CEMEX Strategic Risk Management and Currency Hedging

Introduction to CEMEX and Its Global Strategy

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

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

Risk Management as an Operational Competence

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 approach has been the attention paid to integrating acquired companies 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 local business units, regional entities, and corporate headquarters, and (3) measuring results with a variety of processes and IT tools. (Lessard & Lucea, 2008)

The first step in the integration process is educating new employees in CEMEX's standard management systems using modern information technology. The second step is the dissemination of standard reporting and accountability procedures. The overall goal is to make the latest information on production levels and prices in all served markets available to managers at every level. The CEMEX IT system also relies heavily on a sophisticated capital expenditure model that informs capital allocation decisions among operating units. CEMEX has prided itself on achieving integration results largely through the adoption of standard processes, rather than replacing the management of acquired companies. Another noteworthy risk-reduction factor is the speed of completing the integration process — quick resolution of management and employee concerns is vital to achieving acquisition objectives. (Lessard & Lucea, 2008)

Another benefit of CEMEX's international diversification is the reduced risk and added value 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 cash flow variability, increase overall capacity utilization, or reduce the investment required to support a target sales volume. This basic strategy was refined further when CEMEX attained major trader status and became a substantial player in the terminal and shipping stages. The company found it advantageous to manage trading regionally, close to the markets, while taking shipping decisions from corporate headquarters. (Lessard & Lucea, 2008)

Operating in over 50 countries gives rise to another set of risks: uncertainties associated with environmental regulations and the regulatory environment governing market access and pricing. Nearly every country actively protects its native enterprises against foreign competitors. CEMEX's response is to formally and proactively anticipate changes in the regulatory and social environment in each country market. This often involves lobbying and advertising to ensure that public expectations are properly addressed and, where possible, shaped. Risk mitigation in this area also includes centralized control of shipping and ensuring that internal legal authority is exercised both within individual countries and across borders. (Lessard & Lucea, 2008)

Every major industry faces the common uncertainty of fluctuating energy costs. CEMEX has devised three responses to this challenge: (1) innovation at the factory level to find locally attractive alternatives to oil, including pet-coke and tire chips (though environmental concerns have been raised); (2) actively contracting for and hedging energy prices to provide greater price stability and reduce the risk of supply interruptions; and (3) raising capital only in US dollars and Japanese yen, even while conducting business in many countries with local currencies. CEMEX determined that, apart from energy costs, local costs and revenues are reasonably well balanced, making local-level exchange rate hedging unnecessary. (Lessard & Lucea, 2008)

CEMEX achieved early success with the Zambrano strategy by focusing on high-growth areas of the developing world rather than mature developed markets where cement demand had plateaued. The risks of operating in developing countries — including unstable governments and the potential for political upheaval — were mitigated by geographical diversification. Because local subsidiaries sourced most of their raw materials and energy from within their country of operation, revenues were largely matched with liabilities. CEMEX gained a competitive advantage over local companies through its economies of scale in trading, shipping, information technology, and innovation. It also benefited from a favorable debt rating attributable to its diversified operations and predictable earnings stream. (Spieth, 2005)

Before 2005, CEMEX managed its corporate currency risk primarily through financial derivatives. The company's 2004 annual report disclosed the use of interest rate and currency swaps, currency and equity forward contracts, options, and futures — all supplied by international investment banks. The goals were to hedge against volatility in foreign exchange rates and interest rates on debt obligations, reduce financing costs, hedge forecasted transactions and net assets in foreign subsidiaries, and protect stock-option plans. (Spieth, 2005)

Currency Risk in the Supply Chain

Risks associated with forecasted transactions arise when a commercial contract has been agreed upon but payment will occur in a later period. For example, a subsidiary might contract to purchase raw materials in another country at an agreed price in US dollars, to be paid a year in the future. The subsidiary would buy a forward contract to lock in the current exchange rate, gaining protection against potential losses if the third-party country's currency were to depreciate against the US dollar before the transaction's due date. (Spieth, 2005)

Currency risks related to debt obligations arise when CEMEX borrows in a foreign currency with the expectation that the debt will be serviced and repaid using funds in another currency. This situation can be managed using options or forward contracts to hedge the risk of exchange rate fluctuations prior to maturity. For instance, if CEMEX borrowed in US dollars, it could buy a call option covering the borrowed amount, giving it the right to purchase dollars later at a specific strike price. If the dollar appreciates, CEMEX would exercise the option; if the dollar depreciates, CEMEX would buy dollars at the spot price instead. (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 foreign exchange risk and interest rate fluctuations of one debt instrument for the analogous risks of another. CEMEX appears to use these swaps to access investors in particular markets while avoiding the inherent currency risk in those markets. (Spieth, 2005)

Finally, CEMEX hedges against translation risk — that is, it purchases protection against the possibility that the annual financial results of a subsidiary will depreciate against the Mexican peso (CEMEX's reporting currency) during the reporting period. This risk is mitigated by hedging the net assets of the subsidiary, thereby preserving the appearance of a more stable company for investors. (Spieth, 2005)

Conclusion

Lessard, Donald R. & Lucea, Rafael. (May 2008). Embracing Risk as a Core Competence: The Case of CEMEX. MIT Sloan School and George Washington University.

Spieth, Scott. (December 12, 2005). Cementing the Future: Hedging Foreign Currency Risk at CEMEX.