C H A P T E R 1 2

Identifying, Mea sur ing, and Hedging Currency Risk at Merck

judy c. lewent and a. john kearney

The impact of exchange rate volatility on a company depends mainly on the company’s business structure, both legal and operational, its indus- try profi le, and the nature of its competitive environment. This article recounts how Merck assessed its currency exposures and reached a decision to hedge those exposures. After a brief introduction to the company and the industry, we discuss our methods of identifying and mea sur ing our exchange exposures, the factors considered in deciding whether to hedge such risks, and the fi nan- cial hedging program we put in place.

An Introduction to the Company

Merck & Co., Inc. primarily discovers, develops, produces, and distributes hu- man and animal health pharmaceuticals. It is part of a global industry that makes its products available for the prevention, relief, and cure of disease throughout the world. Merck itself is a multinational company, doing business in over 100 countries.

Total worldwide sales in 1989 for all domestic and foreign research- intensive pharmaceutical companies are projected to be $103.7 billion. Worldwide sales for those companies based in the United States are projected at $36.4 billion—an es- timated 35% of the world pharmaceutical market; and worldwide sales for Merck in 1989 were $6.6 billion. The industry is highly competitive, with no company holding over 5% of the worldwide market. Merck ranks fi rst in phar- maceutical sales in the United States and the world, yet has only a 4.7% market

This chapter was previously published as an article in Journal of Applied Corporate Finance Vol. 2, No. 2 (1990): 19–28. The authors would like to thank Francis H. Spiegel, Jr., Se nior Vice President and CFO of Merck & Co., Inc., and Professors Donald Lessard of M.I.T. and Darrell Duffi e of Stanford for their guidance throughout.

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share worldwide. The major foreign competitors for the domestic industry are Eu ro pe an fi rms and emerging Japa nese companies.

Driven by the need to fund high- risk and growing research expenditures, the U.S. pharmaceutical industry has expanded signifi cantly more into foreign markets than has U.S. industry as a whole. In 1987, the leading U.S. pharma- ceutical companies generated 38% of their sales revenues overseas; and 37% of their total assets were located outside the United States. In contrast, most U.S. industry groups report foreign sales revenues in the range of 20% to 30%. Merck, with overseas assets equal to 40% of its total and with roughly half of its sales overseas, is among the most internationally oriented of U.S. pharma- ceutical companies.

The U.S. pharmaceutical industry also differs in its method of doing busi- ness overseas. In contrast to U.S. exporters, who often bill their customers in U.S. dollars, the pharmaceutical industry typically bills its customers in their local currencies. Thus, the effect of foreign currency fl uctuations on the phar- maceutical industry tends to be more immediate and direct.

The typical structure is the establishment of subsidiaries in many overseas markets. These subsidiaries, of which Merck has approximately 70, are typi- cally importers of product at some stage of manufacture, and are responsible for fi nishing, marketing, and distribution within the country of incorpora- tion. Sales are denominated in local currency, and costs in a combination of lo- cal currency for fi nishing, marketing, distribution, administration, and taxes, and in the currency of basic manufacture and research—typically, the U.S. dollar for U.S.- based companies.

Identifi cation and Mea sure ment of Exposure

It is generally agreed that foreign exchange fl uctuations can affect a U.S. com- pany’s economic and fi nancial results in three ways:

1. By changing the dollar value of net assets held overseas in foreign currencies (known as “translation” exposures) or by changing the expected results of transactions in non- local currencies (“transaction” exposures).

2. By changing the dollar value of future revenues expected to be earned overseas in foreign currencies (“future revenue” exposures).

3. By changing a company’s competitive position—for example, a competitor whose costs are denominated in a depreciating currency will have greater pricing fl exibility and thus a potential competitive advantage (“competitive” exposures).

264 practitioner perspectives

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Any unauthorized use or reproduction of this document is strictly prohibited*.

identifying, measuring, and hedging currency risk 265

Competitive exposures have been the subject of much of the recent aca- demic work done on exchange risk management. Such exposures are best ex- emplifi ed by the adverse effect of the strong dollar on the competitive position of much of U.S. industry in the early 1980s. This was true not only in export markets but also in the U.S. domestic market, where the strengthening U.S. dollar gave Japa nese- and Eu ro pe an- based manufacturers a large competitive advantage in dollar terms over domestic U.S. producers.

For the pharmaceutical industry, however, the pricing environment is such that competitive exposure to exchange fl uctuations is generally not signifi cant. The existence of price controls throughout most of the world generally reduces fl exibility to react to economic changes.

