CRISIL: Hedging strategies shield gold retailers from price volatility

In a study on 63 of its rated gold retailers, CRISIL concluded that prudent inventory hedging will help gold retailers rated by it to maintain stable credit risk profiles. According to the rating agency, the hedging strategies help retailers insulate their margins from volatility in gold prices, and help reduce the impact of increased working capital requirements on the financial risk profile, especially during the expansion phase.

According to Crisil, as the gold retailers are expanding into small cities, they require sizeable investments in gold jewellery, and debt-funding would weaken their financial risk profiles. Also, the prevailing high prices of gold will inflate their working capital investments and raise their average costs of inventory.

Gold prices have risen sharply by around 20 per cent per annum during the five years through March 2011. Says Gurpreet Chhatwal, Director, CRISIL Ratings, “The rise was especially steep in the 12 months through September 2011, at around 40 per cent. Any sharp fall by, say, 15 to 20 per cent in gold prices can impact retailers’ profitability.” The impact will be more pronounced for retailers with sizeable (in comparison to their current scale of operations) expansions, and large inventory acquired at high prices. “However,” adds Chhatwal, “most CRISIL-rated retailers are well placed to protect their margins. They follow either the inventory replenishment model, or gold-on-loan scheme, or a mix of both, to insulate their inventory against volatility in gold prices.” Traditionally, players have followed the replenishment model in inventory stocking—where the quantity of gold sold on a given day is replenished the same day—to mitigate price risk on their gold exposure, to a large extent. In the gold-on-loan scheme, players have flexibility for up to 180 days to fix prices—the scheme comes in handy for players in expansion mode, who are acquiring inventory for the new showrooms.

R Vasudevan, Head, CRISIL Ratings, added that “Increased borrowings to fund inventory for the new showrooms may dent the retailers’ capital structure. However, judicious inventory hedging, supported by benefits from economies of scale following such expansions will underpin the retailers’ credit quality, over the medium term.”