Clearwater Seafoods case Essay
Clearwater Seafoods case
Clearwater Seafood (Clearwater) is a seafood company located on the east coast of Canada, and Clearwater Seafood income Fund with operations around the world. As a result of the increasing importance of the Canadian dollar relative to other currencies of the world, Clearwater recently stopped paying their distributions. The decision faced by the financial director to determine the strategy of the company should take to enable it to recover its distribution. This is due to the choice between various financial and operational resources to hedge currency risks that brought the company to its current situation Background:
Clearwater was founded in 1976 at Bedford, Nova Scotia as a local lobster distributer and later in 2002 went public. Clearwater Seafood harvests, processes, and distributes fresh and frozen fish and shellfish to sell worldwide. It holds major offshore rights to harvest clams, crab, lobster, scallops, and shrimp off the north eastern coast of Canada. Clearwater Seafood operates its own fleet of ships, along with off-shore and on-shore processing facilities. Foreign Exchange Risk:
Foreign exchange risk is the risk to the value of one’s assets when it is valued in another currency. The exchange rate of a currency to another may be volatile. It is this change in value of the currency that gives rise to foreign exchange risk. Depreciation in the currency in which your assets are denominated will result in a lower value of your assets when measured in another currency compared to the period before depreciation. The majority of Clearwater’s customers are international customers. In 2005, majority of Clearwater’s sales were from overseas customers. The source of their foreign exchange risk is the payment method that the company implements. The customers are billed in their domestic currency rather than in Canadian dollars.
Clearwater deals with customers from the US, Japan, Europe and Asia. The company receives payment from its international customers in their respective currency. When the Canadian dollar appreciates in relation to all these currencies, the money that Clearwater receives from their customers loses value. The higher the Canadian dollar appreciates, the less Canadian dollars Clearwater can convert to with the US dollars, euros or yen that they receive from their customers. Risks associated with foreign exchange are partially mitigated by the fact Clearwater operates internationally, which reduces the impact of any country specific economic risks on its business. Clearwater also uses forward exchange contracts to manage its foreign currency exposures.
Clearwater’s sales denominated in U.S. dollars were approximately 55% of annual sales as on December 31st 2005. These forward contracts were such that a one-cent change in the U.S. dollar as converted to Canadian dollars would result in a $505,000 change in sales and gross profit. In addition, approximately 19% of 2005 annual sales were denominated in Euros. Based on the sales and hedges in place on December 31, 2005, a one-cent change in the Euro as converted to Canadian dollars would result in a $285,000 change in sales and gross profit. Also, 8% of 2005 annual sales were denominated in Japanese Yen. Based on 2005 annual sales, every one twentieth of a cent change in the Yen as converted to Canadian dollars would result in a change of ¥118,087,000 in sales and gross profit. It is clear that Clearwater faces significant foreign exchange risk and the implications of an adverse change in the currency conversions can be too huge for the company to endure. Business risk:
Business risk is the possibility that a company will have lower than anticipated profits or the company will incur a loss. Business risk may influenced by numerous factors, including sales volume, per-unit price, input costs, competition, and overall economic climate and government regulations. Clearwater’s business depends on a continuing supply of product that meets its quality and quantity requirements. Water temperatures, feed in the water and the presence of predators all influence the level of the catch and harvesting locations are not necessarily consistently successful from year to year. The availability of seafood in Canadian and Argentinean waters is also dependent on the total allowable catch allocated to Clearwater in a given area.
Although the totals allowable catch in these areas and Clearwater’s enterprise allocations have been largely stable, fishery regulators have the right to make changes in the total allowable catch based on their assessment of the resource from time to time. Any reduction of total allowable catches in the areas from which Clearwater sources seafood, or the reduction of stocks due to changes in the environment or the health of certain species, may have a material adverse effect on Clearwater’s financial condition and results of operations. Resource risk is managed through adherence to the Department of Fisheries and Oceans (”DFO”) policies and guidelines. The guidelines, developed by DFO, are very often a cooperative effort between industry participants and DFO.
Clearwater mitigates the risk associated with resource supply and competition through the diversification across species. Clearwater’s operating costs may be negatively affected by increases in inputs, such as energy costs, raw material and commodity prices. Clearwater uses fuel, electricity, air and ocean freight and other materials in the production, packaging and distribution of its products. Fuel and freight are two significant components of the costs of Clearwater’s products and the distribution thereof the inability of any of Clearwater’s suppliers to satisfy its requirements or a material increase in the cost of these inputs may have an adverse effect on Clearwater’s financial condition and results of operations.
