About Nestle India

Nestle SA is the world’s largest food, beverages and nutrition company with its headquarters at Vevey, Switzerland. It has an annual turnover of $120 bn and employs 280,000 people across 511 factories in 86 countries.

Nestle India is a partly owned subsidiary of Nestle SA (Nestle S.A. is the majority shareholder with a 62% stake). It is one of the largest players in the FMCG space in India with a market cap of over 41,000 crores and an annual turnover of Rs 6260 crores for the FY 2010.

The Company primarily operates in the areas of

Milk Products and Nutrition Beverages Prepared Dishes and Cooking Aids Chocolates and Confectionary

About Nestle India’s Export/Import Portfolio

Nestle India’s exports for the FY 2009-10 stood at Rs 3537 million up from Rs 3286 million the previous year. During the year under review, the Company had earnings from exports of Rs. 3,505 Million, mainly comprising foreign exchange earnings of Rs. 2,473 million (including sales to Russia invoiced in Rupees) and exports to neighbouring countries in Rupees amounting to Rs. 1,030 million.

Nestle India is the largest exporter of processed foods and coffee in the country. The major destination countries for the exports are the USA, Russia, UK and African nations.

Nestle India’s imports are limited mainly to raw materials and capital goods (machines, spares, stores and consumables). The cumulative value of imports for the year stood at Rs 3842 million of which 56 million was for spares, Rs 2628 million was for raw materials and Rs 1190 million was for capital goods.

Nestle India’s exports comprise mainly of shipments to other Nestle business units (For example coffee to Nestle Russia and Nestle Egypt) and export of culinary products to western European and the American markets. The cumulative value of exports for the FY 2010-11 was Rs 3537 million.

A large portion of Nestle India’s export/import portfolio involves trading with other subsidiaries of Nestle SA. For eg: Majority of coffee exports from Nestle India are to Nestle Kuban LLC, a subsidiary of Nestle Russia.

Since the company is a subsidiary of an MNC, it makes a significant amount of payments as dividends in foreign currencies. For the FY 2009-10 it paid a total interim dividend of Rs 2170 million and a final dividend for the previous year of Rs 745 million.

The company also paid a net general license fee of Rs 2157 million to Nestle SA for the FY.

Forex Risks:

We shall concentrate on the 3 types of Forex management risks faced by Nestle India:

1. Transaction exposure risks2. Translation exposure risks3. Economic/Business risks

Transaction Exposure

What is Transaction Exposure?

Transaction exposure, can be defined as the sensitivity of “realized” domestic currency values of the firm’s contractual cashflows denominated in foreign currencies to unexpected

exchange rate changes. It is basically a change in the value of a transaction that was entered into before the change in exchange rate.Since settlements of these contractual cash flows affect the firm’s domestic currency cash flows, transaction exposure is sometimes regarded as a short-term economic exposure. Transaction exposure arises from fixed-price contracting in a world where exchange rates are changing randomly.

Some examples of Transaction Exposure include:1. Purchasing or selling on credit when prices are stated in a foreign currency.2. Borrowing or lending funds when repayment is to be made in a foreign currency.3. Being a party to an unperformed foreign exchange forward contract.4. Acquiring assets or incurring liabilities denominated in a foreign currency.

How can Transaction risk be reduced/mitigated?

1. Financial Contracts:a. Forward Market Hedge: Entering into a forwards contract to buy/sell currency to

hedge against the transaction risk. The forward contract takes the opposite of the anticipated risk i.e. for a contract to receive foreign currency, take up a contract to sell the foreign currency.

b. Money Market Hedge: Involves lending and borrowing in the domestic and foreign money market, the general strategy being to borrow (lend) in foreign currency to hedge its foreign currency receivables (payables) thereby matching its assets and liabilities

c. Options Market Hedge: Using currency options to have a flexible hedge against risks, i.e. limited downside but possibility of an unlimited upside

d. Swap Contracts: A swap contract can be used to exchange a set of cash flows in one currency for another at a future date

