3M is one of Americaâ€™s oldest and most venerable diversified industrial corporations. The company is known for its strong consumer brands, such as Scotch, Scotchgard, Post-it, Scotch-Brite, and ACE Bandages, but in truth its consumer business only constitutes a small part of its activities. The company also has many product offerings with applications in industrial areas such as automotive, health care, electronics, and energy, as well as safety and graphics. 3M has a well-earned reputation for being an innovation machine, plowing 6 percent of its annual revenues back into R&D. A long history of innovation has given 3M a portfolio of 55,000 products, many of which command high margins. Some 30 percent of its sales come from products introduced in the last five years. In addition to being an innovation machine, 3M is also one of the most international of all U.S. companies. The company generates around 60 percent of its $32 billion in annual revenues from sales outside of the United States. This large global business has sales in 200 countries and operations in 70. The company has 200 plants around the world; manufactures many of its own inputs in addition to final products; and has built up networks of regional supply chains to better manage inventory, improve customer responsiveness, achieve economies of scale, and realize the productivity gains that come from manufacturing products in the optimal location. Dealing with this vast array of international sales, as well as intra-company transactions, creates a problem for 3M. Specifically, changes in the value of currencies against each other can significantly affect its earnings and revenues when translated back into U.S. dollars, affect the value of intracompany transactions, and alter the attractiveness of different nations as possible locations for manufacturing activities. 3M estimates that adverse movements in currencies decreased the companyâ€™s pretax profits by $42 million in 2018 and $111 million in 2017. (As an American company, 3M reports its financial results in U.S. dollars.) These estimates include the effect of translating profits from local currencies back into U.S. dollars, the impact of currency fluctuations on the transfer of products between 3M operations located in different nations, and transaction gains and losses including those on derivative instruments designed to reduce foreign currency exchange rate risk. For example, in 2018, an increase in the value of the U.S. dollar against the currencies of many other countries reduced 3Mâ€™s foreign sales (when they were translated back into U.S. dollars) by some 2.3 percent. Of course, the opposite can also occur. Foreign currency risk arises because the value of currencies will fluctuate against each other over time, and it is not easy to forecast how they will move against each other. In 2018, for example, the U.S. dollar increased in value by 5.2 percent against a trade-weighted basket of other currencies, which included the euro, yen, British pound, Swiss franc, and Australian dollar. The implication is that foreign sales, when translated back into U.S. dollars, will have fallen, on average, by 5.2 percent over the year. Page 335 Like many companies, 3M tries to reduce its exposure to such adverse effects by hedging its foreign exchange risk. The company enters into what are known as foreign exchange forward contracts, in advance of a foreign transaction, to â€œlock inâ€ the exchange rate. The company may lock in exchange rates as much as 36 months in advance. For example, if 3M is exporting a product to the euro zone with payment in euros expected in three months, and it thinks that the U.S. dollar might appreciate against the euro over the next three months but itâ€™s not sure about this, 3M might purchase a three-month forward contract that locks in a certain dollarâ€“euro exchange rate. By doing this, 3M knows what revenue it will get from the sale at that time in terms of dollars, and dollar sales are not reduced by a rise in the value of the dollar against the euro over the next three months. Of course, such forward contracts are not free, nor are they perfect. In the face of uncertainty, the company may bet incorrectly and lose out. If the dollar falls against the euro over the next three months, instead of rising as 3M expected, 3M would have been better off not hedging because the unhedged dollar value of its euro sales would have increased. As circumstances warrant, 3M also uses foreign currency forward contracts and foreign currency debt as hedging instruments to protect the value of portions of the companyâ€™s net investments in foreign operations. For example, in 2018, its European operations were partly financed by â‚¬4.1 billion in euro-denominated debt. If that debt were denominated in U.S. dollars, but had to be serviced by 3Mâ€™s European operations, then the cost of servicing that debt in euros for the European subsidiaries would go up if the euro declined in value against the dollar, thereby reducing 3Mâ€™s euro-zone profits when denominated in U.S. dollars. It is by actions such as these that 3M reduces its exposure to the unpredictable movements in currency exchange rates over time.
Should 3M hedge against adverse movements on foreign exchange rates? How should it do this?