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Merck and Hermès, can we reverse engineer the foreign exchange management strategies of these two European and very successful companies with a global footprint? The answer is yes, but it's going to require a good dose of German discipline and French savoir-faire. Welcome to CurrencyCast! My name is Agustin Mackinlay, I'm the Senior Financial Writer at Kantox and your host.
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In this episode, we untangle the foreign exchange risk management strategies at Merck, the well-known pharmaceutical company, and Hermès, one of the leading firms in the high-end luxury sector. A quick glance at the market capitalisation of Merck and Hermès is enough to highlight their success. As of early July 2024, the market capitalisation of Merck, not to be confused with Merck&Co, the American firm, stands at about $66 billion. And at $236 billion the market capitalisation of Hermès puts it in position #45 in a global ranking of the most valuable companies, according to their market capitalisation.
00;01;15;23 - 00;01;46;04
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Now, needless to say, the success of both firms depends on, in a large measure, the talented team of scientists at Merck and the equally talented group of designers, artists and craftspeople over at Hermès. So at first sight, it could be puzzling to see why we would discuss two companies that operate in such different sectors. But there is a common theme in both cases,
00;01;46;07 - 00;02;15;29
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the Finance team. Thanks to its foreign exchange risk management, has made an important contribution to the success of the companies. And thus, keep in mind these are not stories with a beginning, a middle and an end. On the contrary, these are ongoing, open-ended situations from which we can learn a lot and they can learn a lot. One reason we decided to focus on Merck is the availability of information regarding its foreign exchange risk management program.
00;02;16;01 - 00;02;45;16
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As we can see from the recently published management of financial risk guidelines, Merck applies the full gamut of FX management programs. So let me highlight the following five points. #1 systematic hedging. Speculation is strictly prohibited, and there is a separation of powers of source going on as the functions of trading, settlement and control are strictly separated from each other.
00;02;45;18 - 00;03;25;10
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#2 balance sheet hedging. All FX-denominated accounts receivable and payables are hedged in full and the company does that to remove the accounting impact of foreign exchange gains and losses from the P&L. #3 cash flow hedging programs. There is a layered hedging program in place as the company hedges 12 months in advance of forecasted foreign exchange-denominated revenues and expenditures. Starts at a hedge ratio of 25%, and the program ends at a hedge ratio between 40% and 90%.
00;03;25;16 - 00;03;56;13
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#5 firm commitments. All those firm sales orders, or firm purchases or sales, are also hedged. And for how we see that may play out in combination with a previous point. Finally, credit risk management, the company pays special attention to reducing the credit risk in accounts receivable. As we know at Kantox, selling in the currency of your customers and taking ownership of the corresponding FX
00;03;56;13 - 00;04;24;12
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risk management process is a way to reduce the credit risk in your accounts receivable. Because we are not privy to any specific information regarding Merck's foreign exchange hedging program, we can try and reverse engineer it with the available information. So here's a possibility, the finance team at Merck applies what we call it talks a combination of hedging programs, and it could work like this:
00;04;24;14 - 00;05;05;14
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First, a layered hedging program is in place and starting 12 months in advance, layers of hedges are applied to forecasted revenues and expenditures. Then a micro hedging program for firm commitments, that is firm sales or purchase orders, is added. And, as soon as the corresponding accumulated firm commitments are beyond the established hedge ratio by the hedging program, that second program takes over. And now hedges are done on the back of those firm sales orders.
00;05;05;16 - 00;05;34;04
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And as you will notice, this adds an element of precision to the existing hedging program. Now all that is required for the Finance team to leverage all that information is to be able to obtain this information from the different systems, its ERP or ERPs, TMS and others. And that could be achieved thanks to application programming interfaces connectivity.
00;05;34;06 - 00;06;08;02
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Before discussing Hermès, there's one last question about Merck. Why does the company provide investors with so much details about its foreign exchange hedging programs? I think there are three possible answers to that question. #1, that management wants to convey a sense of discipline. By providing such detailed information, investors get the message that management is very serious regarding the protection of the company's profit margins from currency risk.