2. Operational Techniques:a. Invoice Currency: The firm can shift, share or diversify exchange risk by choosing

the currency of invoice. Often firms insist that they be a paid a pre-determined amount in their domestic currency, eliminating risks arising out of changes in foreign currency exchange rates. The risk involved in such an arrangement shifts from one party to the other.

b. Lead and Lag: Another operational technique the firm can use to reduce transaction exposure is leading and lagging foreign currency receipts and payments. To “lead” means to pay or collect early, whereas to “lag” means to pay or collect late. The firm would like to lead soft currency receivables and lag hard currency receivables to avoid the loss from depreciation of the soft currency and benefit from the appreciation of the hard currency. For the same reason, the firm will attempt to lead the hard currency payables and lag soft currency payables.

c. Exposure Netting: Companies with large and diversified risks in multiple currencies (which many times act as a natural hedge) need not individually hedge each currency exposure. The convenient and cost effective technique is to hedge only residual exposures or net exposures. This is called netting.

Nestle India’s Transaction Exposure

Nestle India’s transaction exposure consists of:

1. Imports2. Exports3. Purchase and Sale of fixed assets4. License Fees and Other Expenditures5. Future Transaction exposure arising out of loan in foreign currency (CHF)

1. Imports

The total value of Nestle India’s imports stood at Rs 3842 million with the breakup as given above.

All of the import transactions listed above were carried out in foreign transactions and hence form part of transaction risk.

These form part of transaction risk as these are part of long term contracts with medium to long gestation periods. Changes in the forex rates during the period shall affect the company.

2. Exports

The total value of Nestle India’s exports are Rs 3537 million

However not all the goods exported were denominated in a foreign currency. Transaction risk applies to only those risks that were non-rupee denominated. The transactions that were non-rupee denominated totalled Rs 1503 million. This is the magnitude of transaction risk in the exports.

3. Purchase Or Sale of Fixed Assets

During the year the company had the following foreign exchange outflow/inflow for capital assets transactions:

a. The company purchased fixed assets worth Rs 1189 million using foreign currencyb. The company sold fixed assets worth Rs 1.58 million to Nestle Zimbabwe

However these figures are included in the import/export figures and shall not be considered separately.

4. License Fees and Other Expenditures

Nestle India has to pay Nestle S.A., the holding company a yearly license fee and R&D costs denominated in Swiss Francs. For the FY 2010-11 the license fee paid was Rs 2157 million.

In addition the firm paid Rs 438 million for IT systems and Rs 314 million for miscellaneous. Rs 48 million was the amount recovered.

In totality the Transaction exposure of the firm is as under:

Particulars Amount in Rs MillionImports 3842Exports 1503Fixed Assets 1191License Fees and Others 2957Total 9493

Managing The Transaction Exposure

Nestle India can be thought of as using 3 methods of risk mitigation:

1. Forward Hedges2. Invoicing in domestic currency3. Exposure netting

Forward Hedges

Nestle India primarily employs Forward hedges to hedge against currency fluctuation risks.

The features of these hedges and the reason why nestle uses them are:

1. Firstly, they act as an effective lockdown of value and hedge against adverse risk2. Nestle uses the hedges for a minority of its exposures. This is because a lot of its

exposures benefit from exposure netting from the parent company’s side3. Also locking down a significant part of exposures using forwards limits the profit that

can be made from a favourable change in forex rates.

The company holds forwards contracts against both exports and imports. The cumulative value of the total forward market hedges for exports is Rs 220 million, primarily held in USD.

