CFO Studio Magazine, 3rd Quarter 2012
By Charlie Stough, CFO of Atalanta Corporation

REDUCING COSTS ON INTERNATIONAL TRANSACTIONS

We live and work in a very uncertain world. Any company in the United States that buys or sells products to or from companies in other countries faces currency risk, even if the transaction is denominated in U.S. dollars (USD). Either the buyer or the seller has to manage the risk, and that action has an impact on the agreed-upon price.

Foreign currency exposures are generally categorized into the following three distinct types: transaction exposure, economic exposure, and translation exposure. These exposures pose risks to firms’ cash flows, competitiveness, market value, and financial reporting.

A firm has transaction exposure whenever it has contractual cash flows (receivables and payables) whose values are subject to unanticipated changes in exchange rates due to a contract being denominated in a foreign currency. To realize the domestic value of its foreign denominated cash flows, the firm must exchange foreign currency for domestic currency. As firms negotiate contracts with set prices and delivery dates in the face of a volatile foreign exchange market with exchange rates constantly fluctuating, the firms face a risk of changes in the exchange rate between the foreign and domestic currency. Such outcomes could be troublesome, as export profits could be negated entirely or import costs could rise substantially.

A firm has economic exposure when bidding for foreign projects or negotiating other contracts or foreign direct investments. Such an exposure arises from the potential for a firm to suddenly face a transactional or economic foreign exchange risk, contingent on the outcome of some contract or negotiation. For example, a firm could be waiting for a project bid to be accepted by a foreign business or government that if accepted would result in an immediate receivable. While waiting, the firm faces a contingent exposure from the uncertainty as to whether or not that receivable will happen. If the bid is accepted and a receivable is paid, the firm then faces a transaction exposure, so a firm may prefer to manage contingent exposures.

A firm’s translation exposure is the extent to which its financial reporting is affected by exchange rate movements. As all firms generally must prepare consolidated financial statements for reporting purposes, the consolidation process for multinationals entails translating foreign assets and liabilities or the financial statements of foreign subsidiaries from foreign to domestic currency. While translation exposure may not affect a firm’s cash flows, it could have a significant impact on a firm’s reported earnings and therefore its stock price.

Given the current situation in Europe, many financial teams are spending more time monitoring their euro exposures. Corporations are taking a sharper look at what their hedging strategies need to be in 2012. My company, multinational food importer Atalanta Corporation, certainly is doing so.

Steps to Follow

The first step in preparing to hedge foreign currency transactions needs to be measuring how much of a particular foreign currency your company bought or sold in the last 12 months on a global basis.

The second step is calculating how much of that currency you will buy or sell in the next 12 months, by month, for all divisions on a global basis. Many banks offer “treasury management software systems” which facilitate the gathering of information, the administration and control of outstanding foreign exchange (FX) contracts, etc. When there is significant hedge activity, the cost of such systems can be a good investment for larger companies.

The third step is to formulate both short-term and long-term plans with management, and the audit committee if the company has one, and agree on the range of months forward that you feel comfortable hedging. it could be three, six, or 12 months, depending on recent volatility. This analysis can also include whether there are any “natural hedges” such as the situation where you are selling a product to a company in Canada in Canadian dollars (Cad) and also buying a product from another company in Canada in Cad. In this scenario there would be an opportunity to open a bank account in

Canada and net the two transactions to better manage Cad risk over time. Other examples of “natural hedges” would be building a plant or opening a purchase/sales office in a foreign country where sales and purchases are made.

The fourth step is to determine what proportion of your exposure you feel comfortable hedging. Perhaps it could be 30, 40, or 50 percent depending on recent volatility. If you are hedging for a fixed supply contract it could be for 100 percent of the contract to ensure that your costs and margins are fully protected.

The fifth step is to make a decision on what types of hedging tools your company is comfortable using.

The most basic product is the plain fixed forward. This is a contract to exchange currency on a specific date at the difference between today’s spot exchange rate and the interest rate differential for the time period (for example, lock into buying euros at 1.30 in six months and selling USD on that date).

A variation is a forward window contract, which gives a company the ability to hedge a period of time—30 days, for example—as an alternative to the basic forward contract (hedging to one date in the future). A plain fixed forward is a good tool for a 12-month supply contract, but it does not give you an opportunity to participate in any positive movement of the currency in question.

