|Derivative Instruments and Hedging Activity
The Company uses derivative contracts to hedge portions of its foreign currency exposures and uses derivatives to hedge a portion of its precious metal and copper exposures. The objectives and strategies for using derivatives in these areas are as follows:
Foreign Currency. The Company sells a portion of its products to overseas customers in their local currencies, primarily the euro and yen. The Company secures foreign currency derivatives, mainly forward contracts and options, to hedge these anticipated sales transactions. The purpose of the hedge program is to protect against the reduction in the dollar value of foreign currency sales from adverse exchange rate movements. Should the dollar strengthen significantly, the decrease in the translated value of the foreign currency sales should be partially offset by gains on the hedge contracts. Depending upon the methods used, the hedge contracts may limit the benefits from a weakening U.S. dollar.
The use of forward contracts locks in a firm rate and eliminates any downside from an adverse rate movement as well as any benefit from a favorable rate movement. The Company may from time to time choose to hedge with options or a tandem of options, known as a collar. These hedging techniques can limit or eliminate the downside risk but can allow for some or all of the benefit from a favorable rate movement to be realized. Unlike a forward contract, a premium is paid for an option; collars, which are a combination of a put and call option, may have a net premium but
can be structured to be cash neutral. The Company will primarily hedge with forward contracts due to the relationship between the cash outlay and the level of risk.
The use of foreign currency derivative contracts is governed by policies approved by the Audit Committee of the Board of Directors. A team consisting of senior financial managers reviews the estimated exposure levels, as defined by budgets, forecasts, and other internal data, and determines the timing, amounts, and instruments to use to hedge exposures. Management analyzes the effective hedged rates and the actual and projected gains and losses on the hedging transactions against the program objectives, targeted rates, and levels of risk assumed. Foreign currency contracts are typically layered in at different times for a specified exposure period in order to minimize the impact of market rate movements.
Precious Metals. The Company maintains the majority of its precious metal production requirements on consignment in order to reduce its working capital investment and the exposure to metal price movements. When a precious metal product is fabricated and ready for shipment to the customer, the metal is purchased out of consignment at the current market price. The price paid by the Company forms the basis for the price charged to the customer. This methodology allows for changes in either direction in the market prices of the precious metals used by the Company to be passed through to the customer and reduces the impact changes in prices could have on the Company's margins and operating profit. The consigned metal is owned by financial institutions that charge the Company a financing fee based upon the current value of the metal on hand.
In certain instances, a customer may want to establish the price for the precious metal at the time the sales order is placed rather than at the time of shipment. Setting the sales price at a different date than when the material would be purchased potentially creates an exposure to movements in the market price of the metal. Therefore, in these limited situations, the Company may elect to enter into a forward contract to purchase precious metal. The forward contract allows the Company to purchase metal at a fixed price on a specific future date. The price in the forward contract serves as the basis for the price to be charged to the customer. By doing so, the selling price and purchase price are matched, and the Company's price exposure is reduced.
The Company refines precious metal-containing materials for its customers and typically will purchase the refined metal from the customer at current market prices. In limited circumstances, the customer may want to fix the price to be paid at the time of the order as opposed to when the material is refined. The customer may also want to fix the price for a set period of time. The Company may then elect to enter into a hedge contract, either a forward contract or a swap, to fix the price for the estimated quantity of metal to be purchased, thereby reducing the exposure to adverse movements in the price of the metal. The Company may also enter into hedges to mitigate the risk relating to the prices of the metals which we process or refine.
In certain circumstances, the Company also refines metal from the customer and may retain a portion of the refined metal as payment. The Company may elect to enter into a forward contract to sell precious metal to reduce the Company's price exposure.
The Company may from time to time elect to purchase precious metal and hold in inventory rather than on consignment due to potential credit line limitations or other factors. These purchases are typically held for a short duration. A forward contract will be secured at the time of the purchase to fix the price to be used when the metal is transferred back to the consignment line, thereby limiting any price exposure during the time when the metal was owned.