The total value of the forward hedges against imports is Rs 784 million. The contracts are held majorly in the EUR and USD

The Breakups of the forward hedges are as under:

Currency Exports ImportsUSD 98.6% 36.2%EUR - 49.4%CHF 1.4% 3%GBP - 4.5%Others (AUD, CAD) - 7%

In terms of the proportion of exposures hedged:

Forwards Against Total Value At Risk Value Of Forward PercentageExports 1503 219.2 14.6%Imports 784 3842 20.4%

The extract from the balance sheet detailing these hedges is given below:

The following forex exposures remain unhedged during the year

Invoicing In Domestic Currency

Nestle India invoiced significant portion of its exports in rupees. Out of the total exports of Rs 3537 million, only Rs 1503 million were denominated in a foreign currency. The remaining amount i.e. about Rs 2034 million or about 58% of its exports are not exposed to any transaction risk as they are denominated in rupees.

Exposure Netting

Nestle S.A. enjoys huge risk mitigation, as a lot of the forex transactions carried out are between its subsidiaries. However this indirectly benefits Nestle India as well, as a large amount of its imports and exports end up taking place between its compatriots.

For eg: A loss due to adverse changes in forex in a transaction with Nestle UK does not reduce the competitiveness of Nestle India.

The total sales to fellow subsidiaries totalled Rs 1903 million. Total transactions with fellow subsidiaries was Rs 4876 million which is in excess of 50% of all foreign exchange transactions during the year

Translation Risk

What is Translation Risk?

Translation risk refers to the potential that the firm’s consolidated financial statements can be affected by changes in exchange rates. Whereas transaction risk arises from the possible change in exchange rate between the entering into a financial commitment and recording it, translation risk refers to the change in financial statements due to a change in exchange rates.

What are the different methods of Translation?

1. Current/Non current Method: Current assets and liabilities which have a maturity of one year or less are translated at the current prevailing rate. Assets and liabilities woth maturities of greater than one year are translated at the historical exchange rate in effect that the asset or liability was first recorded in the books.

2. Monetary/Nonmonetary Method: According to the monetary/nonmonetary

method, all monetary balance sheet accounts (for example, cash, marketable securities, accounts receivable, notes payable,accounts payable) of a foreign subsidiary are translated at the current exchange rate. All other (nonmonetary) balance sheet accounts, including stockholders’ equity, are translated at the historical exchange rate in effect when the account was first recorded. In comparison to the current/noncurrent method, this method differs substantially with respect to accounts such as inventory, long-term receivables, and long-term debt. The underlying philosophy of the monetary/nonmonetary method is that monetary accounts have a similarity because their value represents a sum of money whose

currency equivalent after translation changes each time the exchange rate changes. This method classifies accounts on the basis of similarity of attributes rather than similarity of maturities.

3. Temporal Method: Under the temporal method, monetary accounts such as cash, receivables, and payables (both current and noncurrent) are translated at the current exchange rate. Other balance sheet accounts are translated at the current rate, if they are carried on the books at current value; if they are carried at historical costs, they are translated at the rate of exchange on the date the item was placed on the books. Since fixed assets and inventory are usually carried at historical costs, the temporal method and the monetary/nonmonetary method will typically provide the same translation. Nevertheless, the underlying philosophies of the two methods are entirely different. Under current value accounting, all balance sheet accounts are translated at the current exchange rate.

Nestle India follows the monetary/non monetary method of recording its foreign exchange transactions.

The company does import a significant amount of capital goods which are capitalised and shown on the balance sheet. The accounting treatment for this is as under:

1. Transactions in foreign currency are recorded on initial recognition at the exchange rate prevailing at the time of the transaction.

2. Monetary items (i.e. receivables, payables, loans etc.) denominated in foreign currency are reported using the closing exchange rate on each balance sheet date

3. The exchange difference arising on the settlement of monetary items or on reporting these items at rates different from rates at which these were initially recorded/reported in previous financial statements are recognised as income/expense in the period in which they arise.

Nestle’s translation risk for the FY 2009-10 was as under:1. All the entries for foreign exchange risk as shown under Transaction Risks2. Amount paid to Nestle S.A and Maggi Enterprises, the holding companies as final and

interim dividend.3. Amount received from them/Paid to them for miscellaneious.

