Week 4

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Chapter 10

Mini Case

China Noah

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Mini-Case: China Noah

China’s voracious consumer appetites are already reaching into every corner of Indonesia. The increasing weight of China in every market is a global trend, but growing Chinese, as well as Indian, demand is making an especially big impact in Indonesia. Nick Cashmore of the Jakarta office of CLSA, an investment bank, has coined a new term to describe this symbiotic relationship: “Chindonesia.”

—“Special Report on Indonesia: More Than a Single Swallow,” The Economist, September 10, 2009.

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China Noah

In early 2010, Mr. Savio Chow, CFO of China Noah Corporation (Noah), was concerned about the foreign exchange exposure his company could be creating by shifting much of its procurement of wood to Indonesia.

Noah was a leading floorboard manufacturer in China that purchased more than USD100 million in lumber annually, primarily from local wood suppliers in China.

But now Mr. Chow planned to shift a large portion of his raw material procurement to Indonesian suppliers in light of the abundant wood resources in Indonesia and the increasingly tight wood supply market in China. Chow knew he needed an explicit strategy for managing the currency exposure.

China Noah

Noah, a private company owned by its founding family, was one of the largest floorboard producers in China. The company was established in 1982 by the current chairman, Mr. Se Hok Pan, a Macau resident. Most of the company’s senior management team had been with the company since inception.

Noah’s primary product was solid wood flooring, which used 100% natural wood cut into floorboards, sanded, and protected with a layer of gloss.

Rapid Chinese economic growth, together with the rising living standards and the emphasis on environmental conservation in China, had created a consumer preference for timber products for both households and offices. Besides being natural, wood products were considered beneficial for both mental and physical health.

Noah operated five flooring manufacturing plants and a distributor/retail network of over 1,500 outlet stores across China.

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China Noah

As shown in Exhibit A, Noah had grown rapidly in recent years, with sales growing from CNY986 million in 2006 to CNY1,603 million in 2009 (approximately USD200 million at the current spot rate of CNY6.92=USD1.00).

Net profit had risen from CNY115 million to CNY187 million (USD27 million) in the same period.

Mr. Chow was a planner, and as is also illustrated by Exhibit A, he and Noah were expecting sales to grow at an annual average rate of 20% for the coming five years. Noah’s return on sales was expected to be good this year at 13.5%. But if Chow’s forecasts were accurate, they would plummet to 3.7% by 2015.

Supply Chain

One of the key characteristics of the floorboard industry is that wood makes up the vast majority of all raw material and direct cost.

In the past three years Noah had spent between CNY60 and CNY65 on wood purchasing for every square meter of floorboard manufactured. This meant wood was almost 90% of cost of goods sold.

Given the competitiveness of the floorboard industry, the ability to control and potentially lower wood cost was the dominant driver of corporate profitability.

Noah had never owned any forests of its own, buying wood from Chinese forest owners or lumber traders.

Chinese wood prices had long been quite cheap by global standards, partly as a result of a large-scale illegal logging industry. But wood supplies had now tightened dramatically as forest resources became increasingly scarce due to China’s shift toward environmental protection, and this tightening supply was sending wood prices upward.

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Exhibit A China Noah’s Consolidated Statement of Income (actual and forecast, million Chinese yuan)

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China Noah

The World Wildlife Fund estimated that domestic wood supplies met only half of the country’s current timber consumption, and a variety of price forecasts had quite honestly frightened Chow.

For example, Morgan Stanley was forecasting Chinese wood prices to rise by 15% to 20% over the coming five years. Major Chinese floorboard producers, including Noah, were now looking at countries like Brazil, Russia, and Indonesia for more sustainable, legal, and cheaper sources of wood.

Noah’s Indonesia Deal

Over the past few months Chow had been pursuing a number of Indonesian wood supplier deals to replace a portion of its Chinese sourcing. Preliminary price quotes were encouraging, prices of CNY62.6/m2 coming in roughly 8% cheaper than current Chinese prices.

The previous week he had presented a potential Indonesian supplier’s term sheet (Exhibit B) to Noah’s board of directors. The term sheet was based on 30% Indonesian sourcing of the total 17.2 million square meters of flooring Noah expected to sell in 2010.

Chow wished to move quickly to try to control—and possibly reduce—Noah’s wood costs for the current year and possibly for years to come. The current price quote from the consortia of Indonesian wood producers was 84,090 Indonesian rupiah per square meter (IDR/m2), which translated into a price in Chinese yuan per square meter (CNY/m2) of 62.6.