Hence, Merck’s exposure to exchange tends to be limited primarily to net asset and revenue exposures. The potential loss in dollar value of net revenues earned overseas represents the company’s most signifi cant economic and fi – nancial exposure. Such revenues are continuously converted into dollars through interaffi liate merchandise payments, dividends, and royalties, and are an important source of cash fl ow for the company. To the extent the dollar value of these earnings is diminished, the company suffers a loss of cash fl ow— at least over the short term. And, as discussed in more detail later, the resulting volatility in earnings and cash fl ow could impair the company’s ability to exe- cute its strategic plan for growth.

With its signifi cant presence worldwide, Merck has exposures in approxi- mately 40 currencies. As a fi rst step in assessing the effect of exchange rate movements on revenues and net income, we constructed a sales index that mea- sures the relative strength of the dollar against a basket of currencies weighted by the size of sales in those countries.1 When the index is above 100%, foreign currencies have strengthened versus the dollar, indicating a positive exchange effect on dollar revenues. When the index is below 100%, as was the case through most of the 1980s, the dollar has strengthened versus the foreign cur- rencies, resulting in income statement losses due to exchange.

As fi gure 12.1 illustrates, the index was relatively stable from 1972 to 1980. But, as the dollar strengthened in the early 1980s, the index declined to the 60% level, resulting in a cumulative exchange reduction in sales of approximately $900 million. But, then, as the dollar weakened in the later 1980s, the index in- creased to roughly 97%, returning to its 1972–1980 range.

But, as fi gure 12.2 also shows, although the overall index returned as of 1988 to the earlier range, not all currencies have moved together against the dollar. The strengthening in the yen and the deutsche mark has offset the

1. The index uses 1978 as its base year. The currency basket excludes hyperinfl ationary markets where exchange devaluation is mea sured net of price increases.

This document is authorized for use by Suhan Patel, from 1/7/2018 to 4/7/2018, in the course: MBA 7294: Advanced Financial Analysis – John Bish 2018, Wilmington University.

Any unauthorized use or reproduction of this document is strictly prohibited*.

Sa le

s In

de x

Year

’84 ’86 ’88

Sterling

DM

Yen

LIT

FF

Sa le

s In

de x

’72 ’74 ’76 ’78 ’80 ’82

80

100

120

160

140

180

60

40

80

100

120

160

140

60

40

FIGURE 12 . 2

Merck Sales Index 1978—100%

80

90

100

120

110

60

Year

Sa le

s In

de x

’84 ’86 ’88’74 ’76 ’78 ’80 ’82’72

70

50

FIGURE 12 .1

Merck Sales Index

This document is authorized for use by Suhan Patel, from 1/7/2018 to 4/7/2018, in the course: MBA 7294: Advanced Financial Analysis – John Bish 2018, Wilmington University.

Any unauthorized use or reproduction of this document is strictly prohibited*.

identifying, measuring, and hedging currency risk 267

decline of historically weaker currencies such as the Italian lira and French franc, while the British pound is very near 1978 levels.

Resource Allocation

Given the signifi cant exchange exposure of our net overseas revenues as re- fl ected by our experience in the early 1980s, we next decided to review the com- pany’s global allocation of resources across currencies and, in the pro cess, to determine the extent to which revenues and costs were matched in individual currencies. Our analysis (the main fi ndings of which are illustrated in fi gure 12.3) revealed that the distribution of Merck’s assets differs somewhat from the sales mix, primarily because of the concentration of research, manufacturing, and headquarters operations in the United States.

On the basis of this analysis, it was clear that Merck has an exchange rate mismatch. To reduce this mismatch, we fi rst considered the possibility of rede- ploying resources in order to shift dollar costs to a different currency. This pro- cess would have involved relocating manufacturing sites, research sites, and employees such as headquarters and support staff. We soon reached the con- clusion, however, that because so few support functions seemed appropriate candidates for relocation a move would have had only a negligible effect on our global income exposure. In short, we decided that shifting people and re- sources overseas was not a cost- effective way of dealing with our exchange exposure.

Hedging Merck’s Exposures with Financial Instruments

Having concluded that resource deployment was not an appropriate way for Merck to address exchange risk, we considered the alternative of fi nancial

FIGURE 12 .3

Merck’s Geographic Mix of Sales and Assets

Gross AssetsTotal Sales

Domestic

Foreign

48%

52% 40%

60%

This document is authorized for use by Suhan Patel, from 1/7/2018 to 4/7/2018, in the course: MBA 7294: Advanced Financial Analysis – John Bish 2018, Wilmington University.

Any unauthorized use or reproduction of this document is strictly prohibited*.

hedging. Thinking through this alternative involved the following fi ve steps: