreciate by 10% in FY 2013.
Variable costs for the Eurozone diving equipment sales were approximately 40% of revenues in FY 2012. Changes in variable operating costs would track the changes in revenues. That is, if the euro were to depreciate by 10% versus the US dollar in FY 2013, Divemaster’s Eurozone variable operating costs would drop by 12%, when viewed in US dollars, just like the Eurozone revenues. Specifically, Martin estimated that the drop would be from $24 million to $21.12 million.
The indirect operating costs for Divemaster’s Eurozone sales, mainly sales and marketing expenses, were €12 million in FY 2012. At the spot FX rate in late February 2013, 1.333 $/€, €12 million was equivalent to $16 million. The sales and marketing budget is a fixed operating cost, and does not depend on sales volume. So, in US dollars, the indirect costs of the Eurozone sales would drop (rise) by 10% if the euro were to depreciate (appreciate) by 10% versus the US dollar.
In addition, Divemaster’s research is conducted entirely at the large facility in Italy. The FY 2012 research budget was €12 million, equivalent to $16 million at the spot FX rate of 1.333 $/€. Since the research budget does not depend on sales volume, the research expenses are fixed operating costs and would change by the same percentage as the euro, when the research expenses are measured in US dollars.
Martin’s “what if” analysis resulted in an estimate of 0.28 for ART’s FX operating exposure to the euro. The interpretation of the estimate is that for a 10% depreciation of the euro versus the US dollar, ART’s operating cash flow (in US dollars) would likely drop by 2.8%. Martin was a bit surprised to find the relatively low estimate of ART’s FX operating exposure to the euro, given the sizable revenues in euros, but after she thought about it, she realized that the Divemaster’s substantial research program in Italy, the costs of which are incurred in euros, serves as an operational hedge. (Q1)
ART’s FX Equity Exposure to the Euro
Martin turned her attention to an analysis of how an unexpected change in the FX price of the euro versus the US dollar might affect ART’s equity value. ART’s total equity market capitalization was $250 million in late February 2013. Since ART’s net debt position was −$50 million, Martin reasoned that the market’s estimate of ART’s business value was $200 million. Martin believed that ART’s shares were about correctly valued at that time.
Martin recalled that the professor for her international finance course at Michigan State University had stressed that many economists believe that spot FX rates follow a “random walk.” This idea implies that if the euro depreciates by 10%, from 1.333 $/€ to 1.20 $/€, the best guess for the subsequent future spot FX rate would then be 1.20 $/€. With the random walk approach, if the euro were to depreciate by 10%, and thus ART’s operating cash flow was lower in 2013 than in 2012 by 2.80%, the expectation of all of ART’s future operating cash flows would be 2.80% lower, and so ART’s business value would likewise drop by 2.80%. That is, the FX business exposure is the same as the firm’s FX operating exposure. Martin calculated an estimate of 0.224 for ART’s FX equity exposure to the euro. (Q2)
Martin next did a different sort of analysis of ART’s FX equity exposure to the euro. The idea had been introduced in her international finance course. Using five years of recent data, she estimated ART’s FX equity exposure statistically, using a simple Excel regression of ART’s monthly stock returns (dependent variable) on percentage changes in the FX rate for the euro (independent variable). The result was an extremely high estimate of FX equity exposure, 1.40. The interpretation of the estimate is that a 10% depreciation in the euro would be associated with an unexpected equity return of −14%. This finding was significantly different than the FX equity exposure estimate of 0.224 she had obtained through her “what if” analysis. Martin added the finding to her report, anticipating some discussion.