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Exhibit B Term Sheet from an Indonesian Wood Consortium

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China Noah

At CNY 62.6, this was a 7.7% discount to the current Chinese price of 67.8 for the same wood. Since Chinese prices were expected to rise 4% to 5% per year for the foreseeable future, but the Indonesian consortia was willing to contractually limit annual price increases to just 4% per annum, the discount might increase if the IDR/CNY exchange rate remained the same.

Chow expected Noah’s production to more than double over the next five years, from 17.2 million square meters in 2010 to 42.8 million in 2015, as shown in Exhibit C. If he sourced 30% of Noah’s wood from Indonesia in 2010, and then increased that proportion 10% per year, Indonesia would account for roughly half of Noah’s wood sourcing by 2015.

Indonesian Growth

Indonesia’s forests covered 60% of the country. In recent years, the country’s high population and rapid industrialization had already led to serious environmental issues, including large-scale deforestation, and like that in China, much of it illegal. That said, Indonesia was rapidly emerging as an important exporter of wood.

In terms of macroeconomics, Indonesia had been less affected by the recent global recession, in comparison to its neighbors. Statistics indicated that Indonesia’s GDP grew by 4.5% in 2009, and that it was expected to grow by nearly 7% per year over the coming decade. Indonesia could soon move to economic parity with the BRICs (Brazil, Russia, India, and China). Stable political conditions, despite the 2009 elections and strong domestic demand, could deliver that growth.

Foreign Currency Risk

Indonesia had been one of countries hardest hit by the Asian financial crisis of 1997–1998. Against the U.S. dollar, the Indonesian rupiah dropped from about IDR2,600/USD to a low point of IDR14,000/USD, its economy shrinking a shocking 14%—although it did rebound in the following years. The rupiah had since stabilized in the IDR8,000/USD to IDR10,000/USD range.

As illustrated by Exhibit D, the rupiah had traded in a relatively narrow range of IDR1,000/CNY to IDR1,400/CNY over the past 10 years, with the exception of the recent global credit crisis. Because the Indonesian rupiah was a free-floating currency and the Chinese renminbi a highly controlled and managed currency, crisis had always hit the rupiah much harder.

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Exhibit C China Noah Corporation’s Cost of Goods Sold Composition

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Exhibit D Indonesian Rupiah to Chinese Yuan Spot Rate (monthly)

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China Noah

Since Noah was considering a fundamental change in its wood-sourcing strategy and structure, the exchange rate between the rupiah and the yuan over the long-term was considered critical.

Hedging Foreign Exchange Exposure

The Indonesia wood sourcing contract would expose Noah to exchange rate risk over a series of 6-month periods (March 2010, September 2010, March 2011, etc.). Chow, having little experience in managing exchange rate risk, had obtained some detailed advice from Noah’s financial advisors, Morgan Stanley.

Morgan Stanley had noted that the Chinese government was under constant pressure from many countries, including the United States, to revalue the yuan.

Unlike the yuan, the rupiah floated in value, although its value often tracked closely against the U.S. dollar. If the Chinese yuan was indeed revalued against the U.S. dollar, and the Indonesian rupiah tracked the dollar “down,” a weaker rupiah could result.

Chow’s first step in considering hedging alternatives was to collect currency and derivative quotes on the Indonesian rupiah/Chinese yuan spot rate into the immediate future.

Spot Rate Forecast. Morgan Stanley’s forecast of the IDR/CNY spot rate through 2015 showed a rupiah that slowly appreciated against the yuan over the coming five years, as illustrated in Exhibit E.

Forward Rates. Chow had also requested forward rate quotes from several of its bankers. An average of their quotes is also presented in Exhibit E. Unlike the spot rate forecast, the forward rate quotes, based on interest rate differentials, locked in a rapidly discounted rupiah against the yuan out over the same 5-year period.

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China Noah

Currency Options. Forward hedging would eliminate Noah’s downside risk, but would also eliminate any opportunity to benefit from an even weaker Indonesian rupiah—if that were to occur. Given Chow’s limited experience with foreign exchange derivatives, currency options made him nervous.

But, as he told his controller, he was determined to consider all appropriate techniques available.