Alternatives to Consider

As with most things in life, a variety of approaches may deliver the best result. Other alternatives include options such as calls, collars, and puts.

A call option, oft en simply labeled a “call,” is a financial contract between two parties, the buyer and the seller of this type of option. The buyer of the call option has the right, but not the obligation, to buy an agreed quantity of a particular commodity or financial instrument (the “underlying”) from the seller of the option at a certain time (the “expiration date”) for a certain price (the “strike price”). The seller (or “writer”) is obligated to sell the commodity or financial instrument should the buyer so decide. The buyer pays a cash fee (called a “premium”) for this right.

A “put” or “put option” is a contract between two parties to exchange an asset, the underlying, at a specified price, the strike, by a predetermined expiry or maturity. The buyer of the put has the right, but not an obligation, to sell the asset at the strike price by the future date, while the seller has the obligation to buy the asset at the strike price if the buyer exercises the option. The buyer pays a premium for this right.

This is a type of insurance but some companies do not want to spend cash for the product. Approximately 50 percent of all corporations use options to hedge FX exposures. Forty-six percent of those prefer to use zero-cost structures, rather than the cash premium put and call examples above, to buy a “range of values” without paying cash up front.

One option product with zero cost is a “collar,” which provides protection from adverse exchange rate movements and participation in beneficial movements within a “specified range.” Worst-case and best-case scenarios are known up front. For example, buy euro call protection at 1.30 and sell euro put upside at 1.20 for zero cost. In this case your transactions can be no better or worse than the range of 1.20 to 1.30.

A second option product with zero cost is a participating forward, which provides protection at a given level and partial participation in favorable market moves. Worst case is known up front (for example, buy euro call at 1.30 with 50 percent downside participation below 1.30 for zero cost).

A third option product with zero cost is a forward extra, which provides 100-percent protection at a given level, with the ability to participate on a one-to-one basis in favorable market moves down to a barrier. Should the barrier be triggered, your company will be locked into a penalty protection level. So you get the good news up to a certain point, and then the bank moves you back to a rate where you have an unfavorable rate.

A sophisticated bank can offer 20-plus option products, but the best advice is to stick to the basics until you have a good track record.

Choose Your Partners

You are much better off working with a major money center bank if you are buying or selling millions of Canadian dollars, euros, and so on, because they can offer internet-based systems that are more convenient and that can usually provide you with better rates.

Some of the smaller foreign currency shops may offer competitive rates, but you need to test the rates that you are getting periodically, whether using a large institution or a small firm, to make sure that you are receiving market rates.

The sixth step is to start reading the news every day on the currencies that you plan to hedge so you can gain a better understanding of what the trading range is and why the currency is moving up and down.

In the case of the Canadian dollar, it may be primarily interest rate differentials, economic data, the price of oil, etc.

In the case of the euro it is much more complicated and may depend on interest rate differentials, economic data in the U.S. and individual countries in Europe, the price of oil, decisions by countries’ central banks to amend their basket of “reserve currencies” that they hold, world events, and the perceived risk related to currencies other than the USD, which is a safe harbor for many people, etc.

At Atalanta Corporation, we actively hedge the euro and the Cad. Our euro purchases are approximately 25 percent of our total cost of products sold. Of the 25 percent, we have hedged on average 30 or 40 percent. Our five year track record as measured at the end of each year has been an important level of savings.

We have a five-year syndicated loan for approximately $200 million and at various times we have used all of the lending banks for some portion of our currency hedging. The banks are Wells Fargo (agent), TD Bank, Israel Discount Bank, Citibank, Chase, and Banco Santander. The benefits of using banks in the syndication network are that they already have a collateral base, and hopefully can be convinced to offer more favorable rates than financial institutions not already doing business with the company. Each bank in the syndication network that is interested in the business provides a separate line of credit for hedging activity, based on existing collateral and the perceived risk of entering into foreign exchange transactions.

The euro was launched at parity with the U.S. dollar in May 1998. The lowest level was 0.82 USD in October 2000. The strongest level was 1.59 in April 2008 and the mathematical mean has been around 1.20. The volatility of the currency has meant that there were very important opportunities for Atalanta to save money on purchases of cheese, olives, olive oil, and other products from Europe.

