Treasurer Marsha Prentiss uses a variety of tricks to manage the company's huge multinational exposures. She even negotiates with the company's corporate parents.

By Nilly Ostro-Landau

It's the survival of the fittest in the computer business these days. As performance jumps and prices drop, companies face ruthless price competition from manufacturers around the world. Staying competitive in this cutthroat market requires paying particularly close attention to managing currency risks, which could either give a company an important edge on its rivals or send it plummeting to the digital boneyard.

Nobody knows this better than Hitachi Data Systems (HDS). The mainframe computer and disk drive manufacturer faces stiff competition from IBM, Amdahl and EMC. Over 50 percent of its $2 billion in sales comes from outside the U.S.-more than 40 countries in all. Although the company has its fair share of interest rate exposures, the chief challenge facing HDS treasurer Marsha Prentiss is hedging the company's massive FX exposures.

Of course it helps to be the child of two multinational behemoths familiar with managing the translational, transactional and economic exposures that grow out of international commerce. HDS began life as a subsidiary of National Semiconductor Corp. In 1989 it was bought by Japan's Hitachi and quickly spun off as an independent operation. HDS is now an 80/20 joint venture between Hitachi and Electronic Data Systems.

The relationship gives HDS top access to international banks, market know-how and financial acumen. It also allows the company to rely on negotiated risk-sharing agreements that help minimize its reliance on capital markets for hedging of economic risk. Prentiss, who has been with HDS since its inception, was named treasurer in June after former treasurer David Roberson gained some additional responsibilities in his role as senior vice president- finance.

Currency delegate

HDS doesn't try to hedge all the company's currency exposures from headquarters. It employs the dollar as a functional currency for the Americas (including Latin America) and the Asia-Pacific region, but the deutsche mark as the functional currency in Europe. By using a European currency and leaving all cross-rate transactional risk management to its European headquarters and treasury, the American parent needs only worry about the translation impact once a month when the deutsche marks are translated into dollars on the company's consolidated books.

"It's much easier to hedge the cross-currency exposure in deutsche marks or pounds sterling-depending on volume and relative stability-than in the dollar," she explains. This setup also allows HDS to take advantage of some natural hedges. HDS Europe buys equipment from Hitachi Europe and pays in deutsche marks. Deutsche mark receivables are thus naturally offset by deutsche mark payables.

Any residual risk and expected sales are hedged back into deutsche marks, mostly using OTC forwards. Although Prentiss believes exchange-traded products may be cheaper, they would not allow HDS to perfectly time the contracts to the expected cash flows from payment on mainframe systems. Also, forwards allow the U.S. company to maintain a healthy relationship with its banking group by steering business their way. "The transactional risks are usually very manageable and very hedgeable," says Prentiss, adding that Europe can also borrow locally for working capital needs. "One of our biggest FX hedging strategies is local borrowing."

HDS uses options occasionally when there's a question about a particular order's timing or closing potential. In certain cases the company will choose to hedge only a piece of the expected cash flows with options. "If we know that we've got five definite machine sales on the horizon, we will take a balance sheet receivables number and hedge that completely with forwards," Prentiss explains. "But if one machine sale of the five is less certain, we'd rather hedge that one with an option because first, the cash flow may never materialize, and second, even if it does it's more difficult to pinpoint the timing."

In all cases, however, HDS uses only purchased options, and no complex or combination structures for cost-reduction purposes. "We prefer to buy them just slightly out of the money," explains Prentiss. Sure, the premiums may be more pricey, she concedes, "but they work better as a guarantee."

In part, the decision to hedge and the choice of instrument are affected by HDS's sense of the market's direction. For example, if rates are expected to go against HDS, there's more chance it will choose to hedge a greater portion of its anticipated risk. "We try to use market intelligence to the best of our abilities," says Prentiss, "but we do not take market positions."

The hedge horizon for both forwards and options is short term, with the aggregate hedge portfolio less than one year. After all, the company is trying only to hedge its balance sheet exposure, not the broader pricing risks it faces from U.S. competitors. Moreover, says Prentiss, with horizons under one year, "there's usually not a question about getting hedge accounting."

Risk sharing

HDS's currency hedging goes beyond transactional and translation exposures to protect the company from broader economic exposures. Its primary economic exposure is to the yen/dollar exchange rate. HDS eliminates direct FX exposure by purchasing Hitachi products from Hitachi factories in dollars, but the impact quickly pops back up in pricing strategies. If the dollar weakens, for example, it's likely the U.S. joint venture will be asked to pay more dollars for mainframes.