Copper. The Company also uses copper in its production processes. When possible, fluctuations in the purchase price of copper are passed on to customers in the form of price adders or reductions. While over time the Company's price exposure to copper is generally in balance, there can be a lag between the change in the Company's cost and the pass-through to its customers, resulting in higher or lower margins in a given period. To mitigate this impact, the Company hedges a portion of this pricing risk.
The Company will only enter into a derivative contract if there is an underlying identified exposure. Contracts are typically held to maturity. The Company does not engage in derivative trading activities and does not use derivatives for speculative purposes. The Company only uses hedge contracts that are denominated in the same currency or metal as the underlying exposure.
All derivatives are recorded on the balance sheet at fair value. If the derivative is designated and effective as a cash flow hedge, changes in the fair value of the derivative are recognized in other comprehensive income (OCI) until the hedged item is recognized in earnings. The ineffective portion of a derivative's fair value, if any, is recognized in earnings immediately. If a derivative is not a hedge, changes in the fair value are adjusted through income. The fair values of the outstanding derivatives are recorded on the balance sheet as assets (if the derivatives are in a gain position) or liabilities (if the derivatives are in a loss position). The fair values will also be classified as short-term or long-term depending upon their maturity dates.
The following table summarizes the notional amount and the fair value of the Company’s outstanding derivatives not designated as hedging instruments (on a gross basis) and balance sheet classification as of April 2, 2021 and December 31, 2020:
| ||April 2, 2021||December 31, 2020|
|Foreign currency forward contracts|
|Prepaid expenses||$||4,261 ||$||45 ||$||62,012 ||$||107 |
|Other liabilities and accrued items||63,062 ||509 ||7,695 ||55 |
These outstanding foreign currency derivatives were related to balance sheet hedges and intercompany loans. Other-net included $1.6 million and $0.6 million of foreign currency gains related to derivatives in the first quarter of 2021 and 2020, respectively.
The following table summarizes the notional amount and the fair value of the Company’s outstanding derivatives designated as cash flow hedges (on a gross basis) and balance sheet classification as of April 2, 2021 and December 31, 2020:
| ||April 2, 2021||December 31, 2020|
|Foreign currency forward contracts - yen||$||2,887 ||$||108 ||$||— ||$||— |
|Foreign currency forward contracts - euro||12,818 ||129 ||— ||— |
|Precious metal swaps||4,568 ||418 ||2,155 ||127 |
|Copper swaps||6,533 ||550 ||6,225 ||632 |
|Total||26,806 ||1,205 ||8,380 ||759 |
|Foreign currency forward contracts - yen||111 ||2 ||— ||— |
|Foreign currency forward contracts - euro||1,202 ||15 ||— ||— |
|Total||1,313 ||17 ||— ||— |
|Other liabilities and accrued items|
|Foreign currency forward contracts - yen||— ||— ||2,668 ||59 |
|Foreign currency forward contracts - euro||2,179 ||176 ||17,611 ||1,089 |
|Precious metal swaps||515 ||3 ||4,964 ||349 |
|Copper swaps||4,254 ||188 ||2,445 ||27 |
|Total||6,948 ||367 ||27,688 ||1,524 |
|Total||$||35,067 ||$||855 ||$||36,068 ||$||765 |
All of these contracts were designated and effective as cash flow hedges. The Company expects to relieve substantially the entire balance in OCI as of April 2, 2021 to the Consolidated Statements of Income within the next 15-month period. Refer to Note L for additional OCI details.
The following table summarizes the amounts reclassified from accumulated other comprehensive income relating to the hedging relationship of the Company’s outstanding derivatives designated as cash flow hedges and income statement classification as of the first quarter of 2021 and 2020:
| ||First Quarter Ended|
|(Thousands)||April 2, 2021||March 27, 2020|
|Hedging relationship||Line item|
|Foreign currency forward contracts||Net sales||$||140 ||$||(1)|
|Precious metal swaps||Cost of sales||(104)||318 |
|Copper swaps||Cost of sales||(1,534)||321 |