Ifm Case 46i31

XIAN JANSSEN PHARMACETICAL CHINA AND THE EURO Presented Basavraj Ravi Shankar prabhu

Xian-Janssen Pharmaceutical (China) and the Euro

• FACTS:• Paul Young was the financial controller of Xian-Janssen Pharmaceutical Ltd. (XJP), the Chinese subsidiary of the U.S.based multinational, Johnson & Johnson. • Paul was preparing for a meeting with his CEO, Christian Velmer, which would focus on the business plan for the coming 2004 fiscal year. • XJP was expected by leadership (corporate) to generate 1.2 billion renminbi in earnings in 2004, a 20% increase over a highly successful 2003 year This would be a challenge given that XJP was suffering from a number of rising expenses and foreign exchange losses

• XJP of China a t venture, produces and marketed prescription and over-the-counter (OTC) medications to mostly hospitals in China (which made up roughly 80% of sales) • Most sales in the Chinese market were through tender sales, reverse auction markets in which companies produced bids for sales to individual hospitals and were awarded sales on the lowest cost bids (also termed a Dutch Auction in some places in the world) • XJP had closed 2003 with a 98% success rate on tenders • XJP purchased nearly 95% of all its product from Europe • Most product purchases from Europe were from J&J Europe, and therefore the prices were transfer prices – prices set internally within the company

• Paul Young believed that most of the transfer prices XJP was paying were relatively high, increasing the profitability of the European business but increasing his costs in China (and therefore decreasing his profitability) • All European purchases were priced and invoiced in euros, and the euro had been rising significantly in value against the Rmb (since the Rmb was fixed to the dollar, and the dollar had been falling against the euro, the falling Rmb was a certainty) • All XJP payments for product from Europe were made to the European Treasury Center • J&J’s corporate policy required that XJP hedge 80% of all anticipated exposures • Hedging could not exceed 100% of anticipated exposures (this restricted management from taking speculative positions on currency movements) Hedging alternatives were limited; the company attempted to net all payments possible, and then used forward contracts on the identified exposures

1 . How significant an impact do foreign exchange gains and losses have on corporate performance at XJP? What is your opinion of how they structure and manage their currency exposures?

• The income statement for the business unit shows foreign exchange losses of Rmb 60 million in 2003 and another Rmb 75 million forecast for 2004, about 5.7% and 6.9%, respectively. • Although many people may first see these as relatively small losses, a reduction in the operating earnings of an individual business unit from foreign exchange changes alone like this would be considered significant. • One way to note this is to consider that the average return on sales (ROS) for the Fortune 500 in the second quarter of 2005 was about 7.7%. If these bottom line profits were chopped an additional 6%-7% on a consolidated basis, a lot of companies – and shareholders – would be considerably upset.

• The pure use of foreign exchange forwards is most likely the result of a series of factors: • 1) limited availability of other foreign exchange derivatives or risk management alternatives; • 2) corporate policy on the part of J&J; • 3) regulatory restrictions in China on the use of derivative and currency products; and • 4) the unwillingness of the parent company to either carry the risk itself or allow more breadth in management (including remaining uncovered as the euro seemingly peaks) of the foreign exchange exposures of its Chinese unit.

2 .J& J has roughly 200 foreign subsidiaries worldwide. It has always pursued a highly decentralized organizational structure, in which the individual units are responsible for their own performance from the top to the bottom line of the income statement. How is this reflected in the situation XJP finds itself?

• Because J&J gives no capital aid to any of its subsidiaries because of their preferred decentralized management style the individual subsidiaries are responsible for their own financial decisions. • Xian-Janssen Pharmaceutical has found themselves in a tight situation requiring a large amount of hedging and a closing margin of profit on their products from insurance agencies reimbursing generic drugs as opposed to the ones offered by XJP. • The CEO of XJP ed an expected future company earnings to its financial officers in the amount of a 20% increase or increase from 1.006 Rmb to 1.205 Rmb. Due to the fact that XJP operates independently from its parent company they are solely responsible for providing hedging methods to offset future uncertainty of exchange rates.

3. What is the relationship between actual spot exchange rate, the budgeted spot exchange rate, the forward rate, and the expectations for the Chinese subsidiary’s financial results by the U.S. parent company?

• At the end of 2003, the dollar closed at Rmb10.75/Euro making this the actual spot rate. The predicted spot rate, however, for 2003 was significantly lower at an average of Rmb8.60/Euro. • Meeting the parent company's expectations was nearly impossible and therefore the Chinese subsidiary suffered a large loss, which was only recovered by their gains on a housing fund adjustment and an inventory valuation reversal. • The budgeted spot rate for year 2004 was also inaccurate - the actual rate being near Rmb10.75/Euro and the budgeted somewhere between Rmb9.8-10.0/Euro. • The forward rate for 2004 was also on the rise, leaving Young little hope for reaching parent company's goals.

• Xian-Janssen Pharmaceutical Ltd. (XJP) purchased pharmaceutical products from the J&J Europe manufacturer in Belgium for euro 2,500,000. • The purchase was made in June with payment due six months later in December. • Because this is a sizable contract for the firm and because the contract is in euros rather than dollars, XJP is considering several hedging alternatives to reduce the exchange rate risk arising from the sale.

• To help the firm make a hedging decision you have gathered the following information. • ∙ The spot exchange rate is $1.40/euro ∙ XJP's forecast for 6-month spot rates is $1.43/euro . The six month forward rate is $1.38/euro ∙ XJP’s cost of capital is 11% ∙ The Euro zone 6-month borrowing rate is 9% (or 4.5% for 6 months) ∙ The Euro zone 6-month lending rate is 8% (or 4% for 6 months) ∙ The U.S. 6-month borrowing rate is 7% (or 3.5% for 6 months) ∙ The U.S. 6-month lending rate is 6% (or 3% for 6 months) ∙ December call options for euro 625,000 per contract; strike price $1.42, price is $0.02 per euro. ∙ The budget rate, or the highest acceptable purchase price for this project, is $3,625,000 or $1.45/euro

4. If you were Paul Young, what would you do? • This is a very interesting situation. If Paul Young actually has the ability to not hedge his European cost of goods sold, many students will argue that it is worth “the risk” of going unhedged. • One might argue, however, that there should be greater risk associated with running a business unit without hedging its primary cost of goods old as opposed to the declining margins on properly hedged purchases. • In the case of going hedged and suffering the higher costs, the primary downside is the wrath of not meeting the parent company’s expected sales or profits for the year. • The downside of going unhedged, and then suffering some significant adverse exchange rate changes, could very well be much much worse. •

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