Financial Hedging
Martin finished the analysis and forwarded her report to Nunnally. When the two met again, Nunnally thanked Martin, saying that she had done an excellent job with her analysis. Nunnally pointed out that even though the “what if” analysis suggested a relatively small FX exposure to the euro, any reduction in cash flow volatility and stock value volatility would be beneficial for ART. He asked Martin for her thoughts on what, if anything, ART might do about the FX exposure to the euro. Martin responded that she did not think a forward FX position was the way to go, because the need was to hedge the FX exposure in both ongoing cash flows and business value. She suggested having euro-denominated debt, and proposed the number $56 million, based on her “what if” estimate of FX business exposure. (Q3)
Nunnally told Martin:
I agree that a forward FX position does not work in this situation, whereas euro debt would be appropriate, in principle. However, $56 million in euro debt seems like a lot. I cannot argue with your ‘what if’ analysis of the near-term FX operating exposure, but I am less confident in the long-term FX business exposure estimate based on the random walk idea. On the other hand, the recent bank forecasts that the euro is likely to drop over the next year suggests the euro may be overvalued…that would support a higher level of financial hedging. (Q4)
Nunnally added that a secondary benefit of the euro debt would be to reduce some of the volatility of the book value of ART’s equity. Since the book value of ART’s net investment in the Eurozone facility in Italy was about $45 million, ART had ongoing volatility in the book value of its equity due to FX translation gains and losses. “Some analysts like to look at ratios like return on book equity, so it may be beneficial to stabilize equity book value as much as possible,” Nunnally said. (Q5)
“However,” Nunnally told Martin,
I am opposed to putting debt back onto ART’s balance sheet, given all we have done over the past several years to reduce the company’s debt level. But we could accomplish the same objective with a currency swap. Both the economic and accounting implications of a currency swap are the same as euro debt, but the transaction is off-balance sheet. (Q6)
Switching to the statistical analysis, Nunnally told Martin: “Your statistical estimates are really high compared to the estimates of the ‘what if’ analysis.” Nunnally had looked at recent charts for both ART’s stock price and the euro. Both had plummeted during the global financial crisis of 2008, and both had bounced back in the recovery. He told Martin:
Your regression picked up a strong connection between our stock return and the euro, but I don’t think the analysis is really measuring FX equity exposure in the sense of being the response of stock value to a change in the euro. Instead, I think both our share price and the euro moved together in response to the changes in the overall economic conditions. But this connection, and the tough time the company went through during the financial crisis of 2008, has made me wonder about the following tactic. Why not financially hedge euro movements as a way of indirectly hedging economic conditions? (Q7)
Nunnally then told Martin that he wanted to be prepared in case he was asked about ART’s FX exposure to the Malaysian ringgit. He asked Martin to estimate ART’s FX business exposure to the Malaysian ringgit. He also asked her for suggestions on how the FX exposure to the ringgit might be managed. (Q8–Q10)
Questions
1. Show how Martin arrived at her “what if” estimate of 0.28 for ART’s FX operating exposure to the euro.
2. (a) Verify Martin’s “what if” estimate of 0.224 for ART’s FX equity exposure to the euro. (b) For a 10% “what if” deprecation of the euro versus the US dollar, compare the change in ART’s intrinsic equity value with the change in the equity book value, assuming the functional currency of the Eurozone operations is the euro. (c) Is the change in equity book value reflected in ART’s current earnings? Recall that ART’s net investment in Eurozone operations is $45 million.
3. Show how Martin arrived at the estimate that $56 million in euro debt would eliminate ART’s FX equity exposure to the euro, given the “what if” estimate of FX business exposure.
4. Assume that the forecast were for the euro to appreciate versus the US dollar. Qualitatively, how might this forecast affect the financial hedging decision?
5. Discuss the issue of the volatility of ART’s equity book value and the volatility of periodic reported earnings: (a) if ART does not hedge with euro debt versus (b) if ART hedges with $56 million of euro debt.
6. Describe and discuss the pros and cons of using a currency swap position to hedge ART’s FX business exposure. What are the accounting implications if ART’s currency swap position eliminates the FX equity exposure to the euro?
7. (a) Unlever the statistical FX equity exposure estimate of 1.40 to find an estimate of ART’s FX business exposure to the euro (and possibly ART’s exposure to general economic conditions). (b) What swap notional swap principal in US dollars) would hedge the FX exposure? (c) Discuss the use of a currency swap position to hedge economic conditions. (d) (Optional) With data in the Appendix, use Excel to verify Martin’s statistical estimate of 1.40 for ART’s FX equity exposure to the euro.
8. Use the “what if” approach to estimate ART’s FX operating exposure to the Malaysian ringgit. Assume: (a) Divemaster’s non-Eurozone sales are in the United States and are expected to be $90 million in FY 2013. (b) The manufacturing costs of Divemaster’s U.S. equipment sales are incurred in ringgits. (c) At the present spot FX rate between US dollars and Malaysian ringgits, the Malaysian manufacturing costs are 40% of U.S. revenues. (d) The remaining operating costs of Divemaster’s U.S. sales are in US dollars and are 25% of U.S. revenues. Assume no FX economic exposure in the U.S. portion of Divemaster’s revenues.
9. (a) Assume that ART’s FX business exposure to the ringgit is equal to the FX operating exposure. Use a “what if” analysis to estimate ART’s FX equity exposure to the ringgit. (b) ART’s net investment in the Malaysian plant, measured in US dollars, is presently $70 million. The functional currency is the ringgit. For a 10% “what if” deprecation of the ringgit versus the US dollar, compare the change in ART’s intrinsic equity value with the change in the equity book value.
10. Assume that ART’s FX business exposure to the ringgit is equal to the FX operating exposure. Discuss some ways in which the FX business exposure can be managed. Include in the analysis the accounting implications if the book value of ART’s net investment in the Malaysian plant, measured in US dollars, is presently $70 million, and the functional currency is the ringgit.