Futuram’s Risk Management Strategy
Read the following story about this agricultural biotech firm carefully, then answer the questions at the end of the case. This story, all names, characters, and incidents described are fictitious. No identification with actual persons, companies, places, or products is intended or should be inferred. Normally, when Futuram is mentioned in newspapers, it’s usually for a new genetically engineered seed. Yet this agricultural biotech firm, based in California, has turned to financial engineering to ensure its profits.
At its January 2017 annual meeting, Futuram announced a profit of over $1B from its agricultural products and technology solutions designed to improve farm productivity and product quality. And while investors were pleased with this number, they were absolutely stunned by the fact that Futuram made an even larger profit ($1.8B) from financial derivative transactions. Futuram, in order to protect its profits against a weakening dollar, made large trades in foreign exchange options. These trades doubled Futuram’s profits!
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Some investors lauded management for making shrewd financial decisions. Others expressed concern that the company was deviating too much from its mission, citing that Futuram was never intended to be primarily a financial institution. So, do you think that Futuram is making wise financial decisions? Or is the company heading down a new path that might endanger its bottom line?
With headquarters in Sacramento, California, Futuram is a market leader in agricultural biotechnology. As of 2017, its product line focused on crop science and agricultural biologicals. It produces genetically modified (GM) seed for soybeans, sugar beets and corn. In addition, it provides fertilizers and herbicides to ensure more successful crop production. Its seed division is one of the top suppliers of vegetable and fruit seeds worldwide.
The company started in the late 1940s as a chemical company and focused its research on antiseptics and pain relievers. Its owner, Thomas Warder, responding to the increasingly competitive pharmaceutical industry, refocused Futuram’s research efforts on herbicides and fertilizers that would improve farm yield. As of 2008, Futuram was recognized as a world leader is helping farmers grow foods more sustainably, while protecting our natural resources. Futuram is a publicly traded company, with 6 million ordinary shares held by the Warder family and 9 million shares held primarily by institutional investors.
Risk Management Policy
Futuram decide that it would hedge its sales against negative movements in the exchange rate for the next two years. To do this, the company bought and rolled over a portfolio of put options with various maturities of up to two years. As of June 30, 2015, Futuram held options with a notional amount of ?‚¬8 billion and a market value of about ?‚¬0.5 billion. This means that if Futuram had exercised these put option on June 30, 2015, it would sell about ?‚¬8 billion worth of dollars at the pre-determined exchange rate given by the strike of the put options. That amount (?‚¬8 billion) was roughly two times the company’s annual sales outside of the United States. So, the company’s goal of hedging against exposure two years out would be met.
Futuram and its competitors differed in their approach to foreign exchange risks. While Futuram did not believe you could ever outwit the market, certain competitors, such as The B. W. Group, determined that their computer models could fairly accurately forecast exchange rates. Those competitors did not choose to hedge against foreign exchange risks as heavily as Futuram did.
The Gordon Acquisition
In October, 2014, Futuram acquired a 25% stake in Gordon, the English-based world leader in animal husbandry and related computer hardware and software design. This move surprised analysts, who believe that the company should stay focused on its core business of crop science. Gordon, a much larger and more prominent company, was struggling to improve profitability. Its sales topped $3B, while Futuram sales were less than $1B.
Gordon was a potential target for takeover and breakup, as it had been struggling for many years to achieve and maintain a satisfactory level of profitability. Many analysts argued that the company suffered from large inefficiencies. In particular, analysts criticized the use of profits from its animal husbandry division to support expansion of its technology division.
For many years, the company had benefited from an old English law limiting the voting rights of any shareholder to a maximum of 25%. Futuram was counting on a repeal of that mandate by the European Commission. And indeed, that was what happened. In February of 2016, Futuram acquired additional stock, raising its stake in Gordon to 29%.
It also announced that it had purchased enough call options on Gordon’s ordinary shares, so that it faced no price risk in this planned increase in its stake. Then in November of 2016, Futuram announced that it had exercised options for the acquisition of an additional 3.5% of ordinary shares of Gordon, increasing its stake to 32.5%.
Increasing its stake above 30% triggered, by law, a requirement to make a mandatory offer for the remaining Gordon shares. Futuram, however, offered only the minimum price as legally required, 85.30 per ordinary share, 16% below the prevailing market price at the time. Not surprisingly, few shareholders were interested in this offer. So, Futuram still held 29.8% of Gordon’s ordinary shares and had options to buy another 3%. The mandatory offer expired in March. This left Futuram free, should it choose, to increase its stake in Gordon up to 50%.
As you can see, Futuram used call options on Gordon stock extensively in order to build its stake in the company. Management cited this choice as one that helped them hedge against the risk that their actions would cause Gordon’s stock price to increase. It was unknown how many options Futuram held; however, analysts believed it to be a significant number.
Futuram’s foreign exchange hedges and the acquisition of the England-based Gordon stake dramatically increased Futuram’s bottom line in 2017. On sales of about $4 billion, Futuram reported pretax profits of $2.8 billion, up from $1 billion in 2016. Profits from its Gordon stock option trades accounted for $1 billion of these profits. A further $.8 billion came from Futuram’s share of Gordon’s profits, and thus “”only”” about $1 billion from its core business. Notice how much more profit came from trades in financial derivatives than from its basic business.
Needless to say, these results garnered praise from many analysts. Some, however, criticized Futuram’s management, noting that this was a matter of luck, not skill. This group believes that Futuram risks much by not focusing on its core strengths and mission.
Futuram had been considered a company that emphasized cautious risk management. However, the enormous profits garnered from transactions in financial derivatives led some analysts to question their risk management approach. Should Futuram be involved in derivatives transactions on this scale? Was its approach to growing its stake in Gordon a wise decision?