Exhibit F lists possible option positions for Noah with varying strike prices, based on currently available market data. The quotes in Exhibit F are of course only for the first 6-month payment; longer maturities would be needed for the hedging of future rupiah exposures.

Money Market Hedging. Since Noah’s foreign exchange exposure was a payable, Indonesian rupiah at 6-month intervals into the future, money market hedging would entail depositing funds now into Indonesian rupiah denominated accounts bearing rupiah interest.

Indonesian interest rates were consistently higher than comparable rates in China, where rates were subject to government regulations and restrictions. As illustrated in Exhibit G, the 6-month deposit rate in China on CNY was currently 1.98%, while the same rate in Indonesia was a hefty 6.74%.

Currency Adjustment Clauses. Chow was encouraged to also consider a Currency Adjustment Clause or CAC as his banker termed it. Noah’s bankers argued that if the Indonesian sourcing was to become a long-term partnership between Noah and the Indonesian consortia, then a CAC would basically allow the two parties to share the currency risks, up or down.

The rationale for the CAC was similar to a profit/risk-sharing program, where buyers/sellers initially agree to lock in a local currency price on a settlement denominated in a foreign currency—in this case the Indonesian rupiah purchase price. As long as the exchange rate stays within some defined boundary around a central foreign exchange rate, say ±5% around the current spot rate of IDR1344/CNY, the rupiah price would remain fixed.

If, however, the spot rate at the time of payment had moved beyond the ±5% boundary, the two parties could share the difference between the current spot rate and the original central rate.

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Exhibit E Forecast and Forward Rates on the IDR/CNY Spot Rate

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Exhibit F Currency Option Strike Rates and Premiums

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Exhibit G Indonesian and Chinese Deposit Rates of Interest

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China Noah

Mr. Chow estimated that a 4% fluctuation around the spot FX rate would be a reasonable benchmark to trigger the profit/risk sharing. In this sense, a possible CAC for Noah will initially lock in its payment obligation at CNY62.6/M2.

Once the exchange rate movement exceeded the 4% boundary, the CAC would call for an automatic price recalculation by predetermined methods such as using the mid-point between the spot exchange rate and the exchange rate on the settlement date.

Mr. Chow thought that the Indonesian suppliers were likely to respond positively to a CAC because of the many forecasts that the IDR was likely to fall against the CNY.

Time was running short. China Noah’s Board was waiting on a currency management strategy proposal from Mr. Chow.

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China Noah: Case Questions

What is the business reason for China Noah’s potential currency exposure? Does the company really need to subject itself to substantial exchange rate risk? Is the risk “material” to China Noah? Do you think China Noah should hedge?

How does China Noah’s profitability (using return on sales as the primary metric) change depending on whether the IDR/CNY exchange rate follows (a) forecast spot rates, (b) forward rate quotes, or (c) fixed rate baseline assumption?

Assuming Noah made 6-month payments on its wood purchases from Indonesia, what is the schedule of foreign currency amounts over time?

What would be your outlook on the future direction of the Indonesian rupiah and the Chinese renminbi? Should this influence the hedging approach used by Noah?

Which of the hedging choices would you recommend?

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China Noah: Case Questions

China Noah is a wood flooring manufacturer for the Chinese market, therefore requiring a large, growing, and dependable source of wood for its business.

The Chinese marketplace faces an increasing shortage of wood, and wood prices are expected to continue to rise rapidly in the coming years.

Since wood costs make up close to 90% of China Noah’s operating costs – an enormous component by any assessment – there is a undeniable need to control those costs over time.

Is it ‘material’? At 90% of operating costs, absolutely. (The U.S. SEC technically categorizes anything that may alter pre-tax earnings by 5% or more as material.)

The easiest/best solution would be for the Indonesian supplier to accept payment in Chinese yuan, thereby accepting the exchange rate risk. But since the supplier has stated clearly that they will not, and require payment in Indonesian rupiah, China Noah is exposed over the long-term and should definitely hedge this foreign currency exposure.

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China Noah: Case Questions

China Noah’s exposure is its purchase of wood from Indonesia. These purchases are scheduled to start in 2010, and are estimated to constitute 30% of all 17.6 million square meters of wood, or 5.16 million square meters.

The quoted price for 2010 per square meter is IDR 84,090. This is the first of the continuing series of currency exposures to its purchasing over time.