Thus the total translation risk of the company is as under:

Total Transaction Risk

Particulars Amount in Rs MillionImports 3842Exports 1503Fixed Assets 1191License Fees and Others 2957Dividend Paid – Interim 2170Dividend – Final 756Expenses Reimbursed/Incurred 90Total 12509

Translation risk control:

1. It is safe to assume that the forward contracts taken by Nestle India against imports and exports hedge the translation risk as well. These have been described in detail above.

2. Nestle SA can be thought of as providing a balance sheet hedge to Nestle India, by controlling and collating the financial statements of any other subsidiary Nestle India might be involved with. A surplus/Deficit in nestle India’s balance sheet will be matched by a surplus/deficit in the parent company’s balance sheet (For inter-subsidiary and subsidiary-parent transfer payments). This point has also been discussed in detail in the transaction risks section.

Economic Risks

What is Economic Exposure to Forex changes?

Economic exposure can be defined as the extent to which the value of the firm wouldbe affected by unanticipated changes in exchange rates. It is the change in operating cash flows or other incomes or liabilities due to changes n exchange rates that affect the valuation of a company and its competitiveness.

How can Economic Exposure be managed?

1. Selecting low-cost production sites.2. Flexible sourcing policy.3. Diversification of the market.4. Product differentiation and R&D efforts.5. Financial hedging.

Extent Of Nestle India’s Economic/Operating Exposure

Nestle India’s economic exposure consists of the following:

1. Sales and Purchases from other Nestle subsidiariesNestle India exports a large amount of goods to other Nestle companies because of its position as a cheap producer and the advantageous exchange rate.The details are given below. These total to Rs 1903 million.

Similarly the company also purchases raw materials, machinery and finished goods from certain subsidiaries to take advantage of its advantageous exchange rate. The total for this is Rs 163 million.

In all its exposures to sales/purchases is Rs 2720 million. This is part of economic exposure because nestle S.A can shift its procurement or change trade between subsidiaries to take advantage of their production capabilities and the exchange rate.

Nestle India’s numerous forward hedges against exchange rate changes can keep these risks in check. Also its ability to switch production between factories with varying efficiencies heps. Most the Nestle India factory in Pantnagar is located in an SEZ which allows it excise duty breaks. This will ensure that Nestle India’s production remains comparatively cheaper despite changes in the exchange rates.

2. General License FeesNestle India pays Nestle S.A. a license fee denominated in CHF for the right to manufacture products under its brand names. An appreciation in the rupee can reduce the license fee paid whereas a depreciation in the license fee paid on products can raise the overall license fee paid.

This qualifies as an economic exposure to the extent of the change of the exchange rate. This license fee has to be paid. Last year the fee paid was Rs 2157 million. So the exposure would be equal to 2157 million × adverse movement in the exchange rate

3. Long Term DebtDuring Q2 2011 the company took advantages of cheap debt offered to it by Nestle S.A for capacity expansions. The amount borrowed was Rs 2682 million (60mn USD).

The effective interest rate was 4.9%. Now we can analyse how changes in the exchange rate can change the debt payments:

Effective exchange rate on date of assuming debt = Rs 44.7/1 $Effective Yearly Debt Payment = 4.9% × $ 60mn = $ 2.94 mn = Rs 131.42 mn (at Rs 44.7/ 1$)

Now, since the debt has been taken on the rupee has depreciated against the dollar. The effect on the payables of the company is as under:

Current Exchange Rate(on date of assignment) = Rs 49.80Effective Interest payment = $2.94 × Rs 49.80 = Rs 146.41 mnEffective new interest rate keeping in mind old exchange rate = 5.5%

So the company has to pay Rs 15 mn extra each year just for unanticipated changes in the exchange rate. The effects of this can be that the company may not find borrowing from the parent company, which is a cheap source of capital as advantageous as before.

The firm cannot even hedge against such a risk as the high cost of hedging at almost 5% of the amount nullifies any gains from the cheap debt (refer note above).