Challenges brewing

European listed companies now have to report under the revised international financial reporting standards. But for UK brewery Scottish & Newcastle, the introduction of IAS 39 is causing some headaches. By Patrick Fletcher

Scottish & Newcastle (S&N) may not be a household name, but its premium brands – Fosters, Kronenbourg, Becks and Baltika – might be more familiar to the world’s beer drinkers. The UK-based brewer exports to more than 60 countries, and operates or invests in 50 breweries worldwide, including United Brewers in India, Mythos in Greece and the Chonqing Beer Group in China.

Protecting these overseas assets is the focus of the company’s risk management strategy, says Alan Dick, group treasurer at S&N. “Most of our risk management is translation hedging as opposed to transaction hedging. We have large positions in foreign currency assets, but we don’t have a huge currency flow,” he says. The company has around €4.3 billion of assets, which it actively manages.

To manage this position and keep the volatility of balance-sheet items down, the firm uses a combination of debt borrowings and cross-currency interest rate swaps. The company issues debt in various currencies, including sterling, euro, dollar and yen, and uses cross-currency interest rate swaps to maintain a fixed-rate debt position of between 30% and 70% of its total debt. In 2003, this figure was 37%.

Using fixed-rate swaps on its entire position would be too expensive and too inflexible, but could also increase volatility due to the unpredictability of the firm’s cashflows, says Dick. Although the company is reasonably risk-averse, it wants the flexibility to be able to take advantage of positive market conditions when they arise. “This policy gives us reasonable flexibility [across currency groups] and also gives us some certainty of costs,” he says.

With the introduction of international financial reporting standards – in particular, IAS 39 – in January this year, however, the firm’s interest rate hedging policy will come under increasing scrutiny. “We always swap back to floating-rate euros, no matter what we do, and then we’ll do our fixed hedges as an overlay on top of that,” says Dick. This decision is based on the interplay between the company’s fixed-rate profile and its debt maturities. For instance, it has a lot of debt maturing in 2014, but may not want to swap to fixed-rate for the whole of the bond’s tenor.

The problem with this strategy is that, under current IAS 39 rules, the overlay swap is technically a hedge-on-a-hedge. This means that the company cannot get hedge accounting treatment for most of its interest rate swaps portfolio. Mark-to-market movements on the swap book will go to the profit and loss (P&L) account, potentially resulting in greater earnings volatility, says Dick.

Last year, this volatility translated into about £4 million–5 million in P&L terms. That’s not a huge number, says Dick. “But you just don’t know where rates are going to go. So it’s the potential for an adverse situation, which is the problem,” he adds.

This is not a problem unique to S&N – a number of other corporates face the same challenges, says Dick. “Essentially, it is those companies that have either significant overseas operations relevant to their UK businesses and have lower net debt positions than the value of their overseas assets; or they have issued debt in currencies other than the one they have to get back into,” says Dick. The companies plan to send a joint letter to the Association of Corporate Treasurers, the UK treasurer’s trade body, which is collecting complaints about IAS 39 to take up with the International Accounting Standards Board.

However, Dick is adamant that he will not let IAS 39 change the way the company manages its risk. He still wants to be able to raise debt in whichever markets are the most efficient. “If there’s a marked advantage of issuing debt in one particular currency then it seems crazy not to do that. Our view is that the economics should win and not the accounting,” he says.

The investment banking community has struck out with solutions to this problem, says Dick, adding that some institutions have analysed the company’s swap portfolio, yet none has come up with an answer.