Looking only at the Return on Sales for 2010:

If the exchange rate were to chain per the forecast, to IDR = 1.0 CNY in 2010, return on sales is forecast as 14.9%.

If China Noah were to use currency forwards, the 2010 forward rate is IDR 1,450 = 1.0 CNY, return on sales is forecast as 14.6%.

If the exchange rate were to remain unchanged between now and 2010, IDR 1,344 = 1.0 CNY, return on sales is forecast as 13.5%.

Looking only at the Return on Sales for 2011:

Exchange rate forecast at IDR 1,405 = 1.0 CNY, ROS = 12.6%.

Exchange rate at forward rate of IDR 1,470 = 1.0 CNY, ROS = 13.3%.

Exchange rate fixed at IDR 1,344 = 1.0 CNY, ROS = 11.8%.

This profitability analysis using return on sales could be repeated for the entire forecast period of 2010-2015 given the availability of forecast and forward rate quotes. Using this metric, it appears that of the three alternatives considered here the forward rate locks-in the highest average return on sales for the total period.

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China Noah: Case Questions

Assuming Noah made 6-month payments on its wood purchases from Indonesia, what is the schedule of foreign currency amounts over time?

All spreadsheet statements presented in the case are for annual values. Assuming that wood purchasing and use is distributed evenly over the calendar year, a six-month exposure and payment would simply be one-half the annual estimated purchase.

Estimated annual wood purchases from Indonesia:

2010: 5.16 million m2, or 2.58 million m2 every six months.

2011: 6.81 million m2, or 3.41 million m2 every six months.

2012: 8.99 million m2, or 4.50 million m2 every six months.

2013: 11.87 million m2, or 5.93 million m2 every six months.

2014: 15.67 million m2, or 7.83 million m2 every six months.

2015: 20.68 million m2, or 10.34 million m2 every six months.

One added note about this exposure of importance: it is growing rapidly over time as China Noah’s sales and wood sourcing needs grow rapidly. This means that the exposure’s size and significance will likely increase. Risk management of some kind is clearly needed.

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China Noah: Case Questions

What would be your outlook on the future direction of the Indonesian rupiah and the Chinese renminbi (yuan)? Should this influence the hedging approach used by Noah?

The Chinese yuan is clearly a highly managed currency in value. It has largely been managed by the Chinese government in its value against the U.S. dollar over time. Although there has been constant pressure for it to be revalued against the U.S. dollar, there has only been marginal movement to date.

The Indonesian rupiah is historically a relatively weak and volatile currency against major currencies like the U.S. dollar and the now-growing-in-influence Chinese yuan.

If the rupiah was to weaken over time against the dollar, and the yuan to largely remain relatively fixed or slightly revaluing against the dollar, the rupiah’s value should decline over time against the yuan.

A weakening rupiah against the yuan over time would be a favorable exchange rate movement for China Noah – as its foreign currency exposure is a short position (a payable). It will hopefully be buying Chinese yuan over time at ever-cheaper rates.

This expectation – a directional view that the rupiah will weaken over time – if held with confidence by China Noah should cause it to consider option-based hedging solutions. An extreme view would argue for remaining uncovered.

Challenge: Although these expectations in exchange rate movements are by all indications valid, rational and logical, unexpected exchange rate movements do happen. Since wood costs make up such a large portion of China Noah’s operating costs, remaining uncovered would not be recommended.

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China Noah: Case Questions

Which of the hedging choices would you recommend?

The choice of hedging approaches depends on China Noah’s philosophy about currency exposure. If the company believes that it is content to be effectively ‘neutral’ towards exchange rate movements, that currency should not be a source of gain or loss, the risk-sharing approach would be a solid long-term structure to maintain supplier relationships and split currency movements with the supplier.

If China Noah would prefer to try and ‘profit’ from exchange rate movements, to try and reduce operating expenses opportunistically, a derivative-based exchange rate hedging solution is appropriate.

The choice of which hedging choice depends on China Noah’s directional view on the Indonesian rupiah versus the Chinese renminbi (yuan).

Directional view is a bit of a curiosity in this case. The bank forecast of the IDR is for it to appreciate over time against the CNY. Yet the forward rate series quotes indicate a weakening of the IDR against the CNY over time.

This forward rate series is clearly in China Noah’s favor, and as opposed to currency options, would not require the payment of a premium. Combining directional view and advantageous rates for sourcing, the forward rate series appears to be the preferable approach.

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