The strongest level of the Cad the last five years was 0.92 to the USD in 2007. The weakest level was 1.30 to the USD in 2008 and the mathematical mean has been 1.06. The volatility of the currency has meant that there were very important opportunities for Atalanta to save money on purchases of meat from Canada.

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CFO Studio Magazine, 3rd Quarter 2012
By Steven Heumann, Vice President of SEC Reporting and SOX Compliance, ORBCOMM, Inc.

For some companies, stock options have been the primary equity compensation vehicle in long-term incentive plans. The financial downturn and subsequent economic recession of 2008 have pummeled stock prices, and as a result, stock options have gone significantly underwater, wiping away much of their value.

This drop in equity compensation value reduces future expectations and causes major retention and motivation dilemmas for executives and senior management. Most companies grant equity compensation either on a value basis, determined through a binomial; the Black-Scholes option valuation model; or on market value. The lower the stock price, the more shares it takes to reward individuals at levels similar to previous years, thus increasing dilution levels.

As a result, shareholders are pressuring management to rein in dilution in order to maximize their returns. Further, companies may also be caught off guard with a shortage of shares available for grant in their long-term incentive plans and must ask their shareholders to approve amendments to increase the number of shares available for grant.

As the economy begins to recover from the recession, a long-term equity compensation strategy is critical in attracting and retaining talented leaders. Companies must now cope with the challenge of how to recruit and retain key talent, and be in a position to drive innovation and maintain a competitive edge, while rewarding employees for success in a more predictable form of income, all while maximizing shareholder returns.

The challenge is even greater, given the devaluation of stock options and high levels of dilution. Companies are now re-examining their long-term equity compensation strategies, taking into account their specific needs and characteristics and what approach will best serve the company, its shareholders, its executives and senior management. specifically:

For the company. How to achieve business and human capital objectives, while minimizing the economic costs and accounting impact?

For the shareholders. How to create the right alignment of their interests and executive interests, while minimizing dilution and increasing the net return to shareholders?

For the executives and senior management. How to provide perceived value that is commensurate with the level of contribution and effort delivered?

As a result, the structures of long-term incentive plans are undergoing a transformation. Specifically, some companies have deemphasized the use of stock options and begun introducing other time- and performance-based equity vehicles that promote a long-term share ownership perspective for executives and senior management. This strategy closely aligns executives and senior management interests with achievement of longer-term financial objectives that enhance shareholder value, while at the same time limiting the dilutive effects of previous stock option grants.

RSUs Versus SARs

The most prevalent shift is the increasing use of restricted stock units (RSUs), which are considered full-value awards, and stock appreciation rights (SARs), which are considered appreciation value awards. These equity vehicles help lower shareholder dilution because a company can issue fewer shares to provide the same prior year value as compared to stock options. Some companies have replaced stock options entirely with either RSUs or SARs or a combination of both, while other companies are complementing stock options with RSUs, SARs, or a combination of both.

In determining whether an RSU or SAR is the right choice, companies should ensure their compensation strategies meet their business strategy, market characteristics, and talent needs. Just as a company’s business strategy is unique and crafted to create an advantage over its competitors, compensation strategy should also fit the distinct business. Business and talent needs should also help in the decision about which vehicles are right for the company and business strategy.

When considering an RSU or SAR, a company should look at the following elements:

Business needs and market characteristics. Consider business stages and growth potential. For example, a mature company with limited growth potential may favor RSUs. These are also appropriate for a company focused on total return to shareholders, dividends and cash flows, or for one experiencing high stock volatility. In contrast, a company in a high-growth phase or with high stock appreciation or low stock volatility might consider SARs.

Talent needs and characteristics. If employees are more comfortable with vehicles that offer a lower risk and, in exchange, a lower reward, RSUs may be appropriate. A company with a high risk of turnover should also consider RSUs. The opposite situation of high risk and reward or low turnover favors SARs.

Performance/rewards philosophy. Use RSUs to insulate employees from downside risk in a falling market or provide moderate wealth-accumulation opportunities. SARs provide greater upside potential and risk along with significant wealth accumulation opportunities.

What is an RSU?

An RSU is an arrangement whereby no grant of shares is made, rather the individual is granted units, with each unit equal in value to a share of stock on the grant date. On satisfaction of a vesting requirement, the individual is entitled to shares equal to the current value of the units.