To protect both corporate entities from the effects of currency fluctuations, the company engages in a practice called risk sharing. Product prices are adjusted every six months so neither side ends up with a windfall. When it's time to decide on prices, "they [Hitachi] give us the best rate we could expect," says Prentiss. Because the prices are set at the start of a six-month period in U.S. dollars, there are no FX gains on HDS's side. However, if the yen/dollar rate moves in HDS's favor, "we have more room to negotiate the next six months," says Prentiss. "If the situation is reversed, they may give us a bit of a discount or a retro price cut. It's a constant negotiation."

Southern exposure

The second variety of economic exposure appears in Latin America. A typical mainframe buying decision takes about 18 months. During that time, "we have to be sensitive to the prices we quoted," explains Prentiss. Though prices are quoted in dollars, if a customer's currency is devalued by 50 percent over the 18-month period, chances are that customer will not be able to pay the original quoted price. With purchase price tags around the $10 million mark, HDS's belief in proactive risk management requires the U.S. company to take an interest in its customers' ability to pay.

The result is another form of negotiation. In this case, HDS takes advantage of its strong international banking relations to help customers secure currency protection in the form of dollar letters of credit or some other form of dollar-hedged financing. "We don't use the capital markets to hedge against economic risk," says Prentiss. "We rely on relationships and our global banking ties."

Rate ratios

HDS uses capital markets instruments to help manage its $500 million debt portfolio. Interest rate risk is handled mostly through the Santa Clara headquarters. HDS's U.S. treasury manages all working capital needs (under one year) as well as its portfolio of two- to three-year leases and post-acquisition long-term debt (held in a separate holding company).

HDS pursues a similar strategy for both short- and long-term debt. It borrows in floating-which is easier for banks to write-and then swaps some into fixed to help maintain a roughly 50:50 ratio of fixed to floating. The ratio can change to take advantage of different interest rate expectations or attractive rates. The short-term working capital portfolio is fixed by using short-duration interest rate caps. Longer-term debt is swapped into fixed, with rates normally floating at three- or six-month Libor.

This summer and fall, however, interest rate jitters prompted Prentiss to lock in some attractive rates and skew HDS's 50:50 ratio into a higher fixed portion. "For the first time, we went out and sourced 364-day money," she says. The window of opportunity opened when the Fed failed to raise rates at its late September open market committee meeting. Immediately thereafter short-term rates looked incredibly attractive. "Now we've got about one third of our short-term position in one-year money, fixed at under 6 percent. I essentially eliminated the need for some of the caps next year," says Prentiss, hence saving on expected premium cost.

When it's time to buy caps, Prentiss employs an unusual strategy that could make some treasurers lose sleep at night. She places orders with her banks with a designated rate about two weeks before she actually needs the caps. "I found without fail that within two weeks, that rate will trigger for us," she says.

HDS also manages the interest rate risk associated with its credit corporation that offers two- to three-year leases for mainframe buyers. The leasing company is not a separate entity, and Prentiss manages the lease portfolio alongside the working capital and long-term debt. "Really, we perform as a bank, lending money inter-company to the leasing company and hedging the resultant interest rate exposure," she explains.

Though leases are typically three years in duration, customers often want to trade in their two-year-old mainframe for the new generation. Her biggest problem is matching the amortization of these leases with the hedge instrument. So far she's used swaptions (three-year swaps with the option to pick up the swap in one year) to match the average duration of the lease. Usually, a year into the lease, says Prentiss, "we have a pretty good idea of whether or not the machine will come in for a trade early."

Measuring performance

To gauge its hedge portfolio performance, HDS looks at a variety of indicators and compares itself to market rates. However, there are two more important internal barometers. First is the ability to leverage hedging to firm up forecasted revenue figures. "HDS puts value on doing accurate forecasting," says Prentiss. "Interest rate and currency hedges allow me to give an accurate picture of what our interest expenses, and therefore profit before tax figures, would be."

The other barometer is the budget for hedging cost. "We run our hedging operations at a loss," says Prentiss. At the start of each year, money is allocated for hedging expenses. At the end of the year, the company looks for those costs to be effectively zero on a net-net basis and doesn't expect to recover the cost of the forwards and options it purchases. The budgeted number for FX and interest rate hedging expense goes into the company's annual operating plan.

The reason: both a performance measurement criterion and a way of discouraging irresponsible financial behavior. "There is no incentive to try to beat the market or make a trading profit," concludes Prentiss. "I don't want to put the pressure on the organization to feel we need to take unusual market risks to recover the cost of simple hedging."

Was this information valuable? Subscribe to Derivatives Strategy by clicking here!