A Worrisome Trend With Companies Like Porsche, and General Mills

What has me concerned is that companies are straying out of their domain and into things that has absolutely nothing to do with their business. Let me illustrate with Porsche.

Like a sharp-eyed arbitrageur, the German sports carmaker has spotted that the huge shifts in risk appetite that have rocked the credit markets since last summer means it can earn more from low-risk investment now than it costs to borrow the money.

Porsche declined to comment on how it would invest the proceeds of the loan. Originally, €35bn in credit was provided by a consortium of ABN Amro, Barclays Capital, Merrill Lynch, UBS and Commerzbank to finance a complete takeover of Volkswagen but Porsche deliberately made a low-ball offer designed to fail. However, it kept open the €10bn credit line to help it finance lifting its stake in VW from 31 per cent to more than 50 per cent.

The short of this story is that Porsche who needed to finance their takeover deal of VW lined up a huge amount of credit. No problem there. Though because the takeover never happened Porsche has not needed a 10 billion euro line of credit. Seeing what Porsche considers an opportunity they are thinking about taking the credit and giving it to other companies at a higher interest rate, but lower than what the market is currently offering. Porsche makes money on the spread, but takes on the risk of the loan.

This has to make you think hard, why on earth is Porsche getting into this business model? Read no further.

Porsche also made large amounts of money from currency hedging earlier this decade and some analysts have suggested that it is behaving more like a hedge fund than a carmaker.

There you have it, the gambling addict in Porsche has been awakened. They made some money with a bet and now think they rule the world.

Yet Porsche is not along in this field, there are more companies as talked about in this article.

Under mounting pressure from surging commodity prices, makers of the name brand foods that fill the nation’s grocery shelves are fighting back on several fronts, deploying an arsenal that includes jacking up prices, shutting down factories, and shedding less profitable brands.

But one of the most effective weapons used to defend their bottom line — and one they rarely discuss in public — involves placing big bets in the grains market, a strategy known as hedging.

Ah yes the company hedges the costs, but the reality is that there is no such thing as a free lunch. Hedges are simply pushing money and risk from one corner to another. Sure a hedge might contain a cost, but a hedge has a premium and that will take away from your bottom line.

Companies “hedge” because they feel like they can earn money.

General Mills chalked up $151 million in gains from hedges in the volatile agricultural and energy markets during its quarter ended Feb. 24. This added 27 cents a share to the earnings of the Minneapolis maker of Cheerios, Nature Valley snack bars, and Yoplait yogurt.

Companies hedge see the easy money, and they think that they are protected.

“I can tell you that we use sophisticated and flexible hedging strategies to protect our self against volatile commodity conditions…no strategies are executed solely on a directional view of the market,” Sara Lee spokesman Mike Cummins said in an email.

In a book I was reading called Traders Guns, and Money the author talked about hedging, and how hedging ended up costing the companies their existence (Asian crisis?) (pg 90)

You can’t hedge without knowing what is going to happen to the oil price. Is it going up, or down? How volatile is it going to be? Wasn’t hedging meant to reduce risk? Why do I need to know what is going to happen in the price? Aren’t I hedging to eliminate the need to know what is going to happen to the price? Financial people at companies, accountants or the equivalents, are comfortable with known knowns. Hedging is about known unknowns – or is it unknown unknowns. It is a risky business – a true lie.

Any hedging decision is surreal: options can be eliminated from the menu; paying premiums to buy options is wasteful; selling options is gambling. You do nothing or buy forward. Doing nothing has advantages: in corporate life actions of commission are punished more harshly than acts of omission. Buying forward is probably best because you buy certainty and it doesn’t cost you anything. Right? Wrong!

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Does the forward guarantee certainty? The airlines cost of oil is fixed, but its problems are not over. Assume the airline hedges buts its competitors don’t. If the oil price falls then our airline’s cost of oil is fixed, but competitors benefit from lower oil prices.

What the author is talking about is that hedging and the perceived benefits is a lie. To hedge you need to know what the price of commodity is going to go. If you do a straddle then you are saying the price is going way up or way down. What if the price does nothing? Does the hedge premium not end up costing you money? As the author says a hedge is a risky business and a true lie.

I am very concerned that companies like Porsche and General Mills are looking at these techniques as a way to add to the bottom line. Because there will be a day when these techniques will take away from the bottom line.