Compared to a stock option, an RSU results in fewer shares being issued, since it provides the individual with less downside risk. Typically, most companies grant an RSU award equal to 30 to 50 percent of a stock option award. The reason is that an RSU will always be worth something, as the individual will always receive the same number of shares of common stock upon vesting. Additionally, the shares will have value to them, regardless of whether the stock price declines after the grant date. Thus RSUs will almost always provide compensation to an individual in a down market, since they are almost always in the money, compared to a stock option, which could be underwater. For this reason, an RSU would be more favorable to a stock option for the individual.

From the perspective of investors and shareholders, when an RSU vests, the employee is in the same shoes as a shareholder, since they then have voting and dividend rights, which encourage a sense of ownership and identification with the company. As a result, closely aligning employees’ interests with achievement of longer-term financial objectives of the company enhances shareholder value.

For example, if a company grants 10,000 stock options having an exercise price or “strike” price (the stock price on the date of grant) of $5, and subsequently it falls to $3, the stock option is underwater and worthless. On the other hand, if 4,000 RSUs are granted and on the vesting date the stock price is $3, the individual would receive 4,000 shares of common stock valued at $12,000, which is taxed as ordinary income.

It is important to note that the individual does not receive any cash on the vesting date. He or she is responsible for taxes on the vesting date. The way the taxes are paid is determined by the company either by net share settlement

(selling enough shares of the company’s common stock to cover the taxes) or the individual paying cash. The individual may elect to sell the shares on the vesting date or might consider holding onto them, believing that the stock price will increase.

In the case of a net share settlement, the individual will never be in a cash-loss position, because shares were sold on the vesting date to cover the taxes. Subsequently, if shares are sold, the individual has capital gains or losses based on the holding period, which begins at the time of vesting. The tax basis is the amount included as ordinary income.

In the case of paying cash for taxes, the individual could potentially be in a cash loss position if the stock price significantly decreases and is unable to sell for a period of time due to restrictions placed by the company. Most companies carry restrictions prohibiting the sale of shares over a period of time based on (1) black out periods for earnings releases, and (2) liquidity events such as capital raises and merger-and-acquisition transactions that limit the amount of shares entering the market.

What is a SAR?

SARs work much like stock options. A company grants an award, which provides an individual with the ability to profit from the gain made in the value of a set number of shares over and above the price set in the award. However, the holder of a SAR receives no benefit unless the underlying stock value appreciates. So the value of a SAR is a function of corporate performance, giving the holder an incentive to improve financial performance with the expectation of a higher stock price, which leads to creation of shareholder value.

As a result, investors and shareholders begin to focus on the “value transfer” (the amount of company market value granted to individuals) rather than on the number or dollar value of stock options granted. Unlike stock options, SARs offer a solution to individuals where no cash is needed to acquire shares under the award at exercise date, thus making them more attractive than stock options. Depending on the plan’s design, the gain is paid in stock or cash or a combination of both. However, the company does not generate any cash flow from the exercise of a SAR compared to a stock option. For employees, the tax consequences of SARs and non-qualified stock options are the same.

Upon exercise, stock-sett led SARs require the use of fewer shares while delivering the same economic value to individuals as stock options. For example, a company will issue only enough shares to cover the appreciation of the stock price. Because options require payment of an exercise price, a company must issue more shares to deliver the same net value.

Consider two companies, A and B, each with a stock price of $10. Say the companies grant options at $10 and stock price appreciates to $20. To receive $20 in net value, an employee of Company a must exercise two stock options having an aggregate exercise price of $20, for which he will receive two shares, having an aggregate value of $40, in return. To receive the same $20 in net value, the employee of Company b exercises two SARs and receives one share of stock. If the SAR is settled in cash, no shares are issued.

When negotiating loan agreements that give consideration to future financial results, such as loan covenants, it is important to specify the basis of accounting that will be employed by using a “frozen GAAP” clause, wherein the accounting principles employed at the relationship’s start are consistent throughout the term of the agreement.

Typically, companies with significant amounts of stock-based compensation use EBITDA, adjusted for stock-based compensation expense (adjusted EBITDA) to evaluate the effectiveness of operational strategies and evaluate its capacity to service debt. Further, adjusted EBITDA should be used to calculate various interest or debt service coverage ratios.

Companies should review their long-term incentive plan’s design, taking into account their specific business needs and characteristics by identifying what’s right for the company, what’s right for the plan participants, and what’s right for the shareholders.

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