The seafood industry is highly competitive in all of the markets in which Clearwater participates. Some of Clearwater’s competitors have more significant operations within the marketplace, a greater diversification of product lines and greater economic resources than Clearwater and are well established as suppliers to the markets that Clearwater serves. Such competitors may be better able to withstand volatility within the seafood industry and throughout the economy as a whole while retaining greater operating and financial flexibility than Clearwater. There can be no assurance that Clearwater will be able to compete successfully against its current or future competitors or that competition will not affect Clearwater’s financial condition and results of operations. Recommendations for management:
Foreign Exchange Risk:
Clearwater did not completely offset the recent currency fluctuations with their hedge positions and they paid the price for it. It is recommended that they fully hedge all their foreign exchange positions. FPI is an example of a competitor in the industry who has benefited from doing so. FPI was largely unaffected by the currency fluctuation that badly affected Clearwater. This is justified by FPI’s increase in sales from 2003 to 2004 where Clearwater had corresponding drop in sales during the same period. It is also recommended that Clearwater switch its short call options to long call options. In its current short call position, Clearwater is the seller of the option and has no right to exercise the option. Clearwater is responsible to meet its obligations in the case the counterparty exercises the option at strike price.
In a nut shell, under this short call position, Clearwater does not eliminate uncertainty on currency prices, its counterpart however does. Instead of this position, Clearwater should enter in long call options to hedge its foreign exchange risk. They should lock in prices to buy Canadian dollars in all the foreign currencies that they receive as payment such as US dollars, yen, euro, sterling and others. If the Canadian dollar were to appreciate, they would exercise the call option at the stipulated strike price and this would cut their losses of further appreciation. If the Canadian dollar were to depreciate, Clearwater would merely lose the price paid for the option premium. Overall, Clearwater benefits from this long call position regardless whether the exchange rate appreciates or depreciates as they have removed uncertainty in the exchange rate.
Clearwater should also diversify its hedging strategies and enter into a matching receipts and payments strategy. This method involves offsetting receipts and payments. As a major part of their foreign exposure is to the US dollar, it is recommended that they rearrange some of their purchasing arrangement with its current domestic suppliers and switch to suppliers from the United States. By switching to American suppliers, they will be billed in US dollars. The US dollars that Clearwater receives from its American customers can be used to pay the bills that are denominated in US dollars. This directly nullifies any volatility in the US dollar to Canadian dollar exchange rate. Clearwater should enter into agreements with its large counterparties to receive payment in Canadian dollars. This will transfer the risk onto the other party’s head and will allow matching strategy to be implemented.
This may not be possible for the smaller parties that owe Clearwater money. Another alternative would be for Clearwater to hedge their currency positions through investing in gold. It has been a common business practice for many years to use gold or other precious metals to hedge currency positions. The company could consider keeping gold in their portfolios to guard against economic downturns. As the seafood industry is an industry that is primarily based on international trade, the success of any company in this industry will rely on the way the company manages its foreign exchange risk. Clearwater should expand its foreign exchange management program with qualified financial professional who have years of prior knowledge in hedging currency positions. Operating and Business risk:
As compared to its competitors FPI and American Seafoods Group, Clearwater offers more high-value seafood products with higher prices. Therefore it is highly unlikely that the company has the ability to pass on any increases in fuel prices to their customers, without a negative impact on their profit margins. It is recommended that the company buys a fuel swap to hedge against fuel prices. In addition to that, the company could also consider buying a fuel call option. If the price of fuel increases, the company will receive a return on the option that offsets their actual cost of fuel. In terms of expanding its market, I believe that Clearwater should look into entering the Chinese market in the future. The increasing demand for high-value seafood in China has been fuelled by its growing middle class.
The company could market its seafood products as being fresh and natural to beat the local Asian aquaculture competitors who currently dominate that market. In order to fund the fuel hedge as well as the China marketing cost, it is advised that Clearwater sell off surplus TACs. Clearwater currently owns the highest percentage of TACs in Canada. It is recommended that clam TACs be sold as Clearwater currently has full TAC ownership of clams with the largest quota of 44,000.
However clams only make about 15.6% of the company’s sales which suggest that the profit margins on clams is relatively small compared to scallops or lobsters who have sales percentage of 31.3% and 22.5% respectively and TAC quotas of 10,275 and 720 respectively. I believe it is logical to make a small sacrifice to gain funding to hedge volatile fuel cost as well as fund marketing costs into a new segment. Greater good is expected at the cost of a small sacrifice. As the company currently faces difficulty in the foreign exchange market, this way of funding ignores currency rates as Clearwater will be selling their TACs to other Canadian companies which would be paying for the TACs in the Canadian dollars.