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ERM CREDIT FINANCING OUTCOMES

Given the high capital demands of grain handling infrastructure renewal, UGG was also concerned about its ability to finance the rapid growth in crop inputs retailing – specifically the burgeoning demand from farmer customers for extended credit. Within UGG, a division called Crop Production Services managed the retail sales and logistics of these products, which included the extension of UGG retail credit to farm customers. As the levels of working capital and associated risk in the credit program increased, UGG sought to bring it under more rigorous control by placing credit at arm's length from the retail operation, and under the oversight of the corporate treasury.

A cultural shift gradually took place that ensured compliance with improved practices in credit extension, but growth continued to strain working capital. This was alleviated to some extent by renegotiating bank lines, and later by undertaking the first off-balance-sheet securitization of Canadian farm receivables, but then competition was driving retailers to use financing as a tool to promote sales – there was a competitive advantage in being able to provide credit terms that extended repayment until after harvest. Ideally, the solution was to retain some control over the credit product, and to have as much credit capacity as needed, at attractive terms, without putting a strain on the balance sheet.[1]

After lengthy exploration, this was finally accomplished by forming UGG Financial through a strategic alliance between UGG and Scotiabank. Essentially, UGG provided the customers, administration, and reporting while Scotiabank provided the capital. UGG shared an equal level of risk with the bank with a hard cap[2] on the maximum limit. UGG received significant fees from Scotiabank based on the performance of the portfolio. The results were dramatic, effectively freeing up to $200 million in capital, extending customer credit terms up to 12 full months, streamlining application processes and providing greater levels of customer service, and expanding product lines to livestock producers. It was also instrumental in enabling acquisitions of independent retailers' accounts and the merger of UGG with Agricore Cooperative to form AU in 2001. This arrangement forced competitors to engage in similar outsourcing credit arrangements, and it became the standard of the industry. When Saskatchewan Wheat Pool eventually acquired AU, the operation was extending $1.5 billion in credit to 20,000 customers and generating over $10 million in net profits annually.[3]

A third leg of UGG/AU's activities was its Livestock Services division. Accounting for between 10 percent and 15 percent of the company's business, its primary activity was the manufacture and sale of animal feedstuff, the largest segment being to hog farmers. Traditionally highly leveraged, hog farmers were vulnerable to cyclical fluctuations in hog prices. Learning from the statistical techniques employed in assessing UGG/AU's other risks during the ERM process, collaboration between corporate and divisional management identified an opportunity to use these methods to acquire a competitive advantage in supporting feed sales to hog producers.

By analyzing the hog price cycle, it became evident that there was an opportunity for UGG/AU to provide hog price risk management to customers who contracted to purchase their feed from the company. Provided that the customers met strict performance criteria (such as weight gain, morbidity, etc.), the company would agree to support shortfalls in realized prices from a preestablished minimum until prices recovered sufficiently to recover the subventions, thus protecting the producers' cash flow. Clearly there was always a risk that the historical pattern of the hog price cycle could prove an insufficient predictor of the severity or length of future price downturns; however, using statistical modeling techniques, it was possible to stress test the company's exposure to credit risk to ensure that the capital at risk did not exceed preestablished levels based on UGG/AU's required return targets (on the associated feed sales). In this way, the company was able to promote its feed sales to high-performing producers with the quantitative intelligence to provide a high degree of assurance that it would achieve its return targets without excessive risk, secure in the knowledge that if competitors provided more attractive terms under any similar program they risked eroding their financial (and, therefore, long-term competitive) positions.[4]

Apart from the obvious risk mitigation provided by the integrated riskfinancing program, it could be argued that the broader ERM project further increased UGG's ability to take on more risk; as it gained a more precise quantification of the risks it faced, not only as individual risks but in aggregate, this improved understanding of its overall risk profile reduced the need for "precautionary capital."[5]

While by no means all of the risks that UGG/AU confronted could be quantified (and could only be managed procedurally or avoided altogether), the quantification of its major risks substantially enhanced the company's ability to model its anticipated financial performance. While weather could have a dramatic impact on the volume of grain produced, it could also have a significant influence on the volume, timing, and variety of seed, fertilizer, herbicide, and pesticide sales by the Crop Production Services division (e.g., an unusually wet spring that delayed planting could shift sales from one quarter to another, change farmers' planting intentions, and alter their fertilizer, herbicide, and pesticide requirements for the entire crop year).

Such variability could substantially affect UGG/AU's quarterly and annual earnings, even if the impact was not as dramatic as a full-blown drought. UGG had developed a comprehensive financial model of its expected earnings, debt levels, and cash flow. Prior to developing the intelligence derived from the quantification of its major risks during the ERM process, the model had, however, been one that produced average (or normal weather condition) projections – good for long-term planning but of limited use in the short term, as it did not anticipate the consequences of seasonal and year-to-year variability. Given the quantitatively enhanced understanding of the potential range of earnings and cash flow derived from ERM, the company was able to model the complete range of its possible financial outcomes. While this did not significantly enhance its understanding of its expected long-term average results, it did provide a powerful analytical tool: It identified its requirements for contingent capital with more precision; it provided a much better tool for judging its performance against its plans in a set of potentially variable conditions – an infinitely flexible budget; and it improved its capacity to respond appropriately to changing conditions that had, or might have, adverse financial implications.

ERM was also able to bring a more consistent and disciplined treatment of risk exposures across the organization. UGG became better positioned to allocate appropriate resources to ensure that the risks within the different divisions and activities of the company were not over- or undermanaged relative to the corporation's level of risk tolerance.[6]

  • [1] Interviews with Peter Cox and George Prosk.
  • [2] A "hard cap" means that there is a fixed upper limit on the amount of risk that UGG would absorb.
  • [3] Interviews with George Prosk and Peter Cox.
  • [4] Interview with Peter Cox.
  • [5] Interviews with Peter Cox, Brian Hayward, and Michael McAndless.
  • [6] Interviews with Peter Cox, Michael McAndless, and George Prosk.
 
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