00;06;08;04 - 00;06;47;21
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#2, the optimal disclosure hypothesis providing too little information is surely a bad policy. But perhaps providing an excess of information could create confusion and make financial statements difficult to read. Presumably, according to that hypothesis, Merck is providing the optimal level of disclosure. Finally, a recent paper suggests another possibility. Management teams, and especially the Finance team, when they disclose an enormous amount of information regarding, among others, the foreign exchange risk management programs,
00;06;47;23 - 00;07;12;04
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this is because they want to enhance the liquidity of the stock as an acquisition currency in the event of mergers and acquisitions. That is surely a very interesting hypothesis, although it doesn't seem to be the case at Merck because recent purchases have all been conducted in cash. The French luxury designer and manufacturer Hermés is in a league of its own.
00;07;12;06 - 00;07;49;27
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The company has just announced that it had achieved a 42.1 annual operating profit margin in 2024, that's the highest in the company's history. That's quite an extraordinary achievement, and we can only say: Chapeau! But the intriguing part from the point of view of foreign exchange managers is the fact that Hermès has also announced that a contribution to that operating profit margin was due to the currency hedging program applied by its Finance team.
00;07;50;00 - 00;08;21;23
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So that is again, another interesting statement. So let's try and reconstruct the Hermès or reverse engineer Hermès foreign exchange hedging strategy. Now, unlike the case of Merck, there is relatively little information that is published by Hermès regarding its FX management policy. We know, however, that we have information about, what we call at Kantox, the pricing parameters of the firm.
00;08;21;26 - 00;08;57;23
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More specifically, Hermès raised prices by an average of 7% during 2023 and price increases reached double digits in Japan. That's because the JPY depreciated sharply against the EUR in recent months. So what we have here is the fact that the company passes on to its customers the impact of what we call the cliff, a sharp change in the exchange rate between campaign or budget periods.
00;08;57;25 - 00;09;50;26
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And the company is right to do so because its cost base is mostly in euros, as its highly skilled workforce is located around the region of Paris. Again, we're not privy to any specific details regarding any foreign exchange hedging programs. We can only assume that the company may be applying, what we call at Kantox, a combination of hedging programs.
Consisting of a strategic hedging program, in which a worst-case scenario FX rate used in pricing for each individual campaign or budget period is protected with the help of conditional stop-loss orders. And then a micro-hedging program is added to that existing strategic hedging program, outperforming budgeted profit margins is made possible by number one
00;09;51;03 - 00;10;16;11
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forward points management. Today I'm wearing one of the two Hermès ties that I own. I wear a lot less these days. Now, why do I mention this? Is because the silk is imported from Brazil, and Hermès can pick up some extra margin like hedging these purchases at the Brazilian real price at a 5.6 annual discount to the EUR.
00;10;16;13 - 00;10;43;20
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The same can be said for sales in Japan. The JPY trades at a 3.6 annual forward premium to the EUR. Number two, the FX markup. as the Finance team calculates the worst-case scenario that is going to defend during each individual campaign or budget period. It uses a less favourable foreign exchange rate than the one that prevails at the moment when it sets the budget.
00;10;43;27 - 00;11;30;20
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Number three, hedging firm commitments. As the Finance team hedges, incoming firm sales and purchase orders, it does so at a more favourable rate than the worst-case scenario used in pricing. Otherwise, stop-loss orders would have been executed and there would be no exposure left to hedge. Number four, take-profit orders. As the Finance team sets the configuration of the hedging program, they can set profit-taking orders alongside those stop-loss orders to protect the worst-case scenario FX rate. And allows the team to profit from favourable moves in currency markets, which likely happened in 2023 and in the first half of 2024.
00;11;30;28 - 00;12;12;26
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In our hypothetical reverse engineering of the foreign exchange risk management strategies of Merck and Hermès, we have assumed that in both cases, management uses a combination of hedging programs. As we saw earlier, this requires Finance teams to be able to leverage all the information that sits in different company systems, ERP, TMS and others. Technology is also required to perform the task of swap execution and to compile all the required information to perform hedge accounting, a task that both companies undertake. Now,
00;12;12;28 - 00;12;49;26
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this requires what we call at Kantox perfect end-to-end traceability. Namely, the fact that along the transaction journey from an entry to a position, to a conditional order, to an operation and then a payment, or a series of payments in the event of swaps, each element has its own unique reference number. So once again, congratulations to the team of scientists at Merck and to the also very talented team of designers, artists and craftspeople over at Hermès.
00;12;50;02 - 00;13;03;22
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Now, surely the main culprits of the tremendous success of their companies. Let's keep in mind also that the finance team does play a role, especially in its capacity as foreign exchange risk managers.
