Cemex strategic Risk Management Cemex Strategic Risk Management Essay

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CEMEX:Strategic Risk Management

CEMEX: Strategic Risk Management

CEMEX is a leading producer of cement products. Headquartered in Monterrey, Mexico, CEMEX serves customers around the globe. Before the 1970s, CEMEX was a sleepy company, limited in scope to the domestic market, engaged in cement, mining, tourism and petrochemicals. Rising through the ranks of the company his grandfather founded in 1906, CEO Lorenzo Zambrano focused the company on the world market for cement after divesting the non-core businesses. (Spieth, 2005)

Risk Management as an Operational Competence

The single biggest risk to a company with a cement-only strategy is the requirement to commit substantial capital to factory-level plant and equipment, in the face of uncertain and fluctuating demand. This risk is heightened by the commoditization of the products and services which results in prices falling to the level of marginal cost during times when supply exceeds demand. Long-term, the natural ebb and flow of firms entering and leaving the business drives prices toward a sustainable state of equilibrium. In the short-term, an aggressive posture of market dominance though capacity expansion increases the risk of unbalanced supply and demand with the likely outcome being lower prices. (Lessard & Lucea, 2008)

Zambrano's response to this existential risk has been international diversification, primarily through acquisitions. Since the mid-1980s when this strategy was adopted, CEMEX has acquired more than a dozen companies. The secret to the company's success with this strategy has been the attention paid to integrating the acquired company into The CEMEX Way, which involves three core elements. 1) a formal process for recognizing and managing operational risk, 2) a clear assignment of responsibilities among the local business units, regional and corporate entities, and 3) measuring the results with a variety of processes and IT tools. (Lessard & Lucea, 2008)

The first step in the integration process is the education of the new employees in CEMEX's standard management systems using the most modern information technology. The second step is the dissemination of standard reporting and accountability procedures. The overall goal of these steps is to make available to managers at all levels the very latest information on production levels and prices in all served markets. Also, the CEMEX IT system relies heavily on a sophisticated Capex model that informs capital allocation decisions among operating units. CEMEX has prided itself on the integration results which have been accomplished largely through the adoption of standard processes and not through the replacement of the management of the acquired companies. Another risk reduction factor worth noting is the factor of the speed of completing the integration process. Quick resolution of management and employee concerns is vital to achieving the objectives of the acquisition. (Lessard & Lucea, 2008)

Another benefit to CEMEX from its international diversification of assets is the reduced risk and value added from an active commodity trading posture. The challenge of matching supply and demand on a country-by-country basis is mitigated when products can be physically moved from market to market. By actively trading cement in the open market, CEMEX can reduce the variability of cash flows, increase overall capacity utilization or reduce the investment required to support a target sales volume. A refinement of this basic strategy came with the attainment of major trader status as well as a becoming a substantial player on the terminal and shipping stage. CEMEX has found it advantageous to manage trading regionally, close to the markets, and to take shipping decisions from corporate headquarters. (Lessard & Lucea, 2008)

Becoming active in over 50 countries gives rise to another set of risks facing CEMEX: These risks are associated with the uncertainties of environmental regulations as well as the regulatory environment governing market access and pricing. Nearly every country in the world actively protects its native enterprises against foreign competitors. The CEMEX response to this class of risks is to actively and formally attempt to anticipate changes in the regulatory and social environment in each country market. This often involves lobbying and advertising to make sure the public's expectations are properly addressed and influenced. Risk mitigation in this arena also includes the centralized control of shipping and making sure that internal legal authority is exercised within each country and across borders. (Lessard & Lucea, 2008)

Every major industry faces a common uncertainty of the fluctuating cost of energy. CEMEX has devised three responses to this difficult challenge: 1) innovation at the factory level to find locally attractive alternatives to oil, including pet-coke and tire chips (environmental concerns have been raised), 2) actively contracting for and hedging energy prices - providing greater price stability and less volatility of supply interruptions, and 3) CEMEX does business in many countries with local currencies as tender, but raises capital only in U.S. dollars and Japanese yen. CEMEX had determined that, other than energy costs, the local costs and revenues are reasonably well balanced so no hedging of exchange risks is necessary at the local level. (Lessard & Lucea, 2008)

CEMEX enjoyed early success with the Zambrano strategy through its focus on building its business operations in high-growth areas of the world instead of the developed world where demand for cement is on a plateau. The risks of doing business in the developing world, with all its unstable governments and potential for revolution, were mitigated by geographical diversification. Since the local subsidiaries acquired most of their raw materials and energy from within the country of operation, revenues were largely matched with liabilities. CEMEX gained a competitive advantage over local companies owing to its economies of scale in trading, shipping, information technology and innovation. It also enjoyed a favorable debt rating owing to its diversified operations and predictable earnings stream. (Spieth, 2005)

Currency Risk in the Supply Chain

Before 2005, CEMEX had attempted to manage its corporate currency risk by using financial derivatives. CEMEX revealed in its 2004 annual report that it used interest rate and currency swaps, currency and equity forward contracts, options and futures, all supplied by the international investment banks. The goal was to hedge against volatility in foreign exchange rates and interest rates of debt obligations, to reduce financing costs, and to hedge forecasted transactions and net assets in foreign subsidiaries and to protect the stock-option plans. (Spieth, 2005)

Risks associated with forecasted transaction arise when a commercial contract has been agreed and payment will occur in a later period. For instance, a subsidiary could contract to purchase raw materials in another country at an agreed price in U.S. dollars to be paid a year out in the future. The subsidiary would buy a forward contract to lock in the current exchange rate picture to gain insurance against possible losses if the currency of the third-party country should depreciate against the U.S. dollar before the due date of the transaction. (Spieth, 2005)

Currency risks related to debt obligations may be experienced when CEMEX borrows money in a foreign currency with the expectation that the debt will have to be serviced and repaid from funds in another currency. This situation could be resolved by using options or forward contracts to hedge the risk of a fluctuation in exchange rates prior to maturity. As an example, if CEMEX borrowed money in U.S. dollars, it could buy a call option to cover the amount borrowed for the right to purchase dollars later on at a specific strike price. So, if the dollar appreciates, CEMEX would exercise the option, but if the dollar depreciates, CEMEX would rather buy dollars at the spot price. (Spieth, 2005)

In addition to options and forward contracts, CEMEX uses cross currency swaps to hedge currency risks related to debt service. Buyers of these instruments exchange the financial risk of foreign exchange transactions and the interest rate fluctuations of a given debt instrument for the similar risks of another instrument. CEMEX apparently uses these swaps to access the investors in particular markets while avoiding the inherent currency risk in those markets. (Spieth, 2005)

Finally, CEMEX hedges against translation risk. That is to say, the company buys insurance that if the annual financial results of a subsidiary depreciate against the Mexican peso (CEMEX's reporting currency) during the reporting period, the corporate reported results will be protected. This risk is mitigated by CEMEX hedging the net assets of the subsidiary, thereby preserving the appearance of a more stable company for investors. (Spieth, 2005)

Hedging Strategies

Derivatives

CEMEX has traditionally utilized a complex array of tools for hedging currency risk. As mentioned above, derivatives had been a key ingredient in the hedging strategy. Starting in 2005, CEMEX began to pull back from a reliance on derivatives to minimize the costly fees charged by the investment banks. Another factor central to the change in strategy was the fact that the derivatives related to currencies of the countries in the developing world are even more expensive to maintain, and are less available in the amounts or maturities required, owing to the fact that they are not widely traded on the open markets. (Spieth, 2005)

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