Published: September 01, 2012
Brown-Forman has experienced dramatic expansion in recent years, fuelled by the growing domestic and international popularity of brands such as Jack Daniel’s, Southern Comfort, and Finlandia Vodka, to name a few. For example, in 2002, around 23% of our revenues were generated outside of the United States. Today, this figure is around 58%, with growing market share in both Europe and other parts of the world, particularly Mexico, Australia and Turkey. We have embarked on an ambitious strategy to continue expanding both the Jack Daniel’s family of brands and the rest of our portfolio internationally, as well as consolidating our market leadership position in the United States. To successfully achieve these objectives, we have identified a number of both developed markets, such as the United Kingdom, Australia, Germany, France and Spain, and emerging economies such as Poland, Mexico, Russia, China, Brazil and India as target growth regions for the future. To facilitate this continued expansion, and avoid the negative impact of increased exposure to foreign currency volatility, we needed to put in place an efficient and robust forecasting and FX hedging process.
Over recent years, we have evolved our forecasting process to enable greater visibility over exposures. We implemented the final component of SAP’s Corporate Finance Module (our treasury workstation) in 2004, which has helped enormously in bringing together FX exposures from across the group, based on budget information input by business units. Although we have grown through both M&A and organic expansion, we have maintained a highly centralised infrastructure, including a single instance of SAP globally, which ensures the completeness and consistency of forecast information. Furthermore, we are able to record transactions and perform hedge accounting in SAP, which provides a highly integrated process and takes away much of the manual effort that would otherwise be required. In addition, we continue to assume hedge effectiveness via ’critical terms match’ provision for hedge accounting as opposed to performing hedge effectiveness testing, although this capability exists in SAP.
Our hedging approach has also changed significantly. We are principally an exporter, and unlike some of our competitors, that are often able to distribute production to other regions, we do not have substantial natural hedges, as many of our major brands such as Jack Daniel’s are produced in the United States. In the past, we made hedging decisions each year at budget time, so in one year we might hedge a majority of an exposure, but not the same percentage the following year. Additionally, we would put on all of our coverage for our fiscal year over a couple of months period of time to hedge to the budget rate, resulting in a ‘cliff’ effect in our hedging the following year. We therefore wanted to find a way to protect the business against significant currency volatility within an acceptable risk tolerance and cost of hedging. We worked with Barclays, one of our partner banks, to formulate a new FX hedging strategy, and performed a historic analysis of our performance had the proposed new FX strategy been in place. This was a valuable process by enabling us to validate a new approach and improve confidence with less risk.[[[PAGE]]]
Consequently, to fulfill our hedge objectives, we implemented a new strategy that effectively extended the tenor of our hedge transactions whilst reducing the percentage of the total exposure hedged. This strategy involves cash flow hedging across the business, with 50% hedging of our rolling 12 month exposures, and a flat 20% hedge for our rolling 13-24 month exposures, although we hedge our intercompany funding at 100%. This removes the ‘cliff’ effect we experienced before, and enables a more consistent and transparent approach to hedging, without exceeding our overall appetite for FX risk. We typically use FX forwards for hedging, but we have some latitude over our choice of instruments, so we also use zero-cost collars. We review and report our FX exposure hedging and cost twice each month, and make recommendations to our CFO annually or as appropriate in the event of a significant market event or a change to the cost or effectiveness of our hedging strategy and the instruments used to execute it.
Since implementing a new approach to FX hedging, we have reduced the impact of year- on-year FX volatility considerably and smoothed our risk profile, as opposed to experiencing the ‘cliff’ effect to which we were subject before. While we used to hedge at the budget rate on an annual basis, which is an approach commonly employed by corporate treasurers, our hedging strategy now better addresses the FX year-on-year volatility, and avoids the risk of inadvertently creating additional volatility.
Based on our experience of revising our approach to FX hedging, we would recommend that treasurers need a detailed understanding of the company’s overall risk profile and risk tolerance. This requires both the right technology and information to capture the group’s exposures globally and make informed decisions, as well as clear direction from the board in terms of the company’s risk appetite. By establishing a comprehensive global view of risk, treasurers can then identify and take advantage of natural hedges, avoiding the risk of ‘over-hedging’ which frequently occurs if risk management takes place on a decentralised basis. Extending the tenor of hedges reduces year-on-year volatility, although by reducing the percentage of exposures that are hedged, treasurers need to accept greater volatility within the year. Finally, ensuring hedge accounting treatment is achieved is important to further reduce earnings-per-share (EPS) volatility.
Looking ahead, we continue to review and refine our risk management approach, particularly as market events continue to be unpredictable and unprecedented. We continue to look carefully at our euro risk as the crisis continues to unfold, and will both anticipate and respond to changing risk as necessary. We are also conscious that as we continue to expand, the relative risk to our business of FX volatility, and the range of currencies to which we are exposed is increasing, so we may choose to adjust our hedge percentage in some situations. Furthermore, by expanding our activities in emerging markets, particularly in Asia, we need to find ways to manage the effects of currency controls, regulatory restrictions, reporting requirements, and cultural, language and timezone issues. However, we are confident that we have a robust forecasting and hedging framework in place that will enable us to work through these challenges and continue to manage FX volatility.
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